Cash Flow Engineering

Financial Instruments
All financial instruments can be visualized as bundles of cash flows Allow market participants to trade cash flows that have different characteristics and different risks

Cash Flows
Payment or receipt of cash at:
a specific time in a specific currency with a certain credit risk

Special characteristics that can be represented as attributes

Cash Flows of a Loan

$100 A loan from borrowers point of view t0 t1 Time

Borrower receives 100 at t0 and pays 100 plus interest at t1 -$(100 + 5)

The same cash flows from lenders point of view $(100 + 5)

t0 -$100

t1

Time

lender pays 100 at t0 and receives 100 plus interest at t1

Cash Flows with a Default Possibility

+ $105 If no default occurs t0 - $100 cash lent if borrower defaults

A defaultable deposit

t1 No partial recovery of the principal

Cash Flow Attributes

Currency Time Market risk Credit risk Sensitivity to risk factors

Cash Flows in Different Currencies

100 et (EUR)
0

t0 - 100 (USD)

t1

Cash Flows with Timing Differences

USD100

t0 -USD95

t1

Cash Flows with Different Market Risks

Determined at t0 Ft0 N

t0

t1

t2 - Lt1 N Decided here

Cash Flows with Different Credit Risks

Here there are two possibilities No payment if no default If default.. Pay defaulted amount -$100

Fee t0

t1

Different Sensitivities to Market Risk Factor

Price of a 30-year default-free discount bond
100 80 70 60 50 40 30 20

Bond Price

10
0 0.02 0.04 0.06 0.08 0.1 0.2

Price of a 2-year default-free discount bond

100 97.5

Bond Price

95 92.5 90 87.5 85 82.5 0 0.02 0.04 0.06 0.08 0.1 0.2

Yield

Synthetic USD Bond

Receive EUR
Buy EUR denominated bond

t0
Pay EUR

t1

Receive EUR

t0
Pay USD

t1
+1.00 USD

Buy spot Euro

t0

t1
- EUR + 1.00 USD

Sell EUR forward at price Ft0

Adding vertically, all EUR Denominated cash flows cancel......

t0
-B(t0,t1)

t1

Synthetic, default-free USD discount bond. Par value $1.00

Engineering a Currency Forward

Applicable to engineering any linear instrument Begin with target cash flow Detach the individual component cash flows at different dates to represent them as stand alone cash flows Add or subtract new cash flows at chosen dates to convert the detached stand alone cash flows to meaningful financial contracts Ensure that vertical addition of cash flows result in the newly added/subtracted cash flows canceling out and obtaining the original target cash flow

Engineering a Currency Forward (contd.)

Receive 100 currency X

t0
This can be decomposed into two cash flows

t1
Pay (100/Ft0) currency Z

t0

t1

Pay (100/Ft0) currency Z Receive 100 currency X

t0

t1

Engineering a Currency Forward (contd.)

Add a positive currency Z cash flow

CtZ 0

t1
Pay (100/Ft0) currency Z (original cash flow) Receive 100 currency X (original cash flow)

t0

t0

X t0

t1

Add a negative currency X cash flow

CtX (This cancels the newly added currency X cash flow at t0) 0

t0

t1

CtZ (This cancels the newly added currency Z cash flow at t0) 0

Contractual Equation for Synthetic Currency Forward

FX forward Buy currency X against currency Z at t1

Loan Borrow = currency Z at t0 for maturity t1

Spot Operation Buy currency X + against currency Z

Deposit Lend + currency X at t0 for maturity t1

Contractual Equation for Synthetic Currency Forward using Discount Bonds

FX forward Buy currency X against currency Z at t1 Sell Z-denominated = bond at t0 with maturity t1 Spot Operation Buy currency X + against currency Z Buy X-denominated + bond at t0 with maturity t1

Creating a Synthetic T-bill

Motivation to avoid withholding of tax on a T-bill in a given currency as per tax rules of the corresponding government Create a synthetic T-bill in that currency using a T-bill in another currency where corresponding government does not withhold tax

Contractual Equation for Synthetic Currency Forward written in terms of T-bill

Short Z = Denominated T-bill Spot Operation + Buy currency X against Z Buy X + Denominated T-bill

FX forward Buy X against Z

Contractual Equation for Synthetic T-bill

Short Z FX forward - Denominated = + Buy X against Z T-bill

Spot Operation Buy currency X against Z

Buy X + Denominated T-bill

Contractual Equation for Synthetic T-bill (contd.)

Long Z Denominated = T-bill

FX forward + Buy Z against X

Spot Operation Buy X + Denominated Buy currency X against Z T-bill

Engineering a Synthetic T-bill

X Buy X against Z ....

t0
-Z . Buy X-denominated T-bill

t1
(1+r*) X

t0
-X and buy Z forward

t1
100 Z

t0
Adding vertically, gives a long T-bill in Z currency. Par value 100Z

t1

- (1+r*) X

Receive 100 Z

t0
-Z (Present value of 100Z)

t1

Creating a Synthetic Loan

Motivation loan in desired currency not available or very expensive
Was true for Japanese banks wanting USD loans after the collapse of the Hokkaido Takushoku Bank in 1997

Create a synthetic loan in the desired currency by taking a loan in another currency

Contractual Equation for Synthetic USD/JPY Forward

FX forward Loan Spot Operation Sell USD against = Borrow USD with + Buy JPY against JPY for time t1 maturity t1 USD at t0

Deposit + Lend JPY for maturity t1

Contractual Equation for Synthetic USD Loan

FX forward Loan Sell USD against Borrow USD with = JPY for time t1 maturity t1

Spot Operation Buy JPY against USD at t0

Deposit - Lend JPY for maturity t1

Contractual Equation for Synthetic USD Loan (contd.)

USD Loan FX forward Spot Operation Borrow USD with Sell USD against = + Buy USD against maturity t1 JPY for time t1 JPY at t0 Loan + Borrow JPY for maturity t1

Engineering a Synthetic USD Loan

Receive Yen A forward contract of Yen against USD

t0
+ Yen A loan in Yen

t1

Pay USD

t0
+

t1
- Yen with interest

t0
Adding vertically, we get a loan in USD ..

t1

Spot purchase of USD

t0

t1

Creating a Synthetic Currency Spot Contract

Motivation capital controls in a country not allowing spot purchase of a foreign currency (say USD) beyond a certain limit Create a synthetic spot contract for purchasing USD by using a USD forward contract and a USD loan

Contractual Equation for Synthetic USD Spot Contract

FX-Forward Spot Operation Sell X against = Buy USD against X USD for time t1

Loan in USD + Borrow USD at t0 for maturity t1

Deposit in X + Lend X at t0 for maturity t1

Engineering a USD Spot Contract

Receive USD Forward purchase of USD

t0
+

t1

Pay X

t0
+

t1

a deposit in X

t0

t1

a loan in USD

Adding vertically, we get a synthetic USD spot purchase Receive USD

t0

Pay X

t1

Creating a Synthetic Cross Currency Rate

Motivation Insufficient liquidity and higher expense of currency transactions not involving USD (say CHF and INR) Create a synthetic cross currency rate by using USD/CHF and USD/INR contracts

Contractual Equation for Synthetic CHF/INR Cross Rate

Spot Operation Buy CHF against INR

Spot Operation Buy USD against INR

Spot Operation Sell USD against CHF

Engineering a Synthetic CHF/INR Cross Rate

+ USD

t0

- INR + CHF +

t1

t0

- USD

t1

Adding vertically, results in the cross, CHF/INR

+ CHF

t0

- INR

t1

FX Swaps
Can be modeled in terms of a loan in one currency and a deposit in another currency No interim interest payments on loan or deposit Results initially in exchange of two currencies followed later by a reverse exchange of the two currencies with interest

Modeling an FX Swap in terms of a Loan and a Deposit

+ EUR

t0

- EUR with interest

t1

t0
- USD Adding, we get the FX-Swap + EUR

+ USD with interest

t1

+ USD with interest - EUR with interest

t0

- USD

t1

Contractual Equation for FX Swap

FX Swap EUR Loan plus USD Deposit

Loan in EUR

Deposit USD

Engineering a Currency Forward using an FX Swap

+ EUR + USD with interest FX - swap - EUR with interest

t0

- USD

t1

Plus Spot Operation

+ USD

t0

- EUR

t1

Equals forward purchase of USD exchanged at Ft0... + USD

t0

- EUR

t1

Contractual Equation for Forward Contract using FX Swap

FX Swap Exchange EUR Loan for USD Deposit

FX Forward Buy USD against EUR

Spot Operation Buy USD against EUR

Why Banks use FX Swaps?

Interbank instruments
Low credit risk

Does not entail buying/selling of bonds/deposits/loans

Does not move prices

Off balance sheet items

Minimal impact on assets, liabilities, credit risk and capital requirements