JaiShankar's Notes Financal Market-1&2

8/6/2019 JaiShankar's Notes Financal Market-1&2

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FINANCIAL MARKETSDay 1 & 2

W E S P E C I A L I S E I N E X C E L L E N C E


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Financial Markets A Program for DSL Software

TABLE OF CONTENTS

Financial Markets Generic Framework .............................................. 3

Primary Market & Secondary Market ........................................................... 3

Types of Offering .................................................................................. 3

Trading Order Placement ....................................................................... 4

Conventions ........................................................................................ 5

Clearing & Settlement ............................................................................ 6

Activities ............................................................................................ 6

Financial Market Systems ......................................................................... 6

Stock Markets .............................................................................. 8

Key Market Indices ................................................................................ 8

Clearing & Settlement ............................................................................ 9

Custodial services ................................................................................ 10

Stock Pricing ...................................................................................... 11Valuation of Stock ................................................................................ 11

The Bond Market ......................................................................... 13

Participants : ...................................................................................... 13

Interest rate concepts ........................................................................... 13

Bond Pricing ....................................................................................... 15

Valuation Investments ......................................................................... 17

Instruments ........................................................................................ 17

Asset Backed Securities ( ABS ) ................................................................ 19

The Foreign Exchange Market ......................................................... 22

Types of Exchange rates ........................................................................ 23

Trading Position .................................................................................. 23

Currency Forward Markets ...................................................................... 25

Participants ....................................................................................... 27

Activities ........................................................................................... 27

Financial Derivatives Building Blocks .............................................. 28

Interest Rates Arithmetic ....................................................................... 29

References ................................................................................ 31

Catalyst Consulting Page 2

THIS HANDOUT IS STRICTLY FOR THE INTERNAL USE OF DSL SOFTWARE EMPLOYEES ONLY


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The Order room then wires the order to the Commission House Broker (CHB),

an employee of the broker/dealer who trades on the floor of the exchange for that

broker/dealer.

There are 1500 trading booths and 17 trading posts in NYSE

The CHB makes his way over to the respective Trading Post.

At the post, the CHB encounters other folks who want to trade IBM stock.

The deal is executed.

Transaction Report is sent to the originating brokerage firms (buying and

selling). This is followed by the Clearing and Settlement cycle at which time

transfer of ownership (shares for dollars or vice versa) is completed.

Brokerage Firm: credits or debits the customer's account for the number of

shares bought or sold.

Investor: Receives a trade confirmation from his/her firm. If shares were

purchased, the investor submits payment. If shares were sold, the investor's

account is credited with the proceeds.

Global Markets Automated Method

In the automated method the process is the same, except for the fact that the broker will

place the order in an order system and the system will do the process of matching the trade

i.e if there is a buy order for 100 shares of IBM , the system will look for a sale order for IBM,

depending on the nature of order placed.

The various types of orders that can be placed are given below.

Trading Order Placement

ORDER TYPES(Based on price)

Market order Market orders are executed at once, at the market. A market order

guarantees execution, but does not guarantee a price. The final price is determined by

supply and demand.

Limit order - A Limit order is executed at a set price or better and will not be

executed if that price is not met.

Stop order - If the market price hits or passes through the stop price (Trigger), a

market order is Elected. A potential problem with a stop order is that it triggers a

market order, which does not guarantee a purchase or sale price. A stop order must be

triggered (activated or elected) before execution as a market order.

ORDER TYPES(Based on time)

Day order - The order is valid till end of day and if it is unfilled at days end, it gets

cancelled.

Open order or Good Till Cancelled(GTC) - The order can remain open for up to six

months. It is the responsibility of the registered representative to cancel at the




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customers direction. In addition, at the end of April and the end of October, all GTC

orders must be reconfirmed or eliminated.

ORDER TYPES(Based on Volume)

Fill or Kill(FOK) - The order must be immediately filled in one trade or cancelledcompletely.

All or None(AON) - The entire order must be filled or cancelled completely, but unlike

FOK, AON can remain good till cancelled.

Secondary Markets OTC Market

Unlike listed securities that trade on an exchange, unlisted securities trade Over the Counter

(OTC). Most securities actually trade OTC, since U.S. government, Municipal and most

corporate securities trade OTC. OTC price information is either published periodically in paper

form, disseminated over telephone lines, or displayed real-time electronically through

NASDAQ, ATS, ECN.

Conventions

Bid/Offer

Bid:the rate at which the quoting party is willing to buy the security

Offer: the rate at which the the quoting party is willing to sell the security

The Golden Rule - Buy low at bid, sell high at offer.

First bid rate, then offer rate.

e.g. : MSFT = USD 10.25/10.30.

Sometimes to save time, market uses abbreviations (only last two digits are quoted). e.g.,

25/30 in the above example or they may say

Offered at 30 , Bid at 25

Quantities are also mentioned, if not, the counterparty is liable for any amount

Trading Position

When you buy / sell a security, you are said to hold a Position. Position denotes your size ofholding in that security.

When you buy you are said to be going long or overbought

When you sell you are said to be going short or oversold

If you have no position you are said to be square




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Clearing & Settlement

Clearing is the process of determination of obligations. It can be either gross

(transaction by transaction) or net .

Settlement is the actual fulfillment of obligations (e.g., transfer of funds one way and

securities the other)

Role of a Clearing House

It reduces counter party risk. It regulates and controls market and guarantees

settlement Margins.

Settlement Conventions vary across Markets and across countries.

e.g. Settlement convention in Indian Stock markets is T+2.

e.g. Settlement convention in U.S Treasuries is T+1.

e.g. Settlement convention in Currency markets can be T,T+1,T+2 or even >T+2

depending on the nature of the trade.

e.g. Settlement convention in U.S T-Bill Futures

The third business day following the Federal T-bill auction of the third week of

the delivery month

Activities

The activities in a financial market can be classified into

Front Office activity This is where the pre-trade analysis , the actual execution of the trade

on the trading system and the deal capture for accounting and settlement takes place.Middle Office This is where the risk management and the regulatory reporting of the trade

takes place.

Back Office This is where the actual processing and settlement of the trade takes place.

Financial Market Systems

The demands of the capital market transactions, the need for tracking and managing risks, the

pressure to reduce total transaction costs and the obligation to meet compliance requirements

make it imperative that the functions be automated using advanced computer systems. Some

of the major types of systems in capital market firms are briefly described below.

Information dissemination systems

These are information providers that enable you to take trading and investment decisions.

There are a lot of international agencies in this space, namely Reuters, Telerate, Bloomberg

etc.

Analytics and Simulation systems




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These are sophisticated systems that enable you do some pre trade analysis. This could be in

the form of impact on your profit or loss on doing the deal, effect of change in market events

etc.

Trading Systems

The volume of transactions in capital markets demands advanced systems to ensure speed and

reliability. Due to proliferation of Internet technology, trading systems are also now accessible

online allowing even more participants from any part of the world to transact, helping to

increase efficiency and liquidity. The trading systems can be divided into front-end order entry

and back-end order processing systems.

Order entry systems also offer functions such as order tracking, calculation of profit and loss

based on real-time price movements and various tools to calculate and display risk to the value

of investments due to price movement and other factors.

Back-office systems validate orders, route them to the exchange(s), receive messages and

notifications from the exchanges, interface with external agencies such as clearing firm,generate management, investor and compliance reports, keep track of member account

balances etc.

Deal capture and Processing systems

These are systems that include all processes, post the execution of the deal. This includes

recording the deal, accounting for it, and valuing the deal each day to determine how much

money you have made or lost on it.

Control and Risk Monitoring systems

These are systems that monitor the trades once they are entered. These include checking

whether the trade is permitted, within the limits prescribed by the organisation etc. Good

systems throw up alerts in case any limits are exceeded. Automation can be to the extent ofsending out emails to the respective managers on any limit excesses.

Portfolio management and Custodial systems

Accounting systems and Reporting tools

RTGS systems

Nostro reconciliation systems




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Stock Markets

Stock markets are the most commonly known among all financial markets because of the large

participation of retail investors, i.e. common people who invest from their own savings.

Instruments traded are

Equity / Common stock

Represents ownership

unique CUSIP number

exchange listed or OTC

broker or ATS /ECN

Dividends / Capital gains

Voting rights

Perpetual

Entail Credit and Market risk

Preferred stock

Represents ownership

unique CUSIP number

Guaranteed Dividends in case of profit

No Voting rights

Perpetual/Redeemable

Entail mainly Credit Risk

priority over common stock in case of liquidation

Key Market Indices

Market Index

US Diversified market Dow Jones Industrial Average(Dow)

US Technology NASDAQ 100

UK (London) Financial Times Stock Exchange Index (FTSE)

Germany (Frankfurt) DAX

France (Paris) CAC

Switzerland (Zurich) SMIJapan (Tokyo) Nikkei

Hong Kong Hang Seng

Singapore Strait Times Index(STI)

India(Mumbai) Sensex/Nifty




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Market Participants

Member firms or Broker-Dealers

One needs membership of a stock exchange to access the exchange trading system. These

members are called by various names such as brokers, dealers, market makers, specialists etc.

based on the type of membership or services offered. Investors who are not members of theexchanges have to open trading accounts with a member firm. Member firms accept and route

orders on the account, send notifications and take care of settlement of the trade in exchange

for a fee.

Clearing firms

The depository, on receipt of delivery instructions, releases the shares to a firm offering

Clearing and Settlement services, that also receives the money from the buyer and after

verifying the trade details, delivers shares to the demat account of the buyer and money to the

seller (via corresponding broker or member firm). Clearing firm is an organization that works

with the exchanges to handle confirmation, delivery and settlement of transactions.

Depository

Brokers do not hold the shares or money that need to be exchanged when the order is

executed. Most of the securities (shares) are held in electronic (also called dematerialized)

form (i.e. as a record similar to bank balance) in the demat (short for dematerialized)

accounts at firms providing depository services. When a trade is executed, the seller must

release the shares held in the demat account by giving delivery instructions to the

depository.

Clearing & Settlement

Trade Matching

The exchange/clearing house at the end of the day will match all purchases and sale

trade slips and report any reconciliation errors.

Confirmation has to be sent to the brokerage firms (both purchase and sales) who will

then inform their respective clients.

Netting

Settlement takes place through the process of Netting.

Netting Example

Time Buy/Sell Quantity Stock Price

10.00 Buy 100 IBM $10.00

10.30 Sell 50 IBM $10.50

11.00 Buy 100 MSFT $20.00

11.30 Sell 20 IBM $11.00




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12.00 Sell 10 MSFT $20.50

3.30 Sell 30 IBM $9.50

Net position for IBM: +100 50-20-30 = 0.

Net position for MSFT: +100 10 = 90.

How much does the broker owe the exchange?

Net Cash Position

Buy/Sell Quantity Price Amount

Buy 100 $10.00 ($1,000.00)

Sell 50 $10.50 $525.00

Buy 100 $20.00 ($2,000.00)

Sell 20 $11.00 $220.00

Sell 10 $20.50 $205.00

Sell 30 $9.00 $270.00

Total ($1,780.00)

Custodial services

Custody is the safekeeping and administration of securities and cash on behalf of others.

Administrative activities

Trade Processing

Income Collection

Corporate Actions

Cash Management

Trade processing

Monitoring the sale and purchase of securities via brokers

Receiving and delivering securities/funds ( settlement)

Processing foreign exchange to make/receive payment

Reporting to customers of movements in accounts

Safekeeping of shares

Income collection

Collection of dividends and interest

Corporate actions Responding to offers / rights

Processing nominee functions

Reporting

Pricing of positions

Periodic account statements




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Establish master files that produce accurate and updated management and

customer reports

Stock Pricing

The share price is, as noted before, determined by the market forces, i.e. the demand and

supply of shares at each price. The demand and supply vary primarily as the perceived value of

the stock for different investors varies. An investor will consider buying the stock if the market

price is less than his perceived value of the stock, and will consider selling if it is higher. A

large number of factors have a bearing on the perceived value.

Some of them are:

Performance of the company

Performance of the industry to which it belongs

State of the countrys economy where it operates as well as the global economy

Market sentiment or mood relating to the stock and the market as a whole

Apart from these, many other factors, including performance of other financial markets, affect

the demand and supply.

Some specific measures used in the equity markets to value a stock are

EPS and P/E Ratio

Most popular tools for determining valuation.

For example, if the aluminium industry has a P/E ratio of 10 times, and if

Company Z has an EPS of Rs. 12, then the value of Company Z stock should beEPS X P/E Ratio, namely Rs. 120 per share.

Historical P/E

When the market price is compared with past earnings

Projected P/E

When the market price is compared with projected earnings

A high P/E ratio means

The market views the stock favourably, or

The share is over-valued

Valuation of Stock

Exchange guidelines:

Closing price or the Average of last half hour traded prices

Profit/Loss = ( CPT-CPT-1 ) * Holding quantity,where CPT is the closing price today and

CPT-1 is the closing price of the previous day.




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Realized and Unrealized P/L This gives the break up of the amount of profits that

have been actually booked ( in the kitty) and the amount which is purely a case of

valuation based on closing price, and is still to be realized.

Example :

Let us say you buy 100 shares of Reliance at Rs.500.

You sell 40 shares at Rs.550.

Closing price of Reliance is Rs.450.

What is your total profit or loss?

Realised profit:

(550-500)*40 = Rs.2000

Unrealised loss:

(450-500)*60=-Rs.3000

Total profit or loss is Rs.1000.




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The Bond Market

A bond is an instrument that typically carries a specific rate of interest that the issuer agrees

to pay the bond holder, as well as a promise to repay the principal over time / maturity.

The market is primarily OTC.

Participants :

Government

Commercial banks

Corporations

Interest rate concepts

Yield curve: Relationship between interest rate and term to maturity, at a specified time.

Positive yield curve :Interest rate for shorter maturities are lower than the rates for

longer maturities.

Negative yield curve : Interest rate for shorter maturities are higher than the rates for

longer maturities.

Flat yield curve :Same interest rate level across maturities.

Coupon and Yield

Coupon is the interest rate contracted by the issuer in the primary market. This remains the

same irrespective of market conditions.

Yield is the prevalent market interest rate of the same bond for its balance term to maturity.

This will keep changing based on market conditions.

Day Count Conventions

The next concept about interest rates is the day count convention. Simply put, day count

conventions tell us how to count the number of days between two interest dates and convert

the number of days into a year fraction. A year fraction has two parts

1. The numerator that is the number of days between two dates

2. The denominator that is the number of days in a year

The day count conventions that are commonly used are:

Act/360

The number of days between two dates is the Actual number of days. The denominator that

contains the number of days in a year is 360. This is the day count convention used for US

Dollar deposits, and most G7 currency deposits.




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Act/365

This convention is similar to the previous one, except that the denominator used is 365 instead

of 360. This is the day count convention used for INR deposits and most emerging market

currency deposits.

30/360

The denominator year count used is 360. The denominator is the number of 30 day months

between two dates.

Act/Act

This convention is used in the US Treasury bond market. The numerator is the actual number

of days between two interest dates. For the denominator, we take the actual number of days

in the current coupon period and multiply it by the number of coupons paid in a year. So, if the

number of days in the current coupon period is 184 and coupons are paid twice a year, the

denominator will be 2x184 = 368.

There are many more day count conventions, however these cover the most commonly used

ones. The 30/360convention is commonly referred to as the bond convention as it is used forcalculating interest rates in the bond market. The Act/365 convention is known as the money

market convention for the same reason.

Day Count Convention- Examples

Jul 17th Sep 1st

Act/Act 46 days

30/360 44 days

March 1st and Sep 1st

Actual 184 days

30/360 180 days

Floating Interest Rates

Floating interest rates were born because banks could no longer afford to lend or borrow at

fixed rates for long tenors due to interest rate volatility.

Various benchmark rates are available:

LIBOR (London Inter-bank Offered Rate)

SIBOR / MIBOR

Treasury Bill yield

In order to qualify as a benchmark rate, a rate index must satisfy certain criteria

Fairness

Accessibility for borrowing and lending transactions

Liquidity

Transparency




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The most popular international benchmark rate is LIBOR.

LIBOR is determined by a poll of leading international banks. The banks are asked what, in

their view, are the offered rates at which deposits are quoted to prime banks in the London

inter-bank market at 11 am London time. The two highest and two lowest rates are discarded

and an average of the remaining quotes is the fixed as the LIBOR for each tenor.

LIBOR is published every day by Reuters and Telerate.

Bond Pricing

Bond prices change due to various factors affecting demand and supply (Interest rates, time to

maturity, etc.). Price of a bond is the present value of all its future cashflows.

The price of a 5 year, 10% coupon bond, FV 100,interest paid annually, can be calculated given

the current yield to maturity(YTM) of the bond.

If the YTM is 5% , you can present value each of the cashflows ( 10 in year 1 4,and 110 in year

5) using the YTM as the discounting factor to get the price. It works out to 121.65.

Work it out!Similarly , if the price of the bond is known to you , one can compute the YTM. This YTM is the

same as the IRR of the bond.

The above illustration assumes that settlement between the buyer and seller is happening on a

coupon date. But typically an investor will purchase a bond between coupon dates.

To determine the price when Settlement date falls between two coupon dates, we need to

answer the following questions

How many days are there until the next coupon payment

How should we determine PV of cash flows for fractional periods

How much must the buyer compensate the seller

Example:

Suppose that a corporate bond with a coupon rate of 10% maturing March 1, 2006 is purchased

with a settlement date of July 17, 2000. What would be the price of this bond be if it is priced

to yield 6.5%?

Illustration:

The next coupon payment will be made on September 1, 2000. Because the bond is a corporate

bond, based on a 30/360 day count convention, there are 44 days between the settlement date

and the next coupon date.




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Period Cash flow PV factor

PV of cash

flow

0.12222 $5.00 0.992212404 4.961062

0.62222 $5.00 0.960981 4.804903

1.12222 $5.00 0.930732 4.653659

1.62222 $5.00 0.901435 4.507176

2.12222 $5.00 0.873061 4.365303

2.62222 $5.00 0.845579 4.227897

3.12222 $5.00 0.818963 4.094815

3.62222 $5.00 0.793185 3.965923

4.12222 $5.00 0.768217 3.841087

4.62222 $5.00 0.744036 3.720181

5.12222 $5.00 0.720616 3.603081

5.62222 $105.00 0.697933 73.283008

Total $120.028094

The price of this corporate bond would be $120.02809 per $100 par value. The price calculatedin this way is called the full price or dirty price because it reflects the portion of the coupon

interest that the buyer will receive but that the seller has earned.

The buyer must compensate the seller for the portion of the next coupon interest payment the

seller has earned but will not receive from the issuer because the issuer will send the next

coupon payment to the buyer. This amount is called accrued interest and depends on the

number of days from the last coupon payment to the settlement date. The accrued interest is

computed as follows:

AI = c x Number of days from last coupon payment to settlement date

Number of days in coupon period

Where

AI = Accrued interest ($)

c= Semiannual coupon payment ($)

Illustration: Lets continue with the above example. Because the number of days between

settlement(July 17, 2000) and the next coupon payment(September 1, 2000) is 44 days and the

number of days in the coupon period is 180, the number of days from the last coupon payment

date(March 1, 2000) to the settlement date is 136(180-44). The accrued interest per $100 of

par value is

AI = $5 * (136/180) = $3.77778

The full or dirty price includes the accrued interest that the seller is entitled to receive. For

example, in the calculation above, the next coupon of $5 is included as part of the cash flow.

The clean price or flat price is the full price of the bond minus the accrued interest.

The price that the buyer pays the seller is the full price. It is important to note that in

calculation of the full price, the next coupon payment is a discounted value, but in calculation

of accrued interest it is an undiscounted value. Because of this market practice, if a bond is




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selling at par and the settlement date is not a coupon date, the yield will be slightly less than

the coupon rate. Only when the settlement date and the coupon date coincide is the yield

equal to the coupon rate for a bond selling at par.

In the U.S. market, the convention is to quote a bonds clean or flat price. The buyer,

however, pays the seller the full price. In some non-U.S. markets, the full price is quoted.

Valuation Investments

On a daily basis, the Base Yield curve is taken for government securities. The spreads over Base

yield curve for other bonds is based on the risk premium associated with these bonds. The risk

premium is based on the rating or credit risk associated with these bonds.

The yield is converted into a price as in the above method and the profit calculated is as

follows:

(Valuation price Cost price) * holding quantity.

Instruments

Treasury bonds, Treasury notes, Treasury bills

Municipal bonds, Corporate bonds, etc.

The bonds can also be classified based on their characteristics

Secured and Unsecured

Callable bonds

Convertible bonds

Debt Treasury securities

Also called U.S.Treasuries

Issued by the Treasury deptt.

Dutch Auction Mechanism

Safe investment backed by the Govt.

Default risk minimized but interest rate risk remains

High min. investment

Individuals can invest through a mutual fund

Used to regulate money supply

Types of Treasuries

Treasury bills - < 1 year

Quoted on an yield basis

Treasury notes 1 - 10 yrs

Treasury bonds - > 10 yrs

Quoted in 1/32nd of a point

e.g. a bid of 121:16 means that the bond is actually bid at 121 16/32




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If T-bills of $1000 face value and 180 days maturity are auctioned and fetch a price of

$993.7888, what is the yield?

1.25%

If a bank quoted you a discount of 4.67%, for a $1000 T-bill maturing 23 days from now, what

would be the price that you have to pay?

$ 9971.16

Municipal bonds or Municipals

issued by state govt.

tax exempt yield

Corporate Bonds

issued by companies

Callable bonds

Issuer retains the right to retire the debt, fully or partially, before the

scheduled maturity date

Permits the borrower , if market rates fall, to replace the bond issue with a

lower interest cost issue.

Carry higher yield for the investor

Put-call provision

Yield to call ( based on call date)

Interest rate that will make the PV of the cashflows till the call date

equal to the price of the bond

Yield to worst

Compute yield to every coupon date following the first call date and

taking the lowest

Convertibles

Exchanged for specified amounts of common stock

Conversion ratio and price defined in the initial contract terms

Medium Term Notes(MTNs)

Actually range in maturity from 9m to 30 years

Non-callable, unsecured, flexible in terms of, features, continuous offering in

small amounts etc.

Issuer posts offering rates over a range of maturities

Eurobonds

bonds issued and traded outside the jurisdiction of any single country

need not conform to domestic regulations




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Bonds with Sinking Fund provisions

Requires the issuer to retire a certain part of the outstanding debt each year

The firm may purchase the bonds in the open market if below par

Or may make payments to a trustee who will then call a certain number of

bonds chosen by lottery

The investor would then receive the prearranged price

U.S treasuries are free of this provision

Ensures orderly retirement of debt

Ensures a certain degree of price stability as the issuer is there on the buy side

when prices fall

Yield tends to be less than for normal bonds

Asset Backed Securities ( ABS )

Packaging of multiple consumer loans into a portfolio that is turned into a single issue of a

security

Mortgage backed security(MBS) securitisation of retail mortgages

individual mortgage loans are placed into a pool, and securities are issued so that

each security represents a fractional interest in the pool.

Loans act as collateral for the security

helps in releasing balance sheet, and the bank can take on more risk.

principal keeps changing as people make mortgage payments and pay off their loans

Investment in MBS is in terms of amount and not quantity.

MBS carry Prepayment risk

Homeowner has the option to prepay the mortgage in whole or part at any time

No penalty may be imposed for prepayment

Partial prepayment helps reduce mortgage life

An investor is never certain of his cashflows or maturity of the investment

30 year mortgage loan could turn out to be a 1 year loan

Key in analyzing a mortgage pool is the projection of prepayments

MBS can be issued by U.S Govt. agencies

GNMA Govt. National Mortgage association

owned by the govt.

buy mortgages from banks, packages them into securities. credit risk is low

MBS - Classifications

Pass through securities or Participation Certificates(PC)

represent direct ownership in a pool of mortgage loans




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e.g. Ten mortgage loans given by a bank of $100,000 each, totalling $ 1 mio.

10 loans used as collateral against which a security is issued, with the cashflow

on that security reflecting the cashflow from the loans.

Suppose 40 units of the security are issued, each unit worth $25,000 each.

Each unit will be entitled to 2.5% of the cashflow from the loan.

The security created is called a pass-through.

Monthly cashflow from the loan is distributed on a pro-rata basis.

Collateralised Mortgage Obligations (CMOs)

CMOs are divided into tranches(Class A,B& C),such that investors in earlier

tranches are repaid their principal in full, before the owners of the later

tranches are paid any principal.

The final tranche is called a Z-bond

holders receive no cash till all earlier tranches are paid in full, but

interest accumulates and is paid on maturity along with the finalprincipal repayments

minimises prepayment risk

Distributed amongst the three tranches.

Class A absorbs prepayments first, then Class B and then Class C

Class A becomes effectively a shorter term security and Class C the longest

maturity.

MBS- Market Dynamics

maturity of upto 40 years repayments typically monthly

pricing based on assumptions regarding potential repayments based on historical

patterns.

Standard Prepayment model of the Bond Market association

quoted in 1/32nd of a point

As mortgage rates go down , risk of prepayments go up.

Money market instruments

Commercial paper

Short term , unsecured , issued in the open market

90 days most popular ( < 2 m in U.S )

Discount instrument

Certificates of Deposit

Issued by banks for financing their business activities

Interest bearing basis

Typically short term




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Repurchase agreements (Repos)

Lending transaction where the borrower uses a security as collateral for the

borrowing

Specifies the sale and subsequent repurchase at a future date

The difference is the interest cost of the borrowing

Lower than overnight Fed funds rate as it is secured

Amount loaned is less than market value of securities to provide cushion to the

lender in case prices decline (margin 1-3%)

Collateral is Marked to market daily and repo amount adjusted

instrument of monetary policy




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The Foreign Exchange Market

The main feature of this market is that, it is continuous - i.e., open 24 hours a day.

The daily volumes traded is over USD 1.4 Trillion. The major currencies traded are USD, JPY,

EUR, GBP & CHF.

Spot Rates

Foreign Exchange rates express the value of one currency in terms of another currency.

For e.g.,

1 USD = 1.2900 CHF.

1.6750 USD = 1 GBP.

100 yen = 40.00 INR.

USD 0.6495 = 1 AUD.

Last decimal place in the rate = pip.

Foreign Exchange Rates - Bid/Offer

Bid: the rate at which the quoting bank is willing to buy the commodity currency, or sell the

terms currency.

Offer: the rate at which the the quoting bank is willing to sell the commodity currency, or buy

the terms currency.

Cross Rates

A cross rate is a foreign exchange rate between two currencies, via a thirdcurrency.

For e.g., EUR /INR rate via USD :

Rate scenario :

1 EUR = USD 1.2100

1 USD = USD 43.50

What is the EUR /INR rate ?

ALGEBRAICALLY, it is :1.2100*43.50

USD 1 = INR 52.6350




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PROBLEM 1:

A British importer would like to buy JPY in terms of GBP . At what rate can he buy

from the bank if the following market rates prevail?

GBP 1 = USD 1.8350 - 55

USD 1 = JPY 105.20 - 25a) Importer sells GBP to bank. (rate : USD 1.8350)

b) Importer sells USD to bank. (rate : JPY 105.20)

Algebraically, GBP 1 = USD 1.8350, USD 1 = JPY 105.20

Therefore, GBP 1 = JPY 193.04

Types of Exchange rates

SPOT : DELIVERY 2 business days from date of transaction.

FORWARD : DELIVERY 3 or more business days from date of transaction.

CASH and TOM deals : DELIVERY the same day or the next business day respectively.

Trading Position

TOTAL PURCHASES - TOTAL SALES

(Regardless of Maturity)

Example :

BANK 1 buys USD 5 mio against INR AT 45.20

The bank now has a position of USD 5 mio.

The bank is overbought USD 5 mio and oversold INR 226 mio (5 mio * 45.20) In market jargon, the bank is said to be Long USD 5 mio and Short INR 226 mio.

BANK 1 sells USD 5 mio against INR at 45.30.

The bank now has a zero position.

In market jargon, the bank is said to have a square position.

The bank has made a profit of INR 500,000 : ( 45.30 - 45.20)* 5 mio.

BANK 1 sells USD 5 MIO against INR at 45.35.

The bank now has an Oversold position of USD 5mio or an Overbought INR position of

INR 226.75 mio.

In market jargon, the bank is said to be Short USD 5 mio and Long INR 226.75 mio

BANK 1 buys USD 3 mio against INR AT 45.40.

The bank is now short USD 2 mio only.

The bank has incurred a loss of INR 1.5 lacs and has an Open position of USD 2 mio.




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BANK 1 buys 2 mio against INR at 45.35.

The bank has now squared its position.

The loss incurred by the bank is still INR 1.5 lacs as the 2 mio has been purchased at

cost.

Overall bank Position

Simply, all overbought, NET open positions in various currencies are listed in one line

and their LOCAL currency equivalents are determined at a market closing rate.

Similarly, all oversold, NET open positions in various currencies are listed in another

line and their LOCAL currency equivalents are determined at the same market closing

rate.

The greater of the local currency equivalents is taken as the Banks position and is

reported in the Local currency.

Trading position

EXERCISE:

Market Closing rates :

EUR/USD = 1.2200 USD/INR = 45.35

USD / CHF = 1.2700

Open Positions:

EUR 5 MIO Long against USD

USD 5 MIO Long against INR.

USD 5 MIO Short against CHF

OVERBOUGHT POSITIONS OVERSOLD POSITIONS

INR equivalent INR equivalent

EUR 5 MIO 276.63 mio

USD - 6.1 MIO 276.63 MIO

CHF 6.35 MIO 226.75 MIO

POSITION 503.38 MIO 276.63 MIO

Hence the bank's position is the bigger Local currency equivalent, i.e. INR 503.38 MIO

SHORT

Deal Settlement - Example

Transaction : On Jan 7th Zed Bank Manila buys USD 1 mio at DM / USD 1.78 value spot

( i.e. , Jan 9th ) from Chem Bank, Singapore.

Manila : Jan 7th, Zed Bank Manila sends DM payment instructions to Zed Bank

Frankfurt, for value Jan 9th.




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Singapore : Jan 7th, Chem Bank Singapore sends USD payment instructions to

Chem Bank New York, for value Jan 9th.

Frankfurt : Zed Bank Frankfurt debits Zed Bank Manila DM account, and pays

DM 1.78 mio to West Deutsche Frankfurt for account of Chem Bank Singapore,

for value Jan 9th.

New York : Chem Bank New York debits Chem Bank Singapore USD account,

and pays USD 1 MM to Zed Bank New York, for account of Zed Bank Manila for

value Jan 9th.

Currency Forward Markets

Forward Contract :

A contractual commitment to buy or sell a specified amount of foreign exchange for a

specified price (forward exchange rate) at a specified future date (maturity of contract).

Premium/ Discount :

Forward exchange rates can be higher or lower than the applicable spot rate. If the forward

exchange rate is lowerthan the spot rate, the currency is said to be at a forward DISCOUNT.

If the forward exchange rate is higher than the spot rate, the currency is said to be at a

forward PREMIUM.

Market Rates :

3 Month GBP : 4.0 %

3 Month USD : 1.0 %

Spot GBP / USD : 1.7900

Spot rate * Interest rate differential No. of months forward @100 12 Months@

@ or actual number of days

1.7900 * 3 X 3 = 0.0134100 12

SPOT RATE USD 1.7900

SWAP RATE USD 0.0134

Therefore, 3 month forward rate USD 1.7766




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Forward rate can also be computed using the following formula,

S ( 1 + Rt)

F = _________

( 1 + Rc)

Swaps

A swap is a simultaneous purchase/sale and sale/purchase of two currencies across different

tenors. An outright forward transaction can be divided into a spot + swap transaction as the

interbank market does not quote an outright forward price. The spot legs would cancel out and

you would be left with an outright forward which is what you wanted.

Meaning of Swap Quotations :Premium

Spot USD / CHF 1.2820 - 30

3 - month Swap Rate 30 - 40

3- Month outright forward 1.2850 - 70

Discount

Spot USD / Yen 111.30 - 111.40

3 - month Swap Rate 150 - 1303- Month outright forward 109.80 - 110.10

Swap rates/ Forward rates are, therefore, a function of the interest rate differential

between the two currencies involved.

Example

Market rates:

Spot USD/INR = 45.25 / 30

6 months Swap points = 15 / 20

The Bank can buy dollars Spot from the market at 45.30 ( r.h.s).

The bank has to pay swap points when it undertakes a Sell/Buy swap ( USD is at a premium to the INR) in the market. So it has to pay ( i.e 20 points , and not 15 as it

will be the calling party in this case and has to face the market spread, just like the company).

In case of USD/INR , USD is the fixed currency and when the fixed currency is at a premium,

the forward rate is higher than the spot rate ( explained earlier ). Hence we need to add the

swap points.




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So the Outright 6 months Forward rate for the customer will be :

45.30 + 20 = INR 45.50

A Company may have a receivable or payable in a currency other than the USD. In that case

one will have to compute the cross rate e.g CHF / INR or GBP/INR. The only point to rememberis, the cross rate is computed at the last step i.e after the respective outright forward rates

are computed against the USD.

Participants

Authorised Dealers -Banks and FIs

Corporates

Brokers

Central Bank( to stabilize the market in times of volatility)

Activities

As mentioned earlier, all activities in each financial market can be classified into a Front

Office, Middle office and Back office.

Front Office

Pre-Deal Analysis

Deal Execution

Middle office

Limits Monitoring

Bank / Counterparty Limits

Gap Limits Position Limits Overnight and Daylight

Dealer-wise

Currency wise

Regulatory Reporting

Back Office

Deal slip matching

Deal Confirmation

Rate Reasonability

Authorisation

Payment Messages

Nostro reconciliation

Position and Gap reports

Valuation




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Financial Derivatives Building Blocks

Derivatives are financial instruments that derive their value from the value of some other,more basic, underlying financial instrument or variable.

Derivatives are used as an effective hedging tool for Corporate Risk management.

Why hedge?

To Combat Volatility and Risk

To Allow for Long Term Planning

To Avail of Opportunities

To Relieve Distress Costs

To Maximise Shareholder Wealth

Examples of Derivatives

A Equity Warrant - The value of an equity warrant depends on the value of the underlying

equity share

A Contract to purchase a flat one year from today - The value of the contract depends on the

prevailing price of similar flats today

A Car Insurance Policy - The value of the policy depends on value of the car being insured

All Derivatives can be thought of as being a combination of three basic building blocks

Credit Extension

Price Fixing Contracts

Price Insurance Contracts

Credit Extension Products

Credit extension products are forms of extending credit or loans. Various debt securities are

credit extension products such as loans and bonds. Interest paid on debt instruments is known

as Coupon. There are four basic types of credit extension products:

Zero Coupon

Level Coupon

Floating Rate Coupon

Amortizing

Price Fixing Products

Price Fixing Products fix the price at which exchange of value takes place on afuture date.

There are three basic types of price fixing products

Forward Contracts

Futures Contracts




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Swaps

Price Fixing Products are two-sided obligations. Both the parties to the product have to

perform. The buyer and seller of the Price Fixing Product are obligated to deliver assets or cash

flows at the predetermined rate.

Price Insurance Products

Price insurance products are one-sided obligations.

A Price Insurance Product gives the owner the right, but not the obligation to exchange value

at apredetermined rate at afuture date

Price Insurance Products thus provide price insurance to the owner of the product against

adverse movements in the price of the underlying variable or asset

Example of Price Insurance Products - Options

A Price Insurance Product that protects the purchase price is a Call Option

A Price Insurance Product that protects the selling price is a Put Option

Hybrid Financial Products

Hybrid financial products can be constructed by combining basic financial products. We will

take one simple example

Convertible Bond.

A convertible bond is a bond that pays a fixed coupon. In addition, it offers the holder the

option of converting the principal amount into equity shares of the Issuer Company on maturity

Interest Rates Arithmetic

The arithmetic of interest rates is rooted in the time value of money. Very simply, a sum of

money given today is worth more than the same sum of money promised at a future date. This

is because the sum of money can be invested to produce a positive return on the initial

investment over time.

If an amount is invested for Tyears at a compound interest rate of rthen the maturity

value will be

( )TrA +1

This is, of course, the maturity value if the interest rate is compounded annually. Compounding

frequency is the frequency with which interest is paid out. If interest is paid out n times in a

year, then each interest amount is r / n. The principal and this interest amount is re-invested

nTtimes. The maturity value is then




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Tn

n

rA

+1

If the compounding frequency is made more frequent, for the same interest rate r results in a

higher maturity value. In other words, the same nominal interest rate results in a higher

effective interest rate. Lets look at some examples.

Continuously Compounding

In general, the more frequent the compounding the higher the effective interest rate and

lower the nominal interest rate. In the limiting case if we make n a very large number close to

infinity then the interest rate is said to be continuously compounded. The maturity value is

rT

nT

n

nT

n

Aen

rLtA

n

rALt =

+=

+

11

where e is the mathematical constant 2.71828.

Example

What is the continuously compounded interest rate that is equal to an interest rate of 10% per

annum, compounded semi-annually?

Semi-annual compounding implies that n=2. Replacing terms in Equation 5, we have

( ) %758.909758.004879.0205.1log2

2

10.01log2 ====

+=ee

r

Determining discount factors from compound interest rates - Bootstrapping

In the U.S, the money market yield curve (upto 1 year tenor) is based on simple interest rates.

The par yields are the zero coupon yields as there are no intermediate cashflows. However, for

tenors beyond one year interest rates are usually quoted as compound interest rates. In

compound interest rates, interest on the principal is paid at periodic intervals (monthly,

quarterly, or semi-annually) prior to maturity. For example if we are given that the 18 month

USD rate is 7.20% per annum, Act/360 basis, semi-annual payments, it means that interest on

the principal will be paid twice a year for 1.5 years at the end of which we will receive the

principal back. As this stream of cashflows is similar to that of a bond purchased at par, the

yield curve is also known as the par yield curve.

If we invest a sum of USD 100 at this rate for 18 months, the cashflows will look like this

Rate Date Cashflow

7.20% 26-Jul-00 -100.0000




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26-Jan-03 3.6800

26-Jul-03 3.6200

26-Jan-04 103.6800

If the rate is correct, then the present value of the future cashflows must be equal to the sum

invested today. We can determine the PV of the cashflows on 26-Jan-03 and 26-Jul-03 using

the par yields or the zero coupon yields. If we subtract the PV of these two cashflows from

100.00 the residual amount (93.0750) must be the PV of the final cashflow on 26-Jan-04.

18m Rate Date Cashflow DF PV

7.20% 26-Jul-02 -100.0000

26-Jan-03 3.6800 0.96546 3.5529

26-Jul-03 3.6200 0.93153 3.3721

26-Jan-04 103.6800 ? 93.0750

The discount factor for 26-Jan-04 is then simply the present value (93.0750) divided by its

future value (103.6800).

18m Rate Date Cashflow DF PV

7.20% 26-Jul-02 -100.0000

26-Jan-03 3.6800 0.96546 3.5529

26-Jul-03 3.6200 0.93153 3.3721

26-Jan-04 103.6800 0.89771 93.0750

Once we know the discount factor for up to 18 months based on the money market yield curve

up to 1 year and the rate for 18 months, we can determine the discount factor for 2 years using

the previously calculated discount factors up to 18 months. This method of progressively

calculating discount factors is known as bootstrapping so called because it is similar to the

process of trying to pull yourself up by your own bootstraps.

References

For further reference, you may consult any of the following books :

1. The Handbook of Fixed Income Securities by Frank J Fabozzi2. International Financial Management by P.G.Apte

If you have any specific queries, contact us [email protected].

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