aci dealing
DESCRIPTION
ACITRANSCRIPT
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ACI DEALING CERTIFICATE WORKSHOP
Facilitated by Andre Kurten
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The examination consists of a single paper of 2 hours duration divided into the following 9 topic baskets:Section 1 - Basic Interest Rate Calculations - 6 questions - 6 marksSection 2 - Cash Money Market - 6 questions - 6 marksSection 3 - Cash Money Market Calculations - 6 questions - 6 marksSection 4 - Foreign Exchange - 12 questions - 12 marksSection 5 - Foreign Exchange Calculations - 6 questions - 6 marksSection 6 - FRAs, Money Market Futures & Swaps - 12 questions - 12 marksSection 7 - Options - 6 questions – 6 marksSection 8 - Asset and Liability Management - 8 questions - 8 marksSection 9 - Principles of Risk - 8 questions - 8 marksSection 10 - The Model Code - 20 questions - 20 marksTotal maximum score 90 marksThe overall pass level is 60% (54 marks), assuming that the minimum score criteria for each of the topic baskets is met. There is a minimum score criteria of 60% for the Model Code section and 50% for each of the other topic baskets.(extract form the ACI website June 2013)You may use any financial (or scientific) calculator in the examination as long as it is not TEXT PROGRAMMABLE. Alternatively the Microsoft ‘on-screen’ calculator is available on the test screen. Our recommendation is the programmable HP17BII calculator as formulae for the exam can be programmed into this calculator saving valuable time when writing the exam.
Examination Procedure
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The Financial Markets
Where is the market?LocationPrimary and secondary market
Participants in the marketIntermediation disintermediation
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GOVERNMENT
FIRMS
HOUSEHOLDS
FINANCIAL INTER-
MEDIARIES
HOUSEHOLDS
FIRMS
GOVERNMENT
SURPLUS UNITS
DEFICIT UNITS
INTERMEDIATION
FUNDS
FUNDSFUNDS
INSTRUMENTS INSTRUMENTS
INSTRUMENTS
DISINTERMEDIATION
The Financial System
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Markets are where traders and brokers, are involvedTraders work for banks, stockbrokers, Central banksInter-dealer brokers act as agents facilitating trades
between market participantsMarket has evolved significantly in the last 30 yearsProducts traded include:
CurrenciesBondsMoney Market AssetsCommoditiesEquitiesDerivatives
The Market Development
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Formerly known as the Association Cambiste InternationaleEstablished in 1955 to bring together forex traders in major
centre'sIts offices are based in ParisOver 14,000 members in 79 countriesFour regions – the Americas, Asia Pacific, Europe, and Middle
East/AfricaMission Statement – “to be regarded within the business community, financial
services industry and by the authorities and media, as the leading association
representing the interests of the financial markets and to actively promote the
educational and professional interests of the financial markets and industry”
ACI has a council of PresidentsAACI has an executive committee
The ACI – Financial markets Association
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The ACI Model Code – updated in 2013It contains best practice for ethics and code of conduct as
well as best practice for dealing and operations in the OTC financial markets
It does not deal with legal matters or technicalitiesIt aims to set out the manner and spirit in which business is
conductedThe committee for Professionalism - CFP is an ACI body
that is willing to arbitrate disputes between market participants where all avenues have been exhausted to try and resolve the dispute between themselves.
The Role of the ACI
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Basic Interest Rate calculations
Section 1
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To understand the principles of the time value of money. To be able to calculate short-term interest rates and yields, including forward-forward rates, and to use these interest rates and yields to calculate payments and evaluate alternative short-term funding and investment opportunities. Candidates should know what information is plotted in a yield curve, the terminology describing the overall shape of and basic movements in a curve, and the classic theories which seek to explain changes in the shape of a curve. They should also know how to plot a forward curve and understand the relationship between a yield curve and forward curves.
One question basket 6 questions
Section Objectives
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Day Base ConventionsNOTE: Not all currencies calculate interest using the same day base convention.Domestic money markets use:
• ACT/365 or ACT/360• The 365 day base currencies referred to in the exam are
GBP,AUD, NZD, HKD, SGD. All other currencies given in the exam use a 360 day base convention.
• NOTE: Euroyen is the only exception which is ACT/365ACT refers to the actual number of days in the investment
period. You will always be given the days, but NOT the day base in the exam.
Since 1999 USD Treasury bonds, Euro Denominated Treasury bonds, GBP Treasury bonds all use ACT/ACT convention for accrued interest calculations.
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Benchmark RatesLondon Interbank Offered Rate – LIBOR is calculated by the
BBA (British Bankers Association) and is a mean (average) of all the rates collected from the 16 reference banks and published by 11h00 UK time (GMT). This rate applies to ALL currencies traded in London.
EURIBOR is the EUR Interbank Offered Rate calculated by the EBA (European Bankers Association) and is a mean of all the rates collected from the 57 reference banks (47 from European countries) and published by 11h00 Central European Time (CET).
NB: All these benchmarks are quoted to at least 2 decimal places, but not more than 5.
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Overnight Index Benchmarks NOTE: All these benchmarks are WEIGHTED AVERAGE
RATES unlike LIBOR and EURIBOR which are simple average rates
Sterling Overnight Index Average (SONIA) for GBP Euro overnight index average (EONIA) for EUR Fed Funds Effective rate for USD TOIS for CHF . This is a Tom/next rate not an overnight rate TONAR – Tokyo overnight average rate for Japanese Yen
These rates are used for fixing overnight index swaps OISs in each of the respective currencies.
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Rates format and basis points
Fractions Most rates in the exam will be expressed as a
fraction. Therefore they will quote a rate as 4.¼% which is 4.25%. To calculate the decimal divide the numerator by the denominator for example, ¾% is 3 divided by 4 which is 0.75%.Basis points 1 basis point is 0.01% or 0.0001 as a decimal.
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interest Principal Value Future
Simple Interest CalculationsInterest Earned, Future Value, Present Value, Yield or Holding period return
baseday days x rate1
Value Future luePresent va
100 x days actual baseday x principal initial interest Yield
baseday days x rate x principal earnedInterest
100 x countday
basisday x 1 -
inceptionat Amount
maturityat Amount Yield
or
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Exercises – Simple Interest1. Invest USD 5,000,000 at 2.50% for 273 days What interest
is due?
2. You invest GBP 1,000,000 at 3.50% for 180 days. What do you receive back (capital and interest) at maturity?
3. You invest EUR at 2.75% for 60 days and receive 1,025,000 back at maturity. What amount of EUR did you originally invest?
4. You received 75,000 in interest on EUR5,000,000 invested for 180 days. What yield did you receive on your investment?
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Bond and Money market basis
Given a 360 day rate (Bond basis) calculate the equivalent 365 day (Money Market Basis) rate
Given a 365 day (Money Market Basis) rate calculate the equivalent 360 day (Bond basis) rate
365 360 x Rate Basis Bond BasisMarket Money
360 365 x Rate BasisMarket Money Basis Bond
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Bond and MM basis - ExplainedA bond will pay a round amount of interest as its coupon. Therefore a $100,000 bond with an annual coupon of 5% will pay $5,000 in interest at the end of the year (irrespective of the number of days in the year). However, a $100,000 money market deposit at 5% for a year with actual days of 365 will pay interest calculated as follows:100,000 x 0.05 x 365 ÷ 360 = $5,069.44Therefore the a 5% interest rate would offer you a better return in the money market than the bond market because of the more favourable day base convention in the money market. The Money market equivalent of a 5% Bond rate will be LOWER than 5%.NB: The MM basis rate will always be LOWER than its BB Rate equivalent
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1 - 2
rate annual-semi 1 rate annual
2
4.704% or 0.04704 1 - 2
0.0465 1
2
Convert semi-annual to annual rate
Formula given in exam
Convert a semi-annual rate of 4.65% to an annual equivalent:
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2x 1 - rate annual1 rate annual Semi
4.65% or 0.046499 2 x 1 - 0.047041
Formula given in exam
Convert an annual rate of 4.704% to a semi- annual equivalent:
Convert annual to a semi-annual rate
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Rate
Maturity
Classic or Normal Yield CurveYield Curves
This yield curve is gently upward sloping. A positive yield curve is steeply upward sloping. The Liquidity preference theory is used to explain a classic yield curve. A positive yield curve would be explained by the interest rate expectations theory
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Rate
Maturity
Inverse or Negative Yield Curve
Yield Curves
The Interest rate expectations theory is used to explain an inverse yield curve.
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Humped Yield Curve
Rate
Maturity
Yield Curves
The Market segmentation theory is used to describe a humped yield curve.
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Rate
Maturity
Flat Yield Curve
Yield Curves
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Interpolation You may be required to do straight-line interpolation in the exam. This is finding a rate between two points given the rates around that point. The assumption is that it falls on a straight line between the two rates given. For example. Given the 3 month (90 day) rate of 3.50% and the 6 month (180 day) rate of 4.10% calculate the 4 month (120 day) rate. 4.10-3.50 = 0.60. this is the amount by which the rate increases on a straight line basis between 3 and 6 months. Divide 0.60 by 3 = 0.20. this is the rate increase per month. Add 0.20 to 3.50 = 3.70% which is the 4 month (120 day) rate.
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Push EXIT key until this menu appears
choose SOLVE and the menu below will appear
Choose NEW and the then start typing your equation using the alpha characters and the numerals and brackets
The equation must have an equal number of these brackets ( as those brackets) otherwise the equation will be rejected
Once you have completed typing the equation, push EXIT key until it asks you if you want to save the equation push YES and then CALC. If the formula is accepted, it will show you the formula menu. If it is unsuccessful, it will beep you and return to the formula for editing.
Menu steps – Program the HP 17 BII
FIN BUS SUM TIME SOLVE CURRX
DELET NEWEDITCALC
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HP17BII Programmable calculatorGo to the solve function and follow the prompts to type in these formulaeForward forward pricing for FRAsFRA=((1+(LRxLD÷DB÷100))÷(1+(SRxSD÷DB÷100))-1)x(DB÷(LD-SD)x100)Settlement amount of FRAFRASET=(DAYSx(LIB-FRA)xAMT÷DB÷100) ÷(1+(LIB÷100xDAYS÷DB))Secondary market price for CDsCD=FVx(1+(ID÷DBxCR÷100)) ÷((1+(RD÷DBxMR÷100))Forward Points for forward FXPIPS=(SPTx((1+(QCxDY÷100÷DBQ))÷(1+(BCxDY÷100÷DBB)))-SPTSimple interest Present value formulaPV=FV÷(1+(IRxDAYS÷DB÷100))Discount to yieldYLD=DR÷(1-(DR÷100xDAYS÷DB))Effective rateEFF=((1+(R1÷100xD1÷DB))x (1+(R2÷100xD2÷DB))x(1+(R3÷100xD3÷DB))x (1+(R4÷100xD4÷DB))-1)x(DB÷(D1+D2+D3+D4)x100
Formula programming
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Forward forward pricing for FRAsFRA = forward forward rate LR = long rate LD = long days SR= short rate SD= short days DB = day basisSettlement amount of FRAFRASET= FRA settlement amount DAYS = days in the forward period LIB = LIBOR (or equivalent FRA= FRA rate AMT= notional DB = day basisSecondary market price for CDsCD = Secondary market proceeds FV = face value ID = initial days DB = day basis CR = coupon rate RD= remaining days MR= market yieldForward Points for forward FXPIPS= Forward points SPT = Spot QC= quoted currency interest rate DY = days DBQ= day basis for quoted currency BC= base currency interest rate DBB= Day basis for base currencySimple interest Present value formulaPV= present value FV= future value IR= interest rate DAYS = days in period DB= day basisDiscount to yieldYLD= true yield DR= pure discount rate DAYS= days DB= day basisEffective rateEFF= annual effective rate R1 = rate 1 D1 = days in period 1 DB= day basis R2, R3 etc same as for R1 and D1
Formula abbreviations
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Cash Money Market and Calculations
Section 2
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To understand the function of the money market, thedifferences and similarities between the major types of cash money market instrument and how they satisfy the requirements of different types of borrower and lender. To know how each type of instrument is quoted, the quotation, value date, maturity and payment conventions that apply and how to perform standard calculations using quoted prices. Given the greater inherent complexity of repo, a good working knowledge is required of its nature and mechanics.
Two question baskets 6 theory and 6 calculations
Section Objectives
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Interest-Bearing or YIELD InstrumentsDeposits-call and termCertificates of Deposit (CDs)
Discount InstrumentsTreasury BillsBankers Acceptances – referred to as eligible bills
in the UK. (GBP denominated)Promissory NotesCommercial Paper
Not all these instruments are issued by banks, and all are unsecured. However Treasury Bills are seen as risk free as they are issued by Governments
Money Market Instruments
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Deposits made between banks and financial institutions
Why do banks deal with each other in the Interbank market?
How do we distinguish between a domestic currency and a euro currency?
Interbank Deposits
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Maturities in the Money MarketTrading days must be working days in the centre
where the funds are clearedPeriods of trading deposits:
Up to 4 weeks are classified as “short dates”from 1 month to 1 year is classified as “fixed dates”Over 1 year in medium term
Domestic deposits trade out of today or tomorrow, whereas euro deposits usually trade out of spot.
Month end deposits will mature on the last dealing date of the month and this is known as the end-end convention.
Turn of the month is a deal done out of the last working day of the month maturing on the first working day of the next month.
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Quotation of prices
Prices in the money market are ALWAYS quoted as percentages per annum, either in decimals or fractions
Two sides to every price BID and OFFERDifference between bid and offer is known as the
SPREAD.Most centers use Bid/Offer for cash.NB: London market uses Offer/Bid for cash in other words Bid/offer for assets.
5.25/5.15Bid for assetsOffer for cash
Offer for assetsBid for cash
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Dealing on prices
Whenever you are quoted an interest rate or price by the market, you will ALWAYS borrow (buy) at the higher price and lend (sell) at the lower price.
When YOU are quoting a price to a customer they will always borrow (buy) from you at the higher price and lend (sell) to you at the lower price.
If the market quote for USD deposits is 5.25/15 then you would borrow at 5.25 and lend at 5.15.
This principle is VERY IMPORTANT as many questions will test your ability to identify the side on which you are dealing as part of the question.
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Discount InstrumentsIssued at a discount to Face valueHas no coupon rateFace value repaid at maturity dateFixed maturity dateTo compare the return on discount instruments with interest bearing instruments, you need to convert the discount to a yield
Bankers acceptances (eligible Bills are often referred to as “two name paper”)
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Discount Instrument Calculations
To calculate the discount or purchase price of a discount instrument you need:The face valueThe discount rateThe days to maturityThe day count convention i.e. 365 or 360
The purchase price is the face value minus discount
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Discount Paper ACI Formulas
To calculate the discount
basisday
days x ratediscount x valueface discount ofamount
basisday
days x ratediscount - 1 x Value Face
proceedsmarket secondary
To calculate consideration or purchase price
NB: To calculate the purchase price of the DISCOUNT instrument you can simply deduct the discount amount from the face value
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Converting a Discount rate to a Yield
basisday days
x ratediscount - 1
ratediscount yield true
Converting a Yield to a Discount Rate (not required for the exam)
basisday days
x yield 1
Yield ratediscount
or 100 x days actualion x considerat
basisday amount x discount
or 100 x days actual x valueface
basisday amount x discount
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Treasury Bill Exercise
A USD Treasury bill with a face value of 100 is issued at a discount rate of 9.25% p.a. for 90 days
Calculate the discount amountCalculate the purchase pricecalculate the equivalent yield
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Certificate issued in bearer form mostly
immobilized and held by custodiansHas a fixed maturity - usually up to Five years,
but liquid up to one yearHas a fixed interest rate - the Coupon rateInterest paid at maturityTradable - secondary marketUnsecured like normal depositsOnly issued by banks
Certificates Of Deposit
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Trading CDs 1
Issued at face value (denominated in millions)Traded in Secondary Market at current market rates
To calculate secondary market price you need:Face value or Par value of CDCoupon or issue rateYield (Current rate at which CD is traded)Days from issue to maturityDays from settlement to maturity
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Trading CDs – ACI formulas
basisday
maturity
toissue from days
x ratecoupon 1 x valueface
PROCEEDS MATURITY
basisday maturity left to days
x yield 1
proceedsmaturity
PROCEEDS MARKET SECONDARY
days
BasisDay x 1 -
price purchase
proceeds sale
RETURN PERIODHOLDING
NB: This Formula not given in exam
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CD Exercise Give the following information:Face Value = $1mIssue Rate = 6.50% p.a. Full tenure = 180 daysRemaining tenure = 60 daysYield = 6.00%Date convention = ACT/3601. Calculate the maturity proceeds of the CD2. Calculate the consideration of the CD in the
secondary market3. Calculate the holding period return for the
investor
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Solution to CD exercise
500 032, $1, =
360
180 x
100
6,50 + 1 x 000,00 000 $1
VALUE MATURITY
231,022,277. 1.01
1,032,500
360
60 x
100
6.00 1
1,032,500
PROCEEDS MARKET SECONDARY
6.68%
100 x 120 360 x 0.022277
100 x 120
360 x 1 -
001,000,000.
231,022,277.
RETURN PERIODHOLDING
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Calculating the profit/loss on CDWhen calculating the profit or loss on a CD, you need to
consider the difference between the original purchase price plus the accrued interest to date of disposal against the consideration received at sale.
In our example accrued interest is:1,000,000 x 0.065 x 120 ÷ 360 = 21,666.67The “dirty price” received at sale was 1,022,277.23Subtract the accrued interest from the dirty price:1022,277.23 – 21,666.67 = 1,000,610.56 clean priceSubtract the original purchase price from the clean price: 1,000,610.56 – 1,000,000 = $610.56 profit.This makes sense because the HPR is HIGHER than the original yield expected.
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Yield to DiscountSome discount instruments are quoted as a yield to
maturity, but are discount instruments. The purchase price is calculated in the same way as CD
consideration by using the present value calculation. Here we use the face value as the maturity value.
Euro currency commercial paper ECP and GBP (Sterling) Treasury Bills are traded on a true yield rather than a straight discount.
Please note that GBP Treasury Bills are issued for 91,182,or a maximum of 364 days.
US domestic commercial paper – USCP trades on a straight discount and cannot be issued for more than 270 days.
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Yield to discount Exercise
A 91 day Sterling Treasury Bill with a face value of GBP 10m is quoted at a yield of 6.75% p.a.
calculate the purchase price (secondary market proceeds)
calculate the discount rate on the bill
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.53$9,834,497
91/365) x (0.0675 1m 10
Days/365) x (Yield 1
Value Face Price Purchase
Exercise 4 - Solution
100 x
6.638%
36591
x 0.0675 1
0.0675 RateDiscount
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The Repo Market - 1
Repo is short for repurchase agreementOne party lends securities (usually Government
bonds) in return for borrowing fundsThe lender of money has a SECURED deposit,
which usually attracts a lower interest rate than normal money market deposits
The two main transaction types are:All in or Classic Repo – one transaction two legs.
This can be a fixed dated or done on a call basis referred to as open-ended.
Sell/Buy Back – two separate deals one spot and one forward. This CANNOT be open-ended.
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The Repo Market - 2 The repo can either be “special” where a specific bond is
required or General collateral - “GC” where any acceptable bond can be given as collateral. GC repo rates are usually higher than “special” repo rates.
The lender of bonds (repo) bears the MARKET RISK on the bond during the life of the repo.
The lender of cash (reverse repo) bears the CREDIT RISK during the repo.
Under a classic repo there can be substitution (GC not special) of bonds, haircut and margining during the repo, whereas under a sell/buy back, substitution and margining is unusual by can be done by cancelling the buy back leg and entering a new transaction with the new details.
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Reposeller
Repobuyer
At inception - settlement datebond
Cash
Reposeller
Repobuyer
At Maturity Cash plus repo interest
Bond
The Repo structure
The party providing collateral at inception is known as the repo or the repo seller and the party providing cash is known as the reverse repo or repo buyer.
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The All in or classic Repo - 1 One party sell bonds (the repo) to another (the reverse
repo) while simultaneously agreeing to repurchase them on a future date at a specified price.
If you do the repo (lend bonds), you BORROW cash on the offer side of the market quote
If you do the reverse (borrow bonds), you LEND cash at the bid.
The sale and repurchase price are the same except for the repo interest which is simply added to obtain the amount of money due on expiry. This is why a classic repo is considered to be ONE transaction with two legs.
Any coupons paid during the life of the repo which is paid to the buyer by the issuer, must be paid back to the seller immediately.
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The All in or classic Repo - 2 The collateral is exchanged for cash at an agreed rate of
interest for a fixed period or it can be open endedAn initial margin may be charged by the LENDER of cash.
The lender of cash may take collateral which exceeds the value of the amount of cash loaned. This is referred to as the “haircut”.
Margin calls during the life of the repo ensure the cash lender that the value of the security never falls below the current value of cash advanced. The current value is calculated as the cash lent plus the interest earned to date.
Margin calls can be provided either in the form of additional security or the cash equivalent by the repo seller.
BOTH the REPO and the REVERSE REPO are subject to margin calls during the life of the repo.
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The All in or classic Repo - 3 Factors influencing the size of the margin are:
The longer the term of the repo the greater the chance of default
The longer the collateral has to maturity, the greater the change in the collateral value because of a change in interest rates.
The creditworthiness of the counterparty providing collateral The liquidity of the collateralThe legal agreement (or lack thereof) covering the
transaction. “Flat basis” is a repo done with no margin.
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Delivery under a classic repo Delivery of security needs to be considered. The
collateral (bonds) can be held in custody by the repo seller. The danger under this arrangement is that the collateral may be used twice to raise cash. This is known as “double dipping”.
A tri-party repo is one where both counterparts use the same custodian. Segregated accounts will be opened by the custodian for the express purpose of the repo transaction. This kind of repo allows comfort to the buyer as no double dipping can occur and is subject to a legally binding agreement signed by all three parties.
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Sell/Buy Back Two separate bond market transactions; a sale (purchase) in
the spot market and a purchase (sale) in the forward marketRepo rate not explicit, but is implied in the forward priceThe right to any coupon during the life of the repo accrue to
the BUYER of the securities. It will be refunded to the SELLER in the buyback price.
Because full title passes in the spot leg from SELLER to BUYER, ISMA documentation does not apply (although most counterparties will have ISMA/GMRA agreements in place with each other)
Margining is unusual with these repos and is usually done by repricing the repo
Sell/buy backs CANNOT be open ended
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Calculating the “haircut”Fixed bond amount – calculate the start money• Bonds market value (dirty price) divided by (100 plus the
haircut)Example-Dirty price 995,000-Haircut 2%995000/102% = $975,490.20 cash against bond value at start of repo
Fixed cash amount – calculate the bond value at start • Cash amount x (100 plus the haircut) Example-Cash $1m-Haircut 2% 1,000,000 x 102% = 1,020,000 bond value at start of repo
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Dealing the repo rate 1. when doing the REPO (lending or selling bonds), you are borrowing
cash, so you would deal on the OFFER side of the repo rate2. when doing the REVERSE REPO (borrowing or buying bonds), you are
lending cash, so you would deal on the BID side of the repo rate3. The repo done Tom/Next or overnight is 1 day. One week and spot/week
are 7 days and two weeks is 14 days.You need to answer 5 questions when facing a Repo calculation question:4. Am I doing the repo or reverse repo?5. How long is the repo term?6. What is the repo rate and am I borrowing or lending cash?7. What is the collateral worth? 8. Is there a haircut?
Repo rate 1.75/80
When doing the reverse Repo you deal at the bid
When doing the Repo you deal at the offer
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Classic Repo Example FLAT BASIS REPOA bank wishes to place out USD50 million Eurodollar bonds (doing the repo). The bond has a coupon of 5,50% and mature on 12/04/2015. The repo rate is 6.50/6.60 for 7 days. The bond collateral value is $51,633,700. By doing the repo, you are going to borrow funds at 6.60%Determine repo interest and final consideration$51,633,700 x 0.066 x 7/360 = 66,263.25 repo interest (MM convention) 51,633,700 + 66,263.25 = $51,699,963.25 final cash (Buy back price)
REPO WITH HAIRCUT (using the same details as above)If there was a 2% haircut on the repo, then the start money would be different. 51,633,700/102% = $50,621,274.50 is the start money
Determine the repo interest and final consideration$50,621,274.50 x 0.066 x 7/360 = 64,963.97 repo interest $50,621,274.50 + 64,963.97 = $50,686,238.47 final cash (buy back price)
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Foreign Exchange
Section 4
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To understand and be able to apply spot exchange rate quotations. To understand basic spot FX dealing terminology and the role ofspecialist types of intermediary. To recognise the principal risks in spot and forward FX transactions. To calculate and apply forward FX rates, and understand how forward rates are quoted. To understand the relationship between forward rates and interest rates. To understand time options. To be able to describe the mechanics of outright forwards, FX swaps and forward-forward FX swaps, explainthe use of outright forwards in taking currency risk and explain the use of FX swaps in rolling spot positions, hedging outright forwards, creating synthetic foreign currency assets and liabilities, and in covered interest arbitrage. To display a good working knowledge and understanding of the rationale for NDFs. To be able to recognise and use quotes for precious metals, and demonstrate a basicunderstanding of the structure and operation of the international market in precious metals.
Two question baskets 12 theory and 6 calculations
Section Objectives
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Forex JargonValue date - the date when delivery takes place on a currency
dealSpot date - two business days after deal dateBid- the rate at which the price maker is willing to buy the
BASE CurrencyOffer - the rate at which the price maker is willing to sell the
BASE CurrencySpread - the price makers margin between the bid and offer
priceDirect quote - 1 unit of USD in relation to quoted currency e.g.
USD/JPY = 114.25/75Indirect quote- 1 unit of currency other than the USD in
relation to USD e.g. EUR/USD 1.3925/45. NOTE: The currencies quoted indirectly against the USD are the EUR,GBP, AUD, NZD. All others are quoted directly.
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Forex JargonReciprocal quote- if USD/HKD = 7.2500 then the reciprocal
rate is 1/7.25 = HKD/USD 0.1379Forward exchange rate - the rate agreed today for the
exchange of one currency for another at some date in the future other than spot
Swap - a purchase for value one date with a simultaneous sale for a different value date
(Sale With A Purchase) Outright - the purchase or sale of forex for a future value
date Overnight O/N - rolling out a position from today into
tomorrowtom/next T/N - rolling out a position from tomorrow into the
spot dateSpot Next S/N - rolling out of spot into the next day
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Dealing in Spot FX MarketsConsider how you would deal in your own currency
against the USD or other major currenciesAlways look at what you are doing in the base currencyIf you have a QUOTED currency amount, you will
DIVIDE by the exchange rate to get the BASE currency amount
If you have a BASE currency amount, you will MULTIPLY by the exchange rate to get the QUOTED currency amount
NOTE: As a market user receiving several quotes: You buy the base currency at the LOWEST offerYou sell the base currency at the HIGHEST bid
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Cross ratesAn exchange rate which is derived from two other
quoted exchange rates is called a cross rate. (The stronger currency usually becomes the base currency in a cross quote)
EXAMPLE: Deriving a cross rates by using two dollar based or direct quotes.Given the following calculate the CHF/HKD
exchange rate:1USD = HKD 7.2500
1USD = CHF 1.5000
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We can deduce mathematically therefore thatCHF 1.5000 = HKD 7.2500
To find out how many HKD = 1CHF we need to divide both sides by 1.5000 (to arrive at 1CHF on the left-hand side)
1.5000/1.5000 = 7.2500/1.5000 1CHF = HKD4.8333
or CHF/HKD= 4.8333There are some simple rules which help!!!
Cross rates
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TWO DIRECT (OR INDIRECT) QUOTES “Cross and divide” (divide high number by low number). For example to determine the CHF/HKD given
USD/HKD= 7.2515/7.2545
USD/CHF = 1.5030/1.5050BID = 7.2515/1.5050 = 4.8183OFFER = 7.2545/1.5030 = 4.8267CHF/HKD =4.8183/4.8267 (spread is 84 points)
Rules for cross rates
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A DIRECT AND INDIRECT QUOTE (different base currency)“Straight down and Multiply”For example to determine the GBP/HKD given
USD/HKD= 7.2515/7.2545
GBP/USD = 1.4030/1.4050BID = 7.2515x1.4030 = 10.1739OFFER = 7.2545x1.4050 = 10.1926GBP/HKD=10.1739/10.1926 (spread is 187 points)
Rules for cross rates
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Cross Rate Exercise1. Given the following calculate the GBP/HKD exchange rate:
USD/HKD 7.7550/75GBP/USD 1.8325/35
2. Given the following calculate the HKD/JPY exchange rate:
USD/HKD 7.7550/75USD/JPY 114.25/30
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Forward foreign exchangeForward foreign exchange is used to hedge against
adverse currency movementsForward exchange rates can be quoted for any
currency pair.Both spot and forward exchange rates are
influenced greatly by current expectations of future events
Arbitrage will occur where quoted forward points move too far away from the implied fair value forward points
Interest rate parity theorem – The forward points are equal to the difference between the interest rates of the two currencies for the period of an investment.
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AN EXAMPLE (positive Points) Assume that the exchange rate (SPOT) between USD and CHF is 1.25 (USD 1 = CHF 1.25). Let us also assume that the interest rate for one year in USD is 3%, and the interest rate for CHF for one year is 5%
USD 1 CHF 1.25
CHF 1.3125
3% 5%
USD1.03
1 YR
Using the information given:The USD/CHF one year forward rate is:1.3125 ÷1.03 = 1.2743The forward points are: 1.2743 - 1.25 = 0.0243
OR 243 Points
Forward foreign exchange
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Spot -
BCDB
days x BCIR 1
TCDB
days x TCIR 1
x Spot Points Forward
Where:TCIR = terms currency interest rateBCIR = base currency interest rateTCDB = terms currency day baseDCDB = base currency day base
Forward FX formula
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points 246 or 0.0246
1.2500 - 1.2746
1.2500 - 1.030417
1.050694 x 1.25
1.2500 -
360365 x 0.03
1
360365 x 0.05
1 x 1.2500 Points Forward
Forward FX formula example
Using the info from the previous example:
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AN EXAMPLE (Negative Points) Let’s assume that the exchange rate (SPOT) between USD and CHF is 1.2500 (USD 1 = CHF 1.25). Let us also assume that the interest rate for one year in USD is 5%, and the interest rate for CHF for one year is 1%.
Forward foreign exchange
USD 1 CHF 1.25
CHF 1.2625
5% 1%
USD1.05
1 YR
Using the information given:The USD/CHF one year forward rate is:1.2625 ÷1.05 = 1.2024The forward points are: 1.2024 - 1.2500 = - 0.0476
OR negative 476 Points
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Forward FX – Positive points
NOTE: The higher interest rate currency will be at a
forward discount to the lower interest rate currency. Where the base currency interest rates are lower than
the variable currency, then the variable currency is
trading at a discount to the base currency in the forward
market. The points will then be POSITIVE.
Positive points benefit the seller of the base currency on
the forward dates and points would be described as “in
your favour”.
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Forward FX- negative points NOTE: The lower interest rate currency will be at a
forward premium to the higher interest rate currency. Where the base currency interest rates are higher than
the variable currency, then the variable currency is
trading at a premium to the base currency in the forward
market. The points will then be NEGATIVE.Negative points can be identified when the bid is
HIGHER than the offer in the price quoted. This is a
common question type in the exam, so check the points
before you do the calculation.Negative points benefit the buyer of the base currency
on the forward date.
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How do we know if points areNegative or positive?
Base currencyInterest rates
Points Positive
Quoted currencyInterest rates
Points Negative
Base currency Interest rates
Quoted currency interest rates
The gap represents the
points i.e. the interest rate differential
The currency with the higher interest rate in the quoted pair is at a forward discount to the other currency irrespective of whether it is the base currency or not. It is cheaper to buy the discount currency in the forward market.
The gap represents the
points i.e. the interest rate differential
Are higher than
Are higher than
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Change in forward points
The forward points will change because of two factors:A change in the spot – but this will not change the points significantly unless the move is big.A change in the interest rates of the two currencies – This will have a much more significant effect on the forward points.Question: how will the points change when:1. USD I/rates are higher than EUR I/rates and EUR rates fall?2.USD I/rates are higher than JPY I/rates and USD rates fall?3. GBP I/rates are higher than USD I/Rates and USD rates fall?
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Calculating forward points given the spot and outright: Bid Offer
3 month Outright = 179.07 179.42 minus
Spot GBP/JPY = 181.31 181.62
Forward points = -2.24 -2.20OR
224 220Points are NEGATIVE (bid higher than offer). GBP interest rates are therefore higher than JPY interest rates. JPY Premium and GBP discount.
Forward foreign exchange
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This is a transaction with one leg for a forward date other than spot. These transactions are usually referred to as Forward Exchange Contracts - FECs
For example, a exporter in the South Africa has USD receivables in 3 months and wishes to secure a rate today for delivery in 3 months time. The bank quotes 3-month bid at 2000 pips and the spot is 9.0000. The customer will receive 9.2000 for his USD in 3 months time irrespective of the prevailing spot. The bank in turn will use the FX swap market and the spot market to hedge the customer deal. In this example, the bank will buy and sell 3 – months and sell USD/ZAR spot.
Outright Forward Exchange
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Banks offer outright foreign exchange contracts to their customers on the following basis:
1. Fixed dated – This is the most common form of FX outright forward contract. This is a contact where the customer can only take up the contract on the expiry date. The customer can however shorten or extend this contract through the use of a FX swap at their own cost.
2. Time options – this is an FX outright contract where the customer has flexibility on the drawdown date of the contract. Time options can be offered in two ways:
a. Partly optional – This is a contract which can be drawn down only after a certain time has elapsed but must be taken up by the expiry date.
b. Fully optional – this is a contract that can be taken up at anytime from inception but must be taken up at expiry.
FX time Options
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If the contract is partly optional, the customer will sell the base currency to the bank at the bid side of the points for the start of the forward period which will be added to the bid of the spot. If they wish to buy the base currency, they pay the offer side of the points for the full term of the contract added to the offer of the points. If the contract is fully optional, the customer will sell the base currency to the bank at the bid side of the spot. If they wish to buy the base currency, they pay the offer side of the points for the full term of the contract added to the offer side of the spot.ExampleSpot USD/ZAR is 8.5075/85 1-mth points 200/2102-mth points 425/4353 mth points 550/570 a. A 3-month partly optional contract where the contract can be taken up after 1 month would be quoted as USD/ZAR 8.5275/8.5655 ( bid: 8.5075+0.0200 offer: 8.5085+0.0570). b. A 3-month fully optional contract where the contract can be taken up at anytime in the 3 months would be quoted as USD/ZAR 8.5075/8.5655 ( bid: 8.5075 offer: 8.5085+0.0570).
FX time Options - Pricing
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This transaction involves TWO legs namely A spot leg AND a forward leg.
Assuming the dealer wants to buy USD against the CHF 3 months, he will then “sell and buy”. This means he will sell USD/CHF in the spot market and buy the 3 months USD/CHF with the same counterparty simultaneously. Deals are usually interbank.
The spot price is agreed immediately between the buyer and seller when the deal is done and the points are added to the spot. (if the points are negative, then the forward rate will be LOWER than the spot). The spot agreed is usually the mid rate of the current bid/offer.
Forward exchange swaps
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Cross forward fx - An ExampleUSD/NOK spot is 7.8350/60USD/NOK 3 mth Fwd pts 340/380
GBP/USD spot is 1.5400/05GBP/USD 3 mth Fwd pts 70/65Step1- calculate 3 mth fwd for each currency pair3 month USD/NOK outright 7.8350 7.8360+0.0340 +0.0380 7.8690 7.87403 month GBP/USD outright 1.5400 1.5405-0.0070 -0.0065 1.5330 1.5340
Step 2 – calculate the cross GBP/NOK 3 mth outright(Direct and indirect quote use straight down and multiply rule stronger currency is the base) USD/NOK 7.8690 7.8740
GBP/USD 1.5330 1.5340
GBP/NOK 12.0632 12.07873mth outright
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Forward Forward swaps This is a Fx Swap starting at a future date other than spot. For example, a dealer wants to do a FX Swap for 3 months starting in 3 months time. This is described as a 3x6 swap. RULE: Take the far bid and subtract the near offer to get the fwd–fwd bid and take the far offer and subtract the near bid to get the fwd – fwd offer. An example A dealer wants to buy the 3’s and sell the 6’s USD/CHF 3 mth Fwd pts 80/85USD/CHF 6 mth Fwd pts 140/145Spot is 1.7500He buys 3 months at 1.7500 + 0.0085 = 1.7585And sells 6 months at 1.7500 + 0.0140 = 1.7640He has sold the 3x6 at 55 points. The 3 x 6 bid/offer is 55/65. (use the rule to check)
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A Typical Bank Forward Points Quote Page
EUR/USD FORWARDS
PeriodBid OfferO/N 2 3T/N 3.5 4S/N 1.5 21WK 10 111MTH 40 432MTH 80 853MTH 115 1186MTH 220 2309MTH 310 3201YR 405 410
NOTE: Always assume 4 decimal places after the “big figure” when using forward points. (except for JPY where 2 decimal places apply) The 11 points in the 1 week will be written as 0.0011. Where a comma appears in the quote then any figures after the comma are extra decimal places. The 1.5 points in the S/N is then written as 0.00015Where point are shown as PAR it means they are zero.
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NDFs are currency contracts for difference –CFDs. Like FRAs are to interest rates, so NDFs are to foreign exchange rates.
They are traded in countries where there is no formal forward exchange market or an illiquid forward market. They can be used for hedging and speculation.
They are like forward outright FX deals where a future rate of exchange is agreed between the parties but only the DIFFERENCE between the exchange rate fixing at expiry and the NDF contract rate is settled in foreign currency.
If at fixing the prevailing exchange rate is higher that the NDF rate, then the seller pays the buyer the difference. If the prevailing exchange rate is lower, then the buyer pays the seller.
There is never an obligation to take or make delivery of the notional contract amount.
NDFs - Non-Deliverable Forwards
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3-month NDF in USD/CNY at 6.2500.Notional principal USD 10 million2 scenarios in 3 months time:1. USD/CNY fixes at 6.2600.
Difference of 100 pips on USD 10m is CNY100,000. Settlement occurs in USD so 100,000/6.2600 = USD 15,974.44 seller pays the buyer.
2. USD/CNY fixes at 6.2300. Difference of 200 pips on USD 10m is CNY200,000. Settlement occurs in USD so 100,000/6.2300 = USD 32,102.73 Buyer pays the seller.If this contract was used to hedge, the hedgers effective exchange rate will be the NDF rate provided they can procure the additional USD at the fixing rate in the spot market
NDF Example
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Value tomorrow theoretical price convention“switch the points-change the sign-add to spot”For example:The spot rate USD/HKD is 7.2500/7.2515The T/N points are 25/26 What is the theoretical bid/offer rate for tomorrow?
7.2500 7.2515 + +
-0.0026 -0.0025Tom price for USD/HKD = 7.2474/7.2490
Forward foreign exchange
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The precious metals marketISO codes for precious metalsGold – XAUPlatinum – XPTPalladium – XPDSilver – XAG
The four major gold coins traded are: Kruger Rand, American Eagle, British Sovereign all have a gold purity of 22 carats or 0.9167. The Canadian Maple leaf with a purity of 24 carats or 0.9999
The “LIBOR” Rate for gold is the GOFO rate. This is the lending rate for gold loans in the London market
LOCO account – is the equivalent of a Nostro account for gold.
There may be questions on the above points in the foreign exchange section in the exam. Read the section in the study guide for more detail.
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Forward Interest Rates, FRAs, Futures,
and Swaps
Section 4
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To understand the mechanics of and how to use money market interest rate derivatives to hedge interest rate risk.
One question basket 12 questions
Section Objectives
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HedgingDirect hedges e.g. Forward coverIndirect hedges e.g. Currency hedges for motor
manufacturers Speculation
Gearing or leverage (the main cause of large derivative losses)
Big market movesSimulation
Creating a synthetic portfolioArbitrage
To take advantage of mispricing between markets
Derivatives Why Use Them?
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Forward forward interest rates are prices which pertain today to deposit periods commencing in the future
Forward forward rates
What is the rate for this period?
Lend for six months
Short funds for 3 monthsBorrow funds for 3 months0 3 6
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The forward forward pricing Formula
SD-LD
DB X 1 -
SR X SD/DB 1LR X LD/DB 1
FR
WhereFR = forward rateLR = long rateSR = short rateSD = short daysDB = day baseLD = long days
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Calculate the fair value for a USD 3-month LIBOR Interest rate starting in 3 months time (a 3x6) given the following information:
· 6-month LIBOR rate (LR) = 4% (0.04)· 3-month LIBOR rate (SR) = 3.50% (0.035)· SD =90 days· LD =180 days· DB = 360
3-Month LIBOR forward interest rate
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3-Month LIBOR forward interest rate
timemonths 3in ratemonth 3 afor p.a. 4.461%
100 x 90
360 x 1
00875.1
02.1
100 x 90180
360 x 1-
)360
90035.0 (1
)360
18004.0 (1
FR
x
x
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Lend 1m @ 4% for 180 days results in interest payable of $20,000 (1mx0.04x180/360)
Borrow 1m @ 3.5% for 90 days results in interest receivable of $8,750 (1mx0.035x90/360)
Difference in interest is $11,250 (20,000 – 8,750)
To calculate the fair value interest rate for the remaining 90 days, the rate calculated must utilize the capital plus interest after the first 90 days to achieve the amount repayable at the end of 180 days. Calculated as follows:
Checking the formula – An example
period forward 3x6day 90 the for p.a. 4.461%
100 x 90
360 x
1,008,750
11,250
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This is the rate at which the forward period borrowing or lending must be done to breakeven.
In other words: If I borrowed (long cash) for 3 months at 3.50% and lent
for 6 months (short cash) at 4.00%,Then,4.461% is the rate at which I must borrow cash for 3
months in 3 months time (3x6) to breakeven on my money market book.
This forward forward rate calculation is the methodology applied to identify the interest rates for mismatches in the money market books of a bank and is the basis for FRA pricing.
What does this forward rate mean?
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Forward Rate Agreements
DefinitionAn FRA is an agreement between two parties, a Buyer and a Seller that sets (fixes) the level of aninterest rate for a specific time in the future on a notional value. For example 3 months starting 6 months from now. In 6 months time the FRA rate will be compared to the 3 month market benchmark such as EURIBOR or LIBOR and the DIFFERENCE will be settled based on the notional principal. FRAs are therefore referred to as CFDs (contracts for difference).FRAs are the ideal short-term derivative to hedge
mismatches in the money market funding book of a bank.FRA prices are derived using the forward forward model.
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Contract amount:- The Notional Principal Amount e.g. R50m used in the settlement calculation
Contract currency:- The currency in which the contract amount is denominated
Contract rate:- The fixed interest rate agreed under the FRA agreement
Dealing (transaction) date:- The date on which the FRA deal is struck and the FRA rate is agreed
Fixing date:- The date when the reference rate is determined (could be different to the settlement date)
Settlement (value) date:- The date on which the notional borrowing or lending commences and the date on which settlement on the FRA is made
Maturity date:- The date on which the notional borrowing or lending matures
FRA - Terminology
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FRA - Terminology Forward period:- The number of days between the settlement and the
maturity date of the FRA
Reference rate:- The market-based interest rate used on the fixing date to determine the settlement amount payable/receivable e.g. 3 month LIBOR
Settlement amount:- The amount paid by one party to the other on the settlement date of the agreement, based on the difference between the contract rate and the reference rate, calculated on the notional amount of the FRA. Interest is usually paid in arrears, but the settlement on the FRA is paid at the start of the interest period (settlement date on the FRA). The settlement is therefore discounted or net present valued by using LIBOR fixing rate.
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NOTE: Fixing and settlement are on the SAME DAY in domestic FRA markets e.g. GBP FRAs in London fix and settle on the SAME DAY. Foreign currency FRAs settle T+2 e.g. USD FRAs in London fix TWO working days before settlement occurs.
FRA - Diagram
Contract period(FRA can be closed out)
Forward period(notional borrowing period)
Deal Date – when FRA rate is agreed
Fixing Date – when benchmark is determined
Settlement Date – when net payment is made
Maturity Date – nothing happens here!
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Buying or Selling an FRAThe Buyer of the FRAThe buyer of an FRA is a potential future borrower and exposed to
interest rates rising (short cash in the forward period)Buying the FRA is like borrowing money at a fixed rate for a future
period. The buyer will receive the difference between the FRA and the 3 month
LIBOR at fixing if the LIBOR rate is ABOVE the FRA rate, and pay if the LIBOR rate is BELOW the FRA rate.
The Seller of the FRAThe seller of an FRA is a potential future investor, and is exposed to
rates falling (long cash in the forward period)Selling the FRA is like lending money at a fixed rate for a future period.The seller will receive the difference between the FRA and the 3 month
LIBOR at fixing if the LIBOR rate is BELOW the FRA rate, and pay if the LIBOR rate is ABOVE the FRA rate.
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Buying an FRA to hedgeBorrower has a USD 50m floating rate loan priced at 3-month LIBOR. She thinks rates will rise in the next three months.Market rates today3-mth LIBOR 5.75%
3X6 FRA 6.00% Transactions todayBorrows at 5.75% FOR 90 daysBuys 3x6 FRA at 6.00%3 months time 2 scenarios 3-month LIBOR fixes at 6.25% or 5.75%Scenario 1Repays loan and borrows 50m at current LIBOR 6.25%LIBOR is above FRA rate so receives difference 0.25%Therefore effective cost of funding 6.00% for 3 monthsScenario 2Repays loan and borrows 50m at current LIBOR 5.75%LIBOR is below FRA rate so pays difference 0.25%Therefore effective cost of funding 6.00% for 3 monthsNOTE: IRRESPECTIVE of LIBOR rate borrowing cost is 6.00%
Borrows and buys FRA
t 3 6
Borrowing matures
Fixes FRA and borrows again
3x6 FRA period
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Selling an FRA to hedgeA large bank needs to lend USD 100m for 6 months in 6 months time linked to LIBOR. They think interest rates will fall in the next 6 months. They want to lock in the investment rate for that period today.FRA rate today
6X12 FRA 4.25% Transactions todaySells 6x12 FRA at 4.25%
6 months time 2 scenarios 6-month LIBOR fixes at 3.75% or 4.50%Scenario 1Invests 100m at current 6-month LIBOR 3.75%LIBOR is below FRA rate so they receive the difference 0.50%Effective return on investment is 4.25% for 6 months (3.75 + 0.50)Scenario 2Invests 100m at current 6-month LIBOR 4.50%LIBOR is above FRA rate so they pay the difference 0.25%Effective return on investment is 4.25% for 6 months (4.50 – 0.25)NOTE: IRRESPECTIVE of LIBOR rate their return is 4.25%
Sells FRA
t 6 12
Investment matures
Fixes FRA and invests cash
6x12 FRA period
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The agreement is a reciprocal compensation agreement between the two counterparts
If at settlement the reference rate > FRA rate,then
the Seller pays compensation to the Buyer
If at settlement the reference rate < FRA rate,then
the Buyer pays compensation to the Seller
Forward Rate Agreements - Summary
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Calculation of Settlement Amount
( iL - iF) x N xB
d
B
Settlement
Amount =
1 + iL x d
Where:iL = reference interest rate (LIBOR)iF = contract (FRA) rateN = notional principal amountd = actual number of days in the forward periodB = day count convention
(e.g. 360 for USD, 365 for GBP)
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Calculation of Settlement Amount
(0.0625 - 0.05375) x 90/360 x 50,000,000SettlementAmount =
1 + 0.0625 X 90/360
Example • FRA USD 50million (B or day base is 360)• FRA rate 5.375%• 3-month USD LIBOR Fixed at 6.25%• FRA period 90 days
= 109,375/1.015625 = 107,692.31 paid by FRA seller to buyer
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A future contract is a standardised contract between two parties to exchange a standard quantity of a specified underlying asset on a predetermined future date at a price agreed today, traded on an organised Exchange guaranteed by the exchangeThe price of a futures contract can be divided into three main elements:
· The spot price of the underlying asset· The financing cost which includes storage and insurance
cost for the underlying asset in certain cases· Cash flow generated by the underlying asset (if any)
Futures Contracts - A Definition
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Given the following calculate the future price of gold· The current gold price is $865 per ounce. · The 1-year financing cost is 5%p.a. and · The storage and insurance cost is $5 p.a.
The futures price= $865+($865 x 0.05)+$5 = $913.25
NOTE: this is the fair value or “no arbitrage” futures price (ignoring transaction cost). The 1-year gold futures contract may well trade above (contango) or below (backwardation) the spot price.
Pricing Futures - An Example
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Short Term Interest Rate Futures Price
The formula used for pricing short term interest rate is the forward-forward pricing formula. This method applies to FRA and STIR futures fair value interest rates.
However, unlike FRAs, STIR futures are quoted as a PRICE rather than an interest rate
The price is arrived at by deducting the interest rate from 100
For example, a rate of 3,75% will be 100 – 3.75 =96.25Futures prices can be quoted to 3 decimal places
96.255 which = 3.745%
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Interest Rate Futures Specifications3-month Euronext Eurodollar futures are quoted as price and
have a nominal value of $1,000,000. Minimum tick 0.5 or 0.25 for near contract on CME
3-month Euronext Eurosterling futures are quoted as price and have a nominal value of £500,000. Minimum Tick 0.5
3-month Euroyen futures are quoted as price and have a nominal value of ¥100,000,000 Minimum Tick 0.5
3-month Euronext EUR futures are quoted as price and have a nominal value of €1,000,000 Minimum Tick 0.5
3-month Euronext Euroswiss futures are quoted as price and have a nominal value of CHF 1,000,000 Minimum Tick 1
Contract months are known as IMM (International Monetary Market) months. March, June, September and December. The near month contract is the most liquid.
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Tick values3-month USD, CHF, and EUR futures have a full tick value of
25 of the contract currency. For every 1 point move in price (0.01%), the contract value will change by 25. (1m x 0.01% x 3 ÷ 12).
3-month GBP futures have a full tick value of £12.50. (£500,000 x 0.01% x 3 ÷ 12)
3-month JPY futures have a full tick value of ¥2500. (¥100m x 0.01% x 3 ÷ 12).
A tick is usually also used to described as the MINIMUM price movement allowed on a contract. It has become common however that contracts trade in half ticks or in the case of the Eurodollar contract on the CME in 1/4 ticks on the near contract. A half tick would be denoted in the price as 0.005 and quarter ticks by 0.0025. for example or 95.4275 would indicate that the contract price includes a quarter tick.
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Initial Margin is the amount that is put up to open a futures position on an exchange and will be held by the exchange until the contract expires or is closed out. This is usually sufficient to cover a single day loss on an open position. The exchange determines the amount of initial margin required.
Variation margin is payable (receivable) daily in cash based on the contracts revaluation through a process called marking-to-market (M-T-M). The mark to market price is usually determined by an weighted average price calculated using prices (usually the last 5 trades) traded during a period prior to the close of the trading day.
Settlement and trading is guaranteed by the exchange and margins are usually payable between 10h00 and 12h00 on the day following the trade or mark-to-market.
Margining and settlement
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Calculating variation MarginNear 3-mth Euro$ futures Price M-T-M Margin due or
(owing) in USD
Buy 20 contracts 94.50 94.65 7,500
Buy 50 contracts 94.55 94.65 12,500
Sell 50 contracts 94.60 94.65 (6,250)
Buy 20 contracts 94.55 94.65 5,000
Sell 30 contracts 94.65 94.65 0
Long10 contracts at 94.65 Margin due to you
18,750
Note that the exchange MTM each trade, but settles the net amount due at the end of the day. Although 170 contracts were traded, Initial margin will only be required on the OPEN position at the end of the trading day i.e. on 10 contracts.
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STIR Futures vs FRAsFUTURES
Buy futures if you believe rates will FALL
Sell futures if you believe rates will RISE
FRAsSell FRAs if you
believe rates will FALLBuy FRAs if you
believe rates will RISE
Note: Buying FRAs is the same as selling futuresSelling FRAs is the same as buying futures
SOTo hedge a long FRA position BUY futuresTo hedge a short FRA position SELL futures
THIS SLIDE IS IMPORTANT TO REMEMBER!!!!
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An interest rate swap (IRS) can be defined as an exchange of one set of cash flows for another based on a notional principal amount or an exchange for differences on a given set of cash flows.
The concept of a basic IRS is very similar to that of an FRA. The difference is that the FRA is applied to a single period cash flow, and a swap is applied to cash flows over a longer period of time.
The important concept to remember is that the buyer of an IRS (also known as the Fixed rate payer) is protected against rising interest rates and the seller (the Fixed Rate receiver) is protected against declining interest rates.
Interest Rate Swaps - IRSs
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Typical Reuters IRS Screen
Period Bid Offer
1 Yr 5.75 5.80
2 Yr 5.80 5.85
3 Yr 5.85 5.90
4 Yr 5.87 5.92
5 Yr 5.90 5.93
Term of swap
Price at which the bank will pay fixed
Price at which the bank will receive fixed
Reset quarterly against 3-monthLIBOR
Reset quarterly against 3-month LIBOR
Absolute quotation Spread quotationBasis points
added to current government bond price to
arrive at absolute swap
rate
Current government bond price
Period Bid Offer Govn
1 Yr +2 +7 5.73%
2 Yr +4 +9 5.76%
3 Yr +3 +8 5.82%
4 Yr +1 +6 5.86%
5 Yr +3 +6 5.87%
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Plain vanilla swap – This is a fixed for floating rate swap with a fixed notional value for the life of the swap. This is by far the most common IRS done.
Accreting swap - A swap, which has a notional value that increases over the life of the swap.
Amortizing swap - A swap, which has a notional value that decreases over the life of the swap.
Rollercoaster swap - A swap, which has a notional value that increases and decreases during the life of the swap.Basis swap – A swap where one floating rate is swapped for another floating rate. An example would be a 6-month LIBOR against 3-month LIBOR swap.
Interest Rate Swaps Structures
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The Swap Mechanism“A” PAYS fixed to “B”
PARTY A PARTY B“A” RECEIVES floating from “B”
• The rates exchanged can be a fixed rate for a floating rate or floating for floating rate.
• The counterparties will only exchange the difference between the rates based on a Notional Principal amount
• There will always be a start date, expiry date, fixing dates, and settlement dates agreed on the swap
• Day count convention is calendar rolls modified following - CRMF
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Coupon or Plain Vanilla Swaps Over 75% of all swaps are plain vanilla Fixed rate vs. floating rate cash flows Notional Principal amount never exchanged Principal is constant for the life of the swap Reference index - JIBAR, LIBOR, etc. 3Month is the most common benchmark Swaps subject to ISDA documentation. ISDA = International
Swap and Derivatives Association Fixing in advance with Settlement in arrears Settlement is done on a netting basis which reduces the
counterparty risk Payer, receiver quotation convention Absolute Vs. spread quotation in overseas markets
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Settlement calculation1 year Plain vanilla IRS fixed against 3 mth LIBOR
Start dateFirst fixing
Second fixingSettlement of first fixing
0 6 9 123
Third fixingSettlement of second fixing
Fourth fixingSettlement of third fixing
Settlement of fourth fixingSwap matures
• The swap has a notional principal of USD 50 million • The fixed rate is 5.75% on the swap• The first 3–month LIBOR fix is 5.25% done on the start date of the swap
i.e. at 0 on the timeline above.Amount to be paid on second fixing is calculated as follows:50,000,000 x (0.0575-0.05250) x 90/360 = $62,500 paid by the buyer (fixed rate payer) to the seller (floating rate payer) on the second fixing date. This process is repeated over the life of the IRS
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Overnight Index Swap (OIS) an OIS is a fixed/floating interest rate swap floating leg is a daily overnight or tom/next reference rate
floating leg interest is compounded daily the interest difference is exchanged as a single amount at
maturity of the swap settlement is made net with no exchange of principal Sterling Overnight Index Average (SONIA) is the benchmark in
GBP Euro overnight index average (EONIA) used for EUR
overnight index swaps Fed Funds Effective rate used for USD overnight index swaps All overnight index rates are weighted average rates unlike
LIBOR and EURIBOR which are simple averages.
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Cross Currency Interest Rate Swap Differs from a normal IRS in that there is an exchange of
principal and the interest rates swapped are in TWO DIFFERENT CURRENCIES.
This exchange of principal can be done at the start of the swap, but there MUST ALWAYS be an exchange of principal at the end of the swap.
The spot rate used for the principal exchange at expiry of the CIRS is ALWAYS the same as the spot which was prevailing at inception (and which may have been used at inception).
These swaps can be floating for floating and are referred to as a basis swap and are the most common currency swap.
They can also be fixed for floating They are the ONLY swap which can offer fixed for fixed. These swaps are used primarily to hedge long term Foreign
Exchange exposure.
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Options
Section 5
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To understand the fundamentals of options. To recognise the principal classes and types, and understand the terminology, how they are quoted in the market, how their value changes with the price of the underlying asset and the other principal factors determining the premium, how the risk on an option is measured and how they are delta hedged. To recognise basic option strategies and understand their purpose.
One question basket 5 questions
Section Objectives
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An option is a contract that gives the holder (or buyer) of the option the right, but not the obligation to buy (or sell) a specified quantity and quality of a certain asset within a specified period or on a specific date, at a price agreed when the contract was entered into. For this right, the buyer pays a premium and the seller is obliged to honour the contract if called on to do so by the holder.
Definition of an Option
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· A Call option – gives the holder the right but not the obligation to buy the underlying asset at some time in the future.
· A Put option – gives the holder the right but not the obligation to sell the underlying asset at some time in the future.
NOTE: Options can either be American - exercisable at any time up to expiry- or European -exercisable only at expiry. Options can also be styled Asian or Bermudan (see workbook for definition)
Types of Option Contracts
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· The premium of an option is payable when the option is traded. For currency options, the premium is payable value spot. For caps and floors the premium can be paid at the start or over the life of the option.
· The exercise price of the option is known as the STRIKE price.
· When buying options the most you can lose is the premium. NOTE: The CREDIT RISK on a long option position can be GREATER than the premium paid.
· Selling options carries far greater risk than buying options.· Only options which are in-the-money will be exercised at
expiry· Out-the-money options expire worthless
Options Characteristics
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Option status Call option Put option
In-the-money Spot price > strike price Spot price < strike price
At-the-money Spot price = strike price Spot price = strike price
Out-the-money Spot price < strike price Spot price > strike price
The value of an option is the premium which someone is prepared to pay for the option.Intrinsic value represents the money you would make between the exercise price and the market price if you were to exercise the option you are holding immediately Intrinsic value can only be POSITIVE.Time value reflects the amount of premium in excess of the intrinsic value that someone would be prepared to pay in the hope that the option will be worth exercising before it expires
Valuing Option Contracts
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The further out-of-the-money the exercise price, the cheaper the option
The longer the time to expiry, the more expensive the option is
The fair value price of an option is dependent on:the strike pricethe term of the optionthe underlying asset price (spot)the prevailing risk free interest ratethe volatility of the underlying asset price
The pricing model used is usually based on the Black and Scholes options pricing model.
Pricing Option Contracts
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Call values Put values when
Rise Fall Price of underlying rise
Fall Rise Price of underlying fall
Rise Rise Volatility rises
Fall Fall Volatility falls
Fall Fall Time to expiry reduces
Rise marginally Fall marginally Interest rates rise
Fall marginally Rise marginally Interest rates fall
Valuing Options
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Profit
Loss
0
E
Premium
SHORT CALL
B
Asset price
Profit
Loss
0
EPremium
LONG CALL
B
Asset price
Option Contract Expiry Profiles
E = exercise priceB = breakeven
LONG CALL Limited downside risk with unlimited profit potential
SHORT CALLUnlimited downside risk with limited profit potential
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Option Contract Expiry Profiles
Profit
Loss
0
E
Premium
SHORT PUT
B
Asset price
Profit
Loss
0
E
Premium
LONG PUT
B
Asset price
E = exercise priceB = breakeven
Buy a put when you expect a fall in the underlying market price
LONG PUTLimited downside risk with limited profit potential between breakeven and zero
SHORT PUTLimited downside risk between breakeven and zerowith limited profit potential
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Profit
0
Loss
E
Short Straddle Expiry Profile
Sell both a call and put option with the same strike price, notional value, and expiry date
Expect very low volatility during the life of the strategy Maximum profit = premium earned, with unlimited downsideATM Straddles are delta neutral
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Profit
0
Loss
E
Long Straddle Expiry Profile
Buy both a call and put option with the same strike price, notional value, and expiry date
Expect volatility to be high during the life of the strategy Maximum loss = premium paid, with unlimited upsideATM Straddles are delta neutral
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Option short Strangle
Sell a call and a put with different strike prices same expiry date and notional amount.This is a strategy to benefit from low volatility
Profit
0
Loss
Asset PriceA B
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Profit
0
Loss
Asset Price
Option Long Strangle
Buy a call at and a put with different strike prices same expiry date and notional amount.This is a strategy to benefit from high volatility
A B
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E
A synthetic long asset position
Spot Asset PriceLong Call
Short Put
Loss
Profit
Synthetic Long asset
0
Long call + Short put with same strike, notional, and expiry = SYNTHETIC LONG ASSET POSITIONIn theory the price of ATM puts and calls have the same premium and therefore the cost of constructing a synthetic long asset should have little or no premium cost.
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E
A synthetic short asset position
Long put + Short call with same strike, notional, and expiry = SYNTHETIC SHORT ASSET POSITIONIn theory the price of ATM puts and calls have the same premium and therefore the cost of constructing a synthetic short asset should have little or no premium cost.
Spot Asset Price
short Call
Long Put
Loss
Profit
Synthetic short asset
0
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Delta Delta measures the change in the option premium (price)
resulting from a change in the price of the underlying asset The term delta neutral refers to the fact that the option writer
or buyer has sold (or bought) the exact proportion of underlying asset to neutralize the effect that the underlying price has on the option premium, all other factors remaining the same.
Delta on long calls ranges between 0 and +1 and you SELL the underlying to delta hedge
Delta on short calls ranges between 0 and -1 and you BUY the underlying to delta hedge
Delta on long puts ranges between 0 and -1 and you BUY the underlying to delta hedge
Delta on short puts ranges between 0 and +1 and you SELL the underlying to delta hedge
The Option “Greeks”
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Delta hedging is done to neutralize the change in the option premium value.
For options that are at the money (ATM), the delta is usually 0.50 (50%). This means for a 1c move in the market, the premium should change by 0.5c. To delta hedge a short ATM USD/CHF call option in 10m USD, the dealer would need to BUY 5m USD to be delta neutral. The effect is that as the option goes in the money the option value would increase and the option writer would be losing money but because he has bought 5m USD, he will make money on this position, thus neutralizing the loss on the option. If the option goes out of the money, the option writer will make money on the option, but lose on the delta hedge.
Dealers who trade an options curve will use delta hedging as they are looking to make money from the volatility of price and not the direction of price.
Delta Values - 1
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As call options go in the money, the holder (buyer) would needs to sell the underlying to remain delta neutral. They are getting “long of the underlying” through the option. The delta would range between +0.50 and +1. The opposite is true for the person who has written the call as they would be getting “short of the underlying” so their delta would range between -0.50 and -1 and they would need to buy the underlying to remain delta neutral.
As put options go in the money, the holder (buyer) would needs to buy the underlying to remain delta neutral. They are getting “short of the underlying” through the option. The delta would range between -0.50 and -1. The opposite is true for the person who has written the put as they would be getting “long of the underlying” so their delta would range between +0.50 and +1. they would need to sell the underlying to remain delta neutral.
Delta Values- 2
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Gamma Gamma measures the change in the delta
resulting from a change in the price of the underlying asset
Gamma ranges between 0 and 1. The gamma will be most sensitive to change when the option strike is at-the-money close to expiry. Gamma exposure can only be offset by buying or selling) options opposite to those already bought (or sold).
The Option “Greeks”
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Theta Theta measures the change in the option premium
resulting from a change in the time to expiry of the option
The decay of time will result in the option loosing value, all other factors remaining equal.
Time value decays slowly at first and then increases as the option approaches expiry.
Theta is positive for options writers and negative for option buyers.
The Option “Greeks”
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Vega Vega measures the change in the option premium
resulting from a change in the volatility of the underlying asset price
The more volatile the underlying asset price, the more likely the option will expire in the money. So if volatility increases, the value of the option will also increase, all other factor remaining equal.
Volatility measures change but not the direction of prices
The Option “Greeks”
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Rho Rho measures the change in the option premium
resulting from a change in the risk free interest rate Rho is the least important of the Greeks. If the
underlying asset is extremely sensitive to the change in interest rates, then the option value will change, all other factors remaining constant.
The Option “Greeks”
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Interest Rate OptionsCAPS
A Cap is an agreement whereby the buyer buys the right to pay a predetermined fixed rate (strike rate) on a notional principal amount if LIB|OR rises above the strike rate. (used by borrowers)
FLOORSA Floor is an agreement whereby the buyer buys the right to receive a predetermined fixed rate (strike rate) on a notional principal amount if LIBOR falls below the strike rate. (used by lenders)
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Interest Rate OptionsCOLLARSA Collar is the simultaneous purchase of a cap (floor) and sale of a floor (cap) with different strike rates, same notional value and expiry date.This can be used by both lenders and borrowers where they reduce the cost of a hedge by limiting the upside benefit. Borrowers collar – BUY the cap and SELL the floor. Lenders collar – BUY the floor and SELL the cap. Borrowers are guaranteed a worse case rate - the strike on the cap - and will limit the benefit of a favourable market move - the strike on the floor.Lenders are guaranteed a worse case rate - the strike on the floor - and will limit the benefit of a favourable market move - the strike on the cap.
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Currency Options
Characteristics
A currency option is described as at the money when it has a strike price EQUAL to the forward exchange rate.
A Call on one currency is a Put on the other currency.
For example, a USD/ JPY call option is a Call on USD and a Put on JPY.
Currency option premiums are payable value spot after the deal date as a percentage of the base currency notional amount.
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Principles of Asset and Liability
Management
Section 6
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To understand the fundamentals of Asset & LiabilityManagement as a practice of managing and hedging risks that arise due to mismatches between the asset side and the liability side of the balance sheets of abank. To explain how main risk factors like funding and liquidity risk, market risk (FX, Interest Rate, Equity, Commodity, etc.), credit risk, leverage risk, businessrisk and operational risk are interrelated and how they affect the balance sheet of a financial institution. To describe common risk management and hedging techniques which help control these effects and to understand how these techniques are used to set up a state-of-the-art ALM approach.One question basket 8 questions
Section Objectives
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ALM Incorporates the modern techniques used in profitability and risk management of commercial banks. These involve the following:
Creating shareholder wealthProfit centre managementRisk-adjusted performance managementPricing of credit risk and loan provisionThe management of interest rate and liquidity risks
As competition is reducing bank margins, the need for more precise information and a complete asset and liability management system is becoming an absolute necessity.
What is ALM?
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The ALCO comprises the CEO and heads of business units in Credit, retail, corporate and Treasury.
The ALM team or ALCO (asset and Liability Committee) controls profit and risk. They primarily consider the Interest rate risk created by the mismatch of the asset and liability maturities of the banks balance sheet.
What is the function of the ALM team?Banks invest in 5 main assets:1. Reserves with the central bank2. Loans3. Interbank loans4. Bonds5. Fixed assets
Banks have 3 main sources of funds:1. Deposits from clients2. Interbank deposits3. Shareholders equity
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1. Board and senior management oversight of interest rate
risk
2. Adequate risk management policies and procedures
3. Risk measurement and monitoring
4. Internal controls
5. Information for supervisory authorities
6. Capital adequacy
7. Disclosure of interest rate risk
8. Supervisory treatment of interest rate risk in the banking
bookThese guidelines set by the Basel committee have prompted a
significant evolution in systems used by banks for managing interest rate risk, which have gradually become more comprehensive and accurate.
Principals of the BASEL Committee
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There are five key variables driving ROE
ROE
Return on equity
Earnings on assets (EOA)
Margin (EOA – COD)
Operating expenses (OE)
Leverage (debt/equity)
Tax (t)
Leverage (debt/equity) can have a major impact on the ROE of a bank, so banks could be tempted to increase debt while leaving equity unchanged. Central banks are aware of this danger and therefore control the level of debt to equity through the imposition of capital adequacy regulations.
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The Basel accord is the main capital adequacy
structure that bank supervisors use. Basel covers aspects of capital, risk weighting of
assets and the required capital ratio to meet the banks product mix. The basic Capital Adequacy Directive - CAD - sets the minimum capital required at 8% of total risk-weighted assets. (This is known as the Cooke Ratio)
The three pillars of the BASEL Accord:
1. Minimum Capital Requirements
2. The Supervisory Process
3. Market Discipline
Capital Adequacy
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Refers to the adequacy of a banks capital in relation to risk arising from:Assets (loans, negotiable paper)Dealing operationsOff-balance sheet transactionsOther business risk
Equity Capital enables a bank to bear risk and absorb unexpected
losses
Regulatory Capital – Prescribed by the regulatory
authorities in the country. This is split into two main
categories namely Tier 1 (core) and Tier 2. Economic capital – this is the amount of capital needed to
cover the risk being faced by a bank (usually in excess of
Regulatory Capital). This is the capital specifically allocated
to a branch of a bank. It can also be defined as capital at risk
(CaR) and can be measured using VaR
Capital Adequacy under Basel II
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Three tiers of capital: Tier 1 (going concern capital) common equity capital, declared reserves, current
years audited profits.
Under BASEL III there are new targets for capital.
The common equity in Tier 1 must be a minimum of 4.50% with a 2.50% conservation
buffer making a total of 7.00%
Tier 1 capital must be a minimum of 6.0% with a conservation buffer of 2.50% making
Tier 1 total 8.50%. Total capital must be 8% with a 2.50% conservation buffer making a
total of 10.50%Tier 2 (gone concern capital) comprises undisclosed reserves of the bank and
subordinated term debt with a maturity of 5 years or longer , certain reserves and
general provisions. Tier 2 capital can NEVER be more than 100% of tier 1 capital.Tier 3 – Bonds issued to support the trading book of a bank and no longer used.
NOTE: Under BASEL III certain Tier 2 capital will go from being bonds to common
equity if the banks capital ratio falls below a certain level. These are referred to as
CoCos (contingent convertibles). Gone concern capital is where the Tier 2 bonds lose
their status and become common stock if the bank goes into liquidation.
Types of Capital
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Risk weighted assets
Capital AdequacyCredit Risk
Trading Risk
Operational Risk
Credit Risk WeightingTwo approaches: standardized approach which relies on external ratings; that is ratings given by rating agencies such as Moody’s and Standard and Poor or Fitch-IBCAThe second approach which has received the most attention all over the world is the Internal Rating –Based (IRB) approach (available under two options: foundation or advanced)We will examine each approach; the Standardised approach and the foundational approach for IRB.
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The Standardized approach is one where a weighting will be related to the riskiness of the transaction, as identified by the rating of external rating agencies.
AN EXAMPLEAAA - AA- A+ - A- BBB+ - BBB- and below
Corporate 20% 50% 100%
A loan made to a A+ would be rated at 50% therefore a loan of $100 would attract capital of ≥ 8% x ($100 x 50%) = $4
Under Basel I this loan would have simply had a risk weighting of 100% and attracted capital of $8.
Remember unrated loans STILL attract a weighting of 100%
Credit Risk Weighting – Standardized Approach
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In the IRB approach, the banks have to calculate the probability of default of a corporate client over a 1-year time horizon. That is lending to a client today, what is the likelihood of default by the borrower in one years time? This probability of default is referred to as the PD.
NOTE: to apply the IRB approach you need two pieces of information: the PD and the maturity of the loan.
With retail loans (small amounts), a similar PD can be calculated for a portfolio of loans. Basel Committee of Bank Supervision (BCBS) formula to calculate the capital charge contains the following factors:
1. The probability of default (PD) 2. The exposure at default (EAD)3. The loss given default (LGD) Also; Effective maturity (M)
M = maturity; b(PD) = maturity adjustmentR = correlation between defaults
Credit Risk Weighting – Internal Ratings-Based (IRB) Approach
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Securitization is where bonds are issued which have the backing of an income producing asset, typically bank debt in the form of long-term debit instruments such as mortgages or short-term debt instruments, such as credit card receipts.
This is a popular way of banks freeing up capital and transferring credit risk.
There are usually different classes of bonds issued in a single securitisation based on the credit of the underlying securitised asset.
Issuing Bank
Bond MarketTrust or SPV
Balance sheet
Assets against which the bonds are issued
Frees up capital
Removes assets
Issues bonds of differing classes based on the
underlying credit
Credit risk mitigation - Securitisation
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Credit risk mitigation- credit derivatives• Credit derivatives are a relatively new phenomenon, and
have really only become prominent in the mid to late 90’s• A credit derivative is a privately negotiated contract whose
value is derived from the credit risk of a bond, bank loan, or some other credit instrument. Credit derivatives allow the market participant to separate default risk from the other forms of risk, such as interest rate and currency risk
Three basic structuresCredit Default Swap – CDS this bases the payoff on a
specific credit event, such as a bond down grading or default. .
A total return swap - Links a stream of payments to the total return on a specific asset.
Credit spread options - Ties the payoff to the credit spread on a specific bank loan or bond.
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Credit Derivative triggersThe standard ISDA documentation for credit swaps defines a set of credit events which trigger the Credit Derivative. A credit event could be one of the following:
Payment default on an agreed-upon public or private debt issue (the reference asset)
Debt reschedulingA filing for bankruptcyOr some other specified event to which the two parties agree.
As a general rule, the credit event must be an objectively measurable event involving real financial distress; technical defaults are usually excluded. The reference credit is usually a corporation, a government, or some other debt issuer or borrower to which the credit protection buyer has some credit exposure.The contract will contain a materiality clause which will:· Call for a significant move of the reference credit’s underlying stock or
bond price· Ensure that the market recognizes the credit event for what is· Prevent an unnecessary trigger due to a default caused by legal questions
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Remember operational risk refers to losses incurred due to human or systems error.
The standardized approach – this is straight forward:The capital charge is simply a multiple of the gross revenue of an activity, averaged over the last three years. Gross revenue is the sum of net interest margin and non-interest income (such a fee charged).The capital charge under this method is the same for all banks irrespective of their operational control processes. The Advanced Measurement Approach (AMA) – under this
approach, the banks themselves estimate statistically what could be the worst operational losses, for a confidence level of 99.9%. This requires estimation of two factors:
The number (frequency) of operational losses over a years, and the potential magnitude of these operational losses
Operation Risk Weighting – Standardized Approach and Advanced
Measurement (AMA) approach
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Gap conceptInterest rate risk is identified as the possible changes in net interest income . The gap is a concise measure of the interest rate risk that links changes in market interest rates to changes in the net interest income (NII)of the bank. The gap over a given period is defined as the difference between the amount of rate sensitive assets and rate sensitive liabilities. A positive gap is one where rate sensitive assets exceed rate sensitive liabilities. A negative gap is one where rate sensitive liabilities exceed rate sensitive assets.A positive gap benefits from rising interest ratesA negative gap benefits from falling interest rates.
Interest rate risk management
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Liquidity Coverage Ratio - LCRThe Basel II rules insist that a bank maintains a high liquidity coverage ratio. This rule requires banks to have enough cash or near-cash to survive a 30-day market crisis. Net Stable Funding Ratio – NSFR (1 year time horizon) This ratio is applied to reduce the banks dependency on short-term funding and is longer term in nature to limit over-reliance on short-term wholesale funding. Stress testingThese are tools used to identify and manage situations which can cause extra-ordinary losses. They can be based on the following:
1. Replication of the strongest market shocks which occurred in the past2. Statistical measures with extreme multiple of historical volatility3. Subjective assumptions such as a 100BP move up or down in the Yield
Curve
Basel III liquidity risk
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The main aims of internal funds transfer pricing system:1. To transfer interest rate risk from the various units in the bank to one
central unit usually the Treasury. The Treasury can correctly evaluate and manage this risk and where necessary apply the relevant hedging policies
2. To evaluate the actual profitability of this activity by assigning interest rate risk management to a single centralized unit
3. To remove the need for each division from dealing with the funding of their loans or the investment of surplus deposits
4. To provide a more accurate assessment of the contribution of each operating unit to the banks overall profitability.
The bank can either apply a single internal transfer rate -ITR (usually a floating benchmark like LIBOR) or it can apply multiple ITRs reflective of the maturity profile of deposits and loans.
Funds Transfer Pricing
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Principles of Risk
Section 7
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To understand why risk is inherent in banks business models and why effective risk management is a key driver for banks success. Candidates will be able to describe major risk groups: credit, market, liquidity, operational, legal, regulatory, and reputation risk. They will understand the significance of risk groups for different banking businesses and units. Candidates will also get an overview about methods and procedures needed to manage these risk types and extend their understanding to different risk/return profiles of shareholders, regulators and debt providers.
One question basket 8 questions
Section Objectives
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Volatile exchange rates and interest rates together with a market environment that has become increasingly complex, makes risk management within the treasury a vital function.
Treasury risk management staff must have a trading background or at least some technical skill to deal with the risk control function within the treasury. Lack of expertise can result in losses.
Segregation of duties and reporting is also vital within the treasury environment
A professional standards review in addition to the conventional audit is also recommended to review the conduct of treasury officers
Treasury Risk
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Default Risk (counterparty risk) - Exposure to the likelihood or possibility that a counterparty to an outstanding transaction my not be able to settle due to bankruptcy or liquidation. Such a loss leads to the product of the exposure at default (EAD) and the loss given default (LGD).
Country Risk - Caused mainly by a currency crisis where borrowers are unwilling or unable to settle outstanding transactions. Political and economic factors play an important role in the assessment of country risk. There are many reports generated by industry bodies detailing current economic and political events within countries.
Settlement Risk - Usually the risk that payment is effected on a currency transaction without the receipt of payment in turn from the counterparty to the transaction. In currency settlement this risk is referred to as HERSTATT RISK. CLS Bank is the safest way to mitigate settlement risk
Credit Risks - 1
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Replacement riskThis is the cost of replacing a deal which is in default. For example, if you enter into a deal to purchase currency at a forward date and the counterpart to the trade cannot deliver, you can cancel the deal and enter into a new deal to replace the exiting deal. Any price over and above the original price paid is the replacement cost. So you will only lose money if there was a positive unrealized P&L. The only time the full capital amount is at risk is when delivery has already been effected and cannot be revoked. The process of marking-to-market allows a bank to assess the replacement risk on all outstanding deals on an ongoing basis. Close out netting is the commonly used netting where a counterparty is in default.
Credit Risks - 2
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Good credit assessment Credit limits imposed and monitored by
managementBy counterpartyBy industry By country
Credit enhancement – Credit Derivatives Default management – ISDA and ICMA
documentation Termination clauses – used in the IRS market Payment netting – bilateral and multilateral
Minimum Control StandardsFor Credit Risk
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Currency Risk (exchange rate risk) - The cost of closing out open foreign exchange positions in currencies to which the treasury is exposed. This can be as a result of FX or FX derivative positions. A common benchmark for controlling risk in this area is “the maximum loss” permissible for one day on open positions. Real time feeds help to monitor the intra day risk on open positions. Different currency exposure may result from
Transaction exposure – spot or forward transaction losses money due to a change in the exchange rate Translation exposure - value of foreign assets or profits of multinational company due to a devaluation of currency Economic exposure - business profits affected by a change in the exchange rate for exporters or importers
Market Risks
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Interest Rate RiskExposure to the changes in interest rates for interest rate products such as bonds, FRAs, IRSs, caps, floors, and Interest rate futures. Banks also consider the risk of yield curve changing relative to the mismatch between assets and liabilities. Liquidity ladders should be managed to gauge mismatches and monitor the banks liquidity position.NB a vital risk which needs to be carefully managed!!Equity Risk – the risk that a market position is sensitive to
equity market performance (stocks, stock index futures, options)
Commodity risk – the market value of a position is sensitive to commodity price changes
Volatility risk – a market position is sensitive to the volatility of prices in FX, interest rate, equity and commodity markets
Market Risks
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Transaction approval Measurement
Regular marking to market of open positionsGap analysis for interest rate exposureRisk identification using Value at Risk modeling (VaR)
Risk reporting Risk system development – good revaluation Limit approval Timeous inputting of deals Matching of hedges with the hedged instrument
Minimum Control StandardsFor Market Risk
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Value at Risk – VaR is a method of assessing market risk characterised by three key elements:
1. It indicates the MAXIMUM potential loss that a position or portfolio can suffer
2. Within a certain confidence level (lower than 100%)3. Limited to a certain time horizon that the position
will remain constant
Basel Accord recommends a 99% confidence level over a 10 day holding period using historical data of no less than 12 months.
Measuring Market Risk - VaR
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The models most often used to measure VaR are:1. Variance –covariance method2. Monte Carlo simulation3. Historical simulationLimitations of the VaR4. It assumes normal distribution of prices5. It requires an explicit volatility and correlation estimate 6. It assumes a linear payoff hypothesis7. It provides no measure of the excess loss if the actual loss
is greater than the expected loss. One of the ways to overcome this is to apply another risk measure referred to as the Expected Shortfall.
Expected shortfall - is defined as the expected value of all losses in excess of VaR.
Value at Risk Models
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Market risk and credit risk are only limited by the imposition of LIMITS. Credit limits – these are used to control credit risk and are set OUTSIDE of treasury. A dealer must strictly keep within the limits set. Credit limits will be set by counterparty, market sector, and country.Dealing limits – these are limits used to control market risk. Limits will be set per instrument, currency, dealer, desk, and dealing room. LIMITS DO NOT CHANGE unless management adjust them.
Dealing Room Limit Structures
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Legal Risk - Caused by ineffective contracts which result in the inability to enforce them. Before dealing with a client, banks should be clear that all the necessary documentation is in place.
Reputational risk - This is the risk arising from negative perception on the part of customers, counterparties, shareholders, investors or regulators that can adversely affect a bank’s ability to maintain existing, or establish new, business relationships and continued access to sources of funding.Reputational risk may give rise to credit, liquidity, market and legal risk – all of which can have a negative impact on a bank’s earnings, liquidity and capital position.
Regulatory Risk - Caused by the banks non-compliance with regulation, reporting and compliance required by the financial authorities and or the Central Bank. The consequence can be the imposition of fines or in the worse case, the withdrawal of the financial institution’s license to operate.
Specific risk - is a risk that affects a very small number of assets. This is sometimes referred to as "unsystematic risk". In a balanced portfolio of assets there is a spread between general market risk and risks specific to individual components of that portfolio. An example would be the risk of one bond in a portfolio losing value because of a downgrade of the issuer.
Systemic risk - is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries. Often referred to as a ‘knock-on effect’.
Other Risks
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This is broadly defined as the likelihood of a loss, as measured by the value of the loss, on the transaction processed. This is a risk which is CONTROLLABLE by the bank.
Causes may be as a result of:Lack of proper proceduresNo segregation of dutiesLack of internal controlsInsufficient systemsManual interventionsPayment authorizationsUnskilled or shortage of staffCapacityDisaster recovery policies
Operational Risk
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• Timeous transaction processing• Constant Position reconciliation• Timeous input and confirmation• Good Cash management• Security for environment and systems• Proper customer service• Policy and procedure adherence – everyone must
understand the mechanics of the transactions• Strictly controlled database management• Good control and management on the introduction of new
products • Good management information systems / exceptions
reports
Minimum Control Standards For Operational Risk
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Basic documentation is necessary to
establish:The business to be conductedThe limits on deal/transaction sizeWho the authorised dealers are that can
bind the companyWho the authorised signatory/s are on
the confirmations
Basic documentation
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ISDA - International Swap and Derivatives
Association –documentation covers all treasury
instruments except ReposGMRA - Global Master Repurchase Agreement -
encompassing the International Capital Market
Association – ICMA (previously ISMA) and The
Bond Markets Association - TBMAICOM – international Currency Options Market
(Previously LICOM)FEOMA – Foreign Exchange and Options Master
Agreement
Documentation in current use
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What is payment netting?An example would be where two banks have a large volume of treasury transactions outstanding. The net pay and receive amounts for each could be much reduced if these were netted off against each other. Other forms of netting are usually applied when there is default by a counterparty and open positions exist. The main reason is to prevent “cherry picking” by the liquidators
Netting
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Bilateral netting of paymentsAgreed between two parties and they enter into a contract. Very easy to implement from a legal and systems point of view.ONE PAYMENT, PER COUNTERPARTY, PER CURRENCY, PER DAY
Standardised documentation has been set up for OTC derivatives contracts by industry bodies such as the International Swap and Derivatives Association (ISDA) and ICMA (International Capital Market Association)
Netting-2
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Multilateral netting is much more complex and is easiest to understand when examining the structure of a CLEARING HOUSE.
ONE PAYMENT, PER CURRENCY, PER DAY There are several participants in the netting process and there is normally a redistributing of default risk.Continuous linked settlement (CLS) is the most
effective initiative to deal with settlement or default risk.
Netting-3
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Netting by novation – is a netting arrangement where the existing contracts are netted out and cancelled and replaced by a single new (nova) contract
Close out netting – is applied by an area outside of treasury in the instance of a bankruptcy. All open positions are marked to market and a single payment is made to settle all outstanding commitments. This is usually the type of netting applied in ISDA and ISMA documentation in the case of a bankruptcy.
Payment netting does not however reduce BIS capital adequacy guidelines, but does reduce the number of payments required
Netting-4
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Internal recon's – position keepingExternal recon’s – Nostro accountsPosition keeping electronic with manual
adjustments where required reconciliation is based on exception
reporting. Problems are investigated and swiftly handled
to avoid loss or interest penalties
Reconciliation's
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Nostro account is “our” foreign exchange account held with an overseas correspondent bank e.g. from London Bank perspective, their USD account held with Citibank NY
Vostro account is a local currency account held on behalf of an overseas client bank e.g. from Citibank NY perspective, the London Bank USD account held with themselves. Sometimes also referred to as a Loro account.
Note: A Nostro and Vostro account are the same account.
A Loco account is an account for gold in London. It can be described as a “nostro account” for gold.
Nostro and Vostro accounts
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Three main factors that help streamline STP:Front-end (dealing) data captureSSIsImmediate matching of confirmations
Together with Automated payment systems, these
have become the building blocks that have taken
the concept of STP from theory to practice. Deals
can now go from initiation to settlement without
ANY manual intervention.
Straight Through Processing
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Continuous linked settlement• CLS eliminates the settlement risk in cross currency payment
instruction settlement through CLS Bank linking the local central bank Real Time Gross Settlement (RTGS) systems. This occurs during a five-hour window of their overlapping business hours: in this window, settlement instructions for a particular date are settled and funds are requested to be paid in and are paid out by CLS Bank.
• CLS Bank is based in New York and is a multi-lateral netting system for currency settlement.
• Only currencies which are part of CLS can settle through the system.
• Only counterparties in countries which are part of CLS can use the system.
• Currency pair and counterparty determine whether a deal can settle through CLS.
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The ACI Model Code
Section 10
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For candidates to have a thorough knowledge of the provisions of the Model Code and market practices, with particular emphasis on highstandards of integrity, conduct and professionalism as well as the monitor andcontrol mechanisms to be introduced to protect individuals and their institutions from undue risks and resultant losses.Please note that the exam is now based on the new Model CodeOne question basket 20 questions
Section Objectives
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Introduction to the Model Code - 1
The model code was authored by the ACI. It was constructed with reference to a number of existing local codes in affiliated countries, Central Banks of some OECD countries, the FSA, and other regulators.
The objective was to establish a universal code which would transcend the customs and practices of the individual countries and produce a code which promotes ethics and a code of conduct expected of participants in dealing in the markets covered by the ACI financial markets association irrespective of the centre in which deals are being concluded.
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The code does not deal with legal matters or technicalities, but it aims to set out the manner and spirit in which business is conducted.
Regulators have accepted the model code as the basis for the conduct and ethics of its dealers, brokers, and treasury operations staff.
A party who has a dispute with another counterparty which remains unresolved, can present a request for arbitration to the ACI Committee For Professionalism – the CFP. The CFP ruling is not legally binding, but does offer aggrieved parties a professional ruling on the dispute.
Introduction to the Model Code - 2
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1. After hours/off premises dealing – proper management guidelines should be in place to control the process of off-site or after hours dealing.2. Stop loss orders – a clear understanding of these conditions and ramifications should be reached between the two parties before a stop loss order is given or accepted. It is very difficult to definitively determine the market highs and lows in the case of a dispute on the trigger of a stop loss order.3. Position parking – this is often done to disguise the risk on a position. The ACI says that this practice should be forbidden.
Chapter 1Business Hours and Time-Zone related issues
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1. Entertainment and gifts – managements role is to control the nature of gifts offered and accepted. Entertainment should not be offered nor accepted where the host is not present.2.Gambling betting between market participants – this should be strongly discouraged.3.Personal account trading – proper controls should be in place to avoid conflicts of interest with the dealers job.4. Customer relationship, advice and liability – because of the complex nature of some products it is incumbent on the dealer to ensure the customer understands the deal.5. Confidential information - RESPECT confidential information. Don’t “front run” orders! Don’t place an order with a broker to find out who the counterparty is so as to make direct contact to conclude a deal. Don’t pressure the broker to give you information which is improper for them to divulge by threatening to cut off business if they refuse.
Chapter 2Personal conduct issues
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1. Confirmations - confirmations should be sent out as soon as possible after the deal. Brokers should confirm all transactions to both counterparties immediately by an efficient and secure means of communication.2. Verbal confirmations – regular verbal check of deals done is good practice. At least one near the end of the day is recommended.3. Payment instructions – the use of SSI’s is strongly recommended by the ACI.4. Netting – once again the ACI recommends that where practical, payment netting should be used to reduce settlement risk.
Chapter 3Back Office, Payments, and Confirmations
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1. Disputes and mediation – arise mainly due to failure of dealers to use clear and unambiguous language. Management of both parties should take prompt action to resolve or settle the issue quickly and fairly with a high degree of integrity and mutual respect2. Differences between principals – where a disputed deal can result in a loss it is recommended that one party (preferably with the agreement of the other) square the position ASAP.3.Difference with brokers and the use of points – where a broker quotes a price that is unsubstantiated, the bank is entitled to “stick” the broker. Any difference between the price proposed and the actual deal price must be made good by the broker. It is bad practice to insist on a deal at the original price or to refuse a brokers cheque or a reduction in the brokerage bill for the difference.
Chapter 4Disputes, Differences, Mediations and Compliance
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1.Authorisation and responsibility for dealing activity – management should clearly set out, in writing, the authorizations and responsibilities within which the dealing and support staff should operate. It is the responsibility of management to ensure that all employees are adequately trained and aware of their own and their firms responsibilities.2.Terms and documentation – the use of standard terms and conditions contained in standardized documentation such as ISDA and ICMA is strongly recommended.3.Qualifying and preliminary procedures4. Telephone recording5. Use of mobile phones6. Dealing room security
Chapter 5Authorization, Documentation and Call Taping
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1. Role of brokers and the dealer/broker relationship – the choice of brokers is the responsibility of senior management at the bank. Brokers are to act purely as agent. 2. Brokerage – to be agreed in writing between the both the management of the bank and the brokerage. Failure to pay brokerage bills promptly is not considered good practice. 3. Passing of names by brokers – brokers should not divulge the names of principles prematurely, and certainly not until satisfied that both sides display serious intent to transact. Dealers should inform brokers, wherever possible, about names they cannot see for whatever reason4. Name switching – used to close a deal where limits are a problem for the two original banks.
Chapter 6Brokers and Brokerage
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1. Dealing at non-current rate and rollovers – using historical or non-current rates should be avoided. Where it is necessary to do so, it should be fully documented. It is highly unethical for one party to hold another to an erroneously agreed rate when the quotation is demonstrably and verifiably a big figure or more away from the prevailing market rate.2. Consummation of a deal – broker calls “off” as bank hits the price = NO DEAL DONE. Broker hits the bank as the bank calls “off” = DEAL DONE! Holding brokers unreasonably to a price is viewed as unprofessional and should be discouraged by management. Under no circumstance should brokers inform dealers that a deal has been concluded when in fact it has not.3. Dealing reciprocity – informal reciprocity arrangements are unenforceable. However dealers should show integrity and honour.
Chapter 7Dealing Practice
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4. Dealing quotations, firmness, qualification and reference – the market participants must ensure that they make it clear whether the prices they are quoting are firm or just indicative. Brokers prices should be firm in a marketable amount unless otherwise stated. Dealers MUST take their prices off with brokers if they no longer want to deal at the price shown. Brokers have a responsibility to assist dealers by checking with them whether their prices are still firm. Where a price is dealt on, then all other prices in that currency and market are cancelled and the broker will need to firm up all the bids or offers in that market. If you cannot do a name offered, the broker can propose another acceptable name if offered quickly. It is bad practice to revise a price once dealt on if the name does not work.
Chapter 7Dealing Practice (continued)
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1. Dealing using a connected broker – where a banker has a share in a broking firm it should be openly declared.
Chapter 9 14 General Risk Management Principles
The professional dealer must not only understand and manage the market risk pertaining to a trading position, but should also be aware of the credit, legal, liquidity and operational risks related to the business.1. Promote the highest standard of conduct and ethics2. Ensure senior management involvement and supervision3. Organizational structure ensuring independent risk management and controls
Chapter 8Dealing Practice for Specific Transactions
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4. Ensure the involvement of a thoroughly professional management in all administrative processes5. Provide appropriate systems and operational support6. Ensure timely and accurate risk management7. Control market risk exposure by assessing maximum likely exposure under various market conditions8. Always recognize importance of market and cash flow liquidity9.Consider impact of diversification and risk return profiles10. Accept only the highest standard and most rigorous client relationship11. Clients should understand transactions 12. Risk management based on sound legal foundations.13. Ensure adequate expertise in the support area of risk taking14. USE JUDGEMENT AND COMMON SENSE!!
Chapter 9General Risk Management Principles
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Your Top Five Take-Outs –
Shukriah!