Underlying Assets and Reference Indices

QF 301

Contents
Section 1: Equities

Panaroma Ideas about stock prices Stock Exchanges Quotes and Orders Indices

Section 2: Currencies Section 3: Fixed Income Rates

Interest Rate Fundamentals In Practice Modelling Interest Rates

Section 4: Others Section 5: Epilogue

Learning Objectives
To understand derivatives, which are officially first and foremost financial instruments to modify risk profiles of certain underlying assets or reference rates, we need to have an idea what those assets or reference rates are and the respective market mechanisms and factors affecting them This lecture shows you the tip of the iceberg It is hoped that the exposure will illuminate to you the significance of economic/financial/business news in the papers, on the internet and in magazines It is also hoped that the noise that is one component of derivatives pricing and hedging models compresses into several equations an huge area that is highly complex and interesting

Section 1: Equities

Panorama

The Concept of Equity

By issuing shares, companies can raise capital to pursue business opportunities and meet its operational needs Owning shares is like owning a piece of the company; share owner shares risk with the other owners Shares can be bought and sold at will in the market

One share of Disney

Source: www.hugovandermolen.nl/scripophily/Disney.php

Types of Shares
Common Stock

Represent a share in the assets and earnings of a company Dividends are decided by the directors of the company

Preferred Stock

Differ from common stock in regards to voting rights, dividend payout (higher or guaranteed fixed rate of return), priority to obtaining assets in case of dissolution Issued to entice investors (e.g. when company is financially weak)

Share Classes

Different classes of common stock with different dividends and voting rights E.g. Berkshire Hathaway issues Class B stocks with 1/200 voting right and 1/30 ownership value to small investors (Class A stocks sell for over $100,000 per piece)

One of the most admired companies in the world

Business Organization and Capital Structure

Business Organization

Sole proprietorship: Entity has no separate existence from owner, debt of business is debt of owner Partnership
General: Partners manage business and are personally liable for its debt Limited: Certain limited partners give up ability to manage business in exchange for limited liability on debt Limited Liability: All partners have some form of limited liability

Corporation: Artificial legal entity, shareholders have limited liability

Corporations have two ways to raise capital

Issue stocks (equity) Issue bonds (debt) The combination of equity and debt is called capital structure

In the event of dissolution, payment is carried out in order of hierarchy:

Debt: junior/senior, secured/unsecured Equity: common/preferred Chapter 7 Liquidation Chapter 11 - Reorganization

Forms of bankruptcy - bankruptcy chapters in the US

10

Stock mechanics: IPO

IPO (Initial Public Offering)

Company seeks listing on exchange Investment bank sought out to be underwriter Underwriter needs to set IPO price; takes responsibility to buy stocks if price sets too high to sell off into the market over time later

How is the price determined?

IPO stock is often underpriced

Con Less capital raised Pro Ensures stocks are sold

Auction
To minimize underpricing, Dutch auction is sometimes used Dutch auction high asking price lowered until there is a buyer Google Dutch-auctioned its shares at IPO; despite that, still rose 17% on first day

11

The worlds largest IPO ever

Fast Facts: IPO at US$0.39 rose to US$0.45 Hang Seng Index surged 1.1%

12

Top Banks - 2006

Source: Wikipedia

13

Trivia: Which of these banks are not results of mergers?

Top Banks - 2008

14

Source: http://financialranks.com/?p=69 http://skorcareer.com.my/blog/10-worlds-largest-banks-list-in2008/2008/06/18/ http://jaggerkieth.wordpress.com/2008/07/22/10-world%E2%80%99s-largestbanks-in-2008/

Stock Mechanics
Follow-on Offering

Issuance of stock subsequent to IPO Dilutive: New shares are created, more shares therefore value per share is reduced (why do it?) Non-dilutive: Sale of shares by directors or insiders

Primary Offering Issuance of stocks by company Secondary Offering Offer of stock by shareholder

15

Stock Mechanics: Splits and Options

Stock splits

1:5 split = each share becomes 5 shares, value of each share is divided by 5 To make share accessible to investors, prevent fall in liquidity Warren Buffetts Berkshire Hathaway is the most expensive stock in the US; BH has policy not to split stock; if GE hadnt split its stock 9 times since IPO in 1892, it would now be about $160,000 per share

Warrants

Gives right to purchase company stocks at a strike price on a specified future date When warrant is exercised, the company issues new shares of stock (call options differ in this respect) Often added to bond issue for enticement

Employee stock options

Call option that is issued to employee, usually executives, so as to align their motivations with the companys Strike price typically set at the companys stock price on option grant day

16

Backdating Scandal

Why the concern? Who are the victims?

17
Source:http://www.wired.com/science/discoveries/news/2006/08/71533

Pixar options backdating scandal

18

Source: http://www.theregister.co.uk/2008/04/29/ann_mather_sec_filing_backdating/ Date: 29th April 2008

Stock Mechanics: Buyback and Dividends

When company has too much money and has no plan on investing it, it can

Buy back shares

Equal access scheme: company offers to buy back shares prorata Selective buy-back: offers to buy back only from several shareholders Any other reason for share buy-back?

Issue dividends
Frequency: can be regular/announced or irregular/special Forms of payment: Cash, stock, property Dates: Declaration, Ex-dividend, Record, Payment Dividend play: someone buys stock to collect dividendsmart move?

19

Ex-Dividend Date Price Behaviour

Stock price level before

Price falls on ex-dividend date By how much?

Stock price level after

Time Ex-Dividend Date

20

Taxes
Fast Facts Capital Gains Tax: Tax levied on profit upon sales of capital asset Singapore: 0% USA: Long-term capital gains tax 15% France: 27% Dividends Tax: Singapore 0% USA: 15% for most individual taxpayers
Source: Wikipedia

Arguments against: Double Taxation (this and income tax) Arguments for: Different tax rates for income through active or inactive work

For more detailed info: www.oecd.org

21

Snippet: Unintended Consequences

In 1997, the Brazilian government imposed 0.38% tax on all financial transactions to raise revenue Institutional traders then traded Brazilian stocks as American depository receipts (ADRs) in New York to avoid the tax (owners have right to exchange ADRs for shares they are issued by banks) Tax raised less revenue than expected and liquidity in Sao Paulo Bovespa dropped (trading volume from 1.2b reais a day in 1997 to 350m reais a day in 2001) In Sept 2001, the Brazilian government announced that stock transactions would be tax-exempt

22

Stocks Dynamics: M&A

Mergers and Acquisitions

Friendly acquirer

Combine to add value/Empire building Consensual merger/acquisition or hostile takeover

Poison pill White knight

Cash merger/Stock merger/Acquire assets Leveraged Buyout (LBO)

Company X

23

Source: http://www.timelessmyths.com/arthurian/gallery/gareth.jpg

Hostile acquirer

Poison Pill and White Knight

Poison Pill
-

White knight
-

Target company makes its own stock less attractive to the acquirer in order to avoid takeover bids. e.g: allows the existing shareholders (except bidding company) to buy more shares at a discount.

A target company is facing a hostile takeover from another party. The white knight offers the target firm a way out with a friendly takeover.

24

Mittal Steel Company

Mittal Steel Company largest steel company in the world by volume

25

Source: Wikipedia

Arcelor Mittal

26

White knight

Arcelor Mittal

27

Started off hostile

Poison pill

Arcelor Mittal

28

Source: Asia Times Online, Jan 27, 2006

Merger (risk) Arbitrage

Cash merger

Acquirer announces to purchase stocks of target company Stock price rises in anticipation of the sale but not to the purchase price level due to risk that deal may not go through or may be delayed Arbitrageur may buy shares hoping that she may sell the shares at the higher purchase price after the merger

Stock merger

Acquirer announces to exchange stocks of the target for its own stocks at a certain ratio Arbitrageur may go long in one and short in the other in the hope the profit may be reaped upon completion of the M&A

What can affect the deal from going through?

29

Minority Shareholders Rights

A shareholder who owns a substantial amount of shares has a lot of say in the direction of the company Shareholder activism uses equity stake to put pressure on management during AGMs

Change financing structure, cut cost, more environmentally friendly Fund management companies may adopt activism approach

In Singapore: Securities Investors Association (Singapore) or SIAS

30

Minority Shareholders Rights

Carl Icahn - owns 4.98 percent of Yahoo common stock May 13, 2008 - Icahn launched a proxy contest. May 15, 2008 Icahn confirmed to commerce a proxy fight to remove Yahoo's Board of Directors in response to their "irrational" actions in rejecting Microsoft's takeover bid. July 21, 2008 Icahn agreed to join Yahoo's Board of Directors in a deal that would end the proxy fight. According to the agreement, the Yahoo Board will expand by two directors to eleven members. Eight directors will stand for re-election while the remaining three seats will include Icahn and two nominees that Icahn will recommend.

31

Leveraged Buyout
Gain control of company through acquiring equity via the use of debt Asset of acquired company used as collateral for debt Also known as bootstrap transactions Debt is obtained by issuing junk bonds Some notable names:

Kohlberg Kravis Roberts & Co (KKR) Creates limited partnerships to acquire corporations Finance some with own funds, the rest through the issuance of junk bonds Investment banks, such as Drexel Burnham Lambert, led by junk bond king Michael Milken, helped raised funds for LBO

At one point in 2007, BT reports that many firms in Asia were in danger of being taken over not because they were operating badly, but because they were low in debt!

32

Credit Ratings
Investment Grade

Junk For details:

http://www2.standardandpoors.com/portal/site/sp/en/ap /page.article/2,1,1,4,1148442391999.html

33

How does rating affect stock price of company? What criteria are applied? Who pays for the rating?

Sovereign Ratings

Source: www.fitchratings.com/shared/sovereign_ratings_history.pdf

34

Guess the ratings of the major financial institutions in Singapore

DBS UOB OCBC Temasek Holdings GIC
35

Problems with Ratings companies

Little problem when rating companies for straightforward debt issuance Problematic when rating complex instruments Raters from the rating companies were not paid directly by the debt issuing companies no conflict of interest But raters of complex instruments sometimes were paid conflict of interest Ratings companies can roil the market Their pronouncements are important But they are after all humans and are prone to errors in judgement

36

Ideas about Stock Prices

37

Price of stock and value of company

Price of stock is what you read in the papers or off Bloomberg Value of company is a more subjective concept What affects ones valuation of a company?

Management how it funds itself, the investment the company makes The business it is doing and the business environment the risk and opportunities The economy at large

How do most in the market guess the price of the stock?

Work out personal valuation of company Guess prevailing perception of companys value Fundamental analysis Technical Analysis

38

Views of Stock Prices

Forecasters View

Fundamental Analysis: company fundamentals, macroeconomic factors, politics, etc. Technical Analysis: patterns in price history suggests future movements Result: (Strong) Buy/Sell recommendation

39

Views of Stock Prices

Economists View

Efficient Market Hypothesis (EMH): stock prices has already factored in information*, so no point trying to use that sort of information in trying to beat the market Information:
Financial data Weak form All publicly available information Semi-strong form All information Strong form Sensitivity to market returns

Capital Asset Pricing Model (CAPM):

Asset return

Companys stock return

Risk premium

E ( Ri ) = R f + im ( E ( Rm ) R f )
Markets stock return

beta

40

Security Market Line

Risk-free rate

Views of Stock Prices

QF view

Stock prices evolve stochastically No point trying to guess with precision future price moves Instead, the tools of statistics and probability can be used to say something definitive/on average about prices Discrete model: prices evolve per unit of time, each move is either up or down with probability p Continuous model: prices evolve by the Geometric Brownian Motion

41

The Binomial Tree Model

Toss a coin! $X 1 1/2 1/4 $2X
Day i

4 2 1

Day i+1
$0.5X

42

Day 1

Day 2

Continuous limit
Let dt -> 0 What do we see?

43

Random Walk 5 steps

101 100.5 100 99.5 99 98.5 98 97.5 0 2 4 6 8 10 12

44

Random Walk 100 steps

103 102.5 102 101.5 101 100.5 100 99.5 0 2 4 6 8 10 12

45

Random Walk 1000 steps

103 102 101 100 99 98 97 0 2 4 6 8 10 12

46

The Random Walk Model

$X
Day i

Day i+1 2

$X
$(X+2)

The normal distribution

47

The Brownian Motion

As dt -> 0, the motion obtained is called the Brownian motion or Wiener process The limit is said to be continuous Commonly denoted Wt or

Zt

dt

It is the basic building block for continuous price models in finance

48

Some basic continuous models

49

Source: Options, Futures and other Derivative, John C. Hull

Geometric Brownian Motion

Two quantities declared as definitive characteristic of stock price

Mean drift (measures company growth) Volatility (measures degree of price fluctuation/riskiness of company)

Geometric Brownian Motion de facto model of stock price in finance

dSt = dt + dWt St
50
Roughly, but not quite:

d ln St

Not as difficult as you think

Step 1: Discretize

S ( i +1) dt Sidt Sidt

= dt + (W(i +1) dt Widt ) = dt + dt Z

Step 2: Excel

51

Ideas about Models

Models have underlying assumptions Stochastic models such as the Geometric Brownian Motion are not meant for forecasting; they are used because they are mathematically tractable and they come with parameters that we can empirically associate with intuitive/observable financial quantities (drift = growth, vol = riskiness); they give an average sense of the future evolution of prices Stochastic models (GBM, Levy models, etc.) are used to price and hedge financial derivatives

52

Your preference?
Fundamental analysts

Look at fundamental reasons/stories things happening in the world

Technical analysts

Look at patterns in price histories

Financial engineers

Believe in statistics, use statistical models to describe price movements

53

Which style do you prefer?

Stock Exchanges

54

Stock Markets
Stock markets are concentrated at stock exchanges Oldest stock exchange: Amsterdam Stock Exchange

Established 1602 by Dutch East India Company Merged with Brussels Stock Exchange and Paris Stock Exchange on Sept 22, 2000 to form Euronext

55

Traditional open outcry system These days electronic exchanges

Stock Exchanges: Development

56

Stock Exchanges: Development

57

Stock Exchanges: Development

58

Source: http://news.bbc.co.uk/2/hi/business/5039412.stm

Stock Exchanges: Development

59

How does an exchange make money?

Stock Exchanges: as a business

60

Source: http://www.marinemoney.com/forums/SIN04/Presentations/Ein.pdf

Stock Exchanges: as a business

61

http://info.sgx.com/SGXWeb_ST.nsf/NEWDOCNAME/REITS_INTRO?OpenDocument

Stock Exchanges: Highly regulated

62

Stock Exchanges: Highly regulated

63

Excerpt from "Regulating The Capital Markets: Making Market Discipline Work Speech by Tharman Shanmugaratnam, Deputy Managing Director, MAS, at the Investment Fund Awards 2001 Source: http://www.mas.gov.sg/news_room/statements/2001/Regulating_The_Capital_Markets__Making_Market_Discipline_Work__16_Feb_2001.html

Trading rules

64

SGX Rulebooks and Manuals Source: http://info.sgx.com/SGXWeb_RMR.nsf/NEWDOCNAME/Rulebooks_and_Manuals

Trading rules

65

SGX Trading Rules Source: http://info.sgx.com/SGXRuleb.nsf/VwCPForm_SGX_ST_RULES?OpenView

Damping down the activity

Extreme volatility in the market can be prelude to crashes Regulatory responses to extreme volatility

Trading halts: trading is stopped when prices have moved or will imminently move by some specified amount Price limits: all trade prices are required to be within a certain range on a given day Transaction taxes: restrict trading by taxing it Margin requirements and position limits: restrict sizes of positions that traders can accumulate Collars: restrict access to trading systems Uptick rule: short selling is only permitted following a trade which is an uptick

66

Trading Halt
Following 1987 market crash, U.S. stock and futures exchanges adopted a set of coordinated trading halt rules Level 1 halt

Condition: DJIA drops by about more than 10% from its closing value on the previous day Before 2:30pm: halt for an hour Between 2:30pm and 3:30pm: halt for half and hour After 3:30pm: if there is no Level 2 halt, then no halt

Level 2 halt

Condition: DJIA drops by more than 20% from its value on the previous day Before 1pm: halt for 2 hours Between 1pm and 2pm: halt for 1 hour After 2pm: if there is no Level 3 halt, then no halt

Level 3 halt

Condition: DJIA drops by more than 30% from its value on the previous day Halt for the whole day

Why halt?

67

Operational Structure

Dealers/Brokers Order-driven

Investor

Clearing Agent

Settlement T+3

Custodians/ Depositories

68

Brazilian Straddle
Straddle is a trading position in two different types of instruments, one long, one short, risk-offsetting Technically bankrupt traders do not have sufficient wealth to settle their trades; if prices do not change in their favour, they will soon be forced into actual bankruptcy When traders are in technical bankruptcy, they lose nothing by massively increasing their positions

If prices change in their favour, their financial woes are over If not, those who guarantee their trades will suffer the losses

This strategy is called Brazilian straddle: large market position vs one-way air ticket to Brazil Clearing members check on these

69

monitor traders who clear through them closely require frequent position report throughout the day, require margin payments to be made when prices move against their customers prohibit customers who cannot settle from trading contractually allocate profits made by technically bankrupt customers to clearing firm if problem not reported

Quotes and Orders

70

Stock Quotes

Bid/Ask Whos buying/selling?

71

Source: The Business Times, May 4, 2007

Orders
The specifications of an order

Price Number of shares Order type

Market Limit Stop Market-if-touched

Validity/expiration instructions Quantity instructions Other instructions

Display instructions

72

Market and Limit Orders

Market order is an instruction to trade at the best price currently available on the market

Market orders pay the bid-ask spread (price for being impatient)

Limit order:

73

Limit price Instruction to trade at the limit price or a price better than this If its a limit buy order at $5, youre guaranteed to buy at that price Limit buy/sell is usually set lower/higher than market

Limit Order Book

Best prices

74

Source: Trading & Exchanges Market Microstructure for Practitioners, Larry Harris

Validity/Expiry, Quantity and Display Instructions

Examples of validity/expiry instructions

Day orders: valid for trading day only Good-till-cancel: valid till trader expressly cancels Good-until: valid till a certain date Immediate-or-cancel Good-after: valid after a certain date

Examples of quantity instructions

All-or-none Minimum-or-none

Display instructions

To show no more than some maximum quantity to avoid market moving away from them

75

Limit orders are options

When trader issues a limit order, he is in effect writing an option gives the other traders the option to trade with him

Limit buy order: like put option (because expecting price to fall) Limit sell order: like call option (because expecting price to rise)

Factors affecting value of this option

Limit price: too far behind market, little value How long order will stand: allow other traders to defer trading decision Price volatility: in volatile market, limit orders are valuable, because probability of execution is increased

76

Option view explains some phenomena

Bid/ask spreads are wide in volatile market

option valuable, traders dont like to give away valuable options, set the limit price far from the market to reduce value of option they give away

Fast traders have advantage over slow traders

they quickly take up the valuable options

The nature of liquidity

Liquidity is the ability to trade at low cost Traders give away options (limit orders), they offer liquidity, in return, they are compensated with the potential to realize a better trading price

Why do markets consolidate (traders like to trade in the same place)?

They offer lots of options as a whole

77

Other order types

Stop order

Stop price Stop buy/sell order price usually set higher/lower than market

Market-if-touched order

Touch price If market price becomes equal or better than touch price, the market-if-touched order becomes a market order

78

Stop orders and Liquidity

Stop orders accelerate price changes Say a trader has a large stop sell order at $100if best bid falls below $100its activatedtrader then contributes to the falling market by trying to sell the stock Stop orders add momentum to the market Momentum traders

Buy when prices are rising and sell when prices are falling May issue stop orders to brokers Destabilize prices

Contrarian traders

79

Buy when prices are falling and sell when prices are rising May issue limit orders to brokers Stabilize prices

Reflect on this
So is the dynamics/stochastics of stock prices akin to the toss of a coin?

Hmm..what should I bid next? Twice the current bid or half of it? Lets see what the coin says

80

The Trader Thinker

Indices

81

Indices
A market index represents the health of the market as a whole An index may be

Price-weighted: proportional to the sum of prices of the index components

E.g. DJIA, Nikkei 225

Value (capitalization) -weighted: proportional to the sum of market capitalization (price x number) of index components
E.g. S&P 500

What is STI?

Indices are often used as performance benchmarks by mutual funds beat the market

82

Indices
Some major indices

US: S&P 500, Russell 2000, Wilshire 5000 UK: FTSE 100 Brazil: Ibovespa Japan: Nikkei 225, Topix HK: Hang Seng Index Singapore: STI South Korea: KOSPI China: SSE Composite Asia: S&P Asia 50 Latin America: S&P Latin America 40 Europe: S&P Europe 350, FTSE Euro 100

See http://en.wikipedia.org/wiki/List_of_stock_market_indices#Asia

83

The science of indexing

84

Ideas about Indices

Index gives an average view of the market but average can have many dimensions Market capitalization Price Growth Index represents market return and volatility Index represents diversification Investing in an index? Index as an asset? Option on S&P 500: right to buy 500 stocks? Many funds use index as a gauge of performance Hedge funds are also called absolute value funds they dont use index as gauge of performance

85

Index instruments: Options on Indices

86
Source: http://www.cboe.com/LearnCenter/workbench/products/sp500.htm

Index strategies: Index Fund

87

Source: https://flagship.vanguard.com/VGApp/hnw/FundsSnapshot?FundId=0040&FundIntExt=INT

Index Tracking not bad!

88

Source: https://flagship.vanguard.com/VGApp/hnw/FundsPriceHistory?FundId=0040&FundIntExt=INT

How did they do it?

89

One possible way

Total number of stocks Limit the number of shares of each stock 0 or 1 Upper bound on transaction cost Value of tracking portfolio

Units of stock i

90

Source: An evolutionary heuristic for the index tracking problem, J.E. Beasley, N. Meade, T.-J. Chang

One possible way

Tracking error

Objective function Excess return

Index return Tracking portfolio return

What assumptions underlie these techniques?

91

Source: An evolutionary heuristic for the index tracking problem, J.E. Beasley, N. Meade, T.-J. Chang

Buy an index?

Questions: Why does UBS want to buy AIGs commodity index? What determines the success of an index?

Section 2: Currencies

93

Trading Money
Money is traded due to demand and supply forces

Whats the worth of money? Whats its function? What demand forces? What supply forces?

A medium of exchange

Buying a good for S$100 (on the flip side: selling S$100!) How to buy a foreign good? One of the earliest currencies: Greek coins Basic human innovation: better than barter! What have been used as money?
Sheep, shells, whale teeth, tobacco, nails, oxen, fish-hooks, jewels, elephant tails, wampum

94

Greek silver coin, face of Athena, c.480B.C. (Source: Economic History of the World)

Trading Money
A unit of account

Measure value of goods relative to a currency: price tags A finance jargon meaning the same: numeraire

A store of value

Companies hold ready cash for daily transactions What affects currencies worth as store of value?
Banana money zero worth now Germany is known for conservative monetary policy and aversion to inflation historical root? (fear of hyperinflation)

95

Hyperinflation
German hyperinflation (c. 1923)

1923-issue 50 million mark banknote. Worth approximately $1 US when printed, this sum would have been worth approximately $12 million nine years earlier. The note was practically worthless a few weeks later due to continued inflation

Source: Wikipedia

Inflation 192324: a woman feeds her tiled stove with money. At the time, burning money was less expensive than buying firewood.

In a hyperinflation, the value of money relative to goods reduce rapidly

96

Currencies
Governments print paper money, mint coins

Careful about it as it can cause inflation Money is commonly accepted by fiat An avenue of national pride

Singpaores National Coat of Arms

First President of Singapore Yusof bin Ishak

How many currencies are there around the world?

There are slightly more than 200 currencies around the world Some countries do not have their own currencies, e.g. Ecuador, Panama, East Timor

Useful link: https://www.cia.gov/cia/publications/factbook/ Trivia: What is the currency of

97

Luxembourg, South Africa, Botswana

Major Currencies
The United States Dollar (USD) The Euro (EUR) The Japanese Yen (JPY) The Great Britain Pound (GBP) (aka Sterling) The Swiss Franc (CHF) ISO 4217 Currency Code

Usually first 2 letters refer to country, third letter refers to currency name What is CHF? Whats the ISO code for Canadian Dollar? What about Mexican Peso?

98

Foreign Exchange turnover

Source: BIS Triennial Central Bank Survey

99

The Foreign Exchange Market

Has an average daily turnover of about USD 2 trillion (daily turnover at NYSE before merger with Euronext was about USD 40-50 billion) Worlds largest financial market

Some participants relatively larger than others But all small in the grand scale of things

Largely unregulated OTC market

10 0

Central banks monitor currencies together with interest rates (monetary policies)

The Foreign Exchange Market

Key instruments

Spot Forwards Swaps Derivatives: futures, options, exotic options

10 1

The Foreign Exchange Market

FX market is close to 24-7

Opens in Wellington, New Zealand, on their Monday at 7 am Closes on Friday evening in the US

Used to be traded via telephone or telex; now etrades, online Quotes and information readily available (www.forexnews.com, www.dailyfx.com, www.fxstreet.com ), market very liquid

10 2

Spot Quotes

USDCAD

EUR|USD

10 3

Source: Bloomberg.com

Spot Quotes
Currency pair: USDEUR or USD|EUR

Read Dollar Euro USD is base currency, EUR is quote currency First currency thought of as asset, e.g. EURUSD 1.3583 means that 1 Euro is worth USD 1.3582 Its a price: price of 1 USD in terms of EUR

European/indirect terms: USD|EUR American/direct terms: EUR|USD Nicknames: GBP|USD = Cable; AUD|USD = Aussie; NZD|USD = Kiwi

10 4

Spot Quotes
USD|CHF 1.2162
100 pips make 1 big figure 2 pips: smallest quoted unit

Market lingo

I buy dollar yen! A five-pip decline in EUR|USD Euro-Dollar is trading at one-twenty-eight the figure USD|JPY rises one big figure from 111.00

10 5

Triangular arbitrage
USD|EUR 1.3583 EUR|Yen 162.894 Yen|USD 0.0083 Do you smell anything fishy?

10 6

Triangular arbitrage
USD|EUR 0.7362 EUR|Yen 162.894 Yen|USD 0.0083 Still fishy? Tim Weithers, author of Foreign Exchange A Practical Guide to the FX Markets, mentioned someone in class asking UBSs FX spot dealers if they had ever done traingular arbitrageyes, I did, once, back in 1977

10 7

Whos quoting?
Marketmakers

stand ready to buy if client wishes to sell and vice versa Found in banks, brokerages (e.g. www.forex.com)

Earn through bid-ask spread (buy low sell high)

Measure of how liquid the market is (how easy it is to buy and sell) Measure of profit marketmaker makes
The handle

10 8

Quote with bid/ask: EUR|AUD 1.7686|90

What drives exchange rates?

Who determines exchange rates?

Nobody Floating exchange rate era (read history of foreign exchange)

Equilibrium considerations

10 9

Purchasing Power Parity exchange rates are determined by relative prices of similar baskets of goods, e.g. Big Mac costs S$3 in Singapore and US$2 in the US, so the exchange rate by PPP ought to be USD|SIN 1.50 The Economists Big Mac Index is a widely cited indicator of PPP

What drives exchange rates?

Theoretical conception: Equilibrium considerations

Interest rate parity: because one can exchange currencies and deposit at the corresponding interest rate, exchange rates and interest rates satisfy a no-arbitrage relationship

Macroeconomic factors US current account deficits

About US$800b, 7% US GDP spends more than earns Daily international funding is on the order of US$8b Looming fear that it will trigger a large and rapid decline in USD

Japans almost zero interest rate encouraged the yen-carry trade

11 0

Monetary policies, country economics, political stability, happenings in other asset classes, etc.

Snapshot: Thai baht

11 1

Snapshot: Argentine peso

11 2

Section 3: Fixed Income Rates

11 3

Fixed Income - Overview

Investment that gives regular return Institution raises funds with it, incurring debt 2 main market

Money market (< 1yr) Capital market (longer term)

Instruments

Notes and Bonds

Corporate Government, municipal

11 4

Floating rate note (FRN) Swaps Credit-linked products Asset-backed securities (ABS) Collateralized Debt Obligations (CDO) Money market instruments: Commercial Paper (CP), Certificate of Deposit (CD), Bankers Acceptance (BA), T-Bills, Fed Funds, Eurodollar deposits, Repo, money market mutual funds

Interest Rate Fundamentals

11 5

Basic Concepts in Fixed Income

Discounting and Compounding Present Value (PV) Discounting Factor (f) Rate (r)
$K Whats the Present Value?

Today

11 6

N days

Discounting: PV = K x f Compounding: K = PV / f f = 1/(1+r x DAYCOUNTFRAC)Compounding Number

Basic Concept in Fixed Income

Rates are stated annualized Day count convention Simple vs continuous

11 7

Annualized rates
Interest rates are usually stated annualized In other words, it describes the amount of interest earned in 1 year If $100 is deposited at 5% for 6 months, whats the interest at maturity? Interest = x 5% x $100 = $25

11 8

Day count convention

Slightly more generally, what is the interest earned on $100 at 5% if the term is from Jan 10, 2007 till 3 Mar, 2007? The interest earned is $100 x FRAC x 5%, where FRAC is a fraction that depends on the particular daycount convention that is adopted Some common day count conventions: Actual/Actual, Actual/365, Actual/360

11 9

Day count convention

Actual/Actual:

2007 has 365 days (not leap year) Between Jan 10 and Mar 3, there are 52 days FRAC = 52/365 Interest = $100 x 52/365 x 5% = $0.7123 Between Jan 10 and Mar 3, there are 52 days FRAC = 52/365 Interest = $0.7123 Between Jan 10 and Mar 3, there are 52 days FRAC = 52/360 Interest = $0.7222

Actual/365

Actual/360

12 0

Day count convention

Most common is Actual/360 and is used by USD and EUR What is FRAC for Actual/360 when the term is 1 year? Other conventions abound:

30/360: each month is treated as having 30 days ACT/252: common is South American instruments; 252 is the number of business days in a year

12 1

Day count convention

$100 is deposited from Jan 4, 2007 to Jun 8, 2007 Day count convention: Actual/360 Quoted interest rate: 7% What do you get on Jun 8, 2007?

12 2

Compounding
What is the interest earned on $100 at 5% if the term is from Jan 1, 2007 till Jul 1, 2009? For such a long period, the deposits interest is earned by compounding Suppose the compounding frequency is semi-annual If day count convention is not taken into account:
100 100x1.025 100x1.0252 100x1.0253 100x1.0253 =107.6891 6m Jul 1, 2009

6m

6m

6m

12 3

Jan 1, 2007

Compounding
If day count convention, say Actual/360, is taken into account, the actual compounding periods must be determined: e.g. Jul 1, 2007; Jan 1, 2008; Jul 1, 2008; Jan 1, 2009 in addition to the start and maturity

Jan 1, 2007 Jul 1, 2007: 181 days Jul 1, 2007 Jan 1, 2008: 184 days Jan 1, 2008 Jul 1, 2008: 182 days Jul 1, 2008 Jan 1, 2009: 184 days Jan 1, 2009 Jul 1, 2009: 181 days

12 4

Payoff at maturity = 100(1+181/360x5%)(1+184/360x5%)(1+182/360x5%) x (1+184/360x5%)(1+181/360x5%) = 113.3249

General form: Disregarding day count convention

Interest rate: r Principal: N Compounding frequency: n times a year Term: m years The payoff at maturity is: Nx(1+r/n)m/n

12 5

General form: With day count convention

If day count convention is taken into account, the actual dates in the compounding periods must be noted Say: t0, t1, , tk The payoff at maturity is: N(1+FRAC(t0, t1)r) (1+FRAC(t1, t2)r)(1+FRAC(tk-1, tk )r)

12 6

Equivalent annual rate

If rate = 5%, compounding frequency is quarterly, what is the equivalent annual rate? The interest earned in 1 year (on $1 principal) = (1+1/4 * 5%)4 1 = 0.050945 The equivalent annual rate is 5.0945% If compounding frequency is n times a year, what do you think is the equivalent annual rate when n is very large?

12 7

The exponential function

Observe:

(1+1/10 * 5%)10 = 1.051140 (1+1/100 * 5%)100 = 1.051258 (1+1/1000 * 5%)1000 = 1.051270 (1+1/10000 * 5%)10000 = 1.051271

In fact, exp(0.05) = 1.051271

Leonhard Euler (1707-1783) on CHF 10

Generally,

12 8

Interest with continuous rate

If rate = 5% is continuous, what is the interest on $100 deposit after 1 year? Payoff after 1 year = 100e0.05 = 105.1271 Interest = 5.1271 What is the payoff after 2.55 years? Payoff after 2.55 years = 100e2.55x0.05 = 113.5985 Generally, rate = r, term = T years, principal = N => Payoff = NerT

12 9

Difference between rates

Principal = 1 Term = 1 year Rate = r Payoff if rate is continuous: er Payoff if rate is simple: 1+r Payoff if compounding frequency is quarterly: (1+r/4)4 Binomial expansion: (1+r/4)4 = 1+r+6(r/4)2+ Taylor series expansion: er = 1+r+r2/2+r3/6+ The payoffs are roughly equal provided r is small

13 0

Equivalent rates
You own Bank Smiley and you want to pay an interest of $5 for a 1-year deposit on $100 What is the simple rate (equivalent annual rate)? 100x(1+rsimple) = 105 => rsimple = 105/100 1 = 5% What is the continuous rate? 100exp(rcont) = 105 => rcont = ln(105/100) = 4.879016% What is the rate if compounding frequency is quarterly? 100(1+r4/4)4=105=>r4= ((105/100)1/4-1)x4 = 4.908894%

13 1

Snap!
1) What rate of interest with continuous compounding is equivalent to 15% per annum with monthly compounding? 2) A deposit account pays 12% per annum with continuous compounding, but interest is actually paid quarterly. How much interest will be paid each quarter on a $10,000 deposit?

13 2

In Practice

13 3

Bonds terminology
Notional Notional/Face Value Coupon Frequency Maturity Accrued interest Cash/dirty price // Quoted/clean price

Dirty Price = Clean Price + Accrued Interest

Discount (Coupon) Rate

(Reference) Floating, Fixed Payment in fine (reset date and coupon date coincide)/in arrear (reset at beginning of coupon period) Day-count convention

13 4

Yield: a single number that describes the quality of the instrument Currency Issuer/Credit rating

10-yr US Treasury Note

Settlement date: 1/18/2005 Current (trade) date: 1/17/2005 Maturity: 11/15/2014 Coupon rate: 4.25% Coupon frequency: S/A Face value: 1,000,000 Quoted price: 100+10/32+1/64 = 100.328125 per 100 face Day count convention: act/act 11/15/2004-1/18/2005: 64 days

13 5

UST convention: -10 means 10/32; + means 1/64 Bloomberg convention: M = 1,000

Cashflows in a Bond (fixed rate)

Accrued interest belongs to seller Day count convention Face value + coupon Coupon = 4.25% x N/365 x Face

Trade date

Settlement date

Issue date

Interest accrues at 4.25% for this period; Payment at end of period: in-arrear

Maturity

13 6

Coupon frequency: SA Clean price: discount these cashflows to settlement date; nearest coupon only remaining fraction taken

Cash/Dirty vs Quoted/Clean Prices

A tdy 6m 6m

Dirty price = Clean price (buyer receives full coupon A, no accrued Interest for seller)
tdy A

6m

3m 3m

13 7

Dirty price = Clean price + accrued interest (part of A belongs to seller as he has been holding on to the bond for the first 3m of the coupon period)

T-bill
Bid > Ask ?! Free-lunch!? Bid price =100 2.57 = 97.43 per hundred face Ask price = 100-2.56 = 97.44 per hundred face

13 8

Want to invest in fixed income? Think about it

Length of investment bills, notes, bonds Fixed or floating coupon

Bonds: coupon rate is fixed, matures in a (moderately) long time FRNs: floating rate version of bonds

Interest rate environment (the spot curve) changes over time serves as prices of fixed income instruments and as expectations of future rate movements Which strategy do you choose buy-and-hold-tillmaturity or opportunistic trading

13 9

Many rates
LIBOR EURIBOR SIBOR Fed Funds rate Prime rate Overnight rate Swap rate Constant maturity swap rate (CMS) Overnight indexed swap rate (OIS) Spot rate Forward rate Par rate The above are equivalent to each other

Short rate, instantaneous forward rates, market rates

14 0

LIBOR and LIBOR Fixing

One of the most widely watched/referenced rates

CMEs Eurodollar futures (most heavily traded short-term interest rate futures contract) are based on USD LIBOR3m

London Interbank Offered Rate Interest rate at which a bank is willing to lend funds to another bank (inter-bank market) Terms: overnight, 1w, 2w, 1-12m How is it produced?

BBA maintains a panel of 8 contributor banks Top and bottom quartile are disregarded Middle two quartiles are averaged Announced shortly after 11am each day

14 1

Usage of LIBOR rates is via simple compounding with ACT/360 convention: e.g. x (1 + L x ACT/360)

Spot rate
A spot rate of N years is the rate at which interest accrues if cash were deposited for N years from today The graph of the function t |-> r(t), where t is time to maturity and r(t) is the corresponding spot rate, is called the spot (rate) curve Curve under normal conditions looks like this:
r

14 2

Whats your mood, Mr Banker?

r

14 3

Source: http://www.ces.ncsu.edu/AboutCES/smp/19/smhap.gif

Fundamentals of Finance - 1
The Fundamental Strategy of Finance:

Buy Low, Sell High

r

Low

High

14 4

How to capture the discrepancy and realize it as profit?

The Business of Commercial Banking

Borrow short (term), lend long (term) Short term rate r 1 + 1 year Long term rate R 2 years Liability: [(1+r)-1] = r in first year, r + r(1+r) = r2 + 2r in the second year Revenue: (1+R)2 1 = 2R + R2 in the second year

14 5

The interest rate environment extended view

Very low now: Bernanke at the helm in new financial territory

14 6

Volker stepping on the brakes to stop inflation, which began since 1973 oil price shocks

Greenspan Put (lower rates to stimulate economy after Dot Com bust)

Ideas about the spot curve (term structure)

Expectations Theory

Long-term interest rates reflect expectation of future shortterm interest rates

Market Segmentation Theory

Rate of a term indicate demand and supply for borrowing and lending for that term

Liquidity Preference Theory

14 7

Investors like to deposit short-term for liquidity reasons Borrowers like to borrow long-term to lock in rates Banks will need to finance long-term loans with short-term deposits; any change in short-term environment will adversely affect the financing => excessive interest rate risk Banks therefore raise long-term rates to reduce demand for long-term borrowings relative to short-term depositions

What affects rates?

Government monetary policies US FOMC announcement of rate hike/rise

Holds 8 regularly scheduled meetings each year Date of each meeting is confirmed at the meeting preceding it

Happenings in other markets

Stock/commodity market red-hot indicative of inflation pressure

14 8

Federal Reserve and Monetary Policy

Take a look!

14 9

Source: http://www.federalreserve.gov/fomc/fundsrate.htm

Federal Reserve and Monetary Policy

15 0

Fed Dec 16, 2008 Monetary Policy Press Release

This is unconventional

15 1

Fed Funds Rate Target vs Effective

15 2

Source: http://www.schwab.com/public/schwab/research_strategies/market_insight/todays_market/recent_commentary/unconventional_0_to_25_range.html

What now?
Nominal interest rate near zero economists call this (near) liquidity trap That means: people would rather hold on to money than to spend it (or make short term investments rather than long term investments) Major central banks use interest rates as tool to stimulate economy (or cool it down) With rates near 0, and economy needs lots of stimulation HOW? Various views

15 3

Helicopter Money - give money directly to businesses, which is what the 2008 $700B US Govt Bailout Plan is supposed to do Deficit Spending spend on infrastructural projects in recession and under deficit conditions to stimulate economy (the view is that short-term policies should weigh over long-term policies to get out of the present crisisin Keynes words In the long run, were all dead)

Snap!
1) LIBID vs LIBOR

Guess what is LIBID Which is higher?

2) Why are US Treasury rates significantly lower than other rates that are close to riskfree?

15 4

Modelling Interest Rates

15 5

What do you think?

In the long run, whats the difference between the price of a stock (assuming the company thrives and does not go bankrupt) and an interest rate, such as the USD LIBOR3m rate?

15 6

Mean Reversion

15 7

Source: Options, Futures and other Derivatives, John C. Hull

The Vasicek Model

Vasiceks model is
mean reversion speed

dr = a (b r )dt + dz

r = r(t) short rate volatility reversion level

Wiener process

15 8

Vasicek Model is tractable

15 9

Source: Options, Futures and other Derivatives, John C. Hull

Term Structure according to the Vasicek Model

16 0

Source: Options, Futures and other Derivatives, John C. Hull

What is short rate?

Suppose short rate is r(t) (0 <= t <= T) Then discount factor is

0 e

r ( t ) dt

Roughly, the interest earned between the period (t, t+dt) is r(t)dt on $1 If short rate is stochastic, and if the (stochastic) payoff of an instrument (that pays at time T) is fT , then the instrument is worth today at

16 1

0 E e

r ( t ) dt

fT

(taken wrt risk neutral measure)

Interest rate modelling is more difficult than stock price modelling

Theres only 1 stock price Theres a whole term structure of interest rates! Correlation exists between rates: e.g. 1-year spot rate is correlated with 2-year spot rate Why is the Vasicek Model simplistic from this perspective?

16 2

Section 4: Others

16 3

UNDERLYING assets/REFERENCE indices, relative to?

Financial derivatives are financial instruments that stipulate cashflows in the future whose sizes depend on the prices of certain underlying assets or the magnitudes of certain reference indices Vanilla European option

Call option : Payoff Max(ST K, 0) at maturity T Put option : Payoff Max(K - ST, 0) at maturity T

Inverse Floater

16 4

A note that pays coupons periodically (e.g. semi-annually) of a certain percentage of a notional amount What certain percentage? Max(0, 8% - LIBOR3m) x DayCountFraction

Inflation index
Index used is Consumer Price Index Inflation derivatives

Inflation cap Inflation swap Inflation swaption Inflation bond

Inflation cap payoff:

16 5

Temperature
HDD: Heating degree days CDD: Cooling degree days A = average of highest and lowest temperature during the day at a specified weather station A days HDD := max(0,65-A) A days CDD := max(0,A-65) Example of a weather derivative:

16 6

Call option on cumulative HDD during February 2005 Strike price 700 Rate of $10,000 per degree day If cumulative HDD = 820, payoff = (820-700) x 10,000 = 1,200,000

Temperature

16 7

Source: http://www.fenews.com/fen51/one_time_articles/weather-derivatives/weather-derivatives.html

Temperature

16 8

Source: http://www.fenews.com/fen51/one_time_articles/weather-derivatives/weather-derivatives.html

Volatility

16 9

Source: CBOEs website

Volatility

17 0

Source: CBOEs website

Hmm
Property derivatives are making inroads into the mainstream finance world they are based on property indices Interesting thoughthow do writers of exotic derivatives on indices hedge their risks?

17 1

Section 5: Epilogue

17 2

The Points
Financial derivatives are contracts that refer to an underlying asset or a reference index or rate Some of the major asset classes which have commonly served as underlying assets for derivatives are the equities, currencies and commodities. From the fixed income world, interest rates are often used in derivative contracts as reference rates. The significance of being an underlying of a derivative is that the derivative attempts to alter the risk profile of the underlying asset.

17 3

The Points
Prices from different asset classes and different rates are driven by a complicated web of factors. This results in qualitatively different price and return histories. This is important as one fundamental piece of the theory of derivatives pricing is the mathematically assumed model of the underlying price/rate/return stochastics. The Geometric Brownian Model is the de facto model of returns stochastics in finance, even though it is far from being accurate. Financial engineers have improved the modelling by adopting more complicated models of price/rate/return stochastics. This lecture describes the complexities that make up each asset class to highlight the simple-minded nature of the mathematical models.

17 4