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The course would lay foundation so that students may take up careers of foreign exchange dealing.

-

Ms. Ekta Nand Chah



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Management Of Forex Transactions

Course Objective:

The course aims at familiarizing the participants with the basic aspects of mechanics of foreign exchange

transactions as also operations in the foreign exchange market. The course would lay foundation so that

students may take up careers of foreign exchange dealing.

Learning Outcomes

At the end of the course, the student will be able to:

Understand the concept of foreign exchange

Examine the role and evolution of various theories of forex management

Appreciate the international monetary systems and markets

Develop the ability to implement the key forex activities strategically

Develop the ability to calculate financial derivatives

Course Contents:

Module I: Basics of foreign exchange

Definition, Meaning, Determination of foreign exchange. Theories. International monetary system

(impact).on European monetary system. Convertibility. Basic concepts of Balance of payments

Module II: International Financial Market

Introduction, relevant terminology, international financial market, how international financial markets areclassified, the role of international financial markets, participants in international financial markets,

location of international financial markets, financial intermediaries, the international monetary system, the

changing financial landscape.



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Module III: Introduction to derivatives

Derivatives defined, Products, participants and functions ,Types of derivatives, Development of exchange-

traded derivatives, Global derivatives markets, Exchange-traded vs. OTC derivatives markets, Derivatives

market in India, Approval for derivatives trading, Derivatives market at NSE, Trading mechanism,

Membership criteria, Turnover, Clearing and settlement, Risk management system.

Module IV: Forward and Future Markets and Contract

Introduction, Delivery And Settlement Of A Forward Contract, Default Risk And Forward Contracts,

Termination Of A Forward Contract, The Structure Of Global Forward Markets, Types Of Forward

Contracts. History Of Futures Markets, Definition Of Futures, Difference Between Futures And Forwards,

Organization Of Exchanges, Development Of Organized Exchanges, Clearing House, Clearing House

Mechanism, Contract Specifications For Futures, Types Of Margins, Orders In Futures Market, Settlement

Procedures, The Relationship Between Futures Price And Cash Price, Basis, Cost-Of-Carry, Contango And

Backwardation, Motives Behind Using Futures, Types Of Futures

Module V: Introduction to Options and swaps

Introduction to options, Option terminology, Options pay offs, Factors influencing option prices,

Elementary Investment Strategies, Options Clearing Corporation, Other Options, Trading Strategies of

Options, Put-Call Parity, Binomial Option Pricing Model, Black-Scholes Option Pricing Model. Introduction

to swaps, Interest Rate Swaps and Currency Swaps

Text & References:

Text:

Madura Jeff , 2000, International Financial Management, South Western

References:

Shaprio,A.C. Multinational Finance, John Wiley & Sons, New Delhi 2003

Seth A.K. International Financial Management Galgotia, New Delhi 2003

Dimitris N. Chorafas, Treasury Operations and the Foreign Exchange Challenge: A Guide to Risk

Management Strategies for the New World Markets (Wiley Finance), Mar 1992)

Ghassem A. Homaifar, Managing Global Financial and Foreign Exchange Rate Risk, 2003

http://www.amazon.com/Treasury-Operations-Foreign-Exchange-Challenge/dp/0471543934/ref=sr_1_1?ie=UTF8&s=books&qid=1211791859&sr=1-1




http://www.amazon.com/Managing-Global-Financial-Foreign-Exchange/dp/0471281158/ref=sr_1_3?ie=UTF8&s=books&qid=1211791859&sr=1-3








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Ghassem A. Homaifar, Managing Global Financial and Foreign Exchange Rate Risk, 2003

Dominic Bennett, Managing Foreign Exchange Risk: How to Identify and Manage Currency

Exposure (Risk Management), 1997

Laurent L. Jacque, Management and Control of Foreign Exchange Risk, 1997

Bob Steiner, Foreign Exchange and Money Markets: Theory, Practice and Risk Management, 2002




http://www.amazon.com/Managing-Foreign-Exchange-Risk-Management/dp/0273619764/ref=sr_1_4?ie=UTF8&s=books&qid=1211791859&sr=1-4




http://www.amazon.com/Management-Control-Foreign-Exchange-Risk/dp/0792380886/ref=sr_1_6?ie=UTF8&s=books&qid=1211791859&sr=1-6



http://www.amazon.com/Foreign-Exchange-Money-Markets-Management/dp/0750650257/ref=sr_1_8?ie=UTF8&s=books&qid=1211791859&sr=1-8










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Index

Chapter

no.

Particulars Page no.

1 Foreign Exchange 08

2 The International Monetary system 27

3 Balance of Payments 36

4 International financial markets 52

5 Introduction to derivatives 92

6 Introduction to futures 122

7 Introduction to forwards 136

8 Introduction to options 155

9 Introduction to swaps 171



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Module 1



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After reading this module, you will be able to understand

Chapter 1: Foreign Exchange

Meaning

Determination of foreign exchange

Exchange Rate Systems

Flexible Exchange Rate System

Fixed Exchange Rate System

Other Exchange Rate Systems

Theories

Chapter 2: The International Monetary System

The Gold Standard

Bretton Woods Agreements (1944-1973)

Managed floating system and the G-7 Council

Europe's Exchange Rate Mechanism and the Euro

Chapter 3: Balance of payments

Basic concepts of Balance of payments



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CHAPTER 1: FOREIGN EXCHANGE

In the context of international trade, we often use the word ‘FOREX’.

FOREX is the acronym for the wide meaning term- Foreign Exchange Market. It means a market,

where one country’s currency is exchanged for that of another country through an exchange-rate

system. The FOREX is the world’s largest and most liquid financial market, with a current

estimated exchange average of between $1.5 trillion and $2 trillion per day.

FOREX is not actually a market in the traditional sense because there is no central exchange.

Instead, the entire market is run electronically, within a network of banks, continuously over a

24-hour period. That’s Why it is called a VIRTUAL MARKET.

BACKGROUND

In theory, foreign exchange dates back to ancient times, when traders first began exchanging

coins from different countries and groups. However, the foreign exchange industry itself is the

newest of the financial markets. In the last hundred years, the foreign exchange market has

undergone some dramatic transformations. In 1944, the postwar foreign exchange system was

established as a result of a multinational conference held at Bretton Woods, New Hampshire. That

system remained intact until the early 1970’s. At this conference, representatives from 45 nations

met together to discuss the future exchange system. The conference resulted in the formation of

the International Monetary Fund (IMF).

Currencies in an exchange-rate system would tolerate one percent currency fluctuations to gold

values, or to the U.S. Dollar, which was established previously as the “gold standard.” The system

of connecting the currency’s value to gold or the U.S. Dollar was called pegging. In 1971, the

Bretton Woods Accord was first tested because of dramatically uncontrollable currency rate

fluctuations. This started a chain reaction, and by 1973, the gold standard was abandoned by

President Richard Nixon. The fixed-rate system collapsed under heavy market pressures, and

currencies finally were allowed to float freely. The foreign exchange markets officially switched to

a free-floating market after the double demise of the Smithsonian Agreement and the European



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Joint Float. This switch occurred more due to lack of any other available options, but it is

important to understand that the free floating of currency was not, by any mean, imposed. This

means that countries were free to peg, semi-peg, or free-float their currencies.

Pegged: Some smaller economies have attached their currencies to larger economies with which

they hold close economic liaisons. For instance, many Caribbean nations, such as Jamaica, have

pegged their currencies to the U.S. Dollar.

Semi-pegged: Semi-pegged currencies have disappeared since 1993. A perfect example of Semi-

pegging would be the currencies of the European Monetary System (EMS). Those Currencies only

would be allowed to fluctuate within 2.25 percent or, exceptionally, within 6 percent intervention

bands. Following the foreign exchange crisis of 1993, the new EMS intervention rates were

expanded to 15 percent. Semi-pegging would have a slowing-down effect on currencies when

they were reaching the extreme values allowed within the range. Since 1999, the semi-pegged

currencies of the EMS were switched to fully pegged values that form the Euro.

Free-Floating: When the major currencies are free-floating, such as the U.S. Dollar, they move

independently of other currencies. The value of the currency is determined by supply and

demand, which has no specific intervention point that has to be observed, and can be traded by

anybody so inclined. Free-floating currencies are in the heaviest trading demand.

The FOREX market was made available to the average investor in 1998 and is one of the fastest

growing markets in the world, with daily volume of nearly 100 times that of the entire stock

market.

Global Forex Market:

Today, the FOREX market is a nonstop cash market where currencies of nations are traded. The

brokers and banks act as intermediaries between customers & their needs. Foreign currencies are

continually and simultaneously bought and sold across local and global markets. The value of

traders' investments increases or decreases based on currency movements. Foreign exchange

market conditions can change at any time in response to real-time events.



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FEATURES OF FOREX MARKET:

24-hour trading, 5 days a week with nonstop access to global Forex dealers.

An enormous liquid market, making it easy to trade most currencies.

Volatile markets offering profit opportunities.

Standard instruments for controlling risk exposure.

The ability to profit in rising as well as falling markets.

Leveraged trading with low margin requirement

How does the market work?

Markets are places where goods are traded, and the same goes with FOREX. In FOREX markets,

the “goods” are the currencies of various countries (as well as gold and silver). For example, we

might buy euro with US dollars, or we might sell Japanese Yen for Canadian dollars. It’s as basic as

trading one currency for another.

The Activity:

The FOREX Market is peculiar in the sense that there is no “market” as such. In general, there is no

centralized location for the trading activity. The trading occurs over the telephone and through

computer terminals located at various locations across the globe.

Another distinguishing feature of the FOREX Market is a 24 – hour continuous currency exchange.

In short, it is an exchange that “never closes”. There are dealers in every major time zone, in every

major dealing centre.



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How does one profit in the FOREX market?

Obviously, buy low and sell high! The profit potential comes from the fluctuations (changes) in the

currency exchange market. Unlike the stock-market, where share are purchased, Forex trading

does not require physical purchase of the currencies, but rather involves contracts for amount and

exchange rate of currency pairs. The advantageous thing about the Forex market is that regular

daily fluctuations in the regular currency exchange markets.

FOREX trading and a FOREX deal

The investor's goal in FOREX trading is to make profit from foreign currency movements. More

than 95% of all FOREX trading performed today is for speculative purposes (e.g. to profit from

currency movements). The rest belongs to hedging (managing business exposures to various

currencies) and other activities.

FOREX trades are non-delivery trades: currencies are not physically traded, but rather there are

currency contracts which are agreed upon and performed on the maturity date i.e. are known as

Forward Contracts. The two parties involved in the contract undertake to fulfill their respective

obligations: one side undertakes to sell the amount specified, and the other undertakes to buy it.

As mentioned, over 95% of the market activity is for speculative purposes, so there is no intention

on either side to actually perform the contract i.e. the physical delivery of the currency. Thus, the

contract ends by offsetting it against an opposite position, resulting in the profit and loss of the

parties involved.

Factors influencing Market movements:

The general state of affairs prevailing in a country seems to be the primary factor in influencing

the market rates. Key Economic data like the Balance of Payments, Pay – Roll Figures, etc. are the

drivers of this market. A recent example to drive home this point was the weakening of the U.S.

Dollar against the EURO when the U.S. Pay – Roll figures were way below the expected levels.

Thus, it is quite clear that any broad – based economic conditions can cause dramatic currency

price swings.



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It is also interesting to note that the market is also influenced to an extent by news and, at times,

even by rumours. The FOREX market bears resemblance in this regard to the stock markets where

a strong rumour can change the fortune of a company – for the better or for the worse. It can,

hence, be safely said that anticipation of a certain economic condition acts as a stronger catalyst

than the condition itself.

Participants in the FOREX

The foreign exchange market (FOREX) is not a market like the New York stock exchange, where

daily trades of stock are conducted in a central location. Instead, a FOREX market refers to the

activities of major international banks that engage in currency trading. These banks act as

intermediaries between the true buyers and sellers of currencies, ie, governments, businesses,

and individuals. These banks will hold foreign currency deposits and stand ready to exchange

these for domestic currency upon demand. The exchange rate will be determined independentlyby each bank but will essentially be determined by supply and demand in the market. In other

words, the banks set the exchange rate at each moment to equalize its supply of foreign currency

with the market demand. Each bank makes money by collecting a transactions fee for its

"exchange services."

The participants in this market are

i) central and commercial banks,

ii) corporations,

iii) institutional investors,

iv)

hedge funds, andv) private individuals.

It is useful to categorize two distinct groups of participants in the FOREX, those whose

transactions are recorded on the current account (importers and exporters) and those whose

transactions are recorded on the financial account. (investors)



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1. Importers and Exporters

Anyone who either imports or exports goods and services will need to exchange currencies to

make the transactions. This includes tourists who travel abroad since their transactions would

appear as services in the current account. These businesses and individuals will engage in

currency trades daily, however, these transactions are small in comparison to those made by

investors.

2. International Investors, Banks, Arbitrageurs etc.

Most of the daily currencies transactions are made by investors. These investors, be they

investment companies, insurance companies, banks or others, are making currency transactions

to realize a greater return on their investments or holdings. Many of these companies are

responsible to manage the savings of others. Pension plans and mutual funds buy and sell billions

of dollars worth of assets daily. Banks, in the temporary possession of the deposits of others do

the same. Insurance companies manage large portfolios which act as their capital to be used to

pay off claims on accidents, casualties and deaths. More and more these companies look

internationally to make the most of their investments.

It is estimated that over $1 trillion (or $1000 billion) worth of currency is traded every day. Only

about $70-$100 billion of trade in goods and services takes place daily worldwide. This suggests

that much of the currency exchanges are done by international investors rather than importers

and exporters.

Broadly they can be classified as:

3. Hedgers

Hedgers account for less than 5% of the market, but are the key reason futures and other such

financial instruments exist. The group using these hedging tools is primarily businesses and other

organizations participating in international trade. Their goal is to diminish or neutralize the impact

of currency fluctuations.

4. Speculators

Speculators account for more than 95% of the market. This group includes private individuals and

corporations, public entities, banks, etc. They participate in the Forex market in order to create

profit, taking advantage of the fluctuations of interest rates and exchange rates.

Why FOREX Markets?



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The FOREX Market, though has a gigantic turnover, the concept is yet to gain a wider acceptance

in India. Recently, professional investors are venturing into the FOREX arena in the light of the

innumerable benefits it provides to its investors.

1. Liquidity: FOREX markets can dwarf any other market by its trading volumes. This enables

an investor to derive greater benefits in the form of increased liquidity. Liquidity has

always been a powerful attraction for any investor as it gives him the flexibility to enter or

exit & in FOREX parlance, the freedom to open or close a position at will.

2. Access: The fact that the FOREX Market is a 24 – Hour market provides an investor the

benefit of greater access.

3. Flexibility: The FOREX Markets provide an investor with a great degree of flexibility given

the fact he can establish a position for the period of his desire.

4. Execution Costs: Traditionally, the FOREX Market has no brokerage charges. The gains

earned are generally through the difference in the market BID and OFFER rates, called as

“spread”.

5. Trending: Over long periods of time, currencies exhibit substantial and identifiable trends.

With proper analysis of these trends and by utilizing the various charting techniques, the

investor can derive immense benefits out of any divergence experienced in the currency.

The Foreign Exchange Market - Definitions

Exchange Rate - the exchange rate represents the number of units of one currency that

exchanges for a unit of another. There are two ways to express an exchange rate between two

currencies (e.g. the $ and £ [pound]). One can either write $/£ or £/$ . These are reciprocals of

each other. Thus if E is the $/£ exchange rate and V is the £/$ exchange rate then E = 1/V.

For Example, on Jan 8, 1997 the following exchange rates prevailed,

E$/£ = 1.69 which implies V£/$ = 0.59

V¥/$ = 116. which implies E$/¥ = 0.0086

Currency Value



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It is important to note that the value of a currency is always given in terms of another currency.

Thus the value of a US dollar in terms of British pounds is the £/$ exchange rate. The value of the

Japanese yen in terms of dollar is the $/¥ exchange rate.

[Note: we always express the value of all items in terms of something else. Thus, the value of a

quart of milk is given in dollars, not in milk units. The value of car is also given in dollar terms, not

in terms of cars. Similarly, the value of a dollar is given in terms of something else, usually another

currency. Hence the rupee/$ exchange rate gives us the value of the dollar in terms of rupees.]

This definition is especially useful to remember when one is dealing with unfamiliar currencies.

Thus the value of the euro (€) in terms of British pounds is given as the £/€ exchange rate.

The peso/€ exchange rate refers to the value of the euro in terms of pesos.

Currency appreciation - a currency appreciates with respect to another when its value rises in

terms of the other. The dollar appreciates with respect to the yen if the ¥/$ exchange rate rises.

Currency depreciation - a currency depreciates with respect to another when its value falls interms of the other. The dollar depreciates with respect to the yen if the ¥/$ exchange rate falls.

Note that if the ¥/$ rate rises, then its reciprocal, the $/¥ rate falls. Since the $/¥ rate represents

the value of the yen in terms of dollars, this means that when the dollar appreciates with respect

to the yen, the yen must depreciate with respect to the dollar.

The rate of appreciation (or depreciation) is the percentage change in the value of a currency

over some period of time.

Example #1:

On Jan. 8 1997, E¥/$ = 116

On Jan. 8 1996, E¥/$ = 105

Use percentage change formula: (New value - Old value)/Old Value

Multiply by 100 to write as a percentage to get,

0.105 x 100 = +10.5%



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Since we have calculated the change in the value of the $, in terms of yen, and since the

percentage change is positive, this means that the dollar has appreciated by 10.5% with respect to

the yen during the past year.

Example #2:

On Jan. 8 1997, E£/$ = 0.59

On Jan. 8 1996, E£/$ = 0.65

Use percentage change formula: (New value - Old value)/Old Value

Multiply by 100 to write as a percentage to get,

-0.092 x 100 = -9.2%

Since we have calculated the change in the value of the $, in terms of pounds, and since the

percentage change is negative, this means that the dollar has depreciated by 9.2% with respect to

the pound during the past year.

Arbitrage - arbitrage, generally means buying a product when its price is low and then reselling it

after its price rises in order to make a profit. Currency arbitrage means buying a currency in one

market (say New York) at a low price and reselling, moments later, in another market at a higher

price.

Spot Exchange Rate - the spot exchange rate refers to the exchange rate that prevails on the spot ,

that is, for trades to take place immediately.

Forward Exchange Rate - the forward exchange rate refers to the rate which appears on a

contract to exchange currencies either 30, 60, 90 or 180 days in the future.

For example a corporation might sign a contract with a bank to buy DMs for dollars 60 days from

now at a predetermined ER. The predetermined rate is called the 60-day forward rate. Forward

contracts can be used to reduce exchange rate risk.

For example suppose an importer of BMWs is expecting a shipment in 60 days. Suppose that upon

arrival the importer must pay €1,000,000. The current spot ER is 1.20 $/€ thus if the payment

were made today it would cost $1,200,000. Suppose further that the importer is fearful of a $

depreciation. He doesn't currently have the $1,200,000 but expects to earn more than enough in

sales over the next two months. If the $ falls in value to, say, 1.3 $/€ in 60 days time, how much

would cost the importer in dollars to purchase the BMW shipment?



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A. The shipment would still cost €1,000,000. To find out how much this is in dollars multiply

€1,000,000 by 1.3 $/€ = $1,300,000.

Note this is $100.000 more for the cars simply because the $ value changed.

One way the importer could protect himself against this potential loss is to purchase a forward

contract to buy € for $ in 60 days. The ER on the forward contract will likely be different from the

current spot ER. In part its value will reflect market expectations about the degree to whichcurrency values will change in the next two months. Suppose the current 60-day forward ER is

1.25 $/€ reflecting the expectation that the $ value will fall. If the importer purchases a 60-day

contract to buy €1,000,000 it will cost him (1,000,000 x 1.25) = $1,250,000. Although this is higher

than what it would cost if the exchange were made today, the importer does not have the cash

available to make the trade today, and the forward contract would protect the importer from

even an even greater $-depreciation.

When the forward ER is such that a forward trade costs more than a spot trade today costs, there

is said to be a forward premium. If the reverse were true, such that the forward trade were

cheaper than a spot trade then there is a forward discount .

Hedging - a currency trader is hedging if he or she enters into a forward contract to protect

oneself from a downside loss. However by hedging the trader also forfeits the potential for an

upside gain. Suppose in the story above that the spot ER falls rather than rises. Suppose the ER fell

to 1.10 $/€ . In this case, had the importer waited the €1,000,000 would only have cost (1,000,000

x 1.10) = $1,100,000. Thus, hedging protects against loss but at the same time eliminaters

potential unexpected gain.

Investment Concerns - International or Domestic

Investors generally have three broad concerns when an investment is made. They care about how

much money the investment will earn over time, they care about how risky the investment is, and

they care about how liquid, or convertible, the asset is.



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1) Rate of return - the percentage change in the value of an asset over some period of time.

Investors purchase assets as a way of saving for the future. Anytime an asset is purchased the

purchaser is forgoing current consumption for future consumption. In order to make such a

transaction worthwhile the investors hopes (sometimes expects) to have more money for future

consumption than the amount they give up in the present. Thus investors would like to have as

high a rate of return on their investments as possible.

Example 1: Suppose a Picasso painting is purchased in 1996 for $500,000. One year later the

painting is resold for $600,000. The rate of return is calculated as,

Example 2: $1000 is placed is a savings account for 1 year at an annual interest rate of 10%. The

interest earned after one year is $1000 x 0.10 = $100. Thus the value of the account after 1 year is

$1100. The rate of return is,

This means that the rate of return on a domestic interest bearing account is merely the interest

rate.

2) Risk

The second primary concern of an investor is the riskiness of the assets. Generally, the greater theexpected rate of return, the greater the risk. Invest in an oil wildcat endeavor and you might get a

1000% return on your investment ... if you strike oil. The chances of doing so are likely to be very

low however. Thus, a key concern of investors is how to manage the tradeoff between risk and

return.

3) Liquidity

Liquidity essentially means the speed with which assets can be converted to cash. Insurance

companies need to have assets which are fairly liquid in the event that they need to pay out a

large number of claims. Banks have to stand ready to make payout to depositors etc.



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DETERMINATION OF EXCHANGE RATE:

Introduction to Purchasing Power Parity (PPP)

Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare

the average costs of goods and services between countries. The theory introduces the

assumptions about the behavior of importers and exporters in response to changes in the relative

costs of national market baskets.

In another vein, PPP suggests that transactions on a country's current account, affect the value of

the exchange rate on the foreign exchange market. This contrast with the interest rate parity

theory which assumes that the actions of investors, whose transactions are recorded on the

capital account, induces changes in the exchange rate.

PPP theory is based on an extension and variation of the "law of one price" as applied to the

aggregate economy. To explain the theory it is best, first, to review the idea behind the law of one

price.

The Law of One Price (LoOP)

The law of one price says that identical goods should sell for the same price in two separate

markets when there are no transportation costs and no differential taxes applied in the two

markets. Consider the following information about movie video tapes sold in the US and Mexican

markets.

Price of videos in US market (P$v) $20

Price of videos in Mexican market (Ppv) p150

Spot exchange rate (Ep/$) 10 p/$

The dollar price of videos sold in Mexico can be calculated by dividing the video price in pesos by

the spot exchange rate as shown,

To see why the peso price is divided by the exchange rate (rather than multiplied) notice the

conversion of units shown in the brackets. If the law of one price held, then the dollar price in

Mexico should match the price in the US. Since the dollar price of the video is less than the dollar

price in the US, the law of one price does not hold in this circumstance.



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The next question to ask is what might happen as a result of the discrepancy in prices. Well, as

long as there are no costs incurred to transport the goods, there is a profit-making opportunity

through trade. For example, US travelers in Mexico who recognize that identical video titles are

selling there for 25% less might buy videos in Mexico and bring them back to the US to sell. This is

an example of "goods arbitrage." An arbitrage opportunity arises whenever one can buy

something at a low price in one location and resell at a higher price and thus make a profit.

Using basic supply and demand theory, the increase in demand for videos in Mexico would pushthe price of videos up. The increase supply of videos on the US market would force the price down

in the US. In the end the price of videos in Mexico may rise to, say, 180 pesos while the price of

videos in the US may fall to $18. At these new prices the law of one price holds since,

The idea between the law of one price is that identical goods selling in an integrated market,

where there are no transportation costs or differential taxes or subsidies, should sell at identicalprices. If different prices prevailed then there would be profit-making opportunities by buying the

good in the low price market and reselling it in the high price market. If entrepreneurs acted in

this way, then the prices would converge to equality.

Of course, for many reasons the law of one price does not hold even between markets within a

country. The price of beer, gasoline and stereos will likely be different in New York City than in Los

Angeles. The price of these items will also be different in other countries when converted at

current exchange rates. The simple reason for the discrepancies is that there are costs to

transport goods between locations, there are different taxes applied in different states and

different countries, non-tradable input prices may vary, and people do not have perfect

information about the prices of goods in all markets at all times. Thus, to refer to this as an

economic "law" does seem to exaggerate its validity.

From LoOP to PPP

The purchasing power parity theory is really just the law of one price applied in the aggregate,

but, with a slight twist added (more on the twist a bit later). If it makes sense from the law of one

price that identical goods should sell for identical prices in different markets, then the law ought

to hold for all identical goods sold in both markets.

First, let's define the variable CB$ to be the cost of a basket of goods in the US denominated indollars. For simplicity we could imagine using the same basket of goods used in the construction

of the US consumer price index (CPI$). The CPI uses a market basket of goods which are purchased

by an average household during a specified period. The basket is determined by surveying the

quantity of different items purchased by many different households. One can then determine, on

average, how many units of bread, milk, cheese, rent, electricity, etc. are purchased by the typical

household. You might imagine, it's as if all products are purchased in a grocery store, with items



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being placed in a basket before the purchase is made. CB$ then represents the dollar cost of

purchasing all of the items in the market basket. We shall similarly define CBp to be the cost of a

market basket of goods in Mexico denominated in pesos.

Now if the law of one price holds for each individual item in the market basket, then it should hold

for the market baskets as well. In other words,

Rewriting the right-hand side equation allows us to put the relationship in the form commonly

used to describe absolute purchasing power parity. Namely,

If this condition holds between two countries then we would say PPP is satisfied. The condition

says that the PPP exchange rate (pesos per dollars) will equal the ratio of the costs of the two

market baskets of goods denominated in local currency units. Note that the reciprocal

relationship is also valid.

Because the cost of a market basket of goods is used in the construction of the country's

consumer price index, PPP is often written as a relationship between the exchange rate and the

country's price indices.



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PPP as a Theory of Exchange Rate Determination

The PPP relationship becomes a theory of exchange rate determination by introducing

assumptions about the behavior of importers and exporters in response to changes in the relative

costs of national market baskets. Recall, in the story of the law of one price, when the price of a

good differed between two country's markets, there was an incentive for profit-seeking

individuals to buy the good in the low price market and resell it in the high price market. Similarly,

if a market basket, containing many different goods and services, costs more in one market than

another, we should likewise expect profit-seeking individuals to buy the relatively cheaper goods

in the low cost market and resell them in the higher priced market. If the law of one price leads to

the equalization of the prices of a good between two markets, then it seems reasonable to

conclude that PPP, describing the equality of market baskets across countries, should also hold.

However, adjustment within the PPP theory occurs with a twist compared to adjustment in the

law of one price story. In the law of one price story, goods arbitrage in a particular product was

expected to affect the prices of the goods in the two markets. The twist that's included in the PPP

theory is that arbitrage, occurring across a range of goods and services in the market basket, will

affect the exchange rate rather than the market prices.

The PPP Equilibrium Story

To see why the PPP relationship represents an equilibrium we need to tell an equilibrium story. An

equilibrium story in an economic model is an explanation of how the behavior of individuals will

cause the equilibrium condition to be satisfied. The equilibrium condition is the PPP equation

developed above,

The endogenous variable in the PPP theory is the exchange rate. Thus, we need to explain why theexchange rate will change if it is not in equilibrium. In general there are always two versions of an

equilibrium story, one in which the endogenous variable (Ep/$ here) is too high, and one in which it

is too low.

PPP Equilibrium Story 1 - Let's consider the case in which the exchange rate is too low to be in

equilibrium. This means that,



23

where Ep/$ is the exchange rate that prevails on the spot market and, since it is less than the ratio

of the market basket costs in Mexico and the US, is also less than the PPP exchange rate. The

right-hand side of the expression is rewritten to show that the cost of a market basket in the USevaluated in pesos, CB$Ep/$, is less than the cost of the market basket in Mexico also evaluated in

pesos. Thus, it is cheaper to buy the basket in the US, or, more profitable to sell items in the

market basket in Mexico.

The PPP theory now suggests that the cheaper basket in the US will lead to an increase in demand

for goods in the US market basket by Mexico, and, as a consequence, will increase the demand for

US dollars on the foreign exchange market. Dollars are needed because purchases of US goods

require US dollars. Alternatively, US exporters will

realize that goods sold in the US can be sold at a

higher price in Mexico. If these goods are sold in

pesos, the US exporters will wantto convert theproceeds back to dollars. Thus, there is an

increase in US dollar demand (by Mexican

importers) and an increase in peso supply (by US

exporters) on the Forex. This effect is represented

by a rightward shift in the US dollar demand curve

in the adjoining diagram. At the same time, US

consumers will reduce their demand for the

pricier Mexican goods. This will reduce the supply

of dollars (in exchange for pesos) on the Forex

which is represented by a leftward shift in the USdollar supply curve in the Forex market.

Both the shift in demand and supply will cause an increase in the value of the dollar and thus the

exchange rate, Ep/$, will rise. As long as the US market basket remains cheaper, excess demand for

the dollar will persist and the exchange rate will continue to rise. The pressure for change ceases

once the exchange rate rises enough to equalize the cost of market baskets between the two

countries and PPP holds.

PPP Equilibrium Story 2 - Now let's consider the other equilibrium story, that is, the case in which

the exchange rate is too high to be in equilibrium. This implies that,



24

The left-hand side expression says that the spot exchange rate is greater than the ratio of the

costs of market baskets between Mexico and the US. In other words the exchange rate is above

the PPP exchange rate. The right-hand side expression says that the cost of a US market basket,

converted to pesos at the current exchange rate, is greater than the cost of a Mexican market

basket in pesos. Thus, on average US goods are relatively more expensive while Mexican goods

are relatively cheaper.

The price discrepancies should lead consumers inthe US, or importing firms, to purchase less

expensive goods in Mexico. To do so, they will

raise the supply of dollars in the Forex in exchange

for pesos. Thus, the supply curve of dollars will

shift to the right as shown in the adjoining

diagram. At the same time, Mexican consumers

would refrain from purchasing the more

expensive US goods. This would lead to a

reduction in demand for dollars in exchange for

pesos on the Forex. Hence the demand curve fordollars shifts to the left. Due to the demand

decrease and the supply increase, the exchange

rate, Ep/$, falls. This means that the dollar

depreciates and the peso appreciates.

Extra demand for pesos will continue as long as goods and services remain cheaper in Mexico.

However, as the peso appreciates (the $ depreciates) the cost of Mexican goods rises relative to

US goods. The process ceases once the PPP exchange rate is reached and market baskets cost the

same in both markets.

Adjustment to Price Level Changes Under PPP

In the PPP theory, exchange rate changes are induced by changes in relative price levels between

two countries. This is true because the quantities of the goods are always presumed to remain

fixed in the market baskets. Therefore, the only way that the cost of the basket can change is if

the goods' prices change. Since price level changes represent inflation rates, this means that

differential inflation rates will induce exchange rate changes according to the theory.

If we imagine that a country begins with PPP, then the inequality given in equilibrium story #1,

, can arise if the price level rises in Mexico (peso inflation), if the price level

falls in the US ($ deflation), or if Mexican inflation is more rapid than US inflation. According to the

theory, the behavior of importers and exporters would now induce a dollar appreciation and a

peso depreciation. In summary, an increase in Mexican prices relative to the change in US prices

(i.e., more rapid inflation in Mexico than in the US) will cause the dollar to appreciate and the

peso to depreciate according to the purchasing power parity theory.



25

Similarly, if a country begins with PPP, then the inequality given in equilibrium story #2,

, can arise if the price level rises in the US ($ inflation), the price level falls in

Mexico (peso deflation) or if US inflation is more rapid than Mexican inflation. In this case, the

inequality would affect the behavior of importers and exporters and induce a dollar depreciation

and peso appreciation. In summary, more rapid inflation in the US would cause the dollar to

depreciate while the peso would appreciate.

Problems and Extensions of PPP

Problems with the PPP Theory

The main problem with the PPP theory is that the PPP condition is rarely satisfied within a

country. There are quite a few reasons that can explain this and so, given the logic of the theory,

which makes sense, economists have been reluctant to discard the theory on the basis of lack of

supporting evidence. Below we consider some of the reasons PPP may not hold.

Transportation costs and trade restrictions - Since the PPP theory is derived from the law of one

price, the same assumptions are needed for both theories. The law of one price assumed that

there are no transportation costs and no differential taxes applied between the two markets.

These means that there can be no tariffs on imports or other types of restrictions on trade. Since

transport costs and trade restrictions do exist in the real world this would tend to drive prices for

similar goods apart. Transport costs should make a good cheaper in the exporting market and

more expensive in the importing market. Similarly, an import tariff would drive a wedge between

the prices of an identical good in two trading countries' markets, raising it in the import market

relative to the export market price. Thus the greater are transportation costs and trade

restrictions between countries, the less likely for the costs of market baskets to be equalized.

Costs of Non-Tradable Inputs - Many items that are homogeneous, nevertheless sell for differentprices because they require a non-tradable input in the production process. As an example

consider why the price of a McDonald's Big Mac hamburger sold in downtown New York city is

higher than the price of the same product in the New York city suburbs. Because the rent for

restaurant space is much higher in the city center, the restaurant will pass along its higher costs in

the form of higher prices. Substitute products in the city center (other fast food restaurants) will

face the same high rental costs and thus will charge higher prices as well. Because it would be

impractical (i.e., costly) to produce the burgers at a cheaper suburban location and then transport

them for sale in the city, competition would not drive the prices together in the two locations.

Perfect information - The law of one price assumes that individuals have good, even perfect,

information about the prices of goods in other markets. Only with this knowledge will profit-

seekers begin to export goods to the high price market and import goods from the low priced

market. Consider a case in which there is imperfect information. Perhaps some price deviations

are known to traders but other deviations are not known. Or maybe only a small group of traders

know about a price discrepancy and that group is unable to achieve the scale of trade needed to

equalize the prices for that product. (Perhaps they face capital constraints and can't borrow



26

enough money to finance the scale of trade needed to equalize prices). In either case, traders

without information about price differences will not respond to the profit opportunities and thus

prices will not be equalized. Thus, the law of one price may not hold for some products which

would imply that PPP would not hold either.

It is estimated that there are approximately $1 trillion dollars worth of currency exchanged every

day on international Forex markets. That's one-eighth US GDP, which is the value of production in

the US in an entire year! Plus, the $1 trillion estimate is made by counting only one side of eachcurrency trade. Thus, that's an enormous amount of trade. If one considers the total amount of

world trade each year and then divide by 365, one can get the average amount of goods and

services traded daily. This number is less than $100 billion dollars. This means that the amount of

daily currency transactions is more than ten times the amount of daily trade. This fact would seem

to suggest that the primary effect on the daily exchange rate must be caused by the actions of

investors rather than importers and exporters. Thus, the participation of other traders in the

foreign exchange market, who are motivated by other concerns, may lead the exchange rate to a

value that is not consistent with PPP.

Relative PPP

There is an alternative version of the PPP theory called the "relative PPP theory." In essence this is

a dynamic version of the absolute PPP theory. Since absolute PPP suggests that the exchange rate

may respond to inflation, we can imagine that the exchange rate would change in a systematic

way given that a continual change in the price level (inflation) is occurring.

In the relative PPP theory, exchange rate changes over time are assumed to be dependent on

inflation rate differentials between countries according to the following formula:

Here the percentage change in the $ value between period 1 and 2 is given on the lefthand side.

The righthand side gives the differences in the inflation rates between Mexico and the US,

evaluated over the same time period. The implication of relative PPP is that if the Mexican

inflation rate exceeds the US inflation rate, then the dollar will appreciate by that differential over

the same period. The logic of this theory is the same as in absolute PPP. Importers and exporters

respond to variations in the relative costs of market baskets so as to maintain the law of one

price, at least on average. If prices continue to rise faster in Mexico than in the US, for example,

price differences between the two countries would grow and the only way to keep up with PPP isfor the dollar to appreciate continually versus the peso.



27

CHAPTER 2 - INTERNATIONAL MONETARY SYSTEM (IMS)

MNCs operate in a global market, buying/selling/producing in many different countries. For

example, GM sells cars in 150 countries, produces cars in 50 countries, so it has to deal with

hundreds of currencies. What are the mechanics of how currency and capital flows

internationally?

International Monetary System - Institutional framework within which:

1. International payments are made

2. Movements of capital are accommodated

3. Ex-rates are determined

An international monetary system is required to facilitate international trade, business, travel,

investment, foreign aid, etc. For domestic economy, we would study Money and Banking to

understand the domestic institutional framework of money, monetary policy, central banking,

commercial banking, check-clearing, etc. To understand the flow of international capital/currency

we study the IMS. IMS - complex system of international arrangements, rules, institutions,

policies in regard to ex-rates, int'l payments, capital flows. IMS has evolved over time as int'l

trade, finance, and business have changed, as technology has improved, as political dynamics

change, etc. Example: evolution of the European Union and the Euro currency impacts the IMS.

"Spontaneous Order."

HISTORY OF THE IMS

1. BIMETALLISM (pre-1875)

Commodity money system using both silver and gold (precious metals) for int'l payments (and for

domestic currency). Why silver and gold? (Intrinsic Value, Portable, Recognizable,

Homogenous/Divisible, Durable/Non-perishable). Why two metals and not one (silver standard or



28

gold standard vs. bimetallism)? Some countries' currencies in certain periods were on either the

gold standard (British pound) or the silver standard (German DM) and some on a bimetallic

(French franc). Pound/Franc ex-rate was determined by the gold content of the two currencies.

Franc/DM was determined by the silver content of the two currencies. Pound (gold) / DM (silver)

rate was determined by their ex-rates against the Franc.

Under a bimetallic standard (or any time when more than one type of currency is acceptable for

payment), countries would experience "Gresham's Law" which is when "bad" money drives out

"good" money.

The more desirable, superior form of money is hoarded and withdrawn from circulation, and

people use the inferior or bad money to make payments. The bad money circulates, the good

money is hoarded. Under a bimetallic standard the silver/gold ratio was fixed at a legal rate.

When the market rate for silver/gold differed substantially from the legal rate, one metal would

be overvalued and one would be undervalued. People would circulate the undervalued (bad)

money and hoard the overvalued (good) money.

Examples: a) From 1837-1860 the legal silver/gold ratio was 16/1 and the market ratio was 15.5/1.

One oz of gold would trade for 15.5 oz. of silver in the market, but one oz of gold would trade for

16 oz of silver at the legal/official rate. Gold was overvalued at the legal rate, silver was

undervalued. Gold circulated and silver was hoarded (or not minted into coins), putting the US on

what was effectively a gold standard.

b) Page 27 in book, France went from a bimetallic standard to effectively a gold standard after the

discovery of gold in US and Australia in the 1800s. The fixed legal ratio was out of line with the

true market rate. Gold became more abundant, lowering its scarcity/value, silver became more

valuable. Only gold circulated as a medium of exchange.

2. CLASSICAL GOLD STANDARD (1875-WWI).



29

For about 40 years most of the world was on an international gold standard, ended with WWI

when most countries went off gold standard. London was the financial center of the world, most

advanced economy with the most int'l trade.

Gold Standard exists when most countries:

1. Use gold coins as the primary medium of exchange.

2. Have a fixed ex-rate between ounce of gold and currency.

3. Allow unrestricted gold flows - gold can be exported/imported freely.

4. Banknotes had to be backed with gold to assure full convertibility to gold.

5. Domestic money stock had to rise and fall with gold flows.

Under a gold standard, ex-rates would be kept in line by cross-country gold flows. Any mis-

alignment of ex-rates would be corrected by gold flows. Payments could in effect be made by

either gold or banknotes. If market ex-rates ever deviated from the official ex-rate, it would be

cheaper to pay in gold than in banknotes.

Example: Suppose that the U.K. Pound is pegged to gold at: £6/oz., and the French franc is pegged

to gold at FF12/oz., then the ex-rate should be FF2/Pound. If the market rate was FF1.80/£, then

the pound is undervalued in the market (one pound should buy 2 FF, it only buys 1.8 FF).

Arbitrage would re-align the ex-rate:

1. Take £500 and buy 83.33 oz of gold (£500 / 6) in U.K.

2. Sell the gold for FF1000 in France (83.33 oz. x 12)

3. Sell 1000 FF for £555.56 (FF1000 / 1.8FF/£), for an arbitrage profit of £55.56

Arbitrage would appreciate the £, depreciate the FF, and the ex-rate would be restored at 2FF/£.

Also under gold standard, int'l. balance of payments get corrected automatically. Suppose that

UK has a trade surplus (X > M) with France (M > X), which has a trade deficit. UK sold more toFrance than it bought, France bought more from UK than it sold, which brings about a flow of gold

from ______ to _______. The increased (decreased) gold in UK (France) brings about ________ in

UK and _______ in France. As time goes on, Exports from UK will ____ because British prices are

now _____, Imports will _____ because French prices are ______. The trade surplus of UK will



30

_____ and France's deficit will _______. Market forces automatically correct trade

deficits/surpluses, this adjustment mechanism is known as the “price-specie-flow mechanism.”

Advantages of Gold Standard:

1. Ultimate hedge against inflation. Because of its fixed supply, gold standard creates price level

stability, eliminates abuse by central bank/hyperinflation.

2. Automatic adjustment in Balance of Payments due to price-specie-flow mechanism.

Disadvantages of Gold Standard:

1. Possible deflationary pressure. With a fixed supply of gold (fixed money supply), output growth

would lead to deflation.

2. An international gold standard has no commitment mechanism, or enforcement mechanism, to

keep countries on the gold standard if they decide to abandon gold.

3. INTERWAR PERIOD: 1915-1944

When WWI started, countries abandoned the gold standard, suspended redemption of banknotes

for gold, and imposed embargoes on gold exports (no gold could leave the country). After the

war, hyperinflationary finance followed in many countries such as Germany, Austria, Hungary,

Poland, etc. Price level increased in Germany by 1 trillion times!! Why hyperinflation then??

What are the costs of inflation??

US (1919), UK(1925), Switzerland, France returned to the gold standard during the 1920s.

However, most central banks engaged in a process called "sterilization" where they would

counteract and neutralize the price-specie-flow adjustment mechanism. Central banks would

match inflows of gold with reductions in the domestic MS, and outflows of gold with increases in

MS, so that the domestic price level wouldn't change. Adjustment mechanism would not be

allowed to work. If the US had a trade surplus, there would be a gold inflow which should have

increased US prices, making US less competitive. Sterilization would involve contractionary

monetary policy to offset the gold inflow.

In the 1930s, what was left of the gold standard faded - countries started abandoning the gold

standard, mostly because of the Great Depression, bank failures, stock market crashes. Started in



31

US, spread to the rest of the world. Also, escalating protectionism (trade wars) brought int'l trade

to a standstill. (Smoot-Hawley Act in 1930), slowing int'l gold flows. US went off gold in 1933,

France lasted until 1936.

Between WWI and WWII, the gold standard never really worked, it never received the full

commitment of countries. Also, it was period of political instability, the Great Depressions, etc. So

there really was no stable, coherent IMS, with adverse effects on int'l trade, finance and

investment.

4. BRETTON WOODS SYSTEM: 1945-1972

At the end of WWII, 44 countries nations met at Bretton Woods, N.H. to develop a postwar IMS.

The International Monetary Fund (IMF) and the World Bank were created as part of a

comprehensive plan to start a new IMS. The IMF was to supervise the rules and policies of a new

fixed ex-rate regime, the World Bank was responsible for financing development projects for

developing countries (power plants, roads, infrastructure investments).

IMS established by Bretton Woods was a dollar-based, gold-exchange standard of fixed exchange

rates. The US dollar was pegged to gold at a fixed price of $35/ounce, and then each currency hada fixed ex-rate with the $. See Exhibit 2.1 on p. 30.

Examples: $2.80/£, DM4.20/$, FF3.50/$, etc.

Each country was supposed to maintain the fixed rate within 1% of the agreed upon rate, by

buying/selling currency. To increase the foreign exchange value of DM, the central bank would

____ DMs with $; to decrease the value of DM it would ____ DMs for $. US $ was convertible togold, the other currencies were not. Countries held $ and gold for IMS payments. A country with

a "fundamental disequilibrium" could be allowed to change its fixed rate with the $.



32

Advantages of Gold-Exchange System/Bretton Woods in SR:

1. Economizes on scarce resources (gold) by allowing foreign reserves ($s) to be used for IMS

payments. Easier to transfer dollars vs. shipping gold overseas under pure gold std.

2. By holding $ instead of gold as reserves, foreign central banks can earn interest vs. non-interest

bearing gold.

3. Ex-rate stability reduced currency risk, provided a stable IMS, facilitated int'l trade and

investment, led to strong economic growth around the world in 50s and 60s.

In long run, Bretton Woods (gold-exchange system) was unstable. There was no way to:

1) devalue the reserve currency ($) even when it became overvalued or2) force a country to revise its ex-rate upward (appreciate its currency). A country could agree, or

be pressured into devaluation, but there was no way to "revalue" a currency upward (appreciate

through contractionary policy). In the 1960s, US pursued expansionary monetary policy (printed

money) to reduce unemployment, resulting in the dollar being overvalued and foreign currencies

being undervalued according to the fixed ex-rate system. There was no way to devalue the $, and

other countries were not willing to revalue their ex-rates upward (appreciate). Why?

Bretton Woods started to collapse in 1971, temporary measure (Smithsonian Agreement) didn't

work, fixed ex-rate regime was abandoned in 1973. Also, Nixon put wage and price controls went

into effect in 1971, were then lifted, first oil shock started in 1973 (Arab oil embargo after Nixon

gave $2.5B to Israel after Egypt attacked), oil prices doubled, no way to stabilize the dollar. 1973-

fixed ex-rates/Bretton Woods were abandoned.

5. FLEXIBLE EXCHANGE RATES: 1973-PRESENT

IMF members met in Jamaica in 1976 to agree to a new IMS including:



33

a. Flexible ex-rates allowed, central banks could intervene in currency markets. (Under fixed ex-

rates, you lose control over your monetary policy. Monetary policy must be committed to

maintaining the fixed ex-rate, and cannot be used to pursue other macroeconomic goals)

b. Gold was abandoned as a reserve asset.

c. Developing countries were to get more assistance from IMF.

IMF was to provide assistance to countries facing BP/currency difficulties. (Brazil example). IMF

provides grants and loans to countries with problems under the conditions that they follow IMF's

policy prescriptions - "strings attached to aid." Reduced budget deficits, reduced govt.

spending/cutting subsidies, contractionary monetary policy, i.e. responsible fiscal and monetary

policies.

Advantages of Flexible Ex-Rates:

a. Countries have control over monetary policy

b. A true market value is established for currency, fluctuates daily to reflect market forces of S and

D.

c. Flexible ex-rates maintain BP equilibrium. Example: U.S. has trade deficit, M>X, excess dollars in

world currency markets, $ depreciates, £ appreciates, US exports will go up, restore trade

balance.

Disadvantages:

a. More Volatility, see page 33, Exhibit 2.3. MNCs must be concerned about currency risk.

b. Potential abuse by central bank, reckless monetary expansion.

Major currencies like $, £ Yen, etc. are freely floating ex-rates, changing daily to reflect market

forces. Most of the rest of the world is under some type of system of "pegged ex-rates" or"managed floating," where central bank intervention is required to maintain a certain level of ex-

rates. One system results in trading 1:1 with the dollar (Panama, Bahamas, Belize 2:1, Liberia),

other systems trade within a certain band (range). See page 36-37, Exhibit 2.4. Currencies pegged

to $, FF, SDRs, others. 36 are independently floating, no pegging or targeting. More than 40 have

"managed floating" systems that combine market forces with pegging.



34

European Monetary System has been replaced by the Euro, the single currency in Europe (1 ECU =

1 Euro). See Exhibit 2.5 on p. 39. To qualify for euro, countries had to meet certain economic

criteria:

1) Deficits/GDP less than 3%,

2) Price level stability - low and stable inflation, etc. Of the 15 countries in the European Union,three countries decided not to join (UK, Denmark, and Sweden).

As of Jan 1, 1999:

1) the 12 countries fixed their ex-rates against each other and against the Euro, and

2) the Euro became a unit of account. For example, 3.35FF/DM. 6.55 FF/Euro. FF and DM will float

against the $, £ and Yen, but will be fixed against each other and against the Euro. Fixed ex-rate

system for the 12 countries.

Euro currency (euro as a medium of exchange) started to circulate on Jan. 1, 2002. Old currency

and Euros BOTH circulated for the first 6 months, then old currency was taken out of circulation

and only Euros now exist.

Changes:

1) Stores now quote prices in Euros.

2) Payment in Euros can be made with charge cards and checking accounts

3) Euro currencies options are now traded

4) Stock prices/indexes are quoted in Euros.

5) European Central Bank (ECB) established to conduct monetary policy in Europe. Governing

Council made up of 12 ECB governors, one from each country, and 6 member Executive Board.

Main Advantages of Euro (€):

1. Significant reduction in transaction costs for consumers, businesses, governments, etc.

(estimated to be .4% of European GDP, about $50B!)

European Saying: If you travel through all 15 countries and exchange money in each country but

don't spend it, you end up with 1/2 of the original amount!

2. Elimination of currency risk, which will save companies hedging costs.

3. Promote corporate restructuring via M&A activity (mergers and acquisitions), encourage

optimal business location decisions.



35

Main Disadvantage of Euro:

Loss of control over domestic monetary policy and exchange rate determination.

Suppose that the Finnish economy is not well-diversified, and is dependent on exports of

paper/pulp products, it might be prone to "asymmetric shocks" to its economy. If there is a

sudden drop in world paper/pulp prices, the Finnish economy could go into recession,

unemployment could increase. If independent, Finland could use monetary stimulus to lower

interest rates and lower the value of its currency, to stimulate the domestic economy and

increase exports. As part of EU, Finland no longer has those options, it is under the EU Central

Bank, which will probably not adjust policy for the Eurozone to accommodate Finland's recession.

Finland may have a prolonged recession. There are also limits to the degree of fiscal stimulus

through tax cuts, since budget deficits cannot exceed 3% of GDP, a requirement to maintain

membership in EMU (to discourage irresponsible fiscal behavior).

General Consensus: Euro has been a success, and will likely emerge as the second global currency,

with the Yen as a junior partner. The success of the Euro may encourage other areas to explore

cooperative monetary arrangements (Asia, S. America). Three world currencies at some point (¥,

€, $)?



36

CHAPTER-3 BALANCE OF PAYMENTS

Definition of the Balance of Payments

As defined in the BPM, the balance of payments (BOP) is a statistical statement that

systematically summarizes, for a specific time period, the economic transactions of an economywith the rest of the world . Transactions, for the most part between residents and nonresidents,

consist of those involving goods, services, and income; those involving financial claims on, and

liabilities to, the rest of the world; and those (such as gifts) classified as transfers, which involve

offsetting entries to balance—in an accounting sense—one-sided transactions. Each component of

this important definition is subsequently examined.

The balance of payments is concerned with transactions and thus deals with flows rather than

with stocks. That is, the balance of payments deals with economic events that take place during a

reference period and not with outstanding totals of economic assets and liabilities that exist at

particular moments in time.

Double Entry System

The balance of payments is a statistical statement structured in systematic fashion; data in the

statement are presented according to specific accounting rules. The basic accounting convention

for a BOP statement is that every recorded transaction is represented by two entries with exactly

equal values. In a BOP statement, the two entries are used to recognize the giving and receiving

sides of every transaction. Therefore, the BOP statement is analogous to a typical financial

statement prepared in accordance with the double entry system regularly used for business

accounting.

The dual entry system underlying BOP accounting is governed by certain rules. Thus, in

conformity with business and national accounting, in the balance of payments, the term credit is

used to denote a reduction in assets or an increase in liabilities, and the term debit is used to

denote a reduction in liabilities or an increase in assets. This usage has been supplemented by the

rule that every recording of a debit movement shall be matched by the recording of a credit

movement and vice versa. For example, Dromesia borrows 200,000 units in Cromanian currency

from the government of Cromania and deposits the money with a Cromanian commercial bank.

Dromesia then acquires an asset (the bank balance) as well as incurring a liability (the debt to thegovernment of Cromania). The asset account is debited, and the liability account is credited. The

Dromesian BOP entries to record the transaction are:

Credit Debit



37

Liabilities (obligation to

Cromania)

200,00

0Assets (bank balance inCromania)

200,000

The major classifications within the current account:

♦ Goods are broken down into the categories:

o General merchandise,

o Goods for processing,

o Tepairs on goods,

o Goods procured in ports by carriers and

o Non-monetary gold;

♦ Services include

o Transportation,

o Travel,

o All other services (such as construction and financial services);

♦ Income is broken down into

o Compensation of employees and

o Investment income;

♦ Current transfers include

o General government transfers, e.g. relating to current

International cooperation between different governments,

o Payment of current taxes on income and wealth, and

o Other transfers, e.g. workers’ remittances, insurance premiums. Compensation of employees comprises

♦ wages, salaries, and other benefits (in cash or in kind) earned by

individuals, and

♦ the employer share of contributions on behalf of employees to social

security schemes or to private insurance or pension funds to secure

benefits for employees.

Investment income includes

♦ interest,

♦ dividends,

♦ remittances of branch profits, and

♦ direct investors’ shares of the retained earnings of direct investment

enterprises.

Investment income account is classified by

♦ direct investment,

♦ portfolio investment and



38

♦ other investment (income on reserve assets is included here).

Income on direct investment and on portfolio investment is broken down

further into

♦ income on equity

♦ income on debt

The capital account records an economy’s ♦ Capital transfers that include transfers of ownership of fixed assets and

the cancellation, without any counterpart being received in return, of

liabilities by creditors;

♦ Transactions in nonproduced, non-financial assets include nonproduced

tangible assets, e.g., land and subsoil assets, and

nonproduced intangible assets, e.g., patents, copyrights, trademarks,

franchises, etc., and leases or other transferable contracts. Only the

purchase/sale, not the use of such assets, is to be recorded in the

capital account.

The financial account records an economy’s transactions in external financial

assets and liabilities. The financial account is structured around five accounts,

differentiated by the type of financial assets/liabilities involved in the

transaction:

♦ Direct investment reflects the objective of a resident entity in one

economy to obtain a lasting interest in an enterprise resident in another

economy. A “10% ownership criterion” establishes a direct investment

relationship, i.e. the existence of such a lasting interest for the balance

of payments statistics. Once a direct investment has been established,

subsequent financial flows between the related entities are recorded as

direct investment transactions, regardless of the financial instrumentused; Other capital is associated with various inter-company debt

operations. All financial operations between affiliated companies

(borrowing and lending of funds) – including debt securities and

suppliers’ credits (i.e. trade credits) – between direct investors and

subsidiaries, branches and associates.

♦ Portfolio investment includes the following assets insofar as they are

neither direct investment nor reserve assets.

o equity securities and

o debt securities in the form of

bonds and notes and money market instruments;



39

Standard Components of the Balance of Payments

Credit

Debi

t

1. Current Account

A. Goods and

services. a.

Goods

1. General merchandise

2. Goods for processing



40

3. Repairs on goods

4.

Goods procured in ports by carriers

5. Nonmonetary gold

Held as a store of value

Other

2. A. b. Services

1. Transportation

1.1

Sea transportPassenger

Freight

Other1.3

Air transportPassengerFreightOther

1.4

Other transportPassengerFreight

Other2. Travel

2.1 Business

2.2

Personal*

3. Communications services

4. Construction services

5.

Insurance services**

6.

Financial services

7. Computer and information services

8. Royalties and license fees

9. Other business services

9.1

Merchanting and other trade-related services9.2 Operational leasing services

9.3 Miscellaneous business, professional, and technical services*

10. Personal, cultural, and recreational services

10.1 Audiovisual and related services

10.2 Other personal, cultural, and recreational services

11. Government services n.i.e.

1. B. Income

1. Compensation of employees

2. Investment income

2.1 Direct investment2.1.1 Income on equity

2.1.1.1 Dividends and distributed branch profits***

2.1.1.2 Reinvested earnings and undistributed branch profits***

2.1.2 Income on debt (interest)

2.2

Portfolio investment



41

2.2.1

Income on equity (dividends)

2.2.2 Income on debt (interest)

2.2.2.1 Bonds and notes

2.2.2.2 Money market instruments and financial derivatives

2.3

Other investment

***See Supplementary Information table onpage 00 for components.

***If distributed branch profits are notidentified, all branch profits are

***Memorandu

m items: 5.1 Gross premiums considered to be distributed.

5.2 Gross claims



42

Standard Components of the Balance of Payments (continued)

Credit Debit

2. C. Current transfers

1.

General government2. Other sectors

2.1 Workers’ remittances

2.2 Other transfers

2. Capital and Financial Account

A. Capital account

1. Capital transfers

1.1 General government

1.1.1 Debt forgiveness

1.1.2 Other

1.2

Other sectors1.2.1 Migrants’ transfers

1.2.2 Debt forgiveness

1.2.3 Other

2. Acquisition/disposal of non-produced, nonfinancial assets

2. B. Financial account

1.

Direct investment

1.1

Abroad

1.1.1

Equity capital

Claims on affiliated enterprises

Liabilities to affiliated enterprises1.1.2

Reinvested earnings1.1.3 Other capital

Claims on affiliated enterprisesLiabilities to affiliated enterprises

1.2 In reporting economy1.2.1 Equity capital

Claims on direct investorsLiabilities to direct investors

1.2.2

Reinvested earnings1.2.3 Other capital

Claims on direct investors

Liabilities to direct investors2. Portfolio investment

2.1 Assets

2.1.1 Equity securities

Monetary authorities

General government

Banks



43

Other sectors2.1.2

Debt securitiesBonds and notes

Monetary authoritiesGeneral governmentBanksOther sectors

2.1.2.2

Money market instrumentsMonetary authorities

General government

Banks

Other sectors

2.1.2.3 Financial derivatives

Monetary authorities

General government

Banks

Other sectors



44

CLASSIFYING BALANCE OF PAYMENTS TRANSACTIONS

Selected Supplementary Information

1. Liabilities constituting foreign authorities’ reserves

1.1

Bonds and other securities

1.1.1

Monetary authorities1.1.2

General government1.1.3 Banks1.1.4

Other sectors1.2

Deposits1.2.1 Monetary authorities1.2.2

Banks1.3

Other liabilities1.3.1 Monetary authorities1.3.2

General government1.3.3 Banks

1.3.4

Other sectors2. Exceptional financing transactions

2.1 Transfers

2.1.1 Debt forgiveness2.1.2 Other intergovernmental grants

2.1.3 Grants received from Fund subsidy accounts2.2 Direct investment

2.2.1 Investment associated with debt reduction

2.2.2 Other

2.3

Portfolio investment: borrowing by authorities or other sectors on

authorities’ behalf—liabilities*

2.4

Other investment—liabilities*2.4.1 Drawings on new loans by authorities or other sectors on authorities’

behalf2.4.2 Rescheduling of existing debt2.4.3

Accumulation of arrears

2.4.3.1 Principal on short-term debt

2.4.3.2 Principal on long-term debt

2.4.3.3 Original interest

2.4.3.4 Penalty interest

2.4.4

Repayments of arrears

2.4.4.1 Principal

2.4.4.2

Interest2.4.5 Rescheduling of arrears

2.4.5.1

Principal2.4.5.2 Interest

2.4.6

Cancellation of arrears

2.4.6.1 Principal

2.4.6.2

Interest



45

3. Other transactions

3.1 Portfolio investment income3.1.1 Monetary authorities3.1.2 General government3.1.3 Banks3.1.4

Other sectors3.2

Other (than direct investment) income

3.2.1

Monetary authorities3.2.2 General government3.2.3

Banks3.2.4 Other sectors

3.3 Other investment (liabilities)3.3.1

Drawings on long-term trade credits3.3.2 Repayments of long-term trade credits3.3.3

Drawings on long-term loans3.3.4

Repayments of long-term loans

*Specify sector involved and standard component in which the item is included.



46

Selected Supplementary Information (concluded)

4. Services sub-items

4.1 Travel (personal)

4.1.1 Health-related

4.1.2

Education-related4.1.3 Other

4.2 Miscellaneous business, professional, and technical services4.2.1 Legal, accounting, management consulting, and public relations4.2.2

Advertising, market research, and public opinion polling4.2.3 Research and development4.2.4

Architectural, engineering, and other technical services4.2.5 Agricultural, mining, and on-site processing4.2.6 Other



47

MULTIPLE-CHOICE QUESTIONS

1. The relationship between the exchange rate and the prices of tradable goods isknown as the:

a. Purchasing-power-parity theory

b. Asset-markets theory

c. Monetary theory

d. Balance-of-payments theory

2. If the exchange rate between French francs and British pounds is 5 francs per pound,then the number of pounds that can be obtained for 200 francs equals:

a. 20 pounds

b. 40 pounds

c. 60 pounds

d. 80 pounds

3. Low real interest rates in the United States tend to:

a. Decrease the demand for dollars, causing the dollar to depreciate

b. Decrease the demand for dollars, causing the dollar to appreciate

c. Increase the demand for dollars, causing the dollar to depreciate

d. Increase the demand for dollars, causing the dollar to appreciate

4. High real interest rates in the United States tend to:

a. Decrease the demand for dollars, causing the dollar to depreciate

b. Decrease the demand for dollars, causing the dollar to appreciate

c. Increase the demand for dollars, causing the dollar to depreciate

d. Increase the demand for dollars, causing the dollar to appreciate

5. Assume that the United States faces an 8 percent inflation rate while no (zero)



48

inflation exists in Japan. According to the purchasing-power parity theory, the dollarwould be expected to:

a. Appreciate by 8 percent against the yen

b. Depreciate by 8 percent against the yen

c. Remain at its existing exchange rated. None of the above

6. In the presence of purchasing-power parity, if one dollar exchanges for 2 Britishpounds and if a VCR costs $400 in the United States, then in Great Britain the VCRshould cost:

a. 200 pounds

b. 400 pounds

c. 600 pounds

d. 800 pounds

7. If wheat costs $4 per bushel in the United States and 2 pounds per bushel in GreatBritain, then in the presence of purchasing-power parity the exchange rate should be:

a. $.50 per pound

b. $1.00 per pound

c. $2.00 per pound

d. $8.00 per pound

8. A primary reason that explains the appreciation in the value of the U.S. dollar in the1980s is:

a. Large trade surpluses for the United States

b. High inflation rates in the United States

c. Lack of investor confidence in the U.S. monetary policy

d. High interest rates in the United States

9. The high foreign exchange value of the U.S. dollar in the early 1980s can best beexplained by:

a. Additional investment funds made available from overseas

b. Lack of investor confidence in U.S. fiscal policy



49

c. Market expectations of rising inflation in the United States

d. American tourists overseas finding costs increasing

10. When the price of foreign currency (i.e., the exchange rate) is below the

equilibrium level:

a. An excess demand for that currency exists in the foreign exchange market

b. An excess supply of that currency exists in the foreign exchange market

c. The demand for foreign exchange shifts outward to the right

d. The demand for foreign exchange shifts backward to the left

11. When the price of foreign currency (i.e., the exchange rate) is above the

equilibrium level:

a. An excess supply of that currency exists in the foreign exchange market

b. An excess demand for that currency exists in the foreign exchange market

c. The supply of foreign exchange shifts outward to the right

d. The supply of foreign exchange shifts backward to the left

12. The appreciation in the value of the dollar in the early 1980s is explained by all of

the following except :

a. The United States being considered a safe haven by foreign investors

b. Relatively high real interest rates in the United States

c. Confidence of foreign investors in the U.S. economy

d. Relatively high inflation rates in the United States

13. Suppose Germany and France were the only two countries in the world. Thereexists an excess supply of French francs on the foreign exchange market. This suggeststhat:

a. The French balance of payments is in surplus

b. The French balance of payments is in deficit

c. The German balance of payments is in deficit

d. There is an excess supply of German marks

14. If Canada runs a balance-of-trade surplus and exchange rates are floating:



50

a. The value of other currencies will rise relative to the dollar

b. The dollar will depreciate relative to other currencies

c. The price of foreign goods will become cheaper for Canadians

d. The price of foreign goods will rise for Canadians

15. If Germany runs a foreign trade deficit and exchange rates are floating:

a. German exports become more expensive to foreign buyers

b. German exports become less expensive to foreign buyers

c. German imports become less expensive for German buyers

d. German imports become more prestigious to German buyers

16. The international exchange value of the U.S. dollar is determined by:

a. The rate of inflation in the United States

b. The number of dollars printed by the U.S. government

c. The international demand and supply for dollars

d. The monetary value of gold held at Fort Knox, Kentucky

17. For the United States, suppose the annual interest rate on government securitiesequals 8 percent while the annual inflation rate equals 4 percent. For France, supposethe annual interest rate on government securities equals 10 percent while the annualinflation rate equals 7 percent. These variables would cause investment funds to flowfrom:

a. The United States to France, causing the dollar to depreciate

b. The United States to France, causing the dollar to appreciate

c. France to the United States, causing the franc to depreciate

d. France to the United States, causing the franc to appreciate

18. For the United States, suppose the annual interest rate on government securitiesequals 12 percent while the annual inflation rate equals 8 percent. For Germany,suppose the annual interest rate equals 5 percent. These variables would causeinvestment funds to flow from:

a. The United States to Germany, causing the dollar to depreciate

b. The United States to Germany, causing the dollar to appreciate



51

c. Germany to the United States, causing the mark to depreciate

d. Germany to the United States, causing the mark to appreciate

19. Given a system of floating exchange rates, rising income in the United States would

trigger a(n):

a. Increase in the demand for imports and an increase in the demand for foreigncurrency

b. Increase in the demand for imports and a decrease in the demand for foreigncurrency

c. Decrease in the demand for imports and an increase in the demand for foreigncurrency

d. Decrease in the demand for imports and a decrease in the demand for foreigncurrency

20. Given a system of floating exchange rates, falling income in the United Stateswould trigger a(n):

a. Increase in the demand for imports and an increase in the demand for foreigncurrency

b. Increase in the demand for imports and a decrease in the demand for foreigncurrency

c. Decrease in the demand for imports and an increase in the demand for foreign

currency

d. Decrease in the demand for imports and a decrease in the demand for foreigncurrency



52

Chapter 4

Introduction toInternational financial

market



53

After reading this chapter, you will be able to understand

International financial market

Financial markets

Financial market instruments

Introduction to international financial market

How international financial markets are classified

o Foreign exchange market

o Euro currency market

Credit market

Money market

Bond market

Equity market

The role of international financial markets

Functions

Basic terminology used

Participants in international financial markets

Categories

Role

Location of international financial markets, financial intermediaries, the

International monetary system

Risks associated

The changing financial landscape



54

INTRODUCTION

Before staring with the international markets, we should be clear with the meaning offinancial markets.

Financial Markets:

In simple words, Financial markets are often designated as money markets

and capital markets.

*Money Markets are markets for short term financial assets (Short-term

instruments) e.g., T-Bills, CD's, Bankers Acceptance(BAs), Commercial Papers(CP),

Repurchase Agreements (Repos)...

*Capital Markets are markets for long term financial assets like Bonds, Stocks,

Mortgages, etc.

Important features of market instruments can be outlined below:

1. Money Market (MM):

In the MM, investors can buy S-T debts of governments, banks, financial

institutions, and corporations.

Maturity varies from 1 day to 1 year

Highly marketable

Quickly convertible to cash (very liquid)Un-collateralized debt of issuers with high credit rating

Quoted by using annualized discount yields (negotiable CDs are

exceptions)

2. Negotiable CDs:

Denominations of over $100,000

Depositor able to negotiate interest with bank

Maturities range from 14 days to 1 year

3. T-Bills:U.S. Treasury Department sells T-Bills.

The Federal Reserve Bank (FED) acts as fiscal agent and conducts the yield

auction.

3. Commercial Paper (CP):

Unsecured IOUs of corporations with good credit.

Maturities range from a few days to 270 days.

Usually issued in denominations of $100,000 or more.

About 1000 corporations issue CP in the U.S.



55

4. Banker’s Acceptances (BA):

Denominations of over $100,000.

Sold at discounts

5. Repurchase Agreement (REPO):

In a REPO, buyer and seller of a security agree that seller will repurchase

security after a certain length of time or after conditions are met.

Seller repurchases security at a higher price.

6. Euronotes:

Short-term promissory notes issued by a corporation and sold to private or

institutional investors

Typical maturity is 3 to 6 months

Sold originally at a discount from face value.

Trade in secondary markets

Underwritten by international investment/commercial banks

7. Euro Medium Term Notes

Similar to domestic medium term notes, with maturities of 9 month to 10 years.

Fill the gap between S-T and L-T euro debt instruments

8. Eurocommercial Paper

Unsecured short-term notes issued by corporations and banks in the Eurocurrency

Markets

Typical maturities from 1 to 6 months

Placed directly with investors through dealers

9. Eurocredit (bank loans denominated in eurocurrencies and extended by banks

in countries other than in whose currency the loan is denominated)

Loans of one year or longer extended by Eurobanks to MNCs or

governmental agencies

10. Money Market Mutual Funds:

Bring market for T-Bills, Commercial Papers, and others to the small investor.

Basic terminology:

What is a bond?



57

gilts.

Types of international financial markets:

The international financial markets consist of the

1. Credit market,

2. Money market,

3. Bond market

4.

Equity market.



58

The international credit market, also called Euro credit market, is the market that deals

in medium term Euro credit or Euro loans.

International banks and their clients comprise the Eurocurrency market and form thecore of the international money market. There are several other money market

instruments such as the Euro Commercial Paper (ECP) and the Euro Certificate of

Deposit (ECD).

Foreign bonds and Eurobonds comprise the international bond market. There are

several types of bonds such as floating rate bonds, zero coupon bonds, deep discount

bonds, etc.

The international equity market tells us how ownership in publicly owned

corporations is traded throughout the world. This comprises both, the primary sale ofnew common stock by corporations to initial investors and how previously issued

common stock is traded between investors in the secondary markets.

In this chapter, we will try to learn two major components of International Financial

Markets:

The Foreign Exchange Market

Eurocurrency, Eurocredit, & Eurobond Markets

BACKGROUND:

The last two decades have witnessed the emergence of a vast financial market across

national boundaries enabling massive cross-border capital flows from those who have

surplus funds and a search of high returns to those seeking low- cost funding. The

degree of mobility of capital, the global dispersal of the finance industry and the

enormous diversity of markets and instruments, which a firm seeking funds can tap, is

something new.

Major OECD (Organization for Economic Co-operation and Development) countrieshad began deregulating and liberalizing their financial markets towards the end of

seventies. While the process was far from smooth, the overall trend was in the

direction of relaxation of controls, which till then had compartmentalized the global

financial markets. Exchange and capital controls were gradually removed, non-

residents were allowed freer access to national capital markets and foreign banks and

financial institutions were permitted to establish their presence in the various national

markets.

While opening up of the domestic markets began only around the end of seventies, a

truly international financial market had already been born in the mid-fifties and

gradually grown in size and scope during sixties and seventies. This refers to the Euro



59

currencies Market where borrower (investor) from country A could raise (place) funds

from (with) financial institutions located in country B, denominated in the currency of

country C. During the eighties and nineties, this market grew further in size,

geographical scope and diversity of funding instruments. It is no more a "euro" market

but a part of the general category called “offshore markets”.

Alongside liberalization, other qualitative changes have been taking place in the global

financial markets. Removal of restrictions has resulted into geographical integration of

the major financial markets in the OECD countries. Gradually this trend is spreading to

developing countries many of which have opened up their markets-at least partially-to

non-resident investors, borrowers and financial institutions.

Another noticeable trend is functional integration. The traditional distinctions

between different financial institutions-commercial banks, investment banks, finance

companies, etc.- are giving way to diversified entities that offer the full range of

financial services. The early part of eighties saw the process of disintermediation getunderway. Highly rated issuers began approaching investors directly rather than going

through the bank loan route.

On the other side, debt crisis in the developing countries, adoption of capital adequacy

norms and intense competition, forced commercial banks to realize that their

traditional business of accepting deposits and making loans was not enough to

guarantee their long-term survival and growth. They began looking for new products

and markets. Concurrently, the international financial environment was becoming

more volatile- there were fluctuations in interest and exchange rates. These forces

gave rise to innovative forms of funding instruments and tremendous advances in riskmanagement. The decade saw increasing activity in and sophistication of the

derivatives’ market, which had begun emerging in the seventies.

Taken together, these developments have given rise to a globally integrated financial

marketplace in which entities in need of short- or long-term funding have a much

wider choice than before in terms of market segment, maturity, currency of

denomination, interest rate basis, incorporating special features and so forth. The

same flexibility is available to investors to structure their portfolios in line with their

risk-return tradeoffs and expectations regarding interest rates, exchange rates, stock

markets and commodity prices.

The foreign exchange market:

Features:



60

1. The Foreign Exchange Market is the world's largest financial market.

The Bank for International Settlements estimates daily trading volume of about

$3.2 trillion.

2. The Foreign Exchange Market is an over-the-counter market.

That means there is no physical location where traders get together to exchange

currencies. Rather they are located in the offices of major commercial banksaround the world and trading has historically been done by telephone, telex, or the

SWIFT system.

3. The “Society for Worldwide Interbank Financial Telecommunications”(SWIFT)

is an international bank communications network, that electronically links

brokers and traders.

The network connects over 7000 banks and broker-dealers in over 192 countries.

SWIFT transports financial messages in a highly secure way, but does not hold

accounts for its members and does not perform any form of clearing or settlement.

SWIFT does not facilitate funds transfer.

International payment system:

An international payment system should provide:

Security of value - instrument adequately transfers appropriate value

Security of medium - instrument hard to fake.

Storage security – instrument can’t be easily stolen or its value

appropriated.

Portability – instrument can be used to transport sufficient value.

Negotiability – others will accept the instrument.

Convenience – low cost and speed of instrument transfer.

Legal recognition and formalism – rules of the system adequately regulated

by state.

Global Settlement System

CLS Bank International, a New York-based settlement network, is supported

by over 70 of the world’s largest banking and financial institutions.

CLS offers a unique real-time processing that enables simultaneous FX settlement

across the globe thereby eliminating settlement risks caused by delays arising from

time-zone differences.

Trading takes place somewhere in the world 24 hours a day and frequently

between individuals or institutions located in different countries.

Most trading activities take place in a few currencies like the US Dollar, the

Euro, the British Pound, the Japanese Yen, the Canadian Dollar, and the

Swiss Franc

The foreign exchange market is not confined to any one country but

dispersed throughout the world’s leading financial centers: London, New



61

York, Tokyo, Paris, Zurich, Amsterdam, Hong Kong, Frankfurt, Toronto,

Milan, Singapore, Berlin, Vienna, Chicago...

Foreign Exchange traders not only buy and sell currencies but, they create

prices.

Market Makers are those traders in the major money-center banks around

the world who are always ready to buy or sell by quoting the bid/ask prices.

They create the market by creating bid/ask prices and dealing at those

prices.

The difference between the two prices is called the “spread."

Participants in the FX market include importers, exporters, portfolio

managers, central banks, brokers, commercial banks, arbitragers,

speculators, tourists, governments, etc.

Subdivision of Foreign Exchange Market

The Foreign exchange market can be subdivided into:

The Retail Market : permits the firms and individuals to obtain foreign exchange

for business or personal use.

The Interbank Market : major participants are foreign exchange traders

employed by large banks. Also large Multinational Corporations often maintain

trading departments that operate directly in this market. Traders in the

interbank market are called “dealers." They make the market.Brokers: bring buyers and sellers together for a small commission thereby

helping to preserve the anonymity.

Arbitragers: seek to profit from price differences in different foreign exchange

markets.

Speculators: buy and sell in the hope that a price change will result in a profit.

Governments: Central Banks, Treasury Departments and other Government

Agencies sometimes participate in the market in order to influence the

exchange rate of a particular currency.

For Example: FED buys dollars in foreign exchange market to increase the value of the dollars.

FED sells dollars in foreign exchange markets to reduce the value of dollars.

Coordinated efforts among central banks are often used. For example, the US FED

bought the Mexican peso to help prop up its value in early 1995.

Other Participants (mainly in the forward markets)

Traders: Use forward contracts to eliminate or cover the risk of loss on export or

import orders that are denominated in foreign currencies.



62

Hedgers: Hedgers, mostly Multinational corporations, enter into forward contracts

to protect domestic currency value of foreign currency denominated asset and

liabilities on their balance sheets.

The increasing importance attached to exchange rates results from the

globalization or internationalization of modern business, the continuing

growth in world trade, the trend towards economic integration and therapid pace of change in the technology of money transfer.

The Clearing System: Modern technology plays a central role in the international

transfer of funds or settling foreign exchange transactions.

In the U.S., electronic funds transfer takes place

through the “Clearing House Interbank Payment System” (CHIPS).

This is a computerized network developed by the New York Clearing House

Association for transfer of international dollar payments. It links about 150

depository institutions that have offices or affiliates in New York City.

The New York Fed has established a settlement account for member banks in

which the account of a paying bank is charged and the receiving banks account is

credited.

Electronic Trading:

In 1992, Reuters introduced a new service that added automatic execution to the

screen quotations used in telephone trading thereby creating a genuine screen-

based market. Other vendors like

Telerate and Quotron, followed.

Electronic trading systems offer automatic matchingin which traders enter buy and sell orders directly into their terminals

anonymously.

These prices are visible to all market participants and any trader anywhere in the

world can execute a trade by hitting two buttons!

Functions of the Foreign Exchange Market:



63

1. Transfer of Purchasing Power :

International trade and capital transaction usually involve parties with

different functional currencies.

Trade and capital transactions can be invoiced in any convenient currency.Therefore, one or more of the parties must transfer purchasing power to or

from own national currency.

The Foreign exchange market facilitates this transfer of purchasing power

2. Provisions of credit :

Movement of goods and services between countries takes time. This gives

rise to financing of inventory in transit and sales inventory.

The foreign exchange market provides a means of transfer of credit.

Specialized instruments like Bankers' acceptances and letters of credit, are

made possible through the foreign exchange market

3. Minimizing Foreign Exchange Risk :

The foreign exchange market provides "risk transfer" facilities to third parties via

forward, futures, options, and swaps markets.



64

Foreign exchange rate:

The Foreign exchange rate is the domestic currency units per unit of a foreign

currency.

Example: Let the U.S. be "domestic"

1. If you need $1.95 to purchase 1 unit of the British Pound Sterling, then

$/£ = 1.95 (d/f)

Dollars per pound is a direct quote for the pound in the U.S. It means the home

currency, in this case the $, (or domestic currency) needed to acquire one unit of a

foreign currency, in this case the pound.

Alternatively:

The foreign exchange rate can be defined as units of a foreign currency per unit of

domestic currency. This is an indirect quote.

2. If 125 units of the Japanese Yen are needed to purchase one unit of the U.S.

Dollar, then:

¥/$ = 125 (f/d).

This is an indirect quotation for the Yen in the US.

Since the direct and the indirect quotations are alternative means of stating

exchange rates, the two methods are related. One is the inverse of the other. Thus

$ = 1



65

£ £/$

or,

¥ = 1

$ $/¥

Most interbank quotes are quoted around the world are stated in "European"terms which means the foreign currency price of one dollar, e.g., SF/$ = 1.2378,

¥/$ = 132, etc.

The alternate way, dollar price of one unit of foreign currency, is called "American"

Terms e.g. $/£ = 1.7535.

Spot Rates: A spot transaction is the purchase of foreign exchange for immediate delivery

(usually, delivery within the following 2 business days).

Forward Rates: A forward exchange rate or forward rate, is the price agreed on today for purchase

or sale of foreign currency for future delivery (transfer/settlement) and payment.

The rate is agreed on at the time the contract is made, but normally payment and

delivery are not required until maturity.

Forward maturities normally are 30, 60, 90, 180, 360 days in to the future. Odd

maturities may be negotiated for one to two weeks or even up to 5 years.

Cross Rates:

Frequently, the need arises to obtain the relationship (price) between twocurrencies from their relationship with (quotation in) a third currency.

Formally, given two currencies A & B.

If $/A and $/B are given, then the value of A in terms of B (or B per unit of A) is

given by:

$/A = $ * B = B

$/B A $ A

This is the cross rate.

Examples: Given $/£ and $/SF, then$/£ = $ * SF = SF

$/SF £ $ £

Given: $/£ = 1.4155 and SF/£ = 3.1318, then

SF = SF/£ = 3.1318 = 2.2125

$ $/£ 1.4155

Given: $/£ = 1.8632; $/ ¥ = .008013, then

¥ = $/£ = 1.8632 = 232.52

£ $/ ¥ .008013



66

Bid/ Ask:

The Bid is the price at which a broker will buy your stock trading position from you, the

Ask is the price at which he will sell you a position. When stock trading, the distance

between the bid and the ask depends on a number of factors, such as is the securityliquid, how volatile is the market generally, the balance between buyers and sellers

and so on. This is the reason stock trading prices have 2 numbers - for example the

price of IBM might be quoted as 148 - 149. This means that if you want to BUY a share

of IBM, it will cost you 149 dollars, but if you want to SELL a share, you will only get 148

dollars for it. In the morning papers, it is usual for only 1 stock trading price to be

shown, the MID price (the average of the bid and ask).

Think of it like foreign currency - when you go into a UK Bureau de change, they will

give you £60 for your $100, but if you want to sell them that £60 back, you will only get

$95. Spread betting companies have far wider stock trading spreads between bid andask than standard brokers because they don't have commission charges.

Note - the "Best Bid" for a stock is the higest price that a buyer is willing to pay for that

stock at that particular point in time. The "Best Ask" is the lowest price that a seller is

willing to accept for a stock at that point in time. A stock trading Bid is composed of a

Buy Limit Order that has been placed into the market. A stock trading Ask is composed

of an open Sell Limit Order.

The Bid-Ask Spread:

Bid Price: price at which a dealer will buy a currency.Ask price: price at which the dealer will sell a currency (offer price).

Dealers do not normally charge a commission on their currency transactions

but profit from the bid/ask spread.

Computing the bid/ask spread in percentage terms:

Bid/Ask spread = Ask Rate - Bid Rate * 100

Ask Rate 1

This expresses the spread in terms of the "discount" obtained by the dealer.

Alternatively,

Bid/Ask spread = Ask Rate - Bid Rate * 100

Bid Rate 1

This expresses the spread in terms of the markup established by the dealer.

Outright and Points Quotations:

In outright quotations the full price is given to all its decimal points.

In points quotation abbreviations are used.



67

Forward Quotes With Bid/Ask Spreads:

Interbank quotations are expressed as a bid (buy) and an offer (sell or ask).

Bid and Ask quotations may appear complicated because the bid for one currency

is also the ask of another currency.

In outright quotations the full price is given to all its decimal points.

In points quotations abbreviations are used.

When quotations in European terms (indirect) are rendered in American terms

(direct) the bid and the ask reverse.

The reciprocal of the bid becomes the ask and the reciprocal of the ask becomes

the bid

In the Interbank market, dealers usually quote the forward rate as a discount fromor a premium on, the spot rate.

This forward differential is called the "Swap Rate".

Example: Given that:

£: spot $/£ = 1.7860 ¥: spot $/¥ = .007949

90-day Fwd = 1.7580 90-day fwd = .007929

The "Swap Rate" (forward differential) for the £ was quoted as a 280-point discount

(from the spot).

The "Swap Rate" for the 90-day forward Yen was quoted as a 20-point discount

from the spot.A "Swap Rate" can be converted into an outright rate by adding the premium (in

points) to or subtracting the discount (in points) from the spot rate.

When the forward bid (in points) is smaller than the Ask rate (in points) the forward

rate is at a premium and the points should be added to the spot price to compute

the outright quote.

Conversely, if the bid (in points) exceeds the ask (in points), the forward rate is at

a discount and the points must be subtracted from the spot price to obtain the

outright quotes.

Note that the buying rate, spot or the forward, is always less than the selling

rate and forward bid/ask spread always exceeds spot bid/ask spread.

Example:

The following quotes are given for the respective maturities for the £ and the SF.

Spot 1 Month 3 Months 6 Months

£: $2.0015-30 19-17 26-22 42-35

SF: $0.6963-68 4-6 9-14 25-38



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Compute the outright quotes.

This example shows that the SF is selling at a premium while the £ is at a discount

against the $.

• Note the slightly wider spread between outright bid and Ask on the Swiss Franccompared to the spread on the pound. The difference is due to the broader market

in pounds. Also the widening of spreads over time for both currencies is caused by

the greater uncertainty surrounding future exchange rates.

The Bid/Ask Spreads in Cross Rates:

Consider the following quotes:

$/£ = $ 1.7109-36

$/SF = $ 0.6250-67

Find the direct quote for the £ in terms of the SF (with B/A spread). i.e. findSF/£ in b/a quotes.

The bid and ask quotes for SF/£ are:

BID: SF = SF * $ = 1 * 1.7109 = 2.7300

£ $ £ .6267 1

ASK: SF = SF * $ = 1 * 1.7136 = 2.7418

£ $ £ .6250 1

Hence the cross rates with B/A spreads are:

SF/£ = 2.7300 - 2.7418

or = 2.7300 – 418

Sometimes a forward transaction is called an "outright forward" to emphasize thatno spot transaction is involved and to distinguish it from a "swap transaction"

A "swap transaction" involves the sale of a foreign currency with a simultaneous

agreement to repurchase at some later date in the future; OR

The purchase of the foreign currency with an agreement to resell at sometime in

the future.

Generally a forward swap is an arrangement in which two parties agree to

exchange specific amounts of currencies on one date and to reverse the exchange,

usually at a different exchange rate, on a later date. The arrangement can be a

spot-forward or forward-forward swap.

These forward swaps differ from currency swaps in that there are no exchanges

of interest payments and are usually for shorter time periods.

• Spot - fwd swap: Spot now with fwd later;

• Fwd - fwd swap: fwd at t with fwd at t+30.

Example:

City Bank buys SF5 million from the Swiss Bank for $2 million (spot) and

simultaneously agrees to sell the SF back in 6 months for $ 2.1 million.



69

The difference between the sale price and the repurchase price is called the “swap

rate”

This “swap” is a way to borrow one currency for a limited time while giving up the

use of another currency for the same time, i.e., a short-term borrowing of one

currency combined with a short-term loan of an equivalent amount of anothercurrency.

Note:

According to the Bank for International Settlements (BIS), in 2001, spot

transactions account for 33% of the market, forward transactions 11%, and swap

transactions, (involve a package of spot and forward contracts), 56% of the market .

Exercises:

1. A trader quotes the SF against the $ at a Bid/Ask (buy/sell) price of:

SF/$ = 2.3697 - 2.3725.The principle of buy low and sell high applies. The smaller number 2.3697 is the

bid price and the larger number 2.3725 is the ask price.

Obtain the bid/ask prices for $/SF.

2. If a bank quotes bid/ask prices SF/£ = 4.085-4.090. What should be the bid/ask

prices for £/SF?

3. A bank is currently quoting the following rates:

i) SF/$ = 2.3697-2.3725

$/£ = 1.5525-1.5535What SF/£ cross rates bid/ask would the bank quote?

ii) SF/$ = 2.5110-2.5140

¥/$ = 245-246

Find ¥/SF Bid/Ask rates.

iii) DK/$ = 5.5279-5.5289 (DK = Denmark krone)

SK/$ = 6.8681-6.8691 (SK = Sweden krona)

Obtain SK/DK bid/ask rates.

Premium or Discount on Forward Rate:

If the forward rate exceeds the existing spot rate (direct quotes) it contains a

premium. If the forward rate is less than the spot

rate, that forward rate contains a discount.

To compute the Premium (Discount)

Let: F = Forward rate e.g., $/£ = d/f

S = spot rate

n = time to maturity

then:

For a direct quote of the £ (e.g. £ quoted as $/£ = 1.5235):

F-S * 360 gives premium (discount) on the £.



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S n

For an indirect quote, (e.g. £ quoted as £/$ = .6564)

S-F * 360 gives premium (discount) on the pound.

F n

A premium means that the direct price in the forward

market is higher than the direct price in the spot market.A discount is the reverse.

Examples:

Spot ($/SF) .4520

30-day Forward .4541



a. Obtain the p (d) on the Swiss franc in each case.b. Compute the p (d) on the dollar in each case.

Using The Forward Contract: an Example

A U.S. importer of German BMW receives a bill of € 2m for the 700 series. The Bill

is payable in 90 days. Spot $/ € = 1. 3467. The 90-day forward $/ € = 1.3495.

The Forward contract is a means of locking in the price at which euros will be

acquired in 90 days. Discuss.

Percentage Change in Exchange Rates:

The percentage change in exchange rates can be obtained as follows:% change = Ending Rate - Beginning Rate * 100

Beginning Rate 1

Example:

|----------------------------|

Given that: 0 1

at t = 0 : $/£ = 1.7895

t = 1 : $/£ = 1.9795

%Δ = 1.9795 - 1.7895 * 100 = 10.62 1.7895

1

The pound has appreciated in value against the dollar by10.62% during the given period.

Some Common Terms:

Depreciation -- Devaluation -- Weakening

Appreciation -- Revaluation -- Strengthening

Soft Currency -- Expected to decrease in value

Hard Currency -- Expected to maintain its value

to increase in value.

Dollar is Mixed -- The $ did not move in one

direction against the major currencies - up with



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some, down with some.

Arbitrage in Foreign Exchange Market:

Arbitrage is one of the most powerful forces at work in a market economy.

It is the simultaneous purchase and sale of the same (or essentially similar) good or

security in two different markets for advantageously different prices - provided that

the price spread more than offsets transaction costs.

Arbitrage plays a critical role in the analyses of security markets because its effect is

to bring prices to their fundamental values and keep markets efficient. The effect of

arbitrage is to reduce/eliminate price differentials on identical products by

arbitragers buying low and selling high to realize riskless profit.

Locational Arbitrage:

The prices charged by different banks for foreign exchange cannot vary

significantly. Prices are kept more or less in line with each other

through a process called “Locational Arbitrage”

If the price of a foreign exchange varies from one bank to another, an arbitragerwill be able to "buy low" and "sell high."

Such an activity should lead to an increase in the rate at the low-priced bank and

decrease in the rate at the high-priced bank.

Arbitrage activity will continue as long as the difference in prices is large enough to

generate a profit.

EXAMPLE: Bank A Bank B

Bid price for X $ .50 $ .52

Ask price for X $ .51 $ .53

In this example profitable arbitrage opportunity exists. Given that the arbitrager

has $1m.

Buy X from bank A at .51 and simultaneously sell them to Bank B at .52. If $

1,000,000 are available then, $1,000,000 will buy X = 1,000,000/.51 = 1,960,784.

Sell to Bank B for 1,960,784 * $.52 = $ 1,019,608 for a profit of $19,608.

The high demand for X in Bank A leads to an increase in price and increased supply

of X in Bank B leads to a decrease in price.

Such a situation usually disappears before most firms even become aware of it.



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As an example of how arbitrage works, consider a large bank in London. The Chief

of the FOREX department, Dollar($) section, observes over the telex that the $

prices of Pound ($/£) spurts up in New York.

Here is a chance to make some money! To exploit the situation, the arbitrager does

two things: First he/she contacts a broker or a correspondent bank

in New York and sells, say £1m (sells high).

At almost the same time he/she buys the same amount of £s in London.

If the arbitrager does not buy and sell at almost the same instant the spread

appears, there is a risk of missing the opportunity.

The sale of pounds in New York where the price is high and the repurchase in

London, where the price is low, contributes to eliminating the price deferential.

As other market participants take similar actions, the price differences appears.

Triangular Arbitrage: Example 1:

Consider the following quotes in New York, Frankfurt, and London. (Assume no

transaction costs)

FRANKFURT ($/€ = 1.2471)

LONDON (€/£ = 1.4544)

NEW YORK ($/£ = 1.8590)

Is Triangular Arbitrage feasible? Show why/why not.

Describe a strategy to profit from triangular arbitrage.

What percentage profit is possible?

e.g. € ® £ ® $ ® €

Given €1m:

1000000 * 1 * 1.8590 * 1 = 1,024,930

1.4544 1.2471

Profit = € 24,930 » 2.5 % .

Arbitrage activity causes £ to appreciate against € in

London, the $ to appreciate against the £ in New York and the € against the $ in

Frankfort.

Example 2:

Assume no transaction cost. Suppose £1 = $1.8095 in NY,

$1 = C$1.3215 in Toronto and C$1 = £ 0.4342 in London.

Show whether or not triangular arbitrage opportunities exist

How could a trader profit from triangular arbitrage?

Compute the percentage profit possible.

Solution:

Example 3: Assume zero transaction costs:

A: ¥/U$ = 106.50, B: C$/U$ = 1.3215 , C: ¥/C$ = 82.905

Determine if triangular arbitrage is feasible.



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State what you would do to profit from arbitrage.

Obtain the percentage profit possible.

Solution:

By cross rates from A & B,

¥ = ¥ . U$ = 106.50 . 1 = 80.590C$ U$ C$ 1.3215

The C$ is more valuable at C:

Borrow C$ and sell it for ¥ at C, Sell ¥ for U$ at A and the U$ for C$ at B.

e.g. C$ ® ¥ ® U$ ® C$

Given 1C$:

1 * 82.905 * 1 * 1.3215 = C$1.02772

106.50

Profit ≈ 2.8%

Transaction Costs: Assume transaction cost is .6% (.25%, .35%). With a .60% Trans. cost, each

stage the arbitrager receives 99.4% of what he previously received.

There are three transactions in this example and these can be incorporated as

follows:

Derivative Securities Markets: An Overview

These are forwards, futures, options, and swaps.



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Forward Contracts are "private" contracts offered by banks that provide for the

purchase or sale of units of a currency at a specified exchange rate for future

delivery and settlement.

Currency Futures Contract:

Permits the exchange/trading (purchase or sale) of a specified number of contractsof a currency at specified exchange rate for future delivery.

Prices are determined by an auction process on the floor of an organized futures

exchange.

Unlike the forward contracts, the futures contract entails daily settlements

(marking to the market) and the posting of a margin.

Currency futures contracts contain standard units of the underlying currencies.

Currency Options Contract:

Is an exchange traded contract which grants the buyer (holder or owner) the

right, but not the obligation, to purchase or sell a specified number of contracts ofthe underlying currency at a prescribed price (the strike price or exercise price)

within a given period of time.

The buyer pays a premium to acquire this right. Contract sizes are standardized.

A Swap contract is a contractual agreement evidenced by a single document in

which two parties, called counterparties, agree to make period payments to each

other.

The agreement spells out the instrument to be exchanged (which may or may not

be the same), the applicable interest rate on each instrument (which may be fixedor floating), the timetable for making payments, and other provisions.

Swap contracts are tailor-made to meet the needs of the counterparties with the

aid of swap specialists who serve as brokers and/or market makers.

Swaps trade in the OTC market.

The most important Eurocurrencies are the Euro-Canadian dollar, Euro-Euro, Euro-

Swiss franc, Euro-sterling, and Euro-yen.

Smaller offshore banking centers which participate in the Eurocurrency market

include such locations as the Cayman Islands, Bahamas, Bahrain, Luxembourg …. The Singapore market is often called “Asian dollar market.”

The Eurocurrency market therefore consists of those banks, called Eurobanks, that

accept deposits and make loans in foreign currencies.

The Eurocurrency market enables investors to hold short-term claims on

commercial banks, which then act as intermediaries to transform these deposits

into claims on final borrowers.



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2. EURO CURRENCY MARKET

1) The Evolution of the Market:

The development and expansion of the Eurocurrency markets have their roots in

overt and covert events.

In the late 1950s British-owned banks utilized foreign currency deposits (in the UK)

as a lending medium in order to save business that was at that time endangered by

exchange controls (by the UK) on transactions in pounds sterling.

In turn this lead to active solicitation of dollar deposits by banks in Western Europe.

2) The Soviet Union: provided impetus for the early growth of the market. As the

cold war heated up, the Soviet Union began to worry about the U.S. Government

freezing its deposits in New York. The Soviets needed to maintain dollar accounts

for international trade and investment. The dollar was then virtually the only

currency acceptable worldwide.

The Soviet Union responded to this problem by placing its dollar-denominated

deposits in banks outside the U.S. jurisdiction.

British and French banks were the primary recipients of these deposits.

3) Changes in U.S. Balance of Payment Situation: The 1945-50 period saw

persistent surpluses.These were replaced by deficits in 1957. Deficits resulted in

increased foreign holding of dollars. By mid 1958 European market in dollar

deposits and loans had become established.

4) The Market as a Source of Short-term Funds: Supports trade financing

activities of international banks.It facilitates foreign exchange transactions by banks

and provides short-tern money market trading opportunities. International banks

use the market as an outlet for placing surplus funds temporarily at attractive

yields. Eurocurrency interbank market has become the central

mechanism to channel flow of international funds among banks and this gave birth

to the LIBOR as an important international interest rate

5) Regulatory Developments in the U.S. (i)"Regulation Q": Interest rate ceilings existed in the U.S. during the 1960s and

1970s. With higher interest on dollars deposited in the

eurodollar market, funds moved to banks in Europe. Many U.S. banks opened

European offices to receive these funds.

(ii) Federal Reserve "Regulation M": This regulation requires the keeping of

reserves against deposits. Since reserves constitute idle funds, the cost of operating

in the Eurocurrency market is relatively less since there are no reserve

requirements in the eurocurrency market.



76

Many American banks moved some of their operations to the relatively

unregulated eurocurrency market.

(iii) The Controls and Restrictions on Borrowing Funds in the U.S. for

Reinvestment Abroad: (voluntary in 1965, mandatory in 1968) forced many

borrowers to seek sources of loans in Europe, thereby increasing the demand for

funds deposited in the eurocurrency markets.(iv) The U.S. Interest Equalization Tax (1963): Imposed a tax on U.S. residents'

earnings on foreign securities. This

increased the interest foreign borrowers were forced to pay on funds borrowed

directly from the U.S. market. By

channeling funds through the eurocurrency market, this tax is avoided.

6) The Role of Narrow Spreads: The desire of depositors to receive highest

possible yields and of borrowers to pay lowest possible costs are met in the

eurocurrency market. Absence of regulation permits higher yields to depositors

and lower costs to borrowers.

7) Desire of British Banks to maintain their position in international finance plus

the favorable regulatory environment in the United Kingdom.

8) Confidence in Vehicle Currencies especially the dollar

9) The Role of OPEC: OPEC countries invest part of their petrodollars in the

Eurocurrency Market so that the market provides a medium for the so called

"Petrodollar Recycling”.

10) Other Features of the Market:

Costs of complying with regulations are low since there are no deposit

insurance assessments.

Borrowers' credit worthiness is well known so that the need for credit

investigation is low.

No taxes are withheld from interest payments to eurocurrency

depositors.

Taxes and fees levied on euro banking operations are generally lower

than those applied to domestic banking.

Low costs per transaction because of relatively large size oftransactions.

Eurocurrency markets need not be located in Europe, though they

originate in Europe.

For example, in the U.S., domestic banks are (since 1981) permitted to open

International Banking Facilities (IBF), which are computerized account records kept

separate from U.S. banks' domestic accounts.

They must be domiciled inside U.S. territory and focus on international

commerce.They accept foreign currency denominated deposits. These

"onshore/offshore" bank accounts are permitted in an effort to regain deposits lost to

offshore banking operations.



77

IBF accounts are free from reserve requirements and assessment for deposit insurance.

They are also exempt from federal taxes, becoming taxable only when transferred to

regular accounts.

The primary participants in the Eurocurrency market are large banks called Eurobanks.

Transactions are predominantly interbank, hence the market is frequently called the

"interbank market." In addition, large scale or "wholesale" transactions take placebetween banks and non-bank customers.

Transactions are typically priced off the London Interbank Offered Rate (LIBOR)

which is a floating rate at which London banks lend to one another.

Interest rates on Euroloans to governments and their agencies, corporations, and

non-prime banks are set at a fixed margin above LIBOR for the period and currency

chosen.

At the end of each period the interest for the next period is calculated at the same

fixed margin over the new LIBOR.

The drawdown, the period over which the borrower may take down the loan, andthe repayment period vary with borrower’s needs.

A commitment fee of about 0.5% per annum is charged on the unused balance.

Eurodollar loans have multi-currency clauses giving borrowers the right, subject to

availability, to switch from one currency to another on any rollover/reset date.

This feature provides a potentially valuable exposure management for borrowers.

Reference Rates of Interest :

A reference rate of interest, for example U.S. dollar LIBOR, is the rate of interest

used in a standardized quotation, loan agreement, or financial derivative valuation.

LIBOR, London interbank offered rate, is by far the most widely used and quoted.It is an interest rate charged by banks for S-T loans to one another. It is an

important benchmark for mortgages, corporate financing, etc.

It is officially defined by the British Bankers Association (BBA).

The BBA also calculates Yen LIBOR, Euro LIBOR, and other currency LIBOR rates.

Most major financial centers also construct their own interbank offered rates for

local loan agreement purposes.

These include:

FIBOR: Frankfurt interbank offered rate

PIBOR: Paris interbank offered rateSIBOR: Singapore interbank offered rate

MIBOR: Madrid interbank offered rate

EIBOR: Emirate interbank offered rate (interest rate charged by banks in the United

Arab Emirates for interbank transactions)

Eurodeposit Creation:

Eurocurrency deposits are subject to the same multiple expansion feature of a

domestic banking system.

Funds are deposited in a Eurobank which lends them to deficit spending units and,

in effect, creates new deposits.



78

Example:

Stage A:

Assume that IBM purchases computer components from a UK supplier, COMPUK,

for $1m and pays with a check drawn on its Chase Manhattan Bank in New York.

Assume also that COMPUK deposits the check in Westminster Bank, London.

A Eurodollar deposit is now created since COMPUK has a dollar-denominated

account outside the U.S.

Typically, money center banks maintain accounts with one another. So,

Westminster Bank deposits the check at Chase which now shows a change of

ownership on the $1m deposit from IBM to Westminster.

Stage B:

Now, suppose Volvo of Sweden obtains a loan of $900,000 from Westminster and

uses the proceeds to pay for purchases from a another Swedish company,

Stockhm 1.Stockhm 1 deposits the proceeds in the Bank of Sweden, thus creating another

eurodollar deposit. When the Bank of Sweden initiates collection,

$900,000 of Westminster deposit at Chase change ownership to the Bank of

Sweden.

Eurodollar Deposit Expansion: Main Features

Stage A

Chase, NY Westminster, London

Deposits of IBM Deposit at Chase Deposits of COMUK

-$1,000,000 +$1,000,000 +$1,000,000

Deposits of Westminster+$1,000,000

Stage B

Chase, NY Bank of Sweden

Deposits of Westminster Deposit at Chase Deposits of Stockhm1

-$900,000 +$900,000 +$900,000

Deposits of Bank of Sweden

+$900,000

At this point, the level of Eurodollar deposit is $1,900,000 The process of

expansion continues geometrically. The expansion is limited by the level of

voluntary (discretionary) reserve held by each Eurobank.With a zero discretionary reserve, the expansion continues without limit unless the

dollars are used to purchase products or services in the U.S. at which point the

expansion process stops.

The Asian dollar market grew to accommodate the needs of businesses that need

U.S. dollars as a medium of exchange for international trade/investment.

Favorable tax advantages in Singapore and Hong Kong, (e.g., low withholding taxes,

reduced tax on offshore loans) encourage growth of the Asian market.



79

The Eurocredit Market

Loans of 1 to 5 years (medium term) extended by Eurobanks are called Eurocredit

Loans. These loans are popular with corporations/governments.Since Eurobanks accept short-term deposits, there exists the problem of maturity

mismatch between deposits and loans. To avoid the risk Eurobanks commonly offer

floating rate Eurocredit Loans. Loan rates float in accordance with movement of

some market interest, such as the LIBOR - the rate commonly charged for loans

among Eurobanks.Syndicated Eurocredit Loans are provided to large corporate or

government borrowers by a group of banks participating in the syndicate.

The Eurobond Market

Eurocurrency and Eurocredit loans help to accommodate short and medium term

borrowers respectively.

The Eurobond was created to accommodate long-term borrowers.

Partially the result of Interest Equalization Tax imposed in the U.S. in 1963 to

discourage U.S. investors from investing in foreign securities. Foreign borrowers

were thus forced to look elsewhere for funds and enter the Eurobond market.

The Eurobond market facilitates the transfer of long-term funds from surplus

spending units to deficit spending units around the world. Issued by MNCs, large

domestic corps., governments, governmental enterprises, and intern’l institutions.

The market helps to link investors with borrowers around the world, and thus help

to integrate the world's financial system.

The Eurobond market, unlike the domestic bond market, is almost entirely free of

official regulation. It is self-regulated by the Association of International Bond

Dealers.

The bonds are sold outside the countries in whose currencies they are

denominated and underwritten by an international syndicate of banks.Offered

simultaneously in a number of major capital markets

Eurobonds feature different types of issues, including straight fixed-rate, floating

rate note, and equity related/convertible.



80

Foreign BondsUnderwritten by a syndicate and sold within the country of the denominated

currency.

Borrower/issuer is from another country

These include Yankee, Samurai, and Bulldogs bonds.

Note Issuance Facilities and Euronotes:

Eurobanks have responded to the competition from the Eurobond market by

creating a new instrument called the “Note Issuance Facility” (NIF) which is a low-

cost substitute for syndicated credits.

It allows borrowers to issue their own short-term Euronotes which are then

distributed by financial institutions providing the NIF

NIF, sometimes called “short-term note issuance facility”, has some features of the

U.S. commercial paper market and some features of the U.S commercial lines of

credit.

Distinction between Euro Credit and Euro Bond Market

Both Euro bonds and Euro credit (Euro currency) financing have their advantages and

disadvantages. For a given company, under specific circumstances, one method of

financing may be preferred to the other. The major differences are:

1. Cost of borrowing

Euro bonds are issued in both fixed rate and floating rate forms. Fixed rate bonds are

an attractive exposure management tool since the known long-term currency inflowscan be offset by the known long-term outflows in the same currency. In contrast, Euro

currency loans carry variable rates.

2. Maturity

Euro bonds have longer maturities while the period of borrowing in the Euro currency

market has tended to lengthen over time.

3. Size of the issue

Earlier, the funds available for lending at any time have been much more in the inter-

bank market than in the bond market. But of late, this situation does not hold true.Moreover, although in the past the flotation costs of a Euro currency loan have been

much lower than a Euro bond (about 0.5 % of the total loan amount versus about 2.25

% of the face value of a Euro bond issue), compensation has worked to lower Euro

bond flotation costs.

4. Flexibility

In a Euro bond issue, the funds must be drawn in one sum on a fixed date and repaid



81

according to a fixed schedule, unless the borrower pays a substantial prepayment

penalty. By contrast, the drawdown in a floating rate loan can be staggered to suit the

borrower’s needs and can be repaid in whole or in part at any time, often without

penalty. Moreover, a Euro currency loan with a multi-currency clause enables the

borrower to switch currencies on any roll-over date, whereas switching the

denomination of a Euro bond from currency A to currency B would require a costly,combined, refunding and reissuing operation.

5. Speed

Funds can be raised by a known borrower very quickly in the Euro currency market.

Often, a period of two to three weeks should suffice. A Euro bond financing generally

takes more time, though the difference is becoming less significant.

2. Euro Credit Market

Euro credit or Euro Loans are the loans extended for one year or longer. The market

that deals in such loans is called Euro Credit Market.

The common maturity for euro credit loans is 5 years. Since Euro banks accept short-

term deposits and provide long-term loans, it is likely that asset liability mismatch may

arise. To avoid this Euro banks often extend floating rate euro credit loans fixed to

some market interest rate. The London Inter Bank Offer Rate (LIBOR) is the most

commonly used interest rate. It is the rate charged for loans between Euro Banks.

Participants in Euro credit Market

The major lending banks in the Euro credit market are Euro banks, American, Japanese,

British, Swiss, French, German and Asian (specially that of Singapore) banks, Chemical

Bank, JP Morgan, Citicorp, Bankers Trust, Chase Manhattan Bank, First National Bank of

Chicago, Barclay's Bank, National Westminster, BNP, etc. Among the borrowers, there

are banks, multinational groups, public utilities, government agencies, local authorities,

etc.

Dealing in Euro credits

When a borrower approaches a bank for Euro credit, a formal document is prepared on

behalf of potential borrowers. This document contains the principal terms and

conditions of loan, objectives of loan and details of the borrower.

Before launching syndication, the approached bank decides primarily, in consultation

with the borrower, on a strategy to be adopted, i.e. whether to approach a large

market or a restricted number of banks to form the syndicate. Each of the banks in

syndicate lends a part of the loan. The duration of this operation is normally about 6 to

8 weeks.



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Several clauses may be introduced in the contract of Euro-debt:

• Pari-passu clause that prevents the borrower from contracting new debts that

subordinate the interest of lenders;

• Exchange option clause that allows the withdrawal of a part or totality of loan in

another currency;

• Negative guarantee clause that commits the borrower not to contract other debts

that subordinate the interest of lenders.

Characteristics of Euro credit

A major part (more than 80 %) of the Euro debts is made in US dollars. The second (but

far behind) is Pound Sterling followed by Deutsch mark, Japanese yen, Swiss franc andothers.

Most of the syndicated debts are of the order of $50 million. As far as the upper limits

are concerned, amounts involved are of as high magnitude as $5 billion and more. In

1990, Euro tunnel borrowed $6.8 billion.

On an average, maturity periods are of about five years (in some cases it is about 20

years) . The reimbursement of the loan may take place in one go (bullet) or in several

installments.

The interest rate on Euro debt is calculated with respect to a rate of reference,

increased by a margin (or spread). The rates are available and generally renewable (roll

over credit) every six months, fixed with reference to LIBOR. The LIBOR is the rate of

money market applicable to short-term credits among the banks of London. The

reference rate can equally be PIBOR at Paris and FIBOR at Frankfurt, etc. It is revised

regularly.

The margin depends on the supply and demand of the capital as also on the degree of

the risk of these credits and the rating of borrowers. Financial institutions are in

vigorous competition. There is an active secondary market of Euro debts. Numeroustechniques allow banks to sell their titles in this market.

3. Euro Bond Market

Euro Bond issue is one denominated in a particular currency but sold to investors in

national capital markets other than the country that issued the denominating currency.

An example is a Dutch borrower issuing DM-denominated bonds to investors in the UK,

Switzerland and the Netherlands.

The Eurobond market is the largest international bond market, which is said to have



83

originated in 1963 with an issue of Eurodollar bonds by Autostrade, an Italian

borrower. The market has since grown enormously in size and was worth about $ 428

billion in 1994.

Eurobond markets in all currencies except the Japanese Yen are quite free from any

regulation by the respective governments. Straight bonds are priced with reference toa benchmark, typically treasury issues. Thus a Eurodollar bond will be priced to a yield

a YTM (Yield-to-Maturity) somewhat above the US treasury bonds of similar maturity,

the spread depending upon the borrowers ratings and market conditions.

Floatation costs of the Eurobond are comparatively higher than costs indicated with

syndicated Eurocredits.

4. Euro CPs

Commercial paper is a corporate short-term, unsecured promissory note issued on

a discount to yield basis. Commercial paper maturities generally do not exceed 270days. Commercial paper represents a cheap and flexible source of funds While CPs

are negotiable, secondary markets tend to be not very active since most investors

hold the paper to maturity.

The emergence of the Euro Commercial Paper (ECP) is much more recent. It evolved as

a natural culmination of the Note Issuance Facility and developed rapidly in an

environment of securitisation and disintermediation of traditional banking. CP has also

developed in the domestic segments of some European countries offering attractive

funding opportunities to resident entities.

5. Euro CDs

A Certificate of Deposit (CD) is a negotiable instrument evidencing a deposit with a

bank. A CD is a marketable instrument so that the investor can dispose it off in the

secondary market whenever cash is needed. The final holder is paid the face value on

maturity along with the interest. It is used by the commercial banks as short- term

funding instruments.

Euro CDs are mainly issued in London by banks. Interest on CDs with maturity more

than a year is paid annually than semi-annually.6. International Capital Markets

International Capital Markets have come into existence to cater to the need of

international financing by economies in the form of short, medium or long-term

securities or credits. These markets also called Euro markets, are the markets on

which Euro currencies, Euro bonds, Euro shares and Euro bills are traded/exchanged.

Over the years, there has been a phenomenal growth both in volume and types of

financial instruments transacted in these markets. Euro currency deposits are the

deposits made in a bank, situated outside the territory of the origin of currency. For



84

example, Euro dollar is a deposit made in US dollars in a bank located outside the

USA; likewise, Euro banks are the banks in which Euro currencies are deposited. They

have term deposits in Euro currencies and offer credits in a currency other than that

of the country in which they are located.

A distinctive feature of the financial strategy of multinational companies is the widerange of external services of funds that they use on an ongoing basis. British

Telecommunication offers stock in London, New York and Tokyo, while Swiss Bank

Corporation-, aided by Italian, Belgian, Canadian and German banks- helps

corporations sell Swiss franc bonds in Europe and then swap the proceeds back into US

dollars.

Firms have three general sources of funds available: (i) internally generated cash, (ii)

short-term external funds, and (iii) long-term external funds. External investment

comes in the form of debt or equity, which are generally negotiable (tradable)

instruments. The pattern of financing varies from country to country. Companies in theUK get an average of 60-70% of their funds from internal sources. German companies

get about 40-50% of their funds from external suppliers. In 1975, Japanese companies

got more than 70% of their money from outside sources, but this pattern has since

reversed; major chunks of finances come from internal sources.

Another significant aspect of financing behaviour is that debt accounts for the

overwhelming share of external finance. Industry sources of external finance also

differ widely from country to country. German and Japanese companies have relied

heavily on bank borrowing, while the US and British industry raised much more

money directly from financial markets by the sale of securities. However, in allcountries, bank borrowing is on a decline. There is a growing tendency for corporate

borrowing to take the form of negotiable securities issued in the public capital

markets rather than in the form of commercial bank loans. This process known as

securitisation is most pronounced among the Japanese companies.

7. Petro Dollar

During the oil crises of 1973, the Capital markets have played a very important role.

They accepted the dollar deposits from oil exporters and channeled the funds to the

borrowers in other countries. This is called ‘recycling the petrodollars’.

8. Junk Bonds

A junk bond is issued by a corporation or municipality with a bad credit rating. In

exchange for the risk of lending money to a bond issuer with bad credit, the issuer pays

the investor a higher interest rate. "High-yield bond" is a nicer name for junk bond The

credit rating of a high yield bond is considered "speculative" grade or below

"investment grade". This means that the chance of default with high yield bonds is

higher than for other bonds. Their higher credit risk means that "junk" bond yields are

higher than bonds of better credit quality. Studies have demonstrated that portfolios



86

a result the exchange rate risk is very high.

Projects maybe financed with floating rates. In view of the volatility observed on the

rates like LIBOR, the interest rate risk is also significant. Therefore it is necessary to

plan the coverage of all these risks.

2. Foreign Exchange Risk

As corporations expand their international activities, they begin to acquire foreign

assets and foreign liabilities. As exchange rates change, the values of these foreign

assets and liabilities change accordingly. For a corporation, exchange rate risk is the

sensitivity of the value of the corporation when the exchange rates change.

Obviously, the change in the corporation value is related to the net change in the

values of the foreign assets and foreign liabilities. (E.g.foreign direct investment,

foreign exchange loss, sales and income from foreign sources.)

3. Economic Risk

Economic risk is risk created by changes in the economy. Typically, it is related to

technological changes, the actions of competitors, shifts in consumer preferences, etc.

Ideally, a pure domestic firm is affected only by domestic economic conditions - the

domestic economic risk. However, in today's integrated world economy, the concept of

a pure domestic firm has less practical relevance. Many firms that appear strictly pure

domestic confront foreign economic risk indirectly. (E.g.: local restaurant/dept store,

real estate agent)

4. Political Risk

Political risk is risk created by political changes or instability in a country. These factors

include, but are not limited to, nationalization, confiscation, price controls, foreign

exchange and capital controls, administrative hurdles, uncertain property rights,

discriminative or arbitrary regulations on business practices (hiring, contract

negotiation), civil wars, riots, terrorism, etc. Each country in the world presents a

different political profile and represents a unique source of political risk that firms

must assess and manage when they make foreign investments.

In order to minimize this risk, local investors or the local government may beassociated with the project. Insurance against political risk is another useful technique

recommended for the purpose.

What constitutes political risk and how to measure it?

The political risk management typically involves:

- Identifying political risk and its likely consequences



87

- Developing policies in advance to cope with the possibility of political risk

- Strengthening a firm's bargaining position

- Devising measures to maximize compensation in the event of expropriation

Country Risk: It refers to elements of risk inherent in doing business in the economic,

social, and political environment of another country.

5. Counter party Risk - The risk that a counter party will default on a financial

obligation.

6. Liquidity Risk -The risk that a financial position cannot be sold quickly at prevailing

prices.

7. Delivery Risk - The risk that a buyer will not deliver payment of funds after a seller

has delivered securities or foreign exchange that were purchased.

8. Rollover Risk - The risk of being closed out from a financial market and unable to

renew (or roll over) a short-term contract.

9. Other risks - Other risks relate to the risk of cost overruns and bad management.

MULTIPLE CHOICE QUESTIONS

1. The Irawash Co. of Canada has set up a website to sell products to US

consumers. Prices are listed in US dollars but all their costs are in Canadiandollars. Which of the following is a major risk faced by the company?

a) Exchange rate risk.

b) Investment risk.

c) An American boycott.

d) All of the above.

2. Which of the following is an example of foreign exchange?



89

8. Which of the following might affect the cost of a trip to Japan by a resident of

Britain?

a) The depreciation of the Euro.

b) The time at which the British resident purchases Yen.

c)

The depreciation of the US dollar.d) All of the above.

9. A company that functions to unite sellers and buyers of foreign currency-

denominated bank deposits is called:

a) a broker.

b) an investor.

c) a wholesaler.

d)

a bank

10. _____________ contracts are more widely accessible to firms and individuals

than ____________ contracts.

a) Futures; forward

b) Forward; futures

c) Forward; arbitrageur

d) Arbitrageur; forward

11. If the euro dollar deposit rate is 3% per year and the euro-euro rate is 6% per

year, by how much will the euro be expected to devalue in the coming year?

a)

0.3%b) 2.0%

c) 2.9%

d) 3.0%

12. According to which theory will differences in nominal interest rates be

eliminated in the exchange rate?

a) The PPP.

b)

The Fisher effect.



90

c) The Leontief paradox.

d) The combined equilibrium theory.

13. If inflation goes up in the US relative to other countries, it is expected that the

price of the US dollar will:

a) increase.

b) remain the same.

c) fall.

d) may increase or decrease.

14. Which of the following is an exchange risk management technique through

which the firm contracts with a third party to pass exchange risk onto that

party, via instruments such as forward contracts, futures, and options?

a)

Diversification.b) Risk avoidance.

c) Risk transfer.

d) Risk adaptation.

15. What is the base interest rate paid on deposits among banks in the

eurocurrency market called?

a) INEC.

b) EUIN.

c)

LIBOR.d) INEU.

Internet Resources:

www.imf.org/external/fin.html IMF website. Contains exchange rate quotes for

selected currencies

www.ny.frb.org/pihome/ststistics/forex12.shtml

NY Fed site with noon forex rates.

www.bis.org/publ/index.html BIS site contains annual reports, external debts,

foreign exchange market activities etc.

http://www.imf.org/external/fin.html

http://www.ny.frb.org/pihome/ststistics/forex12.shtml

http://www.bis.org/publ/index.html

http://www.bis.org/publ/index.html

http://www.ny.frb.org/pihome/ststistics/forex12.shtml

http://www.imf.org/external/fin.html



91

MODULE 3:

Derivatives



92

Chapter 5 Introduction to derivatives

After reading this chapter, you will be able to understand:

The basic meaning of Derivatives

Products, participants and functions

Types of derivatives

Development of exchange-traded derivatives

Global derivatives markets Exchange-traded vs. OTC derivatives markets



93

Background

1. The origins of derivative financial instruments

Derivatives are financial instruments whose values depend on the value (or othervariables) of an asset (known as the underlying). The underlying asset can be

another financial instrument, a currency, an interest rate or an index (financial

derivatives) or a commodity.

The parties involved in the derivatives market are basically the intermediaries

(banks or securities firms) and the end users. End users include all categories of

financial intermediaries and institutional investors, nonfinancial corporate

enterprises, public entities, supranational institutions and individuals. Each of these

end users participates in the derivatives market for either speculative or hedging

purposes. In the first case the investor acquires a risk hoping to obtain a profit, in

the second case the derivative is

used to hedge against a risk (Fabrizi et al. 2002).

The original goal of derivatives is risk hedging, but soon after they turned into a

system to speculate or a practice to hide or carry forward losses that could not be

easily compensated. The first to bear the burdens arising from the use of such

instruments were the Italian banks which paid high costs to the foreign banks that

had introduced derivatives. For a few years now, many of these foreign banks,together with some Italian banks, have been working with the same objectives:

selling derivative products to Italian small and medium-sized enterprises first, and

more recently, to local authorities, even the smallest-sized ones.

The use of derivatives by local authorities dates back to 1994 when the

abolishment - by Law No. 724 of 23 December 1994 - of the obligation for local

authorities to have recourse to the Cassa Depositi e Prestiti to have access to credit,

opened up new financing opportunities. In spite of the attempt to keep the

mechanism under control, by introducing restrictions to the use of derivatives to

hedge against exchange rate exposure in case of foreign exchange transactions

(Decree of the Ministry of Treasury No. 420 of 5

July, 1996), the 2002 budget law paved the way to the use of derivatives by local

authorities. The introduction of a new provision in the budget law which led local

authorities not to consider these instruments as hazardous, the continuous need

for cash flow, and the devolution of important functions from the central

government to local authorities, resulted in the development of anomalous

schemes of financial support. In those years, the interpretations of the law resulted



94

not only in serious violations – the spending power of local governments was

virtually unlimited and budget deficits and extrabudget liabilities were generated –,

but they also led to the misuse of derivatives

for obtaining immediate resources against larger debt burdens in the future. If the

first interpretations of the law have already “paid dividends” – in fact, from 1989 to

31st December 2007, 428 local authorities were declared in financial default.

2. The different types of derivatives

The value of derivative financial instruments is derived from the price of an

underlying asset; the underlying asset may consist of a real asset (commodity

derivatives), a financial asset (financial derivatives), or a price index or a stock

market index. Different classes of derivatives may be identified on the basis of the

following criteria:

a) the type of underlying asset;

b) the exchanges where derivatives are traded;

c) the technical characteristics of the various instruments.

Although several variants exist within each of the above-mentioned criteria, four

main types of instruments can be identified: the forwards, the futures, the swaps

and the options.

Forward contracts are derivatives whereby an agreement is made between two

parties to buy or sell an asset on a specified future date at a pre4 determined price.

Under a forward contract, therefore, the parties involved set out the terms and

conditions for the performance of a transaction on a future date. This type of

derivative is usually entered into “over the counter” and is used to hedge against

an exchange rate risk.

Futures are like forwards. Also in this case there is an agreement to buy or sell an

asset on a future date and at a specified price. The difference from forwards is thatfutures are usually traded on exchanges. Futures contracts are highly standardized,

therefore the contract subject-matter, the unit value, the settlement date, the

settlement terms and conditions and everything but the price are pre-determined

by the market.

Interest-rate swaps are contracts whereby two parties agree to exchange interest

payments based on a notional principal amount over a specified period.

The most common and simplest type of interest-rate swaps is known as the plain

vanilla swap, whereby a party makes floating interest rate payments and receives



95

fixed interest rate payments for the entire period of the contract. Swaps (the plain

vanilla being certainly the simplest example) are used to manage a position in the

interest rate market. Hence, if interest rates are expected to rise the operator

would be willing to pay a fixed rate and

collect the floating one.

Finally, the option contract is a forward purchase agreement by which one of the

parties involved reserves the possibility to buy or sell an asset on a set date against

payment of a premium to the counterparty.

Several variants may exist within the above-mentioned categories and they lead to

two different types of activity. If a derivative is used for speculative purposes, the

operator acquires a risk based on his expectations and he can have a profit or a

loss. When derivatives are used to hedge against a given risk, operators may createa series of assets and liabilities with characteristics that meet their financial needs.

Under this perspective, derivatives might have been a useful tool to reduce risks,

but they have been used improperly and mainly for speculative purposes (Fabrizi et

al. 2002).

3. From UK to Italy: the size of the phenomenon

Derivatives packaged for the Italian local authorities, mostly in the UK, aretransactions based on a debt and its relevant interest. In other terms, a proposal to

hedge against the risk of rising interest rates by taking out an insurance policy

(derivative) is made to an indebted institution. Local authorities believe that with

such policy they are able to convert the floating interest rate on their debts into a

fixed one, but they actually worsen their position.

An oversimplified explanation would be that derivatives are a form of speculation

in that, in some cases, local authorities sign a contract – the content of which they

do not really understand due to its objective complexity – whereby they are driven

to bear implicit operation costs that they ignore, against an immediate income and

the shifting of their debts to the future administrations. Indeed, not all derivatives

carry the same risks: with some derivatives, the entire invested capital may be lost,

with other derivatives not only the invested capital is put in jeopardy, whereas

other derivatives are real insurance policies carrying little risk. Of course, the latter

were the least proposed and sold by banks, because the lower the risk, the lower

the return on the operation.



96

The lack of standardization of the products and the complexity of derivatives

operations make it difficult to assess the phenomenon. However, even from such

fragmentariness it is possible to understand how diffused and dangerous the

phenomenon is.

In June 2004, the notional amounts of the derivatives positions held by companies

and local authorities in Italy reached approximately 146 billion Euro, with the

average losses incurred by local authorities being much higher than those suffered

by corporate investors (approx. €430,000 for local authorities versus €76,000 for

enterprises; this was also due to the higher

size of contracts concluded by the public sector, with an overall notional amount of

approximately 12 million Euro vs. 2.6 million Euro for enterprises).

At the end of 2006, regional, provincial and municipal governments had aderivatives exposure to Italian banks estimated at around 13 billion Euro in terms

of notional value, corresponding to 36 percent of the total indebtedness toward

resident intermediaries.

According to the data reported by the Department of Treasury, the phenomenon is

continuously increasing; in fact, until 31st December, 2007, more than 900

derivatives contracts were written by 559 public bodies (497 municipalities, 44

provincial governments and 18 regional governments), with a negative mark-to-

market value of over one billion Euro, that is approximately 2.9% of local

authorities’ cash indebtedness. The data mentioned above, although high,

underestimates the phenomenon, since it does not take into account the recourse

by Italian local authorities to foreign intermediaries, for which precise data is not

available.

The above-mentioned data shows a growing phenomenon, whose size is unknown,

and the reasons of which are to be found in the legislative provisions in force prior

to the coming into effect of the 2008 budget law. In fact, prior to the amendments

brought about by the last budget law, the mark to market or the potential loss at

the expiration of the contract did not represent an expenditure item in the three-

year economic planning of a local authority and there was no obligation to record it

off the balance sheet, with risks and

potential losses that were disregarded in the balance accounts.

The 2002 budget law opened up the opportunity for local authorities to have

recourse to derivatives and the legislative provisions enacted in 2003 and 2004 to

set out permissible operations and provide local authorities with rules in this

respect were of little use. Subsequently, several legislative provisions have been



97

enacted over the years to exercise preventive control over the use of derivatives by

local authorities, until the 2007 and 2008 budget laws.

The 2007 budget law, in paragraph 737 et seq, laid down an obligation for local

authorities to submit all the underwritten contracts to the Department of Treasury

so that preventive control measures could be taken prior to the conclusion of said

contracts, and an obligation to send the contracts concluded in violation of the

prescription above to the Court of Auditors so that the necessary measures could

be taken.

Also the 2008 budget law established rules providing for a “double level”

transparency. The first level of transparency consists of the obligation to include in

the contract all the information required and specified under Decree of the

Ministry of Economy and of an explicit declaration by the authority’s administrators

in which they state to be aware of the risks involved in the derivative; such

declaration of awareness is an acknowledgement and acceptance of the

responsibilities arising from the operation.

The second level of transparency is based on the inclusion of a note to the accounts

in which budget commitments and obligations are reported.

This is a considerable step forward since, for the first time, these operations will be

entered into the accounts, indicating the mark-to-market value, the inflows and

outflows generated from the transaction date, the projected cash flows for the

next three years, the quarterly mark-to-market adjustments and a report on the

operation performance (Pozzoli 2008). Furthermore, Article 62 of Decree Law No.

112, enacted on 25 June 2008, in stressing the riskiness of such instruments, laid

down a prohibition for local authorities to underwrite

derivatives until the Ministry of Economy, having heard the Bank of Italy and the

National Commission for Listed Companies and the Stock Exchange (CONSOB),

establishes a set of rules for the subscription of such financial instruments.

Therefore, besides law provisions, it is essential that local authorities deploy

internal supervision and rules aimed at:

1. being sure that they have thoroughly understood the nature of the

operation that is being performed. The operations that cannot be understood or

evaluated should not be performed. The officers who effected the Orange County

and Hammersmith Fulham derivatives transactions, although facing multi-million



98

dollar exposure, had poor knowledge of the financial instruments they were

buying.

2. setting out well-defined limits of the risk that they are willing to assume.

Obviously, these limits must be set out by the authority’s council, must be bindingon the financial managers and prevent them from being drawn into the vortex of

speculation. At the same time, the supervision of the authority’s council must be

firm and must ensure that the pre-established exposure limits are not exceeded

even when a gain is generated. The initial operations conducted by Robert Citron in

the early 1990’s were very profitable

for Orange County. For this reason, the authority’s managers disregarded the risks

taken by the treasurer, who hoped for new profits. As a matter of fact, things did

not go in the right direction and in 1994 Orange County suffered losses that weremuch higher than the previous gains.

3. not thinking to be able to beat the market . A very experienced trader will be

able to predict the future market trends in 60 percent of cases. If such percentage

is exceeded, it is due to fortuitous circumstances that are unlikely to be replicated

and that should not result in the rise of the preestablished exposure limits.

Therefore, local authorities must ensure that a hedger, tempted by a successful

operation, does not get sucked into speculation

becoming exposed beyond the pre-established exposure limits.

4. diversifying the risk . A spread strategy allows investors to reduce the risk

considerably. If the investment were concentrated on a single security, then the

investor would have to show great ability in choosing the right security.

5. performing scenario analysis and stress testing. A correct choice would be that

of using historical data series and choosing the most extreme events as scenarios

and limits to be set out (Hull 2003). Internal supervision, in connection with the

enforcement of existing legislative provisions, must be aimed at defining the

investment strategies of local authorities performing transactions in derivatives. It

is fairly obvious that rules are not effective if they are circumvented with the

complicity of those responsible for supervision.



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Introduction

Derivatives can be defined as a ‘product’ whose value is derived from the value of

one or more basic variables, called bases (underlying asset, index, or reference rate), in

a contractual manner. The underlying asset can be equity, forex or commodity or any

other asset.

For example, wheat farmer may wish to sell their harvest at a future date to eliminate

the risk of a change in prices by the date. Such a transaction is an example of a

derivative. The price of this derivative is driven by the spot price of wheat which is the

‘underlying’.

According to the Securities Contracts (Regulation) Act, 1956 (SC(R) A)

“derivative” includes –

1. A security derived from a debts instrument, share, loan whether secured orunsecured, risk instrument or contract for differences or any other form of security.

2. A contract, which derives its value from the prices, or index of price, of underlying

securities. The derivatives are securities under the (SC(R)A) and hence the trading of

derivatives is governed by the regulatory framework under the (SC(R)A).

A derivative is any financial instrument, whose payoffs depend in a direct way onthe value of an underlying variable at a time in the future. This underlying variable is

also called the underlying asset, or just the underlying.



100

Examples of underlying assets include

Usually, derivatives are contracts to buy or sell the underlying asset at a future time,

with the price, quantity and other specifications defined today. Contracts can be

binding for both parties or for one party only, with the other party reserving the option

to exercise or not. If the underlying asset is not traded, for example if the underlying is

an index, some kind of cash settlement has to take place. Derivatives are traded in

organized exchanges as well as over the counter [OTC derivatives]. Examples of

derivatives include forwards, futures, options, caps, floors, swaps, collars, and many

others.

BackgroundThales of Miletus used a money-spinning device which, though it was ascribed to his

prowess as a philosopher, is in principle open to anybody. The story is as follows: people

had been saying reproachfully to him that philosophy was useless, as it had left him a

poor man. But he, deducing from his knowledge of the stars that there would be a good

crop of olives, while it was still winter and he had little a money to spare, used it to pay

deposits on all the oil-presses in Miletus and Chios, thus securing their hire. This cost

him only a small sum, as there were no other bidders. Then the time of the olive-harvest

came, and as there was a sudden and simultaneous demand for oil-presses he hired

them out at any price he liked to ask. He made a lot of money, and so demonstratedthat it is easy for philosophers to become rich, if they want to; but that is not their

objective in life.

Derivative contracts in general and options in particular are not novel securities. It has

been nearly 25 centuries since the above abstract appeared in Aristotle's Politics,

describing the purchase of a call option on oil-presses. More recently, De La Vega

(1688), in his account of the operation of the Amsterdam Exchange, describes traded

contracts that exhibit striking similarities to the modern traded options



101

Nevertheless, the modern treatment of derivative contracts has its roots in the inspired

work of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorous

mathematical representation of an asset price evolution through time. Bachelier used

the concepts of random walk in order to model the fluctuations of the stock prices, and

developed a mathematical model in order to evaluate the price of options on bond

futures. Although the above model was incomplete and based on assumptions that arevirtually unacceptable in recent studies, its importance lies on the novelty of its ideas,

both from an economist's and a mathematician's point of view. Unfortunately, this

work was not developed further, despite the publication of the Einstein paper on

Brownian motion in 1905, which would shed light on the properties of the model and

perhaps highlight its misspecifications.

The above treatment of security prices was long forgotten until the 70s, when

Professor Samuelson and his co-workers at MIT rediscovered Bachelier's work andquestioned its underlying assumptions. By construction, the payoff of a call option on

the expiration day will depend on the price of the underlying asset on that day, relative

to the option's exercise price. Common reasoning declares that therefore, the price of

the call option today has to depend on the probability of the stock price exceeding the

exercise price. One could then argue that a mathematical model that can satisfactory

explain the underlying asset's price is sufficient in order to price the call option today,

just by constructing the probabilistic model of the price on the expiration day.

Professors Black, Merton and Scholes recognized that the above reasoning is incorrect:

Since today's price incorporates the probabilistic model of the future behavior of the

asset price, the option can (and has to) be priced relative to today's price alone. Theyrealized that a levered position, using the stock and the riskless bond, that replicates

the payoff of the option is feasible, and therefore the option can be priced using no-

arbitrage restrictions. Equivalently, they observed that the true probability distribution

for the stock price return can be transformed into one which has an expected value

equal to the risk free rate, the so called risk adjusted or risk neutral distribution; the

pricing of the derivative can be carried out using the risk neutral distribution when

expectations are taken.



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Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide

range of European products such as interest rate & index products), and CME

Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the

Chicago Board of Trade and the 2008 acquisition of the New York Mercantile

Exchange).

According to BIS, the combined turnover in the world's derivatives exchanges

totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also

may trade on traditional exchanges.

For instance, hybrid instruments such as convertible bonds and/or convertible

preferred may be listed on stock or bond exchanges. Also, warrants (or "rights")

may be listed on equity exchanges. Performance Rights, Cash x PRTs and various

other instruments that essentially consist of a complex set of options bundled into

a simple package are routinely listed on equity exchanges. Like other derivatives,

these publicly traded derivatives provide investors access to risk/reward andvolatility characteristics that, while related to an underlying commodity,

nonetheless are distinctive.

Functions of a derivatives market :

The derivatives market performs a number of economic functions:

1. Transferring Risks: They help in transferring risks from risk averse people to

risk oriented people

2. Prediction: They help in the discovery of future as well as current prices

3. Catalyze: They catalyze entrepreneurial activity

4. Increases Trade volume: They increase the volume traded in markets because

of participation of risk averse people in greater numbers

5. Increases Savings & Investments: They increase savings and investment in the

long run



105

option one has to pay a minute fraction of the possible payoffs, speculators can

attempt to materialize extensive profits.

Speculators use futures and options contracts to get extra leverage in betting

on

future movements in the price of an asset. They can increase both the potential

gains and potential losses by usage of derivatives in a speculative venture

Arbitrageurs: They lock riskless profits by taking positions in two or more

markets. They do not hedge nor speculate, since they are not exposed to any

risks in the very first place. For example if the price of the same product is

different in two markets, the arbitrageur will simultaneously buy in the lower

priced market and sell in the higher priced one. In other situations, more

complicated arbitrage opportunities might exist. Although hedging and [mainly]

speculating are the reasons that have made derivatives [im]famous, the

analysis of pricing them fairly depends solely on the actions of the arbitrageurs,

since they ensure that price differences between markets are eliminated, and

that products are priced in a consisted way.

Arbitrageurs are in business to take advantage of a discrepancy between prices

in

two different markets. If, for example, they see the futures price of an asset

getting

out of line with the cash price, they will take offsetting positions in the two

marketsto lock in a profit

Why derivatives?

Every candidate underlying asset will have a value that is affected by a variety of

factors, therefore inheriting risk. Derivative contracts, due to the leverage that they

offer may seem to multiply the exposure to such risks. However, derivatives are rarely

used in isolation. By forming portfolios utilizing a variety of derivatives and underlying

assets, one can substantially reduce her risk exposure, when an appropriate strategy is

considered.

Derivative contracts provide an easy and straightforward way to both reduce risk -

hedging, and to bear extra risk -speculating. As noted above, in any market conditions

every security bears some risk. Using active derivative management involves isolating

the factors that serve as the sources of risk, and attacking them in turn. In general,

derivatives can be used to

hedge risks;



106

reflect a view on the future behavior of the market, speculate;

lock in an arbitrage profit;

change the nature of a liability;

change the nature of an investment;

Example 1 (Sources of risk): Suppose that a British investor holds a number of 10 yearUS T-Notes, and wants her investment to expire on the 1st December 01.

1.4 The face value of the notes is , and at the current market prices they

are worth . The exchange rate today is . Therefore, if she

decides to liquidize the notes now, the investor would receive . There

are two sources of risk in this setting: Exchange rate risk and interest rate risk .

Example 2 (cont. Exchange rate risk) The British pound might keep rising against thedollar. This is illustrated in figure 1.1. In this case, the value of the investment will

decline. The investor examines the futures markets, and observes that the quote for a

exchange rate future that expires on the 1st December 01 is . By

selling futures worth she will ensure a payment of

.The above does not describe the perfect hedge position! Since the investor keeps the

money in the 10y note until next year, she will enjoy the interest -and the possible

coupons, offered through that year. The right amount to be converted would be the

one that will include those payments. But what is this value? The actual value of the

notes will depend on the short rates that will be in place next year. This gives rise to

the interest rate risk.

Figure 1.1: Alternative exchange rate events

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108

2. The futures contract:

This contract is an agreement to buy or sell an asset at a certain time in the future for a

certain price. Futures are traded in exchanges and the delivery price is always such that

today's value of the contract is zero. Therefore in principle, one can always engage into

a futures without the need of an initial capital: the speculators heaven!

Future contracts are special types of forward contract in the sense that the former are

standardized exchange-traded contracts.

Although similar in nature, these two instruments exhibit some fundamental

differences in the organization and the contract characteristics. The most important

differences are given in table 1.1.

Table 1.1: Differences between forwards and futures contracts

Forwards Futures

Primary market Dealers Organized Exchange

Secondary market None the Primary market

Contracts Negotiated Standardized

Delivery Contracts expire Rare delivery

Collateral None Initial margin, mark-the-market

Credit risk Depends on parties None [Clearing House]

Market participants Large firms Wide variety

In the example 3, a futures contract was not available for the investor to hedge against

the interest rate risk. One can now see that she could alternative go to some

investment company seeking for a forward contract that would suit her needs.

3. Options:

Futures and forwards share a very important characteristic: when the delivery date

arrives, the delivery must take place. The agreement is binding for both parties: the

party with the short position has to deliver the goods, and the party with the long

position has to pay the agreed price. Options give the party with the long position one

extra degree of freedom: she can exercise the contracts if she wants to do so; whereas

the short parties have to meet the delivery if they are asked to do so. This makes

options a very attractive way of hedging an investment, since they can be used as to

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109

enforce lower bounds on the financial losses. In addition, options offer a very high

degree of gearing or leverage, which makes them attractive for speculative purposes

too.

The main characteristics of a plain vanilla option contract are the following:

The maturity : The time in the future, up to which the contract is valid;

The strike or exercise price : The delivery price. Remember that the long

party will assess whether or not this price is better than the current market

price. If so, then the option will be exercised. If not the option will be left to

expire worthless;

Call or put: The call option gives the long party the right to buy the underlying

security at the strike price from the short party. The put option gives the long

party the right to sell the underlying security at the strike price to the short

party. The short party has to obey the long party's will;

American or European: The American option gives the right to the long party toexercise the contract at any time they wish, up to the maturity date. If the

option is European, it can be exercised on the maturity date only; and

Details concerning the delivery.

Apart from the plain vanilla contracts which are American or European, a lot of other

exotic options have appeared recently, mostly as

OTC contracts: These include Asian options, digital options, look back options, etc.

Traders have been rather imaginative when it comes to designing new derivative

securities.

Unlike the forward or futures contracts, and because of the payoff asymmetries, the

initial value of an option, say , is not equal to zero. Apart from the above

characteristics, the option price is generally affected by:

The volatility [or uncertainty] of the underlying asset, from today up to the

maturity date. In fact, it is common in the literature for option markets to be

described as markets where volatility is traded;

The level of the interest rates, in fact the whole term structure, and the

stochastic behavior of them if they are unknown;

The dividends, coupon payments, costs of storage, and other cash flows that

are possible before the maturity date; and

Commissions and the way the margin is marked.

As an example of the payoff asymmetries, the profits from a long European call option

position look typically like the ones given in figure 1.3. A great deal of time will be

dedicated discussing how option contracts are priced.

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110

Figure 1.3: European call option payoffs

Financial Derivatives Market and its Development

Financial markets are, by nature, extremely volatile and hence the risk factor is an

important concern for financial agents. To reduce this risk, the concept of derivatives

comes into the picture. Derivatives are products whose values are derived from one or

more

basic variables called bases. These bases can be underlying assets (for example forex,

equity, etc), bases or reference rates. For example, wheat farmers may wish to sell

theirharvest at a future date to eliminate the risk of a change in prices by that date. The

transaction in this case would be the derivative, while the spot price of wheat would be

the

underlying asset.

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with

one

another. Forward contracting dates back at least to the 12th century, and may wellhave

been around before then. Merchants entered into contracts with one another for

future

delivery of specified amount of commodities at specified price. A primary motivation

for

pre-arranging a buyer or seller for a stock of commodities in early forward contracts

was to

lessen the possibility that large swings would inhibit marketing the commodity after a

harvest.



111

Development of derivatives market in India

The first step towards introduction of derivatives trading in India was the promulgation

of

the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition onoptions in securities. The market for derivatives, however, did not take off, as there

was no

regulatory framework to govern trading of derivatives. SEBI set up a 24 –member

committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop

appropriate regulatory framework for derivatives trading in India. The committee

submitted

its report on March 17, 1998 prescribing necessary pre –conditions for introduction of

derivatives trading in India. The committee recommended that derivatives should be

declared as ‘securities’ so that regulatory framework applicable to trading of

‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the

Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in

derivatives market in India. The report, which was submitted in October 1998, worked

out

the operational details of margining system, methodology for charging initial margins,

broker net worth, deposit requirement and real –time monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December 1999 to

include derivatives within the ambit of ‘securities’ and the regulatory framework was

developed for governing derivatives trading. The act also made it clear that derivativesshall be legal and valid only if such contracts are traded on a recognized stock

exchange,

thus precluding OTC derivatives. The government also rescinded in March 2000, the

three –

decade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final

approval to this effect in May 2001. SEBI permitted the derivative segments of two

stock

exchanges, NSE and BSE, and their clearing house/corporation to commence trading

and

settlement in approved derivatives contracts. To begin with, SEBI approved trading in

index futures contracts based on S&P CNX Nifty and BSE –30(Sensex) index. This was

followed by approval for trading in options based on these two indexes and options on

individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in

options on individual securities commenced in July 2001. Futures contracts on

individual

stocks were launched in November 2001. The derivatives trading on NSE commenced

with



112

S&P CNX Nifty Index futures on June 12, 2000. The trading in index options

commenced

on June 4, 2001 and trading in options on individual securities commenced on July 2,

2001.

Single stock futures were launched on November 9, 2001. The index futures and

optionscontract on NSE are based on S&P CNX

Trading and settlement in derivative contracts is done in accordance with the rules,

byelaws, and regulations of the respective exchanges and their clearing

house/corporation

duly approved by SEBI and notified in the official gazette. Foreign Institutional

Investors

(FIIs) are permitted to trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the

NSE

report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the F&O

segment. It constituted 70 per cent of the total turnover during June 2002. Aprimary reason attributed to this phenomenon is that traders are comfortable with

single-stock futures than equity options, as the former closely resembles the

erstwhile badla system.

• On relative terms, volumes in the index options segment continues to remain poor.

This may be due to the low volatility of the spot index. Typically, options are

considered more valuable when the volatility of the underlying (in this case, the

index) is high. A related issue is that brokers do not earn high commissions by

recommending index options to their clients, because low volatility leads to higher

waiting time for round-trips.

• Put volumes in the index options and equity options segment have increased since

January 2002. The call-put volumes in index options have decreased from 2.86 in

January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the

traders are increasingly becoming pessimistic on the market.

• Farther month futures contracts are still not actively traded. Trading in equity

options on most stocks for even the next month was non-existent.

• Daily option price variations suggest that traders use the F&O segment as a less



113

risky alternative (read substitute) to generate profits from the stock price

movements. The fact that the option premiums tail intra-day stock prices is

evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day.

If calls and puts are not looked as just substitutes for spot trading, the intra-day

stock price variations should not have a one-to-one impact on the option premiums.

Commodity Derivatives

Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking,

castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18

commodity exchanges located in various parts of the country. Futures trading in other

edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new

commodities, especially in edible oils, is expected to commence in the near future. The

sugar industry is exploring the merits of trading sugar futures contracts.

The policy initiatives and the modernisation programme include extensive training,

structuring a reliable clearinghouse, establishment of a system of warehouse receipts,

and

the thrust towards the establishment of a national commodity exchange. The

Government

of India has constituted a committee to explore and evaluate issues pertinent to the

establishment and funding of the proposed national commodity exchange for the

nationwide trading of commodity futures contracts, and the other institutions and

institutional processes such as warehousing and clearinghouses.

With commodity futures, delivery is best effected using warehouse receipts (which are

like

dematerialised securities). Warehousing functions have enabled viable exchanges to

augment their strengths in contract design and trading. The viability of the national

commodity exchange is predicated on the reliability of the warehousing functions. The

programme for establishing a system of warehouse receipts is in progress. The Coffee

Futures Exchange India (COFEI) has operated a system of warehouse receipts since

1998

Exchange-traded vs. OTC (Over The Counter) derivativesmarkets

The OTC derivatives markets have witnessed rather sharp growth over the last few

years,

which has accompanied the modernization of commercial and investment banking and

globalisation of financial activities. The recent developments in information technology

have contributed to a great extent to these developments. While both exchange-

traded and



115

and gains, if any, of speculative business. In the absence of a specific provision, it is

apprehended that the derivatives contracts, particularly the index futures which are

essentially cash-settled, may be construed as speculative transactions and therefore

the

losses, if any, will not be eligible for set off against other income of the assessee and

willbe carried forward and set off against speculative income only up to a maximum of

eight

years .As a result an investor’s losses or profits out of derivatives even though they are

of

hedging nature in real sense, are treated as speculative and can be set off only against

speculative income.

1.

Which of the following contract terms is not set by the futures exchange?

a. the price

b. the deliverable commodities



116

c. the dates on which delivery can occur

d. the size of the contract

e. the expiration months

2. Find the forward rate of foreign currency Y if the spot rate is $4.50, thedomestic interest rate is 6 percent, the foreign interest rate is 7 percent, and theforward contract is for nine months.

a. $5.104

b. none are correct

c. $4.458

d. $4.532

e. $4.468

3. Margin in a futures transaction differs from margin in a stock transaction because

a. stock transactions are much smaller

b. delivery occurs immediately in a stock transaction

c. no money is borrowed in a futures transaction

d. futures are much more volatile

4. Most futures contracts are closed by

a. exercise

b. offset

c. default

d. none are correct

e. delivery



117

5.

Which of the following is not a forward contract?

a. an automobile lease non-cancelable for three years

b. none are correct

c. a signed contract to buy a house in six months

d. a long-term employment contract at a fixed salary

e. a rain check

6. One of the advantages of forward markets is

a. none are correct

b. the contracts are private and customized

c. trading is conducted in the evening over computers

d. performance is guaranteed by the G-30

e. trading is less costly and governed by more rules

7.

Which of the following best describes normal contango?

a. none are correct

b. the futures price is less than the spot price

c. the cost of carry is negative

d. the expected spot price is less than the futures price

e. the spot price is less than the futures price

8. Suppose you sell a three-month forward contract at $35. One month later, newforward contracts are selling for $30. The risk-free rate is 10 percent. What is thevalue of your contract?

a. $4.55



118

b. $4.96

c. $4.92

d. $5

e. none are correct

9. Futures prices differ from spot prices by which one of the following factors?

a. the systematic risk

b. the risk premium

c. the spread

d. none are correct

e. the cost of carry

10.

Suppose there is a risk premium of $0.50. The spot price is $20 and the futures price is $22. What is the expected spot price at expiration?

a. $21.50

b. none are correct

c. $24.50

d. $22.50

e. $20.50

References

Fabrizi, P., G. Forestieri and P. Mottura (2002), Gli strumenti e i servizi finanziari ,

Milano: Egea

Hull, J.C. 2003. Opzioni, futures e altri derivati , Milano: Finanza e Mercati

Pozzoli, S. 2008. “Doppia trasparenza sui contratti derivati”, Il Sole 24Ore

Tenuta, P. 2007. Crisi finanziaria e strumenti di previsione del risk

management nelle aziende pubbliche locali , Milano: Franco Angeli



120

Module IV

Forward and

Futures



121

After reading this module, you will be able to understand:

Introduction

Delivery And Settlement Of A Forward Contract

Default Risk And Forward Contracts

Termination Of A Forward Contract

The Structure Of Global Forward Markets

types Of Forward Contracts

History Of Futures Markets

Definition Of Futures

Difference Between Futures And Forwards

Organization Of Exchange

Development Of Organized Exchanges,

Clearing House,

Clearing House Mechanism,

Contract Specifications For Futures,

Types Of Margins,

Orders In Futures Market,

Settlement Procedures,

The Relationship Between Futures Price And Cash Price,

Basis, Cost-Of-Carry, Contango And Backwardation,

Motives Behind Using Futures,

Types Of Futures



122

Chapter 6 Introduction to forward Contracts

1 Background

From the 1970s financial markets became riskier with larger swings in interest rates

and equity and commodity prices. In response to this increase in risk, nancial

institutions looked for new ways to reduce the risks they faced. The way found was the

development of exchange traded derivative securities. Derivative securities are assets

linked to the payments on some underlying security or index of securities. Many

derivative securities had been traded over the counter for a long time but it was from

this time that volume of trading activity in derivatives grew most rapidly.

The most important types of derivatives are futures, options and swaps. An option

gives the holder the right to buy or sell the underlying asset at a specified date for a

pre-specified price. A future gives the holder the

obligation to buy or sell the underlying asset at a specified date for a pre-specified

price. Swaps allow investors to exchange cash ows and can be regarded as a portfolio

of futures contracts.

Options and futures are written on a range of major stocks, stock market indices, major

currencies, government bonds and interest rates. Most options and futures in the UK

are traded on the London International Financial Futures Exchange (http://www.li

e.com/) and most options and futures in the US are traded on the Chicago Board of

Trade (http://www.cbot.com/). It is also possible to trade futures contracts on a range

of different individual stocks from across the world at Euro next(http://www.universal-stockfutures.com/). Such exchange traded derivatives might be

described as o -the-peg or generic as the details of the derivative are specified by the

Exchange House. Other derivatives are traded over the counter. They are tailor-made

and designed specifically to meet the needs of individual traders, the party and counter

party.

Derivatives allow investors a great deal of flexibility and choice in determining their

cash flows and thus are ideal instruments for hedging of existing risk or speculating on



123

the price movements of the underlying asset. Thus for example it is possible to o set

the risk that a stock will fall in price by buying a put option on the stock. It is possible to

gain if a large change in the price of the underlying asset is anticipated even if the

direction of change is unknown. It is also possible by using an appropriate portfolio of

options to guarantee that you buy at the lowest price and sell at the highest price | a

trader's dream made reality.

2 Forward Contracts

Forwards and futures contracts are a special type of derivative contract. For-ward

contracts were initially developed in agricultural markets. For example an orange

grower faces considerable price risk because they do not know at what price their

crops will sell. This may be a consequence of weather conditions (frost) that will affect

aggregate supply. The farmer can insure or hedge against this price risk by selling thecrop forward on the forward orange con-centrate market. This obligates the grower to

deliver a specific quantity of orange concentrate at a specific date for a specified price.

The delivery and the payment occur only at the forward date and no money changes

hands initially. Farmers can, in this way, eliminate the price risk and be sure of the

price they will get for their crop. An investor might also engage in such a forward

contract. For an example an investor might sell orange concentrate forward for

delivery in March at 120. If the price turns out to be 100, the investor buys at 100 and

delivers at 120 making a pro t of 20. If the weather was bad and the price in March is

150, the investor must buy at 150 to fulfill her obligation to supply at 120, making a

loss of 30 on each unit sold. The farmer is said to be a hedger as selling the orange

concentrate forward reduces the farmer's risk. The investor on the other hand is taking

a position in anticipation of his beliefs about the weather and is said to be a specula-

tor. This terminology is standard but can be misleading. The farmer who does not

hedge their price risk is really taking a speculative position and it is difficult to make a

hard and fast distinction between the two types of traders.

Why trade forward?

For an investor the forward market has both pros and cons. The advantage is that

there is no initial investment. That is it costs nothing now to buy or sell forward. The

disadvantage is that there is a change of suffering a large loss.

The price of a forward contract



124

Let's consider a forward contract for a particular underlying asset, e.g. IBM stock, with

a maturity date of T . The price of such a forward contract is easy to determine. In the

absence of any transactions or storage cost the price of the forward contract is the

future value of the current spot price.

Position Cost Now Payoff at Maturity

(1) Long Underlying S0 ST

(2) Long Forward 0 (ST F )

(3) Short Forward 0 (F ST )

(4) Long Discount Bond

F

F (1+r)

Table 1: Forward Price

Let F be the forward price and S0 be the current spot price and let r0T be the risk-free

rate of interest from now until the maturity date T , then

F = (1 + r0T )S0:

To simplify the notation denote r0T simply by r. Then F = (1 + r)S0. To see that this

formula is correct, let's consider the payoff and cost of the positions that can be takenon the stock, the forward contract and a risk-free discount bond with a face value of F

and a maturity date of T . If we take a long position in the stock, the cost now is S 0 and

the payoff at the maturity date is ST . We don't know what ST will be since the payoff to

the asset is uncertain. If we take a long position in the forward contract, the cost now

is zero and the payoff at maturity is ST F . That is we are obligated to buy at F and the

underlying asset can be sold for ST . If ST > F , then we buy at F and can immediately sell

at ST for a pro t of ST F . If on the other hand ST < F then we must buy at F but can only

sell at ST so we have a loss since ST F < 0. In addition suppose we buy the discount

bond. It costs F=(1 + r) now and pays out the face value F at maturity. We cansummarise all this information in Table 1.

Now consider the following trading strategy: go long in the forward con-tract and buy

the discount bond. The payoff to the forward contract is (ST F ), you are committed to

buy at F but can sell for ST , and the payoff to the bond is simply F , so the total payoff

is ST . Thus this trading strategy replicates the payoff to the underlying asset. We then

invoke the arbitrage principle that since this trading strategy has the same payoff at

maturity as the underling asset, it must cost exactly the same as buying the underlying

asset itself. The strategy costs F=(1 + r) as the forward contract involves no



125

Position Cost Now Payo at Maturity

(1) + (3) = (4) S0 F

(2) + (4) = (1)

FST

(1+r)

Table 2: Forward

initial outlay, therefore it must be the case that F=(1 + r) = S0 or

F = (1 + r)S0:

That is, the forward price is simply the future value of the stock. The long position in

the stock (1) is equivalent to a portfolio of a long position in the forward and a long

position in the discount bond (2) + (4).

As an alternative suppose you go long in the stock and short on the forward contract,

that is a portfolio of (1) and (3). The overall payoff at maturity is S T + (F ST ) = F . The

cost of this strategy is S0 but has the same payoff as a risk-free bond with face value of

F and is thus equivalent to position (4). Thus as before F=(1 + r) = S0. This is summarizedby Table 2.

As yet another possibility consider buying the underlying stock and going short on the

discount bond with face value of F (that is borrow an amount F=(1 + r)). At maturity

one has an asset worth ST but and obligation to repay F and thus a net worth of ST F.

This is exactly the same as the long forward contract. Since the payoff s are the same

we are said to have synthesized or replicated the forward contract. The cost of this

synthetic forward contract is the cost of the stock now S0 less what we borrowed, F= (1

+ r), so that the net cost is

FS0 (1 + r)

:

The payoff is the same as the forward contract. Yet the forward contract involves no

exchange of money upfront. So the cost of the synthetic forward must be zero too:FS0 (1 + r)

= 0

which again the delivers the same conclusion that F = (1 + r)S0.

Exercises:



126

Exercise 1: If F > (1+r)S0 identify a arbitrage opportunity. Put together a portfolio which

gives you money now and only o setting obligations at the maturity date.

Exercise 2: If F < (1+r)S0 identify a arbitrage opportunity. Put together a portfolio which

gives you money now and only o setting obligations at the maturity date.

Exercise 3: If the stock pays out a dividend D at the maturity date T , so the total payo

to holding the stock is ST + D, calculate the forward price if the interest rate is r

Forward Value

The forward contract is initially negotiated so that there is no initial outlay. That is the

delivery price on the forward contract is chosen so that the value of the contract is

zero. However, as maturity approaches the price of the underlying asset changes but

the delivery price does not. Thus as time progresses the forward contract may have a

positive or negative value. Let K be the delivery price and let St denote the price of the

underlying asset at time t with time T t left to maturity. The forward price is Ft = St(1 +

rtT ) where rt

T is the risk-free interest rate from t until T .

The same argument can be used above can now be used to find how the value of the

forward contract changes as the time moves to maturity. Let this value be v t. Consider

the portfolio of one long forward contract and the purchase of a discount bond with

face value of K and maturity date of T. The payoff to the forward contract is (ST K) but

the payoff to the bond is

K leaving a net payoff of ST . The cost of this portfolio is vt +

K

. Since T(1+rt )

it replicates exactly the underlying (which has a price of S t) we have

v = S

K

=(F

tK)

t(1 + rt

T ) t (1 + rt

T )



127

where the last part follows since St = Ft=(1 + rtT ). To check that this makes

sense rst consider what happens at t = 0. At t = 0 the delivery price is chosen so

vt = 0, that is K = S0(1 + r0T

) = F0 and the forward price is equal to the deliveryprice. Next consider t = T . Then r t

T = 0 and we get vT = ST K which is just the

payo to the forward contract at maturity.

To presage what we will do subsequent, the value of the forward contract can

also be calculated by using the stochastic discount factor k.1 A forward

contract with a delivery price of K has a payo at maturity of ST K. Thus the value

of this payo is

Kv

t

= E[k

(S

T

K)] = E[k S

T

]

KE[k] =

S

t (1 + rtT )

where the last part of the equation follows since E[k] measure the appropri-

ately discounted payo of one unit of payo for sure and thus is equal to the

discount factor 1=(1 + rtT ).

Futures Contracts

So far we have used the terms forward and futures interchangeably and theyare equivalent if there is no interest rate uncertainty. There are however, some

differences between forward and futures contracts.

Forward contracts are normally traded over the counter and futures con-tracts

are generally exchange traded with futures prices reported in the - nancial

press. With a futures contract therefore the exchange provides a standardised

contract with a range of speci ed delivery periods. Thus a wheat futures

contract will be specify the delivery of so many bushels of wheat for delivery in

a particular month. The quality and delivery place will also be speci ed. The

exact day of delivery within the month is usually left to the discretion of the

writer of the contract.

1We will study risk-neutral probabilities and the stochastic discount factor later

in the

course.



128

The key difference between forward and futures contracts is that forwards are

settled at maturity, whereas futures contracts are settled daily. This daily

settlement is done by requiring the investor to hold a margin account with the

exchange. Thus although the contract costs nothing initially, the investor is

required to deposit a certain amount of funds, the initial margin with the

exchange. This margin account is marked to market to re ect the daily gains or

losses on the contract. Thus for example if you buy a futures contract on

Wednesday for 250 and the following day the futures price has fallen to 240,

you will have su ered a loss of 10 and this amount will be deducted from your

margin account. In e ect the futures contract is closed out and rewritten everyday. The exchange will also specify a maintenance margin which is the amount

which must be maintained in the margin account, usually about 75% of the

initial margin. If the margin account does fall below the maintenance margin

the investor will be required to deposit extra funds, the variation margin, with

the exchange. Most futures contracts are closed out prior to maturity and don't

actually result in delivery of the underlying. Thus an investor will settle the

futures contract and withdraw the amount in the margin account on that day.

Traders on futures (and other types of exchange markets) can place condi-

tional trade as well as trade orders. There are three main types of order that

can be executed. (i) A \Market" order will trade immediately at the current

market price once the order is made there is no turning back! (ii) \Limit" orders

are used to set a price at which the trader is prepared to trade. For example if

the prices are currently high, the trader can input a price a bit lower than the

current o er, and place a conditional order to buy. The order will now move

into a working orders account and will be executed if the o er price falls to the

limit level speci ed. (iii) \Stop" orders enable the trader to limit losses in his/her

portfolio. This involves setting a conditional price at which to sell the asset if

the market moves too much in the wrong direction. The trader speci es a price

and volume at which to sell. The order will again be placed in the working

orders account and will be executed if the price falls to the level speci ed.



129

Day Position Futures Price Gain/loss Future Value

10

Long(1+r)T 1 G0 - -

1 G1 G0

G0 1 Long(1+r)T 2 G1

(1+r)1 G1

1 G1 G0

G1 2 Long

(1+r)T 3 G2 (1+r)

2 G2

T 2 1 3 GT 3Long

(1+r)GT 2 (1+r)

2

GT 2

T 1 Long 1GT 1

2GT 1

GT 2(1+r)

T 0 GT GT

GT 1 G

TGT 1

Table 3: Equivalence of Futures and Forward Prices

Although futures are settled daily we now show that the forward price and the

futures price are the same if interest rates are known even if the forward

contract cannot be traded. For simplicity suppose that the interest rate is

constant and let r denote the daily interest rate and suppose that the futures

contract matures on date T and let G0; G1; G2; : : : ; GT 1; GT denote the futures

price on each of the trading days. Suppose that we have a position

1 1of

(1+r)T t 1 on day t. Thus initially our position is (1+r)T 1 and we increment our position on a daily basis. The change in the value of our position on day

1 isG1 G0 :

(1 + r)T

1

To calculate the future value of this gain or loss compounded to date T we

multiply by (1+ r)T 1 as there are T 1 days to go. Thus the future value is

simply G1 G0. The positions and future value on each day is summarised in Table3.

Overall the future value from this portfolio is GT G0. Since the futures price at

maturity must equal the spot price, GT = ST , the future value is ST G0. If we

combine this portfolio with a the purchase of a risk-free asset at time zero with

a face value of G0 the portfolio has a payo of ST . Since the futures contracts

cost nothing to purchase the overall cost of the portfolio



131

2The o er price is also known as the ask price, particularly in

the U.S.



132

Backwardation and Contango

We have shown that the forward price is just the future value of the un-

derlying, F = (1 + r0T )S0. Perhaps surprisingly the expected value of the

underlying asset at time T , E[ST ] does not a ect the forward price at all. Yet it is

also clear that the forward price tends to the current spot price as the contracts

tends to maturity. To see this suppose that we are very close to the delivery

period. If the forward price were below the current spot price, then it would be

possible buy the forward contract, wait for delivery and sell almost surely at

the higher spot price. This will tend to drive the forward price up toward the

spot price. Similarly if the forward price were above the spot price one couldsell the forward contract, buy at the lower spot price and make the delivery

generating an almost sure pro t. With everyone doing this the forward price will

fall toward the spot price.

A situation where the forward price is below the expected spot price, F < E[S T ],

is called backwardation. A reverse situation where the forward price is above

the expected spot price is called contango. An interesting question, and one

that exercised Hicks and Keynes in the 1930s, is whether forward prices

normally exhibit backwardation or contango and why.

To consider the relationship between the forward price and the expected

future spot price it is necessary to consider the risk involved in holding a

forward or futures position. Consider an investor or speculator who holds a

long position in a forward contract. This obligates the investor to pay out F the

forward price at maturity in return for an asset that will be worth the unknown

amount ST . For simplicity suppose the investor F=(1 + r) in a risk-free

investment now which will deliver F at time T to o set his/her obligations. The

cash- ow is thus a certain F=(1 + r) now and an uncertain amount ST at time T .

The question that remains is how to value the risky future payo ST . As in

corporate nance we could evaluate this payo using a CAPM so that the



133

value of the future cash ow is

E[ST ]

(1 + r )

where r = r + (rM r) is the required rate of return, is the beta of the underlying asset and rM is the expected rate of return on the marketportfolio. Then the value of the investors portfolio is

F E[ST ]

(1 + r)+ (1 + r )

:

As the asset is priced so that S0 = E[ST ]=(1 + r ), if this term where positive ornegative, there would be an arbitrage opportunity. For example if F=(1 + r) >

E[ST ]=(1 + r ) then there would be an arbitrage opportunity to borrow F=(1 + r),

buy the underling asset at the price S0 = E[ST ]=(1 + r ) and short the forward

contract. This would create a net in ow of cash today and o setting cash ows at

the maturity date as illustrated in Table 4. Thus we must have that the forward

price satis es

(1 + r)F = E[ST ]

(1 + r ) :

If the beta of the underlying asset were zero then r = r and the forward price

would be equal to the expected spot price. In these circumstances we would

say the the forward price is an unbiased predictor of the expected future spot

price. We do however, know that for most assets the beta of the asset is

positive and hence r > r. That is to say the asset has some systematic risk that

cannot be diversi ed away and hence an expected return higher than the risk-

free rate is required to compensate. In this typical case

F < E[ST ]

and we have backwardation.3 If the returns on the market were negatively

correlated with the underlying asset then we would have < 0 and hence F >

E[St] and hence contango.

The same argument can also be made by using the stochastic discount fac-tor

and hence does not rely on a speci c pricing model such as the CAPM.

3Since it is the typical case it is often referred to as normal

backwardation.



134

Position Cost Now Payoff at Maturity

Long Underlying S0 = E[ST ]=(1 + r ) ST

Short Forward 0 (F ST )

Short Discount Bond (1+Fr) F

Table 4: Arbitrage Possibility

Since the current stock value reflects the appropriately stochastically dis-

counted value of possible future values, S0 = E[k ST ]. Since F = S0(1 + r) we have

that F = (1 + r)E[k ST ]. Using the covariance rule

F = (1 + r)E[k ST ] = (1 + r)E[k]E[ST ] + (1 + r)Cov(k; ST ) = E[ST ] + (1 +

r)Cov(k; ST )

since E[k] = 1=(1 + r). It can be seen from the above equation that whether

there is backwardation or contango depends on the sign of cov(k; ST ). Typi-

cally, because individuals are risk averse, the demand will be for assets that o

er insurance and the price of returns in low payo states will be high. Thus for

most assets the covariance will be negative. Typically then F < E[S T ] and the

forward will exhibit backwardation.

Exercises:

Exercise 4: The current gold price is $500 per ounce. The forward price for

delivery in one year is $575 per ounce. The cost of storing an ounce of gold for

one year is $40 and this must be paid now in advance. The risk-free rate of

interest is 10% per annum. If you own ten ounces of gold, how can you exploit

an arbitrage opportunity to make $190?

Exercise 5: Consider a forward contract written on a non-dividend paying asset.

The current spot price is $65. The maturity of the contract is in 90 days and the

interest rate over this period is 1.1%. Determine the forward price. What is the

value of this contract? A corporate client wants a 90-day



135

forward contract with the delivery price set at $60. What is the value of this contract? (See Hull

p.108).

Exercise 6: Consider a one year futures contract on an underlying com-modity that pays no

income. It costs $5 per unit to store the commodity with payment being made at the end of the

period. The current price of the commodity is $200 and the annual interest rate is 6%. Find the

arbitrage-free price of the futures contract. (See Hull p.116).



136

CHAPTER 7 INTRODUCTION TO FUTURE

Future markets were designed to solve the problems that exist in forward markets. A future

contract is an agreement between two parties to buy or sell an asset at a certain time in the

future at a certain price. But unlike forward contracts, the future contracts are standardized

and exchange traded. To facilitate liquidity in the future contracts, the exchange specifies

certain standard features of the contract. It is a standardized contract with standard underlying

instrument, a standard quantity and quality of the underlying instrument that can be delivered,

(or which can be used for reference purpose in settlement) and a standard time of such

settlement. A future contract may be offset prior to maturity by entering into an equal and

opposite transaction. More than 99% of future transactions ate offset this way.

The standardized items in a future contract are:

· Quantity of the underlying.

· Quality of the underlying.

· The date and the month of delivery.

· The units of price quotation and minimum price change.

· Location of settlement.

FEATURES OF A FUTURE CONTRACT

· Future contracts are organized / standardized contracts, which are traded on the exchanges.

· These contracts, being standardized and traded on the exchanges are very liquid in nature.

· In futures market, clearing corporation/ house provides the settlement guarantee.

DISTINCTION BETWEEN FUTURE AND FORWARD CONTRACTS:



137

Future contracts are often confused with future contracts. The confusion is primarily because

both serve essentially the same economic functions of allocating risk in the presence of future

price uncertainty. However futures are a significant improvement over the forward contracts as

they eliminate counterparty risk and offer more liquidity.

FEATURES FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Not traded on

exchange

Traded on exchange

Contract

Specifications

Differs from trade to

trade.

Contracts are

standardized

contracts.

Counterparty Risk Exists Exists, but assumedby Clearing

Corporation/ house.

Liquidation Profile Poor Liquidity as

contracts are tailor

maid contracts.

Very high Liquidity as

contracts are

standardized

contracts.

Price Discovery Poor; as markets are

fragmented.

Better; as fragmented

markets are brought to

the common platform.

FUTURE TERMINOLOGY

· Spot Price: The price at which an asset trades in the spot market.

· Future Price: The price at which the future contracts trades in the market.

· Contract Cycle: The period over which a contract trades. The index futures contracts on the

NSE have one-month, two-months and three-months expiry cycle, which expire on the last

Thursday of the month. Thus a January expiration contract would expire on the last Thursday of

January and a February expiration contract would cease trading on the last Thursday of



138

February. On the Friday following the last Thursday, a new contract having a three-month

expiry would be introduced for trading.

· Expiry Date: It is the date specified in the future contract. This is the last day on which the

contract will be traded, at the end of which it will cease to exist.

· Contract Size: The amount of asset that has to be delivered under one contract. For instance,

the contract size on NSE’s futures market is 200 Nifties.

· Basis: Basis is usually defined as the spot price minus the future price. There will be a different

basis for each delivery month for each contract. In a normal market, basis will be negative. This

reflects that futures prices normally exceed spot prices.

· Cost of Carry: The relationship between futures prices and spot prices can be summarized in

terms of what is known as the cost of carry. This measures the storage cost plus the interest

that is paid to finance the asset less the income earned on the asset.

· Initial Margin: The amount that must be deposited in the margin account at the time a futures

contract is first entered into is known as initial margin.

· Marking-to-Market: In the future market, at the end of each trading day, the margin account

is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is

called marking-to-market.

· Maintenance Margin: This is somewhat lower than the initial margin. This is set to ensure that

the balance in the margin account never becomes negative. If the balance in the margin

account falls below the maintenance margin, investor receives a margin call and is expected to

top up the margin account to the initial level before trading commences on the next day.

DIFFERENCE BETWEEN FUTURES AND OPTIONS



139

At a practical level, the option buyer faces an interesting situation. He pays for the option in full

at the time it is purchased. After this, he only has an upside. There is no possibility of the

options position generating any further losses to him (other than the funds already paid for

option). This is different from futures, which is free to enter into, but can generate very large

losses. This characteristic makes options attractive to many occasional market participants, whocannot put in the time to closely monitor their future options. Buying put option means that

you are buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the

full extent to which Nifty drops below the strike price of the put option. This is attractive to

many people, and to mutual funds creating “guaranteed return products”. The Nifty index fund

industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to

create a new kind of a Nifty index fund, which gives the investor protection against extreme

drops in Nifty.

Selling put option is selling insurance, so anyone who feels like earning revenues by selling

insurance can set himself up to do so on the index option market. More generally, option offer

“nonlinear payoffs” whereas futures only have “linear payoffs”. By combining futures and

options, a wide variety of innovative and useful payoff structures can be created.

PAYOFF FOR DERIVATIVES CONTRACT

Payoff is likely profit/loss that would accrue to a market participant with change in the price of

the underlying asset. This is generally depicted in the form of payoff diagrams, which show the

price of the underlying asset on the X-axis and the profit/losses on the Y-axis.

Payoff for Futures:

Future contracts have linear payoffs. It means that the losses as well as profits for the buyer

and the seller of a future contract are unlimited. These linear payoffs are fascinating as they can

be combined with options and the underlying to generate various complex payoffs.

Payoff for buyer for futures: Long Futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who

holds an asset. He has a potentially unlimited upside as well as a potentially unlimited

downside. Take the case of a speculator who buys a two-month Nifty index futures contract

when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the

index moves down it starts making losses



140

PROFIT

0 1220

LOSS NIFTY

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contracts is similar to the payoff for a person who

shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited

downside. Take the case of a speculator who sells a two-month Nifty index futures contract

when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the

index moves down, the short future position starts making profits, and when the index moves

up, it starts making losses.

PROFIT

1220

0

NIFTY



141

LOSS

USING INDEX FUTURES

There is always risk involved when we trade in a stock market. The risk cannot be eradicated

fully but can be minimized up to some extent. Following are the types of risks that can be

minimized through futures:

· Basic objective of introduction of futures is to manage the price risk.

· Index futures are used to manage the systemic risk, vested in the investment in securities.Basically there are eight basic modes of trading on the index futures

market;

Hedging

H1 Long stock, short Nifty futures

H2 Short stock, long nifty futures

H3 Have portfolio, short Nifty futures

H4 Have funds, long Nifty futures

Hedge Terminology:

Long hedge- When you hedge by going long in futures market.

· Short hedge - When you hedge by going short in futures market.

· Cross hedge - When a futures contract is not available on an asset, you hedge your position in

cash market on this asset by going long or short on the futures for another asset whose prices

are closely associated with that of your underlying.

· Hedge Contract Month- Maturity month of the contract through which hedge is

accomplished.

· Hedge Ratio - Number of future contracts required to hedge the position.



142

Speculation

Speculation is all about taking position in the futures market without having the underlying.

Speculators operate in the market with motive to make money. They take:

- Position in any future contract.

- Opposite positions in two future contracts. This is a conservative

speculative strategy. Speculators bring liquidity to the system, provide insurance to the

hedgers and facilitate the price discovery in the market.

S1 Bullish index, long Nifty futures

S2 Bearish index, short Nifty futures



144

exposure. The basic point of this hedging strategy is that the stockpicker proceeds with

his core skill, i.e. picking stocks, at the cost of lower risk.

NOTE: hedging does not remove losses. The best that can be achieved by using hedging is the

removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profitthan the un-hedged position, half the time. One should not enter into a hedging strategy

hoping profit for sure; all that can come out of

hedging is reduced risk.

H2: Short stock, long Nifty futures

If a person feels that the stock is over evaluated or the profits and the quality of the company

made it worth a lot less as compared to what the market thinks, he can take a short position on

the cash market. This will give rise to two types of risks:

1. His understanding can be wrong, and the company is really worth more than the market

price.

2. The entire market moves against him and generates losses even though the underlying idea

was correct. The second outcome happens all time. A person may sell Reliance at Rs.190

thinking that Reliance would announce poor result and the stock price would fall. And if after

few days if the Nifty rises, he will incur loss, even if the intrinsic understanding of Reliance was

correct. There is a peculiar problem here. Every sell position on a stock is simultaneously a sell

position on Nifty. This is because a SHORT RELIANCE position generally gains if Nifty falls and

generally loses if Nifty rises. In this sense, a SHORT RELIANCE position is not a focused play on

the valuation of Reliance. It carries a SHORT NIFTY position along with it, as incidental baggage.

The stock picker may be thinking he wants to be SHORT RELIANCE, but a short position on

Reliance on the market effectively forces him to be SHORT RELIANCE + SHORT NIFTY.

Even if we think that WIPRO is overvalued, the position SHORT WIPRO is not purely about

WIPRO; it is also about the Nifty. Every trader who has a SHORT WIPRO position is forced to be

an index speculator, even though he may not have any interest in the index.

individual stocks.

well.



145

There is a simple way out. Every time we adopt a short position on a stock, we should buy some

amount of Nifty futures. This will help in offsetting the hidden Nifty exposure that is every

short-stock position. Once this is done, we will have a position, which will be purely about the

performance of the stock. The position SHORT WIPRO + LONG NIFTY is a pure play on the value

of WIPRO, without any risk from fluctuation of the market index. When this will be done thestockpicker has “hedged away” his index exposure. The basic point of this hedging strategy is

that the stockpicker proceeds with his core skill, i.e. picking stocks, at the cost of lower risk.

H3: Have Portfolio, short Nifty futures

Some of us might have experienced the feeling of owing an equity portfolio, and then one day,

we become uncomfortable about the overall stock market. Sometimes we have a view that the

stock prices will fall in the near future. At other times, we may see that the market is in for a

few days or weeks of massive volatility, and we do not have an appetite for this kind of

volatility. The best example of this volatility is the union budget. Market positions become

volatile for one week before and two weeks after the budget. Many investors want to eradicate

this three weeks volatility. This becomes a peculiar problem if we are thinking of selling the

shares in the near future, for example, in order to finance a purchase a house. This planning can

go wrong if by the time we sell shares, Nifty has dropped sharply.

There are two main alternatives, when one faces this type of problem:

1. Sell shares immediately. This sentiment generates “panic selling” which is rarely optimal for

the investor.

2. Do nothing, i.e. suffer the pain of volatility. This leads to political pressure for government to

“do something” when stock prices fall. Here in this case, with the index futures market, a third

and a remarkable alternative becomes available

3. Remove your exposure to index fluctuations temporarily using index futures. This will allow

rapid response to market conditions, without “panic selling” of shares. It will allow an investor

to be in control of his risk, instead of doing nothing and suffering the risk. The idea here is that

every portfolio contains a hidden index exposure. This statement is true for all portfolios,

whether a portfolio is composed of index stock or not. In the case of portfolios, most of the

portfolio risk is accounted for by index fluctuations. Hence a

position LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG

PORTFOLIO position. Is suppose we have a portfolio of Rs.1 billion, which is having a beta of

1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures.



146

H4: Have funds, buy Nifty futures

A person may be in a situation where he is having funds, which needed to be invested in equity,

or he may be expecting to get funds in future to be invested in equity. The following can be the

occurrences in the above conditions:

-end fund, which just finished its initial public offering, has cash, which is not yet

invested.

complete. It takes several weeks from the date that it becomes sure that the

funds will come to the date that the funds are actually are in hands.

-ended fund has just sold fresh units and has received funds. To get oneself invested

in equity sounds quite easy but it involves the following problems:

1. A person may need time to research stocks, and carefully pick stocks that are expected to do

well. This process of research takes time. For that time the investor is partly invested in cash

and partly invested in stocks. During this time, he is exposed to the risk of missing out if the

overall market index goes up.

2. A person may have made up his mind on what portfolio he seeks to buy, but going to the

market and placing the market order would generate large ‘impact cost’. The execution would

be improved substantially if he could instead place a limit orders and gradually accumulate the

portfolio at favorable prices. This takes time, and during this time, he is exposed to the risk of

missing out if the Nifty goes up.

3. In some cases, such as land sale above, the person may not simply have cash to immediately

buy the shares, hence he is forces to wait even if he feels that Nifty is unusually cheap. He is

exposed to the risk of missing out if Nifty rises.

The three alternatives that are available with an investor are as follows:

A person who expects to obtain Rs.5 million by selling land would immediately enter into a

position LONG NIFTY worth Rs.5 million. Similarly a close-end fund, which has just finished its

initial public offering and has cash, which is not yet



147

invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested into

equity. The index futures market is likely to be more liquid than individual

stocks so it is possible to take extremely large position at a low impact cost.

-end fund can gradually acquire stocks. As and when shares areobtained, one would scale down the LONG NIFTY position correspondingly. No matter how

slowly the stocks are purchased, this strategy would fully capture a rise in Nifty, so there is no

risk of missing out on a broad rise in the stock market while this process is taking place. Hence,

this strategy allows the investor to take more care and spend more time in choosing stocks and

placing aggressive limit orders.

VALUATION OF A FORWARD CONTRACT

Valuation of an ASSET that provides no income

The valuation of an asset that provides no income such as non-dividend paying stocks, zero-

coupon bonds or gold is obvious:

F0 = the forward price

S0 = the current price of the asset

r = continuous compounding risk free rate

T = time to maturity

At time T the customer will pay F0 (fixed at time t=0) to get the asset.

Based upon the discussion on the forward market efficiency (where S0 = 10$, T = 1 year and the

fair F0 = 10.45$), we would have:

If , arbitrageurs would buy the asset and short forward contracts on that

asset.

If , arbitrageurs would sell the asset and enter a long forward contracts on

that asset.

http://www.pascalroussel.net/equity_and_currency_forwards.htm#forward_market_efficiency






148

Valuation of an ASSET that provides a fixed income

The fixed income could be a coupon that the bond owner will receive before the maturity. Let’s

note “ I “ the present value of that income. In a way, due to that income the investor will pay

less than S0 to purchase the asset. The amount “ I “ has to be subtracted from the current price

of the asset so that we have

F0 = the forward price

S0 = the current price of the asset

r = continuous compounding risk free rate

T = time to maturity

I = present value of the known income

For example if the asset is a bond:

current value S0 = 1000$,

coupon = 20$ paid in 5 months,

T = 9 months,

risk free continuous rate from today to 5 months is 3%

risk free continuous rate from today to 9 months is 4%

with

Valuation of an ASSET that provides a known yield

Suppose an asset that is expected to provide a yield of 6%p.a.. For instance, this could meanthat

Yield

income is paid once a year and is equal to

6% of the asset price at the time it is paid6% annual compounding



150

As time passes, there can be changes in the value of the asset and also in the value of the risk

free rate.

Let’s consider a time t, such that t < T .

Since it is a given fact that the investor (the short) will receive K at time T, if we discount backthat amount K to the time t we have

with

r = continuous compounding risk free rate applicable from that time t to maturity

We can compare both the asset value at time t ( = S t ) and the amount K at the same time t. This

is the value f at time t of the short forward contract:

since we agreed to say that the value of an instrument is related to a long position we have:

equation 1

If the investor would sell a new forward contract for the same asset to be delivered at time T

the price Ft would be:

equation 2

from equation 2 above we have

in equation 1 this gives the value f, at time t, of a long forward contract based upon the price

Ft of an equivalent forward contract concluded at that same time t:

equation 3

Note: the value of a short forward contract is “-f”



152

or

St = the value of the Asset at time t

K = the delivery price agreed at the origin of the contract (t=0)

T = maturity time when the asset will be delivered

t = time elapsed since the contract was signed

q = the average yield p.a. with continuous compounding, on the asset during the remaining life

of a forward contract

r = continuous compounding risk free rate applicable from that time t to maturity

Ft = price of an equivalent forward contract for the same asset concluded at time t

Note: the value of a short forward contract is “-f”

Valuation of a FORWARD CONTRACT of currency

We will show in section "valuation of futures contracts on currencies" that a currency is an

asset that provides a known yield. Therefore we just need to replace q with rB and r with rA in

the formula just above.

We have the value f at time t of the long forward contract (concluded some times ago) of an

asset that provides a known yield:

rA = the continuous risk free rate of currency A

rB = the continuous risk free rate of currency B

SA/1B = the spot exchange rate at time t such that “SA/1B “ amount of currency A = 1 currency B

K = the delivery exchange rate agreed at the origin of the contract (t=0)

http://www.pascalroussel.net/futures_prices.htm#futures_forward_contracts_on_currencies





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After reading you will be able to understand the following:

Introduction to options

Option terminology

Options pay offs Factors influencing option prices

Elementary Investment Strategies

Options Clearing Corporation

Other Options

Trading Strategies of Options

Put-Call Parity

Binomial Option Pricing Model

Black-Scholes Option Pricing Model

Introduction to swaps

Interest Rate Swaps and

Currency Swaps



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Foreign Currency

DenominatedBalance Sheet

Profit & Loss

Swaps

Options

Vanilla

Exotic

Derivative

CHAPTER 8 INTRODUCTION TO OPTIONS

Definition:

Derivatives are deferred settlement contracts which derive their value from the underlying.

Derivatives in Indian Context are divided into two parts which are further sub divided as shown in the

figure below:

Figure 1.5

The Swaps which affects the balance sheets of the companies include the

Term Exposures i.e. loans taken in foreign currency or in Indian rupee denomination. Whereas the

derivatives which affect the P/L A/c are the options which help in mitigating the risk involved in the Sales

and Purchases.

Options:

Simply stated, an option is a choice. The buyer of an option acquires the right and not the obligation, to

buy or sell an underlying asset under specific conditions in exchange for the payment of a premium. It is

entirely up to the buyer whether or not to exercise that right; only the seller of the option is obligated to

perform.

Thus, a currency Option is characterised by underlying currency on which the option is based.

Options Terminologies:



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Following are some of the concepts and terminologies which are essential in understanding the

fundamentals of Options:

Call Option: A call option conveys on the option buyer the right to buy the underlying asset at a

predetermined price. If the buyer of the call exercises his right, i.e., he decides to buy the underlying

asset, then the seller of the call has to oblige, i.e., he has to sell the underlying asset.

Put Option: A put option gives the buyer the right to sell the underlying asset at a predetermined price.

If the buyer of the put option exercises his right, i.e., he decides to sell the underlying asset, then the

seller of the put, he has to buy the underlying asset.

Figure 1.6

Diagrammatically,

Call Option

Buy Sell

Right to

Buy

Obligation

to Sell

Put Option

Buy Sell

Right to

Sell

Obligation

to buy



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Spot Rate: Simply put, it is the current market rate of the currency. For instance, if the spot rate of

USD/INR is 40.80, it means that corporate would have to pay 40.80 for every US Dollar purchased.

Strike rate: This is the rate at which an Option contract has been entered into.

Expiration Date: This is the date at which the option expires.

In The Money, At The Money, Out Of Money: These concepts are very important as far as Options Go. It

is essential to understand that what holds true for the Call option, exactly the reverse holds true for the

Put option. The following table gives a clear idea as regards these concepts.

Table 1.1

Call Option Put Option

In The Money (ITM)

When the price of the

underlying is greater than the

strike price

When the price of the

underlying is lower than the

strike price.

At the Money (ATM)When the strike rate is equal to

the price of the underlying

When the strike rate is equal to

the price of the underlying

Out Of Money (OTM)When the price of theunderlying is lower than the

strike rate

When the price of theunderlying is higher than the

strike rate



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All the above mentioned concepts are very important as they play a major role in understanding the

concepts of “Option Pricing” which takes into account various factors i.e. Strike Price, Volatility, Time,

Price of Underlying, Interest Rate Differential and Option Premium which affects the option pricing.

Types of Options:

Options can be bifurcated on the following basis:

On the basis of their exercisability – American or European:

An American option gives the buyer the right to exercise his option at any point of time during the

option period. The European option is inflexible in this regard as the buyer can exercise his right only

on the maturity date. As the American option offers more flexibility, it commands a higher premium

in comparison to its European counterpart.

On the basis of the parameters on which the option is structured – Plain Vanilla or Exotic:

Factors like the Strike rate, Spot date, Date of expiry, Volatility influence the Option premium. An

Option which considers only these factors is called as “Plain Vanilla Option”. An option which

incorporates any other parameter than those mentioned above is called as “Exotic Option”. An

Exotic Option may include some barriers. The advantage of such options is that it helps to reduce

the amount payable as option premium to a great extent.

However, it is to be noted that Exotic Options are not permitted in USD/INR trade by the Central

Bank in India. Only European Options are permitted in case of INR structures.

Options v/s Forwards:

To understand the advantages of Options in a better manner, an attempt has been made to distinguish

between the two:

Table 1.2

Options Forwards



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recognised only by the Indian Banks! The same structures may be known by a totally different name

elsewhere in the world!

The following are the renowned option structures which are quite frequently used:

In case of Plain Vanilla Options:

1) Sea Gull Structure

2) Range Forward Structure

3) Zero Cost Structure

In case of Exotic Options:

Barrier Options could be Single Barrier options or Double Barrier Options.

It may also be noted that both the barrier options can further be classified into “Knock-In” Option and

“Knock-Out” Option.

Sea Gull Structure:

Term Sheet:

Buy USD Put INR Call 1 Mio @ 43.65

Sell USD Call INR Put 1 Mio @ 44.00

Sell USD Put INR Call 1 Mio @ 43.25

Table 1.3

Sea Gull



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From the above spreadsheet, it can be seen that for depreciation of every paisa above the 44.00 levels,

we incur an additional loss to the extent of 1 paisa.

Likewise, at all levels between the 43.25 and 43.65 level, we incur an additional gain to the extent of 1

paisa.

Similarly, at all levels between the 43.65 and 44.00 level, we incur a loss to the extent of:

Buy USD put INR Call

USD 5 Mio @ 43.65

Duration 6

months

Sell USD call INR put

USD 5 Mio @ 44.0000

Sell USD put INR call

USD 5 Mio @ 43.2500

Spot on Maturity

Spot Rate Payoff Spot

Rate

Payoff Spot

Rate

Payoff Spot

rate

payoff

44.01 -0.01 43.64 0.01 43.66 -0.34 43.24 0.4

44.02 -0.02 43.63 0.02 43.67 -0.33 43.23 0.4

44.03 -0.03 43.62 0.03 43.68 -0.32 43.22 0.4

44.04 -0.04 43.61 0.04 43.69 -0.31 43.21 0.4

44.05 -0.05 43.6 0.05 43.7 -0.3 43.2 0.4

44.06 -0.06 43.59 0.06 43.71 -0.29 43.19 0.4



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(Higher strike – Middle Strike) - (Spot Rate – Middle Rate)

In this illustration, it is (44.00 – 43.65) – (43.66 – 43.65) = 0.34 and so on.

At all levels below the 43.25 levels, the gain is to the extent of 40 Paisa.

Thus, in the context of the above example, it can be said that the Best Rate that we would be able to sell

our Dollars is 44.00. At the same time, we can also infer that the Worst Rate would be Spot Rate + 40

Paisa.

OPTION PRICING TECHNIQUES:

The Black and Scholes Model:

The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out

working to create a valuation model for stock warrants. This work involved calculating a derivative to

measure how the discount rate of a warrant varies with time and stock price. The result of this

calculation held a striking resemblance to a well-known heat transfer equation. Soon after this

discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing

model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved

version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of

Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the

risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding

investor's risk preferences.



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In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the

expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the

change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second

part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration

day. The fair market value of the call option is then calculated by taking the difference between these

two parts.

Assumptions of the Black and Scholes Model:

1) The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might seem a serious limitation to the

model considering the observation that higher dividend yields elicit lower call premiums. A common

way of adjusting the model for this situation is to subtract the discounted value of a future dividend

from the stock price.

2) European exercise terms are used



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European exercise terms dictate that the option can only be exercised on the expiration date. American

exercise term allow the option to be exercised at any time during the life of the option, making american

options more valuable due to their greater flexibility. This limitation is not a major concern because very

few calls are ever exercised before the last few days of their life. This is true because when you exercise

a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the

end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.

3) Markets are efficient

This assumption suggests that people cannot consistently predict the direction of the market or an

individual stock. The market operates continuously with share prices following a continuous Itô process.

To understand what a continuous Itô process is, you must first know that a Markov process is "one

where the observation in time period t depends only on the preceding observation." An Itô process is

simply a Markov process in continuous time. If you were to draw a continuous process you would do so

without picking the pen up from the piece of paper.

4) No commissions are charged

Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay

some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial

and can often distort the output of the model.

5) Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality

there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with

30 days left until maturity is usually used to represent it. During periods of rapidly changing interest

rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the

model.

6) Returns are lognormally distributed

This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable

for most assets that offer options.



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The Black and Scholes Model:

Delta:

Delta is a measure of the sensitivity the calculated option value has to small changes in the share price.

Gamma:

Gamma is a measure of the calculated delta's sensitivity to small changes in share price.

Theta:

Theta measures the calcualted option value's sensitivity to small changes in time till maturity.

Vega:

Vega measures the calculated option value's sensitivity to small changes in volatility.

Rho:



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Graphs of the Black and Scholes Model:

This following graphs show the relationship between a call's premium and the underlying stock's price.

The first graph identifies the Intrinsic Value, Speculative Value, Maximum Value, and the Actual

premium for a call.

The following 5 graphs show the impact of deminishing time remaining on a call with:

S = $48

E = $50

r = 6%

sigma = 40%

Graph # 1, t = 3 months

Graph # 2, t = 2 months

Graph # 3, t = 1 month

Graph # 4, t = .5 months

Graph # 5, t = .25 months



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Graph #1

Graph #2



168

Graph #3

Graph #4



169

Graph #5

Graphs # 6 - 9, show the effects of a changing Sigma on the relationship between Call

premium and Security Price

S = $48

E = $50

r = 6%

sigma = 40%

Graph # 6, sigma = 80%




Graph #6



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Graph #7

Graph #8



171

Graph #9

CHAPTER 9 INTRODUCTION TO SWAPS

INTRODUCTION

Swaps have been growing at a mind boggling rate. The market is designing creative and

complex structures to provide tailor-made solutions. The regulators are unable to design

systems to effectively assess risks involved in these transactions. Today the term “swapfinancing” is used to describe a funding and a currency exposure management technique. It

enables corporations, agencies and institutions to cope with the problems of fluctuating rates,

imperfect capital markets, restrictive exchange control regulations and accounting standards.

Swaps are derivatives, which involve a private agreement between two parties to exchange

cash flows in the future according to a prearranged formula. The underlying instruments are

liabilities or assets with interest expenses or incomes. Swap is essentially a derivative used for

hedging and risk management.

Historically, swaps had been arranged opportunistically when two companies had requirements, which

are exactly equal and opposite. The first recorded swaps were negotiated in 1982. Since then, the

markets have grown very rapidly. The expansion in the swap market has occurred in response to the



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challenging phenomena, which have characterized financial markets today – arbitrage opportunities, tax

regulations, capital controls, etc., as a result of market imperfection, need for protection against interest

rate and exchange rate risk, improvements in computer technology and increasing integration of world

capital markets. Thus, swaps are powerful tool propelling global capital market integration.

The diverse requirements of corporate treasurers, bank liability managers, finance minister and portfolio

manage account for the rapid growth of the swap market. A currency swap involves exchange of

principal and interest payments in two different currencies between two different parties. Swaps are

privately negotiated customized transactions; swaps are off balance sheet transactions and have grown

at a phenomenal rate. In a currency swap, one party agrees to exchange principal and make regular

interest payments in one currency to a counter party for principal and periodic interest payments in

another currency. Swaps are useful in hedging exchange rate and interest rate risks by taking

advantages of arbitrage opportunities that arise due to the prevailing imperfections in the capital

market.

The interest rate swap market, in which borrowers contract to exchange interest rate payments, has

grown substantially in recent years. These instruments are used by financial managers to reduce

borrowing costs, increase asset returns, or hedge interest rate risk. Major market participants include

commercial and investment banks, which both use and deal in swaps, securities firms, savings and loan

institutions, corporations and government agencies.

BACKGROUND

Many literatures has demonstrated that gaps which are computed as functions of the duration

of assets and liabilities are more meaningful and useful measures of interest rate risk exposure

for depository institutions than are the simpler and more commonly used maturity gaps.

Bierwag and Kaufman (1992) derived duration gaps for depository institutions for economic net

worth of economic net income, and book value interest income. They extended duration gaps

to off balance sheet accounts including futures contracts and swap agreements and show the

sensitivity of the market value of net worth and income measures to interest rate fluctuations.

Bierwag, Kaufman, and Toeys (1983) reviewed the historical development of duration and ituses in summarizing in one variable the cash flow characteristics of bonds, approximating the

price sensitivity of bonds, and developing bonds portfolio strategies, particularly those that

attempt to immunize against interest rate risk. In all these uses, duration has shown to be

superior to term to maturity. By the Macaulay measures, duration performs reasonably well in

comparison to its more sophisticate counterparts and, because of its simplicity appears to be

cost-effective. For portfolio managers who wish to immunize portfolios of bonds against



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interest rate risk, or who wish use duration in formulating active strategies single factor models

should outperform naïve maturity models while matching the performance of more complex

multifactor models.

Yawitz, Kaufold, Macirowki, and Smirlock (1987) examined the pricing and duration of floating rate

bonds that have experienced changes in credit risk. They showed that the price of a floater whose credit

risk has changed can be viewed as equal to the face value of the bond minus an annuity the investor is

short if credit risk has increased and vice-versa.

In the general, larger companies are more active in the swaps market than smaller ones, and

treasures are more likely to transact swaps than accountants. Most companies tend to transact

swaps fairly regularly as business circumstances change, such as cash flow profiles, the funding

structure and business strategies. Once a company has transacted one swap, the many uses of

the market normally result in a company transacting many more, with about 60 per cent of

companies having transacted more than ten swaps.

Interest-rate swaps are used more than currency swaps, partly because the foreign exchange

market can sometimes be used instead of the currency swaps market. Non-users of the market

are often newly established enterprises where it is more important to get markets and products

right rather than treasury policy. Most non-users, however, agree with users that there are

positive benefits to be gained from using the market.

Table 1

Size comparison Small Large

No. of swaps 2-10 Over 10

Type of swap Interest rate swap (IRS) IRS and currency swap

No. with master

agreements

57% 91%

Never revalue 57% 15%

Sector Capital goods/properly ConsumerProblems Complicated/legal Tax/counterparty risk



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Most companies have ISDAs (master agreements with standard terms and conditions) agreed

with banks, from just one bank to as many as 30 to 40 banks. This makes it very easy to transact

a swap, as just a phone call is required to arrange the swap. Normally three quotes are

obtained from banks by companies before entering into a swaps contract, to ensure that prices

are reasonable and the deal is transacted with the cheapest bank. Counterparty credit is of

some concern and for a swap of less than about ten years; a bank with an AA or better credit

ratings is normally required.

There is an enormous difference in the sophistication of different users in the market. Very

active participants speak to each bank at least once a month and very often will speak to five or

six banks a day. These participants are maintaining relationship and are also obtaining

information on how aggressive each bank is to receive or pay a fixed rate of interest or

currency. Thus, when the company needs to do a swap it has already engaged in an extensive

pre-marketing campaign and will contact those banks which it already knows will be in a

position to offer a competitive price. These users often find the prices quoted by banks are very

close, with perhaps just one or even no basis points difference between them. Less frequent

users of the market, however, find that prices can vary quite widely between banks. This may

be because these companies are not aware of how each bank’s swaps book is placed to know

which banks to phone for favorable prices, and maybe also the banks try to earn an extra basis

point or two from infrequent and less sophisticated users. In general, though, whether a

company is a small or a large user, it pays to shop around to obtain several prices before

determining which bank to deal with. After phoning for a quote, companies normally expect to

be called back within about 10 to 25 minutes with a price. For very complex structures deals a

price may be expected early the next day. It is normally good practice to complete a swap

before 4 pm as the swaps market is not so efficient after the futures market closes.

Although the majority of participants transact only plain vanilla deals, A plain vanilla deal is a

simple, straightforward deal with no complexities as one stated ‘we believe in the KISS (keep it

simple, stupid) approach’, 28 per cent have done exotic swaps, such as amortizing and zero



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coupon swaps, which were by far the most commonly cited exotic swaps used by respondents.

The general view is that it is better to use plain vanilla instruments and to build up the required

hedge using a number of vanillas. Beware of banks salesmen trying to sell new financial

products! However, using plain vanillas can be less convenient and so exotics are very useful in

certain circumstances. Banks price exotics by building up all the vanilla elements themselves

and a company should understand the breakdown of the exotic and all the possible outcomes

of the transaction under a number of different scenarios. This may be of interest rates

doubling, trebling, halving or not changing or of there being a dramatic movement in exchange

rates. Sterling suffered in the ERM crisis of September 1992 and rates went from £/DM

2.95down to about £/DM 2.2 today. Some companies have stories to tell of ding swaps and

fixing their interest payments when rates were at 15 per cent and expected to rise. The

transactions at the time were done for very sensible commercial reasons, but there has to be

awareness that rates may change dramatically from the levels expected! As one financial

manager stated, ‘Swaps and other derivatives are very risky if accompanied by inadequate back

office controls and systems, poor understanding by senior management of risk management

policy and a failure to articulate a clear policy and strategy to guide the actions of the treasury

department’.

Generally, companies do not have any problems about using the swaps market. They do not

consider there to be any legal, accounting, regulatory or tax problems and they do not think

that they are costly, complicated or difficult to arrange. Counterparty risk is not a problem,

provided that swaps are transacted with reputable financial institutions.

Interest rate swaps are thought to be very efficient and the pricing is realistic. There are lots of

quotes available in a very competitive market, and there is certainty of the outcome of swap

transactions. The minimum size of a swaps transaction has declined in size from £5m just a few

years ago to no minimum size at all now. This reduction in the minimum size of swaps has

therefore attracted some smaller companies into the market. Interest-rate risk management



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and are the preferred product to use by many companies. Interest rate swaps are also off

balance sheet.

Other derivative instruments are used by corporations, especially options, FRAs and foreign

exchange forwards. Futures are not used as regularly. There were very mixed views about

options, some companies thought that they were very cheap and others that they were too

expensive.

Bierwag, Kaufman, and Toeys (1983) reviewed Factor analysis, using a principal components

approach, revealed that there are essentially five reasons for doing swaps. First, there are the

‘sophisticated’ uses such as exposure management and synthetics. Second are sues involved in

a ‘new issue’ of finance, such as the ability to do a swap immediately and to obtain a cheaper

funding cost. The third factor was related to ‘restructuring’ the existing debt profile of the

company, such as switching from fixed to floating rate finance, unlocking high coupon debt and

that a swap is cheaper than refinancing. The fourth reason related to exploiting market

imperfections or ‘arbitrage’ strategies. Finally, there was ‘risk separation’, enabling the

separation of risks such as interest rate risk from their own risk premium and unbundling the

funding decision from the payment decision. As one commented, Probably (one of) the most

important inventions to come out of the financial community in the last 15 year is the ability to

separate interest rate risk from debt maturity. It’s a godsend to treasurers’. Table 2 summarizes

the use of swaps. Using swaps to match asset and liability cash flows and managing the balance

sheet better is by far the most important. Most financial managers use the market for interest

rate risk management and matching asset and liability cash flows.

Ten companies were selected in ten different industrial sectors and different geographical

areas. They included two non-users, seven users and one who stated that it would not use

swaps again. There were three subsidiaries and seven head offices, highly geared companies

and lowly geared companies and six users of exotic swaps. Table 3 summarizes the findings

from these visits.



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Table 2 Uses of swaps

Managing the balance sheet and matching asset and liability cash flows

Obtaining finer terms in raising new finance

Restructuring the balance sheet around existing asset and liability structures

Exploiting arbitrage opportunities

Separating risks to enable more effective risk management of the individual risk

components

The swaps market has seen enormous growth since its inception in 1981 because financial

managers have found many uses of the market and do not think there are any major problems.

As one treasurer explained, ‘As in individual who was a treasurer before swaps existed, the

contrast in the “before” and “after” is quite extraordinary. How did we do our job without their

existence?’

The BCG growth-share matrix displays the various business units on a graph of the market growth rate

vs. market share relative to competitors:



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BCG Growth-Share Matrix

Resources are allocated to business units according to where they are situated on the grid as

follows:

Cash Cow - a business unit that has a large market share in a mature, slow growing

industry. Cash cows require little investment and generate cash that can be used to

invest in other business units.

Relative Market Share

M a r k e t G r o

w t h R a t e

High

Low

International Swap MarketIndian Swap Market

High

Low



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Star - a business unit that has a large market share in a fast growing industry. Stars may

generate cash, but because the market is growing rapidly they require investment to

maintain their lead. If successful, a star will become a cash cow when its industry

matures.

Question Mark (or Problem Child) - a business unit that has a small market share in a

high growth market. These business units require resources to grow market share, but

whether they will succeed and become stars is unknown.

Dog - a business unit that has a small market share in a mature industry. A dog may not

require substantial cash, but it ties up capital that could better be deployed elsewhere.

Unless a dog has some other strategic purpose, it should be liquidated if there is little

prospect for it to gain market share.

According to this growth matrix International Swap market can be placed at Stars Position as it

large market share in a fast growing industry. As market is growing rapidly they require

investment to maintain their lead. If successful,

Similarly Indian Swap Market can be placed at Question mark position as it has a small market

share in a high growth market. it require resources to grow market share, but whether they will

succeed and become stars is unknown.

In India there are certain factors which are forcing the market upwards and certain obstacles

which prevent the market to grow. The situation of India can be explained through Deriving

and restraining forces with the help of Kurtin Lewin Model which is explained to show the

driving forces and restraining forces. These are the pairs of opposites in which driving forces

push the growth of one’s market forward and on the other hand restraining forces push the

growth backward.

In the context of swap market in India following can be summarized in Kurtin lewin model:



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Driving forces Restraining Forces

1. Creates link between distinct 1. Non availability of

Markets or firms with differential acceptable bench mark.

access to fund sources.

2. Provide a way to reduce total funding 2. Lack of developed

cost of debt. term Money Market

3. Flexible and convenient way for companies 3. Lack of active market

to manage balance sheet. for floating loans

4. Minimize the cost of regulation and tax 4. Non availability of

variety of acceptable

yield curves



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Bank Cor orate

Pays Fixed Rate

Types of Swap:

Interest Rate Swap (IRS)

Coupon Only Swap (COS)

Principal Only Swap (POS)

Currency Coupon Interest Rate Swap (CCIRS)

Swap Mechanism:

Swap involves exchange of a floating to fixed interest rate or fixed to floating interest rate.

Figure 1.8

“Plain

Vanilla”

Interest

Rate Swap:

The corporate has taken a loan of $ 1 mio at 6 month LIBOR rate for 3 years. So in order to minimise the

cost, the corporate enters into a Swap. The client enters into an agreement to receive 6 month LIBOR

and pay a fixed rate of 3.50% per annum for 3 years on a notional principal of $ 1 mio.



182

Table 1.6

Cash Flow in an IRS:

Date

Corporate

Receives

Corporate Pays Net Flow

15-Oct-06 5.22% 3.50% 1.72%

15-Apr-07 5.40% 3.50% 1.90%

15-Oct-07 5.14% 3.50% 1.64%

15-Apr-08 4.78% 3.50% 1.28%

15-Oct-08 4.83% 3.50% 1.33%

15-Apr-09 4.77% 3.50% 1.27%

15-Oct-09 4.85% 3.50% 1.35%

So, eventually the client ends up paying only 3.50% on $ 1 mio for the tenor of the underlying. In this

way, the cost of borrowing can be reduced by entering into a Swap transaction.



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CURRENCY SWAPS

A currency swap can be looked upon as any transaction undertaken to eliminate (or hedge) either

partially or fully, the financial consequences of movements in foreign exchange rates or to substitute

exposure to one currency for exposure to another. These consequences relate either to the assets and

liabilities of the institution or to its revenues and expenses. The need for currency swaps derives from

foreign exchanges risks, which can be, identified under two main headings-

i) Accounting /Translation Exposure

ii) Transaction Exposure.

Accounting Exposure also known as translation exposure arises because MNC’s may wish to translate

financial statements of foreign affiliates into their home currency in order to prepare consolidated



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financial statements or to compare financial results. As investors all over the world are interested in

home currency values, the foreign currency balance sheet and income statement are restated in the

parent country’s reporting currency. For example, foreign affiliates of US companies must restate the

franc, sterling or mark statements into US dollars so that the foreign values can be added to the present

US dollar denominated balance sheet and income statement. This accounting process is called

‘translation’.

Translation exposure measures the effect of an exchange rate change on published financial statements

of a firm. Assets and liabilities that are translated at the current exchange rate are considered to be

exposed, as the balance sheet will be affected by fluctuations in currency values over time; those

translated at a historical exchange rate fluctuations. So, the difference between exposed assets and

exposed liabilities is called translation exposure.

Under the generally accepted US accounting principles, the net monetary asset position of a subsidiary

is used to measure its parent’s foreign exchange exposure. The net monetary asset position is monetary

assets such as cash and accounts receivable minus monetary liabilities such as account payable and

long-term debt.

Translation Exposure = Exposed Assets – Exposed Liabilities

Four methods of foreign currency translation have been developed in various countries.

1. The current rate method

2.

The monetary/non-monetary method

3. The temporal method

4. The current/non-current method

Transaction exposure arises whenever a company is committed to a foreign currency denominated

transaction entered into before the change in exchange rate. Transaction exposure measures the effect

of an exchange rate change on outstanding obligations, which existed before the change, but were

settled after the exchange rate change. Transaction exposure, thus, deals with changes in cash flows

that result from existing contractual obligation due to exchange rate changes.



186

MULTIPLE CHOICE QUESTIONS

i. The value of an option depends on the stock's price, the risk-free rate, and the

a. Exercise price.

b. Variability of the stock price.

c. Option's time to maturity.

d. All of the above.

e. None of the above.

ii. An option which gives the holder the right to sell a stock at a specified price at some time in thefuture is called a(n)

a. Call option.

b. Put option.

c. Out-of-the-money option.

d. Naked option.

e. Covered option.

iii. There are call options on the common stock of XYZ Corporation. Which of the following bestdescribes the factors affecting the value of these call options?

a. The price of the call options is likely to rise if XYZ’s stock price rises.

b. The higher the strike price on the call option, the higher the call option price.

c. Assuming the same strike price, a call option which expires in one month will sell for ahigher price than a call option which expires in three months.

d. All of the answers above are correct.

e. None of the answers above is correct.



187

iv. Which of the following statements is correct?

a. Put options give investors the right to buy a stock at a certain exercise price before aspecified date.

b. Call options give investors the right to sell a stock at a certain exercise price before aspecified date.

c. Options typically sell for less than their exercise value.

d. LEAPS are very short-term options which have begun trading on the exchanges in recentyears.

e. Option holders are not entitled to receive dividends unless they choose to exercise theiroption.

v. An investor who writes call options against stock held in his or her portfolio is said to be selling ___________ options.

a. in-the-money

b. put

c. naked

d. covered

e. out-of-the-money

vi. Suppose you believe that Du Pont's stock price is going to decline from its current level of$82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put optiongiving you the right to sell 100 shares at a price of $83.00 per share. If you bought a 100-sharecontract for $510.25 and Du Pont's stock price actually dropped to $63.00, you would make

a. $1,950.00

b. $1,439.75

c. $1,489.75

d. $2,000.00

e. $2,435.00



188

vii. Which of the following statements about interest rate and reinvestment rate risk is correct?

a. Variable, or floating rate, securities have a high degree of interest rate (price) risk.

b. Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while

reinvestment rate risk is the risk of earning less than expected when interest payments ordebt principal are reinvested.

c. Price risk can be eliminated by purchasing zero coupon bonds.

d. Reinvestment rate risk can be eliminated by purchasing variable, or floating, rate bonds.

e. All of the statements above are correct.

viii. A commercial bank estimates that its net income suffers whenever interest rates increase. Thebank is looking to use derivatives to reduce its interest rate risk. Which of the following

strategies best protects the bank against rising interest rates?

a. Buying inverse floaters.

b. Entering into an interest rate swap where the bank receives a fixed payment stream, and inreturn agrees to make payments that float with market interest rates.

c. Purchase principal only (PO) strips that decline in value whenever interest rates rise.

d. Enter into a short hedge where the bank agrees to sell interest rate futures.

e. Sell some of the banks floating rate loans and use the proceeds to make fixed rate loans.

ix. Company A can issue floating rate debt at LIBOR + 1 percent and can issue fixed rate debt at 9percent. Company B can issue floating rate debt at LIBOR + 1.4 percent and can issue fixed ratedebt at 9.4 percent. Suppose A issues floating rate debt and B issues fixed rate debt. Theyengage in the following swap: A will make a fixed 7.95 percent payment to B, and B will make afloating rate payment equal to LIBOR to A. What are the resulting net payments of A and B?

a. A pays a fixed rate of 9 percent, B pays LIBOR + 1.5 percent.

b. A pays a fixed rate of 8.95 percent, B pays LIBOR + 1.45 percent.

c. A pays LIBOR plus 1 percent, B pays a fixed rate of 9.4 percent.

d. A pays a fixed rate of 7.95 percent, B pays LIBOR.




189

x. Deeble Construction Co.’s stock is trading at $30 a share. There are also call options on thecompany’s stock, some with an exercise price of $25 and some with an exercise price of $35. Alloptions expire in three months. Which of the following best describes the value of theseoptions?

a. The options with the $25 exercise price will sell for $5.

b. The options with the $25 exercise price will sell for less than the options with the $35exercise price.

c. The options with the $25 exercise price have an exercise value greater than $5.

d. The options with the $35 exercise price have an exercise value greater than $0.

e. If Deeble’s stock price rose by $5, the exercise value of the options with the $25 exerciseprice would also increase by $5.

xi. Which of the following are not ways in which riskmanagement can increase the value of a company?

a. Risk management can increase debt capacity.

b. Risk management can help a firm maintain its optimal capital budget.

c. Risk management can reduce the expected costs of financial distress.

d. Risk management can help firms minimize taxes.

e. Risk management can allow managers to maximize their bonuses.

xii. A swap is a method for reducing financial risk. Which of the following statements about swaps,if any, is incorrect ?

a. A swap involves the exchange of cash payment obligations.

b. The earliest swaps were currency swaps, in which companies traded debt denominated indifferent currencies, say dollars and pounds.

c. Swaps are generally arranged by a financial intermediary, who may or may not take theposition of one of the counterparties.

d. A problem with swaps is the lack of standardized contracts, which limits the development ofa secondary market.

e. All of the statements above are correct.



190

xiii. Which of the following statements is most correct?

a. One advantage of forward contracts is that they are default free.

b. Futures contracts generally trade on an organized exchange and are marked to market daily.

c. Goods are never delivered under forward contracts, but are almost always delivered underfutures contracts.

d. Answers a and c are correct.


xiv. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80-07. If

annual interest rates go up by 1 percentage point, what is the gain or loss on the futures

contract (assume $1,000 par value)?

a. Loss of $78

b. Gain of $78

c. Loss of $145

d. Gain of $145

e. None of the above

.

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