If Compiled

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CONCEPTS QUESTIONS: 1) Gold Bullion Standard: The basis of money remains a fixed weight of gold but the currency in circulation consist of paper notes with the authorities standing ready to convert unlimited amounts of paper currency in to gold and vice-versa, on demand at a fixed conversion ratio. Thus a pound sterling note can be exchanged for say ‘x’ ounces of gold while a dollar note can be converted into say ‘y’ ounces of gold on demand. 2) Gold Exchange Standard: Gold Exchange Standard was established in order to create additional liquidity in the international markets. Hence the some of the countries committed themselves to convert their currencies into the currency of some other country on the gold standard rather than into gold. The authorities were ready to convert at a fixed rate, the paper currency issued by them into the paper currency of another country, which is operating a gold specie or gold bullion standard. Thus, if rupees are freely convertible into dollars and dollars in turn into gold, rupee can be said to be on a gold exchange standard. 3) The Gold Standard: This is the oldest system which was in operation till the beginning of the First World War and a for few years thereafter ie it was basically from 1870 - 1914. The essential feature of this system was that the gouvernment gave an unconditional guarentee to convert their paper money to gold at a prefixed rate at any point of time or demand. 4) Triffins Paradox: The Bretton Woods System had some contradictions which were pointed out by Prof. R Tryffin which were :- The system depended on the dollar performing and its role as a key currency. Countries other than the U.S had to accumulate dollar balances as the dollar was the means of International payment. This meant that the US had to run BOP deficits so that other countries could build up a stock of claims on the US. When the US deficits started mounting, other countries started losing faith in the ability of the US to convert their dollar asset into gold. 5) Fixed exchange rate As the name suggests, under fixed exchange rate system, the value of a currency in terms of another is fixed. These rates are determined by governments or central banks of the respective countries. The fixed exchange rates result from pegging their currencies to either some common commodity or to some particular currency. The rates remain constant or they may fluctuate within a narrow range. When a currency tends crossing

http://www.linny.org/forum/ over the limits, governments intervene to keep within the band. Normally countries pegs its currency to the currency in which the major transactions are carried out or some countries even peg their currencies to SDR. For example : - US dollar has 24 currencies pegged to itself whereas French franc has 14 currencies and 4 currencies are pegged to SDRs. The major advantage of this system is that it provides stability to international trade and exchange rate risk is reduced to some extent. Because of the fixed exchange rate system, exporters and importers are clear how much they have to pay each other on the due date. The disadvantage is that it is prone to speculation i.e. a speculator anticipating devaluation of pound sterling will buy US dollars at a forward rate so as to sell them when devaluation of the pound takes place. 6) Floating Exchange Rates: When the relative price of currencies are determined purely by force of demand and supply and when the authorities make no attempt to hold the exchange rate at any particular level within a specific band or move it in a certain direction by intervening in the exchange markets, it is referred to as Floating Exchange Rate. 7) Crawling Peg: A crawling peg rate is a hybrid of fixed and flexible exchange rate systems. Under this system, while the value of a currency is fixed in terms of a reference currency, this peg keeps on changing itself in accordance with the underlying economic fundamentals, thus letting the market forces play a role in the determination of the change in exchange rate. There are several bases which could be used to determine the direction of change in the exchange rate for example – the actual exchange rate ruling the market, t there is gradual modifications with permissable variations around the parity restricted to a narrow band. The change in parity per unit period is subject to a ceiling with an additional short term constraint, e.g. parity change in a month cannot be more than 1/12th of the yearly ceiling. Parity changes are carried out , based on a set of indicators. They may be discretionary, automatic or presumptive. The indicators are : current account deficits, changes in reserves, relative inflation rates and moving average of past spot rates. Countries such as Portugal and Brazil have in the part adopted variants of Crawling Peg. 8) Adjustable Peg: Adjustable Peg system was established which fixed the exchange rates, with the provision of changing them if the necessity rose. Under the new system, all the members of the newly set up IMF were to fix the par value of their currency either in terms of gold, or in terms of US dollar. The par value of the US dollar was fixed at $ 35 per ounce. All these values were fixed with the approval of the IMF, and were reflected in the change economic and financial scenario in the countries engaged in international trade. The member countries agreed to maintain the exchange rates for their currency within a band of one percent on either sides of the fixed par value. The extreme points were to be

http://www.linny.org/forum/ referred to as upper and lower support point, due to which requirement that the countries do not allow the exchange rate to go beyond these points. The monetary authorities were to stand ready to buy or sell the US dollar and thereby support the exchange rates. For this purpose, a country which would freely buy and sell gold at the aforementioned par value for the settlement of international transactions was deemed to be maintaining its exchange rate within the one percent band. 9) Special Drawing Rights(SDRs): The IMF created an asset called Special Drawing Rights by simply opening an account in the name of each member country and crediting it with a certain amount of SDRs. The total volume created has to be ratified by the gouverning board and its allocation among the members is propotional to their quotas. The members can use it for settling payments among themselves as well as for transactions with the fund. E.g. paying the reserve tranch contribution of an increase in their quotas. 10) Devaluation : The lowering of a country’s official exchange rate in relation to a foreign currency (or to gold) so that exports compete more favourably in the overseas markets. Devaluation is the opposite to revaluation. 11) Lerms: An acronym for liberalization Exchange Management System that was introduced from March 1, 1992 under which the rupee was made partially convertible. The objective was to encourage exporters and induce a greater inflow of remittances through proper channels as well as bring about greater efficiency in import substitution. Under the system, percent of eligible foreign exchange receipts such as exports earnings or remittances was to be converted at the market rate and the balance 40% at the official rate of exchange. Importers could obtain their requirements of foreign exchange from authorized dealers at the market rate. Because of certain weaknesses, this system was replaced by a unified exchange rate in March 1993. This unification was recommended as an important step towards full convertibility by the committee on balance of payments under the chairmanship of C Ragranajan. Under the unified rate system all foreign exchange transactions through authorized dealers out at market determined rate exchange. 12) Custom Union: Custom Union is a form of economic integration in which two or more nations agree to free all internal trade amongst themselves while levying a common external tariff on all non-member countries. The theory of custom unions and economic integration is associated primarily with the work of Prof. Jacob Viner in the 1940’s. This theory mainly focuses on optimum utilization of resources present in the member countries. Integration

http://www.linny.org/forum/ provides the opportunity of industries that have not yet been established as well as for those that have to take advantage of economies of large scale production made possible by expanded markets. 13) Dirty float: The authorities are intervened more or less intensely in the foreign exchange market in which there are no officially declared parties, but there is official intervention that has come to be known as managed or dirty float. 14) Gold Tranche: Member countries have an absolute claim on the IMF upto the amountof gold subscriptions they have made. In operational terms, they can draw this amount (= 25% of their quota) from IMF any time. This is called ‘reserve tranche’ or “gold tranche” and is treated as the reserve of the country concerned. However, this sum is reimbursed to the IMF within a specified period varying from 3 months to 5 years. 15) Credit Tranches : Any member can unconditionally borrow the part of its quota which it has contributed in the form of SDRs or foreign currency. When it can borrow upto 100% of its quota in four futher tranches it is called credit tranches. (Tranche means a ‘slice’) 16)International Liquidity : It refers to the stock of means of international payment 17) Extended Fund Facility (EFF): This facility was established in 1974 by the IMF to help countries address more protracted balance-of-payments problems with roots in the structure of the economy. Arrangements under the EFF are thus longer (3 years) and the repayment period can extend to 10 years, although repayment is expected within 4½ -7 years. 18) FDI FDI is the acquisition of a controlling interest in a foreign firm or affiliate (branch, subsidiary, etc.). There are a variety of ways that FDI can occur, including building new foreign facilities from scratch ("Greenfield investment"), merging with a foreign firm, taking over a foreign firm, and entering a partnership with a foreign firm (Example; a joint venture).

http://www.linny.org/forum/ Horizontal FDI involves investing in a firm that is in the same industry. Vertical FDI involves investing in a supplier or customer firm. 19) PI Portfolio investments consist mainly of the holding of transferable securities or guaranteed by the govt. of the capital importing country. Such holdings do not amount to right to control the company. E.g. shares, debenture, bonds etc. 20) GDR “Global Depositary Receipts mean any instrument in the form of a depositary receipt or certificate (by whatever name it is called) created by the Overseas Depositary Bank outside India and issued to non-resident investors against the issue of ordinary shares or Foreign Currency Convertible Bonds of issuing company.” They are negotiable certificates that usually represent a company’s publicly traded equities and can be denominated in any freely convertible foreign currency. They are listed on a European stock exchange, often Luxembourg or London. Each DR represents a multiple number or fraction of underlying shares or alternatively the shares correspond to a fixed ratio, for example, 1 GDR = 10 Shares. 21) ADR A GDR issued in America is an American Depositary Receipt (ADR). An ADR represents an ownership interest in foreign securities. It is a negotiable instrument issued by an American Depository bank certifying that shares of a non-US issuing company are held by the depository’s custodian bank abroad. Each unit of ADR is called an American Depository Share (ADS). They are an ideal way for foreign companies to raise funds to expand their international capital base and get name and product exposure in the US. ADR could be listed on the New York stock exchange, NASDAQ or could be issued as private placement securities under rule 144a in the US. 21) ODA (Official Development Assistance) Many developing countries continue to struggle under the grips of extreme poverty. The trends in globalization and economic transition have had both a bright and dark side. Certain countries have been left behind by or out of the entire process, and in others, the gulf between the rich and poor has widened. As a result of this they are in a constant need

http://www.linny.org/forum/ of funds and other forms of assistance to develop them. The assistance provided for this purpose from one country to another is termed as ODA. Previously it was granted to a country that needed to rebuild itself after the war. ODA came in the form of infusions of aid from the international community, ODA is a vehicle through which countries strive to cultivate a sound international environment and promote ties of goodwill with other countries ODA was instrumental in helping lay essential infrastructure and in other ways set the stage for the economic takeoff of developing countries. ODA can serve as a vital diplomatic tool for to help create a desirable international climate and promote closer ties with other states. The main goals of ODA can be included in following points: • •

•

Providing humanitarian assistance for the purpose of attaining global prosperity and development. Tackling Global Issues such as global environmental degradation, the population explosion, the food and energy crises, AIDS and other infectious diseases, to drug abuse, terrorism, crimes against international society, and now financial turmoil. Creating a harmonious environment of security in terms of ensuring peace and security for the human race and the world at large,

22) Foreign Aid One of the important methods of financing trade is through aid. Larger trade is possible through larger aid and it is in this context that a study of the mechanics of aid is relevant in international finance. Movement of money from one country to another in the form of aid is referred to as the foreign aid. The donor countries not only look into their own capacity to grant aid but at the recipient country’s capacity to absorb aid. The latter is judged by the efficiency and productivity in the resource allocation in the pattern of planning and investment and in priorities of allocation, the methods of raising resources and the overall performance of the economy. Availability of foreign aid for the purpose of investment would accelerate growth by helping the cooperating factors at home to be fully deployed and by accelerating the rate of investment. This would enable the necessary technical innovation and accelerate the entrepreneurial function. Foreign aid augments domestic economic growth. The pattern of flows under foreign aid does not depend upon pure economic factors nor on pure commercial considerations but more on politico-economic factors. The effect of foreign aid on the foreign exchange market is to: • increase the supply and ease the pressures of demand, • to facilitate the transfer mechanism in the currency markets and • to obviate the need for frequent changes in the exchange rates, pending the process of structural adjustment in the domestic economy. The inflow of foreign aid would however increase the money supply, which may not lead to inflationary pressures so long as funds are efficiently and productively used in the

http://www.linny.org/forum/ development process. The basic postulate is that foreign aids fills in the gaps make available non-available and complimentary resources and augments the investment process. 23) Multilateral Investment Guarantee Multilateral Investment Guarantee is a non-commercial guarantee (insurance) for investments made in developing countries. Such a guarantee protects investors against the risks of transfer restriction (including convertibility), expropriation, war and civil disturbance and breach of contract. MIG has a joint sponsorship by developed and developing countries and multilateral character. MIG supplements national and private agencies supporting foreign direct investment through their own investment insurance programmes. The MIG encourages foreign investments by providing viable alternatives in investment insurance against noncommercial risks in developing countries thereby creating investment opportunities in those countries. E.g. Investors who would like to invest in a developing country like Africa would surely like to get a cover for their investments and can attain this insurance through a Multilateral Guarantee and thus can invest jointly in such an investment project. 24) Multilateral Aid Multilateral means "many sides". Here organisations that involve many countries, give help. This aid is run by groups such as the World Health Organisation (WHO) and United Nations Educational, Scientific and Cultural Organisation (UNESCO) - both of which are part of the United Nations (UN). Economic aid for development by the developed countries is based on political affinities with the recipient country. Such an aid may be bilateral or multilateral. Multilateral aid is through international financial institutions for use in the import of goods and services from any country. Multilateral aid is usable anywhere and hence its rate of utilization will be high. 25) Bilateral Aid Bilateral means "two sides". This type of aid is from one country to another. An example would be Britain giving money and sending experts to help build a dam in Turkey. Quite often bilateral aid is also tied Aid. This is the most common type of aid. In this type of aid the giving (or donor) country also benefits economically from the aid. This happens, as the receiving country has to buy goods and services from the donor country to get the aid in the first place. In building a dam, for example, the Britain may insist that their companies, experts and equipment are used. Whether the aid is given may depend on the receiving country agreeing to buy e.g. military jets from the donor. Bilateral aid is from one government to the other. Generally bilateral aid constitutes the bulk of the total aid granted to any country. It may be tied or untied.

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26) Petro Dollar During the oil crises of 1973, the Capital markets have played a very important role. They accepted the dollar deposits from oil exporters and channeled the funds to the borrowers in other countries. This is called ‘recycling the petrodollars’. 27) Junk Bonds A junk bond is issued by a corporation or municipality with a bad credit rating. In exchange for the risk of lending money to a bond issuer with bad credit, the issuer pays the investor a higher interest rate. "High-yield bond" is a nicer name for junk bond The credit rating of a high yield bond is considered "speculative" grade or below "investment grade". This means that the chance of default with high yield bonds is higher than for other bonds. Their higher credit risk means that "junk" bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk. Junk bonds became a common means for raising business capital in the 1980s, when they were used to help finance the purchase of companies, especially by leveraged buyouts, the sale of junk bonds continued to be used in the 1990s to generate capital 28) Samurai Bonds They are publicly issued yen denominated bonds. They are issued by non-Japanese entities. The Japanese Ministry of Finance lays down the eligibility guidelines for potential foreign borrowers. These specify the minimum rating, size of issue, maturity and so forth. Floatation costs tend to be high. Pricing is done with respect to Long-term Prime Rate. 29) Shibosai Bonds They are private placement bonds with distribution limited to banks and institutions. The eligibility criteria are less stringent but the MOF still maintains control. 30) Shogun / Geisha Bonds They are publicly floated bonds in a foreign currency while Geisha are their private counterparts. 31) Yankee Bonds These are dollar denominated bonds issued by foreign borrowers. It is the largest and most active market in the world but potential borrowers must meet very stringent disclosure, dual rating and other listing requirements, options like call and put can be incorporated and there are no restrictions on size of the issue, maturity and so forth.

http://www.linny.org/forum/ Yankee bonds can be offered under rule 144a of Sec. These issues are exempt from elaborate registration and disclosure requirements but rating, while not mandatory is helpful. Finally low rated or unrated borrowers can make private placements. Higher yields have to be offered and the secondary market is very limited. 32) Value Date: The settlement of a transaction takes place by transfers of deposits between two parties. The day on which these transfers are effected is called the Settlement Date or the Value Date. 33) Spot Rate: When the exchange of currencies takes place on the second working day after the date of the deal, it is called spot rate. 34) Forward Transactions: If the exchange of currencies takes place after a certain period from the date of the deal (more than 2 working days), it is called a forward rate. A trader may quote a forward transaction for any future date. It is a binding contract between a customer and dealer for the purchase or sale of a specific quantity of a stated foreign currency at the rate of exchange fixed at the time of making the contract. 35) Swap Transaction: A swap transaction in the foreign exchange market is combination of a spot and a forward in the opposite direction. Thus a bank will buy DEM spot against USD and simultaneously enter into a forward transaction with the same counter party to sell DEM against USD against the mark coupled with a 60- day forward sale of USD against the mark. As the term ‘swap’ implies, it is a temporary exchange of one currency for another with an obligation to reverse it at a specific future date. 36) Bid Rate: The bid rate denotes the number of units of a currency a bank is willing to pay when it buys another currency. 37) Offer Rate: The offer rate denotes the number of units of a currency a bank will want to be paid when it sells a currency. 38) Bid - Offer Rate: The bid offer Rate is the rate which states both, the price which is the bank is willing to pay to buy other currencies and the price the bank expects when it sells the same currency. Bid and Ask will always be from a bank’s point of view. Thus (A/B)bid will denote the number of units of A the bank will pay when it buys one unit of B and (A/B)ask will mean the number of units of A the bank will want to be paid in order to sell one unit of B. 39) European Quote:

http://www.linny.org/forum/ The quotes are given as number of units of a currency per USD. Thus DEM1.5675/USD is a European quote. 40) American Quotes: American quotes are given as number of dollars per unit of a currency. Thus USD0.4575/DEM is an American quote. 41) Direct Quotes: in a country, direct quotes are those that give unit of the currency of that country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote in India. 42) Indirect Quote: Indirect or Reciprocal Quotes are stated as number of units of a foreign currency per unit of the home currency. Thus USD 3.9560/INR 100 is an indirect quote in India. 43) Arbitrage: Arbitrage may be defined a san operation that consists in deriving a profit without risk from a differential existing between different quoted rates. It may result from 2 currencies, also known as, geographical arbitrage or from 3 currencies, also known as, triangular currencies.

http://www.linny.org/forum/ Examine the transformation of the European Union from a political and economic union to a monetary union. Ans: - The basis of the European Monetary Union was to build a united Europe after the World War II. This was initiated by when the European nations created the European Coal and Steel community, with a view to freeing trade in these two sectors. The pricing policies and commercial practices of the member nations of this community were regulated by a supranational agency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxemburg and the Netherlands to form the European Economic Community (EEC), whereby they agreed to make Europe a common market. While they agreed to lift restrictions on movements of all factors of production and to harmonize domestic policies, the ultimate aim was economic integration. The EEC achieved the status of a customs union by 1968. In the same year, it adopted a Common Agricultural Policy (CAP), under which uniform prices were set for farm products in the member countries, and levies were imposed on imports from non- member countries to protect the regional industry from lower external prices. In the European unification, power was given to all member countries that they could veto any decision taken by other members. This hindrance was removed when the members approved of the Single European Act, in 1986, making it possible for a lot of proposals to be passed by weighted majority voting. This paved way for the unifications of the markets for capital and labour, which converted EEC practically into a market on January 1, 1993. The Heads of State and governments of the countries of the EU decided at Maastricht on 9th and 10th December 1991 to put in place the European Monetary Union (EMU). Adhering to the EMU meant irrevocable fixed exchange rates between different countries of the Union. The setting up of the EMU had been a step forward towards the introduction of a common currency in the member states of EU, as per the Maastricht Treaty. It had been ratified by all 12 countries which constituted the union at that point of time. The EMU completed the mechanism that started with the Customs Union of the Treaty of Rome and the big Common Market of the Single Act. The objectives of the EMU are:• • •

Adoption of an economic policy, based on a close coordination between economic policies of the member states. Fixing of irrevocable exchange rates leading to a single currency. Development of a single monetary policy having objective of price stability and the support to the economic policies of the member states in general.

The primary advantage of EMU was that it helped in stabilizing exchange rates in the currencies of member states. It also helped in elimination of transaction costs, greater transparency in prices and greater credibility with respect to the world outside. Also, EMU signified giving up a independent national monetary policy. There seemed to be an agreement among the member states that the effect of the EMS would be beneficial for the economic growth of Europe. However it was anticipated there would be some problems in short and medium term. For instance, the programmes of structural

http://www.linny.org/forum/ adjustment carried out by the countries like Italy, Spain, Germany to reduce public deficits and inflation by a restrictive policy had negative effects on internal demand and growth. This policy also had negative effects on neighboring countries in terms of reduction of their international business. The countries which had not attained a required level of economic convergence found it difficult for maintaining the currency within the EMS. Thus the transformation of the European Union from a political and economic union to a monetary union has explained above along with the features of the EMU.

http://www.linny.org/forum/ DISCUSS THE RELEVANCE / IMPORTANCE OF THE BOP STATEMENTS? BOP statistics are regularly compiled, published and are continuously monitored by companies, banks and government agencies. A set of BOP accounts is useful in the same way as a motion picture camera. The accounts do not tell us what is good or bad, nor do they tell us what is causing what. But they do let us see what is happening so that we can reach our own conclusions. Below are 3 instances where the information provided by BOP accounting is very necessary: 1. Judging the stability of a floating exchange rate system is easier with BOP as the record of exchanges that take place between nations help track the accumulation of currencies in the hands of those individuals more willing to hold on to them. 2. Judging the stability of a fixed exchange rate system is also easier with the same record of international exchange. These exchanges again show the extent to which a currency is accumulating in foreign hands, raising questions about the ease of defending the fixed exchange rate in a future crisis. 3. To spot whether it is becoming more difficult for debtor counties to repay foreign creditors, one needs a set of accounts that shows the accumulation of debts, the repayment of interest and principal and the countries ability to earn foreign exchange for future repayment. A set of BOP accounts supplies this information. This point is further elaborated below. The BOP statement contains useful information for financial decision makers. In the short run, BOP deficit or surpluses may have an immediate impact on the exchange rate. Basically, BOP records all transactions that create demand for and supply of a currency. When exchange rates are market determined, BOP figures indicate excess demand or supply for the currency and the possible impact on the exchange rate. Taken in conjunction with recent past data, they may conform or indicate a reversal of perceived trends. They also signal a policy shift on the part of the monetary authorities of the country unilaterally or in concert with its trading partners. For instance, a country facing a current account deficit may raise interest to attract short term capital inflows to prevent depreciation of its currency. Countries suffering from chronic deficits may find their credit ratings being downgraded because the markets interpret the data as evidence that the country may have difficulties its debt. BOP accounts are intimately with the overall saving investment balance in a country’s national accounts. Continuing deficits or surpluses may lead to fiscal and monetary actions designed to correct the imbalance which in turn will affect exchange rates and interest rates in the country. In nutshell corporate finance managers must monitor the BOP data being put out by government agencies on a regular basis because they have both short term and long term implications for a host of economic and financial variables affecting the fortunes of the company.

http://www.linny.org/forum/ Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain specified time in future for certain specified price. In this, it is similar to a forward contract. However, there are a number of differences between forwards and futures. These relate to the contractual features, the way the markets are organized, profiles of gains and losses, kinds of participants in the markets and the ways in which they use the two instruments. Futures contracts in physical commodities such as wheat, cotton, corn, gold, silver, cattle, etc. have existed for a long time. Futures in financial assets, currencies, interest bearing instruments like T-bills and bonds and other innovations like futures contracts in stock indexes are a relatively new development dating back mostly to early seventies in the United States and subsequently in other markets around the world. Major Features Of Futures Contracts The principal features of the contract are as follows: Organized Exchanges Unlike forward contracts which are traded in an over-the-counter market, futures are traded on organized exchanges with a designated physical location where trading takes place. This provides a ready, liquid market in which futures can be bought and sold at any time like in a stock market. Standardization In the case of forward currency contracts, the amount of commodity to be delivered and the maturity date are negotiated between the buyer and seller and can be tailor-made to buyer's requirements. In a futures contract both these are standardized by the exchange on which the contract is traded. Thus, for instance, one futures contract in pound sterling on the International Monetary Market (IMM), a financial futures exchange in the US, (part of the Chicago Board of Trade or CBT), calls fore delivery of 62,500 British Pounds and contracts are always traded in whole numbers i.e. you cannot buy or sell fractional contracts. A three-month sterling deposit on the London International Financial Futures Exchange (LIFFE) has March, June, September, December delivery cycle. The exchange also specifies the minimum size of price movement (called the "tick") and, in some cases, may also impose a ceiling on the maximum price change within a day. In the case of commodity futures, the commodity in question is also standardized for quality in addition to quantity in a single contract. Clearing House The exchange acts as a clearinghouse to all contracts struck on the trading floor. For instance, a contract is struck between A and B. Upon entering into the records of the exchange, this is immediately replaced by two contracts, one between A and the clearing house and another between B and the clearing house. In other words, the exchange interposes itself in every contract and deal, where it is a buyer toe very seller and a seller to every buyer. The advantage of this is that A and B do not have to undertake any exercise to investigate each other's creditworthiness. It also guarantees the financial

http://www.linny.org/forum/ integrity of the market. The exchange enforces delivery for contracts held until maturity and protects itself from default risk by imposing margin requirements on traders and enforcing this through a system called "marking to market". Margins Like all exchanges, only members are allowed to trade in futures contracts on the exchange. Others can use the services of the members as brokers to use this instrument. Thus, an exchange member can trade on his own account as well as on behalf of a client. A subset of the members is the "clearing members" or members of the clearinghouse and non-clearing members must clear all their transactions through a clearing member. The exchange requires that a margin must be deposited with the clearinghouse by a member who enters into a futures contract. The amount of the margin is generally between 2.5% to 10% of the value of the contract but can vary. A member acting on behalf of a client, in turn, requires a margin from the client. The margin can be in the form of cash or securities like treasury bills or bank letters of credit. Marking To Market The exchange uses a system called marking to market where, at the end of each trading session, all outstanding contracts are repriced at the settlement price of that trading session. This would mean that some participants would make a loss while others would stand to gain. The exchange adjusts this by debiting the margin accounts of those members who made a loss and crediting the accounts of those members who have gained. This feature of futures trading creates an important difference between forward contracts and futures. In a forward contract, gains or losses arise only on maturity. There are no intermediate cash flows. Whereas, in a futures contract, even though the gains and losses are the same, the time profile of the accruals is different. In other words, the total gains or loss over the entire period is broken up into a daily series of gains and losses, which clearly has a different present value. Actual Delivery Is Rare In most forward contracts, the commodity is actually delivered by the seller and is accepted by the buyer. Forward contracts are entered into for acquiring or disposing off a commodity in the future for a gain at a price known today. In contrast to this, in most futures markets, actual delivery takes place in less than one percent of the contracts traded. Futures are used as a device to hedge against price risk and as a way of betting against price movements rather than a means of physical acquisition of the underlying asset. To achieve this, most of the contracts entered into are nullified by a matching contract in the opposite direction before maturity of the first. Types of futures As is evident from the previous discussion, trading in futures is equivalent to betting on the price movements in futures prices. If such betting is used to protect a position - either long or short - in the underlying asset, it is termed as hedging. On the other hand, if the activity is undertaken only with the objective of generating profits from absolute or

http://www.linny.org/forum/ relative price movements, it is termed as speculation. It must be noted that speculators provide liquidity to the markets by their willingness to enter open positions. We shall briefly look at currency, interest rate and stock index futures. There are others like commodity futures as well which are not covered under this section. Currency Futures We shall look at both hedging and speculation in currency futures. Corporations, banks and others use currency futures for hedging purposes. The underlying principle is as follows: Assume that a corporation has an asset e.g. a receivable in a currency A that it would like to hedge, it should take a futures position such that futures generate a positive cash whenever the asset declines in value. In this case, since the firm in long, in the underlying asset, it should go short in futures i.e. it should sell futures contracts in A. Obviously, the firm cannot gain from an appreciation of A since the gain on the receivable will be eaten away by the loss on the futures. The hedger is willing to sacrifice this potential profit to reduce or eliminate the uncertainty. Conversely, a firm with a liability in currency A e.g. a payable, should go long in futures. In hedging too, the corporation has the option of a direct hedge and a cross hedge. A British firm with a dollar payable can hedge by selling sterling futures (same effect as buy dollar futures) on the IMM or LIFFE. This is an example of a direct hedge. If the dollar appreciates, it will lose on the payable but gain on the futures, as the dollar price of futures will decline. An example of a cross hedge is as follows: A Belgian firm with a dollar payable cannot hedge by selling Belgian franc futures because they are not traded. However, since the Belgian franc is closely tied to the Deutschemark in the European Monetary System (EMS). It can sell DM futures. An important point to note is that, in a cross hedge, a firm must choose a futures contract on an underlying currency that is highly positively correlated with the currency exposure being hedged. Also, even when a direct hedge is available, it is extremely difficult to achieve a perfect hedge. This is due to two reasons. One is that futures contracts are for standardized amounts as this is designed by the exchange. Evidently, this will only rarely match the exposure involved. The second reason involves the concept of basis risk. The difference between the spot price at initiation of the contract and the futures price agreed upon is called the basis. Over the term of the contract, the spot price changes, as does the futures price. But the change is not always perfectly correlated - in other words, the basis is not constant. This gives rise to the basis risk. Basis risk is dealt with through the hedge ratio and a strategy called delta hedging. A speculator trades in futures to profit from price movements. They hold views about the future price movements - if these differ from those of the general market, they will trade to profit from this discrepancy. The flip side is that they are willing to take the risk of a loss if the prices move against their views of opinions.

http://www.linny.org/forum/ Speculation using futures can be in the either open position trading or spread trading. In the former, the speculator is betting on movements in the price of a particular futures contract. In the latter, he is betting on the price differential between two futures contracts. An example of open position trading is as follows: $/DM Prices Spot

0.5785

March Futures

0.5895

June Futures

0.5915

September Futures

0.6015

These prices evidently indicate that the market expects the DM to appreciate over the next 6-7 months. If there is a speculator who holds the opposite view - i.e. he believes that the DM is actually going to depreciate. There is another speculator who believes that the DM will appreciate but not to the extent that the market estimates - in other words, the appreciation of the DM will fall short of market expectations. Both these speculators sell a September futures contract (standard size - DM 125,000) at $ 0.6015. On September 10, the following rates prevail: Spot $/DM - 0.5940, September Futures - 0.5950 Both speculators reverse their deal with the purchase of a September futures contract. The profit they make is as follows: $(0.6015-0.5950) i.e. $0.0065 per DM or $(125000 x 0.0065) i.e. $ 812.5 per contract. A point to be noted in the above example is that the first speculator made a profit inspite the fact that his forecast was faulty. What mattered therefore, was the movement in September futures price relative to the price that prevailed on the day the contract was initiated. In contrast to the open position trading, spread trading is considered a more conservative form of speculation. Spread trading involves the purchase of one futures contract and the sale of another. An intra-commodity spread involves difference in prices of two futures contract with the same underlying commodity and different maturity dates. These are also termed as time spreads. An inter-commodity spread involves the difference in prices of two futures contracts with different but related commodities. These are usually with the same maturity dates. Interest Rate Futures Interest rate futures is one of the most successful financial innovations in recent years. The underlying asset is a debt instrument such as a treasury bill, a bond or time deposit in

http://www.linny.org/forum/ a bank. The International Monetary Market (IMM) - a part of the Chicago Mercantile Exchange, has futures contracts on US Government treasury bonds, three-month Eurodollar time deposits and medium term US treasury notes among others. The LIFFE has contracts on euro-dollar deposits, sterling time deposits and UK Government bonds. The Chicago Board of Trade offers contracts on long term US treasury bonds. Interest rate futures are used by corporations, banks and financial institutions to hedge interest rate risk. A corporation planning to issue commercial paper can use T-bill futures to protect itself against an increase in interest rate. A treasurer who is expecting some surplus cash in the near future to be invested in some short term investments may use the same as insurance against a fall in interest rates. Speculators bet on interest rate movements or changes in the term structure in the hope of generating profits. A complete analysis of interest rate futures would be a complex exercise as it involves thorough understanding and familiarity with concepts such as discount yield, yield-tomaturity and elementary mathematics of bond valuation and pricing. Stock Index Futures A stock index futures contract is an obligation to deliver on the settlement date an amount of cash equivalent to the value of 500 times the difference between the stock index value at the close of the last trading day of the contract and the price at which the futures contract was originally struck. For example, if the S&P 500 Stock Index is at 500 and each point in the index equals $ 500, a contract struck at this level is worth $ 250,000 (500 * $500). If, at the expiration of the contract, the S&P 500 Stock Index is at 520, a cash settlement of $ 10,000 is to be made [ (520 - 510) * $500]. It must be noted that no physical delivery of stock is made. Therefore, in order to ensure that sufficient funds are available for settlement, both parties have to maintain the requisite deposit and meet the variation margin calls as and when required. Options A options agreement is a contract in which the writer of the option grants the buyer of the option the right purchase from or sell to the writer a designated instrument for a specified price within a specified period of time. The writer grants this right to the buyer for a certain sum of money called the option premium. An option that grants the buyer the right to buy some instrument is called a call option. An options that grants the buyer the right to sell an instrument is called a put option. The price at which the buyer an exercise his option is called the exercise price, strike price or the striking price. Options are available on a large variety of underlying assets like common stock, currencies, debt instruments and commodities. Also traded are options on stock indices and futures contracts – where the underlying is a futures contract and futures style options. Options have proved to be a versatile and flexible tool for risk management by themselves as well as in combination with other instruments. Options also provide a way for individual investors with limited capital to speculate on the movements of stock

http://www.linny.org/forum/ prices, exchange rates, commodity prices etc. The biggest advantage in this context is the limited loss feature of options. Types Of Options As mentioned earlier, the underlying asset for options could be a spot commodity or a futures contract on a commodity. Another variety is the futures-style option. An option on spot foreign exchange gives the option buyer the right to buy or sell a currency at a stated price (in terms of another currency). If the option is exercised, the option seller must deliver or take delivery of a currency. An option on currency futures gives the option buyer the right to establish a long or short position in a currency futures contract at a specified price. If the option is exercised, the seller must take the opposite position in the relevant futures contract. For example, suppose you had an option to buy a December DM contract on the IMM at a price of $ 0.58 / DM. You exercise the option when December futures are trading at $ 0.5895. You can close out your position at this price and take a profit of $ 0.0095 per DM or, meet futures margin requirements and carry a long position with $ 0.0095 per DM being credited to your margin account. The option seller automatically gets a short position in December futures. Futures style options are a little bit more complicated. Like futures contracts, they represent a bet on a price. The price being betted on, is the price of an option on spot foreign exchange. Simply put, the buyer of the option has to pay a price to the seller of the option i.e. the premium or the price of the option. In a futures style option, you are betting on the changes in this price, which, in turn depends on several factors including the spot exchange rate of the currency involved. For instance, a trader feels that the premium on a particular option is going to increase. He buys a futures-style call option. The seller of this call option is betting that the premium will go down. Unlike the option on the spot, the buyer does not pay the premium to the seller. Instead, they both post margins related to the value of the call on spot. Options Terminology To reiterate, the two parties to an options contract are the option buyer and the option seller, also called the option writer. For exchange traded options, as in the case of futures, once the agreement is reached between two traders, the exchange (the clearing house) interposes itself between the two parties becoming buyer to every seller and seller to every buyer. The clearing house guarantees performance on the part of every seller. Call Option A call option gives the option buyer the right to purchase currency Y against currency X, at a stated price X/Y, on or before a stated date. For exchange traded options, one contract represents a standard amount of the currency Y. The writer of a call option must deliver the currency if the option buyer chooses to exercise his option. Put Option

http://www.linny.org/forum/ A put option gives the option buyer the right to sell a currency Y against currency X at a specified price on or before a specified date. The writer of a put option must take delivery if the option is exercised. Strike Price (also called exercise price) The price specified in the option contract at which the option buyer can purchase the currency (call) or sell the currency (put) Y against X. Maturity Date The date on which the option contract expires is the maturity date. Exchange traded options have standardized maturity dates. American Option An option, call or put, that can be exercised by the buyer on any business day from initiation to maturity. European Option A European option is an option that can be exercised only on maturity date. Premium (Option price, Option value) The fee that the option buyer must pay the option writer at the time the contract is initiated. If the buyer does not exercise the option, he stands to lose this amount. Intrinsic value of the option The intrinsic value of an option is the gain to the holder on immediate exercise of the option. In other words, for a call option, it is defined as Max [(S-X), 0], where s is the current spot rate and X is the strike rate. If S is greater than X, the intrinsic value is positive and is S is less than X, the intrinsic value will be zero. For a put option, the intrinsic value is Max [(X-S), 0]. In the case of European options, the concept of intrinsic value is notional as these options are exercised only on maturity. Time value of the option The value of an American option, prior to expiration, must be at least equal to its intrinsic value. Typically, it will be greater than the intrinsic value. This is because there is some possibility that the spot price will move further in favor of the option holder. The difference between the value of an option at any time "t" and its intrinsic value is called the time value of the option. At-the-Money, In-the-Money and Out-of-the-Money Options A call option is said to be at-the-money if S=X i.e. the spot price is equal to the exercise price. It is in-the-money is S>X and out-of-the-money is S<X. Conversely, a put option is at-the-money is S=X, in-the-money if S<X and out-of-the-money if S>X. Option Pricing Black & Scholes, in their celebrated analysis on option pricing, reached the conclusion that the estimated price of a call could be calculated with the following equation: Pc = [Ps][N(d1) – [Pe][antilog (-Rft)[N(d2)]

http://www.linny.org/forum/ Where: Pc - market value of the call option Ps - price of the stock Pe - strike price of the option Rf - annualized interest rate t - time to expiration in years antilog – to the base e N(d1) and N(d2) are the values of the cumulative normal distribution, defined as follows: d1 = Ln (Ps / Pe) + (Rf + 0.5 s 2)t sÖt d2 = d1 - (s Ö t) where: Ln (Ps / Pe) is the natural logarithm of (Ps / Pe) s 2 is the is the variance of continuously compounded rate of return on stock per time period. Admittedly, the definitions of d1 and d2 are difficult to grasp for the reader as they involve complex mathematical equations. However, the basic properties of the Black-Scholes model are easy to understand. What the model establishes is that the estimated price of options vary directly with an option’s term to maturity and with the difference between the stock’s market price and the option’s strike price. Further, the definitions of d1 and d2 indicate that option prices increase with the variance of the rate of return on the stock price, reflecting that the greater the volatility, higher the chance that the option will become more valuable. Relationship Between The Option Premium And Stock Price It is obvious that the option premium fluctuates as the stock price moves above or below the strike price. Generally, option premiums rarely move point for point with the price of the underlying stock. This typically happens only at parity, in other words, when the exercise price plus the premium equals the market price of the stock. Prior to reaching parity, premiums tend to increase less than point per point with the stock price. One reason for this are that point per point increase in premium would result in sharply reduced leverage for the option buyers – reduced leverage means reduced demand for the option. Also, a higher option premium entails increased capital outlay and increased risk, once again reducing demand for the option. Declining stock prices also do not result in a point per point decrease in option premium. This is because, even a steep decline in the stock price in a span of a few days has only a slight effect on the option’s total value – its time value. This term to maturity effect tends to exist as the option is a wasting asset.

http://www.linny.org/forum/ Option Strategies This section deals with some of the most basic strategies that can be devised using options. The idea is to familiarize the reader with the flexibility of options as a risk management tool. In order to keep matters simple, we make the following assumptions: • •

•

We shall ignore brokerage, commissions, margins etc. We shall assume that the option is exercised only on maturity and not prematurely exercise - in other words, we assume that we are only dealing with European options All exchange rates, strike prices and premia will be in terms of dollars per unit of a currency and the option will be assumed to be on one unit of the currency.

Call Options A call option buyer's profit can be defined as follows: At all points where S<X, the payoff will be -c At all points where S>X, the payoff will be S-X- c, where S = Spot price X = Strike price or exercise price c = call option premium Conversely, the option writer's profit will be as follows: At all points where S<X, the payoff will be c At all points where S>X, the payoff will be -(S-X- c) To illustrate this, let us look at an example and construct the payoff profile. Consider a trader who buys a call option on the Swiss Franc with a strike price of $ 0.66 and pays a premium of 1.95 cents ($0.0195). The current spot rate is 0.6592. His gain or loss at time T when the option expires depends upon the value of the spot rate at that time. For all values of S below 0.66, the option buyer lets the option lapse since the Swiss francs can be bough in the spot market at a lower price. His loss then will be limited to the premium he has paid. For spot values greater than the strike price, he will exercise the option. Let us look at the payoff profile of the call option buyer. Spot Rate

Gain (S-X-c)

Loss (-c)

0.6000

-

-0.0195

0.6500

-

-0.0195

0.6600

-

-0.0195

http://www.linny.org/forum/

0.6700

-

-0.0195

0.6795

-

-

0.6800

0.0005

-

0.6900

0.0105

-

0.7000

0.0205

-

Similarly, we can construct the payoff profile for the call writer. This will be as follows: Spot Rate

Gain (c)

Loss (S-X-c)

0.6000

0.0195

-

0.6500

0.0195

-

0.6600

0.0195

-

0.6700

0.0195

-

0.6795

-

-

0.6800

-

-0.0005

0.6900

-

-0.0105

0.7000

-

-0.0205

Put Option A put option buyer's profit can be defined as follows: At all points where S<X, the payoff will be X-S-p At all points where S>X, the payoff will be -p, where S = Spot price X = Strike price or exercise price p = put option premium Conversely, the put option writer's profit will be as follows: At all points where S<X, the payoff will be -(X-S- p) At all points where S>X, the payoff will be p For example, let us take the case of a trader who buys a June put option on pound sterling at a strike price of $1.7450, for a premium of $0.05 per sterling. The spot rate at that time is $ 1.7350.

http://www.linny.org/forum/ For all values of S greater than $1.7450, the option will not be exercised as the sterling has a higher price in the spot market. For values between $1.6950 and $ 1.7450, the option will be exercised, though there will still be a loss. Here the option buyer is trying to minimize the loss. For values of spot rate below $ 1.6950, the option will be exercised and will lead to a net profit. At expiry, the put option buyer's payoff profile can be depicted as follows: Spot Rate

Gain (X-S-p)

Loss (-p)

1.6600

0.0350

-

1.6800

0.0150

-

1.6900

0.0050

-

1.6950

-

-

1.7400

-

-0.0450

1.7500

-

-0.0500

1.7800

-

-0.0500

1.8000

-

-0.0500

Similarly, we can construct a payoff profile for the put option writer. His gains and losses will look as follows: Spot Rate

Gain (p)

Loss -(X-S-p)

1.6600

-

-0.0350

1.6800

-

-0.0150

1.6900

-

-0.0050

1.6950

-

-

1.7400

0.0450

-

1.7500

0.0500

-

1.7800

0.0500

-

1.8000

0.0500

-

http://www.linny.org/forum/ Spread Strategies Spread strategies with options involve simultaneous sale and purchase of two different option contracts. The objective in these strategies is to realize a profit if the underlying price moves in a fashion that is expected and to limit the magnitude of loss in case it moves in an unexpected fashion. Evidently, these are speculative in nature. However, these strategies are such that they provide limited gains while also ensuring limited losses. Spread strategies involving options with same maturity but different strike prices are called vertical spreads or price spreads. The types of vertical spread strategies are bullish call spreads, bearish call spreads, bullish put spreads and bearish put spreads. The expectation when going in for these strategies is that the underlying rate is likely to either appreciate or depreciate significantly. Horizontal or time spread strategies involve simultaneous buying and selling of two options which are similar in all respects except in maturity. The basic idea behind this is that the time value of the short maturity option will decline faster than that of the long maturity option. The expectation when going for this strategy is that the underlying price will not change drastically but the difference in premia will over time. Vertical Spread Strategies A bullish call consists of selling the call with the higher strike price and buying the call with the lower strike price. The expectation is the underlying currency is likely to appreciate. The investor however, would like to limit his losses. Since a lower priced call is being bought i.e. higher premium is paid and a higher priced call is being sold i.e. lower premium is received, the initial net investment would be the difference in the two premia. The maximum profit potential will be the difference in the strike prices minus the initial investment. The maximum loss is the initial investment. This strategy thus yields a limited profit if the currency appreciates and a limited loss if the currency depreciates. On the other hand, if the investor expects the currency to depreciate, he can go in for the bearish call spread. This is the reverse of the bullish spread i.e. the call with the higher strike price is bought and that with the lower strike price is sold. The maximum gain will be the difference in the premia. The maximum loss will be the difference is premia minus the difference in the strike prices. A bullish put spread consists of selling a put option with higher strike price and buying a put option with a lower strike price. In this case, if there is a significant appreciation in the underlying rate, neither put will be exercised and the net gain will be the difference in premia. Maximum loss will be the difference in strike prices minus the difference in premia. A bearish put spread is the opposite of a bullish put spread. An extension of the idea of vertical spreads is the butterfly spread. A butterfly spread involves three options with different strike prices but same maturity. A butterfly spread is bought by purchasing two calls with the middle strike price and selling one call each with the strike price on either side. The investor's expectation is that there will be a significant movement in the underlying rate - he is, however, unsure of the direction of this movement. This strategy yields a limited profit if there is a significant movement in the

http://www.linny.org/forum/ underlying rate - appreciation or depreciation. But if the movements are moderate or not very significant, it tends to result in a loss. Selling a butterfly spread involves selling two intermediate priced calls and buying one on either side. As opposed to the buyer of a butterfly spread, the seller here is betting on moderate or non-significant movements. He does not expect drastic movements either way. Therefore, this strategy yields a small profit if there are moderate changes in the exchange rate and a limited loss if there are large movements on either side. Horizontal Or Time Spreads As mentioned earlier, horizontal or time spread strategies involve simultaneous buying and selling of two options which are similar in all respects except in maturity. The basic idea behind this is that the time value of the short maturity option will decline faster than that of the long maturity option. Straddles And Strangles A Straddle strategy consists of buying a call and a put both with identical strikes and maturity. If there is a drastic depreciation, the investor gains on the put i.e. by exercising the option to sell. If there is a drastic appreciation, the investor exercises the call and purchases at the lower price. However, if there is a moderate movement either way, the investor will suffer a loss. A strangle is similar to a straddle. It consists of buying a call with strike above the current spot rate and a put with a strike price below the current spot. Like the straddle, it yields a profit for drastic movements and a loss for moderate movements. Currency options thus, provide the corporate treasurer a tool for hedging foreign exchange risks arising out of the firm's operations. Unlike the forward contracts, options allow the hedger to gain from favorable exchange rate movements while being protected against unfavorable movements

http://www.linny.org/forum/ Swaps Financial swaps are a funding technique, which permit a borrower to access one market and then exchange the liability for another type of liability. The global financial markets present borrowers and investors with a wide variety of financing and investment vehicles in terms of currency and type of coupon - fixed or floating. Floating rates are tied to an index which could be the London Interbank borrowing rate (LIBOR), US treasury bill rate etc. This helps investors exchange one type of asset for another for a preferred stream of cash flows. It must be noted that swaps by themselves are not a funding instrument; they are a device to obtain the desired form of financing indirectly. The borrower might otherwise have found this too expensive or even inaccessible. A common explanation for the popularity of swaps concerns the concept of comparative advantage. The basic principle is that some companies have a comparative advantage when borrowing in fixed rate markets while other companies have a comparative advantage in floating rate markets. This may lead to some companies borrowing in fixed markets when the need is of a floating rate loan and vice versa. Swaps are used to transform the fixed rate loan into a floating rate loan. Types Of Swaps All swaps involve exchange of a series of periodic payments between two parties. A swap transaction usually involves an intermediary who is a large international financial institution. The two payment streams are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant markets. The two most widely prevalent types of swaps are interest rate swaps and currency swaps. A third is a combination of the two to result in cross-currency interest rate swaps. Of course, a number of variations are possible under each of these major types of swaps. Interest Rate Swaps An interest rate swap as the name suggests involves an exchange of different payment streams which fixed and floating in nature. Such an exchange is referred to as a exchange of borrowings or a coupon swap. In this, one party, B, agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. At the same time, party A agrees to pay party B cash flows equal to interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of interest cash flows are the same. The life of the swap can range from two years to over 15 years. This type of a standard fixed to floating rate swap is also called a plain vanilla swap in the market jargon. London Inter-bank Offer Rate (LIBOR) is often the floating interest rate in many of the interest rate swaps. LIBOR is the interest rate offered by banks on deposits from other banks in the Eurocurrency markets. LIBOR is determined by trading between banks and changes continuously as the economic conditions change. Just as the Prime Lending Rate (PLR) is used as the benchmark or the peg for many Indian floating rate instruments, LIBOR is the most frequently used reference rate in international markets.

http://www.linny.org/forum/ Usually, two non-financial companies do not get in touch with each other to directly arrange a swap. They each deal with a financial intermediary such as a bank who then structures the plain vanilla swap in such a way so as to earn them a margin or a spread. In international markets, they typically earn about 3 basis points (0.03%) on a pair of offsetting transactions. At any given point of time, the swap spreads are determined by supply and demand. If more participants in the swap markets want to receive fixed rather than floating, swap spreads tend to fall. If the reverse is true, the swap spreads tend to rise. In real life, it is difficult to envisage a situation where two companies contact a financial institution at exactly the same time with the proposal to take opposite positions in the same swap. Most large financial institutions are therefore prepared tow are house interest rate swaps. This involves entering into a swap with a counterparty, then hedging the interest rate risk until an opposite counterparty us found. Interest rate future contracts are resorted to as a hedging tool in such cases. Currency Swaps Currency swaps involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an approximately equivalent loan in another currency. Suppose that a company A and company B are offered the fixed five-year rates of interest in U.S. dollars and sterling. Also suppose that sterling rates are generally higher than the dollar rates. Also, company A enjoys a better creditworthiness than company B as it is offered better rates on both dollar and sterling. What is important to the trader who structures the swap deal is that difference in the rates offered to the companies on both currencies is not the same. Therefore, though company A has a better deal in both the currency markets, company B does enjoy a comparatively lower disadvantage in one of the markets. This creates an ideal situation for a currency swap. The deal could be structured such that company B borrows in the market in which it has a lower disadvantage and company A in which it has a higher advantage. They swap to achieve the desired currency to the benefit of all concerned. A point to note is that the principal must be specified at the outset for each of the currencies. The principal amounts are usually exchanged at the beginning and the end of the life of the swap. They are chosen such that they are equal at the exchange rate at the beginning of the life of the swap. Like interest rate swaps, currency swaps are frequently warehoused by financial institutions that carefully monitor their exposure in various currencies so that they can hedge their currency risk. Other Swaps A swap in its most general form is a contract that involves the exchange of cash flows according to a predetermined formula. There is no limit to the number of innovations that can be made given this basic structure of the product. One innovation is that principal in a swap agreement can be varied throughout the term of the swap to meet the needs of the two parties. In an amortizing swap, the principal reduces in a predetermined way. This could be designed to correspond to the amortization

http://www.linny.org/forum/ schedule on a particular loan. Another innovation could be the deferred or forward swaps where the two parties do not start exchanging interest payments until some future date. Another innovation is the combination of the interest and currency swaps where the two parties exchange a fixed rate currency A payment for a floating rate currency B payment. Swaps are also extendable, where one party has the option to extend the life of the swap or puttable, where one party has the option to terminate the swap before its maturity. Options on swaps or Swaptions, are also gaining in popularity. A constant maturity swap (CMS) is an agreement to exchange a LIBOR rate for a swap rate. Foe example, an agreement to exchange 6-month LIBOR for the 10-year swap rate every six months for the next five years is a CMS. Similarly, a constant maturity treasury swap (CMT) involves swapping a LIBOR rate for a treasury rate. An equity swap is an agreement to exchange the dividends and capital gains realized on an equity index for either a fixed or floating rate of interest. These are only a few of the innovations in swaps that exist in the financial markets. The above have been mentioned to underscore the fact that swaps and other derivatives that have been dealt with in this module are all born out of necessity or needs of the many participants in the international financial market.