microsoft powerpoint - module 2, 1 [compatibility mode]

8/9/2019 Microsoft PowerPoint - MODULE 2, 1 [Compatibility Mode]

1/80

International financial

Management

Harisha.B.V.AIP(finance & control)IIMB

HARISHA.B.V.

AIP(FINANCE AND CONTROL)

IIM BANGALORE

MODULE 2


2/80

Module 2

Foreign exchange markets-


unc ons Participants

Currency derivatives

interest rate futures

Speculations.


3/80

Foreign exchange markets

The foreign exchange market is that in whichcurrencies are bought and sold against each other.


The bulk of this is accounted for a small number

of currencies US dollar,deutsche mark, yen,

pound ,Swiss franc, Canadian dollar,Dutch

guider,Italian lira,Belgian franc,euro.


4/80

Over the counter market

Foreign exchange market is an over the countermarket.

The market s ans all the time zones of the world


and function virtually round the clock,enabling atrader to offset a position created in one market

using another market.

The major ones are London, New York,Tokyo,Zurich,Frankfurt,Hong Kong, and

Singapore.


5/80

Structure of foreign exchange

market

It is made up of

Retail market-travellers and tourists and other


individuals uses this market.the total turnover andaverage size are very small.

Wholesale market- this is interbankmarket.commercial banks,investmentbanks,corporations and central bank participate.theaverage transaction and size is very large.


6/80

Primary price markers and

secondary price makers

Primary price makers or professional dealers make

a two way market to each other and to theirclients.they will give a two way price .They makethe prices.


First tier consists of a giant MNB deal in a largenumber currencies in large amounts and often dealdirectly with each other without using brokers.

The second tier are large banks who deal in asmaller number of currencies and use the services

of brokers more often.


7/80

Secondary price makers

Secondary price makers are entities whichmake foreign exchange prices but do not


MARKET).

Restaurants , hotels, shops catering to

tourists buy foreign currency in payment ofbills.


8/80

Other important points

The spread between buying and selling prices with

secondary price makers or retail market will be


price makers.

Foreign exchange brokers act as middle menbetween two market makers. The brokers do not

buy or sell on their own account.


9/80

Role o central banks


Central banks intervene in the market from

time to time to attempt to move exchange

rates in a particular direction.


10/80

Contribution of volume

Cross border exchanges of goods and servicesaccount for a very small proportion .


The large volume will be from capital account .

As banks usually aim to maintain square or near

square positions, a lot of turnover is simple

attributable to banks offsetting their positions.


11/80

speculators

There is no distinct class of speculators inthe foreign exchange market.

Price makin banks often carr uncovered


positions to profit from exchange ratemovements.

A non financial corporations which does not

hedge its foreign currency export receivableor import payable is as much a speculator.


12/80

The mechanics of currency

trading

The international standard organization has developed three lettercodes.

USD-US DOLLAR

GBP-GREAT BRITAIN POUND


-

CHF-SWISS FRANC

SEK-SWEDISH KRONER

CAD-CANADIAN DOLLAR

BEF-BELGIAN FRANC

NLG-DUTCH GUIDER

DEM-DEUTSCHE MARK

SAR-SAUDI RIYAL


13/80

Inter bank dealing

A typical spot transaction

Monday 21 sep 10.45 a.m.


an : p ease Bank B: 40-45


14/80

Bank B is specifying a two way price, it isquoting last two digits.


The actual price will be 0.8740/0.8745

The last two digits are called points or pips.

Then bank A says mine(willing to buy)

If it wants to sell then it might have said yours


15/80

Warehousing deal and Back to

Back dealing

When Bank B gives the quote which isbased on information about the currentmarket it is called as warehousing deal.


When B calls C and gets the quote and thengives to A .If A does a deal, B will

immediately offset it with C.this is back toback dealing.


16/80

Short and long positions

If any bank has sold more then what it has


bought it is said to have a net short position. If any bank has bought more then what it

has sold it is said to have a net long

position.


17/80

SWIFT

Society for World wide Interbank FinancialTelecommunication.

This is non rofit Bel ian co o erative with main


and regional centers around the world connectedby data transmission lines.

When bank deals through brokers,they transmit

their buy and sell orders to a broker who showsthem to the market without revealing the identities

of the parties.


18/80

Types of transactions

The day on which transfers are effected iscalled the settlement date or the value date.


are

Spot

Forward Swap.( a combination of spot and forward)


19/80

Value dates or settlement dates

Spot transaction is normally T+2 days. Forward contract maturities are normally 1 ,

2 3 6 9 12 months.


Swap transaction

If a bank A purchases USD from Bank Bspot,and simultaneously enter into forwardtransaction with the same counter party tosell USD after 1 month.


20/80

Outright forward and

forward forward swap

Forward contracts without anaccompanying spot deal are known as


.

A one month forward purchase of USD

against GBP coupled with three monthsForward sale of USD against GBP isforward forward swap.


21/80

Exchange rate quotations and

arbitrage

Quotation will be given either on


units of a currency per US dollar.exampleINR 45/ USD

American terms(quotes given as number ofUS dollars per unit of currency.exampleUSD 1.6525/ GBP)


22/80

Direct and indirect quotes

Direct quotes- it give units of the homecurrency per unit of foreign


.

Indirect quotes number of units of foreign

currency per unit of the homecurrency.example USD 2.051010/ INR 100


23/80

Bid ask spreads

A bid is the price at which dealer will buyone currency for another currency.


currency for another currency

The difference between bid and ask is called

as spread which will the dealers margin.


24/80

Example

USD/CHF spot: 1.4550/ 1.4560

Dealer will bu at 1.4550


Dealer will sell at 1.4560

Spread = 1.4560-1.4550

Percentage spread =

(1.4560-1.4550)/1.4560* 100

Quotations are generally shortened to 1.4550/60


25/80

Arbitrage

Arbitrage in finance refers to a set oftransactions, selling and buying or lending


groups of assets ,to profit from pricediscrepancies within a market or across

markets.

Equivalent here means having identical cash

flows and risk characteristics.


26/80

Arbitraging between banks

Though the term market rate is used there isno one single market rate among all the


.

The rate will be close to each other .

Obviously such a situation gives rise to

arbitrage opportunity.


27/80

Example

Bank A is quotingGBP/USD 1.4550/1.4560


Bank B is quoting

GBP/USD 1.4538/1.4548

Here there is a possibility of arbitrage


28/80

Example 2

Bank A

GBP/ USD 1.4550/1.4560


Bank BGBP/USD 1.4545/1.4555

Here there is no arbitrage possibilities.

What is its implications?


29/80

Inverse quotes and two point

arbitrage

BANK IN NEW YORKUSD/ AUD 1.8885/90( SPOT )


BANK IN ZURICH

AUD/USD: 0.5275/0.5280(SPOT)

IS THERE ANY ARBITRAGE?


30/80

CROSS RATES


that is derived from the exchange rates ofthose currencies with a third currency is

known as a cross rate.


31/80

Example

GBP/USD ; 1.6545/1.6552 EUR/USD: 1.3655/1.3665


WHAT IS GBP/EUR?

GBP/EUR bid = (GBP/USD) bid * (USD/EUR)bid

GBP/EUR ask = (GBP/USD) ask * (USD/EUR)ask


32/80

Triangular Arbitrage


GBP 1 = USD 1.96 IN NEW YORKGBP 0.2 = 1 DEM IN LONDON

2.5 DEM = USD 1 IN FRANKFURT.


33/80

COVERED INTEREST RATE

ARBITRAGE

Spot Rate 50 Rs = 1$ Interest rate in India 8%


n eres ra e n s . One year forward rate is 48 RS.


34/80

Golden rule

If the interest rate differential is greater than


e prem um or scoun . p ace e moneyin the currency that has higher rate of

interest or vice versa.

Interest rate differential = differencebetween two countries.


35/80

Forward premium or discount

(Forward rate spot rate) / spot rate * 100 * 12/N



36/80

Example

Spot rate RS 42.0010 = $ 1 6 month forward rate : RS 42.8020


rupee=12% Annualized interest rate on 6 month dollar =

8%

Calculate the arbitrage possibilitiesassuming 1000 $ as investment.


37/80

Swap markets exchange rate

determination

A typical swap quotations appears asfollows


.

1- MONTH SWAP 15/8


38/80

PROBLEM

USD/INR SPOT 48.75/80 2 MONTH SWAP 12/20


. .

2 MONTH SWAP 20/15

FIND INR/JPY 2 MONTH OUTRIGHT


39/80

Derivatives

A derivative is a two party contract whose value isderived from the value of an underlying asset.

The underl in asset ma be Index, stock,


currency, interest rate, commodity. In finance derivatives means a financial product

which has been derived from a market .

It has no independent existence.


40/80

Types of derivatives


Futures (Forwards)

Options

Swaps ?


41/80

MARKET CREATED PRODUCTS

USED FOR HEDGING THE PRICE VARIATION RISK

Often investors split the risk of underlying position intoseveral components and manage the risk which they dontwant to have through derivatives

Derivatives products


TWO TYPES OF DERIVATIVE PRODUCTS

PRODUCTS WHICH ENSURE A FIXED PRICE(FUTURES)

PRODUCTS WHICH ELIMINATES DOWNSIDE RISKOF THE PRICE (OPTIONS)

DERIVATIVE PRODUCTS EXIST ON BOTHCOMMODITY AND FINANCIAL PRODUCTS


42/80

Exchange-traded futures and options

standardized products

trading floor or computerized trading

virtuall no credit risk


Over-the-Counter forwards, options, & swaps

often non-standard (customized) products

telephone (dealer) marketsome credit risk


43/80

Uses of Derivatives

To hedge or insure risks; i.e., shift risk. To reflect a view on the future direction of themarket, i.e., to s eculate.


To lock in an arbitrage profit To change the nature of an asset or liability. To change the nature of an investment without

incurring the costs of selling one portfolio andbuying another.


44/80

Currency future

At a glance a currency future like a forwardcontract is a contract for future delivery.

A currenc future is the rice of a articular


currency for settlement at a specified future date. The two popular future exchanges are the

Singapore international Monetary Exchange

(SIMEX) and International Money Market(Chicago, IMM).


45/80

PRODUCTS TRADED IN FUTURES EXCHANGESPRODUCTS TRADED IN FUTURES EXCHANGES

(FINANCIAL PRODUCTS)(FINANCIAL PRODUCTS)

CURRENCY: AUSTRALIAN DOLLAR, POUND,

DEUTSCHEMARK, FINNISH CURRENCY, FRENCH

FRANC, JAPANESE YEN, NZ DOLLAR, SWISS FRANC,


CROSS-CURRENCY RATE, CURRENCY INDEXINTEREST RATE: T.BILL, BONDS, EURODOLLAR,

BOND INDICES

STOCK INDEX & EQUITY CONTRACTS

MISCELLANEOUS PRODUCTS


46/80

Features of futures contract

Futures are traded on organized exchanges.

Clearing houseFutures are traded through brokers.


The contracts are standardized.

margins

Marking to market

Actual delivery is rare

S t f M i


47/80

System of MarginsInitial margin : When position is opened

Variation Margin: Settlement of daily gains and losses

Maintenance Margin : Minimum balance in margin account.

Balance falls below this, margin call issued. If not met,position liquidated.

Regulators specify minimum margins between clearing


members and clearinghouse. Margins at other levelsnegotiated

Margins can be deposited in cash or specified securities such

as T-bills. Interest on securities continues to accrue to owner.

Margin is a performance bond.

Levels of margins may be changed if volatility increases.


48/80

System of Margins

With clearing house guarantee, buyer-seller need notworry about each others creditworthiness.


liquidity.

Protects clearing house; enhances financial

integrity of the exchange. Credit risk issues

almost eliminated


49/80

Futures and Forwards: A Comparison Table

Default Risk: Borne by Clearinghouse Borne by Counter-Parties

What to Trade: Standardized Negotiable

The Forward/Futures Agreed on at Time Agreed on at TimePrice of Trade Then, of Trade. Payment at

Marked-to-Market Contract Termination

Futures Forwards


When to Trade: Standardized Negotiable

Liquidity Risk: Clearinghouse Makes it Cannot Exit as Easily:

Easy to Exit Commitment Must Make an Entire

New Contrtact

How Much to Trade: Standardized Negotiable

What Type to Trade: Standardized Negotiable

Margin Required Collateral is negotiable

Typical Holding Pd. Offset prior to delivery Delivery takes place


50/80

Theoretical Futures Price

Let C denote the present value of carrying costs, St the

s ot rice, r the interest rate, and FU the futures rice


,

for delivery at T, Then theoretical futures price is givenby

FUt,T = (St + C)[1 + r(T-t)]

F t d F d


51/80

Futures and Forwards on

Currencies

A foreign currency isanalogous to a security

providing a dividend yield


yield is the foreign risk-free interest rate

It follows that if rf is the

foreign risk-free interest

rate F S e r r T

f0 0=

( )

F Ser r Tf0 0=( )


52/80

In practice futures price does not exactly equaltheoretical futures price. Reasons:


,

2 In some cases, restrictions on short sales (Does not

apply to currency futures)

3 Non-constant interest rates

4 Mark-to-market gains/losses.


53/80

Hedging with futures/forwards typically involves taking a position in a futuresmarket that is opposite the position already held in a cash market.

A Short (or selling) Hedge: Occurs when a firm holds a long cash position andthen sells futures/forward contracts for protection against downward price exposurein the cash market.

Hedging Fundamentals


A Long (or buying) Hedge: Occurs when a firm holds a short cash position andthen buys futures/forward contracts for protection against upward price exposure inthe cash market. Also known as an anticipatory hedge.

A Cross Hedge: Occurs when the asset underlying the futures/forward contractdiffers from the product in the cash position.

Firms can hold long and short hedges simultaneously (but for different price risks).


54/80

Options Terminology

The two parties to an option contract are theoption buyerand the option seller also calledoption writer

Call Option: A call option gives the optionbuyer the right to purchase a currency Y against


a currency X at a stated price Y/X, on or beforea stated date.

Put Option: A put option gives the option buyerthe right to sell a currency Y against a currencyX at a specified price on or before a specifieddate


55/80

Options Contracts: PreliminariesAn option gives the holder the right, but not the obligation,

to buy or sell a given quantity of an asset in the future, at

prices agreed upon today.

Calls vs. Puts


Call options gives the holder the right, but not theobligation, to buy a given quantity of some asset at sometime in the future, at prices agreed upon today.

Put options gives the holder the right, but not theobligation, to sell a given quantity of some asset at sometime in the future, at prices agreed upon today.

Options Terminology


56/80

Options Terminology

A call option is said to be at-the-money ifCurrent Spot Price (St ) = Strike Price (X),

in-the-money if St > X and out-of-the-money if


St< X

A put option is said to be at-the-money if

St = X, in-the-money if St < X and out-of-the-money if St > X

In the money options have positive intrinsicvalue; at-the-money and out-of-the moneyoptions have zero intrinsic value.


57/80

Options Contracts: Preliminaries

European vs. American options


European options can only be exercised on the

expiration date.

American options can be exercised at any time up

to and including the expiration date.

Since this option to exercise early generally has

value, American options are usually worth more

than European options, other things equal.

A CALL OPTION


58/80

A trader buys a call option on US dollar with a strike price of

Rs.46.50 and pays a premium of Rs.1.50. The current spot rate, St,

is Rs.45.50. His gain/loss at time T when the option expires

depends upon the value of the spot rate, ST, at that time :

ST Gain(+)/Loss(-)44.5000 -Rs.1.50

45.0000 -Rs.1.50


45.5000 -Rs.1.50

46.0000 -Rs.1.50

46.5000 -Rs.1.50

47.0000 -Rs.1.00

47.5000 -Rs.0.5048.0000 Rs.0.0048.5000 +Rs.0.5049.0000 +Rs.1.00

49.5000 +Rs.1.50

PUT OPTION


59/80

A trader buys a put option on pound sterling at a strike price of$1.7500, for a premium of $0.07 per sterling. The spot rate at the

time is $1.7465. At expiry, his gains/losses are as follows :

ST Gain(+)/Loss(-)1.6000 +$0.0800

1.6300 +$0.0500


. .

1.6600 +$0.02001.6800 $0.0000

1.6900 -$0.0100

1.7300 -$0.0500

1.7500 -$0.0700

1.7700 -$0.0700

1.8000 -$0.0700

Option Payoff


60/80

Option Payoff

LONG CALL SHORTCALL


LONG PUT SHORT PUT


61/80

The BSOPM Formula

dNSdNeKpdNeKdNSc

rT

rT

=

=

102

210

)()()()(


where N(di) = the cumulative standard normal distributionfunction, evaluated at d

i, and:

TdT

TrKS

d

T

TrKSd

=

+

=

++

=

1

0

2

01

)2/2()/ln(

)2/()/ln(

where


62/80

Black scholes

C = S N(d1) - E e -rtN(d2)

C = CALL VALUE


r = RISK-FREE RATE

S = CURRENT MARKET PRICE

t = TIME TO EXPIRATION

E = EXERCISE PRICE

N(d) = Cumulative normal probability density function d1 = {ln(S/E) + (r + 0.5 VAR) t} / {SD * SQRT(t)}

d2 = d1 - {SD * SQRT(t)}


63/80

Computing Volatility

Find the daily return of the stock over a period Rt = ln(Pt/Pt-1)

Find the Standard Deviation of daily returns as computed in


the above step This is standard deviation of daily return

To annualise the standard deviation of daily return,

SD (daily return) * SQRT(250)

where 250 refers to number of trading days in a year.

Formulas for Currency Options


64/80

Formulas for Currency Options

dNeSdNKep

dNKedNeSc

TrrT

rTTr

f

f

=

=

)()(

)()(

102

210


T

TfrrKSd

Tf

rr

d

+

=

++

=

)2/2()/ln(

n

0

2

0

1

where

Alternative Formulas


65/80

Alternative Formulas

F S e r r Tf

0 0=

( )

UsingdKNdNFec rT = 210 )]()([


TddT

TKFd

dNFdKNep rT

=

+=

=

12

2

01

102

2/)/ln(

)]()([

Elementary Option Strategies


66/80

Elementary Option Strategies

Spread Strategies

Bullish Call Spread: Consists of selling the call with the higherstrike price and buying the call with the lower strike price

Bearish Call spread: If the investor expects the foreign currencyto depreciate, he can adopt the reverse strategy viz. buy the


Bullish Put Spread: Consists of selling puts with higher strikeand buying puts with lower strike

Bearish Put Spread: Opposite of Bullish Put Spread

These strategies, involving options with same maturity butdifferent strike prices are called vertical or price spreads

Bull Spread Using Calls


67/80

ull Sp ead Using Calls

Profit


K1 K2

ST

Bull Spread Using Puts


68/80

p g

Profit

Harisha.B.V.AIP(finance & control)

IIMB

K1 K2 ST

Butterfly Spreads


69/80

Butterfly Spreads

This is an extension of the idea of vertical spreads. Suppose

the current spot rate NZD/USD is 0.6000. The call options with

same expiry date are available :

Strike Premium

0.58 0.07


IIMB

0.62 0.03

0.66 0.01

A butterfly spread is boughtby buying two calls with the

middle strike price of 0.62, and writing one call each with strikeprices on either side, here, 0.58 and 0.66. The profit table is as

below :

Butterfly Spread Using Calls


70/80

f y p g

Profit


IIMB

K1 K3 STK2

Butterfly Spread Using Puts


71/80

f y p g

Profit


IIMB

K1 K3 STK2


72/80

Elementary Option StrategiesStraddles and Strangles Volatility Bets

A long straddle consists of buying a call and a putboth with identical strikes and maturity. Usually bothare at-the-money.


IIMB

A long strangle consists of buying an out-of-the-money call and an out-of-the-money put

Both are bets that the underlying price is going to

make a strong move up or down I.e. market is goingto be more volatile.

Delta


73/80

Theta.

Delta

Delta (D) is the rate of change of the option price with

respect to the underlying

Theta of a derivative or ortfolio of

derivatives) is the rate of change of the value withrespect to the passage of time

The theta of a call or put is usually negative. This

means that, if time passes with the price of theunderlying asset and its volatility remaining the

same, the value of the option declines


74/80

Gamma

Gamma () is the rate of change of delta ()

with respect to the price of the underlying


IIMB

asset

Gamma is greatest for options that are close

to the money


75/80

Vega

Vega () is the rate of change of the value

of a derivatives portfolio with respect tovolatility


IIMB

Vega tends to be greatest for options that

are close to the money


76/80

Rho

Rho is the rate of change of thevalue of a derivative with respect to


IIMB

For currency options there are 2

rhos


77/80

Forward Rate Agreements (FRAs)

A FRA is a forward contract on an interest rate (not on abond, or a loan).

The buyer of a FRA profits from an increase in interest


IIMB

. .

The buyer effectivelyhas agreed to borrow an amount ofmoney in the future at the stated forward (contract) rate. Theseller has effectively locked in a lending rate.

FRAs are cash settled.


78/80

Forward Rate Agreements (FRAs)


IIMB

Only the difference in interest rates is paid. The principal

is not exchanged.

FRAs are cash settled.


79/80

An Example of an FRA

A firm sells a 5X8 FRA, with a NP of $300MM, and acontract rate of 5.8% (3-mo. forward LIBOR).

On the settlement date (five months hence), 3 mo.


IIMB

spo s . .

There are 91 days in the contract period (8-5=3months), and a year is defined to be 360 days.

Five months hence, the firm receives:

Source- debousfky


80/80

FRA Example (continued)

$524,077.11, which is calculated as:

-


IIMB

=

, , . .

1+[(0.051)(91/360)]

, , . - .

1+[(0.051)(91/360)](300,000,000)(0.058-0.051)(91/360)

1+[(0.051)(91/360)]300000000*(.058-.051)(91/360)

1+(.051*91/360)

microsoft powerpoint - module 2, 1 [compatibility mode]

Documents