Beruflich Dokumente
Kultur Dokumente
41461
Four days
Distinguish differences between investment banking and retail banking models and identify key performance metrics Value various equity and fixed income products Use a range of derivative products to hedge client risk Describe the drivers of foreign exchange markets Understand the dynamics of different market structures.
Investment banking Overview of an investment bank The role of an investment bank Advisory Sales, trading and research Clients of an investment bank
Afternoon
Key elements of the financial statements The income statement - revenue sources The income statement - cost drivers The balance sheet - assets and funding sources Equities Types of equities and equity like instruments Primary and secondary markets Exchanges Market making versus order driven Types of orders Exercise MSFT order book
Discounted cash-flow review The time value of money Future values, present values and discount factors Calculating the discount factor Valuing a perpetuity Exercise Heinz price winners draw
Structuring a DCF calculation The forecast period The terminal value Exercise Valuing Honda
Investor criteria for equity selection - multiples Define market capitalization Overview of the principles of relative valuation Calculating Price/Earnings, Price/Sales and Price/Book The drivers of the multiples and sector norms
Capital asset pricing model and WACC Risk free rate Equity risk premium Understanding beta Calculating the cost of equity Calculating the WACC Exercise WACC calculations Market making simulation round 2
Bond basics Different products Reviewing bonds in Bloomberg Government bonds versus corporate bonds Credit ratings Exercise The bond is right
Bond pricing review Bond pricing in Excel Benchmark rates and simple spreads Interest yield and redemption yields Exercises Bond pricing practice - using Excel Calculating yields - for various types of bonds in Excel
Accrued interest Concept Convention A/A, 30/360, A/365 Cash and quoted prices
Exercise Calculate the cash price - checking the AI calculation in Bloomberg for an Indian government bond Yield curve Typical shapes Interpreting the curve Impact of inflation, short term interest rates and technical supply and demand issues Examples from various economies
Group work Yield curve mix and match Money market securities Securities that trade in the money market including T-Bills, CP, CDs, inter-bank deposits and repo Money market and discount basis conventions Using Actual/360 (and Actual/365)
Duration Metric of interest rate risk Macaulay and modified duration Key drivers: maturity, coupon and yield Exercise Duration exercise Market making simulation results
Basic fixed income trading strategies Duration trades Flatteners and Steepeners Bullet and barbell strategies
Convexity The convexity adjustment Convexity calculations Drivers of convexity Derivative basics Derivative markets Key features of a future Margin accounts Single stock futures Exercise Working at the margin
Determining the future price The impact of carry costs and returns on the spot/ future basis Contango and backward markets Reading the Bloomberg Contract Table screen Currency, commodity, equity and bond futures
Introduction to options Calls versus puts Strike price and exercise dates European versus American Intrinsic value Time value The impact of volatility The impact of time exercise
Binomial valuation One step model Up and down factors Probabilities Discounting Two step model Exercises Binomial Inc
Delta for options What delta measures Using delta to calculate market exposure Hedging a position Rule of thumb delta values for calls and puts Reading delta off the Bloomberg Exercise Delta force
Introduction to Interest Rate Swaps Plain vanilla structure Notional and cash flows Hedging interest rate risk
IRS variations Ammortizing swaps Accreting swaps Forward start swaps Exercise IRS mix and match
Credit default swaps Definition, terminology and structure Credit events Settlement The Big Bang Protocol Risks around CDS Exercise Heres the deal
What drives currencies Demand and supply of FX Macroeconomic factors Official policy
How rates are quoted FX spot as an exchange of funds Base and pricing currency Bid offer spread Case studies Code red Smash and grab FX forwards and swaps FX forward quotes Pricing forward FX Relationship between spot and forward markets Risk from forward and swap transactions Using forwards to hedge Case study Calculating FX forward rates
Investment banking
41484
An investment bank can broadly divided into two parts. Capital markets operations sell and execute trade ideas to clients in a number of cash and derivative markets. The investment banking are is often called advisory, whereby expertise is sold to clients in a range of areas such as M&A advisory and debt and capital markets.
The primary role of the capital markets is to bring investors (people with cash) together with people that need cash who will in turn issue securities such as stocks or bonds. Broadly speaking, issuers will generally be investment banking clients, looking for advise as to the most efficient way to raise capital, whereas investors will generally be clients of the capital market divisions. However, there will always be a high degree of interaction between divisions within an investment bank.
An investment banker works in the industry referred to corporate finance. In this field, advice is given to clients in numerous areas. For example, advise may be giving on appropriate merger targets, or advise may be given around placing shares in the equity markets. Clients may also come to investment bankers for strategic advise as to the future direction of their business. Many of the solutions provided to investment banking clients will utilize the services of the capital markets divisions. For example, an investment banking client may want to hedge their currency risk, in which case the derivatives division of the capital markets division may be asked to create the appropriate hedging vehicle.
Advisory services can broadly be classified as above. Capital structure and raising is involved in raising and issuing debt or equity. Merger and Acquisition advisory will help find targets for growth by combining with other companies (in an either friendly manner where the target is also keen to combine or a hostile manner where the target does not want to join forces). Risk management advisory helps clients avoid or mitigate risk by either offering strategic advise or via the use of derivative instruments.
Capital market clients are looking for investments. Different clients have vastly different objectives in terms of risk appetite and investment horizons, as well as other possible restrictions such as ethical guidelines. The capital markets division of an investment bank can help their clients by providing both access to markets as well as being a vital component to providing liquidity in markets. Liquidity is an important feature of an efficient market.
Within the equity and debt capital market divisions, people that work in investment banks have specialized and focused roles. Each of the three areas listed above require different and specific skill sets from the people that work in them.
While the capital markets division of an investment bank will have a variety of customers, they can broadly be classified in two ways. Real money accounts have raised the cash with which they wish to invest. These clients are referred to the traditional buy side, as traditionally these were the clients buying services from the investment bank i.e. the sell side). Traditional buy side clients are Pension funds, Mutual funds, Insurance companies and retails clients, each with their unique investment objectives.
With the advent of hedge funds in the middle of the 20th century, a new buy side group of investors were formally defined. While the vast array of hedge fund strategies ensure defining hedge funds is challenging, most tend to make use of leverage in order to make their strategies more profitable. Hedge funds are an important client base of investment banks, whose needs are usually catered for by Primer Services.
DB financial statements
Review the attached simplified version of the Banks income statement and balance sheet. Answer the following questions: 1. What is the return on equity? 2. What do you think is the key profit figure for the bank? 3. What is the capital in the balance sheet and what does it represent? 4. Why is the regulator interested in the size of capital
Deutsche Bank balance sheet Dec 31 2012 (in million) Total assets 2,012,329 Dec 31 2011 (in million) 2,164,103
Total liabilities
1,957,919
2,109,443
Total equity
54,410
54,660
2,012,329
2,164,103
Deutsche Bank income statement Dec 31 2012 (in million) Net interest income (after provision for credit losses) Dec 31 2011 (in million)
14,170
15,606
17,850
15,783
32,020
31,389
(31,236)
(25,999)
784
5,390
Tax
(493)
(1,064)
291
4,326
A typical non-bank: Assets are non-current and current. These include property, goodwill, inventories, cash. Businesses are funded by debt and equity Deutsche Bank: The assets in a bank are different to that of a normal business The assets of a bank include loans, financial assets and intangibles The funding of a bank includes deposits, financial liabilities, debt and equity.
Equities
41099
There are two distinct markets for equities. The primary market is where issuers first issue equity securities to investors. The secondary market is available for investors to but and sell shares amongst themselves once the shares have been issued. Secondary markets are either order driven (where shares trade as soon as there is a buy and sell match) or quote driven, whereby market makers stand in the market willing to buy and sell shares at any time for a given set of quotes. A characteristic of equities markets that has rapidly evolved over the past five years is the use of computer driven, or algorithmic, trading.
The most populous type of equity instrument issued globally is common stock. This gives holders an ownership interest in the underlying company, pro rated based on the number of shares in the company they own. Preferred stock is sometimes issued by companies. While they trade in the same, usually the dividend is fixed but cumulative, they may or may not have the same voting rights as common stock and they rand above ordinary shareholders in the event of bankruptcy. ADRs are issued by investment banks as a way domestic investors to gain easy access to overseas stocks, often from emerging markets. While the above are examples of cash instruments, there are a wide variety of derivative instruments based on equity securities.
Exchanges are a means of bringing buyers and sellers of equities in the secondary market together. Some exchanges use market makers, some use order books, and many nowadays use a combination of both in recognition of the advantages each mechanism brings. For example, market makers work well in illiquid markets whereas order books work well in markets with higher liquidity. Order book systems allows investors to trade more cheaply, while market makers are not prone to the technical glitches that affect exchanges from time to time.
The bid a market maker quotes is what they are willing to buy the security at and the offer is what they are will to sell the security for. In other words, the market maker is providing liquidity for the market. Many exchanges allow market makers to use their floor to advertise their prices - on the New York Stock Exchange these market makers are called Specialists.
In an order book mechanism, dealers from around a country are linked to the stock exchanges order book system. As soon as a buyer and sellers price matches, the trade happens right away. In this system, it is the investors that are supplying the liquidity. With the growing use of algorithmic trading on order book systems, many investment banks have invested large amounts of money to be co-located to exchanges, so their orders reach the order book faster.
When using an order book mechanism, there are several different types of orders dealers can place. Limit orders ensure that if a dealer is buying, they pay no more than a certain price and if they were selling, the sell for no less than a certain price. On this slide, a dealer has entered an order to buy 200 stocks at no more than 98. Naturally they would be very happy should they buy these stocks for less than this.
The book is simply a way of quoting all the orders on the order book at any point in time. Depending on the front office trading system the dealer is using, the ladder may look like this slide. The number of stocks dealers want to buy are listed on the left hand side at the limit (highest price) the dealer is prepared to pay. On the right hand side, all the offers that dealers have put on the market are listed, with the quantity for sale next to the limit (lowest price) they will take. The market quote is the current highest bid and lowest offer. In this example, no trading will occur until either a higher bid enters the market, a lower offer enters the market, or both.
This slide shows an example of what a book may look like right before the market opens. The highest a dealer is willing to pay once the market opens is 104 while the lowest a dealer is prepared to sell for is 96 - it looks certain that once the market opens there are deals to be made. Once the market opens, exchanges have algorithms to ensure as many trades are filled. All these trades that happen on the pen will execute at the same price. Looking at this ladder, the opening price will be around 99 or 100, all the marketable orders will trade, all the orders in the market will trade and the resultant bid and offer will be 98 101.
A market order has no limit - it is an order to trade immediately at whatever prices the current market is at. Using the ladder on page 7, can you answer these questions?
A The dealer will buy all 500 stocks being sold at a limit of 101, and buy the remaining 100 stocks at 103 for an average price of 101.33. This average price is 0.33 higher than the offer quoted at the time of the trade, resulting in an extra 600 being paid by the buyer.
A stop loss is a type of order that creates a floor for a dealers losses should the market move against them. In the above example, this order does not hit the stock exchanges order book unless the stock drops to $26.50, at which point it becomes a market order to sell.
If done orders are also called contingent i.e. they are contingent on another order happening first. In this example, a stop loss order is entered only if the dealer buys the stocks at 26.90.
This order extends the example on the previous slide. Here there are two if done orders placed, contingent on the dealers limit order to buy being successful.
Other orders that dealer place may have time constraints attached to them. Exchanges will have their own regulations that dictate how long an unexecuted order can sit on the order book before it is cancelled.
06 40301 IB CORE
INET publish their full order book on the internet. The book for Microsoft has been reproduced for you overleaf. How would each of the following orders be dealt with? Assume for each order it is the next one to hit the book. In each case state whether it would trade and what the price would be, and what the new market spread would be. Qty 1. Sell 40 at market 2. Buy 100 at market 3. Sell 50 at 26.80 4. Buy 400 at 27 5. Sell 200 at market 40 Price 26.72 Spread 26.62 / 26.96
07 40177 IB CORE
Congratulations! Youre one of the five lucky people who found a mystery message at the bottom of a recently purchased can of Heinz Baked Beans. You can choose one of the following prizes: a. b. c. d. e. 200,000 now 360,000 five years from now 22,800 a year, forever 38,000 for each of ten years 13,000 next year, and increasing thereafter by 5% per year.
If the discount rate is 12%, which prize offers the highest present value?
It is best to break down a DCF valuation into a number of phases. The term Discounted Cash Flow indicates that a discount rate is required. The discount rate will be the average return required by the providers of finance. In a DCF model the cash flows are split between a forecast period, which is typically between 5 and 10 years followed by a terminal value.
The discount rate is the average return required by the providers of finance. In the example the business is funded by a mixture of debt and equity.
As the funding is split equally between debt and equity the cost of funds, termed the weighted average cost of capital (WACC) is 10%. Business managers know that when they raise money from debt and equity investors they need to generate returns to pay interest, dividends and to grow the share price. In this example assets of the firm need to generate a 10% return to satisfy the investors. When valuing a company the WACC is used to discount the cash flows that the firm is forecast to generate.
In the example, cash flows have been forecast for the next five years. It is important to remember that all the cash flows must be future cash flows. The process for forecasting cash flows starts with an understanding of the economic climate, the industry, the companys strategy and the strength of the management team. From a deep understanding of the business, analysts will forecast revenues, costs, capital expenditure and funding structures. They will make these forecasts typically for a period of between five and ten years.
Discounting the cash flows that have been forecast, using the WACC as the discount rate, gives the PV of the forecast period. The next stage is to value all the cash flows that will occur after the forecast period. In this example, that will be the cash flows from year 6 onwards.
After the forecast period analysts accept that they cant forecast revenues, costs or levels of investment with much accuracy. When valuing a company it is common practice to assume that the cash flows either continue at the same level after the forecast period or grow at a constant rate. The value of the cash flows from year 6 onwards in our example is called the terminal value. In the example it is assumed that the cash flows will grow at a rate of 2% per year forever.
An infinite series of cash flows, where they grow from one year to the next is known as a growing perpetuity. The formula given above is well known and not too difficult to prove. Using the assumptions in the example the value attributable to the cash flows from year 6 onwards has been calculated.
The enterprise value of the company is estimated to be 1,652.26. To calculate the value of the companys equity the net debt must be deducted.
You have been asked to perform a discounted cash flow valuation for Honda. You have had a chat with one of the equity analysts and they have provided you with the following forecasts. The forecast free cash flows are: Yr 1 Yr 2 Yr 3 TV cash flow Y404 billion Y567 billion Y555 billion Y575 billion
The business has a cost of capital of 7.0%, and analysts are using a growing perpetuity for the terminal value assuming 1% growth. The net debt of the business amounts to Y2,860 billion. Shares in issue amount to 1.811 billion. The shares are currently trading at Y3,475 on the TSE.
Required It is your job to assess the fair value of Hondas equity (i.e. share price) using these cash flows by performing a discounted cash flow valuation. Do you feel that the shares are fairly priced in the market?
11 38533 IB CORE
You have been provided with five companies operating in different sectors. For each you have been provided with a brief description of the company and an overview of the main sectors it operates within. You also have a range of valuation multiples, both at the equity and enterprise value level, for the five companies. You should match the multiples to the companies and ensure you are able to justify your answers. You should be prepared to discuss your conclusions. The five companies are: 1. Ford Motor Company Ford Motor Company designs, manufactures and services cars and trucks. The company also provides vehicle-related financing, leasing and insurance through its subsidiary.
2. J.P Morgan
JPMorgan Chase & Co. provides global financial services and retail banking. The Company provides services such as investment banking, treasury and securities services, asset management, private banking, card member services, commercial banking, and home finance. JP Morgan Chase serves business enterprises, institutions, and individuals.
3. GlaxoSmithKline
GlaxoSmithKline plc is a research-based pharmaceutical group that develops, manufactures and markets vaccines, prescription and over-the-counter medicines, as well as health-related consumer products. The Group, which also provides laboratory testing and disease management services, specializes in treatments for respiratory, central nervous system, gastrointestinal and genetic disorders.
4. Google Inc.
Google Inc. is a global technology company that provides a web based search engine through its website. The Company offers a wide range of search options, including web, image, groups, directory, and news searches.
5. Wal-Mart
Wal-Mart Stores, Inc. operates discount stores, supercenters, and neighborhood markets. The Company's discount stores and supercenters offer merchandise such as apparel, housewares, small appliances, electronics, and hardware. Wal-Mart's markets offer a full-line supermarket and a limited assortment of general merchandise. The Company operates nationally and internationally.
B 6.8 12 2.1
C 0.1
D 4.2 23 5.6
E 3.1 14 0.5
US version.pdf
The cost of capital is the return that is required by the providers of capital. Remember that the two main forms of capital for a business are equity and debt. These two classes of investors will each have a different requirement for returns. Typically the equity investors require a higher return than the debt investors as they are taking on more risk. It is the job of management to generate an adequate return for the providers of capital. Many companies will use the tax-adjusted cost of capital to set targets for their business.
The cost of equity is the return that shareholders should fairly expect for investing in the business. The cost of equity should be a function of the risk that the investors are taking. Equity investors will only invest in higher risk businesses if they expect to earn a higher rate of return. The most commonly used model for estimating the cost of equity is the Capital Asset Pricing Model (CAPM). This model uses a measure of risk called Beta. An average stock in the market has a beta of one. More risky stocks have higher betas and more stable stocks have lower betas. Beta can be calculated using a statistical technique called linear regression. As well as beta the calculation also requires a risk free rate which is normally obtained from a government bond market. It also requires an estimate of the equity risk premium. This is how much more investors require for putting their money in the stock market compared to the government bond market.
Beta measures the sensitivity of the stock to movements in the market as a whole. Stocks that move by more than the market on average have Betas of more than one. Stocks that move by less than the market have Betas of less than one.
Given the risk free rate, equity risk premium and the Beta for a stock then the capital asset pricing model can be used to determine the cost of capital. A Beta of 0.5 gives a cost of capital of 6.5% (5% + 0.5 x 3%) A Beta of 1.5 gives a cost of capital of 9.5% (5% + 1.5 x 3%)
An alternative to using the risk return graph is to write CAPM as a formula. Here the cost of equity is equal to the risk free rate plus the Beta adjusted equity risk premium. The risk free rate is taken from the bond market. Many analysts will use the yield on the 10 year benchmark bond. The equity risk premium is more subjective.
The overall cost of capital needs to include the cost of debt. Cost of debt The cost of debt can be taken from the yield in the bond markets for traded debt or the rate of interest for bank debt. It is important to remember that interest is tax deductible so the after tax cost of debt must be calculated. Weighted Average Cost of Capital (WACC) The overall cost of capital is an average of the cost of equity and the cost of debt. Because the two sources of funding are unlikely to be equal it is important to take a weighted average. Analyst will use the market values of debt and equity to calculated the weights.
Remember to use the after tax cost of debt and to weight the cost of equity and the cost of debt in your calculation.
It is natural to ask what the best funding mix is between equity and debt. From a valuation perspective the funding mix that gives the lowest weighted average cost of capital will give the highest valuation. The optimal point is hard to estimate. However it is true to say that a cash generative mature business will have an optimal point which includes a higher proportion of debt than a growing business that generate less stable and smaller cash flow. Modigliani and Miller wrote extensively on this topic.
13 38280 IB CORE
Bond basics
38280
A Bond is an 'IOU' in which an investor agrees to loan money to a company or government in exchange for a predetermined interest rate. Investors purchase them with the understanding that the issuer will pay back their original principal (the amount the investor loaned to the company) plus any interest that is due by a set date (this is called the "maturity" date).
Companies used to issue bond certificates to investors. Possession of the bond certificate was all that was needed to infer ownership, hence the term bearer bonds. Now like stocks, bonds are issued in electronic form rather than paper form, a process known as dematerialization.
In this bond, the issuer is MDA Training. The notional value (also known as the face value) is 1000 - this is the amount that MDA Training has to return to the investor who owns this bond when the bond matures. The maturity date is 30 September 2022 and the coupon rate is 10% semi annual. This means every six months, the owner of this bond receives a coupon of 50.
The securities in the bond market can be classified either by the type of issuer for example government bonds or by the way the interest is paid for example floating rate notes (explained later).
Supranational The World Bank has members including the US, Japan, China, Germany, UK governments. It raises money for reconstruction and development projects in various countries around the world. It is the banking arm of the International Monetary Fund. Governments Governments borrow money when they have a budget deficit. That is when they have spent more than they have raised in taxes. Regions and municipalities This might include the State of California, the City of New York or Transport for London. Companies Many large companies raise money in the bond markets to fund their operations and growth.
Coupon bearing bonds - These are the most common type of bonds and pay a regular coupon. Zero coupon bonds - No coupon is paid on these bonds. The investor makes a return by buying them at a discount (less than 100) and finally redeeming them at par (100). Floating rate notes - The coupon is linked to LIBOR, the London Interbank Offered Rate. Coupons are normally paid quarterly. Convertible bonds - The investor has the choice of receiving a predetermined number of shares instead of the notional in cash. Inflation linked bonds - The coupon and the notional are both linked to inflation, which protects the purchasing power of the investors money.
14 36781 IB CORE
You are considering making an investment in the fixed income market. You have obtained the descriptions of a number of issues from your Bloomberg terminal. Using the information attached assess which bonds you would choose under various criteria.
Which bond would you invest in if you: 1. Wanted the best possible credit quality? 2. Thought interest rates were going to rise? 3. Wanted to participate in the equity of a company if it performed well? 4. Wanted exposure to the British corporate debt market and a strengthening Euro? 5. Wanted the highest possible income? 6. Wanted to protect the purchasing power of your investment? 7. Wanted to make the best possible investment? 8. Which three bonds would you choose to build a portfolio and why?
To value bonds, as in other financial instruments, investors use the discounted cash flow (DCF) framework. This approach takes forecasted cash flows from the bond (coupons and the principal) and discounts these to take into account the inherent risk of owning these bonds and the time value of money. The appropriate discount rate to use in the discount factor is the yield to maturity (YTM) of the bond. We always price a bond per 100 of par, regardless of the actual par value of one bond. If the price of the bond is more than 100, we say the bond is trading at a premium. There may be a number of reasons as to why the bond is trading at a premium, from a fall in interest rates to a decrease in the credit risk of the bond.
If we discount the future cash flows of a bond and the resultant price is 100, then we say the bond is trading at par. In this instance, the coupon rate and the YTM will be equal.
A bond is trading at a discount if the price of the bond is less than 100. There may be a number of factors that have contributed to the fall in the price of the bond, from a rise in interest rates to an increase in the credit risk of that particular bond.
The important relationship between bond prices and yields is that they are inversely related to each other. This is important for any party interested in fixed income markets to understand.
Price the following bonds. Term (years) 10 10 10 5 5 5 2.5 2.5 2.5 Coupon Coupon frequency Annual Annual Annual Annual Annual Annual Semi annual Semi annual Semi annual Required return 5% 6% 4% 5% 6% 4% 10% 12% 8% Price
Accrued interest
38846
The price of a bond may be given to investors in two different ways. Firstly, the clean price (also known as the quoted price) does not take into any account interest payments due to the seller of the bond. If an investor owns a bond, they earn interest, calculated daily, and paid to them in the form of a coupon. If an investor sells their bond part-way between coupon payments, they have already accrued part of the coupon. The buyer of the bond is required to pay this part coupon to the seller of the bond in the form of accrued interest. The dirty price (or invoice price) is the clean price plus the accrued interest.
The day count convention of the bond is used to calculate the accrued interest of a bond. There are a number of day count methodologies used in the fixed income markets. While in principle they use the same process, each methodology calculates the number of days in slightly different ways.
To calculate how far through the current coupon period we are, we take the actual number of days between the last coupon date and the trade date divided by the total number of days in the current coupon period. This leads to the implication that the daily rate of accrual is a function of the actual number of days in the coupon period, which changes depending on whether the current coupon period is in the first or second half of the year.
To see how the daily rate of accrual can differ under the actual/actual day count method, consider the above bond. There are 181 days in the coupon period in the first half of the year, leading to a daily accrual rate of 5.00/181 = 0.02762 per 100 of par. There are 184 days in the coupon period in the second half of the year, leading to a daily accrual rate of 5.00/184 = 0.02717 per 100 of par.
Because the daily accrual rate differs from the first half of the year to the second half of the year, selling the bond after the same number of days will result in different accrued interest figures. If an investor holds the bond for 46 days before selling, in the first half of the year the accrued interest will be 1.2707 per 100 of par. In the second half of the year, selling the bond 46 days into the coupon period will amount to accrued interest of 1.2500 per 100 of par. This accrued interest is paid by the buyer of the bond to the seller of the bond.
The day count convention for US Treasuries is Actual/Actual. In this Bloomberg screenshot, we see that the number of days between the last coupon payment and the settlement date is 83 days. The total number of days in the coupon period is 182. The bond pays a coupon of 2% semi annually. The accrued interest per 1,000,000 of par for the bond therefore is (83/182) * (1% * 1,000,000) = 4560.44
The 30/360 method was invented in the days before computers to make computations easier. In this method, all months, including February, have 30 days, and all years have 360 days. This has the effect of making the daily accrual rate for interest the same, regardless of what part of the year the coupon period falls in.
It can be seen in this example that the daily rate of interest accrual is the same in each of the coupon periods i.e. 0.027778 per day per 100 of par. This means selling the bond 46 days into either of the coupon periods will result in the same accrued interest.
The issue with the 30/360 day count convention falls around February. Obviously there are only 28 days (29 days in a leap year) in February, so moving the accrual period from the end of February to the 1st of March increases the amount of accrued interest by up to three days.
The day count convention for this Wal-Mart corporate bond is 30/360. In this Bloomberg screenshot, we see that the number of days between the last coupon payment and the settlement date is 37 days. The total number of days in the coupon period is 180 - this will always be the case for a semi annual bond with a 30/360 day count. The bond pays a coupon of 4.5% semi annually. The accrued interest per 1,000,000 of par for the bond therefore is (37/180) * (2.25% * 1,000,000) = 4625.00
The Actual/365 day count convention assumes there are 365 days in the year so that each six monthly coupon period has a total of 182.5 days regardless of when this coupon period falls in the year. This means the daily rate of accrual is the same in each semi annual coupon period. However, because the numerator is based on the actual number of days in the period, which can be more than 182.5 days, we sometimes get the result that the accrued interest is higher than the actual coupon payment.
The daily rate of accrual is the same in each semi annual coupon period. This means, after selling the bond after the same number of days in each period, the investor will receive the same amount of accrued interest. If the investor sold the bond on the last day of the year, the accrued interest would be higher than the value of the actual coupon.
The day count convention for this Japanese JGB is Act/365 In this Bloomberg screenshot, we see that the number of days between the last coupon payment and the settlement date is 51 days (this JGB matures on 20 December 2021). The total number of days in the coupon period is 182.5 - this will always be the case for a semi annual bond with a Act/365 day. The bond pays a coupon of 1% semi annually. The accrued interest per 1,000,000 of par for the bond therefore is (51/182.5) * (0.5% * 1,000,000) = 1397
18 41114 IB CORE
Case study
You have been supplied with the following Bloomberg screens: Indian government bond
Corporate bond
Calculate the accrued interest using the appropriate day count convention. Use the street convention yield to calculate the price bond. Check the price agrees with the Bloomberg screens.
Corporate bond
19 38284 IB CORE
Yield curves
38284
The yield curve normally slopes upwards meaning that long term investments pay a higher return than shorter term investments. In the government markets this higher return is compensation for inflation risk as well as credit risk depending on which government it is.
The government can normally borrow at the lowest rate in any economy. There are exceptions but this is generally true. Companies and other issuers pay higher rates of interest dependent mainly of then credit quality. There is therefore a spectrum of credit curves that sit above the benchmark government curve. The more credit risk the larger the spread between the interest rate on the issuers debt and the interest rate of government debt with the same term.
The major rating agencies include Standard and Poor's and Moodys Investor Services. The agencies are paid by the issuers to rate their debt. The rating helps the issuers sell their debt in the market place. Debt with a rating of BBB- or better is know as investment grade. Debt with a rating of BB+ or lower is know as high yield or junk.
There are two key benchmark curves. The government curve shows the cost of borrowing for the government over various terms. The swap curve shows the cost of borrowing for large financial institutions such as banks. The swap curve is derived from the rates on interest rate swaps which are based on LIBOR (London Interbank Offer Rate), the rate at which banks lend to each other. The spread between the two curves represents how much more risky banks are than the government. This spread is viewed by the markets as a barometer for credit risk in the economy as a whole. When companies find it more difficult to repay their bank loans, banks become more risky and the spread increases.
The Bloomberg screenshot shows how the swap spread increased during the 2008 financial crisis. Banks found it difficult to borrow money as there were concerns that they might fail.
The yield curve is normally upward sloping reflecting the higher rates required to compensate investors for inflation risk in longer term investments. An inverted curve means that short term rates are higher than long term rates. This occurs when the market believes that central banks will have to reduce rates to stimulate the economy. Central banks rates are at the short end of the curve. This is generally regarded a leading indicator that the economy will shrink or at least grow more slowly. A humped shape sometimes occurs when there is significant demand or supply at one particular point in the curve. For example high demand for pension funds for long dated bonds together with limited supply of long term bonds will push up prices and bring down yields at the long end of the curve.
The yield curve may twist and/or butterfly as well as shift upwards or downwards.
match.pdf
Overleaf are six yield curves for the following markets, as they were in May 2012. 1. Greece 2. Indonesia 3. Japan 4. India 5. UK 6. USA
Required Identify which yield curve correctly depicts the yields in each market.
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Money market securities are debt securities that mature within one year. Included in this group are short-term certificates of deposit, banker acceptances, and commercial paper.
The yield on a money market instrument tells investors what their returns are, based on current market prices. Different instruments quote their yields using different conventions, but all use simple interest to annualize the returns. An instrument quoted on a discount yield basis is calculated using the equation discount/par. In other words, these instruments are issued at a discount and are redeemed at par. An instrument quoted on a money market yield basis is calculated using the equation interest/par. In other words, these instruments are issued at par and are redeemed at par plus interest received for the period.
Repos are financial instruments used in the money markets and capital markets. A more accurate and descriptive term is Sale and Repurchase Agreement, since what occurs is that the cash receiver (seller) sells securities now, in return for cash, to the cash provider (buyer), and agrees to repurchase those securities from the buyer for a greater sum of cash at some later date. There is little that prevents any security from being employed in a repo; so, Treasury or Government bills, corporate and Treasury / Government bonds, and stocks / shares, may all be used as securities involved in a repo. A reverse repo is simply a repurchase agreement as described from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a 'repo', while the buyer in the same transaction would describe it a 'reverse repo'. So 'repo' and 'reverse repo' are exactly the same kind of transaction, just described from opposite viewpoints.
The buyer earns the interest/return on the underlying hypothecated security for the period the money has been lent to the borrower. A repo transaction is closed out when the party in the first leg that sold the underlying security buys it back for a greater sum of money. That greater sum being all of the cash lent and some extra cash (constituting interest, known as the repo rate). Because of the collateral posted by the seller, they can often borrow at sub LIBOR rates. The length of the repo deal may vary but over night repo, one and two week repo and one month repo are common terms. Repos trade on a money market basis with a ACT/360 day count for USD, EUR and JPY.
A certificate of deposit (CD) is a product used to loan money to a bank or credit union. The certificate of deposit earns interest at a fixed rate over a set period of time. The interest rate is usually a higher rate than a savings account, because the money cannot be withdrawn until maturity. If it is, the bank will charge a penalty. The other option for the holder of a CD is to sell it on the secondary market CDs trade on a money market basis.
Commercial paper is an unsecured obligation issued by a corporation (or bank) to finance its short-term credit needs, such as accounts receivable and inventory. Maturities typically range from 2 to 270 days. Commercial paper is usually issued by companies with high credit ratings, meaning that the investment is almost always relatively low risk. Commercial paper trades on a discount basis.
On any given day, some banks receive more payments than expected, or make more payments than expected. Interbank lending forms an important part of a banks ability to operate on a day to day basis. Without the ability to borrow from one another, banks would need to hold more capital, which comes at a cost, to offset these random movements. In normal times, banks lend to each other at large volume and low cost, for periods ranging from overnight to a few months. Interbank lending trades on a money market basis.
A treasury bill is a short term (less than one year) government zero coupon bond. As they are zero coupon bonds, treasury bills do not pay interest. They are instead issued at a discount to their face value. Treasury bill prices are used to determine short term risk free rates. Bills trade on a discount basis.
A sales colleague of yours was in the middle of arranging five money market trades on behalf of five clients, but had a sudden very violent sneezing attack. This scattered all the paperwork and put the individual in hospital. Time is running out and you now have to quickly identify which trade belongs to which client, armed only with the following information:
Trade one Trade two Trade three Trade four Trade five
the purchase of a certificate of deposit a reverse repo transaction the purchase of commercial paper the purchase of a T-Bill an inter-bank deposit.
Client A
Is a high net worth individual who wishes to buy a money market instrument quoted on a discount yield basis, not issued by a bank and with credit risk. Is a bank that wishes to invest in a money market instrument quoted on a money market yield basis, issued by a bank and with credit risk. Is a high net worth individual that wants to buy a money market instrument quoted on a discount yield basis, not issued by a bank and with no credit risk. Is a high net worth individual who wants to buy a money market instrument quoted on a money market yield basis, issued by a bank and with credit risk. Is a trader in an investment bank who wants to invest in a money market instrument quoted on a money market yield basis and requires collateral to protect themselves from credit risk
Client B
Client C
Client D
Client E
Duration
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The price of a fixed coupon bond has an inverse relationship with interest rates. That is, when interest rates rise, fixed coupon bond prices fall. Duration is a measurement of a bonds price sensitivity to changes in interest rates. A high-duration bond, or one whose maturity date is a long way out in the future, is more sensitive to interest rate changes than a bond with a shorter maturity date. Duration is measured in years.
A general rule is that a bond with a longer duration is far more sensitive than a bond with a shorter duration. Additionally, zero coupon bonds have the same duration and maturity and therefore have the highest risk to interest rate changes.
Each cash flow in a fixed coupon bond has a duration, just like the cash flow from a zero coupon bond has a duration. The duration for a fixed coupon bond will be slightly less than the time to maturity. Duration for a fixed coupon bond is the weighted average term to maturity of a bonds cash flows.
To calculate the duration of a fixed coupon bond, begin by setting up a table as if pricing the bond. Two additional columns are required - these are needed to calculate the weighted term to maturity of each cash flow in the bond. The sum of these gives Macaulay Duration.
Cash flows from conventional bonds are the coupons and the repayment at final maturity. The size and timing of these cash flows is what determines a bonds duration Because the final repayment is much larger than the coupons received, the timing of this repayment is the biggest factor influencing duration - the longer the maturity of the bond, the longer the duration. This is the single most important driver of duration. Holding maturity constant, a bond's duration is longer when the coupon rate is lower. This rule is due to the impact of early higher coupon payments. Holding other factors constant, the duration of a coupon bond is longer when the bond's yield to maturity is lower. This principle applies to coupon bonds. For zero-coupon bonds, the Macaulay Duration equals time to maturity, regardless of the yield to maturity. From this then, we know that the longest duration bonds will have a long maturity date and a low (even zero) coupon rate, and the shortest duration bonds will have short maturity dates and high coupon rates.
We can use Macaulay Duration to determine the P&L for small changes in yield. For a given change in yield, the market value of our position changes by Change in yield x Duration. This gives us the % change in the value of our portfolio. To calculate the P&L, we take this % change in the value of our portfolio and multiply it by the Market value of our position.
Macaulay Duration measures the average term of the cash flows that make up the returns on a bond. The units for Macaulay Duration is therefore years. Modified Duration expands or modifies Macaulay Duration to measure the responsiveness of a bonds price to interest rate changes. It is defined as the percentage change in price for a change in yield.
Previously we calculated the P&L for the above positions using the Macaulay Duration. Now we can calculate the P&L for the above positions using the Modified Duration. Remember, the Modified Duration is given by: Modified Duration = Macaulay Duration/(1+YTM)
Duration exercise
You have a position with a market value of 10MM in the 10% JLS bond which is trading at a yield of 8%.
Required 1. Calculate the price of the JLS Inc Bond. 2. Calculate the Macaulay and Modified Durations. 3. What P&L will result from a 10bp reduction in yield? 4. What P&L will result from a 20bp increase in the yield?
Hint: For parts one and two use a notional of 100 to calculate the price and duration.
Proforma JLS Inc Year Cash flow Discount factor 0.9259 0.8573 0.7938 0.7350 0.6806 PV % % Yr
1 2 3 4 5
Modified Duration
There are a number of common trading strategies investors in the fixed income markets should be aware of. We will look at four strategies.
When interest rates change, the value of existing bonds in the market will move in the opposite direction. The sensitivity of the bonds price to changes in interest rates is measured using duration. An investors view of future interest rate movements will help them determine whether they want to invest in bonds with a long duration or a short duration. If the investor believes rates will rise in the future, they will want to invest in bonds with a short duration as the prices of these bonds will only fall by a small amount. If the investor believes rates will fall in the future, they will want to invest in bonds with a long duration as the prices of these bonds will only rise by the greatest amount.
Interest rate movements affect the shape of the yield curve. Interest rates often move by different amounts and/or different directions at different points of the yield curve. For example, a flattening twist means short term interest rates are falling while longer term rates are rising. In this instance, a fixed income investor may want to sell longer dated bonds as the values are decreasing (due to a rise in interest rates) and buy short dated bonds whose values are rising (due to falling interest rates).
Consider two bond portfolios. The first portfolio (bar bell) consists of 60% two year zeros and 40% seven year zeros. The bullet portfolio is 100% four year zero coupon bonds. Calculating the duration of each portfolio will enable the investor to predict the change in value of each portfolio given a change in interest rates, and hence determine the most appropriate trading strategy. However, the nature of the change in interest rates (e.g. flattening or steepening twist) is also important.
The Macaulay duration of a zero coupon bond is equal to its maturity. Using a weighted average, the duration of the bar bell portfolio is four years, which is the same as the Macaulay duration of the bullet portfolio. However, this does not necessarily mean they react in the same way to changes in rates.
Assume a flat yield curve at 5%. For a parallel shift in yields, both portfolios change by a very similar amount. However, the situation is different for a flattening twist, which describes short term rates increasing and long term rates decreasing. Because yields at the four year mark does not change, the value of the bullet portfolio does not change. However, the value of the bar bell portfolio does change. The value of the two year zeros decrease due to a rise in short term rates. The value of the seven year zeros rise in value dues to a fall in rates at the longer end of the yield curve. However, as seven year bonds have a longer duration, these rise in value by more than the two year zeros fall in value. This means that overall the value of the bar bell portfolio increases.
Another trading consideration for fixed income investors concerns changes in credit spreads. Credit spreads measure the difference in yields between different types of bonds e.g. government bonds and corporate bonds. Under improving economic conditions, the credit risk of corporate bonds decrease as they are more able to meet their bond obligations. This means the spreads between government bonds and corporate bonds decrease. A fixed income investor may chose therefore to sell government bonds and buy corporate bonds - the falling yields of the corporate bonds indicate a rise in value of existing corporate bonds.
Finally, if a bond is trading above its normal yield curve, this indicates the bond is relatively cheap to its peers. This may represent a buying opportunity. However, the investor should ensure there are no reasons for this that may justify its higher yield and that it is in fact mis-priced.
26 41490 IB
Butterfly Bank
You are an investment manager for Butterfly Bank. You are currently managing an index plus bond portfolio. The Macauley Duration of the index is five years and the portfolio policy requires that you maintain that duration. The yield curve is currently flat with spot rates for all maturities of 6%. You believe that long term and short rates will decrease but five year rates will remain constant. You are considering adding some new bonds to your portfolio and the following securities are available.
Two year zero coupon Five year zero coupon 10 year zero coupon.
Required a) What proportion of each bond will you purchase in order to maximize your gain from the forecast interest rate movements but maintain the duration of the portfolio? If two and 10 years rates both fall by 0.25% and five year rates remain the same what would be the value of the bonds purchased in part (a)? If the duration constraint is removed what bond would you purchase and what gain would you expect from the purchase?
b) c)
27 37887 IB CORE
Convexity
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Modified Duration can be used to approximate the price change of a bond in a linear manner. However, the price and yield relationship is not exactly linear. The relationship is actually curvilinear. The diagram above shows the approximation using Modified Duration as a straight line and the actual price-yield relationship as a curve. The degree of the curvature is known as the convexity and this must be taken into account when accurately calculating the price movement of a bond with respect to changes in yields
The formula for calculating convexity looks very much like the formula for modified duration. This is because both duration and convexity are derivatives of the price of a bond as a function of changes in its yield. Duration is the first derivative. Convexity is the second derivative of the price with respect to yield. The bonds convexity is equal to the sum of the last column above, divided (1 + YTM) squared.
Investors can add convexity to the modified duration used previously in order to calculate the bonds new price for a given change in yield using the formula above. This formula says that the percentage change in the price of a bond for a given change in its yield to maturity is arrived at by multiplying its modified duration by the change in YTM and adding the convexity based correction factor.
Convexity is a desirable feature of a bond. The example above demonstrates why. The current market price of a 3 year 5% annual bond is 102.78, and an investor currently owns 1MM. If rates rise by 1%, the price of the bond falls, but because of convexity it doesnt fall by as much as predicted by using duration alone (26,980 fall compared to a fall of 27,500. Conversely, if rates fall, the price of the bond rises by even more than is predicted by using duration alone (28,020 compared to 27,500).
Because both duration and convexity are derivatives of the price of a bond as a function of its yield, the factors that drive duration also drive convexity. An increase in term, and a decrease in both the coupon and yield to maturity all have the same effect on convexity, namely increasing it.
Derivative markets can be seen to be linked closely with other commercial markets. Physical markets are found throughout the economy. Goods and services are exchanged for cash or payment in kind. Capital markets are the core of the financial markets. Firms and governments access funds via the capital markets by issuing shares and/or bonds. In essence, these are the markets which have developed over time to match lenders with borrowers. By contrast, derivatives markets have developed to transfer price risk from one entity to another. Example An oil refinery buys physical crude oil and sells refined products, such as heating oil, just fuel and diesel. From a price risk perspective the refiner will lose money if Crude oil price rises Refined product prices fall.
The owner of the refinery may look to reduce these potential losses by using derivatives to fix the prices for a certain time period. In this way the refinery has passed by risk to the derivative counterparty. Speculators - look to generate revenue by buying and selling financial assets Hedgers - look to pass on price risk and thus reduce exposure to change is price Arbitragers - look to generate revenue from price differences between markets.
In over the counter (OTC) markets, institutions trade directly with each other. Thus counterparty risk must be considered for all such transactions. Counterparty risk is defined as the credit risk (chance of not getting paid either interest or principle) by trading with a specific counterparty. The OTC markets are viewed as the tailored markets. Customers can find solutions which are fully flexible to specific requirements in terms of: Volume Dates Changes during life of the product Currency.
By way of contrast, exchange traded markets have none of the flexibility of the OTC markets. All contract have fixed characteristics which are set before a single trade is executed. Trades are executed with a central counterparty and credit risk is controlled by a system of daily mark to market and margin payments. In this way exchange traded markets are regarded as having close to zero counterparty risk. In reality this appears to be true as there has not been a bankruptcy of an exchange in history; even during the extreme volatility of the credit crisis.
An example of the fixed definitions of a future contract. Contract size - one contract has the risk and profit and loss characteristics of the defined volume. In this case 100 Troy ounces. Trading (delivery) months - each specific contract has an end date. At any given time a certain number of contracts into the future are available. In this case contracts are available with delivery dates in the next three months. Then six contracts are available for the next two years of dates and only two contracts are available for two year to five year delivery. Tick size - this is the minimum price movement that can be traded. Quality - some contracts can be physically delivered. In the case of delivery the quality of the physical product has to be defined. Differing quality can be seen to change the value of the contract. In the case of gold a lower fineness would have a lower value. Delivery - in the case of physical delivery there is a method for executing this delivery.
Description page for Gold future. Related dates First and last delivery is listed. This contract has physical delivery during the delivery month. It is not practical to force physical delivery of commodities onto one calendar day, so a delivery month is found.
Agreement between two parties Traded on a recognized futures exchange To exchange a specific quantity and quality Of defined asset At agreed price On agreed date or dates In the Future.
Future description page from Bloomberg for the FTSE future. Contract specifications These are set by the exchange and cannot be changed. Name - December 2012 FTSE 100 equity index future. Ticker - Bloomberg code. Z is the FTSE 100 equity index futures. Z2 means December 2012. Exchange - Liffe NYSE. Underlying - the physical market which the future prices against Contract size - defined at the index * 10. Value of 1.0pt - monetary value of one contract and a price movement of 1.0 i.e. 5,803.5 to 5,804.5. Tick size - 0.5. Tick value - 5, tick value = tick size x contract size = 0.5 x 10. Futures Profit/loss = tick value * number of ticks * number of contracts. The definition above states that a price movement of 1.0 equates to 10 of profit. Thus, with a tick defined as a price movement of 0.5 the value of that tick becomes 5. Price - current index level. Contract value - the index * 10. With equity index futures buying one contract produces the same exposure as buying this value of the shares which make up the index.
Margin Money that is placed as collateral per contract. Initial - placed when trade is executed Trading hours Period during which futures can be bought and sold. Related dates Cash settled - this contract is not physically settled at maturity. The final trading price of the future (exchange delivery settlement price) is used to calculate final profit and loss of all open positions. Last trade - on this day the future stops trading. Valuation date - date when final profit and loss on final open positions is calculated. Month symbols: Jan (F), Feb (G), Mar (H), Apr (J), May (K), Jun (M), Jul (N), Aug (Q), Sep (U), Oct (V), Nov (X), Dec (Z).
Future description page from Bloomberg for the Nikkei 225 future. BBGID Identification code introduced by Bloomberg. Trading hours The Nikkei 225 futures trade in both electric and pit format. Pit trading is sometimes known as open outcry and involves a physical market where trading wearing coloured jackets used hand signals to communicate with each other. Price range Limit set to manage large price movements over a short period. This is slowly becoming less popular and many exchanges no longer operate with price ranges in place e.g. CBOT, Eurex.
Description page for single stock future Sony Corporation. Traded in Chicago in USD. Thus conversion between the Japanese share price and the future is the USD/JPY FX rate.
Margins
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The NYSE LIFFE (London International Financial Futures Exchange) cocoa future settles through the LCH.Clearnet SA clearing house. After clearing, both buyer and seller of the future have a position with the clearing house, via a member firm, often known as a futures broker.
The central counterparty takes margin from both buyer and seller. The central counterparty only deals directly with member firms. Investors and traders that are not members of the central counterparty must have an account with a clearing broker in order to place a trade.
Both the buyer and seller will deposit initial margin when the position is opened. The value of the initial margin is set by the exchange.
Each day the position is marked to market. Variation margin will be either paid or received each day as the price moves. This example shows a long position, so variation is paid out when the price falls (loss) and is received when the price rises (gain).
The total margin paid over the five days from the previous page is 100. The future is physically settled for the spot price on the final day. The sum of the variation margin payments and the final settlement price equals the price that the future was entered at.
When the trade is opened both parties deposit margin into their accounts with the exchange. Then each day variation is paid or received. Margin is paid by the party incurring a loss and received by the party enjoying a gain. There is often a secondary or maintenance margin set at a lower level than the initial margin. Margin calls occur when the maintenance margin level is reached. In this example the maintenance and initial margin have been set at the same level.
At the end of the contract the initial margin can be withdrawn. If the contract is physically settled a final exchange of cash and asset is made.
A single stock futures contract on OneChicago for American Express has the following features. Contract size Quotation Tick size Tick value 100 shares of underlying security $ per share $0.01 $1.00
The settlement prices of the futures contract between June 5 and 8 are: June 5 6 7 8 $51.00 $51.25 $51.10 $50.85
A long position is taken in one contract on June 5 at $51.05 and closed on June 9 at $50.80.
Requirement 1. Calculate the variation margin payable and receivable each day from June 5 to June 9 on a per share and per contract basis. 2. Assume that June 9 was the last day of the contract and 50.80 was therefore the delivery price. What price would have been paid in total for the shares. Your answer should show the two components of the total price, variation margin and the delivery price on a per share and a per contract basis.
There is a simple relationship between the spot and forward prices of many assets. To understand the relationship requires an understanding of cash and carry arbitrage which is explained in the following pages.
Cash and carry price The cash and carry price is the all in cost of buying an asset in the spot or cash market and holding or carrying the asset until some future date. Some costs will be incurred by holding the asset including interest on the money borrowed to buy the asset, storage and insurance. These are called carry costs. The asset may generate some income, for example shares pay dividends and bonds pay coupons. This income is called a carry return. The cash and carry price is the spot price of the asset plus carry costs less any carry returns.
The future or forward price is price that can be locked into using a future or forward contract for delivery on some future date.
If the cash and carry price and the future price are not the same then there is an opportunity to arbitrage a profit. In the example above, $100 can be made by buying 100 Oz's of gold in the spot market and selling it in the futures market.
In an arbitrage free market the future price and the cash and carry price will be the same. When they are the same a simple relationship holds between the future and spot prices.
Contango The future price will be higher than the spot price when the carry costs are larger than the carry returns. If this is true then the market is said to trade contango. Backwardation The future price will be lower than the spot price when the carry costs are smaller than the carry returns. The market is said to be in backwardation.
The gold market is trading contango. That is, the future prices are higher than the spot prices. Gold trades contango because the carry costs are higher than the carry returns.
In this example the US equity market is trading in backwardation. The future prices are lower than the spot price. The carry cost is the interest on the money borrowed to buy the shares. The carry returns are the dividends on the shares. In this example the carry costs are smaller than the carry returns.
Arbitrage opportunities
Spot Future
The future prices are for delivery in 12 months. The cost of finance is 1% per annum and the dividend yield on the S&P 500 is expected to be 3% pa.
Requirement 1. Identify any arbitrage opportunities that exist in the precious metal markets What trade would you make as an arbitrager? 2. Calculate the expected future price for the S&P 500. Formula Future price = Spot price + Carry cost - Carry return
Short term interest rate (STIR) futures settle at maturity against three month LIBOR. These contracts can be seen as lending money for three months when buying the futures: If three month rates fall the money can be borrowed at a lower rate, thus making a profit. Falling rates will be reflected as a rise in the price of the future, thus making a profit.
In a similar way, borrowing money for three months is the same as selling futures: If three month rates rise the money can be lent out at a higher rate, thus making a profit. Rising rates will be reflected as a fall in the price of the future, thus making a profit.
The opposite is true for a seller of futures: Profit if the futures falls in price, as rates rise Loss if the futures rise in price, as three month rates fall.
Eurodollar futures trade for 10 years into the future. Each contract represents the specific 90 day period in to the future. Calculation of tick value These are interest rate contracts so profit/loss is calculated using the formula for interest cash flow. Interest cash flow = Nominal * interest rate move * day count Using the table above: Interest cash flow = $1,000,000 * 0.005% * 90/360 = $12.50 Thus, the profit and loss from one contract and a movement in the price of the future of 0.005 is $12.50, the tick value
Cash settlement All STIRs are cash settled at maturity against the Exchange Delivery Settlement Price (EDSP) on the final trading day. This is because it would be totally impractical to physically settle into a three month loan; particularly in terms of credit exposure. Profit and loss calculation Profit or loss = number of contracts * number of ticks * tick value For example, a trader buys 100 Eurodollar contracts at 98.980 and sells them at 99.115. The price has increased by 0.135 which is 13.5bp or 27 ticks (as the tick size is 0.5bp = 0.005%). Profit/loss = 100 * 27 *12.50 = $33,750
This table shows the available Eurodollar contracts at any given point in time. Each contact represents a 3 month period which starts on the maturity of the future contract, which is normally the 15th of the month. For example: Mar 3 (EDH2) - 15th March 2013 to 14th Jun 2013 Jun 3 (EDM2) - 15th June 2013 to 14th September 2013 Sep 3 (EDU2) - 15th September 2013 - 14th December 2013 Dec 3 (EDZ2) - 15th December 2013 - 14th March 2014. 1st year is known as the whites 2nd year is known as the reds 3rd year is known as the greens 4th year is known as the blues.
A Forward Rate Agreement (FRA) is an OTC product which allows a customer to agree the funding rate for a particular period ahead of time. As an OTC product, FRAs can be tailored to the exact customer requirement in terms of dates and volume. By contrast, futures have fixed dates and volumes.
Equity options
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Single Stock Futures (SSFs) are futures contracts on individually listed shares. They are standardised contracts with set specifications regarding size, expiry dates and tick movement. The value of a SSF contract is normally equal to 100 times the particular shares futures price. When trading in futures contracts an investor can take one of two positions: Long (buy) or Short (sell). A long position profits from a rise in value of the futures contract while a short position profits from a fall in value of the futures contract.
An option is a contract in which the holder has the right (but not the obligation) to buy or sell the underlying asset at an agreed-upon price on or before the expiration date of the contract, regardless of the prevailing market price of the underlying asset. A call option gives the holder of the option the right to buy the underlying asset. The holder of the option will exercise the option if the underlying price is higher than the strike price. A put option gives the holder of the option the right to sell the underlying asset. The holder of the option will exercise the option if the underlying price is lower than the strike price.
When a person buys an option, they pay the option seller a premium. The call option holder will exercise the option if the price of the underlying asset is higher than the strike price on expiration. The writer of the option must deliver the underlying asset or pay a cash amount depending on the underlying asset.
When a person buys an option, they pay the option seller a premium. The put option holder will exercise the option if the price of the underlying asset is lower than the strike price on expiration. The writer of the option must buy the underlying asset or pay a cash amount depending on the underlying asset.
Pay off diagrams for options are a good way to understand what happens to the value of an option position as the value of the underlying changes. For a long call option, we pay a premium to buy the contract and profit from the position if the underlying rises by more than the strike + premium. For a long put option, we pay a premium to buy the contract and profit from the position if the underlying decreases by more than the strike - premium.
For a short call option, we earn a premium but lose money if the underlying asset rises by more than the strike + premium. For a short put option, again we earn a premium but lose money if the underlying asset falls by more than the strike - premium.
An option is considered in-the-money if at that time the holder of the option could profit from their position by exercising the option i.e. the underlying asset price is higher than the strike price for a call option. An option is out-of-the-money if at that time the option would expire worthless to the option holder i.e. the underlying asset price is below the strike price for a call option. An option is at-the-money if the price of the underlying asset equals the strike price.
This strategy is a relatively simple hedging policy used by a fund manager who is worried about the short-term prospects for the market. The most commonly used options in this example would be put index options, which would mitigate any sharp falls in the underlying basket of stocks being managed. Naturally the index options would be against the index that the fund manager is specifically trying to outperform or are most closely associated with, whether it be the FTSE 100, the Hang Seng or the S&P 500. The reason why this strategy is attractive is because the typical long only fund manager will remain fully invested in line with his mandate.
This table calculates the fund managers return based on various levels of the S&P 500 at expiration. For example, assume the fund manager buys portfolio insurance by holding the three month S&P 500 put with a strike of 1,360 and premium of 30. At expiration the S&P 500 was at 1,360 the fund manager loses 40 on the value of their underlying but has also paid a premium of 30 on an option they will not exercise as it is at-the-money. This net loss is 70 for a ROI of (5.00%). If the fund manager chose not to buy a protective put, the loss on the unhedged position would be 40/1400 = (2.86%). However the protective put limits the loss to (5.00%) regardless of how low the S&P 500 falls. For example, should the index fall to 1,280 the ROI becomes: (1,400 1,280) - (1,360 1,280) + 30 = 70/1,400 = (5.00%)
A buy write (also called a covered call) strategy is the name given to the strategy by which one sells a call option, thereby collecting a premium while owning the underlying stock, i.e. cover for delivery. The writer or seller of a call option takes on the opposing position to the call option buyer, and assumes the obligation to sell the shares in the underlying stock at the fixed strike price if the option is assigned. An uncovered call writer would be obliged to buy shares he or she does not own in order to deliver them upon exercise, and this could prove very expensive to the fund manager.
The call option writer should be mildly bullish, towards the underlying stock. By writing a call option against a stock, one always decreases the risk of owning the stock. It may even be possible to profit from a covered write if the stock declines slightly. However, the covered call limits profit potential and therefore the fund manager may not fully participate in a strong upward move in the price of the underlying stock, as it will inevitably be assigned at the strike price. The fund manager can construct the pay-off diagram for a buy write strategy by combining the pay-off diagram for a short call and being long the underlying stock.
A buy write strategy is an example of a yield enhancing strategy. Yield enhancing strategies in general involve writing options to collect a premium - when an investor writes a call when owning the underlying it is called a covered call while if an investor writes a call when not owning the underlying this is referred to as an uncovered or naked call. Investors may also write puts when implementing a yield enhancement strategy. If you are interested in buying XYZ Inc. you could place a limit order to buy at no more than 90. However, in writing a put with a strike of 90 you are promising to pay the buyer of the put XYZ Inc. at 90 (which is equivalent to the limit order) with the added bonus (i.e. the yield enhancement) of collecting the 0.58 premium.
This table compares the strategy of placing a limit order to purchase a stock against that of writing a put on a stock. If the stock falls to 90, the put is exercised and the writer will have to buy the stock at the strike price of 90, equivalent to the buy order with a limit of 90. However, as the writer earned a premium of 90 they end up buying the put at a more favorable price. This is the yield enhancement. In the other scenarios when the stock doesnt fall to the target price of 90, even though both strategies fail to acquire the stock, the option writer has at least earned a premium of 0.58. One advantage of the limit order is that it can be cancelled at any time with no fee as long as the order has not been partially filled (in which case there will be a trading fee to pay).
A bull call spread uses a combination of two calls, but is a single direction strategy - i.e. the investor believes the price of the underlying will increase. The investor buys a single call contract at any strike price, and then sells a single call contract at a higher strike price (i.e. farther out of the money) on the same underlying asset. The profit comes from the difference in the strike prices of the two calls. If the price of the underlying moves up a small amount, the long call will go into profit yielding a positive return to the investor, but the short call will not be exercised. If the price of the underlying moves up by a large amount, both calls will be exercised. If the price moves down, neither call will be exercised. The profit of a bull call spread is calculated as: Maximum profit = Short call strike price - Long call strike price - Initial debit where the initial debit is the cost of the long call minus the premium received for the short call.
The pay-off diagram for a bull call spread is a combination of the pay-off diagram for a long call (at a lower strike price) and a short call (with a higher strike price). As the strike for the long call is lower, the premium will be higher than the premium of the short call. However, as the investor is earning the premium for the short call, this goes someway in financing their long call position. The strategy is moderately bullish (hence the term bull in the name of the strategy). It is less bullish than simply purchasing the long call as the investor forgoes the chance of making a large profit in the event that the underlying asset price skyrockets. However, the risk is reduced due to the income generated from the short call.
A bull put spread uses a combination of two puts, but is still a single direction strategy like the bull call spread i.e. the investor believes the value of the underlying will increase. The investor buys a single put contract at any strike price, and then sells a single put contract at a higher strike price (i.e. farther in the money). The profit comes from the difference in the strike prices of the two puts. If the price moves up a small amount, the long put will expire worthless, but the short put will expire in profit, and if the price moves up by a large amount, both puts will expire worthless. If the price moves down, both puts will go into profit. The profit of a bull put spread is calculated as: Maximum profit = Initial credit where the initial credit is the premium received for the short put minus the cost of the long put. As the long put has a lower strike price, the premium will be lower as it is less likely to be exercised.
A long straddle involves buying an at-the-money call and at-the-money put, in combination. At-the-money options have a Delta that is 0.50 while an at-the-money put has a Delta of -0.5. Therefore, if we own a call (positive Delta) and own a put (negative Delta), both of which have the same Delta value but different signs, then we can calculate the position Delta easily. The Deltas of -0.50 and +0.50 cancel out, leaving position Delta at zero.
By combining call and put options, sophisticated pay-off scenarios can be generated. You will find details below of eight option strategies. Overleaf you will find seven payoff diagrams. 1. Long call @ 5.00 2. Long put @ 5.00 3. Short straddle short call @ 5.00 short put @ 5.00 4. Long straddle long call @ 5.00 long put @ 5.00 5. Short call @ 5.00 6. Long strangle long put @ 5.00 long call @ 8.00 7. Bull spread long call @ 5.00 short call @ 8.00 8. Short put.
Required Match each strategy to its payoff diagram. Which strategy has no payoff diagram? Draw its diagram in the space overleaf.
Value judgements
You are working on the equity derivatives desk managing the trading book for Microsoft. A junior employee is unsure about how various factors will affect an options premium. You decide to create a simple cheat sheet for them. Driver Stock price Strike price Time Volatility Risk free rate Dividend yield Call Put
Required Complete the cheat sheet showing how the option premium will react for calls and puts to an increase in each of the drivers.
While under the normal distribution there is a continuous range of outcomes for the stock return, the binomial option pricing model allows for a simplifying assumption to be made when pricing an option on the underlying stock. We assume that the stock price can either go up by a certain amount with a given probability, or down by a certain amount with a given probability. This means at the end of the period there are only two possible outcomes for the stock price, and hence the name binomial pricing model. This example uses a one year European equity call option. The fair premium of this option is equal to the present value of the future pay-offs an option holder would receive if they owned the option. To calculate this fair premium, the option holder will need to work out what the future stock price will be, whether they will exercise the option, and what their pay-off will be if they do exercise the option.
Firstly, an investor will need to calculate the possible future stock prices. Secondly, for each of these possible future prices the investor will need to determine whether they will exercise the option or not and hence what their pay-off will be. Finally, they will discount these future pay-offs to calculate the value of the future pay-offs to calculate their present values. The sum of these present values will give the investor the fair option premium.
The first step is to calculate the possible future stock prices. Using an up factor of 1.25 (i.e. if the stock moves up, the price after one year will be 1.25 times the price today) and a down factor of 0.8 (i.e. if the stock moves , the price after one year will be 0.8 times the price today) the two future prices can be calculated.
Once the two possible stock prices are known, the option holder can determine whether they will exercise the option or not, and hence what their pay-off will be. For call option, if the stock price is higher than the strike price the option holder will exercise the option. Otherwise they will let the option lapse.
Once the option holder knows the expected future payoffs, they need to discount the expected values to find their present values. The expected value of a future cash flow is the weighted average of the values that it can take on, where each possible value is weighted by its respective probability. In the above example, there is a 60% chance of receiving a pay-off of 35, giving the option holder an expected cash flow of 21 (60% x 35) and a 40% chance receiving a cash flow of 0. To discount these future cash flows, multiply them by a discount factor of 1/(1+r%)^n where r% is the discount rate and n is the time period. Over one year, this is equivalent to dividing the sum of the expected cash flows by (1+r%), or 1.07. This yields a fair value for the option of 19.63. Another way of expressing this is that the present value of the future expected pay-off from owning this call option is 19.63.
A more accurate answer is obtained by increasing the number of discount periods. The approach however is the same: the option holder must first determine the possible future values of the underlying stock using the input data.
Starting with a current price of 100, there are three possible outcomes for the underlying stock, each with its own probability of occurrence. The option holder now must decide whether they will exercise the call option or not.
To calculate the option pay-off, if the stock price is higher than the strike price, the option holder will exercise the option and receive the difference. If the stock price is lower than the strike price, the option holder will let the option lapse and the pay-off will be 0.
As this is a two step model, the discounting in done in two steps, one for each period.
To discover the fair option premium, the option holder must discount the expected values after one year back to the present using the same DCF methodology. Here, a two year European call option has a fair value premium of 25.03. This means, based on the inputs, the present value of the expected future cash flows the option holder will receive is 25.03.
There are several advantages the binomial option pricing model has over other option pricing models. While it is relatively easy to implement, the big advantage the binomial model has over other models is that it can be used to accurately price American options. This is because with the binomial model it's possible to check at every point in an option's life (i.e. at every step of the binomial tree) for the possibility of early exercise (i.e. where, due to e.g. a dividend, or a put being deeply in the money the option price at that point is less than its intrinsic value). However, there are drawbacks. A major limitation however is that it does not reflect the full range of possible future stock prices. The binomial option pricing model assumes that there are discrete outcomes for the price of the stock, whereas in reality the stock price can finish any where along a continuum. Other models address this drawback.
The distribution of possible outcomes is approximately a normal distribution, a well known probability distribution producing a bell shaped curve. The location and shape of the normal distribution will be determined by two parameters. The location refers to where the expected outcome of the stock price will be at the end of the period - this expected outcome the is denoted by . The shape (or how spread out the distribution is) will be determined by the volatility of the stock, measured by standard deviation (). European options are valued in practice using the Black and Scholes model which inputs instead of our single point outcomes as discussed in the binomial option pricing model.
The so-called Greeks are universally used within finance to measure the sensitivity of an option premium to changes in one of the option price inputs. The commonly used Greeks are: Delta - sensitivity to changes in the spot price Vega - sensitivity to changes in level of implied volatility Theta - sensitivity to the passage of time Rho - sensitivity to changes in funding rates.
Delta can be thought of in three ways: 1.As a likeness factor to the underlying market, or the change in the option premium for a given change in the underlying market. In the example in the slide the option premium moves half as fast as the underlying market. 2.As the probability of exercise. An option with a delta of 0.5, or 50%, thus there is roughly a 50:50 chance of being exercised. 3.As a hedge ratio. Market exposure to the underlying security can be calculated and then a hedge to this exposure can be transacted if required.
The premium of a call option will rise as the stock price rises. Delta measures this rise. The dotted line shows a point some time before maturity, while the solid line shows the value on the exercise date.
The language of options includes in-the-money-ness. A call option which is in the money will likely be exercised has a delta of close to one A call option which is out of the money will likely expire worthless has a delta of close to zero As the likelihood of exercise increases, the delta increases.
Selling 5,000 shares will hedge the option delta exposure. If the stock price moves higher by 2, the option premium will increase by 1. Profit on the option will be 10,000 options x 1 = 10,000 Loss on the hedge will be 5,000 shares x 2 = 10,000 Using futures to hedge will provide a macro hedge to the call option purchase.
For put options the delta is negative. The premium increases as the stock price goes down. A put option which will likely be exercised has a delta of close to minus one A put option which will likely expire worthless has a delta of close to zero.
However, the language of options does not include this negative sign. As such, a put option which is likely to be exercise is said to have a delta which approaches 1. It is assumed that all of those who discuss options know that a put has a negative delta.
Delta from the put is 20,000 options x delta -0.4 = a short position 8,000 shares. This can be hedged by buying 8,000 shares.
When looking on a portfolio basis, delta of any number of options can be added to give a portfolio delta. In this example, the monetary value of the delta is shown. This can be divided by the stock price to give the correct number of shares to purchase to put on a delta hedge for the portfolio.
This useful cheat sheet gives the sign of the delta for positions in calls, puts and futures.
It is a feature of any option that the delta is dynamic; it will change as the stock level changes. The dynamism is called Gamma. Re-hedging an option portfolio generates the need to re-set the delta hedge thus generating an extra streams of profit and loss from the series of hedges.
part one.pdf
You have had a busy day meeting client orders for options over Microsoft stock. You are concerned that you may be taking on a significant market position. Your positions are set out below: Long Short Long Long Short Puts @ $25.00 Puts @ $30.00 Puts @ $34.00 Calls @ $30.00 Calls @ $33.00 200 contracts 200 contracts 150 contracts 100 contracts 250 contracts
Microsoft is currently trading at $30.02. Details for each option contract are set out in the Bloomberg data attached.
Required 1. Using the pro-forma attached calculate: the delta exposure for each option position. add the deltas to calculate the net market position. 2. Is the net position bullish or bearish? 3. What instruments could be used to make the position market neutral? Which would you use and why?
Delta force - proforma Position Option Number of contracts a Contract size b Number of stocks c (a b) Stock price d Total stock value e (c d) Delta Delta value
f (e f)
Long
Put 20
40 38288 IB CORE
An interest rate swap is an agreement between two counterparties Based on a notional principal To exchange interest payments On an agreed set of dates Calculated on different basis One counterparty will PAY FIXED payments agreed at time of transaction One counterparty will PAY FLOATING payments calculated each period based on a fixing (e.g. LIBOR).
All interest rates are quoted as annual rates as this swap is semi annual, 2% is paid every six months on the fixed side. The floating payments are based on six month LIBOR. As these payments are also semi annual the quoted rate must be halved. The net interest payment is exchanged each period between the two counterparties. Although the principal amounts have been included here as only net payments are made the principal amounts will not be exchanged.
The grid shows the payments that will be made each period. In each case the two payments are netted off and only the resultant net payment is actually paid. Although the principal amount have been included they net to zero and so are not exchanged.
Fund managers Fund managers use interest rate swaps to manager the interest rate risk in their funds. Remember bond prices and yields move in opposite directions. Therefore a fund manager might worry about an increase in interest rates. They can hedge their exposure by paying fixed and receiving floating on an interest rate swap. If rates do rise then the higher floating payments they will receive will help to offset losses in the bond portfolio.
The swap curve is a particular yield curve. It is plotted by charting the fixed rate on new swaps against their maturities. As the fixed rate is swapped for LIBOR, the fixed side is a proxy for what the market believes LIBOR will be on average over various terms. The swap curve therefore indicates the borrowing rates for banks. It is a benchmark curve widely used in the markets. The other benchmark is the government curve.
The table from Bloomberg shows all the swap rates that have been used to construct the swap curve. Notice that for terms of 3 months or less are used for terms of 3 months to 11 months interest rate futures are used and for terms of a year or more swaps are used. Also notice that some swaps have maturities for as long as 30 years.
41 38289 IB CORE
Swap manager.pdf
Swap manager
A corporate client has recently issued some additional fixed rate debt in the bond market with a coupon of 3%. They believe that interest rates will be falling shortly and would like to pay floating instead. You have reviewed the Bloomberg Swap Manager screen (SWPM). You are advising the client on how they can manage their interest rate exposure using an Interest Rate Swap.
Required:
Should they pay or receive fixed on the swap? Will the first settlement be a cash inflow or outflow? (Use the figures given on Bloomberg.) What is the term of the swap in the SWPM? What do you think is measured using DV01?
Interest rate swaps are perhaps the most flexible instrument in finance. Banks can tailor individual IRS deals to perfectly match the requirements from an individual customer. Some of the different ways of tailoring a vanilla IRS are looked at here.
It is very common for end users to require smaller or larger principal amounts during the life of an IRS. These deals are used for hedging interest rate risk and when this risk comes from real physical transactions in a business it is easy to imagine reasons for a change in principal; such as paying off some debt each year, or drawing down tranches of a term loan.
In this example notice how the principal amount reduces from one year to the next.
Any IRS has a present value of zero. For each period principal amount times interest rate is calculated to find the interest payment. These are then turned into present values (1/(1+i)^n). Finally, the sum of the PV of the fixed cash flows is compared to the sum of the PV of the floating cash flows to come up with the IRS value.
In this example notice how the principal amount increases from one year to the next.
Forward starting IRS are also the underlying when considering interest rate options. For example with a one year option into a 10 year IRS, in one year the buyer of the option can exercise into a 10 year IRS. Forward starting swaps are easily priced in the same way as IRS which have a change in principal.
Interest rate swaps are perhaps the most flexible instrument in finance. Banks can tailor individual IRS deals to perfectly match the requirements from an individual customer. Some of the different ways of tailoring a vanilla IRS are looked at here.
It is very common for end users to require smaller or larger principal amounts during the life of an IRS. These deals are used for hedging interest rate risk and when this risk comes from real physical transactions in a business it is easy to imagine reasons for a change in principal; such as paying off some debt each year, or drawing down tranches of a term loan.
In this example notice how the principal amount reduces from one year to the next.
Any IRS has a present value of zero. For each period principal amount times interest rate is calculated to find the interest payment. These are then turned into present values (1/(1+i)^n). Finally, the sum of the PV of the fixed cash flows is compared to the sum of the PV of the floating cash flows to come up with the IRS value.
In this example notice how the principal amount increases from one year to the next.
Forward starting IRS are also the underlying when considering interest rate options. For example with a one year option into a 10 year IRS, in one year the buyer of the option can exercise into a 10 year IRS. Forward starting swaps are easily priced in the same way as IRS which have a change in principal.
US version.pdf
As an expert in swap products, you have been asked for your advice on the following scenarios. 1. Blue Inc. will be raising capital in the fixed income debt market. The bond is due to be issued in three months time. The treasurer would prefer to be exposed to floating rate interest. 2. Yellow Inc. has a loan at LIBOR + 120bp. The loan was used for the acquisition of a cash generative business. Yellow Inc.s strategy is to pay down the loan using the cash flow from the acquisition. 3. Purple fixed income fund is being managed to generate value from movements of the yield curve. The managers models predict an upward shift in the curve. 4. Green Power Generation Inc. is building a new hydroelectric plant. The floating rate funding has been agreed and will be drawn as the project progresses. The Company wants to pay a fixed rate of interest. 5. Red Inc. pays a fixed rate of interest on all of their debt. The corporate treasurer would like to take advantage of falling interest rates. Listed below are five swap structures:
Amortizing swap Accreting swap Forward start swap IRS - fixed rate payer IRS - fixed rate receiver.
Required Determine for each scenario which swap structure is most appropriate. Be prepared to justify your answers.
45 38290 IB CORE
Credit default swaps are a type of insurance policy on bonds and loans. The buyer of a policy will typically make an upfront payment and then pay a regular premium. If the bond or loan suffers a credit event they will be able to make a claim. The original players in this market where banks that wanted to insure themselves against losses in their loan books. If they made a large loan they could insure some of the risk with another bank. Today, Credit Default Swaps are also used by traditional and hedge fund managers to hedge or take views in the market. If there is a default then the CDS buyer is entitled to claim the loss from the CDS seller. It is worth noting that the CDS buyer is allowed to make a claim even if they dont actually own the bonds. In this sense, CDS are different to traditional insurance. In the traditional insurance market you are only allowed to insure your own possessions or assets that you have an interest in.
The CDS buyer pays a regular premium to the CDS seller. The premium has two components which are the points up front and the coupon. For example: Notional 10,000,000 Points up front 300bp (3%) Coupon 100bp (1%) The buyer will make an upfront payment of 3% x 10,000,000 = 300,000. The coupon is paid quarterly but the 100bp is per year. The quarterly payments will be approximately x 100bp x 10,000,000 = 25,000
If there is a default then the CDS buyer can claim the loss from the CDS seller. CDS can be either physically or cash settled. In a physical settlement the defaulted bonds are exchanged for their notional value in cash. In the example the bonds are trading at 40 and will be exchanged for cash of a 100. The value of the claim is therefore 60.
If there is a default and the CDS is cash settled then the seller pays the buyer the loss on the bonds relative to par (100). In the example the bonds are trading at 40, which is a loss of 60 from par of 100. Therefore the settlement is 60. When a default occurs the large investment banks take part in an auction to determine how much the bonds are worth.
Physical settlement There is no need to calculate the post default value of the bonds as whatever they are worth they will be exchanged at par for cash. The seller of protection will receive the defaulted bonds. As a creditor to the company they will get to take part in the negotiations when the company is liquidated. Physical settlement is normally chosen when the CDS buyer owns the bonds. Cash settlement The advantage of cash settlement is that there is no need to physically deliver the bonds. Cash settlement is normally chosen when the CDS buyer does not own the bonds.
In the example the CDS buyer pays points up front and a coupon. Points up front = 2% x 10,000,000 = 200,000 Annual coupon = 1% x 10,000,000 = 100,000
If the bonds default then the CDS buyer will make a claim. If the claim is physically settled then the 10,000,000 par of bonds are exchanged for 10,000,000 of cash. If the claim is cash settled then the loss is settled in cash. As the bonds are trading at 40 after the default they have lost 60% relative to par of 100. The claim is therefore; 60% x 10,000,000 = 6,000,000
CDS indices allow market participants to hedge and take views across a broad range of the credit markets using a single contract. The main European contact covers 125 different companies. Buying the Itraxx index is similar to buying CDS on each of the 125 names. If anyone of the names defaults a claim can be made and the remaining 124 contracts will continue to run.
With reference to the CDSW screens for Exxon Mobil and American Airlines answer the following questions:
1.
2.
3.
4.
5.
6.
Estimate the upfront payment in dollars and state which party will pay it (buyer or seller)?
47 37842 IB CORE
Overview
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Foreign exchange is one of the oldest and most mature of the financial markets. Many of the features of modern markets were first developed in the FX markets; for example electronic trading and exotic options.
The market is enormous is terms of volume. Market participants Banks - provide market making. Commercial companies - translating cash from one currency to another Central banks - managing foreign currency reserves and executing policy Hedge funds - trading.
The currencies of the largest economies dominate volume. This excludes economies which have fixed exchange rates (Hong Kong, Middle East) or a currency which is not currently convertible in international markets (China).
Spot means to trade a currency for delivery in 2 days Forward means to trade a currency with delivery beyond two days FX futures do trade on a number of exchanges but volumes are low compared to the OTC markets FX swaps have two dates. Currencies are swapped in one direction on the first date and then swapped back on the second date. They are different from cross currency interest rate swaps. Options trade over the counter and on exchanges for FX. ETFs or Exchange Traded Funds are a convenient way for many investors to trade in FX.
48 37843 IB CORE
An FX transaction is an exchange of currency. The quotation shows the units of one currency that are required to buy or sell one unit of another currency. Drivers of FX rates Speculation International trade flows Economic fundamentals; for example purchasing power parity.
Theory of markets suggests that the price at which buyers and sellers are satisfied will be found. As the supply or demand curves move the price will move.
International trade and investment are the major drivers of supply and demand, along with short term speculative flows. UK exporters will be looking to sell USD and buy GBP US exporters will be looking to sell GBP and buy USD.
Investment may be direct investment (for example factories) or portfolio investment in financial securities.
Purchasing power parity (PPP) is an economic theory which suggests that all goods and services should cost the same amount in each country if exchange rates are at the correct level. For many years the Economist has published the so-called Big Mac index which explored PPP by using the price of the afore named burger.
Central banks may have substantial foreign exchange reserves. These can be used to finance imports. In the mid 1970s the UK had to go to the IMF to borrow foreign currency (particularly USD) as the Bank of England had run out.
Putting the drivers of FX on a time line. Speculative flows explain why FX rates move from one day to the next or even one minute to the next. In the medium term FX can be explained by supply and demand of currency for trade and direct investment. In the long term economic theory suggests that PPP drives exchange rates.
1.
Inflation - if the general price level (inflation) in the UK is rising relative to that of the US, what will happen to the value of sterling (with reference to demand and supply)?
S0
D0 Q
2.
Short-term interest rates - if the UK Bank of England Monetary Policy Committee (MPC) raises short-term interest rates significantly above the rates in most other countries, what will happen to the value of sterling?
S0
D0 Q
3.
Speculation - if foreign currency speculators expect sterling to depreciate what will happen to the value of sterling (assuming there are no other influencing factors).
S0
D0 Q
4.
Purchasing power - if a McDonald's Big Mac costs 1 in the UK and $1.50 in the US and the current exchange rate is $1.40/1, is sterling under or overvalued? And why?
50 37846 IB CORE
SWIFT is the primary communications tool between banks. It covers all sorts of communications. MT300 message series cover FX and money market transactions. For example, MT381 is for FX order confirmation.
The swift code for a currency consists of 3 letters. Typically the first two letters refer to the country and the final letter refers to the currency, with the notable exception of the Euro (EUR). As these are the codes that will be used in any payment system it is best practice to always use SWIFT codes whenever referring to a currency.
A quote EUR/USD does not mean EUR over USD, but rather USD per EUR. Thinking about FX in terms of algebra generally leads to confusion.
Most quotes within the FX market are above 1, which means that the heavier currency is normally the Base currency. This is not universally the case and there are currently a number of exceptions. When observing a quote it is very important to understand the Base and Pricing currency concept. The quote is in terms of the Base currency. In the example above a higher quote means that the EUR has strengthened relative to the USD as 1 EUR is worth more USD. Thus, buying the FX quote above means buying EUR and selling USD.
When dealing FX it is assumed that the big figure is known. Only the small figure, or pips, are quoted.
Understanding the bid offer spread leads to a greater understanding of how the currencies move relative to each other. An example transaction: A Japanese electronics firm wishes to repatriate receipts of $10m from sales in the US to Japan It receives a quote from a bank in USD/JPY of 77.59/63 Firm sells $10m at 77.59 Value date 2 business days firm will pay bank $10m and receive 77,590,000.
When calculating the volumes for settlement either the base or pricing currency volume is known. Pricing currency volume = rate * base currency volume Base currency volume = rate * pricing currency volume
When observing an FX quote the Base currency rule allows for an understanding of what is quoted. This is a useful rule to remember. The rule illustrates the exceptions to the currency pairs which are quoted below 1. The EUR should be below GBP, and when it was first quoted was quoted GBP/EUR which was higher than 1. The feeling is that politics required the markets to switch the EUR to be Base currency, as the UK was not participating in the single currency. EUR is always Base currency.
An FX trade results in two cash flows. Profits will be in the Pricing currency account unless converted to the Base currency.
This can be worked out using the Base and Pricing currency accounts. The formula is a quick way of calculating P/L and very similar to the way futures P/L is calculated. FX: P/L = number millions * number pips * pip value Futures: P/L = number lots * number ticks * tick value.
The standard is that all currency as quoted versus the USD. So for example if a market participants asked for the price of GBP, it would be assumed they meant GBP/USD. An exchange rate that does not include the USD is known as a cross rate. For example GBP/JPY or EUR/CHF.
Same side, divide is a catchy phrase for remembering how to calculate a cross rate from the rates versus the dollar. Here the GBP/AUD cross rate is calculated from the GBP/USD and AUD/USD rates.
If the rates are not on the same side then they should be multiplied in order to calculate the cross rate. In the example the rates for EUR/USD and USD/CHF are multiplied together to give the cross rate EUR/CHF.
51 37847 IB CORE
Code red.pdf
Code red
Swift codes are used internationally to unambiguously identify currencies. Each code consists of three letters. The first two letters identify the country (in the domestic language) and the third letter identifies the currency's name.
Example AU D Australian Below are 15 Swift codes: 1. 2. 3. 4. 5. 6. 7. 8. 9. USD EUR NZD CLP THB MYR KES ILS SAR Dollar
10. SGD 11. RUB 12. EGP 13. INR 14. BRL 15. ZAR
Required In your groups try to name the country and currency for each of the codes above.
52 37848 IB CORE
Requirement In your group, rank the value of each bag of cash from the most valuable to the least valuable.
53 37849 IB CORE
Approximately 50% of daily FX volumes is FX Swaps, where forward value FX transactions are traded.
The bank will buy USD in 1 year and sell JPY in 1 year; the task is to work out the correct rate for this trade. Following the hedging strategy that the bank will use allows the price to be calculated. Assuming this deal cannot be hedged directly in the FX forward market, there are three stages to match up the cash flows. 1. Borrow USD for 1 year and pay interest 2. Exchange the USD for JPY in the spot market. i.e sell USD/JPY 3. Lend the JPY for 1 year and earn interest
The market parameters used to construct the forward rate are: Spot USD/JPY 93.55 USD 1 year rate 3.0% JPY 1 year rate 1.8%.
The strategy is to borrow $970,873.79 today, which means with interest $1m will be repayable in 1 year. Sell the $970,873.79 at USD/JPY 93.55 to receive JPY 90.825m Lend the JPY 90.825m and earn interest. The loan will be repaid for JPY 92.460m in one year. In one year the bank will receive $1m from the client which it can use to pay off the loan. The bank will receive JPY 92.460m which it can pay to the client. The effective exchange rate is therefore USD/JPY 92.46
The forward rate of 92.46 reflects the fair value at this point in time. The market maker will add the bid/offer spread to the fair value rate, so as to earn a margin. The market maker can hedge the position perfectly if lending and borrowing can be achieved. In reality real libor deals are rare and so the market maker will use STIR futures to hedge the libor exposure. The customer agrees the rate now for a physical exchange of currency in 1 year.
For most currencies Act/360 is used. With GBP Act/365 is the convention.
This relationship can be seen from the forward price formula. Buying the Base currency and selling Pricing currency spot and holding for 1 year: If Base currency has higher libor than pricing currency then carry is positive, so forward price is lower than spot If Base currency has lower libor than pricing currency then carry is negative, so forward price is higher than spot.
In many banks the FX forwards traders have the largest exposure to short term rates in the organisation. An FX forward desk will normally quote rates out until two years. Longer maturity FX forwards are quotes by the interest rate swap desk.
FX swap points, swap points or forward points are all terms for the same thing; namely the forward rate - spot rate.
Pips for most currency pairs are the 4th decimal place. For USD/JPY pips are the second decimal place, thus points of -109 takes spot of 93.55 to forward or 92.46
One of the market conventions in FX is that negative points are quoted as an inverted or backwardated price i.e. 56/52. Such a price indicates that the forward points are negative.
FX swaps language Buying and Selling FX swaps is meaningless If buying EUR/USD value spot and selling EUR/USD value 1 week the language used is buy and sell signifying buying the front date and selling the far date If selling EUR/USD value spot and buying EUR/USD value 1 week the language used is sell and buy.
Process mapping
Q A
A representation of the sequence of activities (activity workflow) which describes how work is done rather than how work is organised (i.e. by department).
17850 p 1
Process mapping
Q A
17850 p 2
Process mapping
17850 p 3
1 MEGA
1.1 MAJOR
1.1.1 SUB
1.1.1.1 ACTIVITY
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1.1.1.1
Find video
1.1.1.2
1.1.1.3
Video available?
Yes
Register rental
Yes
Take money
No End
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Gathering information
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55 40306 IB CORE
Qty 1. Sell 40 at market 2. Buy 100 at market 3. Sell 50 at 26.80 4. Buy 400 at 27.00 5. Sell 200 at market 40 100 300 40 100 60
Spread 26.62 / 26.96 26.72 / 26.96 26.72 / 26.80 27.00 / 27.06 26.61 / 26.96
a) b)
= 190,000 d) PV of 38,000 for each of ten years = 38,000 5.650 = 214,700 e) Present value of 13,000 this year and increasing thereafter at 5% a year forever PV of a growing perpetuity =
c r g 13,000 0.12 0.05
= =
185,714
Answer: You would therefore take 38,000 for each of the next ten years (option d).
1.0% 8.0%
TV 580
PV of forecast period TV Cashflow Value in Yr 3 PV of TV Enterprise Value Net Debt Equity Value Number of shares Fair share price Market Price
1,765
58 38540 IB CORE
Price is right
solution.pdf
A.
J.P. Morgan
There are no sales figures, so PS cannot be calculated Banks are typically valued on price to book or price earnings The PB looks about right for a bank, although the PE is fairly high, although in line with market averages.
B.
GlaxoSmithKline
Relatively high price to book indicative of a highly rated business and/or few assets Likely to be a pharmaceutical business The clincher is the price to sales multiple which is indicative of a business with very high margins, therefore the pharmaceutical business. Surprisingly lowly rated business though.
C.
Loss making business from operating level - therefore no PE Price to sales are very low, hence low margin business No PB as equity and earnings are both negative.
D.
Google Inc.
Very highly rated business - PE extremely high PB very high - plenty of intangible assets Net cash business.
E.
Wal-Mart
Solidly rated company Low margin Some traditional assets PS typical for food retailers.
1.
= = = =
46 million 8 million 14.8% 85.2% 7% 0.7 = 4.9% Cost of capital Weighting 85.2% 14.8% WACC Weighted cost 8.52% 0.73% 9.25%
Equity Debt
10% 4.9%
2.
Cost of equity
= = = = = =
Rf + market risk premium 4% + 0.8 5% 8% 5.0% 0.70 = 3.50% 722 million 7.69 = 5,552m 2,466m Cost of capital Weighting 69.24% 30.76% WACC Weighted cost 5.54% 1.08% 6.62%
Equity Debt
8.0% 3.5%
3.
Market value of equity Market value of debt Debt/equity Cost of debt (pre-tax) Cost of debt =
= = = =
12% 0.65 = 7.8% Cost of capital Weighting 86% 14% WACC Weighted cost 10.3% 1.1% 11.4%
Equity Debt
12.0% 7.8%
60 36782 IB CORE
solution.pdf
You are considering making an investment in the fixed income market. You have obtained the descriptions of a number of issues from your Bloomberg terminal. Using the information attached assess which bonds you would choose under various criteria. Which bond would you invest in if you: 1. Wanted the best possible credit quality? The US and UK government bonds would be regarded in the market as have the best quality The International Bank for Reconstruction and Development and General Electric would also be good choices. 2. Thought interest rates were going to rise? When interest rates and yields rise, generally bond prices fall This is because their fixed coupons look less attractive as rates rise The coupon on a floating rate note rises with interest rates, and so the drop in price of an FRN is less pronounced Jet Blue LIBOR + 23bp, would therefore be a good choice. 3. Wanted to participate in the equity of a company? Holders of convertible debt can receive a fixed number of shares in lieu of par for their bonds Therefore the AAL bond is a good choice. 4. Wanted exposure to the British corporate debt market and a strengthening Euro? Tescos is a British company and it has raised debt in Euros The debt was most likely raised to finance their expansion into Europe. 5. Wanted the highest possible income? The coupon on the bond provides the income By dividing the annual coupon by the bonds price you can calculate the income yield The yield for Ford is 6.6% (5.22/79) The yield for Lloyds is 12.4% (15/121) but this is a CoCo bond.
6. Wanted to protect the purchasing power of your investment? To protect the purchasing power of your investment you need a bond that is linked to an inflation index The UK Indexed Linked note would be a good choice. 7. Wanted to make the best possible investment? Of course this depends on your risk appetite and the market price of the securities relative to your view of the credit quality of the issuer All the bonds are contenders as long as you can defend your choice. 8. Which three bonds would you choose to build a portfolio and why? There is no wrong answer to this question; The two possible solutions are: Choose three bonds that will provide good diversification, perhaps a range of currencies, issuers and markets A core and satellite strategy with the majority of the investment in one of the higher quality bonds, plus some small investments in the more speculative securities.
Answer: Indonesia
Answer: UK
Answer: USA
Answer: India
Answer: Greece
Answer: Japan
Quotation basis Money market yield Money market yield Discount yield Discount yield
Answer d) e) a) c)
5. Interbank deposit
Yes
Yes
No
b)
Duration - solution
a Time 1 2 3 4 5
1. Price = 107.99 2. Macaulay Duration = 4.20 Modified Duration = 3.89 (4.20 1.08) 3. Profit of 38,900 = 10MM 10bp 3.89 4. Loss of 77,800 = 10MM 20bp 3.89
64 41491 IB
a)
p 10 + (1-p) 2 = 5 8p + 2 = 5 P = 3/8 = 37.5% Purchase $375,000 $625,000 10 year zero coupons Two year zero coupons
b) Two year
% Change 0.473%
10 year
2.39%
Gain
c)
1.
51.00 - 51.05 51.25 - 51.00 51.10 - 51.25 50.85 - 51.10 50.80 - 50.85
Margin (paid)/ rec per share $ (0.05) 0.25 (0.15) (0.25) (0.05) (0.25)
2.
Delivery Margin
5,080 25 5,105
1.
Gold - theoretical future price = = = Spot price 1,700 1,717 + Carry cost + 17 Carry return 0
2.
Silver - theoretical future price = = = Spot price 35.00 35.35 + Carry cost + 0.35 Carry return 0
3.
S&P 500 - theoretical future price = = = Spot price 1,300 1,274 + Carry cost + 13 Carry return 39 (dividend)
Long straddle
Short straddle
Long call
Long put
Long strangle
Short call
Short put
Bull spread
Driver Stock price Strike price Time Volatility Risk free rate Dividend yield
Call
Put
Position
Option
Number of contracts
Contract size
Number of stocks
Stock price
Delta
Delta value
70 38298 IB CORE
1. 3%
Corporate Corporate
Swap Swap
LIBOR
The client should receive fixed on the swap turning a fixed rate debt into floating rate debt because of a perceived decrease in interest rates.
2.
Outflow of
0.28810 % 4
3.
Five years.
4.
DV01 measures the monetary value that this swap would make or lose over a 1 basis point change in yield. This swap will make or lose 4,909.79 for each 1bp change.
1. 2. 3. 4. 5.
Blue Inc - forward start swap Yellow Inc - amortizing swap Purple fund - IRS - fixed rate payer Green Power - accreting swap Red Inc - IRS - fixed rate receiver.
solution.pdf
With reference to the CDSW screens for Exxon Mobil and American Airlines answer the following questions.
1.
What is the term (maturity) of the deal? Both CDS deals have five year terms. This is the most common term for CDS.
2.
What is the probability of survival for the term (maturity)? XON: (1-0.0169) = 0.9831 = 98.31% probability of survival during the term F: (10-1318) = 0.8682 = 86.82% probability of survival during the term
3.
Which company does the market believe is more likely to default? F: 86.82% probability of default during the term.
4.
What recovery rate is assumed? Both CDS deals incorporate a 40% recovery rate assumption. This is the standard assumption.
5.
What is the quarterly payment in dollars? XON: 100bps x $10,000,000 x (1/4) = $25,000 F: 100 bps x $10,000,000 x (1/4) = $25,000
6.
Estimate the upfront payment in dollars and state which party will pay it (buyer or seller)? XON: -3.98793% x $10,000,000 = $398,793.00 (buyer recieves) F: +3.095824% x $10,000,000 = $309,582.00 (buyer pays)
1.
Inflation - if the general price level (inflation) in the UK is rising relative to that of the US, what will happen to the value of sterling (with reference to demand and supply)?
S0 S1
P0 P1 D0 D1 Q0 Q
If UK inflation is higher than that in the US, UK exports become relatively expensive in US markets and imports from the US become relatively cheap in the UK. This causes the demand curve for pounds to move to the left and the supply curve to move to the right. As a result, sterling depreciates. In general, if the price level of one country is rising relative to that of another country, the equilibrium value of its currency will be falling relative to that of the other country.
2.
Short-term interest rates - if the UK Bank of England Monetary Policy Committee (MPC) raises short-term interest rates significantly above the rates in most other countries, what will happen to the value of sterling?
P P1 P0
S0
D0 Q0 Q1 Q
D1
If UK interest rates rise above the rates in most other countries, there will be an inflow of short-term capital into the UK in an effort to take advantage of the high rate. Demand for sterling will rise, shifting the demand curve to the right and leading to an appreciation of the currency. The supply curve for sterling might also move to the left as less UK based short-term capital leaves the UK for investment overseas. This will cause the pound to appreciate further. If UK short-term interest rates fall, there will most likely be a sudden shift of short-term capital out of the UK, reducing demand for sterling and causing the pound to depreciate.
3.
Speculation - if foreign currency speculators expect sterling to depreciate what will happen to the value of sterling (assuming there are no other influencing factors).
S0
P0 P1 D1 Q1 Q0 D0
If speculators expect the pound to depreciate, they will be reluctant to hold UK financial assets. The demand curve for sterling will shift to the left and sterling will depreciate. The speculators' actions amount to a self-fulfilling prophecy. If speculators expect the pound to appreciate, they will rush to buy assets denominated in pounds. This excess demand shifts the demand curve for sterling to the right and sterling appreciates. Wild swings in the demand for and supply of a currency may cause volatile and extreme movements in the currency that does not reflect the underlying fundamental condition of the economy.
4.
Purchasing power - if a McDonald's Big Mac costs 1 in the UK and $1.50 in the US and the current exchange rate is $1.40/1, is sterling under or overvalued? And why? If the exchange rate is $1.50/1, one-pound sterling would be able to buy a Bug Mac in both the UK and US. Economists call this purchasing power parity. Empirical research shows that exchange rates will tend toward purchasing power parity over the long-term. At an exchange rate of $1.40/1, one pound can buy a Big Mac in the UK but not in the US. Sterling in this instance is said to be undervalued. If the exchange rate is $1.60/1, sterling would be overvalued. As we have seen, short-term capital movements pull a currency away from purchasing power parity in the short-term. When interest rates are raised, the exchange rate will rise above its long run equilibrium level. This is called exchange rate overshooting. Over the long-term however, there will be pressure on the exchange rate to gradually depreciate back to purchasing power parity. As a result, a policy that raises domestic interest rates above world levels will cause a short-term appreciation and a long-term depreciation of the currency.
74 37856 IB CORE
Code red
solution.pdf
USD EUR NZD CLP THB MYR KES ILS SAR SGD RUB EGP INR BRL ZAR
US Dollar Euro New Zealand Dollar Chilean Peso Thai Baht Malaysian Ringgit Kenyan Shilling Israeli Shekel Saudi Arabian Riyal Singapore Dollar Russian Ruble Egyptian Pound Indian Rupee Brazilian Real South African Rand
75 37857 IB CORE
solution.pdf
Requirement In your group, rank the value of each bag of cash from the most valuable to the least valuable.
76 37858 IB CORE
solution.pdf
Borrow USD 100MM at 1.05% Sell USD/JPY at spot Put JPY on deposit at 0.53%
USD 100MM / (1 + 1.05%) = USD 98,960,910 USD 98,960,910 x 82.50 = JPY 8,164,275,111 JPY 8,164,275,111 x (1 + 0.53%) = JPY 8,207,545,769
82.5000 82.0755