1_FinancialPrincAndInstruments

8/13/2019 1_FinancialPrincAndInstruments

1/60

Introduction toFinancial Principles

and Instruments

Reval100 Broadway, 22 nd Floor

New York, NY 10005


2/60

Introduction to Financial Principles and Instruments

2008; Reval. 2

Copyright 2008 Reval. All rights reserved.

The enclosed material is proprietary to Reval, and is therefore copyrighted. This documentmay not be disclosed in any manner to anyone other than the addressee and the employeesof the addressed firm who are directly responsible for the evaluation of its contents. Thisdocument may not be used in any manner other than for the purpose that it was distributed.

Any unauthorized use, reproduction or transmission in any form is strictly prohibited. Therecipient of this document should not construe any information furnished herein as any legal,

tax, accounting, investment or risk-management opinion, recommendation, strategy oradvice.

Trademarks

Reval , HedgeRx , FAS 133 Doctor , and IAS 39 Doctor are registered trademarks of Reval.CICA 3865 Doctor TM is a trademark of Reval. Other product names mentioned in thisdocument may be trademarks or registered trademarks and are hereby acknowledged.


3/60


2008; Reval. 3

Table of Contents

1 About this Course and Document ..........................................................................41.1 Document History ...........................................................................................41.2 Conventions used in this manual....................................................................41.3 Course Description and Objectives ................................................................51.4 Pre-requisites for this Course .........................................................................51.5 Course Agenda...............................................................................................5

2. What is Treasury Management?............................................................................72.1. What are Cash and Liquidity Management?...................................................8

3. What is Risk Management? .................................................................................113.1. What is Hedging? .........................................................................................113.2. How do Firms Hedge? ..................................................................................123.3. What are Derivatives? ..................................................................................13

4. Financial Concepts ..............................................................................................164.1. What is the Time Value of Money?...............................................................164.2. What is an Index? What is a Benchmark? ...............................................204.3. What Types of Pricing can be used in Transactions? ...................................204.4. How is interest calculated? ...........................................................................204.5. How is Net Present Value (NPV) / Fair Value (FV) calculated?....................224.6. What is an Exchange trade versus an Over-the-Counter one? ....................224.7. What are Stress Testing and Scenarios? .....................................................23

5. What are the Front, Middle and Back Offices responsible for? ............................26

6. What are Interest Rates?.....................................................................................276.1. What are Interest Rate Swaps?....................................................................28

6.1.1 How is an interest rate swaps value calculated? ..................................307. What is Foreign Exchange?.................................................................................33

7.1. What are Foreign Exchange Forwards? .......................................................357.2. What is the value of a Foreign Exchange Forward? .....................................357.3. When are Foreign Exchange Forwards used for hedging?...........................397.4. What are Foreign Exchange Swaps? ...........................................................39

8. Commodities........................................................................................................49

8.1. What are Commodity Futures and Forwards? ..............................................498.2. Similarities and Differences of Futures and Forwards ..................................518.3. What are Commodity Swaps? ......................................................................52

9. Investments .........................................................................................................5610. Glossary...........................................................................................................58


4/60


5/60


2008; Reval. 5

1.3 Course Description and Objectives

The Introduction to Financial Principles and Instruments course willintroduce participants to basic financial and hedge accounting topics. Bythe completion of this course, the participant will be able to:

Explain treasury management, risk management and hedgeaccounting

Discuss why firms hedge

Explain various financial and hedge accounting terminology

Define asset classes: foreign exchange, interest rate, andcommodities

Perform calculations for various products.

1.4 Pre-requisites for this Course

There are no pre-requisites for this course. The knowledge gained fromthis course is a pre-requisite for the Introduction to HedgeRx course.

1.5 Course Agenda

The agenda for this course follows. Please note that it is subject to

change.

Introduce treasury management

Describe risk management and how firms hedge risk

Examine asset classes, related products and valuationso Financial Concepts:

Time value of money

Pricing

Curves/indexes and Benchmarks Interest calculation and zero coupon rates

Net present value/mark-to-market

Exchange traded versus over-the-counter

Stress testing and scenarios


6/60


2008; Reval. 6

o Interest rate

Swapso Foreign exchange

Forwards

Swapso Commodities

Forwards

Swapso Investments

Held to Maturity (HTM)

Available for Sale (AFS)

Trading

Pricing Analy tics

Deal Capture Portfolio

Allocations Term Sheets

MarketExposureRisk

What-if Analysis

Mark-to-Market

Inventory P/L Resets Payment Option

Expiry Audit

Reports

Documentation Hedge

Designation Analy tics Reporting FAS 133

Doctor TM

InterestRates

ForeignExchange

Energy Metal Agricult ural

F i n a n c

i a l

C o m m o

d i t y

aarrk k eett DD aattaa

Front Office Middle Office Back Office FAS 133/IAS 39 Asset Classes

CClliieenn tt SSuu p p p p oorrtt

Revals Hedging Management Solution


7/60


2008; Reval. 7

2. What is Treasury Management?

Reval provides web-based treasury and risk management solutionsand services to corporations and financial institutions. Reval blendsfinance, technology, software, and operations expertise to delivereffective and rapidly deployable solutions that bring immediate return oninvestment to clients.

Treasury management is at the financial core of an organization handledby the treasury department. The department is responsible for managingthe firms assets and liabilities: issuing new shares, receiving assets,borrowing and/or investing money, etc. The department deals withinternal and external issues such as:

Internal issues External issues

Wages Financial markets

Benefits Investors

Bonuses Creditors

Rating agenciesConsultant and/orliaison to otherdepartments

Debt issuers

Treasury management affects risk. It is involved in:

Cash management

Liquidity management

Risk management.

Today, organizations have more financial obligations than in years past.There are more regulations to abide by. Organizations are more globaland need to control risk factors external to the business that effectinternational activities. Also, organizations are more volatile. Changesin exchange rates, interest rates, and commodity prices are rapid andcan adversely affect a company.

The size of the treasury department is usually correlated to revenuesize:


8/60


2008; Reval. 8

Larger companies generally have:

Greater exposures/risk management needs

Bigger treasury department

Greater number of derivative trades.

2.1. What are Cash and Liquidity Management?

Cash management is the key role of treasury departments. It is theefficient movement of cash to maximize revenue opportunities. Cashmanagement includes:

Forecasting and protecting cash and assets

Controlling cash receipts and distributions

Investing excess cash and managing debt, when needed.

Cash management starts with a forecast of cash flows, present andfuture. There are various methods to forecast cash flows:

Scheduling : Schedule large-volume inflows or outflows (e.g.,wire transfers)

Distribution : Forecasting multiple distributions as one (e.g.,check clearings or trade receivables)

Statistical Analysis : Regression analysis creates a formulathat attempts to explain the link between an event and related,dependent cash flows. The R-squared statistic shows thestrength of this relationship.

Source: TreasuryStrategies 2003Corporate TreasurySurvey


9/60


2008; Reval. 9

Liquidity is the ability of an organization to meet its short-term financialresponsibilities. Organizations must be able to take advantage ofopportunities that arise, such as funding an acquisition. Treasurymanagement is responsible for maintaining cash balances and, thus,making sure the organization has liquid funding available.

Note: While cash management focuses on methods used to managecash, liquidity management focuses on the balances that result from thecash management transactions.

Liquidity is managed using a variety of financial instruments:

Money markets : Short-term, fixed-income securities

Government securities : Including treasury bills (discount obligations

issued by the U.S. Treasury of one-year or less durations), bondsissued by government agencies (e.g., Federal National Mortgage Association, Fannie Mae), and municipal bonds (issued by city andcommunity governments)

Bankers Acceptances (BAs) : Issues of corporate debt that havebeen accepted/guaranteed by a bank

Foreign Exchange Swaps (FX swaps) : Consists of a spottransaction with a simultaneous forward transaction. Currencies areexchanged both at the spot and forward dates; the rates are set at thebeginning of the transaction so their difference reflects the interest

differential between the two currencies over the length of the swap. FXswaps may be entered into the same day (cash value), the nextbusiness day (tom-next) or two business days (spot next).

Scenario : ABC Company has excess Euros that it would like to invest forthe next six months. It would like U.S. dollars in the interim to pay offexpenses. After the six month interval, ABC will exchange the U.S. dollarsback for Euros.

Solution : ABC enters into an FX swap today with XYZ selling 1,000,000Euros for 1,560,000 U.S. dollars (exchange rate of 156 U.S. dollars perEuro). ABC and XYZ also agree to a swap for value six months from today- XYZ will sell back the 1,000,000 Euros for 1,500,000 U.S. dollars. Thedifference is a result of the interest rate differential between the twocurrencies for the six months.

Result : ABC Company has invested Euros for six months and gained U.S.dollars.


10/60


2008; Reval. 10

T REASURY M ANAGEMENT R EVIEW

1. Define treasury management.

________________________________________________

________________________________________________

2. Define cash management.

________________________________________________

________________________________________________

3. Define liquidity management.

________________________________________________

________________________________________________

4. Name three issues treasury management must monitor.

________________________________________________

________________________________________________ ________________________________________________

________________________________________________

5. What is the main difference between cash management andliquidity management?

________________________________________________

________________________________________________


11/60


2008; Reval. 11

3. What is Risk Management?

Risk management is the responsibility of the treasury department toreact to the uncertainties of the financial markets. It deals with the

possibility that some future event will cause harm to the company. Itprovides strategies, techniques, and approaches to recognize andconfront any threat to the organization. It must identify the source(s),measure and address the risk. There are various types of risk that needto be monitored such as:

Interest rate risk : risk that the value of an interest-bearing asset(e.g., loan or bond) will decline due to an increase in interest rate,can be hedged with an interest rate swap.

Currency risk : risk that arises from the change in price of onecurrency against another; when companies have assets or business

across borders, they may be exposed to currency risk. Currency riskmay be hedged by taking an off-setting position.

Credit risk : risk that a borrower will not pay money owed; lendersgenerally charge a higher rate for higher risk customers.

Liquidity risk : risk that a firm will not be able to sell an asset ormeet financial obligations; liquidity risk is difficult to isolate as itimpacts credit risk, market risk, etc.

Commodity price risk : risk associated with price volatility of thecommodity.

3.1. What is Hedging?

The term hedging is derived from the phrase hedging your bets usedin gambling. For example, within the game of roulette, placing a hedgebet is one where the chips cover the lines between two numbers on thetable. The bet covers all numbers involved at a reduced stake. Theterm now is used within risk management to cover a range of risk-reduction activities such as various investments.

A hedge investment reduces or cancels risk in anotherinvestment, similar to an insurance policy against a negativeevent. Hedging is the strategy designed to mitigate exposure tounwanted risk, so if the negative event occurs the damage isminimized. Hedging is used to reduce exposure to potential risks.

Types ofrisk


12/60


2008; Reval. 12

Hedging uses instruments in the marketplace to strategically offset riskof adverse price movements. In other words, companies hedge oneinvestment by entering into another. The goal of the hedge is not tomake money but to mitigate risk. While the companys profits may bereduced in an upside, so will their losses in a downside.

Example hedge : A company has outstanding fixed-rate debt andbelieves that interest rates will decrease. They enter into a receivefixed, pay floating rate swap to hedge the fluctuation in interest rates.

3.2. How do Firms Hedge?

There are many hedging strategies that an organization can use.Hedging generally involves the use of derivatives , such as futures andoptions. Usually the derivative trade moves in the opposite direction ofthe initial investment: a loss in the investment will cause a gain in thederivative and vice-versa. Companies may hedge all or part of their risk.

Definition : Companies hedge price changes in physical material byoffsetting the risk in the futures market.

About the company: Southwest Airlines originally served three cities inTexas: Dallas, Houston and San Antonio. They are now the largestairline in the United States and in the world measured by the number ofpassengers carried per year.

About the hedge : Southwest is dependent on jet fuel. They havehedged fuel prices for years. In 2000, Southwest said it had adjustedits hedging strategy to utilize financial derivative instruments...it appearsthat the Company can take advantage of historically low jet fuel prices.Southwest used a combination of options and swaps to lock in lowhistorical prices. Southwest hedged for forward years: 2008 is 65%hedged at $49/barrel, 2009 is 50% hedged at $51/barrel, 2010 is over25% hedged at $63/barrel. The hedging strategy continues until 2012.

Result : Risk managers have suggested that Southwest wasspeculating on energy prices, without a formal rationale for hedgingthe business risk. At present, Southwest has enjoyed a strongfinancial boost from its energy trading. Whether a volatility hedge or

just a speculative one, Southwest has reaped the benefits of hedging.(At the time this was written in 2008, jet fuel cost 158.60 USD perbarrel, over a 109 USD savings for Southwest Airlines).


13/60


2008; Reval. 13

There are many different types of options and futures contracts.Companies can hedge against almost anything: commodities, stock,interest rate, currency, weather, etc.

Every hedge has a cost. Similar to insurance, the benefit of the hedgemay never be recognized; however, the cost is still there. Companiesneed to decide if the potential benefits justify the cost. The goal of thehedge is not to profit, but to offset risk and decrease potential losses.The company must consider the cost of the hedge in light of the implicitcost of not hedging to correctly evaluate the cost of the hedge.

3.3. What are Derivatives?

Derivatives are financial instruments whose value is derived fromchanges in the value of an underlying asset such as a commodity, debtinstrument, interest rate or unit of currency. According to FAS 133, aderivative is an instrument with all three of the following characteristics:

1. Underlying or either a notional amount of payment provision or both

2. Relatively small initial net investment

3. Net settlement or its equivalent.

Derivatives are used to manage risk and may require FAS 133 or IAS 39accounting (discussed in later sections of this manual). The followingchart shows some example derivatives.

Derivative Underlying Notional Amount

Interest rateswap

Interest index Dollar amount

Currencyforward

Exchange rate Number of currencyunits

Commodityfuture

Commodityprice

Number of commodityunits

Important terms when discussing derivatives include:

Notional amount : Principal amount of the transaction, quantity

Start Date : Beginning date of the transaction; effective date

Derivativesdefinition


14/60


2008; Reval. 14

Maturity Date : End date of the transaction

Trade Date : Date the trade was entered into

Settlement Date : Date when the buyer must pay for the securitiesdelivered

Reset Date : Date a floating rate is set for a period of time Floating Rate : Variable rate based on an index such as LIBOR

Fixed Rate : Set amount

Day Count Factor : Determines the number of days between twointerest payments for investments such as swaps, bonds, loans, etc.It determines the way interest is accrued over time.

Specific day count factors are discussed within the How is interestcalculated? section of the next chapter.

R ISK M ANAGEMENT R EVIEW

1. Define risk management.

_____________________________________________________

_____________________________________________________

_____________________________________________________

2. Name three types of risk that firms need to manage.

_____________________________________________________

_____________________________________________________

_____________________________________________________

3. What are the similarities between a treasury management systemand a risk management system?

________________________________________________

________________________________________________

________________________________________________


15/60


2008; Reval. 15

4. What are the differences between a treasury managementsystem and a risk management system?

________________________________________________

________________________________________________

________________________________________________

5. How can a company manage interest rate risk?

_____________________________________________________

_____________________________________________________

6. Define the term hedging.

_____________________________________________________

_____________________________________________________

_____________________________________________________

7. What is a derivative?

_____________________________________________________

_____________________________________________________

_____________________________________________________

8. What is an underlying asset?

_____________________________________________________

_____________________________________________________

_____________________________________________________

9. What is meant by the notional?

_____________________________________________________

_____________________________________________________


16/60


2008; Reval. 16

4. Financial Concepts

There are various financial concepts that are universal to all instrumentsand asset classes. The following terms are highlighted in this section:

Time value of money

Types of pricing

Curves / indexes / benchmarks

Interest calculation

Net present value / mark-to-market

Exchange traded versus over-the-counter

Stress testing and scenarios

4.1. What is the Time Value of Money?

Congratulations! Youre a winner!You have won $1,000,000 U.S. dollars.Would you like to receive it today or tenyears from today?

Most people would choose to take themoney now! It can be invested, used tomake a purchase or utilized for otherthings. If the winner chooses to investthe money at 8% for ten years,compounded annually, it will be worthapproximately $2,158,925. Why take$1,000,000 in ten years when it couldbe worth $2,158,925 by that time?

A dollar today does not equal a dollar tomorrow. All else being equal,you would prefer to receive your payment today rather than the samepayment at a future date. As illustrated in the above example, thewinner or lender could invest the money to increase the future value.

The following two boxes show the time value of money. The discountrate is the interest rate used to determine the present value of futurecash flows.


17/60


2008; Reval. 17

The calculation highlighted in turquoise illustrates the future value of$10,000 today compounded annually at a rate of 5%. The calculationhighlighted in orange illustrates the present value of $16,288.95 in tenyears from today, compounded annually at a rate of 5%.

$10,000 today equals $16,288.95 ten years from nowat a rate of 5%

periodsof number period)per rateinterest(1*AmountValueFuture ++++====

Example : The future value of $10,000 in ten years, compounded annually

at a rate of 5%, is approximately $16,288.95.16,288.95 = 10,000 * (1 + .05) 10

periods of number period)per rateterestin1(ValueFuture luePresent Va

++++====

Example : The present value of $16,288.95 in ten years, compoundedannually at a rate of 5%, is approximately $10,000.

10,000 = 16,288.95 / (1 + .05) 10

periods of number period)per rateinterest1(1 factor ValueesentPr

++++====

OR

PVf = PV / FV

Example : The present value factor of an annual interest rate of 5%, isapproximately .95238.

. 95238 = 1 / (1 + .05)

Time value ofmoneyexamplecalculations


18/60


2008; Reval. 18

1. Using the exponential of (1.05) 10 which equals 1.628895 will create aPVf of approximately .6139.

.6139 = 1 / (1.05) 10

2. Multiplying .6139 by the $16,288.95 brings us back to the original$10,000 of the deal.

3. Another way of calculating the PVf is to divide the PV by the FV.

.6139 = 10,000 / 16,288.95

Rates may be calculated similar to the calculation of zero couponinterest rates . Zero coupon interest rates mean that there is onlyone interest flow, interest is paid only at maturity (simple interest). Inthis example, there are no interim coupon payments between todayand ten years; all interest flow (i.e., coupons) is paid at the end of theterm of the deal. Actually, money market rates (with maturities ofone year or less) are quoted as zero coupon interest rates. If thedeal had a one-year maturity (as in money markets), all interestwould have been paid at the end of the year.

Deals with greater than one year maturity actually use swap rates tocalculate PV factors. These swap rates derive the yield curve(discussed in a later section).

Zero couponrate definition


19/60


2008; Reval. 19

O N - YOUR - OWN PRESENT AND FUTURE VALUE CALCULATIONS

1. Calculate the present value of $2,000,000 in ten years fromtoday. Assume the interest rate is 5%.

_____________________________________________________

_____________________________________________________

_____________________________________________________

_____________________________________________________

2. Calculate the future value of $2,000,000 in five years with an

interest rate of 7%. _____________________________________________________

_____________________________________________________

_____________________________________________________

_____________________________________________________

3. If $10,000 equals $10,500 in one year, what is the present valuefactor?

_____________________________________________________

_____________________________________________________

_____________________________________________________

_____________________________________________________


20/60


2008; Reval. 20

4.2. What is an Index? What is a Benchmark?

An index is a statistical composite that measures changes in financialmarkets. For example, the Consumer Price Index (CPI) moves up and

down as the rate of inflation changes. Indexes within markets are usedto reflect market prices of bonds, commodities, interest rates, etc. Forexample, there are different indexes for the natural gas locations.

A benchmark is a standard or reference against which prices arecompared or calculated. Benchmarks usually are used because acommodity exists in many forms that can be distinguished by differentproperties or quality. For example, the various natural gas indexes arecompared to the NYMEX, the benchmark for natural gas prices.

4.3. What Types of Pricing can be used in Transactions?

There are two types of pricing used in transactions:

Fixed : Price is set; no matter what happens in the market the priceof the deal (or leg) will remain the same

Float : Price is variable; it fluctuates based off of an index. The pricemay be the index price plus/minus a spread or a percentage of theindex. Interest adjustments are made periodically (e.g., semi-annually, quarterly, etc.) at the reset date .

4.4. How is interest calculated?

Interest accrues between payments throughout the life of the deal.Accrued interest represents the amount of accumulated interestbetween the last payment and the sale of the fixed-income instrument.

)(PrincipalXpayment)lastsincedays(Xrate)(CouponInterestAccrued ====

Whether accrued interest is included in the price of the security dependson the pricing method used:

Clean price : Represents the price of the security without theaccrued interest included

Dirty price : Represents the price of the security with the accruedinterest included.


21/60


2008; Reval. 21

How the number of days since the last payment is calculated dependson the day count factor used in the transaction.

period)referenceindays# /datesbetweendays(#Factor CountDay====

Some day count factors are:

Actual/365F : The number of accrued days is equal to the actualnumber of days between d_e and d_t. This accrual is often usedin the money market and in calculating accrued interest of bondsor swaps.

Actual/360 : Same as Actual/365(fixed). This accrual is oftenused in the money market and in calculating accrued interest ofbonds or swaps. The year is assumed to have 360 days.

Actual/Actual Swap : The accrual factor is the sum of theaccrued days of the non-leap year divided by 365 and theaccrued days of the leap year divided by 366.

Actual/Actual Bond : This accrual method is primarily related tobonds. However, in the context of accrual factors, the time inyears is calculated as follows: if the period is less than one yearthe accrual factor is equal to the actual number of days betweend_e and d_t divided by the number of days in the period from (d_t

1 year) to d_t (either 365 or 366). If the period is greater thanone year, the accrual factor is equal to the number of whole yearsplus the accrual of a stub period calculated as above.

30/360 : Also known as 'bond basis'. This accrual methodassumes 30 days per month and 360 days per year. However, ifthe first date of an accrual period is not the 30th or 31st, and thelast date of the period is the 31st of the month then that month isconsidered to have 31 days. Hence, the accrual factor is simplythe number of accrued days divided by 360.

30E/360 : This is know as 30/360 European. It is a slightlysimpler version of 30/360 in that if the first date or the last date ofan accrual period is on the 31st of a month, then the date is set tothe 30th. Hence, the accrual factor is simply the number ofaccrued days divided by 360.

Actual/Actual ISMA : The accrual factor is the sum of the accrueddays of the non-leap year divided by 365 and the accrued days ofthe leap year divided by 366.


22/60


2008; Reval. 22

Actual/Actual : Each month and year is calculated using theactual number of days that have passed. This accrual methodcalculates the actual number of days between two dates andassumes the year basis to be 365 days for non-leap years and366 for leap years. If a short stub period (< 1 year) contains a

leap day, the number of days is divided by 366 otherwise thenumber of days is divided by 365.

The zero coupon rate is the discount rate implied by the market invaluing a single future payment, such as the redemption of a zerocoupon bond. Zero coupon rates are used to value streams of cashflows, such as swaps. Zero coupon securities are ones sold at deepdiscounts but do not pay interest.

4.5. How is Net Present Value (NPV) / Fair Value (FV) calculated?

Net Present Value or Fair Value is the difference between cash inflowsand cash outflows at todays value. NPV uses the discount factor tocompute the dollar value today for all cash flows, present (cost ofinvestment) and future.

====

++++====n

0t

periodsof number period)per rateinterest(1NPV

Calculating NPV or MTM is often called mark-to-market or simplymark .

4.6. What is an Exchange trade versus an Over-the-Counter one?

An exchange is a central location or marketplace where trading occurs.Securities, commodities, derivatives and other financial instruments aretraded on an exchange. The exchange ensures fair and orderly trading.Exchanges may be physical locations where traders meet to conductbusiness or an electronic platform. Example exchanges are the National

Association of Securities Dealers Automatic Quotation System, NewYork Mercantile Exchange, and London Metals Exchange.


23/60


2008; Reval. 23

Contracts traded on futures exchanges are standardized. Futures andoptions are examples of exchange traded instruments.

In contrast, an over-the-counter (OTC) transaction is one that occursdirectly between two counterparties. An OTC contract is agreed upon bytwo parties and is settled in the future. Forwards and swaps areexamples of OTC instruments. Derivatives are usually governed by anInternational Swaps and Derivatives Association (ISDA) agreement anddocumented under master agreements.

The following table highlights some differences between exchangetrades and over-the-counter trades:

Exchanges Over-the-Counter

Central location orelectronic platform

Standardized contracts

Futures and options

Occurs directly betweentwo counterparties

Settled in the future

Forwards and swaps

4.7. What are Stress Testing and Scenarios?

A stress test determines how a portfolio or transaction will react to

different financial situations. It assesses performance of the transactionor portfolio under certain market changes.

Scenarios are the different events that are tested within the stress test.For example, what would happen to the trade if the price increased by10%? What would happen to the value of the portfolio if the pricedecreased by 10%?

Stress testing often is called what-if analysis, assesses potentiallosses by looking at the value of an instrument(s) under differentscenarios. Scenarios may involve one change such as a price increaseor decrease or multiple changes such as a price change combined witha change in a foreign exchange rate.

Stress testing trades is a good way to assess a firms risk exposures.Proper actions can be in place should unacceptable exposures bedetermined. Proper planning may prevent poor performance.


24/60


2008; Reval. 24

F INANCIAL C ONCEPTS R EVIEW

1. What are the similarities and differences between a fixedprice and a float price? Give examples of each.

________________________________________________

________________________________________________

2. What are the similarities and differences between an indexand a benchmark? Give examples of each.

________________________________________________

________________________________________________

3. What is/are the similarities and differences between anexchange trade and an over-the-counter trade?

________________________________________________

________________________________________________

4. Define the terms stress testing and scenario.

________________________________________________

________________________________________________

5. A firm wants to see what would happen to its portfolio if theLIBOR curve increased and decreased by 10%. What wouldthe firm need to do to assess the risk?

________________________________________________

________________________________________________

________________________________________________

6. The start date of a security is January 1 st . Interest is paidsemi-annually at the rate of 5% on a $100,000 notional.Today is July 15 th. How much interest has been accruedassuming a day count factor of Actual/360?

________________________________________________

________________________________________________

________________________________________________

________________________________________________


25/60


2008; Reval. 25

7. The start date of a ten-year, $100,000 bond is January 1 st .Interest is paid annually at the rate of 5% on a $120,000notional. Today is June 30 th of the first year of the life of thebond. What is the clean price and dirty price of the security?

Clean:___________________________________________

Dirty:____________________________________________

________________________________________________

________________________________________________

8. The cost of a ten-year security is $40,000. The security willdistribute $500 each year to the owner, the prevailing discountrate is expected to be 10% over the ten years, and anadditional $100,000 at maturity. Is this security a good

investment? ________________________________________________

________________________________________________

________________________________________________

9. The cost of a thirty-year security is $300,000. The security willdistribute $100 each year to the owner, the interest rate isexpected to be 5%, and it will pay out $1,000,000 at maturity.Is this security a good investment?

________________________________________________ ________________________________________________

________________________________________________

10. The cost of a five-year security is $60,700 with an interest rateof 10.5%. The security will pay out $100,000 at maturity. Isthis security a good investment?

________________________________________________

________________________________________________ ________________________________________________

________________________________________________


26/60


2008; Reval. 26

5. What are the Front, Middle and Back Offices responsible for?

The front office is the term used to describethe trading responsibility of a financial

company. The front office is the locationwithin the organization where revenues aregenerated. Various trading desks (interestrate, foreign exchange, and commodity) areconsidered to be part of the front-office. Thefront-office has also been defined as the salespersonnel.

The middle office is the group of employees withinan organization that is in charge of monitoring and

managing risk exposures and setting credit limits.The middle office draws from the knowledge of boththe front and back offices. It generally consists of therisk and credit departments and may include theinformation technology department, depending on theorganization.

The back office is responsible for the supportfunctions of the financial services company, includingthe trade confirmation (written acknowledgement of atransaction between two parties), trade settlement(delivery of instrument in exchange for payment),record keeping, accounting and compliance/regulatoryissues.

F RONT , M IDDLE AND B ACK O FFICE R EVIEW

1. Match the office on the left to the definition on the right.

Back office _____ a. Set credit limits and manageexposures

Front office _____ b. Confirmations, settlementsand accounting

Middle office _____ c. Trading desks


27/60


2008; Reval. 27

6. What are Interest Rates?

Interest rates reflect the price of money and are determined by supplyand demand. A greater demand for money is likely to drive up the priceof money, reflected in the interest rate. Demand depends on factorssuch as the nation's economic health, the level of government borrowingto support budgets, etc. Rates are adjusted upward in an attempt to slowthe economy, and downward to act as a stimulus.

Interest rate payments are the fees paid to the lender to borrow moneysince the lender is foregoing other useful investments that could havebeen paid with the financing. Generally, they are quoted annually, theannual rate of interest.

The amount lent is called the principal or notional amount. Simpleinterest is paid only on the principal or what is remaining from the

principal. Compound interest charges interest on the interest; interestis paid on both the principal and the interest.

Benchmark interest rates are often used such as treasury, Libor, andFed Funds rates. Rates may be fixed or floating. As stated in theprevious section, a fixed rate is set and does not change. Floating ratesare indexed to a benchmark rate; for example, the Libor plus or minus acertain percentage.

The yield curve represents the relationship between interest rates andtime to maturity of the deal. The yield curve is usually upward slopingand accounts for the time value of money, interest rates being higher in

the future.

A dollar today does not equal a dollar tomorrow. All else being equal, alender would prefer to receive payment today rather than the samepayment at a future date. The lender could invest the money to increaseits future value.

Time to maturity

Yield (%)


28/60


2008; Reval. 28

6.1. What are Interest Rate Swaps?

A swap is a contract specifying the exchange of one cash flow foranother at a future point in time. These cash flows are linked to interest

rates.These agreements state the exchange of periodic interest payments ona predetermined principal amount (the notional amount). One party maypay a fixed rate and the other party may pay a floating, variable ratebased on an index such as in a plain vanilla swap . An example swapis the exchange of the 3M Libor for 5% paid semi-annually for five years.

Each payment stream is called a leg of the swap. The side of the swapthat pays the fixed rate purchased the swap.

The table below shows the sides and legs of a swap. Assuming fourpayment periods, the swap has two sides and four legs.

Pay Side Receive Side

Payment leg 1 Receive leg 1




Long swaps (buying a swap) pay fixed and receive floating. Short swaps (selling a swap) pay floating and receive fixed.

The fixed swap rate usually is set so that the present value of the swapis zero. A swap is used to mitigate risk, not make a profit. Swaps areover-the-counter transactions and require documentation standardizedby the International Swaps and Derivatives Association (ISDA).


29/60


2008; Reval. 29

Example Interest Rate Swap

Step 1 : Training Inc. enters into an agreement with Lender to Receivea Loan and pay a Floating (variable) Rate. Training Inc. does not want

to pay a Floating Rate but wants to pay a Fixed Rate soStep 2: Training Inc. enters into an agreement with Swap Co. to Pay aFixed Rate and Receive a Floating Rate (an interest rate swap)

End result : The Floating Rate passes through Training Inc. from SwapCo. to Lender and Training Inc. Receives the Loan from Lender andPays Swap Co. the Fixed Rate.

A basis swap occurs if both parties pay floating rates, as shown below.

Interest rate swaps are used by hedgers to manage their fixed or floating

assets and liabilities. For example, a swap may be used to protectagainst a debt that has interest rate risk built in based on movements ofthe benchmark.

Interest rate swaps are easy to price and are traded in the over-the-counter market so they can be structured to match the cash flows of theunderlying. However, the interest payments are locked in and if theindex does not go in the owners favor, the owner is obligated to pay theagreed upon interest rate.

Lender

Training Inc. Swap Co.

Pa Float Receive LoanStep

1

Receive Float

Pa Fixed

Step 2

Training Inc. Swap Co.

Pay Float

Receive Float


30/60


2008; Reval. 30

6.1.1 How is an interest rate swaps value calculated?

An interest rate swaps value is the difference between the presentvalues of the swaps sides. For example, if the swap pays out a fixedrate and receives a floating rate, the value will be calculated by taking

the present value of the floating side and subtracting the present valueof the fixed side. The day count factor enters into the equation for eachinterest payment.

The following formulas are from Wikipedia.com.

The value of the fixed leg is the present value of the fixed couponpayments known at the start of the swap:

C = swap rateM = number of fixed paymentsP = notional amountti = number of days in the periodTi = basis according to the day count factordf i = discount factor

The value of the floating leg is the present value of the floating couponpayments determined at the agreed upon dates for each payment:

N = number of floating paymentsP = notional amountf j = floating ratet j = number of days in the periodT j = basis according to the day count factordf j = discount factor


31/60


2008; Reval. 31

Scenario : Company A purchases a swap from Bank B. Company A willpay a fixed-rate of 5% semi-annually. Bank B will pay the floating ratebased off of the six-month USD Libor. The notional amount is onemillion USD. Assume the six-month Libor rate is known to be 4.8% and5.2% when the reset periods come, the day count factor is Actual/360,

and for simplicity, the actual number of days is 180 and the discountfactor is 1.

The present value of the fixed side equals:

= .05 * [(1,000,000 * (180/360) * 1) + (1,000,000 * (180/360) * 1)]= .05 * [500,000 + 500,000]= 50,000

The present value of the floating side equals:

= [(1,000,000*.048*(180/360)*1)+(1,000,000*.052*(180/360)*1)]= 24,000 + 26,000= 50,000

Conclusion : The present value of the swap equals zero. It is a break-even swap.


32/60


2008; Reval. 32

I NTEREST R ATE R EVIEW

1. Define the following terms:

Term Definition

Interest rate

Simpleinterest

Compoundinterest

Yield curve

2. Party A enters into a swap with Party B, agreeing to pay the 3-month Libor rate. Bank B agrees to pay Party A the 6-monthLibor rate. What type of transaction is entered into?

________________________________________________

________________________________________________

3. Party C purchases a one-year, ten-million USD swap from BankB. Party C agrees to pay Bank B a fixed-rate of 10% and Bank B

agrees to pay Party C a floating rate based on the 6-month Liborrate. Assume the Libor rate is known to be 7% and 11% at thedates of reset, the day count factor is Actual/360 (actual numberof days is 180), and the discount factor is 1. What is the value ofthe swap?

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________ ________________________________________________

________________________________________________

________________________________________________

________________________________________________


33/60


2008; Reval. 33

7. What is Foreign Exchange?

Foreign exchange trades occur for several reasons: to buy or sell acommodity in a foreign currency or country, take advantage of exchangerates, or to leverage activities of an organization. The date that thefunds are exchanged is known as the settlement date or delivery date .Foreign exchange transactions may be:

Spot settlement : Immediate delivery; within two days after the tradeis booked (T + 2). [Note: There are some exceptions to this such asthe Canadian dollar and British pound sterling which have T + 1settlement.] Spot exchange rates adjust to compensate for therelative inflation rates between the two countries.

Forward : The exchange occurs at some specified date in the future,perhaps months into the future.

Foreign exchange rates are the prices of currencies relative to oneanother. As a result, they may be quoted as either currency relative tothe other. Exchange rates fluctuate often. According to Wikipedia, thetop ten traded currencies are:

Rank Currency ISO code% dailyshare(4/04)

1 United States dollar USD ($) 88.7%

2 Euro EUR () 37.2%

3 Japanese yen JPY () 20.3%

4 British pound sterling GBP () 16.9%

5 Swiss franc CHF (Fr) 6.1%

6 Australian dollar AUD ($) 5.5%

7Canadian dollar

CAD ($) 4.2%

8 Swedish krona SEK (kr) 2.3%

9 Hong Kong dollar HKD ($) 1.9%

10 Norwegian krone NOK (kr) 1.4%


34/60


35/60


2008; Reval. 35

7.1. What are Foreign Exchange Forwards?

A forward contract is an obligation. In a forward transaction, the sellerpromises to deliver a specific amount of goods to a buyer at a future

date at a fixed price. In many ways, forward transactions are similarbooking a trip. Many people prefer to lock in a price before they travelrather than purchasing a hotel room once they reach their destination.

A foreign exchange forward is an agreement to buy or sell a specifiedamount of currency at a specified date for future delivery. Most FXforwards mature within one to two years. The price of the forwardconsists of the spot price plus or minus forward points (the interestrate differential between the two currencies). The total price is knownas the all-in price . Time is money the price of a current trade and afuture trade will be different.

7.2. What is the value of a Foreign Exchange Forward?

Would you agree to purchase an asset today for 50 USD and agree tosell it in one weeks time for 45 USD? Probably not. What if there was apremium of 5 USD paid to you? Maybe.

In general, the forward price (F) is based on the spot price (S) plus theinterest cost/cost to carry it minus the benefit of holding the asset (timevalue of money):

F = S + Cost - Benefit

Example scenario: 1

Assume an asset is trading at 45 USD. Interest rates are 5.00%. Theperiod to hold the asset is one-year and in that time, it will pay a dividendof 0.25 quarterly. What is the one-year forward price?

In this example:

S = 45 USD

Cost = 5.00%

Benefit = .25 * 4 = 1.00

1 The scenarios and calculations are adapted from Foreign Exchange: A Practical Guide to the FXMarkets by Tim Weithers.


36/60


2008; Reval. 36

Therefore:

F = 45 + (45 * .05) 1.00

F = 45 + 2.25 1.00

F = 46.25

Relating this equation to FX, we need to convert one currency to theother one within the currency pair. Suppose, for example, we areexchanging the USD for CHF.

Assume the exchange rate for USD/CHF is 1.10.

From whose perspective is this deal and who benefits?

What is the cost?

Since CHF is the underlying asset (think of the underlying asset as thecurrency in the denominator), the perspective is of the Swiss Francholder.

What is the cost to the Swiss Franc holder of entering into this deal? Hecannot put his money in a bank and earn interest or he has to pay toborrow the money, pay interest. Either way, the cost is the interest lost.

So, if we put the above variables into the equation from before, theformula would be:

F = S + (S r CHF t) - (1 r USD t)

The problem with this equation is that it compares Swiss Francs with USdollars (like comparing apples with oranges). The cost is written in CHFbut the benefit (interest) is in USD. In addition, the Future and Spotprices are also in CHF.

It makes sense to quote the Future and Spot prices in CHF, the samecurrency. Therefore, we can leave the cost as CHF and we need to

adjust the benefit from USD to CHF.How do we do this?

Multiplying the USD rate by the spot price will convert the interestpayment to CHF. Therefore:

F = S + (S r CHF t) - S (1 r USD t)

F = S + (S r CHF t) - ( S r USD t)


37/60


2008; Reval. 37

F = S + S [(r CHF t) - ( r USD t)]

F = S + S [(r CHF ) - (r USD )] t

F = S + S (r CHF - r USD ) t

The difference between the two interest rates is interest rate parity . Asshown, if the Swiss and U.S. interest rates were the same, then thefuture price would equal the spot price.

However, the US interest rate is realized in the future (at the end of thedeal) and the Swiss interest rate is realized at spot. So, the spot priceand future prices are not equal. Is there a price in todays money atwhich we can exchange USD for CHF at the point in the future? Theanswer is the forward price. So, the equation is:

F = S + (S r CHF t) - F (r USD t)

F = S (1 + r CHF t) F (r USD t)F + F (r USD t) = S (1 + r CHF t)

F ( 1 + r USD t) = S (1 + r CHF t)

F = S (1 + r CHF t) _________________

(1 + r USD t)

F t)r (1t)r (1S

2

1++++

++++====

Example scenario :

If USD/JPY is trading in the spot market at 110.00, Japanese interestrates are 1.00% and US rates are 5.00%. What do you expect the one-year USD/JPY forward price to be?

In this example:

F = ?

S = 110.00

R1 = 1.00

R2 = 5.00


38/60


2008; Reval. 38

F = [110 (1 + (.01*1) )] / [ 1 + (.05*1) ]

F = 110 (1.01) / (1.05)

F = 111.1 / 1.05

F = 105.81

The majority of interest rate forwards are done under one year so simpleinterest rates, rather than compound interest rates, are used.

If the exchange rate is trading at a higher level than the current domesticfutures spot rate for a maturity period, the forward is trading at a

discount . The market expects the domestic currency to depreciateagainst the other currency. This may or may not happen.

Discount = Spot Rate Futures Rate

If the spot futures exchange rate, with respect to the domestic currency,is trading at a higher spot exchange rate than it is currently, the forwardis trading at a premium . The market expects the domestic currency toappreciate against the other currency.

Premium = Futures Rate Spot Rate

Some parameters within a foreign exchange forward are:

Spot price: The prevailing price in the spot market; current marketprice

Forward points: Interest rate differential between two currenciesexpressed in exchange rate points

All-in price: Rate at which contract is entered into today forsettlement at a specified future date; Spot price + (forwardpoints/10,000)

Delivery Type: Deliverable (physical) or Non-deliverable (cash)


39/60


40/60


2008; Reval. 40

Therefore, when valuing a currency swap, the valuation of one side ofthe swap will involve currency conversion.

Example scenario :2

Assume a US multinational company wants to borrow 100,000,000 USDcheaply for five years. How does an FX swap come into play?

The best rate the company can find within the United States is 5.00%.

While the company may be able to borrow money within the UnitedStates, it thinks that it should get a better rate. The company looksabroad. A Swiss company knows the US company and is willing to loanthe company Swiss Francs at 2.50% until maturity (but the discount rateis 3.00%). Is this a good deal? Should the company accept the 5.00%USD rate or the 2.50% CHF rate?

While many companies like to borrow money on a long-term floating ratebasis, we will assume, for simplicity of this example, the loan is of afixed-rate. We will also assume that the USD/CHF spot rate is 1.2500.While usually not the case, we will assume that the Swiss rate is flat at3.00% and the US rate is flat at 5.00% throughout the loan.

The company can accept the loan in CHF and enter into a swap withSwap Company for USD. They will cover their coupon payments in CHFwhile allowing them to pay in USD.

2 The scenario and calculations are adapted from Foreign Exchange: A PracticalGuide to the FX Markets by Tim Weithers.

ABC Dealer

USD Fix

EUR Float

USD Principal Exchange

EUR Principal Exchange


41/60


2008; Reval. 41

1. First, we need to calculate the interest payments for each of thefive years. In order to do that, we need to calculate the value ofthe notional in CHF.

If the spot rate is 1.2500 and the USD notional is 100,000,000,what is the notional in CHF?

CHF notional = 100,000,000 * 1.25

CHF notional = 125,000,000

So the company will receive 125,000,000 CHF from the swap andgive the Swap company 100,000,000 USD.

2. Next, what are the cash payments of 125,000,000 CHF that thecompany will receive at the rate of 2.50%?

125,000,000 * .025 = 3,125,000 CHF

3. What amounts will be exchanged at the end of the swap? Thesame amounts at the beginning plus the final coupon.

0

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

140,000,000

1 2 3 4 5

Year

I n t e r e s

t P a y m e n

t s i n C H F

SwissCompany

U.S.Company

SwapCompany

1.25M CHF

CHF interestpayments &

principal

CHF interestpayments &

principal

USD interestpayments &

principal


42/60


2008; Reval. 42

4. What are the payments for the 100,000,000 USD? Remember,the companys goal is to have an interest rate of less than 5.00%.What is the fair rate to charge for USD?

In order to answer this question, we need to know the presentvalue of the Swiss Franc cash flows. Since the interest rate is3.00% for the five years, the PV factors are:

Year Equation PVf

1 1 / (1.03) .9709

2 1 / (1.03) 2. .9426

3 1 / (1.03) 3 .9151

4 1 / (1.03) 4 .8885

5 1 / (1.03) 5 .8626

Now that we have the PV factors, we need to multiply them byeach cash flow to get their present values.

Year Equation PV Cash Flows

1 .9709 * 3,125,000 3,033,980.58

2 .9426 * 3,125,000 2,945,612.22

3 .9151 * 3,125,000 2,859,817.69

4 .8885 * 3,125,000 2,776,522.02

5 .8626 * 128,125,000 110,521,750.50

Total Cash flow 122,137,683.01

Note: The company gained 125,000,000 CHF but the presentvalue is only 122,137,683.01. The company saved 2,862,317.00CHF (equal to 2,289,853.59 USD) from this swap compared toborrowing at 5.00% USD!

5. But, what is the fair coupon rate for the USD payments? The totalpayment should be valued at:

100,000,000 2,289,853.59 = 97,710,146.41 USD


43/60


2008; Reval. 43

6. Next, we need to know the PV factors for the USD coupons.Keeping in mind that the interest rate is 5.00%:

Year Equation PVf1 1 / (1.05) .9524

2 1 / (1.05) 2. .9070

3 1 / (1.05) 3 .8638

4 1 / (1.05) 4 .8227

5 1 / (1.05) 5 .7835

So, the coupon rate (c), will be multiplied by each payment toobtain the profit of 97,710,146.41 USD:

97,710,146.41 = .9524c + .9070c + .8638c + .8227c +

.7835(c + 100,000,000)

= c(.9524+.9070+.8638+.8227+.7835) + 78,350,000

= 4.3295c + 78,352,616.65

switching the two sides.

4.3295c = 97,710,146.41 78,352,616.65

4.3295c = 19,357,529.76

c = 4,471,101.53

OR

4.47110143% which much less than the 5.00% offered in the US!Going abroad to get the money was beneficial to the company.

7. So lets plot this out to show the payments and receipts in USDand CHF.


44/60


2008; Reval. 44

-120,000,000-105,000,000

-90,000,000-75,000,000-60,000,000-45,000,000-30,000,000-15,000,000

015,000,00030,000,00045,000,00060,000,00075,000,00090,000,000

105,000,000120,000,000135,000,000150,000,000

1 2 3 4 5

USD paymentsCHF Payments

Another way to analyze this is to look at FX forward prices:

Note that given the time horizon of five years, we need to use thecompounding interest rate formula, rather than the simple rate one:

F = S [ (1 + r 1) / (1 + r 2) ] t

= S [(1 + r CHF ) / (1 + r USD )] t

Lets review the cash flows for each year:

Year CHF payment USD payment

1 3,125,000 -4,471,101.53

2 3,125,000 -4,471,101.53

3 3,125,000 -4,471,101.53

4 3,125,000 -4,471,101.53

5 128,125,000 -104,471,101.53


45/60


2008; Reval. 45

1. Convert them all to USD using the given FX forward rates:

S = 1.25

r 1 = 1.03

r 2 = 1.05

Year ForwardRate

CHF Paymentsin USD

USD Payments

Year 1 1.2262 2,548,523.8950 -4,471,101.53

Year 2 1.2028 2,598,104.4230 -4,471,101.53

Year 3 1.1799 2,648,529.5364 -4,471,101.53

Year 4 1.1574 2,700,017.2801 -4,471,101.53

Year 5 1.1354 112,845,693.1478 -104,471,101.53Total 123,340,868.2823 -122,355,507.6424

The receipts are definitely more than the USD payments and thecompany gains $985,360.64 in total. But, is it really almost onemillion USD? We need to calculate the present value of eachcash flow to find out the true dollar amount in todays value.

2. Whats the present value of the difference in each payment?

Difference PVf PV of Difference-1,922,577.6335 0.9524 -1,831,026.3176

-1,872,997.1055 0.9070 -1,698,863.5877

-1,822,571.9921 0.8638 -1,574,406.2128

-1,771,084.2484 0.8227 -1,457,075.3942

8,374,591.6193 0.7835 6,561,711.6672

340.1549

Note: The differences in the above table are caused byrounding the PVf to four decimal places.


46/60


2008; Reval. 46

3. What if the company took the loan at 5.00% USD? Workingthrough this exercise again with the value of 5.00% USD interestwould create payments of 5,000,000 annually.

Year CHF payment inUSD Received

USD paymentPaid

1 2,548,523.89 -5,000,000.00

2 2,598,104.42 -5,000,000.00

3 2,648,529.54 -5,000,000.00

4 2,700,017.28 -5,000,000.00

5 112,845,693.15 -105,000,000.00

Total in USD 123,340,868.28 -125,000,000.00

4. And the PV of the difference between the two?

PVf Difference PV of Difference

.9524 -2,451,476.1050 -2,334,739.1477

.9070 -2,401,895.5770 -2,178,590.0925

.8638 -2,351,470.4636 -2,031,288.5983

.8227 -2,299,982.7199 -1,892,201.4756

.7835 7,845,693.1478 6,147,305.8754

Total -2,289,513.4387

The difference is 2,289,513.44 USD, which is close to the2,289,853.59.00 USD difference calculated in step #4 of theprevious set of steps (the inequality in the two numbers is causedby rounding).

Given that the company can borrow cheaper abroad, itpays to issue a bond abroad and do the cross-currency swapto eliminate or hedge the exchange rate risk.


47/60


2008; Reval. 47

F OREIGN E XCHANGE R EVIEW 3

1. You enter into a spot-forward arbitrage given the following:

EUR/USD S = 1.2940

t = 1 year

r US = 3.00%

r EUR = 4.00%

Spot notional EUR = 100,000,000

What is the one-year forward rate?

________________________________________________

________________________________________________ ________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

2. If a U.S. company issues a 3.00% annual coupon bond in CHF inSwitzerland and does a cross-currency swap, show how itaffectively will be borrowing at 5.00% in USD, given the followinginformation:

USD/CHF S = 1.2500

r US = 5.00%

r CHF = 3.00%

Notional (paid back at maturity) CHF = 100,000

PVf for the five years, as calculated in the section:

3 Exercises adapted from Foreign Exchange: A Practical Guide to the FX Markets by Tim Weithers.


48/60


2008; Reval. 48

Year CHF USD

1 0.9709 0.9524

2 0.9426 0.9070

3 0.9151 0.8638

4 0.8885 0.8227

5 0.8626 0.7835

________________________________________________

________________________________________________

________________________________________________

________________________________________________ ________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________


49/60


2008; Reval. 49

8. Commodities

Commodities are physical items such as energy, electricity, metals,grains, textiles, food stock, etc. Commodity trades may be physical(delivery of the commodity) or financial (cash flow from one party toanother at maturity of the contract, no exchange of the underlyingcommodity). Commodity prices are extremely volatile which results inhedging actions.

As with interest rates, spot trading takes delivery immediately. All othertransactions are included in the forward market. Various risks areassociated with the commodities market:

Price risk : Fluctuation of the commodity cost

Transportation risk : Something happens within the line oftransporting the commodity from the seller to the buyer

Delivery risk : Concerns the quality of the commodity delivered

Credit risk : Counterparty default risk.

8.1. What are Commodity Futures and Forwards?

A commodity forward contract is an agreement between two parties atday 0 to exchange a stated quantity of a commodity at a fixed future

date for an amount defined at day 0.4

A commodity futures transactionhas the same general features as a forward but has a standard contractsize and is transacted through an exchange. The clearing house of theexchange takes away almost all of the credit risk associated with thetransaction.

Futures facilitate trading of commodities in the market. They alsoprovide a method for hedging against price risk . They provide a way fortraders or producers to guarantee a price at a specific point in time.Ideally, the price set in the contract will equal the spot price for the futuredate.

The buyer, known as the long, agrees to take delivery of the commodity.The seller, known as the short, agrees to make delivery of thecommodity. A small percentage of contracts traded are actuallydelivered. Most contracts are liquidated with an equal and oppositecontract before expiration. The idea behind the liquidation with anoffsetting contract is that a loss in one market should be offset by a gainin the other market.

4 Definition adapted from Commodities and Commodities Derivatives by Hlyette Geman

Commodityrisks


50/60


2008; Reval. 50

Example commodity futures hedge : A producer of natural gas holds(long) 10,000 MMBTU of natural gas. The producer can hedge byselling (short) one natural gas futures contract.

Scenario: Oil producer fears a price decline

An oil producer wants to stabilize cash flow with a hedge on the futuresmarket. On March 1 st , the manager notices that they will have extraproduction for the next two months. The manager wants to capture themarket prices now rather than wait for lower prices in April and May.

In the futures market, the producer agrees to sell 10 contracts in Apriland May at $120 per barrel (1,000 barrels in a contract) in April and$125 per barrel in May. Assuming two pricing scenarios: pricesincrease to $122 and $126 in April and May in scenario 1 (shown in thetable below in pink) and prices decrease to $118 and $124 in April andMay in scenario 2 (shown in the table below in gray), the producer willloss or gain $30,000. The producer is obligated to deliver thecommodity or settle the transaction in cash.

====

====n

0tPrice)Actual-PriceFutures(sProfit/Los

Long forward : whenpurchasing long, the profitand loss potential isinfinite.

Spot

P&L

Futureprice

Short forward : when sellingshort, the profit and losspotential is limited to amountsbefore the price falls belowspot.

Spot

P&L

Future

rice


51/60


2008; Reval. 51

Month Scenario 1:Prices

Increase

Scenario 1:Profit/Loss

Scenario2: PricesDecrease

Scenario 2:Profit/Loss

April $122 (120-122) * (10,000) =-20,000

$118 (120-118) *(10,000) = 20,000

May $126 (125-126) * (10,000) =-10,000

$124 (125-124) *(10,000) = 10,000

Total Loss of 30,000 Total Profit of30,000

8.2. Similarities and Differences of Futures and Forwards

The following table shows similarities and differences of futures andforwards.

Characteristic Futures Forwards

Definition Seller is obligated to deliver specificamount of specific item at aspecified future date

Same

Settlement Cash or physical settlement Same

ContractType Standard contracts Customcontracts

Where traded Exchange Over-the-counter

Delivery date Typically closed out before contractmatures by making an off-settingdeal

End of contract

Reason fortransaction

Offset risk (hedge with an equal andopposite trade) or speculate onchange in price of item (offset

losses).

Buy or sellitem, physicalor financial

Valuation Marked-to-market daily; participantsadjust positions regularly to keep thevalue constant

At the end ofthe contract

Counterparty Dont know Known


52/60


2008; Reval. 52

8.3. What are Commodity Swaps?

Swaps in the commodities market have the same definition as in theinterest-rate markets and are a generalization of forward contracts.

Interest payments are paid generally monthly, quarterly, semi-annuallyor annually. Interest payments equal a defined quantity multiplied by thecurrent price (either fixed or floating based on an index). Commodityswaps allow purchasers to lock in the price of the commodity.

For example, a one-year commodity swap paying quarterly paymentswould look like:

On the set interest dates, the buyer of the swap will pay the fixed pricemultiplied by the quantity and the seller will pay the floating price (basedoff an index) multiplied by the quantity. In our example above, thepayments occur quarterly from the date of inception to the maturity dateof the swap.

==== ====

====FixedN

0t

FloatingN

0tfactor)(discount(Quantity)(Price)-factor)(discount(Quantity)(Price)swapof Value

t= 0 Payment 1 Payment 2 Payment 3 Final payment(t+1year)

3 months 3 months 3 months 3 months

Buyer Seller

Fixed price payments

Floating price payments

The value of the swap is the difference between the sums of each legs paymentspresent value:


53/60


2008; Reval. 53

Scenario:

Mobility Gas Company enters into a commodity fixed-floating swap withGogo Gas Company. Mobility will pay a fixed price of $11.30 perMMBTU (USD) and Gogo will pay a floating price based off of the

NYMEX. The quantity is 100,000 MMBTU of natural gas each month.The deal will commence on January 1 st and end on June 30 th.Payments will be exchanged quarterly for cash settlement. Assume adiscount factor of 1 and that the NYMEX has the following prices on therespective dates:

March 31 st : $11.35 June 30 th: $11.25

What is the value of the commodity swap?

1. What information is given? We know:

Fixed price: $11.30 Floating prices: $11.35 and $11.25 Payments: calculated and paid every 3 months Quantity: 100,000 MMBTU/month (300,000/period) Discount Factor: 1

2. What are the values of the cash flows?

Date Fixed Calculation FixedPayment

Floating Calculation FloatingPayment

March 31 300,000 * 11.30 * 1 -3,390,000 300,000 * 11.35 * 1 3,405,000

June 30 300,000 * 11.30 * 1 -3,390,000 300,000 * 11.25 * 1 3,375,000

Total -6,780,000 6,780,000

3. What is the difference between the leg totals?

Zero. Therefore, this is a break-even swap and it is a good hedgeto pay fixed rate instead of a floating one.


54/60


2008; Reval. 54

C OMMODITIES R EVIEW

1. Today is January 1 st of the current year and natural gas prices are$12.05 per MMBTU. Gogo Gas Company is concerned thatprices are going to increase. Gogo enters into an agreement topurchase 100,000 MMBTU per month for the second quarter ofthe current year at $12.05 flat for all three months. What is thevalue of this transaction assuming the discount factor is 1 and theprices for the months are actually:

April: $11.75 May: $12.25 June: $12.15

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________ ________________________________________________

________________________________________________

2. Mobility Gas Company purchases a three-year swap, payingannually. The terms of the swap are:

Fixed price: $12.004 Floating prices: $12.15, $12.20, $11.65 Quantity: 100,000 MMBTU per month Discount Factor:

Year df1 .99752 .97503 .9525

What is the value of the swap?


55/60


2008; Reval. 55

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________

________________________________________________ ________________________________________________

________________________________________________

________________________________________________

________________________________________________ ________________________________________________

________________________________________________

________________________________________________

________________________________________________ ________________________________________________

________________________________________________

________________________________________________

________________________________________________


56/60


2008; Reval. 56

9. Investments

Trading Available for Sale

(AFS)

Held to Maturity

(HTM)AccountingMethod

MTM MTM Amortized costNo MTM

P&L Impact Earnings OCI None

FinancialStatement

Gains / LossesIncome Statement

Balance sheet Interest onBalance Sheet

A security available for Trading is one that is you can buy todayand sell tomorrow. The main reason for purchasing the securityis for arbitrage reasons, to buy and sell constantly. As a result,according to FAS 115, it is marked-to-market and the MTM isrequired to flow through as earnings to profit and loss. Hence,the security is included on the income statement (as equity). Forexample, you purchase a 10-year bond with the intent to sell itnext week and purchase a different security.

An Available for Sale (AFS) security is one which you buy toown without the intent to trade it. If the right price comes along,you will sell it. However, the initial reason for purchase was toown the security. It is marked-to-market at fair value. The profitor loss is recorded as Other Comprehensive Income (OCI), notearnings. Hence, it is included on the equity side of the balancesheet. For example, you purchase a 10-year bond to redeems in10 years but if the price increases, you will see your bond.

A Held to Maturity (HTM) security is one that you purchase withthe intent to hold it until its maturity. There is no impact on profitand loss. The amortized cost is included within the balance sheetand the only interest is recognized as earnings on the balancesheet. For example, you purchase a 30-year bond to redeem in30 years from today.


57/60


2008; Reval. 57

Transfers between Categories

Type ofTransfer

MeasurementBasis

Impact of Transfer onStockholders Equity

Impact of Transferon Net Income

Tradingto AFS

Transferred at fairvalue to AVScategory and is thenew cost basis of

security

Unrealized gains /losses at date oftransfer increase /decrease stockholders

equity

Unrealized gains /losses at date oftransfer arerecognized in

incomeAFS toTrading

Transferred at fairvalue at the date oftransfer andbecomes the newcost basis ofsecurity

Unrealized gains /losses at date oftransfer increase /decrease stockholdersequity

Unrealized gains /losses at date oftransfer arerecognized inincome

HTM toAVS

Transferred at fairvalue at the date oftransfer

Unrealized gains /losses at date oftransfer increase /decrease a separatecomponent of equity

None

AVS toHTM

Transferred at fairvalue at the date oftransfer

Unrealized gains /losses at date oftransfer is carried as aseparate component ofequity and is amortizedover the remaining lifeof the security

None


58/60


2008; Reval. 58

10. Glossary

Term Definition

Accrued interest Represents the amount of interest that hasaccumulated between the last payment and the sale ofthe fixed-income instrument.

Back office Responsible for the support functions of the financialservices company, including the trade confirmationand settlement, record keeping, accounting andcompliance/regulatory issues.

Base currency Local currency; does not change when the exchangerate changes.

Benchmark Standard or reference against which prices arecompared or calculated.

Cash management Includes: cash forecasting, control of cash receiptsand distributions, protecting assets from fraud or loss,investment of excess cash, and debt managementwhen needed.

Clean price Price of fixed-income instrument without accruedinterest included.

Commodity forward Agreement between two parties at day 0 to exchangea stated quantity of a commodity at a fixed future datefor an amount defined at day

Commodity futures Same general features as a forward but has astandard contract size and is transacted through anexchange. The clearing house of the exchange takesaway almost all of the credit risk.

Commodity swap Has the same definition as in the interest-rate marketsand are a generalization of forward contracts.

Credit risk Risk that a borrower will not pay money owed; lendersgenerally charge a higher rate for higher riskcustomers.

Cross currency swap Exchanges one currency for another. Interestpayments are exchanged throughout the life of theswap. They are not netted, as in interest rate swaps,because they are exchanged in two differentcurrencies. Also, the principal amounts areexchanged either at the swaps inception, maturity orboth. .


59/60


2008; Reval. 59

Currency risk Risk that arises from the change in price of onecurrency against another; when companies haveassets or business across borders, they may beexposed to currency risk. Currency risk may be

hedged by taking an off-setting position. Day count factor Determines the number of days between two interest

payments for investments such as swaps, bonds, etc.

Delivery risk Concerns the quality of the commodity delivered

Derivative Financial instrument whose value is derived fromchanges in the value of an underlying asset such as acommodity, debt instrument, interest rate or unit ofcurrency.

Direct quote The number of units of a local currency exchangeablefor one unit of foreign currency. Exchange ratesquoted with another currency, such as the Britishsterling, Australian dollar, euro, etc. as the basecurrency. For example, .0096 U.S. dollars perJapanese yen.

Dirty price Price of fixed-income instrument with accrued interestincluded.

Discount Rate Interest rate used to determine the present value offuture cash flows.

Exchange Central location or marketplace where trading occurs.

Fair value Also called Net Present Value; difference betweencash inflows and cash outflows at todays value.

Fixed price Price is set.

Floating price Price is variable.

Forward The exchange occurs at some specified date in thefuture, perhaps months into the future.

Forward points Interest rate differential between two currencies.

Front office Trading responsibility of a financial company.

FX swap Consists of a spot transaction and a simultaneousreverse forward transaction.

Hedging Mitigate exposure to unwanted risk, so if the negativeevent occurs the damage is minimized.

Index Used to reflect market prices of stocks, bonds,commodities, interest

1_FinancialPrincAndInstruments

Documents

Transcript of 1_FinancialPrincAndInstruments