The course would lay foundation so that students may take up careers of foreign exchange dealing.

Ms. Ekta Nand Chahal

1

Management Of Forex Transactions

Course Objective:
The course aims at familiarizing the participants with the basic aspects of mechanics of foreign exchange
transactions as also operations in the foreign exchange market. The course would lay foundation so that
students may take up careers of foreign exchange dealing.

Learning Outcomes
At the end of the course, the student will be able to:
Understand the concept of foreign exchange
Examine the role and evolution of various theories of forex management
Appreciate the international monetary systems and markets
Develop the ability to implement the key forex activities strategically
Develop the ability to calculate financial derivatives

Course Contents:
Module I: Basics of foreign exchange
Definition, Meaning, Determination of foreign exchange. Theories. International monetary system
(impact).on European monetary system. Convertibility. Basic concepts of Balance of payments

Module II: International Financial Market

Introduction, relevant terminology, international financial market, how international financial markets are
classified, the role of international financial markets, participants in international financial markets,
location of international financial markets, financial intermediaries, the international monetary system, the
changing financial landscape.

Module III: Introduction to derivatives

Derivatives defined, Products, participants and functions ,Types of derivatives, Development of exchangetraded derivatives, Global derivatives markets, Exchange-traded vs. OTC derivatives markets, Derivatives
market in India, Approval for derivatives trading, Derivatives market at NSE, Trading mechanism,
Membership criteria, Turnover, Clearing and settlement, Risk management system.

Module IV: Forward and Future Markets and Contract

Introduction, Delivery And Settlement Of A Forward Contract, Default Risk And Forward Contracts,
Termination Of A Forward Contract, The Structure Of Global Forward Markets, Types Of Forward
Contracts. History Of Futures Markets, Definition Of Futures, Difference Between Futures And Forwards,
Organization Of Exchanges, Development Of Organized Exchanges, Clearing House, Clearing House
Mechanism, Contract Specifications For Futures, Types Of Margins, Orders In Futures Market, Settlement
Procedures, The Relationship Between Futures Price And Cash Price, Basis, Cost-Of-Carry, Contango And
Backwardation, Motives Behind Using Futures, Types Of Futures

Module V: Introduction to Options and swaps

Introduction to options, Option terminology, Options pay offs, Factors influencing option prices,
Elementary Investment Strategies, Options Clearing Corporation, Other Options, Trading Strategies of
Options, Put-Call Parity, Binomial Option Pricing Model, Black-Scholes Option Pricing Model. Introduction
to swaps, Interest Rate Swaps and Currency Swaps

Text & References:

Text:
Madura Jeff, 2000, International Financial Management, South Western
References:
Shaprio,A.C. Multinational Finance, John Wiley & Sons, New Delhi 2003
Seth A.K. International Financial Management Galgotia, New Delhi 2003
Dimitris N. Chorafas, Treasury Operations and the Foreign Exchange Challenge: A Guide to Risk
Management Strategies for the New World Markets (Wiley Finance), Mar 1992)
Ghassem A. Homaifar, Managing Global Financial and Foreign Exchange Rate Risk, 2003
3

Ghassem A. Homaifar, Managing Global Financial and Foreign Exchange Rate Risk, 2003
Dominic Bennett, Managing Foreign Exchange Risk: How to Identify and Manage Currency
Exposure (Risk Management), 1997
Laurent L. Jacque, Management and Control of Foreign Exchange Risk, 1997
Bob Steiner, Foreign Exchange and Money Markets: Theory, Practice and Risk Management, 2002

Index
Chapter

Particulars

Page no.

no.
1

Foreign Exchange

The International Monetary system

Balance of Payments

08
27
36

International financial markets

52

Introduction to derivatives

92

Introduction to futures

122

Introduction to forwards

136

Introduction to options

155

Introduction to swaps

171

Module 1

After reading this module, you will be able to understand

Chapter 1: Foreign Exchange
Meaning
Determination of foreign exchange
Exchange Rate Systems
Flexible Exchange Rate System
Fixed Exchange Rate System
Other Exchange Rate Systems
Theories
Chapter 2: The International Monetary System
The Gold Standard
Bretton Woods Agreements (1944-1973)
Managed floating system and the G-7 Council
Europe's Exchange Rate Mechanism and the Euro

Chapter 3: Balance of payments

Basic concepts of Balance of payments

CHAPTER 1: FOREIGN EXCHANGE

In the context of international trade, we often use the word FOREX.

FOREX is the acronym for the wide meaning term- Foreign Exchange Market. It means a market,
where one countrys currency is exchanged for that of another country through an exchange-rate
system. The FOREX is the worlds largest and most liquid financial market, with a current
estimated exchange average of between $1.5 trillion and $2 trillion per day.
FOREX is not actually a market in the traditional sense because there is no central exchange.
Instead, the entire market is run electronically, within a network of banks, continuously over a
24-hour period. Thats Why it is called a VIRTUAL MARKET.
BACKGROUND
In theory, foreign exchange dates back to ancient times, when traders first began exchanging
coins from different countries and groups. However, the foreign exchange industry itself is the
newest of the financial markets. In the last hundred years, the foreign exchange market has
undergone some dramatic transformations. In 1944, the postwar foreign exchange system was
established as a result of a multinational conference held at Bretton Woods, New Hampshire. That
system remained intact until the early 1970s. At this conference, representatives from 45 nations
met together to discuss the future exchange system. The conference resulted in the formation of
the International Monetary Fund (IMF).
Currencies in an exchange-rate system would tolerate one percent currency fluctuations to gold
values, or to the U.S. Dollar, which was established previously as the gold standard. The system
of connecting the currencys value to gold or the U.S. Dollar was called pegging. In 1971, the
Bretton Woods Accord was first tested because of dramatically uncontrollable currency rate
fluctuations. This started a chain reaction, and by 1973, the gold standard was abandoned by
President Richard Nixon. The fixed-rate system collapsed under heavy market pressures, and
currencies finally were allowed to float freely. The foreign exchange markets officially switched to
a free-floating market after the double demise of the Smithsonian Agreement and the European
8

Joint Float. This switch occurred more due to lack of any other available options, but it is
important to understand that the free floating of currency was not, by any mean, imposed. This
means that countries were free to peg, semi-peg, or free-float their currencies.

Pegged: Some smaller economies have attached their currencies to larger economies with which
they hold close economic liaisons. For instance, many Caribbean nations, such as Jamaica, have
pegged their currencies to the U.S. Dollar.
Semi-pegged: Semi-pegged currencies have disappeared since 1993. A perfect example of Semipegging would be the currencies of the European Monetary System (EMS). Those Currencies only
would be allowed to fluctuate within 2.25 percent or, exceptionally, within 6 percent intervention
bands. Following the foreign exchange crisis of 1993, the new EMS intervention rates were
expanded to 15 percent. Semi-pegging would have a slowing-down effect on currencies when
they were reaching the extreme values allowed within the range. Since 1999, the semi-pegged
currencies of the EMS were switched to fully pegged values that form the Euro.
Free-Floating: When the major currencies are free-floating, such as the U.S. Dollar, they move
independently of other currencies. The value of the currency is determined by supply and
demand, which has no specific intervention point that has to be observed, and can be traded by
anybody so inclined. Free-floating currencies are in the heaviest trading demand.
The FOREX market was made available to the average investor in 1998 and is one of the fastest
growing markets in the world, with daily volume of nearly 100 times that of the entire stock
market.
Global Forex Market:
Today, the FOREX market is a nonstop cash market where currencies of nations are traded. The
brokers and banks act as intermediaries between customers & their needs. Foreign currencies are
continually and simultaneously bought and sold across local and global markets. The value of
traders' investments increases or decreases based on currency movements. Foreign exchange
market conditions can change at any time in response to real-time events.
9

FEATURES OF FOREX MARKET:

24-hour trading, 5 days a week with nonstop access to global Forex dealers.
An enormous liquid market, making it easy to trade most currencies.
Volatile markets offering profit opportunities.
Standard instruments for controlling risk exposure.
The ability to profit in rising as well as falling markets.
Leveraged trading with low margin requirement

How does the market work?

Markets are places where goods are traded, and the same goes with FOREX. In FOREX markets,
the goods are the currencies of various countries (as well as gold and silver). For example, we
might buy euro with US dollars, or we might sell Japanese Yen for Canadian dollars. Its as basic as
trading one currency for another.
The Activity:
The FOREX Market is peculiar in the sense that there is no market as such. In general, there is no
centralized location for the trading activity. The trading occurs over the telephone and through
computer terminals located at various locations across the globe.
Another distinguishing feature of the FOREX Market is a 24 hour continuous currency exchange.
In short, it is an exchange that never closes. There are dealers in every major time zone, in every
major dealing centre.
10

How does one profit in the FOREX market?

Obviously, buy low and sell high! The profit potential comes from the fluctuations (changes) in the
currency exchange market. Unlike the stock-market, where share are purchased, Forex trading
does not require physical purchase of the currencies, but rather involves contracts for amount and
exchange rate of currency pairs. The advantageous thing about the Forex market is that regular
daily fluctuations in the regular currency exchange markets.
FOREX trading and a FOREX deal
The investor's goal in FOREX trading is to make profit from foreign currency movements. More
than 95% of all FOREX trading performed today is for speculative purposes (e.g. to profit from
currency movements). The rest belongs to hedging (managing business exposures to various
currencies) and other activities.
FOREX trades are non-delivery trades: currencies are not physically traded, but rather there are
currency contracts which are agreed upon and performed on the maturity date i.e. are known as
Forward Contracts. The two parties involved in the contract undertake to fulfill their respective
obligations: one side undertakes to sell the amount specified, and the other undertakes to buy it.
As mentioned, over 95% of the market activity is for speculative purposes, so there is no intention
on either side to actually perform the contract i.e. the physical delivery of the currency. Thus, the
contract ends by offsetting it against an opposite position, resulting in the profit and loss of the
parties involved.
Factors influencing Market movements:
The general state of affairs prevailing in a country seems to be the primary factor in influencing
the market rates. Key Economic data like the Balance of Payments, Pay Roll Figures, etc. are the
drivers of this market. A recent example to drive home this point was the weakening of the U.S.
Dollar against the EURO when the U.S. Pay Roll figures were way below the expected levels.
Thus, it is quite clear that any broad based economic conditions can cause dramatic currency
price swings.

11

It is also interesting to note that the market is also influenced to an extent by news and, at times,
even by rumours. The FOREX market bears resemblance in this regard to the stock markets where
a strong rumour can change the fortune of a company for the better or for the worse. It can,
hence, be safely said that anticipation of a certain economic condition acts as a stronger catalyst
than the condition itself.

Participants in the FOREX

The foreign exchange market (FOREX) is not a market like the New York stock exchange, where
daily trades of stock are conducted in a central location. Instead, a FOREX market refers to the
activities of major international banks that engage in currency trading. These banks act as
intermediaries between the true buyers and sellers of currencies, ie, governments, businesses,
and individuals. These banks will hold foreign currency deposits and stand ready to exchange
these for domestic currency upon demand. The exchange rate will be determined independently
by each bank but will essentially be determined by supply and demand in the market. In other
words, the banks set the exchange rate at each moment to equalize its supply of foreign currency
with the market demand. Each bank makes money by collecting a transactions fee for its
"exchange services."
The participants in this market are
i)
ii)
iii)
iv)
v)

central and commercial banks,

corporations,
institutional investors,
hedge funds, and
private individuals.

It is useful to categorize two distinct groups of participants in the FOREX, those whose
transactions are recorded on the current account (importers and exporters) and those whose
transactions are recorded on the financial account. (investors)
12

1. Importers and Exporters

Anyone who either imports or exports goods and services will need to exchange currencies to
make the transactions. This includes tourists who travel abroad since their transactions would
appear as services in the current account. These businesses and individuals will engage in
currency trades daily, however, these transactions are small in comparison to those made by
investors.
2. International Investors, Banks, Arbitrageurs etc.
Most of the daily currencies transactions are made by investors. These investors, be they
investment companies, insurance companies, banks or others, are making currency transactions
to realize a greater return on their investments or holdings. Many of these companies are
responsible to manage the savings of others. Pension plans and mutual funds buy and sell billions
of dollars worth of assets daily. Banks, in the temporary possession of the deposits of others do
the same. Insurance companies manage large portfolios which act as their capital to be used to
pay off claims on accidents, casualties and deaths. More and more these companies look
internationally to make the most of their investments.
It is estimated that over $1 trillion (or $1000 billion) worth of currency is traded every day. Only
about $70-$100 billion of trade in goods and services takes place daily worldwide. This suggests
that much of the currency exchanges are done by international investors rather than importers
and exporters.
Broadly they can be classified as:
3. Hedgers
Hedgers account for less than 5% of the market, but are the key reason futures and other such
financial instruments exist. The group using these hedging tools is primarily businesses and other
organizations participating in international trade. Their goal is to diminish or neutralize the impact
of currency fluctuations.
4. Speculators
Speculators account for more than 95% of the market. This group includes private individuals and
corporations, public entities, banks, etc. They participate in the Forex market in order to create
profit, taking advantage of the fluctuations of interest rates and exchange rates.
Why FOREX Markets?
13

The FOREX Market, though has a gigantic turnover, the concept is yet to gain a wider acceptance
in India. Recently, professional investors are venturing into the FOREX arena in the light of the
innumerable benefits it provides to its investors.
1. Liquidity: FOREX markets can dwarf any other market by its trading volumes. This enables
an investor to derive greater benefits in the form of increased liquidity. Liquidity has
always been a powerful attraction for any investor as it gives him the flexibility to enter or
exit & in FOREX parlance, the freedom to open or close a position at will.
2. Access: The fact that the FOREX Market is a 24 Hour market provides an investor the
benefit of greater access.
3. Flexibility: The FOREX Markets provide an investor with a great degree of flexibility given
the fact he can establish a position for the period of his desire.
4. Execution Costs: Traditionally, the FOREX Market has no brokerage charges. The gains
earned are generally through the difference in the market BID and OFFER rates, called as
spread.
5. Trending: Over long periods of time, currencies exhibit substantial and identifiable trends.
With proper analysis of these trends and by utilizing the

various charting techniques, the

investor can derive immense benefits out of any divergence experienced in the currency.
The Foreign Exchange Market - Definitions
Exchange Rate - the exchange rate represents the number of units of one currency that
exchanges for a unit of another. There are two ways to express an exchange rate between two
currencies (e.g. the $ and [pound]). One can either write $/ or /$ . These are reciprocals of
each other. Thus if E is the $/ exchange rate and V is the /$ exchange rate then E = 1/V.
For Example, on Jan 8, 1997 the following exchange rates prevailed,
E$/ = 1.69 which implies V/$ = 0.59
V/$ = 116. which implies E$/ = 0.0086
Currency Value

14

It is important to note that the value of a currency is always given in terms of another currency.
Thus the value of a US dollar in terms of British pounds is the /$ exchange rate. The value of the
Japanese yen in terms of dollar is the $/ exchange rate.
[Note: we always express the value of all items in terms of something else. Thus, the value of a
quart of milk is given in dollars, not in milk units. The value of car is also given in dollar terms, not
in terms of cars. Similarly, the value of a dollar is given in terms of something else, usually another
currency. Hence the rupee/$ exchange rate gives us the value of the dollar in terms of rupees.]
This definition is especially useful to remember when one is dealing with unfamiliar currencies.
Thus the value of the euro () in terms of British pounds is given as the / exchange rate.
The peso/ exchange rate refers to the value of the euro in terms of pesos.
Currency appreciation - a currency appreciates with respect to another when its value rises in
terms of the other. The dollar appreciates with respect to the yen if the /$ exchange rate rises.
Currency depreciation - a currency depreciates with respect to another when its value falls in
terms of the other. The dollar depreciates with respect to the yen if the /$ exchange rate falls.
Note that if the /$ rate rises, then its reciprocal, the $/ rate falls. Since the $/ rate represents
the value of the yen in terms of dollars, this means that when the dollar appreciates with respect
to the yen, the yen must depreciate with respect to the dollar.
The rate of appreciation (or depreciation) is the percentage change in the value of a currency
over some period of time.
Example #1:
On Jan. 8 1997, E/$ = 116
On Jan. 8 1996, E/$ = 105
Use percentage change formula: (New value - Old value)/Old Value

Multiply by 100 to write as a percentage to get,

0.105 x 100 = +10.5%

15

Since we have calculated the change in the value of the $, in terms of yen, and since the
percentage change is positive, this means that the dollar has appreciated by 10.5% with respect to
the yen during the past year.
Example #2:
On Jan. 8 1997, E/$ = 0.59
On Jan. 8 1996, E/$ = 0.65
Use percentage change formula: (New value - Old value)/Old Value

Multiply by 100 to write as a percentage to get,

-0.092 x 100 = -9.2%
Since we have calculated the change in the value of the $, in terms of pounds, and since the
percentage change is negative, this means that the dollar has depreciated by 9.2% with respect to
the pound during the past year.
Arbitrage - arbitrage, generally means buying a product when its price is low and then reselling it
after its price rises in order to make a profit. Currency arbitrage means buying a currency in one
market (say New York) at a low price and reselling, moments later, in another market at a higher
price.
Spot Exchange Rate - the spot exchange rate refers to the exchange rate that prevails on the spot,
that is, for trades to take place immediately.
Forward Exchange Rate - the forward exchange rate refers to the rate which appears on a
contract to exchange currencies either 30, 60, 90 or 180 days in the future.
For example a corporation might sign a contract with a bank to buy DMs for dollars 60 days from
now at a predetermined ER. The predetermined rate is called the 60-day forward rate. Forward
contracts can be used to reduce exchange rate risk.
For example suppose an importer of BMWs is expecting a shipment in 60 days. Suppose that upon
arrival the importer must pay 1,000,000. The current spot ER is 1.20 $/ thus if the payment
were made today it would cost $1,200,000. Suppose further that the importer is fearful of a $
depreciation. He doesn't currently have the $1,200,000 but expects to earn more than enough in
sales over the next two months. If the $ falls in value to, say, 1.3 $/ in 60 days time, how much
would cost the importer in dollars to purchase the BMW shipment?
16

A. The shipment would still cost 1,000,000. To find out how much this is in dollars multiply
1,000,000 by 1.3 $/ = $1,300,000.
Note this is $100.000 more for the cars simply because the $ value changed.
One way the importer could protect himself against this potential loss is to purchase a forward
contract to buy for $ in 60 days. The ER on the forward contract will likely be different from the
current spot ER. In part its value will reflect market expectations about the degree to which
currency values will change in the next two months. Suppose the current 60-day forward ER is
1.25 $/ reflecting the expectation that the $ value will fall. If the importer purchases a 60-day
contract to buy 1,000,000 it will cost him (1,000,000 x 1.25) = $1,250,000. Although this is higher
than what it would cost if the exchange were made today, the importer does not have the cash
available to make the trade today, and the forward contract would protect the importer from
even an even greater $-depreciation.
When the forward ER is such that a forward trade costs more than a spot trade today costs, there
is said to be a forward premium. If the reverse were true, such that the forward trade were
cheaper than a spot trade then there is a forward discount.
Hedging - a currency trader is hedging if he or she enters into a forward contract to protect
oneself from a downside loss. However by hedging the trader also forfeits the potential for an
upside gain. Suppose in the story above that the spot ER falls rather than rises. Suppose the ER fell
to 1.10 $/ . In this case, had the importer waited the 1,000,000 would only have cost (1,000,000
x 1.10) = $1,100,000. Thus, hedging protects against loss but at the same time eliminaters
potential unexpected gain.

Investment Concerns - International or Domestic

Investors generally have three broad concerns when an investment is made. They care about how
much money the investment will earn over time, they care about how risky the investment is, and
they care about how liquid, or convertible, the asset is.
17

1) Rate of return - the percentage change in the value of an asset over some period of time.
Investors purchase assets as a way of saving for the future. Anytime an asset is purchased the
purchaser is forgoing current consumption for future consumption. In order to make such a
transaction worthwhile the investors hopes (sometimes expects) to have more money for future
consumption than the amount they give up in the present. Thus investors would like to have as
high a rate of return on their investments as possible.
Example 1: Suppose a Picasso painting is purchased in 1996 for $500,000. One year later the
painting is resold for $600,000. The rate of return is calculated as,

Example 2: $1000 is placed is a savings account for 1 year at an annual interest rate of 10%. The
interest earned after one year is $1000 x 0.10 = $100. Thus the value of the account after 1 year is
$1100. The rate of return is,

This means that the rate of return on a domestic interest bearing account is merely the interest
rate.
2) Risk
The second primary concern of an investor is the riskiness of the assets. Generally, the greater the
expected rate of return, the greater the risk. Invest in an oil wildcat endeavor and you might get a
1000% return on your investment ... if you strike oil. The chances of doing so are likely to be very
low however. Thus, a key concern of investors is how to manage the tradeoff between risk and
return.
3) Liquidity
Liquidity essentially means the speed with which assets can be converted to cash. Insurance
companies need to have assets which are fairly liquid in the event that they need to pay out a
large number of claims. Banks have to stand ready to make payout to depositors etc.

18

DETERMINATION OF EXCHANGE RATE:

Introduction to Purchasing Power Parity (PPP)
Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare
the average costs of goods and services between countries. The theory introduces the
assumptions about the behavior of importers and exporters in response to changes in the relative
costs of national market baskets.
In another vein, PPP suggests that transactions on a country's current account, affect the value of
the exchange rate on the foreign exchange market. This contrast with the interest rate parity
theory which assumes that the actions of investors, whose transactions are recorded on the
capital account, induces changes in the exchange rate.
PPP theory is based on an extension and variation of the "law of one price" as applied to the
aggregate economy. To explain the theory it is best, first, to review the idea behind the law of one
price.
The Law of One Price (LoOP)
The law of one price says that identical goods should sell for the same price in two separate
markets when there are no transportation costs and no differential taxes applied in the two
markets. Consider the following information about movie video tapes sold in the US and Mexican
markets.
Price of videos in US market (P$v)

$20

Price of videos in Mexican market (Ppv)

p150

Spot exchange rate (Ep/$)

10 p/$

The dollar price of videos sold in Mexico can be calculated by dividing the video price in pesos by
the spot exchange rate as shown,

To see why the peso price is divided by the exchange rate (rather than multiplied) notice the
conversion of units shown in the brackets. If the law of one price held, then the dollar price in
Mexico should match the price in the US. Since the dollar price of the video is less than the dollar
price in the US, the law of one price does not hold in this circumstance.
19

The next question to ask is what might happen as a result of the discrepancy in prices. Well, as
long as there are no costs incurred to transport the goods, there is a profit-making opportunity
through trade. For example, US travelers in Mexico who recognize that identical video titles are
selling there for 25% less might buy videos in Mexico and bring them back to the US to sell. This is
an example of "goods arbitrage." An arbitrage opportunity arises whenever one can buy
something at a low price in one location and resell at a higher price and thus make a profit.
Using basic supply and demand theory, the increase in demand for videos in Mexico would push
the price of videos up. The increase supply of videos on the US market would force the price down
in the US. In the end the price of videos in Mexico may rise to, say, 180 pesos while the price of
videos in the US may fall to $18. At these new prices the law of one price holds since,

The idea between the law of one price is that identical goods selling in an integrated market,
where there are no transportation costs or differential taxes or subsidies, should sell at identical
prices. If different prices prevailed then there would be profit-making opportunities by buying the
good in the low price market and reselling it in the high price market. If entrepreneurs acted in
this way, then the prices would converge to equality.
Of course, for many reasons the law of one price does not hold even between markets within a
country. The price of beer, gasoline and stereos will likely be different in New York City than in Los
Angeles. The price of these items will also be different in other countries when converted at
current exchange rates. The simple reason for the discrepancies is that there are costs to
transport goods between locations, there are different taxes applied in different states and
different countries, non-tradable input prices may vary, and people do not have perfect
information about the prices of goods in all markets at all times. Thus, to refer to this as an
economic "law" does seem to exaggerate its validity.
From LoOP to PPP
The purchasing power parity theory is really just the law of one price applied in the aggregate,
but, with a slight twist added (more on the twist a bit later). If it makes sense from the law of one
price that identical goods should sell for identical prices in different markets, then the law ought
to hold for all identical goods sold in both markets.
First, let's define the variable CB$ to be the cost of a basket of goods in the US denominated in
dollars. For simplicity we could imagine using the same basket of goods used in the construction
of the US consumer price index (CPI$). The CPI uses a market basket of goods which are purchased
by an average household during a specified period. The basket is determined by surveying the
quantity of different items purchased by many different households. One can then determine, on
average, how many units of bread, milk, cheese, rent, electricity, etc. are purchased by the typical
household. You might imagine, it's as if all products are purchased in a grocery store, with items
20

being placed in a basket before the purchase is made. CB$ then represents the dollar cost of
purchasing all of the items in the market basket. We shall similarly define CBp to be the cost of a
market basket of goods in Mexico denominated in pesos.
Now if the law of one price holds for each individual item in the market basket, then it should hold
for the market baskets as well. In other words,

Rewriting the right-hand side equation allows us to put the relationship in the form commonly
used to describe absolute purchasing power parity. Namely,

If this condition holds between two countries then we would say PPP is satisfied. The condition
says that the PPP exchange rate (pesos per dollars) will equal the ratio of the costs of the two
market baskets of goods denominated in local currency units. Note that the reciprocal

relationship

is also valid.

Because the cost of a market basket of goods is used in the construction of the country's
consumer price index, PPP is often written as a relationship between the exchange rate and the
country's price indices.

21

PPP as a Theory of Exchange Rate Determination

The PPP relationship becomes a theory of exchange rate determination by introducing
assumptions about the behavior of importers and exporters in response to changes in the relative
costs of national market baskets. Recall, in the story of the law of one price, when the price of a
good differed between two country's markets, there was an incentive for profit-seeking
individuals to buy the good in the low price market and resell it in the high price market. Similarly,
if a market basket, containing many different goods and services, costs more in one market than
another, we should likewise expect profit-seeking individuals to buy the relatively cheaper goods
in the low cost market and resell them in the higher priced market. If the law of one price leads to
the equalization of the prices of a good between two markets, then it seems reasonable to
conclude that PPP, describing the equality of market baskets across countries, should also hold.
However, adjustment within the PPP theory occurs with a twist compared to adjustment in the
law of one price story. In the law of one price story, goods arbitrage in a particular product was
expected to affect the prices of the goods in the two markets. The twist that's included in the PPP
theory is that arbitrage, occurring across a range of goods and services in the market basket, will
affect the exchange rate rather than the market prices.

The PPP Equilibrium Story

To see why the PPP relationship represents an equilibrium we need to tell an equilibrium story. An
equilibrium story in an economic model is an explanation of how the behavior of individuals will
cause the equilibrium condition to be satisfied. The equilibrium condition is the PPP equation
developed above,

The endogenous variable in the PPP theory is the exchange rate. Thus, we need to explain why the
exchange rate will change if it is not in equilibrium. In general there are always two versions of an
equilibrium story, one in which the endogenous variable (Ep/$ here) is too high, and one in which it
is too low.
PPP Equilibrium Story 1 - Let's consider the case in which the exchange rate is too low to be in
equilibrium. This means that,
22

where Ep/$ is the exchange rate that prevails on the spot market and, since it is less than the ratio
of the market basket costs in Mexico and the US, is also less than the PPP exchange rate. The
right-hand side of the expression is rewritten to show that the cost of a market basket in the US
evaluated in pesos, CB$Ep/$, is less than the cost of the market basket in Mexico also evaluated in
pesos. Thus, it is cheaper to buy the basket in the US, or, more profitable to sell items in the
market basket in Mexico.
The PPP theory now suggests that the cheaper basket in the US will lead to an increase in demand
for goods in the US market basket by Mexico, and, as a consequence, will increase the demand for
US dollars on the foreign exchange market. Dollars are needed because purchases of US goods
require US dollars. Alternatively, US exporters will
realize that goods sold in the US can be sold at a
higher price in Mexico. If these goods are sold in
pesos, the US exporters will wantto convert the
proceeds back to dollars. Thus, there is an
increase in US dollar demand (by Mexican
importers) and an increase in peso supply (by US
exporters) on the Forex. This effect is represented
by a rightward shift in the US dollar demand curve
in the adjoining diagram. At the same time, US
consumers will reduce their demand for the
pricier Mexican goods. This will reduce the supply
of dollars (in exchange for pesos) on the Forex
which is represented by a leftward shift in the US
dollar supply curve in the Forex market.
Both the shift in demand and supply will cause an increase in the value of the dollar and thus the
exchange rate, Ep/$, will rise. As long as the US market basket remains cheaper, excess demand for
the dollar will persist and the exchange rate will continue to rise. The pressure for change ceases
once the exchange rate rises enough to equalize the cost of market baskets between the two
countries and PPP holds.
PPP Equilibrium Story 2 - Now let's consider the other equilibrium story, that is, the case in which
the exchange rate is too high to be in equilibrium. This implies that,

23

The left-hand side expression says that the spot exchange rate is greater than the ratio of the
costs of market baskets between Mexico and the US. In other words the exchange rate is above
the PPP exchange rate. The right-hand side expression says that the cost of a US market basket,
converted to pesos at the current exchange rate, is greater than the cost of a Mexican market
basket in pesos. Thus, on average US goods are relatively more expensive while Mexican goods
are relatively cheaper.
The price discrepancies should lead consumers in
the US, or importing firms, to purchase less
expensive goods in Mexico. To do so, they will
raise the supply of dollars in the Forex in exchange
for pesos. Thus, the supply curve of dollars will
shift to the right as shown in the adjoining
diagram. At the same time, Mexican consumers
would refrain from purchasing the more
expensive US goods. This would lead to a
reduction in demand for dollars in exchange for
pesos on the Forex. Hence the demand curve for
dollars shifts to the left. Due to the demand
decrease and the supply increase, the exchange
rate, Ep/$, falls. This means that the dollar
depreciates and the peso appreciates.
Extra demand for pesos will continue as long as goods and services remain cheaper in Mexico.
However, as the peso appreciates (the $ depreciates) the cost of Mexican goods rises relative to
US goods. The process ceases once the PPP exchange rate is reached and market baskets cost the
same in both markets.
Adjustment to Price Level Changes Under PPP
In the PPP theory, exchange rate changes are induced by changes in relative price levels between
two countries. This is true because the quantities of the goods are always presumed to remain
fixed in the market baskets. Therefore, the only way that the cost of the basket can change is if
the goods' prices change. Since price level changes represent inflation rates, this means that
differential inflation rates will induce exchange rate changes according to the theory.
If we imagine that a country begins with PPP, then the inequality given in equilibrium story #1,
, can arise if the price level rises in Mexico (peso inflation), if the price level
falls in the US ($ deflation), or if Mexican inflation is more rapid than US inflation. According to the
theory, the behavior of importers and exporters would now induce a dollar appreciation and a
peso depreciation. In summary, an increase in Mexican prices relative to the change in US prices
(i.e., more rapid inflation in Mexico than in the US) will cause the dollar to appreciate and the
peso to depreciate according to the purchasing power parity theory.
24

Similarly, if a country begins with PPP, then the inequality given in equilibrium story #2,
, can arise if the price level rises in the US ($ inflation), the price level falls in
Mexico (peso deflation) or if US inflation is more rapid than Mexican inflation. In this case, the
inequality would affect the behavior of importers and exporters and induce a dollar depreciation
and peso appreciation. In summary, more rapid inflation in the US would cause the dollar to
depreciate while the peso would appreciate.
Problems and Extensions of PPP
Problems with the PPP Theory
The main problem with the PPP theory is that the PPP condition is rarely satisfied within a
country. There are quite a few reasons that can explain this and so, given the logic of the theory,
which makes sense, economists have been reluctant to discard the theory on the basis of lack of
supporting evidence. Below we consider some of the reasons PPP may not hold.
Transportation costs and trade restrictions - Since the PPP theory is derived from the law of one
price, the same assumptions are needed for both theories. The law of one price assumed that
there are no transportation costs and no differential taxes applied between the two markets.
These means that there can be no tariffs on imports or other types of restrictions on trade. Since
transport costs and trade restrictions do exist in the real world this would tend to drive prices for
similar goods apart. Transport costs should make a good cheaper in the exporting market and
more expensive in the importing market. Similarly, an import tariff would drive a wedge between
the prices of an identical good in two trading countries' markets, raising it in the import market
relative to the export market price. Thus the greater are transportation costs and trade
restrictions between countries, the less likely for the costs of market baskets to be equalized.
Costs of Non-Tradable Inputs - Many items that are homogeneous, nevertheless sell for different
prices because they require a non-tradable input in the production process. As an example
consider why the price of a McDonald's Big Mac hamburger sold in downtown New York city is
higher than the price of the same product in the New York city suburbs. Because the rent for
restaurant space is much higher in the city center, the restaurant will pass along its higher costs in
the form of higher prices. Substitute products in the city center (other fast food restaurants) will
face the same high rental costs and thus will charge higher prices as well. Because it would be
impractical (i.e., costly) to produce the burgers at a cheaper suburban location and then transport
them for sale in the city, competition would not drive the prices together in the two locations.
Perfect information - The law of one price assumes that individuals have good, even perfect,
information about the prices of goods in other markets. Only with this knowledge will profitseekers begin to export goods to the high price market and import goods from the low priced
market. Consider a case in which there is imperfect information. Perhaps some price deviations
are known to traders but other deviations are not known. Or maybe only a small group of traders
know about a price discrepancy and that group is unable to achieve the scale of trade needed to
equalize the prices for that product. (Perhaps they face capital constraints and can't borrow
25

enough money to finance the scale of trade needed to equalize prices). In either case, traders
without information about price differences will not respond to the profit opportunities and thus
prices will not be equalized. Thus, the law of one price may not hold for some products which
would imply that PPP would not hold either.
It is estimated that there are approximately $1 trillion dollars worth of currency exchanged every
day on international Forex markets. That's one-eighth US GDP, which is the value of production in
the US in an entire year! Plus, the $1 trillion estimate is made by counting only one side of each
currency trade. Thus, that's an enormous amount of trade. If one considers the total amount of
world trade each year and then divide by 365, one can get the average amount of goods and
services traded daily. This number is less than $100 billion dollars. This means that the amount of
daily currency transactions is more than ten times the amount of daily trade. This fact would seem
to suggest that the primary effect on the daily exchange rate must be caused by the actions of
investors rather than importers and exporters. Thus, the participation of other traders in the
foreign exchange market, who are motivated by other concerns, may lead the exchange rate to a
value that is not consistent with PPP.
Relative PPP
There is an alternative version of the PPP theory called the "relative PPP theory." In essence this is
a dynamic version of the absolute PPP theory. Since absolute PPP suggests that the exchange rate
may respond to inflation, we can imagine that the exchange rate would change in a systematic
way given that a continual change in the price level (inflation) is occurring.
In the relative PPP theory, exchange rate changes over time are assumed to be dependent on
inflation rate differentials between countries according to the following formula:

Here the percentage change in the $ value between period 1 and 2 is given on the lefthand side.
The righthand side gives the differences in the inflation rates between Mexico and the US,
evaluated over the same time period. The implication of relative PPP is that if the Mexican
inflation rate exceeds the US inflation rate, then the dollar will appreciate by that differential over
the same period. The logic of this theory is the same as in absolute PPP. Importers and exporters
respond to variations in the relative costs of market baskets so as to maintain the law of one
price, at least on average. If prices continue to rise faster in Mexico than in the US, for example,
price differences between the two countries would grow and the only way to keep up with PPP is
for the dollar to appreciate continually versus the peso.

26

CHAPTER 2 - INTERNATIONAL MONETARY SYSTEM (IMS)

MNCs operate in a global market, buying/selling/producing in many different countries. For

example, GM sells cars in 150 countries, produces cars in 50 countries, so it has to deal with
hundreds of currencies. What are the mechanics of how currency and capital flows
internationally?
International Monetary System - Institutional framework within which:
1. International payments are made
2. Movements of capital are accommodated
3. Ex-rates are determined
An international monetary system is required to facilitate international trade, business, travel,
investment, foreign aid, etc. For domestic economy, we would study Money and Banking to
understand the domestic institutional framework of money, monetary policy, central banking,
commercial banking, check-clearing, etc. To understand the flow of international capital/currency
we study the IMS. IMS - complex system of international arrangements, rules, institutions,
policies in regard to ex-rates, int'l payments, capital flows. IMS has evolved over time as int'l
trade, finance, and business have changed, as technology has improved, as political dynamics
change, etc. Example: evolution of the European Union and the Euro currency impacts the IMS.
"Spontaneous Order."

HISTORY OF THE IMS

1. BIMETALLISM (pre-1875)
Commodity money system using both silver and gold (precious metals) for int'l payments (and for
domestic currency). Why silver and gold? (Intrinsic Value, Portable, Recognizable,
Homogenous/Divisible, Durable/Non-perishable). Why two metals and not one (silver standard or
27

gold standard vs. bimetallism)? Some countries' currencies in certain periods were on either the
gold standard (British pound) or the silver standard (German DM) and some on a bimetallic
(French franc). Pound/Franc ex-rate was determined by the gold content of the two currencies.
Franc/DM was determined by the silver content of the two currencies. Pound (gold) / DM (silver)
rate was determined by their ex-rates against the Franc.

Under a bimetallic standard (or any time when more than one type of currency is acceptable for
payment), countries would experience "Gresham's Law" which is when "bad" money drives out
"good" money.

The more desirable, superior form of money is hoarded and withdrawn from circulation, and
people use the inferior or bad money to make payments. The bad money circulates, the good
money is hoarded. Under a bimetallic standard the silver/gold ratio was fixed at a legal rate.
When the market rate for silver/gold differed substantially from the legal rate, one metal would
be overvalued and one would be undervalued. People would circulate the undervalued (bad)
money and hoard the overvalued (good) money.

Examples: a) From 1837-1860 the legal silver/gold ratio was 16/1 and the market ratio was 15.5/1.
One oz of gold would trade for 15.5 oz. of silver in the market, but one oz of gold would trade for
16 oz of silver at the legal/official rate. Gold was overvalued at the legal rate, silver was
undervalued. Gold circulated and silver was hoarded (or not minted into coins), putting the US on
what was effectively a gold standard.

b) Page 27 in book, France went from a bimetallic standard to effectively a gold standard after the
discovery of gold in US and Australia in the 1800s. The fixed legal ratio was out of line with the
true market rate. Gold became more abundant, lowering its scarcity/value, silver became more
valuable. Only gold circulated as a medium of exchange.

2. CLASSICAL GOLD STANDARD (1875-WWI).

28

For about 40 years most of the world was on an international gold standard, ended with WWI
when most countries went off gold standard. London was the financial center of the world, most
advanced economy with the most int'l trade.

Gold Standard exists when most countries:

1. Use gold coins as the primary medium of exchange.
2. Have a fixed ex-rate between ounce of gold and currency.
3. Allow unrestricted gold flows - gold can be exported/imported freely.
4. Banknotes had to be backed with gold to assure full convertibility to gold.
5. Domestic money stock had to rise and fall with gold flows.
Under a gold standard, ex-rates would be kept in line by cross-country gold flows. Any misalignment of ex-rates would be corrected by gold flows. Payments could in effect be made by
either gold or banknotes. If market ex-rates ever deviated from the official ex-rate, it would be
cheaper to pay in gold than in banknotes.

Example: Suppose that the U.K. Pound is pegged to gold at: 6/oz., and the French franc is pegged
to gold at FF12/oz., then the ex-rate should be FF2/Pound. If the market rate was FF1.80/, then
the pound is undervalued in the market (one pound should buy 2 FF, it only buys 1.8 FF).
Arbitrage would re-align the ex-rate:
1. Take 500 and buy 83.33 oz of gold (500 / 6) in U.K.
2. Sell the gold for FF1000 in France (83.33 oz. x 12)
3. Sell 1000 FF for 555.56 (FF1000 / 1.8FF/), for an arbitrage profit of 55.56

Arbitrage would appreciate the , depreciate the FF, and the ex-rate would be restored at 2FF/.

Also under gold standard, int'l. balance of payments get corrected automatically. Suppose that
UK has a trade surplus (X > M) with France (M > X), which has a trade deficit. UK sold more to
France than it bought, France bought more from UK than it sold, which brings about a flow of gold
from ______ to _______. The increased (decreased) gold in UK (France) brings about ________ in
UK and _______ in France. As time goes on, Exports from UK will ____ because British prices are
now _____, Imports will _____ because French prices are ______. The trade surplus of UK will
29

_____ and France's deficit will _______. Market forces automatically correct trade
deficits/surpluses, this adjustment mechanism is known as the price-specie-flow mechanism.

Advantages of Gold Standard:

1. Ultimate hedge against inflation. Because of its fixed supply, gold standard creates price level
stability, eliminates abuse by central bank/hyperinflation.
2. Automatic adjustment in Balance of Payments due to price-specie-flow mechanism.

Disadvantages of Gold Standard:

1. Possible deflationary pressure. With a fixed supply of gold (fixed money supply), output growth
would lead to deflation.
2. An international gold standard has no commitment mechanism, or enforcement mechanism, to
keep countries on the gold standard if they decide to abandon gold.

3. INTERWAR PERIOD: 1915-1944

When WWI started, countries abandoned the gold standard, suspended redemption of banknotes
for gold, and imposed embargoes on gold exports (no gold could leave the country). After the
war, hyperinflationary finance followed in many countries such as Germany, Austria, Hungary,
Poland, etc. Price level increased in Germany by 1 trillion times!! Why hyperinflation then??
What are the costs of inflation??

US (1919), UK(1925), Switzerland, France returned to the gold standard during the 1920s.
However, most central banks engaged in a process called "sterilization" where they would
counteract and neutralize the price-specie-flow adjustment mechanism. Central banks would
match inflows of gold with reductions in the domestic MS, and outflows of gold with increases in
MS, so that the domestic price level wouldn't change. Adjustment mechanism would not be
allowed to work. If the US had a trade surplus, there would be a gold inflow which should have
increased US prices, making US less competitive. Sterilization would involve contractionary
monetary policy to offset the gold inflow.

In the 1930s, what was left of the gold standard faded - countries started abandoning the gold
standard, mostly because of the Great Depression, bank failures, stock market crashes. Started in
30

US, spread to the rest of the world. Also, escalating protectionism (trade wars) brought int'l trade
to a standstill. (Smoot-Hawley Act in 1930), slowing int'l gold flows. US went off gold in 1933,
France lasted until 1936.

Between WWI and WWII, the gold standard never really worked, it never received the full
commitment of countries. Also, it was period of political instability, the Great Depressions, etc. So
there really was no stable, coherent IMS, with adverse effects on int'l trade, finance and
investment.

4. BRETTON WOODS SYSTEM: 1945-1972

At the end of WWII, 44 countries nations met at Bretton Woods, N.H. to develop a postwar IMS.
The International Monetary Fund (IMF) and the World Bank were created as part of a
comprehensive plan to start a new IMS. The IMF was to supervise the rules and policies of a new
fixed ex-rate regime, the World Bank was responsible for financing development projects for
developing countries (power plants, roads, infrastructure investments).

IMS established by Bretton Woods was a dollar-based, gold-exchange standard of fixed exchange
rates. The US dollar was pegged to gold at a fixed price of $35/ounce, and then each currency had
a fixed ex-rate with the $. See Exhibit 2.1 on p. 30.

Examples: $2.80/, DM4.20/$, FF3.50/$, etc.

Each country was supposed to maintain the fixed rate within 1% of the agreed upon rate, by
buying/selling currency. To increase the foreign exchange value of DM, the central bank would
____ DMs with $; to decrease the value of DM it would ____ DMs for $. US $ was convertible to
gold, the other currencies were not. Countries held $ and gold for IMS payments. A country with
a "fundamental disequilibrium" could be allowed to change its fixed rate with the $.

31

Advantages of Gold-Exchange System/Bretton Woods in SR:

1. Economizes on scarce resources (gold) by allowing foreign reserves ($s) to be used for IMS
payments. Easier to transfer dollars vs. shipping gold overseas under pure gold std.

2. By holding $ instead of gold as reserves, foreign central banks can earn interest vs. non-interest
bearing gold.
3. Ex-rate stability reduced currency risk, provided a stable IMS, facilitated int'l trade and
investment, led to strong economic growth around the world in 50s and 60s.

In long run, Bretton Woods (gold-exchange system) was unstable. There was no way to:
1) devalue the reserve currency ($) even when it became overvalued or
2) force a country to revise its ex-rate upward (appreciate its currency). A country could agree, or
be pressured into devaluation, but there was no way to "revalue" a currency upward (appreciate
through contractionary policy). In the 1960s, US pursued expansionary monetary policy (printed
money) to reduce unemployment, resulting in the dollar being overvalued and foreign currencies
being undervalued according to the fixed ex-rate system. There was no way to devalue the $, and
other countries were not willing to revalue their ex-rates upward (appreciate). Why?

Bretton Woods started to collapse in 1971, temporary measure (Smithsonian Agreement) didn't
work, fixed ex-rate regime was abandoned in 1973. Also, Nixon put wage and price controls went
into effect in 1971, were then lifted, first oil shock started in 1973 (Arab oil embargo after Nixon
gave $2.5B to Israel after Egypt attacked), oil prices doubled, no way to stabilize the dollar. 1973fixed ex-rates/Bretton Woods were abandoned.

5. FLEXIBLE EXCHANGE RATES: 1973-PRESENT

IMF members met in Jamaica in 1976 to agree to a new IMS including:

32

a. Flexible ex-rates allowed, central banks could intervene in currency markets. (Under fixed exrates, you lose control over your monetary policy. Monetary policy must be committed to
maintaining the fixed ex-rate, and cannot be used to pursue other macroeconomic goals)
b. Gold was abandoned as a reserve asset.
c. Developing countries were to get more assistance from IMF.

IMF was to provide assistance to countries facing BP/currency difficulties. (Brazil example). IMF
provides grants and loans to countries with problems under the conditions that they follow IMF's
policy prescriptions - "strings attached to aid." Reduced budget deficits, reduced govt.
spending/cutting subsidies, contractionary monetary policy, i.e. responsible fiscal and monetary
policies.

Advantages of Flexible Ex-Rates:

a. Countries have control over monetary policy

b. A true market value is established for currency, fluctuates daily to reflect market forces of S and
D.
c. Flexible ex-rates maintain BP equilibrium. Example: U.S. has trade deficit, M>X, excess dollars in
world currency markets, $ depreciates, appreciates, US exports will go up, restore trade
balance.

Disadvantages:

a. More Volatility, see page 33, Exhibit 2.3. MNCs must be concerned about currency risk.
b. Potential abuse by central bank, reckless monetary expansion.

Major currencies like $, Yen, etc. are freely floating ex-rates, changing daily to reflect market
forces. Most of the rest of the world is under some type of system of "pegged ex-rates" or
"managed floating," where central bank intervention is required to maintain a certain level of exrates. One system results in trading 1:1 with the dollar (Panama, Bahamas, Belize 2:1, Liberia),
other systems trade within a certain band (range). See page 36-37, Exhibit 2.4. Currencies pegged
to $, FF, SDRs, others. 36 are independently floating, no pegging or targeting. More than 40 have
"managed floating" systems that combine market forces with pegging.
33

European Monetary System has been replaced by the Euro, the single currency in Europe (1 ECU =
1 Euro). See Exhibit 2.5 on p. 39. To qualify for euro, countries had to meet certain economic
criteria:
1) Deficits/GDP less than 3%,
2) Price level stability - low and stable inflation, etc. Of the 15 countries in the European Union,
three countries decided not to join (UK, Denmark, and Sweden).
As of Jan 1, 1999:
1) the 12 countries fixed their ex-rates against each other and against the Euro, and
2) the Euro became a unit of account. For example, 3.35FF/DM. 6.55 FF/Euro. FF and DM will float
against the $, and Yen, but will be fixed against each other and against the Euro. Fixed ex-rate
system for the 12 countries.

Euro currency (euro as a medium of exchange) started to circulate on Jan. 1, 2002. Old currency
and Euros BOTH circulated for the first 6 months, then old currency was taken out of circulation
and only Euros now exist.
Changes:
1) Stores now quote prices in Euros.
2) Payment in Euros can be made with charge cards and checking accounts
3) Euro currencies options are now traded
4) Stock prices/indexes are quoted in Euros.
5) European Central Bank (ECB) established to conduct monetary policy in Europe. Governing
Council made up of 12 ECB governors, one from each country, and 6 member Executive Board.

Main Advantages of Euro ():

1. Significant reduction in transaction costs for consumers, businesses, governments, etc.
(estimated to be .4% of European GDP, about $50B!)
European Saying: If you travel through all 15 countries and exchange money in each country but
don't spend it, you end up with 1/2 of the original amount!
2. Elimination of currency risk, which will save companies hedging costs.
3. Promote corporate restructuring via M&A activity (mergers and acquisitions), encourage
optimal business location decisions.

34

Main Disadvantage of Euro:

Loss of control over domestic monetary policy and exchange rate determination.

Suppose that the Finnish economy is not well-diversified, and is dependent on exports of
paper/pulp products, it might be prone to "asymmetric shocks" to its economy. If there is a
sudden drop in world paper/pulp prices, the Finnish economy could go into recession,
unemployment could increase. If independent, Finland could use monetary stimulus to lower
interest rates and lower the value of its currency, to stimulate the domestic economy and
increase exports. As part of EU, Finland no longer has those options, it is under the EU Central
Bank, which will probably not adjust policy for the Eurozone to accommodate Finland's recession.
Finland may have a prolonged recession. There are also limits to the degree of fiscal stimulus
through tax cuts, since budget deficits cannot exceed 3% of GDP, a requirement to maintain
membership in EMU (to discourage irresponsible fiscal behavior).

General Consensus: Euro has been a success, and will likely emerge as the second global currency,
with the Yen as a junior partner. The success of the Euro may encourage other areas to explore
cooperative monetary arrangements (Asia, S. America). Three world currencies at some point (,
, $)?

35

CHAPTER-3 BALANCE OF PAYMENTS

Definition of the Balance of Payments

As defined in the BPM, the balance of payments (BOP) is a statistical statement that
systematically summarizes, for a specific time period, the economic transactions of an economy
with the rest of the world. Transactions, for the most part between residents and nonresidents,
consist of those involving goods, services, and income; those involving financial claims on, and
liabilities to, the rest of the world; and those (such as gifts) classified as transfers, which involve
offsetting entries to balancein an accounting senseone-sided transactions. Each component of
this important definition is subsequently examined.
The balance of payments is concerned with transactions and thus deals with flows rather than
with stocks. That is, the balance of payments deals with economic events that take place during a
reference period and not with outstanding totals of economic assets and liabilities that exist at
particular moments in time.
Double Entry System
The balance of payments is a statistical statement structured in systematic fashion; data in the
statement are presented according to specific accounting rules. The basic accounting convention
for a BOP statement is that every recorded transaction is represented by two entries with exactly
equal values. In a BOP statement, the two entries are used to recognize the giving and receiving
sides of every transaction. Therefore, the BOP statement is analogous to a typical financial
statement prepared in accordance with the double entry system regularly used for business
accounting.

The dual entry system underlying BOP accounting is governed by certain rules. Thus, in
conformity with business and national accounting, in the balance of payments, the term credit is
used to denote a reduction in assets or an increase in liabilities, and the term debit is used to
denote a reduction in liabilities or an increase in assets. This usage has been supplemented by the
rule that every recording of a debit movement shall be matched by the recording of a credit
movement and vice versa. For example, Dromesia borrows 200,000 units in Cromanian currency
from the government of Cromania and deposits the money with a Cromanian commercial bank.
Dromesia then acquires an asset (the bank balance) as well as incurring a liability (the debt to the
government of Cromania). The asset account is debited, and the liability account is credited. The
Dromesian BOP entries to record the transaction are:

Credit

Debit
36

Liabilities (obligation to
Cromania)
Assets (bank balance in
Cromania)

200,00
0

200,0
00

The major classifications within the current account:

Goods are broken down into the categories:
o General merchandise,
o Goods for processing,
o Tepairs on goods,
o Goods procured in ports by carriers and
o Non-monetary gold;
Services include
o Transportation,
o Travel,
o All other services (such as construction and financial services);
Income is broken down into
o Compensation of employees and
o Investment income;
Current transfers include
o General government transfers, e.g. relating to current
International cooperation between different governments,
o Payment of current taxes on income and wealth, and
o Other transfers, e.g. workers remittances, insurance premiums.
Compensation of employees comprises
wages, salaries, and other benefits (in cash or in kind) earned by
individuals, and
the employer share of contributions on behalf of employees to social
security schemes or to private insurance or pension funds to secure
benefits for employees.
Investment income includes
interest,
dividends,
remittances of branch profits, and
direct investors shares of the retained earnings of direct investment
enterprises.
Investment income account is classified by
direct investment,
portfolio investment and
37

 other investment (income on reserve assets is included here).

Income on direct investment and on portfolio investment is broken down
further into
income on equity
income on debt
The capital account records an economys
Capital transfers that include transfers of ownership of fixed assets and
the cancellation, without any counterpart being received in return, of
liabilities by creditors;
Transactions in nonproduced, non-financial assets include nonproduced
tangible assets, e.g., land and subsoil assets, and
nonproduced intangible assets, e.g., patents, copyrights, trademarks,
franchises, etc., and leases or other transferable contracts. Only the
purchase/sale, not the use of such assets, is to be recorded in the
capital account.
The financial account records an economys transactions in external financial
assets and liabilities. The financial account is structured around five accounts,
differentiated by the type of financial assets/liabilities involved in the
transaction:
Direct investment reflects the objective of a resident entity in one
economy to obtain a lasting interest in an enterprise resident in another
economy. A 10% ownership criterion establishes a direct investment
relationship, i.e. the existence of such a lasting interest for the balance
of payments statistics. Once a direct investment has been established,
subsequent financial flows between the related entities are recorded as
direct investment transactions, regardless of the financial instrument
used; Other capital is associated with various inter-company debt
operations. All financial operations between affiliated companies
(borrowing and lending of funds) including debt securities and
suppliers credits (i.e. trade credits) between direct investors and
subsidiaries, branches and associates.
Portfolio investment includes the following assets insofar as they are
neither direct investment nor reserve assets.
o equity securities and
o debt securities in the form of
bonds and notes and
money market instruments;

38

Standard Components of the Balance of Payments

Credit
Debi
t
1. Current Account
A.
Goods
and
services.
a.
Goods
1. General merchandise
2. Goods for processing
39

3. Repairs on goods
4. Goods procured in ports by carriers
5. Nonmonetary gold
Held as a store of value
Other
2. A. b. Services
1. Transportation
1.1 Sea transport
Passenger
Freight
Other
1.3Air transport
Passenger
Freight
Other
1.4Other transport
Passenger
Freight
Other
2. Travel
2.1 Business
2.2 Personal*
3. Communications services
4. Construction services
5. Insurance services**
6. Financial services
7. Computer and information services
8. Royalties and license fees
9. Other business services
9.1 Merchanting and other trade-related services
9.2 Operational leasing services
9.3 Miscellaneous business, professional, and technical services*
10. Personal, cultural, and recreational services
10.1
Audiovisual and related services
10.2
Other personal, cultural, and recreational services
11. Government services n.i.e.
1. B. Income
1. Compensation of employees
2. Investment income
2.1 Direct investment
2.1.1
Income on equity
2.1.1.1
Dividends and distributed branch profits***
2.1.1.2
Reinvested earnings and undistributed branch profits***
2.1.2
Income on debt (interest)
2.2Portfolio investment
40

2.2.1
Income on equity (dividends)
2.2.2
Income on debt (interest)
2.2.2.1
Bonds and notes
2.2.2.2
Money market instruments and financial derivatives
2.3Other investment
***See Supplementary Information table on
page 00 for components.
***Memorandu
m items: 5.1 Gross premiums
5.2 Gross claims

***If distributed branch profits are not

identified, all branch profits are
considered to be distributed.

41

Standard Components of the Balance of Payments (continued)

Credit

Debit

2. C. Current transfers
1. General government
2. Other sectors
2.1 Workers remittances
2.2 Other transfers
2. Capital and Financial Account
A. Capital account
1. Capital transfers
1.1 General government
1.1.1
Debt forgiveness
1.1.2
Other
1.2Other sectors
1.2.1
Migrants transfers
1.2.2
Debt forgiveness
1.2.3
Other
2. Acquisition/disposal of non-produced, nonfinancial assets
2. B. Financial account
1. Direct investment
1.1 Abroad
1.1.1
Equity capital
Claims on affiliated enterprises
Liabilities to affiliated enterprises
1.1.2
Reinvested earnings
1.1.3
Other capital
Claims on affiliated enterprises
Liabilities to affiliated enterprises
1.2In reporting economy
1.2.1
Equity capital
Claims on direct investors
Liabilities to direct investors
1.2.2
Reinvested earnings
1.2.3
Other capital
Claims on direct investors
Liabilities to direct investors
2. Portfolio investment
2.1 Assets
2.1.1
Equity securities
Monetary authorities
General government
Banks
42

Other sectors
2.1.2
Debt securities
Bonds and notes
Monetary authorities
General government
Banks
Other sectors
2.1.2.2
Money market instruments
Monetary authorities
General government
Banks
Other sectors
2.1.2.3
Financial derivatives
Monetary authorities
General government
Banks
Other sectors

43

CLASSIFYING BALANCE OF PAYMENTS TRANSACTIONS

Selected Supplementary Information
1. Liabilities constituting foreign authorities reserves
1.1Bonds and other securities
1.1.1 Monetary authorities
1.1.2 General government
1.1.3 Banks
1.1.4 Other sectors
1.2Deposits
1.2.1 Monetary authorities
1.2.2 Banks
1.3Other liabilities
1.3.1 Monetary authorities
1.3.2 General government
1.3.3 Banks
1.3.4 Other sectors
2. Exceptional financing transactions
2.1Transfers
2.1.1 Debt forgiveness
2.1.2 Other intergovernmental grants
2.1.3 Grants received from Fund subsidy accounts
2.2Direct investment
2.2.1 Investment associated with debt reduction
2.2.2 Other
2.3Portfolio investment: borrowing by authorities or other sectors on
authorities behalfliabilities*
2.4Other investmentliabilities*
2.4.1 Drawings on new loans by authorities or other sectors on authorities
behalf
2.4.2 Rescheduling of existing debt
2.4.3 Accumulation of arrears
2.4.3.1
Principal on short-term debt
2.4.3.2
Principal on long-term debt
2.4.3.3
Original interest
2.4.3.4
Penalty interest
2.4.4 Repayments of arrears
2.4.4.1
Principal
2.4.4.2
Interest
2.4.5 Rescheduling of arrears
2.4.5.1
Principal
2.4.5.2
Interest
2.4.6 Cancellation of arrears
2.4.6.1
Principal
2.4.6.2
Interest
44

3. Other transactions
3.1Portfolio investment income
3.1.1 Monetary authorities
3.1.2 General government
3.1.3 Banks
3.1.4 Other sectors
3.2Other (than direct investment) income
3.2.1 Monetary authorities
3.2.2 General government
3.2.3 Banks
3.2.4 Other sectors
3.3Other investment (liabilities)
3.3.1 Drawings on long-term trade credits
3.3.2 Repayments of long-term trade credits
3.3.3 Drawings on long-term loans
3.3.4 Repayments of long-term loans
*Specify sector involved and standard component in which the item is included.

45

Selected Supplementary Information (concluded)

4. Services sub-items
4.1Travel (personal)
4.1.1
Health-related
4.1.2
Education-related
4.1.3
Other
4.2Miscellaneous business, professional, and technical services
4.2.1
Legal, accounting, management consulting, and public relations
4.2.2
Advertising, market research, and public opinion polling
4.2.3
Research and development
4.2.4
Architectural, engineering, and other technical services
4.2.5
Agricultural, mining, and on-site processing
4.2.6
Other

46

MULTIPLE-CHOICE QUESTIONS
1. The relationship between the exchange rate and the prices of tradable goods is
known as the:
a. Purchasing-power-parity theory
b. Asset-markets theory
c. Monetary theory
d. Balance-of-payments theory
2. If the exchange rate between French francs and British pounds is 5 francs per pound,
then the number of pounds that can be obtained for 200 francs equals:
a. 20 pounds
b. 40 pounds
c. 60 pounds
d. 80 pounds
3. Low real interest rates in the United States tend to:
a. Decrease the demand for dollars, causing the dollar to depreciate
b. Decrease the demand for dollars, causing the dollar to appreciate
c. Increase the demand for dollars, causing the dollar to depreciate
d. Increase the demand for dollars, causing the dollar to appreciate
4. High real interest rates in the United States tend to:
a. Decrease the demand for dollars, causing the dollar to depreciate
b. Decrease the demand for dollars, causing the dollar to appreciate
c. Increase the demand for dollars, causing the dollar to depreciate
d. Increase the demand for dollars, causing the dollar to appreciate
5. Assume that the United States faces an 8 percent inflation rate while no (zero)
47

inflation exists in Japan. According to the purchasing-power parity theory, the dollar
would be expected to:
a. Appreciate by 8 percent against the yen
b. Depreciate by 8 percent against the yen
c. Remain at its existing exchange rate
d. None of the above
6. In the presence of purchasing-power parity, if one dollar exchanges for 2 British
pounds and if a VCR costs $400 in the United States, then in Great Britain the VCR
should cost:
a. 200 pounds
b. 400 pounds
c. 600 pounds
d. 800 pounds
7. If wheat costs $4 per bushel in the United States and 2 pounds per bushel in Great
Britain, then in the presence of purchasing-power parity the exchange rate should be:
a. $.50 per pound
b. $1.00 per pound
c. $2.00 per pound
d. $8.00 per pound
8. A primary reason that explains the appreciation in the value of the U.S. dollar in the
1980s is:
a. Large trade surpluses for the United States
b. High inflation rates in the United States
c. Lack of investor confidence in the U.S. monetary policy
d. High interest rates in the United States
9. The high foreign exchange value of the U.S. dollar in the early 1980s can best be
explained by:
a. Additional investment funds made available from overseas
b. Lack of investor confidence in U.S. fiscal policy
48

c. Market expectations of rising inflation in the United States

d. American tourists overseas finding costs increasing
10. When the price of foreign currency (i.e., the exchange rate) is below the
equilibrium level:
a. An excess demand for that currency exists in the foreign exchange market
b. An excess supply of that currency exists in the foreign exchange market
c. The demand for foreign exchange shifts outward to the right
d. The demand for foreign exchange shifts backward to the left
11. When the price of foreign currency (i.e., the exchange rate) is above the
equilibrium level:
a. An excess supply of that currency exists in the foreign exchange market
b. An excess demand for that currency exists in the foreign exchange market
c. The supply of foreign exchange shifts outward to the right
d. The supply of foreign exchange shifts backward to the left
12. The appreciation in the value of the dollar in the early 1980s is explained by all of
the following except:
a. The United States being considered a safe haven by foreign investors
b. Relatively high real interest rates in the United States
c. Confidence of foreign investors in the U.S. economy
d. Relatively high inflation rates in the United States
13. Suppose Germany and France were the only two countries in the world. There
exists an excess supply of French francs on the foreign exchange market. This suggests
that:
a. The French balance of payments is in surplus
b. The French balance of payments is in deficit
c. The German balance of payments is in deficit
d. There is an excess supply of German marks
14. If Canada runs a balance-of-trade surplus and exchange rates are floating:
49

a. The value of other currencies will rise relative to the dollar

b. The dollar will depreciate relative to other currencies
c. The price of foreign goods will become cheaper for Canadians
d. The price of foreign goods will rise for Canadians
15. If Germany runs a foreign trade deficit and exchange rates are floating:
a. German exports become more expensive to foreign buyers
b. German exports become less expensive to foreign buyers
c. German imports become less expensive for German buyers
d. German imports become more prestigious to German buyers
16. The international exchange value of the U.S. dollar is determined by:
a. The rate of inflation in the United States
b. The number of dollars printed by the U.S. government
c. The international demand and supply for dollars
d. The monetary value of gold held at Fort Knox, Kentucky
17. For the United States, suppose the annual interest rate on government securities
equals 8 percent while the annual inflation rate equals 4 percent. For France, suppose
the annual interest rate on government securities equals 10 percent while the annual
inflation rate equals 7 percent. These variables would cause investment funds to flow
from:
a. The United States to France, causing the dollar to depreciate
b. The United States to France, causing the dollar to appreciate
c. France to the United States, causing the franc to depreciate
d. France to the United States, causing the franc to appreciate
18. For the United States, suppose the annual interest rate on government securities
equals 12 percent while the annual inflation rate equals 8 percent. For Germany,
suppose the annual interest rate equals 5 percent. These variables would cause
investment funds to flow from:
a. The United States to Germany, causing the dollar to depreciate
b. The United States to Germany, causing the dollar to appreciate
50

c. Germany to the United States, causing the mark to depreciate

d. Germany to the United States, causing the mark to appreciate
19. Given a system of floating exchange rates, rising income in the United States would
trigger a(n):
a. Increase in the demand for imports and an increase in the demand for foreign
currency
b. Increase in the demand for imports and a decrease in the demand for foreign
currency
c. Decrease in the demand for imports and an increase in the demand for foreign
currency
d. Decrease in the demand for imports and a decrease in the demand for foreign
currency
20. Given a system of floating exchange rates, falling income in the United States
would trigger a(n):
a. Increase in the demand for imports and an increase in the demand for foreign
currency
b. Increase in the demand for imports and a decrease in the demand for foreign
currency
c. Decrease in the demand for imports and an increase in the demand for foreign
currency
d. Decrease in the demand for imports and a decrease in the demand for foreign
currency

51

Chapter 4

Introduction to
International financial
market

52

After reading this chapter, you will be able to understand

International financial market
Financial markets
Financial market instruments
Introduction to international financial market
How international financial markets are classified
o Foreign exchange market
o Euro currency market
Credit market
Money market
Bond market
Equity market
The role of international financial markets
Functions
Basic terminology used
Participants in international financial markets
Categories
Role
Location of international financial markets, financial intermediaries, the
International monetary system
Risks associated
The changing financial landscape

53

INTRODUCTION
Before staring with the international markets, we should be clear with the meaning of
financial markets.
Financial Markets:
In simple words, Financial markets are often designated as money markets
and capital markets.
*Money Markets are markets for short term financial assets (Short-term
instruments) e.g., T-Bills, CD's, Bankers Acceptance(BAs), Commercial Papers(CP),
Repurchase Agreements (Repos)...
*Capital Markets are markets for long term financial assets like Bonds, Stocks,
Mortgages, etc.
Important features of market instruments can be outlined below:
1. Money Market (MM):
In the MM, investors can buy S-T debts of governments, banks, financial
institutions, and corporations.
Maturity varies from 1 day to 1 year
Highly marketable
Quickly convertible to cash (very liquid)
Un-collateralized debt of issuers with high credit rating
Quoted by using annualized discount yields
(negotiable CDs are
exceptions)
2. Negotiable CDs:
Denominations of over $100,000
Depositor able to negotiate interest with bank
Maturities range from 14 days to 1 year
3. T-Bills:
U.S. Treasury Department sells T-Bills.
The Federal Reserve Bank (FED) acts as fiscal agent and conducts the yield
auction.
3. Commercial Paper (CP):
Unsecured IOUs of corporations with good credit.
Maturities range from a few days to 270 days.
Usually issued in denominations of $100,000 or more.
About 1000 corporations issue CP in the U.S.
54

4. Bankers Acceptances (BA):

Denominations of over $100,000.
Sold at discounts
5. Repurchase Agreement (REPO):
In a REPO, buyer and seller of a security agree that seller will repurchase
security after a certain length of time or after conditions are met.
Seller repurchases security at a higher price.
6. Euronotes:
Short-term promissory notes issued by a corporation and sold to private or
institutional investors
Typical maturity is 3 to 6 months
Sold originally at a discount from face value.
Trade in secondary markets
Underwritten by international investment/commercial banks
7. Euro Medium Term Notes
Similar to domestic medium term notes, with maturities of 9 month to 10 years.
Fill the gap between S-T and L-T euro debt instruments
8. Eurocommercial Paper
Unsecured short-term notes issued by corporations and banks in the Eurocurrency
Markets
Typical maturities from 1 to 6 months
Placed directly with investors through dealers
9. Eurocredit (bank loans denominated in eurocurrencies and extended by banks
in countries other than in whose currency the loan is denominated)
Loans of one year or longer extended by Eurobanks to MNCs or
governmental agencies
10. Money Market Mutual Funds:
Bring market for T-Bills, Commercial Papers, and others to the small investor.

Basic terminology:
What is a bond?
55

A bond is a loan and you are the lender. The borrower is usually the government, a
state, a local municipality or a big company like General Motors. All of these entities
need money to operate -- to fund the federal deficit, for instance, or to build roads and
finance factories -- so they borrow capital from the public by issuing bonds.
When a bond is issued, the price you pay is known as its "face value." Once you buy it,
the issuer promises to pay you back on a particular day -- the "maturity date" -- at a
predetermined rate of interest -- the "coupon." Say, for instance, you buy a bond with
a $1,000 face value, a 5% coupon and a 10- year maturity. You would collect interest
payments totaling $50 in each of those 10 years. When the decade was up, you'd get
back your $1,000 and walk away.
A key difference between stocks and bonds is that stocks make no promises about
dividends or returns. General Electric's dividend may be as regular as a heartbeat, but
the company is under no obligation to pay it. And while GE stock spends most of its
time moving upward, it has been known to spend months -- even years -- going the
other way.
When GE issues a bond, however, the company guarantees to pay back your principal
(the face value) plus interest. If you buy the bond and hold it to maturity, you know
exactly how much you're going to get back (in most cases, anyway). That's why bonds
are also known as "fixed-income" investments -- they assure you a steady payout or
yearly income. And although they can carry plenty of risk, this regular income is what
makes them inherently less volatile than stocks.
Global Bond: They have a minimum value of $1 billion and are effected simultaneously
in Europe, America and Asia. The salient features of these bonds are that they permit
to raise very high amounts. They offer very high liquidity since they are quoted on
several exchanges while secondary market functions round the clock, with uniform
price all over the world. They are especially used by governments, public enterprises,
international organisations and private financial institutions.
External Bond Market: The external bond market refers to bond trading activity
wherein the bonds are underwritten by an international syndicate, are offered in
several countries simultaneously, are issued outside any country's jurisdiction, and are
not registered. The Eurobond market is a major external bond market. The external
bond market combined with the internal bond market comprises the global bond
market. Examples of an external bond are the "global bond," issued by the World Bank,
and Eurodollar bonds.
Internal Bond Market: The internal bond market refers to all bond trading activity in a
given country and is comprised of both a domestic bond market and a foreign bond
market. Also referred to as the "national bond market." The internal and external bond
markets comprise the global bond market
Bulldog Bonds: A sterling denominated foreign bond, priced with reference to the UK
56

gilts.

Types of international financial markets:

The international financial markets consist of the
1. Credit market,
2. Money market,
3. Bond market
4. Equity market.
57

The international credit market, also called Euro credit market, is the market that deals
in medium term Euro credit or Euro loans.
International banks and their clients comprise the Eurocurrency market and form the
core of the international money market. There are several other money market
instruments such as the Euro Commercial Paper (ECP) and the Euro Certificate of
Deposit (ECD).
Foreign bonds and Eurobonds comprise the international bond market. There are
several types of bonds such as floating rate bonds, zero coupon bonds, deep discount
bonds, etc.
The international equity market tells us how ownership in publicly owned
corporations is traded throughout the world. This comprises both, the primary sale of
new common stock by corporations to initial investors and how previously issued
common stock is traded between investors in the secondary markets.
In this chapter, we will try to learn two major components of International Financial
Markets:
The Foreign Exchange Market
Eurocurrency, Eurocredit, & Eurobond Markets

BACKGROUND:

The last two decades have witnessed the emergence of a vast financial market across
national boundaries enabling massive cross-border capital flows from those who have
surplus funds and a search of high returns to those seeking low- cost funding. The
degree of mobility of capital, the global dispersal of the finance industry and the
enormous diversity of markets and instruments, which a firm seeking funds can tap, is
something new.
Major OECD (Organization for Economic Co-operation and Development) countries
had began deregulating and liberalizing their financial markets towards the end of
seventies. While the process was far from smooth, the overall trend was in the
direction of relaxation of controls, which till then had compartmentalized the global
financial markets. Exchange and capital controls were gradually removed, nonresidents were allowed freer access to national capital markets and foreign banks and
financial institutions were permitted to establish their presence in the various national
markets.
While opening up of the domestic markets began only around the end of seventies, a
truly international financial market had already been born in the mid-fifties and
gradually grown in size and scope during sixties and seventies. This refers to the Euro
58

currencies Market where borrower (investor) from country A could raise (place) funds
from (with) financial institutions located in country B, denominated in the currency of
country C. During the eighties and nineties, this market grew further in size,
geographical scope and diversity of funding instruments. It is no more a "euro" market
but a part of the general category called offshore markets.
Alongside liberalization, other qualitative changes have been taking place in the global
financial markets. Removal of restrictions has resulted into geographical integration of
the major financial markets in the OECD countries. Gradually this trend is spreading to
developing countries many of which have opened up their markets-at least partially-to
non-resident investors, borrowers and financial institutions.
Another noticeable trend is functional integration. The traditional distinctions
between different financial institutions-commercial banks, investment banks, finance
companies, etc.- are giving way to diversified entities that offer the full range of
financial services. The early part of eighties saw the process of disintermediation get
underway. Highly rated issuers began approaching investors directly rather than going
through the bank loan route.
On the other side, debt crisis in the developing countries, adoption of capital adequacy
norms and intense competition, forced commercial banks to realize that their
traditional business of accepting deposits and making loans was not enough to
guarantee their long-term survival and growth. They began looking for new products
and markets. Concurrently, the international financial environment was becoming
more volatile- there were fluctuations in interest and exchange rates. These forces
gave rise to innovative forms of funding instruments and tremendous advances in risk
management. The decade saw increasing activity in and sophistication of the
derivatives market, which had begun emerging in the seventies.
Taken together, these developments have given rise to a globally integrated financial
marketplace in which entities in need of short- or long-term funding have a much
wider choice than before in terms of market segment, maturity, currency of
denomination, interest rate basis, incorporating special features and so forth. The
same flexibility is available to investors to structure their portfolios in line with their
risk-return tradeoffs and expectations regarding interest rates, exchange rates, stock
markets and commodity prices.

The foreign exchange market:

Features:
59

1. The Foreign Exchange Market is the world's largest financial market.

The Bank for International Settlements estimates daily trading volume of about
$3.2 trillion.
2. The Foreign Exchange Market is an over-the-counter market.
That means there is no physical location where traders get together to exchange
currencies. Rather they are located in the offices of major commercial banks
around the world and trading has historically been done by telephone, telex, or the
SWIFT system.
3. The Society for Worldwide Interbank Financial Telecommunications(SWIFT)
is an international bank communications network, that electronically links
brokers and traders.
The network connects over 7000 banks and broker-dealers in over 192 countries.
SWIFT transports financial messages in a highly secure way, but does not hold
accounts for its members and does not perform any form of clearing or settlement.
SWIFT does not facilitate funds transfer.

International payment system:

An international payment system should provide:
Security of value - instrument adequately transfers appropriate value
Security of medium - instrument hard to fake.
Storage security instrument cant be easily stolen or its value
appropriated.
Portability instrument can be used to transport sufficient value.
Negotiability others will accept the instrument.
Convenience low cost and speed of instrument transfer.
Legal recognition and formalism rules of the system adequately regulated
by state.
Global Settlement System
CLS Bank International, a New York-based settlement network, is supported
by over 70 of the worlds largest banking and financial institutions.
CLS offers a unique real-time processing that enables simultaneous FX settlement
across the globe thereby eliminating settlement risks caused by delays arising from
time-zone differences.
Trading takes place somewhere in the world 24 hours a day and frequently
between individuals or institutions located in different countries.
Most trading activities take place in a few currencies like the US Dollar, the
Euro, the British Pound, the Japanese Yen, the Canadian Dollar, and the
Swiss Franc
The foreign exchange market is not confined to any one country but
dispersed throughout the worlds leading financial centers: London, New
60

York, Tokyo, Paris, Zurich, Amsterdam, Hong Kong, Frankfurt, Toronto,

Milan, Singapore, Berlin, Vienna, Chicago...
Foreign Exchange traders not only buy and sell currencies but, they create
prices.
Market Makers are those traders in the major money-center banks around
the world who are always ready to buy or sell by quoting the bid/ask prices.
They create the market by creating bid/ask prices and dealing at those
prices.
The difference between the two prices is called the spread."
Participants in the FX market include importers, exporters, portfolio
managers, central banks, brokers, commercial banks, arbitragers,
speculators, tourists, governments, etc.

Subdivision of Foreign Exchange Market

The Foreign exchange market can be subdivided into:
The Retail Market: permits the firms and individuals to obtain foreign exchange
for business or personal use.
The Interbank Market: major participants are foreign exchange traders
employed by large banks. Also large Multinational Corporations often maintain
trading departments that operate directly in this market. Traders in the
interbank market are called dealers." They make the market.
Brokers: bring buyers and sellers together for a small commission thereby
helping to preserve the anonymity.
Arbitragers: seek to profit from price differences in different foreign exchange
markets.
Speculators: buy and sell in the hope that a price change will result in a profit.
Governments: Central Banks, Treasury Departments and other Government
Agencies sometimes participate in the market in order to influence the
exchange rate of a particular currency.
For Example:
FED buys dollars in foreign exchange market to increase the value of the dollars.
FED sells dollars in foreign exchange markets to reduce the value of dollars.
Coordinated efforts among central banks are often used. For example, the US FED
bought the Mexican peso to help prop up its value in early 1995.
Other Participants (mainly in the forward markets)
Traders: Use forward contracts to eliminate or cover the risk of loss on export or
import orders that are denominated in foreign currencies.

61

Hedgers: Hedgers, mostly Multinational corporations, enter into forward contracts

to protect domestic currency value of foreign currency denominated asset and
liabilities on their balance sheets.
The increasing importance attached to exchange rates results from the
globalization or internationalization of modern business, the continuing
growth in world trade, the trend towards economic integration and the
rapid pace of change in the technology of money transfer.
The Clearing System: Modern technology plays a central role in the international
transfer of funds or settling foreign exchange transactions.
In the U.S., electronic funds transfer takes place
through the Clearing House Interbank Payment System (CHIPS).
This is a computerized network developed by the New York Clearing House
Association for transfer of international dollar payments. It links about 150
depository institutions that have offices or affiliates in New York City.
The New York Fed has established a settlement account for member banks in
which the account of a paying bank is charged and the receiving banks account is
credited.
Electronic Trading:
In 1992, Reuters introduced a new service that added automatic execution to the
screen quotations used in telephone trading thereby creating a genuine screenbased market.
Other vendors like
Telerate and Quotron, followed.
Electronic trading systems offer automatic matching
in which traders enter buy and sell orders directly into their terminals
anonymously.
These prices are visible to all market participants and any trader anywhere in the
world can execute a trade by hitting two buttons!

Functions of the Foreign Exchange Market:

62

1. Transfer of Purchasing Power:

International trade and capital transaction usually involve parties with
different functional currencies.
Trade and capital transactions can be invoiced in any convenient currency.
Therefore, one or more of the parties must transfer purchasing power to or
from own national currency.
The Foreign exchange market facilitates this transfer of purchasing power
2. Provisions of credit:
Movement of goods and services between countries takes time. This gives
rise to financing of inventory in transit and sales inventory.
The foreign exchange market provides a means of transfer of credit.
Specialized instruments like Bankers' acceptances and letters of credit, are
made possible through the foreign exchange market
3. Minimizing Foreign Exchange Risk:
The foreign exchange market provides "risk transfer" facilities to third parties via
forward, futures, options, and swaps markets.

63

Foreign exchange rate:

The Foreign exchange rate is the domestic currency units per unit of a foreign
currency.
Example: Let the U.S. be "domestic"
1. If you need $1.95 to purchase 1 unit of the British Pound Sterling, then
$/ = 1.95 (d/f)
Dollars per pound is a direct quote for the pound in the U.S. It means the home
currency, in this case the $, (or domestic currency) needed to acquire one unit of a
foreign currency, in this case the pound.
Alternatively:
The foreign exchange rate can be defined as units of a foreign currency per unit of
domestic currency. This is an indirect quote.
2. If 125 units of the Japanese Yen are needed to purchase one unit of the U.S.
Dollar, then:
/$ = 125 (f/d).
This is an indirect quotation for the Yen in the US.
Since the direct and the indirect quotations are alternative means of stating
exchange rates, the two methods are related. One is the inverse of the other. Thus
$ =
1
64


or,
=
$

/$
1
$/

Most interbank quotes are quoted around the world are stated in "European"
terms which means the foreign currency price of one dollar, e.g., SF/$ = 1.2378,
/$ = 132, etc.
The alternate way, dollar price of one unit of foreign currency, is called "American"
Terms e.g. $/ = 1.7535.

Spot Rates:
A spot transaction is the purchase of foreign exchange for immediate delivery
(usually, delivery within the following 2 business days).

Forward Rates:
A forward exchange rate or forward rate, is the price agreed on today for purchase
or sale of foreign currency for future delivery (transfer/settlement) and payment.
The rate is agreed on at the time the contract is made, but normally payment and
delivery are not required until maturity.
Forward maturities normally are 30, 60, 90, 180, 360 days in to the future. Odd
maturities may be negotiated for one to two weeks or even up to 5 years.

Cross Rates:
Frequently, the need arises to obtain the relationship (price) between two
currencies from their relationship with (quotation in) a third currency.
Formally, given two currencies A & B.
If $/A and $/B are given, then the value of A in terms of B (or B per unit of A) is
given by:
$/A = $ * B = B
$/B A $
A
This is the cross rate.
Examples: Given $/ and $/SF, then
$/ = $ * SF = SF
$/SF

Given:

$/ = 1.4155 and SF/ = 3.1318, then

SF = SF/ = 3.1318 = 2.2125
$
$/
1.4155

Given: $/ = 1.8632; $/ = .008013, then

= $/ = 1.8632 = 232.52

$/
.008013
65

Bid/ Ask:
The Bid is the price at which a broker will buy your stock trading position from you, the
Ask is the price at which he will sell you a position. When stock trading, the distance
between the bid and the ask depends on a number of factors, such as is the security
liquid, how volatile is the market generally, the balance between buyers and sellers
and so on. This is the reason stock trading prices have 2 numbers - for example the
price of IBM might be quoted as 148 - 149. This means that if you want to BUY a share
of IBM, it will cost you 149 dollars, but if you want to SELL a share, you will only get 148
dollars for it. In the morning papers, it is usual for only 1 stock trading price to be
shown, the MID price (the average of the bid and ask).
Think of it like foreign currency - when you go into a UK Bureau de change, they will
give you 60 for your $100, but if you want to sell them that 60 back, you will only get
$95. Spread betting companies have far wider stock trading spreads between bid and
ask than standard brokers because they don't have commission charges.
Note - the "Best Bid" for a stock is the higest price that a buyer is willing to pay for that
stock at that particular point in time. The "Best Ask" is the lowest price that a seller is
willing to accept for a stock at that point in time. A stock trading Bid is composed of a
Buy Limit Order that has been placed into the market. A stock trading Ask is composed
of an open Sell Limit Order.
The Bid-Ask Spread:
Bid Price: price at which a dealer will buy a currency.
Ask price: price at which the dealer will sell a currency (offer price).
Dealers do not normally charge a commission on their currency transactions
but profit from the bid/ask spread.

Computing the bid/ask spread in percentage terms:

Bid/Ask spread = Ask Rate - Bid Rate * 100
Ask Rate
1
This expresses the spread in terms of the "discount" obtained by the dealer.
Alternatively,
Bid/Ask spread = Ask Rate - Bid Rate * 100
Bid Rate
1
This expresses the spread in terms of the markup established by the dealer.
Outright and Points Quotations:
In outright quotations the full price is given to all its decimal points.
In points quotation abbreviations are used.
66

Forward Quotes With Bid/Ask Spreads:

Interbank quotations are expressed as a bid (buy) and an offer (sell or ask).
Bid and Ask quotations may appear complicated because the bid for one currency
is also the ask of another currency.
In outright quotations the full price is given to all its decimal points.
In points quotations abbreviations are used.
When quotations in European terms (indirect) are rendered in American terms
(direct) the bid and the ask reverse.
The reciprocal of the bid becomes the ask and the reciprocal of the ask becomes
the bid
In the Interbank market, dealers usually quote the forward rate as a discount from
or a premium on, the spot rate.
This forward differential is called the "Swap Rate".
Example: Given that:
: spot $/ = 1.7860 : spot $/ = .007949
90-day Fwd = 1.7580
90-day fwd = .007929
The "Swap Rate" (forward differential) for the was quoted as a 280-point discount
(from the spot).
The "Swap Rate" for the 90-day forward Yen was quoted as a 20-point discount
from the spot.
A "Swap Rate" can be converted into an outright rate by adding the premium (in
points) to or subtracting the discount (in points) from the spot rate.
When the forward bid (in points) is smaller than the Ask rate (in points) the forward
rate is at a premium and the points should be added to the spot price to compute
the outright quote.
Conversely, if the bid (in points) exceeds the ask (in points), the forward rate is at
a discount and the points must be subtracted from the spot price to obtain the
outright quotes.
Note that the buying rate, spot or the forward, is always less than the selling
rate and forward bid/ask spread always exceeds spot bid/ask spread.
Example:
The following quotes are given for the respective maturities for the and the SF.
Spot
1 Month
: $2.0015-30
19-17
SF: $0.6963-68 4-6

3 Months
26-22
9-14

6 Months
42-35
25-38
67

Compute the outright quotes.

This example shows that the SF is selling at a premium while the is at a discount
against the $.
Note the slightly wider spread between outright bid and Ask on the Swiss Franc
compared to the spread on the pound. The difference is due to the broader market
in pounds. Also the widening of spreads over time for both currencies is caused by
the greater uncertainty surrounding future exchange rates.

The Bid/Ask Spreads in Cross Rates:

Consider the following quotes:
$/ =
$ 1.7109-36
$/SF = $ 0.6250-67
Find the direct quote for the in terms of the SF
(with B/A spread). i.e. find
SF/ in b/a quotes.
The bid and ask quotes for SF/ are:
BID: SF = SF * $ =
1 * 1.7109 = 2.7300

.6267
1
ASK: SF = SF * $ =
1 * 1.7136 = 2.7418

.6250
1
Hence the cross rates with B/A spreads are:
SF/ = 2.7300 - 2.7418
or = 2.7300 418
Sometimes a forward transaction is called an "outright forward" to emphasize that
no spot transaction is involved and to distinguish it from a "swap transaction"
A "swap transaction" involves the sale of a foreign currency with a simultaneous
agreement to repurchase at some later date in the future; OR
The purchase of the foreign currency with an agreement to resell at sometime in
the future.
Generally a forward swap is an arrangement in which two parties agree to
exchange specific amounts of currencies on one date and to reverse the exchange,
usually at a different exchange rate, on a later date. The arrangement can be a
spot-forward or forward-forward swap.
These forward swaps differ from currency swaps in that there are no exchanges
of interest payments and are usually for shorter time periods.
Spot - fwd swap: Spot now with fwd later;
Fwd - fwd swap: fwd at t with fwd at t+30.
Example:
City Bank buys SF5 million from the Swiss Bank for $2 million (spot) and
simultaneously agrees to sell the SF back in 6 months for $ 2.1 million.
68

The difference between the sale price and the repurchase price is called the swap
rate
This swap is a way to borrow one currency for a limited time while giving up the
use of another currency for the same time, i.e., a short-term borrowing of one
currency combined with a short-term loan of an equivalent amount of another
currency.
Note:
According to the Bank for International Settlements (BIS), in 2001, spot
transactions account for 33% of the market, forward transactions 11%, and swap
transactions, (involve a package of spot and forward contracts), 56% of the market.
Exercises:
1. A trader quotes the SF against the $ at a Bid/Ask (buy/sell) price of:
SF/$ = 2.3697 - 2.3725.
The principle of buy low and sell high applies.
The smaller number 2.3697 is the
bid price and
the larger number 2.3725 is the ask price.
Obtain the bid/ask prices for $/SF.
2. If a bank quotes bid/ask prices SF/ = 4.085-4.090. What should be the bid/ask
prices for /SF?
3. A bank is currently quoting the following rates:
i)
SF/$ = 2.3697-2.3725
$/ = 1.5525-1.5535
What SF/ cross rates bid/ask would the bank quote?
ii)
SF/$ = 2.5110-2.5140
/$ = 245-246
Find /SF Bid/Ask rates.
iii)
DK/$ = 5.5279-5.5289 (DK = Denmark krone)
SK/$ = 6.8681-6.8691 (SK = Sweden krona)
Obtain SK/DK bid/ask rates.

Premium or Discount on Forward Rate:

If the forward rate exceeds the existing spot rate (direct quotes) it contains a
premium.
If the forward rate is less than the spot
rate, that forward rate contains a discount.
To compute the Premium (Discount)
Let:
F = Forward rate e.g., $/ = d/f
S = spot rate
n = time to maturity
then:
For a direct quote of the (e.g. quoted as $/ = 1.5235):
F-S * 360 gives premium (discount) on the .
69

S
n
For an indirect quote, (e.g. quoted as /$ = .6564)
S-F * 360 gives premium (discount) on the pound.
F
n
A premium means that the direct price in the forward
market is higher than the direct price in the spot market.
A discount is the reverse.
Examples:
Spot
($/SF)
.4520
30-day Forward
.4541
90-day Forward
.4585
180-day Forward .4654
a. Obtain the p (d) on the Swiss franc in each case.
b. Compute the p (d) on the dollar in each case.
Using The Forward Contract: an Example
A U.S. importer of German BMW receives a bill of 2m for the 700 series. The Bill
is payable in 90 days. Spot $/ = 1. 3467. The 90-day forward $/ = 1.3495.
The Forward contract is a means of locking in the price at which euros will be
acquired in 90 days. Discuss.
Percentage Change in Exchange Rates:
The percentage change in exchange rates can be obtained as follows:
% change = Ending Rate - Beginning Rate * 100
Beginning Rate
1
Example:
|----------------------------|
Given that:
0
1
at t = 0 : $/ = 1.7895
t = 1 : $/ = 1.9795
% = 1.9795 - 1.7895 * 100 = 10.62
1.7895
1
The pound has appreciated in value against the dollar by
10.62% during the given period.
Some Common Terms:
Depreciation -- Devaluation -- Weakening
Appreciation -- Revaluation -- Strengthening
Soft Currency -- Expected to decrease in value
Hard Currency -- Expected to maintain its value
to increase in value.
Dollar is Mixed -- The $ did not move in one
direction against the major currencies - up with
70

some, down with some.

Arbitrage in Foreign Exchange Market:

Arbitrage is one of the most powerful forces at work in a market economy.
It is the simultaneous purchase and sale of the same (or essentially similar) good or
security in two different markets for advantageously different prices - provided that
the price spread more than offsets transaction costs.
Arbitrage plays a critical role in the analyses of security markets because its effect is
to bring prices to their fundamental values and keep markets efficient. The effect of
arbitrage is to reduce/eliminate price differentials on identical products by
arbitragers buying low and selling high to realize riskless profit.
Locational Arbitrage:
The prices charged by different banks for foreign exchange cannot vary
significantly.
Prices are kept more or less in line with each other
through a process called Locational Arbitrage
If the price of a foreign exchange varies from one bank to another, an arbitrager
will be able to "buy low" and "sell high."
Such an activity should lead to an increase in the rate at the low-priced bank and
decrease in the rate at the high-priced bank.
Arbitrage activity will continue as long as the difference in prices is large enough to
generate a profit.
EXAMPLE:
Bank A
Bank B
Bid price for X
$ .50
$ .52
Ask price for X
$ .51
$ .53
In this example profitable arbitrage opportunity exists. Given that the arbitrager
has $1m.
Buy X from bank A at .51 and simultaneously sell them to Bank B at .52. If $
1,000,000 are available then, $1,000,000 will buy X = 1,000,000/.51 = 1,960,784.
Sell to Bank B for 1,960,784 * $.52 = $ 1,019,608 for a profit of $19,608.
The high demand for X in Bank A leads to an increase in price and increased supply
of X in Bank B leads to a decrease in price.
Such a situation usually disappears before most firms even become aware of it.
71

As an example of how arbitrage works, consider a large bank in London. The Chief
of the FOREX department, Dollar($) section, observes over the telex that the $
prices of Pound ($/) spurts up in New York.
Here is a chance to make some money! To exploit the situation, the arbitrager does
two things:
First he/she contacts a broker or a correspondent bank
in New York and sells, say 1m (sells high).
At almost the same time he/she buys the same amount of s in London.
If the arbitrager does not buy and sell at almost the same instant the spread
appears, there is a risk of missing the opportunity.
The sale of pounds in New York where the price is high and the repurchase in
London, where the price is low, contributes to eliminating the price deferential.
As other market participants take similar actions, the price differences appears.

Triangular Arbitrage:
Example 1:
Consider the following quotes in New York, Frankfurt, and London. (Assume no
transaction costs)
FRANKFURT ($/ = 1.2471)
LONDON (/ = 1.4544)
NEW YORK ($/ = 1.8590)
Is Triangular Arbitrage feasible? Show why/why not.
Describe a strategy to profit from triangular arbitrage.
What percentage profit is possible?
e.g. $
Given 1m:
1000000 *
1
* 1.8590 *
1
= 1,024,930
1.4544
1.2471
Profit = 24,930 2.5 % .
Arbitrage activity causes to appreciate against in
London, the $ to appreciate against the in New York and the against the $ in
Frankfort.
Example 2:
Assume no transaction cost. Suppose 1 = $1.8095 in NY,
$1 = C$1.3215 in Toronto and C$1 = 0.4342 in London.
Show whether or not triangular arbitrage opportunities exist
How could a trader profit from triangular arbitrage?
Compute the percentage profit possible.
Solution:
Example 3: Assume zero transaction costs:
A: /U$ = 106.50, B: C$/U$ = 1.3215 , C: /C$ = 82.905
Determine if triangular arbitrage is feasible.
72

State what you would do to profit from arbitrage.

Obtain the percentage profit possible.
Solution:
By cross rates from A & B,
= . U$ = 106.50 . 1 = 80.590
C$ U$ C$
1.3215
The C$ is more valuable at C:
Borrow C$ and sell it for at C, Sell for U$ at A and the U$ for C$ at B.
e.g. C$ U$ C$
Given 1C$:
1 * 82.905 *
1
* 1.3215 = C$1.02772
106.50
Profit 2.8%
Transaction Costs:
Assume transaction cost is .6% (.25%, .35%). With a .60% Trans. cost, each
stage the arbitrager receives 99.4% of what he previously received.
There are three transactions in this example and these can be incorporated as
follows:

Derivative Securities Markets: An Overview

These are forwards, futures, options, and swaps.
73

Forward Contracts are "private" contracts offered by banks that provide for the
purchase or sale of units of a currency at a specified exchange rate for future
delivery and settlement.
Currency Futures Contract:
Permits the exchange/trading (purchase or sale) of a specified number of contracts
of a currency at specified exchange rate for future delivery.
Prices are determined by an auction process on the floor of an organized futures
exchange.
Unlike the forward contracts, the futures contract entails daily settlements
(marking to the market) and the posting of a margin.
Currency futures contracts contain standard units of the underlying currencies.
Currency Options Contract:
Is an exchange traded contract which grants the buyer (holder or owner) the
right, but not the obligation, to purchase or sell a specified number of contracts of
the underlying currency at a prescribed price (the strike price or exercise price)
within a given period of time.
The buyer pays a premium to acquire this right. Contract sizes are standardized.
A Swap contract is a contractual agreement evidenced by a single document in
which two parties, called counterparties, agree to make period payments to each
other.
The agreement spells out the instrument to be exchanged (which may or may not
be the same), the applicable interest rate on each instrument (which may be fixed
or floating), the timetable for making payments, and other provisions.
Swap contracts are tailor-made to meet the needs of the counterparties with the
aid of swap specialists who serve as brokers and/or market makers.
Swaps trade in the OTC market.
The most important Eurocurrencies are the Euro-Canadian dollar, Euro-Euro, EuroSwiss franc, Euro-sterling, and Euro-yen.
Smaller offshore banking centers which participate in the Eurocurrency market
include such locations as the Cayman Islands, Bahamas, Bahrain, Luxembourg .
The Singapore market is often called Asian dollar market.
The Eurocurrency market therefore consists of those banks, called Eurobanks, that
accept deposits and make loans in foreign currencies.
The Eurocurrency market enables investors to hold short-term claims on
commercial banks, which then act as intermediaries to transform these deposits
into claims on final borrowers.

74

2. EURO CURRENCY MARKET

1) The Evolution of the Market:
The development and expansion of the Eurocurrency markets have their roots in
overt and covert events.
In the late 1950s British-owned banks utilized foreign currency deposits (in the UK)
as a lending medium in order to save business that was at that time endangered by
exchange controls (by the UK) on transactions in pounds sterling.
In turn this lead to active solicitation of dollar deposits by banks in Western Europe.
2) The Soviet Union: provided impetus for the early growth of the market. As the
cold war heated up, the Soviet Union began to worry about the U.S. Government
freezing its deposits in New York. The Soviets needed to maintain dollar accounts
for international trade and investment. The dollar was then virtually the only
currency acceptable worldwide.
The Soviet Union responded to this problem by placing its dollar-denominated
deposits in banks outside the U.S. jurisdiction.
British and French banks were the primary recipients of these deposits.
3) Changes in U.S. Balance of Payment Situation: The 1945-50 period saw
persistent surpluses.These were replaced by deficits in 1957. Deficits resulted in
increased foreign holding of dollars. By mid 1958 European market in dollar
deposits and loans had become established.
4) The Market as a Source of Short-term Funds: Supports trade financing
activities of international banks.It facilitates foreign exchange transactions by banks
and provides short-tern money market trading opportunities. International banks
use the market as an outlet for placing surplus funds temporarily at attractive
yields.
Eurocurrency interbank market has become the central
mechanism to channel flow of international funds among banks and this gave birth
to the LIBOR as an important international interest rate
5) Regulatory Developments in the U.S.
(i)"Regulation Q": Interest rate ceilings existed in the U.S. during the 1960s and
1970s.
With higher interest on dollars deposited in the
eurodollar market, funds moved to banks in Europe. Many U.S. banks opened
European offices to receive these funds.
(ii) Federal Reserve "Regulation M": This regulation requires the keeping of
reserves against deposits. Since reserves constitute idle funds, the cost of operating
in the Eurocurrency market is relatively less since there are no reserve
requirements in the eurocurrency market.

75

Many American banks moved some of their operations to the relatively

unregulated eurocurrency market.
(iii) The Controls and Restrictions on Borrowing Funds in the U.S. for
Reinvestment Abroad: (voluntary in 1965, mandatory in 1968) forced many
borrowers to seek sources of loans in Europe, thereby increasing the demand for
funds deposited in the eurocurrency markets.
(iv) The U.S. Interest Equalization Tax (1963): Imposed a tax on U.S. residents'
earnings on foreign securities.
This
increased the interest foreign borrowers were forced to pay on funds borrowed
directly from the U.S. market.
By
channeling funds through the eurocurrency market, this tax is avoided.
6) The Role of Narrow Spreads: The desire of depositors to receive highest
possible yields and of borrowers to pay lowest possible costs are met in the
eurocurrency market. Absence of regulation permits higher yields to depositors
and lower costs to borrowers.
7) Desire of British Banks to maintain their position in international finance plus
the favorable regulatory environment in the United Kingdom.
8) Confidence in Vehicle Currencies especially the dollar
9) The Role of OPEC: OPEC countries invest part of their petrodollars in the
Eurocurrency Market so that the market provides a medium for the so called
"Petrodollar Recycling.
10) Other Features of the Market:
Costs of complying with regulations are low since there are no deposit
insurance assessments.
Borrowers' credit worthiness is well known so that the need for credit
investigation is low.
No taxes are withheld from interest payments to eurocurrency
depositors.
Taxes and fees levied on euro banking operations are generally lower
than those applied to domestic banking.
Low costs per transaction because of
relatively large size of
transactions.
Eurocurrency markets need not be located in Europe, though they
originate in Europe.
For example, in the U.S., domestic banks are (since 1981) permitted to open
International Banking Facilities (IBF), which are computerized account records kept
separate from U.S. banks' domestic accounts.
They must be domiciled inside U.S. territory and focus on international
commerce.They accept foreign currency denominated deposits. These
"onshore/offshore" bank accounts are permitted in an effort to regain deposits lost to
offshore banking operations.
76

IBF accounts are free from reserve requirements and assessment for deposit insurance.
They are also exempt from federal taxes, becoming taxable only when transferred to
regular accounts.
The primary participants in the Eurocurrency market are large banks called Eurobanks.
Transactions are predominantly interbank, hence the market is frequently called the
"interbank market." In addition, large scale or "wholesale" transactions take place
between banks and non-bank customers.
Transactions are typically priced off the London Interbank Offered Rate (LIBOR)
which is a floating rate at which London banks lend to one another.
Interest rates on Euroloans to governments and their agencies, corporations, and
non-prime banks are set at a fixed margin above LIBOR for the period and currency
chosen.
At the end of each period the interest for the next period is calculated at the same
fixed margin over the new LIBOR.
The drawdown, the period over which the borrower may take down the loan, and
the repayment period vary with borrowers needs.
A commitment fee of about 0.5% per annum is charged on the unused balance.
Eurodollar loans have multi-currency clauses giving borrowers the right, subject to
availability, to switch from one currency to another on any rollover/reset date.
This feature provides a potentially valuable exposure management for borrowers.
Reference Rates of Interest:
A reference rate of interest, for example U.S. dollar LIBOR, is the rate of interest
used in a standardized quotation, loan agreement, or financial derivative valuation.
LIBOR, London interbank offered rate, is by far the most widely used and quoted.
It is an interest rate charged by banks for S-T loans to one another. It is an
important benchmark for mortgages, corporate financing, etc.
It is officially defined by the British Bankers Association (BBA).
The BBA also calculates Yen LIBOR, Euro LIBOR, and other currency LIBOR rates.
Most major financial centers also construct their own interbank offered rates for
local loan agreement purposes.
These include:
FIBOR: Frankfurt interbank offered rate
PIBOR: Paris interbank offered rate
SIBOR: Singapore interbank offered rate
MIBOR: Madrid interbank offered rate
EIBOR: Emirate interbank offered rate (interest rate charged by banks in the United
Arab Emirates for interbank transactions)
Eurodeposit Creation:
Eurocurrency deposits are subject to the same multiple expansion feature of a
domestic banking system.
Funds are deposited in a Eurobank which lends them to deficit spending units and,
in effect, creates new deposits.
77

Example:
Stage A:
Assume that IBM purchases computer components from a UK supplier, COMPUK,
for $1m and pays with a check drawn on its Chase Manhattan Bank in New York.
Assume also that COMPUK deposits the check in Westminster Bank, London.
A Eurodollar deposit is now created since COMPUK has a dollar-denominated
account outside the U.S.
Typically, money center banks maintain accounts with one another. So,
Westminster Bank deposits the check at Chase which now shows a change of
ownership on the $1m deposit from IBM to Westminster.
Stage B:
Now, suppose Volvo of Sweden obtains a loan of $900,000 from Westminster and
uses the proceeds to pay for purchases from a another Swedish company,
Stockhm 1.
Stockhm 1 deposits the proceeds in the Bank of Sweden, thus creating another
eurodollar deposit.
When the Bank of Sweden initiates collection,
$900,000 of Westminster deposit at Chase change ownership to the Bank of
Sweden.
Eurodollar Deposit Expansion: Main Features
Stage A
Chase, NY
Westminster, London
Deposits of IBM
Deposit at Chase Deposits of COMUK
-$1,000,000
+$1,000,000
+$1,000,000
Deposits of Westminster
+$1,000,000
Stage B
Chase, NY
Bank of Sweden
Deposits of Westminster
Deposit at Chase Deposits of Stockhm1
-$900,000
+$900,000
+$900,000
Deposits of Bank of Sweden
+$900,000
At this point, the level of Eurodollar deposit is $1,900,000 The process of
expansion continues geometrically.
The expansion is limited by the level of
voluntary (discretionary) reserve held by each Eurobank.
With a zero discretionary reserve, the expansion continues without limit unless the
dollars are used to purchase products or services in the U.S. at which point the
expansion process stops.
The Asian dollar market grew to accommodate the needs of businesses that need
U.S. dollars as a medium of exchange for international trade/investment.
Favorable tax advantages in Singapore and Hong Kong, (e.g., low withholding taxes,
reduced tax on offshore loans) encourage growth of the Asian market.

78

The Eurocredit Market

Loans of 1 to 5 years (medium term) extended by Eurobanks are called Eurocredit
Loans.
These loans are popular with corporations/governments.
Since Eurobanks accept short-term deposits, there exists the problem of maturity
mismatch between deposits and loans. To avoid the risk Eurobanks commonly offer
floating rate Eurocredit Loans. Loan rates float in accordance with movement of
some market interest, such as the LIBOR - the rate commonly charged for loans
among Eurobanks.Syndicated Eurocredit Loans are provided to large corporate or
government borrowers by a group of banks participating in the syndicate.

The Eurobond Market

Eurocurrency and Eurocredit loans help to accommodate short and medium term
borrowers respectively.
The Eurobond was created to accommodate long-term borrowers.
Partially the result of Interest Equalization Tax imposed in the U.S. in 1963 to
discourage U.S. investors from investing in foreign securities. Foreign borrowers
were thus forced to look elsewhere for funds and enter the Eurobond market.
The Eurobond market facilitates the transfer of long-term funds from surplus
spending units to deficit spending units around the world. Issued by MNCs, large
domestic corps., governments, governmental enterprises, and internl institutions.
The market helps to link investors with borrowers around the world, and thus help
to integrate the world's financial system.
The Eurobond market, unlike the domestic bond market, is almost entirely free of
official regulation. It is self-regulated by the Association of International Bond
Dealers.
The bonds are sold outside the countries in whose currencies they are
denominated and underwritten by an international syndicate of banks.Offered
simultaneously in a number of major capital markets
Eurobonds feature different types of issues, including straight fixed-rate, floating
rate note, and equity related/convertible.
79

Foreign Bonds
Underwritten by a syndicate and sold within the country of the denominated
currency.
Borrower/issuer is from another country
These include Yankee, Samurai, and Bulldogs bonds.
Note Issuance Facilities and Euronotes:
Eurobanks have responded to the competition from the Eurobond market by
creating a new instrument called the Note Issuance Facility (NIF) which is a lowcost substitute for syndicated credits.
It allows borrowers to issue their own short-term Euronotes which are then
distributed by financial institutions providing the NIF
NIF, sometimes called short-term note issuance facility, has some features of the
U.S. commercial paper market and some features of the U.S commercial lines of
credit.
Distinction between Euro Credit and Euro Bond Market
Both Euro bonds and Euro credit (Euro currency) financing have their advantages and
disadvantages. For a given company, under specific circumstances, one method of
financing may be preferred to the other. The major differences are:
1. Cost of borrowing
Euro bonds are issued in both fixed rate and floating rate forms. Fixed rate bonds are
an attractive exposure management tool since the known long-term currency inflows
can be offset by the known long-term outflows in the same currency. In contrast, Euro
currency loans carry variable rates.
2. Maturity
Euro bonds have longer maturities while the period of borrowing in the Euro currency
market has tended to lengthen over time.
3. Size of the issue
Earlier, the funds available for lending at any time have been much more in the interbank market than in the bond market. But of late, this situation does not hold true.
Moreover, although in the past the flotation costs of a Euro currency loan have been
much lower than a Euro bond (about 0.5 % of the total loan amount versus about 2.25
% of the face value of a Euro bond issue), compensation has worked to lower Euro
bond flotation costs.

4. Flexibility
In a Euro bond issue, the funds must be drawn in one sum on a fixed date and repaid
80

according to a fixed schedule, unless the borrower pays a substantial prepayment

penalty. By contrast, the drawdown in a floating rate loan can be staggered to suit the
borrowers needs and can be repaid in whole or in part at any time, often without
penalty. Moreover, a Euro currency loan with a multi-currency clause enables the
borrower to switch currencies on any roll-over date, whereas switching the
denomination of a Euro bond from currency A to currency B would require a costly,
combined, refunding and reissuing operation.
5. Speed
Funds can be raised by a known borrower very quickly in the Euro currency market.
Often, a period of two to three weeks should suffice. A Euro bond financing generally
takes more time, though the difference is becoming less significant.
2. Euro Credit Market
Euro credit or Euro Loans are the loans extended for one year or longer. The market
that deals in such loans is called Euro Credit Market.
The common maturity for euro credit loans is 5 years. Since Euro banks accept shortterm deposits and provide long-term loans, it is likely that asset liability mismatch may
arise. To avoid this Euro banks often extend floating rate euro credit loans fixed to
some market interest rate. The London Inter Bank Offer Rate (LIBOR) is the most
commonly used interest rate. It is the rate charged for loans between Euro Banks.
Participants in Euro credit Market
The major lending banks in the Euro credit market are Euro banks, American, Japanese,
British, Swiss, French, German and Asian (specially that of Singapore) banks, Chemical
Bank, JP Morgan, Citicorp, Bankers Trust, Chase Manhattan Bank, First National Bank of
Chicago, Barclay's Bank, National Westminster, BNP, etc. Among the borrowers, there
are banks, multinational groups, public utilities, government agencies, local authorities,
etc.

Dealing in Euro credits

When a borrower approaches a bank for Euro credit, a formal document is prepared on
behalf of potential borrowers. This document contains the principal terms and
conditions of loan, objectives of loan and details of the borrower.
Before launching syndication, the approached bank decides primarily, in consultation
with the borrower, on a strategy to be adopted, i.e. whether to approach a large
market or a restricted number of banks to form the syndicate. Each of the banks in
syndicate lends a part of the loan. The duration of this operation is normally about 6 to
8 weeks.
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Several clauses may be introduced in the contract of Euro-debt:

Pari-passu clause that prevents the borrower from contracting new debts that
subordinate the interest of lenders;
Exchange option clause that allows the withdrawal of a part or totality of loan in
another currency;
Negative guarantee clause that commits the borrower not to contract other debts
that subordinate the interest of lenders.
Characteristics of Euro credit
A major part (more than 80 %) of the Euro debts is made in US dollars. The second (but
far behind) is Pound Sterling followed by Deutsch mark, Japanese yen, Swiss franc and
others.
Most of the syndicated debts are of the order of $50 million. As far as the upper limits
are concerned, amounts involved are of as high magnitude as $5 billion and more. In
1990, Euro tunnel borrowed $6.8 billion.
On an average, maturity periods are of about five years (in some cases it is about 20
years) . The reimbursement of the loan may take place in one go (bullet) or in several
installments.
The interest rate on Euro debt is calculated with respect to a rate of reference,
increased by a margin (or spread). The rates are available and generally renewable (roll
over credit) every six months, fixed with reference to LIBOR. The LIBOR is the rate of
money market applicable to short-term credits among the banks of London. The
reference rate can equally be PIBOR at Paris and FIBOR at Frankfurt, etc. It is revised
regularly.
The margin depends on the supply and demand of the capital as also on the degree of
the risk of these credits and the rating of borrowers. Financial institutions are in
vigorous competition. There is an active secondary market of Euro debts. Numerous
techniques allow banks to sell their titles in this market.
3. Euro Bond Market
Euro Bond issue is one denominated in a particular currency but sold to investors in
national capital markets other than the country that issued the denominating currency.
An example is a Dutch borrower issuing DM-denominated bonds to investors in the UK,
Switzerland and the Netherlands.
The Eurobond market is the largest international bond market, which is said to have
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originated in 1963 with an issue of Eurodollar bonds by Autostrade, an Italian

borrower. The market has since grown enormously in size and was worth about $ 428
billion in 1994.
Eurobond markets in all currencies except the Japanese Yen are quite free from any
regulation by the respective governments. Straight bonds are priced with reference to
a benchmark, typically treasury issues. Thus a Eurodollar bond will be priced to a yield
a YTM (Yield-to-Maturity) somewhat above the US treasury bonds of similar maturity,
the spread depending upon the borrowers ratings and market conditions.
Floatation costs of the Eurobond are comparatively higher than costs indicated with
syndicated Eurocredits.
4. Euro CPs
Commercial paper is a corporate short-term, unsecured promissory note issued on
a discount to yield basis. Commercial paper maturities generally do not exceed 270
days. Commercial paper represents a cheap and flexible source of funds While CPs
are negotiable, secondary markets tend to be not very active since most investors
hold the paper to maturity.
The emergence of the Euro Commercial Paper (ECP) is much more recent. It evolved as
a natural culmination of the Note Issuance Facility and developed rapidly in an
environment of securitisation and disintermediation of traditional banking. CP has also
developed in the domestic segments of some European countries offering attractive
funding opportunities to resident entities.
5. Euro CDs
A Certificate of Deposit (CD) is a negotiable instrument evidencing a deposit with a
bank. A CD is a marketable instrument so that the investor can dispose it off in the
secondary market whenever cash is needed. The final holder is paid the face value on
maturity along with the interest. It is used by the commercial banks as short- term
funding instruments.
Euro CDs are mainly issued in London by banks. Interest on CDs with maturity more
than a year is paid annually than semi-annually.
6. International Capital Markets

International Capital Markets have come into existence to cater to the need of
international financing by economies in the form of short, medium or long-term
securities or credits. These markets also called Euro markets, are the markets on
which Euro currencies, Euro bonds, Euro shares and Euro bills are traded/exchanged.
Over the years, there has been a phenomenal growth both in volume and types of
financial instruments transacted in these markets. Euro currency deposits are the
deposits made in a bank, situated outside the territory of the origin of currency. For
83

example, Euro dollar is a deposit made in US dollars in a bank located outside the
USA; likewise, Euro banks are the banks in which Euro currencies are deposited. They
have term deposits in Euro currencies and offer credits in a currency other than that
of the country in which they are located.
A distinctive feature of the financial strategy of multinational companies is the wide
range of external services of funds that they use on an ongoing basis. British
Telecommunication offers stock in London, New York and Tokyo, while Swiss Bank
Corporation-, aided by Italian, Belgian, Canadian and German banks- helps
corporations sell Swiss franc bonds in Europe and then swap the proceeds back into US
dollars.
Firms have three general sources of funds available: (i) internally generated cash, (ii)
short-term external funds, and (iii) long-term external funds. External investment
comes in the form of debt or equity, which are generally negotiable (tradable)
instruments. The pattern of financing varies from country to country. Companies in the
UK get an average of 60-70% of their funds from internal sources. German companies
get about 40-50% of their funds from external suppliers. In 1975, Japanese companies
got more than 70% of their money from outside sources, but this pattern has since
reversed; major chunks of finances come from internal sources.
Another significant aspect of financing behaviour is that debt accounts for the
overwhelming share of external finance. Industry sources of external finance also
differ widely from country to country. German and Japanese companies have relied
heavily on bank borrowing, while the US and British industry raised much more
money directly from financial markets by the sale of securities. However, in all
countries, bank borrowing is on a decline. There is a growing tendency for corporate
borrowing to take the form of negotiable securities issued in the public capital
markets rather than in the form of commercial bank loans. This process known as
securitisation is most pronounced among the Japanese companies.
7. 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.
8. 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
84

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
9. 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.
10. 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.

Risks associated with international

MARKETS
1. Financial risk
In general, international projects are prone to greater financial risk as a bulk of
finance is in the form of debt. The major factors affecting financial risk are degree of
indebtedness, the terms and conditions of repayment of debt and currency used.
Some projects will have expenses and revenues that involve several currencies. As
85

a result the exchange rate risk is very high.

Projects maybe financed with floating rates. In view of the volatility observed on the
rates like LIBOR, the interest rate risk is also significant. Therefore it is necessary to
plan the coverage of all these risks.
2. Foreign Exchange Risk
As corporations expand their international activities, they begin to acquire foreign
assets and foreign liabilities. As exchange rates change, the values of these foreign
assets and liabilities change accordingly. For a corporation, exchange rate risk is the
sensitivity of the value of the corporation when the exchange rates change.
Obviously, the change in the corporation value is related to the net change in the
values of the foreign assets and foreign liabilities. (E.g.foreign direct investment,
foreign exchange loss, sales and income from foreign sources.)
3. Economic Risk
Economic risk is risk created by changes in the economy. Typically, it is related to
technological changes, the actions of competitors, shifts in consumer preferences, etc.
Ideally, a pure domestic firm is affected only by domestic economic conditions - the
domestic economic risk. However, in today's integrated world economy, the concept of
a pure domestic firm has less practical relevance. Many firms that appear strictly pure
domestic confront foreign economic risk indirectly. (E.g.: local restaurant/dept store,
real estate agent)
4. Political Risk
Political risk is risk created by political changes or instability in a country. These factors
include, but are not limited to, nationalization, confiscation, price controls, foreign
exchange and capital controls, administrative hurdles, uncertain property rights,
discriminative or arbitrary regulations on business practices (hiring, contract
negotiation), civil wars, riots, terrorism, etc. Each country in the world presents a
different political profile and represents a unique source of political risk that firms
must assess and manage when they make foreign investments.
In order to minimize this risk, local investors or the local government may be
associated with the project. Insurance against political risk is another useful technique
recommended for the purpose.

What constitutes political risk and how to measure it?

The political risk management typically involves:
- Identifying political risk and its likely consequences
86

- Developing policies in advance to cope with the possibility of political risk

- Strengthening a firm's bargaining position
- Devising measures to maximize compensation in the event of expropriation

Country Risk: It refers to elements of risk inherent in doing business in the economic,
social, and political environment of another country.
5. Counter party Risk - The risk that a counter party will default on a financial
obligation.
6.

Liquidity Risk -The risk that a financial position cannot be sold quickly at prevailing
prices.

7.

Delivery Risk - The risk that a buyer will not deliver payment of funds after a seller
has delivered securities or foreign exchange that were purchased.

8. Rollover Risk - The risk of being closed out from a financial market and unable to
renew (or roll over) a short-term contract.
9. Other risks - Other risks relate to the risk of cost overruns and bad management.

MULTIPLE CHOICE QUESTIONS

1. The Irawash Co. of Canada has set up a website to sell products to US
consumers. Prices are listed in US dollars but all their costs are in Canadian
dollars. Which of the following is a major risk faced by the company?
a)
b)
c)
d)

Exchange rate risk.

Investment risk.
An American boycott.
All of the above.

2. Which of the following is an example of foreign exchange?

87

a)
b)
c)
d)

Exchange of cash issued by a foreign central bank.

Exchange of claims denominated in another currency.
Exchange of bank deposits.
All of the above.

3. US firms often find that borrowing from foreign markets:

a) is disadvantageous because the exchange rate risk increases the cost of
borrowing.
b) is about the same as borrowing domestically.
c) is more expensive.
d) is less expensive.
4. If Euros are quoted at price $1.2055 in Citibank in New York, this means that:
a) large banks will quote their own rate while small banks will follow the lead of
Citibank.
b) every other bank is quoting the same price.
c) this is the price used by the Central Bank.
d) most banks will probably be in that range.
5. Which of the following are usual suppliers of Euros?
a)
b)
c)
d)

US foreign investors remitting profits.

European direct investors.
US exporters.
All of the above.

6. The vast majority of large-scale foreign exchange transactions in the US are:

a)
b)
c)
d)

done through foreign exchange brokers.

done through Morgan-Chase and Deutsche Bank of America.
done through Interbank.
done through the Chicago Mercantile Exchange

7. If a company contracts today for some future date of actual currency exchange,
they will be making use of a:
a)
b)
c)
d)

stock rate.
variable rate.
futures rate.
forward rate.
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8. Which of the following might affect the cost of a trip to Japan by a resident of
Britain?
a) The depreciation of the Euro.
b) The time at which the British resident purchases Yen.
c) The depreciation of the US dollar.
d) All of the above.

9. A company that functions to unite sellers and buyers of foreign currencydenominated bank deposits is called:
a)
b)
c)
d)

a broker.
an investor.
a wholesaler.
a bank

10. _____________ contracts are more widely accessible to firms and individuals
than ____________ contracts.
a)
b)
c)
d)

Futures; forward
Forward; futures
Forward; arbitrageur
Arbitrageur; forward

11. If the euro dollar deposit rate is 3% per year and the euro-euro rate is 6% per
year, by how much will the euro be expected to devalue in the coming year?
a)
b)
c)
d)

0.3%
2.0%
2.9%
3.0%

12. According to which theory will differences in nominal interest rates be

eliminated in the exchange rate?
a) The PPP.
b) The Fisher effect.
89

c) The Leontief paradox.

d) The combined equilibrium theory.
13. If inflation goes up in the US relative to other countries, it is expected that the
price of the US dollar will:
a)
b)
c)
d)

increase.
remain the same.
fall.
may increase or decrease.

14. Which of the following is an exchange risk management technique through

which the firm contracts with a third party to pass exchange risk onto that
party, via instruments such as forward contracts, futures, and options?
a)
b)
c)
d)

Diversification.
Risk avoidance.
Risk transfer.
Risk adaptation.

15. What is the base interest rate paid on deposits among banks in the
eurocurrency market called?
a)
b)
c)
d)

INEC.
EUIN.
LIBOR.
INEU.

Internet Resources:
www.imf.org/external/fin.html IMF website. Contains exchange rate quotes for
selected currencies
www.ny.frb.org/pihome/ststistics/forex12.shtml
NY Fed site with noon forex rates.
www.bis.org/publ/index.html BIS site contains annual reports, external debts,
foreign exchange market activities etc.

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MODULE 3:
Derivatives

91

Chapter 5

Introduction to derivatives

After reading this chapter, you will be able to understand:

The basic meaning of Derivatives

Products, participants and functions
Types of derivatives
Development of exchange-traded derivatives
Global derivatives markets
Exchange-traded vs. OTC derivatives markets

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Background
1. The origins of derivative financial instruments
Derivatives are financial instruments whose values depend on the value (or other
variables) of an asset (known as the underlying). The underlying asset can be
another financial instrument, a currency, an interest rate or an index (financial
derivatives) or a commodity.
The parties involved in the derivatives market are basically the intermediaries
(banks or securities firms) and the end users. End users include all categories of
financial intermediaries and institutional investors, nonfinancial corporate
enterprises, public entities, supranational institutions and individuals. Each of these
end users participates in the derivatives market for either speculative or hedging
purposes. In the first case the investor acquires a risk hoping to obtain a profit, in
the second case the derivative is
used to hedge against a risk (Fabrizi et al. 2002).
The original goal of derivatives is risk hedging, but soon after they turned into a
system to speculate or a practice to hide or carry forward losses that could not be
easily compensated. The first to bear the burdens arising from the use of such
instruments were the Italian banks which paid high costs to the foreign banks that
had introduced derivatives. For a few years now, many of these foreign banks,
together with some Italian banks, have been working with the same objectives:
selling derivative products to Italian small and medium-sized enterprises first, and
more recently, to local authorities, even the smallest-sized ones.
The use of derivatives by local authorities dates back to 1994 when the
abolishment - by Law No. 724 of 23 December 1994 - of the obligation for local
authorities to have recourse to the Cassa Depositi e Prestiti to have access to credit,
opened up new financing opportunities. In spite of the attempt to keep the
mechanism under control, by introducing restrictions to the use of derivatives to
hedge against exchange rate exposure in case of foreign exchange transactions
(Decree of the Ministry of Treasury No. 420 of 5
July, 1996), the 2002 budget law paved the way to the use of derivatives by local
authorities. The introduction of a new provision in the budget law which led local
authorities not to consider these instruments as hazardous, the continuous need
for cash flow, and the devolution of important functions from the central
government to local authorities, resulted in the development of anomalous
schemes of financial support. In those years, the interpretations of the law resulted
93

not only in serious violations the spending powerof local governments was
virtually unlimited and budget deficits and extrabudget liabilities were generated ,
but they also led to the misuse of derivatives
for obtaining immediate resources against larger debt burdens in the future. If the
first interpretations of the law have already paid dividends in fact, from 1989 to
31st December 2007, 428 local authorities were declared in financial default.
2. The different types of derivatives
The value of derivative financial instruments is derived from the price of an
underlying asset; the underlying asset may consist of a real asset (commodity
derivatives), a financial asset (financial derivatives), or a price index or a stock
market index. Different classes of derivatives may be identified on the basis of the
following criteria:
a) the type of underlying asset;
b) the exchanges where derivatives are traded;
c) the technical characteristics of the various instruments.
Although several variants exist within each of the above-mentioned criteria, four
main types of instruments can be identified: the forwards, the futures, the swaps
and the options.
Forward contracts are derivatives whereby an agreement is made between two
parties to buy or sell an asset on a specified future date at a pre4 determined price.
Under a forward contract, therefore, the parties involved set out the terms and
conditions for the performance of a transaction on a future date. This type of
derivative is usually entered into over the counter and is used to hedge against
an exchange rate risk.
Futures are like forwards. Also in this case there is an agreement to buy or sell an
asset on a future date and at a specified price. The difference from forwards is that
futures are usually traded on exchanges. Futures contracts are highly standardized,
therefore the contract subject-matter, the unit value, the settlement date, the
settlement terms and conditions and everything but the price are pre-determined
by the market.
Interest-rate swaps are contracts whereby two parties agree to exchange interest
payments based on a notional principal amount over a specified period.
The most common and simplest type of interest-rate swaps is known as the plain
vanilla swap, whereby a party makes floating interest rate payments and receives
94

fixed interest rate payments for the entire period of the contract. Swaps (the plain
vanilla being certainly the simplest example) are used to manage a position in the
interest rate market. Hence, if interest rates are expected to rise the operator
would be willing to pay a fixed rate and
collect the floating one.
Finally, the option contract is a forward purchase agreement by which one of the
parties involved reserves the possibility to buy or sell an asset on a set date against
payment of a premium to the counterparty.
Several variants may exist within the above-mentioned categories and they lead to
two different types of activity. If a derivative is used for speculative purposes, the
operator acquires a risk based on his expectations and he can have a profit or a
loss. When derivatives are used to hedge against a given risk, operators may create
a series of assets and liabilities with characteristics that meet their financial needs.
Under this perspective, derivatives might have been a useful tool to reduce risks,
but they have been used improperly and mainly for speculative purposes (Fabrizi et
al. 2002).

3. From UK to Italy: the size of the phenomenon

Derivatives packaged for the Italian local authorities, mostly in the UK, are
transactions based on a debt and its relevant interest. In other terms, a proposal to
hedge against the risk of rising interest rates by taking out an insurance policy
(derivative) is made to an indebted institution. Local authorities believe that with
such policy they are able to convert the floating interest rate on their debts into a
fixed one, but they actually worsen their position.
An oversimplified explanation would be that derivatives are a form of speculation
in that, in some cases, local authorities sign a contract the content of which they
do not really understand due to its objective complexity whereby they are driven
to bear implicit operation costs that they ignore, against an immediate income and
the shifting of their debts to the future administrations. Indeed, not all derivatives
carry the same risks: with some derivatives, the entire invested capital may be lost,
with other derivatives not only the invested capital is put in jeopardy, whereas
other derivatives are real insurance policies carrying little risk. Of course, the latter
were the least proposed and sold by banks, because the lower the risk, the lower
the return on the operation.

95

The lack of standardization of the products and the complexity of derivatives

operations make it difficult to assess the phenomenon. However, even from such
fragmentariness it is possible to understand how diffused and dangerous the
phenomenon is.
In June 2004, the notional amounts of the derivatives positions held by companies
and local authorities in Italy reached approximately 146 billion Euro, with the
average losses incurred by local authorities being much higher than those suffered
by corporate investors (approx. 430,000 for local authorities versus 76,000 for
enterprises; this was also due to the higher
size of contracts concluded by the public sector, with an overall notional amount of
approximately 12 million Euro vs. 2.6 million Euro for enterprises).
At the end of 2006, regional, provincial and municipal governments had a
derivatives exposure to Italian banks estimated at around 13 billion Euro in terms
of notional value, corresponding to 36 percent of the total indebtedness toward
resident intermediaries.
According to the data reported by the Department of Treasury, the phenomenon is
continuously increasing; in fact, until 31st December, 2007, more than 900
derivatives contracts were written by 559 public bodies (497 municipalities, 44
provincial governments and 18 regional governments), with a negative mark-tomarket value of over one billion Euro, that is approximately 2.9% of local
authorities cash indebtedness. The data mentioned above, although high,
underestimates the phenomenon, since it does not take into account the recourse
by Italian local authorities to foreign intermediaries, for which precise data is not
available.
The above-mentioned data shows a growing phenomenon, whose size is unknown,
and the reasons of which are to be found in the legislative provisions in force prior
to the coming into effect of the 2008 budget law. In fact, prior to the amendments
brought about by the last budget law, the mark to market or the potential loss at
the expiration of the contract did not represent an expenditure item in the threeyear economic planning of a local authority and there was no obligation to record it
off the balance sheet, with risks and
potential losses that were disregarded in the balance accounts.
The 2002 budget law opened up the opportunity for local authorities to have
recourse to derivatives and the legislative provisions enacted in 2003 and 2004 to
set out permissible operations and provide local authorities with rules in this
respect were of little use. Subsequently, several legislative provisions have been
96

enacted over the years to exercise preventive control over the use of derivatives by
local authorities, until the 2007 and 2008 budget laws.
The 2007 budget law, in paragraph 737 et seq, laid down an obligation for local
authorities to submit all the underwritten contracts to the Department of Treasury
so that preventive control measures could be taken prior to the conclusion of said
contracts, and an obligation to send the contracts concluded in violation of the
prescription above to the Court of Auditors so that the necessary measures could
be taken.
Also the 2008 budget law established rules providing for a double level
transparency. The first level of transparency consists of the obligation to include in
the contract all the information required and specified under Decree of the
Ministry of Economy and of an explicit declaration by the authoritys administrators
in which they state to be aware of the risks involved in the derivative; such
declaration of awareness is an acknowledgement and acceptance of the
responsibilities arising from the operation.
The second level of transparency is based on the inclusion of a note to the accounts
in which budget commitments and obligations are reported.
This is a considerable step forward since, for the first time, these operations will be
entered into the accounts, indicating the mark-to-market value, the inflows and
outflows generated from the transaction date, the projected cash flows for the
next three years, the quarterly mark-to-market adjustments and a report on the
operation performance (Pozzoli 2008). Furthermore, Article 62 of Decree Law No.
112, enacted on 25 June 2008, in stressing the riskiness of such instruments, laid
down a prohibition for local authorities to underwrite
derivatives until the Ministry of Economy, having heard the Bank of Italy and the
National Commission for Listed Companies and the Stock Exchange (CONSOB),
establishes a set of rules for the subscription of such financial instruments.

Therefore, besides law provisions, it is essential that local authorities deploy

internal supervision and rules aimed at:
1. being sure that they have thoroughly understood the nature of the
operation that is being performed. The operations that cannot be understood or
evaluated should not be performed. The officers who effected the Orange County
and Hammersmith Fulham derivatives transactions, although facing multi-million
97

dollar exposure, had poor knowledge of the financial instruments they were
buying.
2. setting out well-defined limits of the risk that they are willing to assume.
Obviously, these limits must be set out by the authoritys council, must be binding
on the financial managers and prevent them from being drawn into the vortex of
speculation. At the same time, the supervision of the authoritys council must be
firm and must ensure that the pre-established exposure limits are not exceeded
even when a gain is generated. The initial operations conducted by Robert Citron in
the early 1990s were very profitable
for Orange County. For this reason, the authoritys managers disregarded the risks
taken by the treasurer, who hoped for new profits. As a matter of fact, things did
not go in the right direction and in 1994 Orange County suffered losses that were
much higher than the previous gains.
3. not thinking to be able to beat the market. A very experienced trader will be
able to predict the future market trends in 60 percent of cases. If such percentage
is exceeded, it is due to fortuitous circumstances that are unlikely to be replicated
and that should not result in the rise of the preestablished exposure limits.
Therefore, local authorities must ensure that a hedger, tempted by a successful
operation, does not get sucked into speculation
becoming exposed beyond the pre-established exposure limits.
4. diversifying the risk. A spread strategy allows investors to reduce the risk
considerably. If the investment were concentrated on a single security, then the
investor would have to show great ability in choosing the right security.
5. performing scenario analysis and stress testing. A correct choice would be that
of using historical data series and choosing the most extreme events as scenarios
and limits to be set out (Hull 2003). Internal supervision, in connection with the
enforcement of existing legislative provisions, must be aimed at defining the
investment strategies of local authorities performing transactions in derivatives. It
is fairly obvious that rules are not effective if they are circumvented with the
complicity of those responsible for supervision.

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Introduction
Derivatives can be defined as a product whose value is derived from the value of
one or more basic variables, called bases (underlying asset, index, or reference rate), in
a contractual manner. The underlying asset can be equity, forex or commodity or any
other asset.
For example, wheat farmer may wish to sell their harvest at a future date to eliminate
the risk of a change in prices by the date. Such a transaction is an example of a
derivative. The price of this derivative is driven by the spot price of wheat which is the
underlying.

According to the Securities Contracts (Regulation) Act, 1956 (SC(R) A)

derivative includes
1. A security derived from a debts instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form of security.
2. A contract, which derives its value from the prices, or index of price, of underlying
securities. The derivatives are securities under the (SC(R)A) and hence the trading of
derivatives is governed by the regulatory framework under the (SC(R)A).

A derivative is any financial instrument, whose payoffs depend in a direct way on

the value of an underlying variable at a time in the future. This underlying variable is
also called the underlying asset, or just the underlying.

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Examples of underlying assets include

Usually, derivatives are contracts to buy or sell the underlying asset at a future time,
with the price, quantity and other specifications defined today. Contracts can be
binding for both parties or for one party only, with the other party reserving the option
to exercise or not. If the underlying asset is not traded, for example if the underlying is
an index, some kind of cash settlement has to take place. Derivatives are traded in
organized exchanges as well as over the counter [OTC derivatives]. Examples of
derivatives include forwards, futures, options, caps, floors, swaps, collars, and many
others.

Background
Thales of Miletus used a money-spinning device which, though it was ascribed to his
prowess as a philosopher, is in principle open to anybody. The story is as follows: people
had been saying reproachfully to him that philosophy was useless, as it had left him a
poor man. But he, deducing from his knowledge of the stars that there would be a good
crop of olives, while it was still winter and he had little a money to spare, used it to pay
deposits on all the oil-presses in Miletus and Chios, thus securing their hire. This cost
him only a small sum, as there were no other bidders. Then the time of the olive-harvest
came, and as there was a sudden and simultaneous demand for oil-presses he hired
them out at any price he liked to ask. He made a lot of money, and so demonstrated
that it is easy for philosophers to become rich, if they want to; but that is not their
objective in life.
Derivative contracts in general and options in particular are not novel securities. It has
been nearly 25 centuries since the above abstract appeared in Aristotle's Politics,
describing the purchase of a call option on oil-presses. More recently, De La Vega
(1688), in his account of the operation of the Amsterdam Exchange, describes traded
contracts that exhibit striking similarities to the modern traded options

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Nevertheless, the modern treatment of derivative contracts has its roots in the inspired
work of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorous
mathematical representation of an asset price evolution through time. Bachelier used
the concepts of random walk in order to model the fluctuations of the stock prices, and
developed a mathematical model in order to evaluate the price of options on bond
futures. Although the above model was incomplete and based on assumptions that are
virtually unacceptable in recent studies, its importance lies on the novelty of its ideas,
both from an economist's and a mathematician's point of view. Unfortunately, this
work was not developed further, despite the publication of the Einstein paper on
Brownian motion in 1905, which would shed light on the properties of the model and
perhaps highlight its misspecifications.

The above treatment of security prices was long forgotten until the 70s, when
Professor Samuelson and his co-workers at MIT rediscovered Bachelier's work and
questioned its underlying assumptions. By construction, the payoff of a call option on
the expiration day will depend on the price of the underlying asset on that day, relative
to the option's exercise price. Common reasoning declares that therefore, the price of
the call option today has to depend on the probability of the stock price exceeding the
exercise price. One could then argue that a mathematical model that can satisfactory
explain the underlying asset's price is sufficient in order to price the call option today,
just by constructing the probabilistic model of the price on the expiration day.
Professors Black, Merton and Scholes recognized that the above reasoning is incorrect:
Since today's price incorporates the probabilistic model of the future behavior of the
asset price, the option can (and has to) be priced relative to today's price alone. They
realized that a levered position, using the stock and the riskless bond, that replicates
the payoff of the option is feasible, and therefore the option can be priced using noarbitrage restrictions. Equivalently, they observed that the true probability distribution
for the stock price return can be transformed into one which has an expected value
equal to the risk free rate, the so called risk adjusted or risk neutral distribution; the
pricing of the derivative can be carried out using the risk neutral distribution when
expectations are taken.

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Types of derivatives
In broad terms, there are two distinct groups of derivative contracts, which are
distinguished by the way they are traded in the market:
1. OTC
2. exchange-traded
Lets go more deep into their meanings:
1.

Over-the-counter (OTC): OTC derivatives are contracts that are

traded (and privately negotiated) directly between two parties, without going
through an exchange or other intermediary.

Products such as swaps, forward rate agreements, and exotic options are almost
always traded in this way.
The OTC derivative market is the largest market for derivatives, and is largely
unregulated with respect to disclosure of information between the parties, since
the OTC market is made up of banks and other highly sophisticated parties, such as
hedge funds.
Reporting of OTC amounts are difficult because trades can occur in private, without
activity being visible on any exchange.
According to the Bank for International Settlements, the total outstanding notional
amount is $684 trillion (as of June 2008).[6] Of this total notional amount, 67% are
interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange
contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are
other. Because OTC derivatives are not traded on an exchange, there is no central
counter-party. Therefore, they are subject to counter-party risk, like an ordinary
contract, since each .counter-party relies on the other to perform.
2.

Exchange-traded derivative contracts (ETD):

ETDs are those derivatives instruments that are traded via specialized
derivatives exchanges or other exchanges.

A derivatives exchange is a market where individuals trade standardized contracts

that have been defined by the exchange.
A derivatives exchange acts as an intermediary to all related transactions, and takes
Initial margin from both sides of the trade to act as a guarantee. The world's
largest[8] derivatives exchanges (by number of transactions) are the Korea
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Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide
range of European products such as interest rate & index products), and CME
Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the
Chicago Board of Trade and the 2008 acquisition of the New York Mercantile
Exchange).
According to BIS, the combined turnover in the world's derivatives exchanges
totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also
may trade on traditional exchanges.
For instance, hybrid instruments such as convertible bonds and/or convertible
preferred may be listed on stock or bond exchanges. Also, warrants (or "rights")
may be listed on equity exchanges. Performance Rights, Cash x PRTs and various
other instruments that essentially consist of a complex set of options bundled into
a simple package are routinely listed on equity exchanges. Like other derivatives,
these publicly traded derivatives provide investors access to risk/reward and
volatility characteristics that, while related to an underlying commodity,
nonetheless are distinctive.

Functions of a derivatives market:

The derivatives market performs a number of economic functions:
1. Transferring Risks: They help in transferring risks from risk averse people to
risk oriented people
2. Prediction: They help in the discovery of future as well as current prices
3. Catalyze: They catalyze entrepreneurial activity
4. Increases Trade volume: They increase the volume traded in markets because
of participation of risk averse people in greater numbers
5. Increases Savings & Investments: They increase savings and investment in the
long run

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Factors driving the growth of financial

derivatives:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international
markets,
3. Marked improvement in communication facilities and sharp decline in their
costs,
4. Development of more sophisticated risk management tools, providing
economic agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns
over a large number of financial assets leading to higher returns, reduced risk as
well as
transactions costs as compared to individual financial assets.

The market participants

Three kinds of dealers engage in market activities: hedgers, speculators and
arbitrageurs. Each type of dealer has a different set of objectives, as discussed below.

Hedgers: Hedging includes all acts aimed to reduce uncertainty about future
[unknown] price movements in a commodity, financial security or foreign
currency. This can be done by undertaking forward or futures sales or
purchases of the commodity security or currency in the
Hedgers use futures or options markets to reduce or eliminate the risk
associated
with price of an asset.
OTC forward or the organized futures market. Alternatively, the hedger can
take out an option which limits the holder's exposure to price fluctuations.

Speculators: Speculation involves betting on the movements of the market

and try to take advantage of the high gearing that derivative contracts offer,
thus making windfall profits. In general, speculation is common in markets that
exhibit substantial fluctuations over time. Normally, a speculator would take a
``bullish'' or ``bearish'' view on the market and engage in derivatives that will
profit her if this view materializes. Since in order to buy, say, a European call
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option one has to pay a minute fraction of the possible payoffs, speculators can
attempt to materialize extensive profits.
Speculators use futures and options contracts to get extra leverage in betting
on
future movements in the price of an asset. They can increase both the potential
gains and potential losses by usage of derivatives in a speculative venture

Arbitrageurs: They lock riskless profits by taking positions in two or more

markets. They do not hedge nor speculate, since they are not exposed to any
risks in the very first place. For example if the price of the same product is
different in two markets, the arbitrageur will simultaneously buy in the lower
priced market and sell in the higher priced one. In other situations, more
complicated arbitrage opportunities might exist. Although hedging and [mainly]
speculating are the reasons that have made derivatives [im]famous, the
analysis of pricing them fairly depends solely on the actions of the arbitrageurs,
since they ensure that price differences between markets are eliminated, and
that products are priced in a consisted way.
Arbitrageurs are in business to take advantage of a discrepancy between prices
in
two different markets. If, for example, they see the futures price of an asset
getting
out of line with the cash price, they will take offsetting positions in the two
markets
to lock in a profit

Why derivatives?
Every candidate underlying asset will have a value that is affected by a variety of
factors, therefore inheriting risk. Derivative contracts, due to the leverage that they
offer may seem to multiply the exposure to such risks. However, derivatives are rarely
used in isolation. By forming portfolios utilizing a variety of derivatives and underlying
assets, one can substantially reduce her risk exposure, when an appropriate strategy is
considered.
Derivative contracts provide an easy and straightforward way to both reduce risk hedging, and to bear extra risk -speculating. As noted above, in any market conditions
every security bears some risk. Using active derivative management involves isolating
the factors that serve as the sources of risk, and attacking them in turn. In general,
derivatives can be used to
hedge risks;
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reflect a view on the future behavior of the market, speculate;

lock in an arbitrage profit;
change the nature of a liability;
change the nature of an investment;
Example 1 (Sources of risk): Suppose that a British investor holds a number of 10 year
US T-Notes, and wants her investment to expire on the 1st December 01.
1.4

The face value of the notes is

, and at the current market prices they

are worth
. The exchange rate today is
. Therefore, if she
decides to liquidize the notes now, the investor would receive
. There
are two sources of risk in this setting: Exchange rate risk and interest rate risk.
Example 2 (cont. Exchange rate risk) The British pound might keep rising against the
dollar. This is illustrated in figure 1.1. In this case, the value of the investment will
decline. The investor examines the futures markets, and observes that the quote for a

exchange rate future that expires on the 1st December 01 is

selling futures worth

. By

she will ensure a payment of

.
The above does not describe the perfect hedge position! Since the investor keeps the
money in the 10y note until next year, she will enjoy the interest -and the possible
coupons, offered through that year. The right amount to be converted would be the
one that will include those payments. But what is this value? The actual value of the
notes will depend on the short rates that will be in place next year. This gives rise to
the interest rate risk.

Figure 1.1: Alternative exchange rate events

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Example 3 (cont. Interest rate risk): If the US rates go up during the next year, the
value of the investment will decline -the bond prices will fall. How can the investor
hedge against this kind of risk? By selling T-Note futures. Setting up the portfolio for
this hedge is not as easy for the investor as it sounds. Unlike the FX futures contract,
there is no 10y T-Note futures contract available that expires on the 1st Dec 01. She
investigates a bit more and collects some similar instruments that might be helpful:
these are described in the following table.

Unfortunately, the instruments on the 10y T-Note do not have the appropriate
maturity, whereas the instruments that have the correct maturity have a different
underlying. The 10y and 30y instruments move in principle in the same directions, but
they do not move in exactly the same way. Using the 30y T-Bond will not hedge
perfectly, the risk that remains from such situations is called the basis risk which will be
discussed in chapter 2. A perfect hedge is feasible using options management, the
investor could ensure a minimum price for the investment by buying puts, or she could
construct some kind of collar using both calls and puts, but these instruments expire
before the investment. The investor can proceed until new derivatives enter the
market, or seek for over-the-counter forward contracts that are tailor made.
The purpose of the above example was to highlight the use of derivatives as a hedging
tool, and the way that the different sources of risk which are combined to generate the
underlying asset's uncertainty are decomposed in order to achieve the perfect hedge.
It addition it has also made use of two very similar types of contracts, the futures and
the forward contracts.

PRODUCTS OF A DERIVATIVE MARKET:

1. The forward contract:
A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at todays pre-agreed price
In other words, the forward contract is an over-the-counter [OTC] agreement between
two parties, to buy or sell an asset at a certain time in the future for a certain price.
The party that has agreed to buy has a long position.
The party that has agreed to sell has a short position.
Usually, the delivery price is such that the initial value of the contract is zero. The
contract is settled at maturity.
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2. The futures contract:

This contract is an agreement to buy or sell an asset at a certain time in the future for a
certain price. Futures are traded in exchanges and the delivery price is always such that
today's value of the contract is zero. Therefore in principle, one can always engage into
a futures without the need of an initial capital: the speculators heaven!
Future contracts are special types of forward contract in the sense that the former are
standardized exchange-traded contracts.
Although similar in nature, these two instruments exhibit some fundamental
differences in the organization and the contract characteristics. The most important
differences are given in table 1.1.

Table 1.1: Differences between forwards and futures contracts

Forwards

Futures

Primary market

Dealers

Organized Exchange

Secondary market

None

the Primary market

Contracts

Negotiated

Standardized

Delivery

Contracts expire

Rare delivery

Collateral

None

Initial margin, mark-the-market

Credit risk

Depends on parties None [Clearing House]

Market participants Large firms

Wide variety

In the example 3, a futures contract was not available for the investor to hedge against
the interest rate risk. One can now see that she could alternative go to some
investment company seeking for a forward contract that would suit her needs.
3. Options:
Futures and forwards share a very important characteristic: when the delivery date
arrives, the delivery must take place. The agreement is binding for both parties: the
party with the short position has to deliver the goods, and the party with the long
position has to pay the agreed price. Options give the party with the long position one
extra degree of freedom: she can exercise the contracts if she wants to do so; whereas
the short parties have to meet the delivery if they are asked to do so. This makes
options a very attractive way of hedging an investment, since they can be used as to
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enforce lower bounds on the financial losses. In addition, options offer a very high
degree of gearing or leverage, which makes them attractive for speculative purposes
too.
The main characteristics of a plain vanilla option contract are the following:
The maturity : The time in the future, up to which the contract is valid;
The strike or exercise price : The delivery price. Remember that the long
party will assess whether or not this price is better than the current market
price. If so, then the option will be exercised. If not the option will be left to
expire worthless;
Call or put: The call option gives the long party the right to buy the underlying
security at the strike price from the short party. The put option gives the long
party the right to sell the underlying security at the strike price to the short
party. The short party has to obey the long party's will;
American or European: The American option gives the right to the long party to
exercise the contract at any time they wish, up to the maturity date. If the
option is European, it can be exercised on the maturity date only; and
Details concerning the delivery.
Apart from the plain vanilla contracts which are American or European, a lot of other
exotic options have appeared recently, mostly as
OTC contracts: These include Asian options, digital options, look back options, etc.
Traders have been rather imaginative when it comes to designing new derivative
securities.
Unlike the forward or futures contracts, and because of the payoff asymmetries, the
initial value of an option, say , is not equal to zero. Apart from the above
characteristics, the option price is generally affected by:
The volatility [or uncertainty] of the underlying asset, from today up to the
maturity date. In fact, it is common in the literature for option markets to be
described as markets where volatility is traded;
The level of the interest rates, in fact the whole term structure, and the
stochastic behavior of them if they are unknown;
The dividends, coupon payments, costs of storage, and other cash flows that
are possible before the maturity date; and
Commissions and the way the margin is marked.
As an example of the payoff asymmetries, the profits from a long European call option
position look typically like the ones given in figure 1.3. A great deal of time will be
dedicated discussing how option contracts are priced.

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Figure 1.3: European call option payoffs

Financial Derivatives Market and its Development

Financial markets are, by nature, extremely volatile and hence the risk factor is an
important concern for financial agents. To reduce this risk, the concept of derivatives
comes into the picture. Derivatives are products whose values are derived from one or
more
basic variables called bases. These bases can be underlying assets (for example forex,
equity, etc), bases or reference rates. For example, wheat farmers may wish to sell
their
harvest at a future date to eliminate the risk of a change in prices by that date. The
transaction in this case would be the derivative, while the spot price of wheat would be
the
underlying asset.

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with
one
another. Forward contracting dates back at least to the 12th century, and may well
have
been around before then. Merchants entered into contracts with one another for
future
delivery of specified amount of commodities at specified price. A primary motivation
for
pre-arranging a buyer or seller for a stock of commodities in early forward contracts
was to
lessen the possibility that large swings would inhibit marketing the commodity after a
harvest.
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Development of derivatives market in India

The first step towards introduction of derivatives trading in India was the promulgation
of
the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on
options in securities. The market for derivatives, however, did not take off, as there
was no
regulatory framework to govern trading of derivatives. SEBI set up a 24member
committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop
appropriate regulatory framework for derivatives trading in India. The committee
submitted
its report on March 17, 1998 prescribing necessary preconditions for introduction of
derivatives trading in India. The committee recommended that derivatives should be
declared as securities so that regulatory framework applicable to trading of
securities
could also govern trading of securities. SEBI also set up a group in June 1998 under the
Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in
derivatives market in India. The report, which was submitted in October 1998, worked
out
the operational details of margining system, methodology for charging initial margins,
broker net worth, deposit requirement and realtime monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in December 1999 to
include derivatives within the ambit of securities and the regulatory framework was
developed for governing derivatives trading. The act also made it clear that derivatives
shall be legal and valid only if such contracts are traded on a recognized stock
exchange,
thus precluding OTC derivatives. The government also rescinded in March 2000, the
three
decade old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2001. SEBI permitted the derivative segments of two
stock
exchanges, NSE and BSE, and their clearing house/corporation to commence trading
and
settlement in approved derivatives contracts. To begin with, SEBI approved trading in
index futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was
followed by approval for trading in options based on these two indexes and options on
individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in
options on individual securities commenced in July 2001. Futures contracts on
individual
stocks were launched in November 2001. The derivatives trading on NSE commenced
with
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S&P CNX Nifty Index futures on June 12, 2000. The trading in index options
commenced
on June 4, 2001 and trading in options on individual securities commenced on July 2,
2001.
Single stock futures were launched on November 9, 2001. The index futures and
options
contract on NSE are based on S&P CNX
Trading and settlement in derivative contracts is done in accordance with the rules,
byelaws, and regulations of the respective exchanges and their clearing
house/corporation
duly approved by SEBI and notified in the official gazette. Foreign Institutional
Investors
(FIIs) are permitted to trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the
NSE
report on the futures and options (F&O):
Single-stock futures continue to account for a sizable proportion of the F&O
segment. It constituted 70 per cent of the total turnover during June 2002. A
primary reason attributed to this phenomenon is that traders are comfortable with
single-stock futures than equity options, as the former closely resembles the
erstwhile badla system.
On relative terms, volumes in the index options segment continues to remain poor.
This may be due to the low volatility of the spot index. Typically, options are
considered more valuable when the volatility of the underlying (in this case, the
index) is high. A related issue is that brokers do not earn high commissions by
recommending index options to their clients, because low volatility leads to higher
waiting time for round-trips.
Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from 2.86 in
January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the
traders are increasingly becoming pessimistic on the market.
Farther month futures contracts are still not actively traded. Trading in equity
options on most stocks for even the next month was non-existent.
Daily option price variations suggest that traders use the F&O segment as a less
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risky alternative (read substitute) to generate profits from the stock price
movements. The fact that the option premiums tail intra-day stock prices is
evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day.
If calls and puts are not looked as just substitutes for spot trading, the intra-day
stock price variations should not have a one-to-one impact on the option premiums.

Commodity Derivatives
Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking,
castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18
commodity exchanges located in various parts of the country. Futures trading in other
edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new
commodities, especially in edible oils, is expected to commence in the near future. The
sugar industry is exploring the merits of trading sugar futures contracts.
The policy initiatives and the modernisation programme include extensive training,
structuring a reliable clearinghouse, establishment of a system of warehouse receipts,
and
the thrust towards the establishment of a national commodity exchange. The
Government
of India has constituted a committee to explore and evaluate issues pertinent to the
establishment and funding of the proposed national commodity exchange for the
nationwide trading of commodity futures contracts, and the other institutions and
institutional processes such as warehousing and clearinghouses.
With commodity futures, delivery is best effected using warehouse receipts (which are
like
dematerialised securities). Warehousing functions have enabled viable exchanges to
augment their strengths in contract design and trading. The viability of the national
commodity exchange is predicated on the reliability of the warehousing functions. The
programme for establishing a system of warehouse receipts is in progress. The Coffee
Futures Exchange India (COFEI) has operated a system of warehouse receipts since
1998

Exchange-traded vs. OTC (Over The Counter) derivatives

markets
The OTC derivatives markets have witnessed rather sharp growth over the last few
years,
which has accompanied the modernization of commercial and investment banking and
globalisation of financial activities. The recent developments in information technology
have contributed to a great extent to these developments. While both exchangetraded and

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OTC derivative contracts offer many benefits, the former have rigid structures
compared to
the latter. It has been widely discussed that the highly leveraged institutions and their
OTC
derivative positions were the main cause of turbulence in financial markets in 1998.
These
episodes of turbulence revealed the risks posed to market stability originating in
features of
OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity,
and
for safeguarding
the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchanges self-regulatory organization, although they are affected indirectly by
national
legal systems, banking supervision and market surveillance.
Accounting of Derivatives :
The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on
accounting of index futures contracts from the view point of parties who enter into
such
futures contracts as buyers or sellers. For other parties involved in the trading process,
like
brokers, trading members, clearing members and clearing corporations, a trade in
equity
index futures is similar to a trade in, say shares, and does not pose any peculiar
accounting
problems.
Taxation
The income-tax Act does not have any specific provision regarding taxability from
derivatives.The only provisions which have an indirect bearing on derivative
transactions
are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect
of a
speculative business carried on by the assessee, shall not be set off except against
profits
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and gains, if any, of speculative business. In the absence of a specific provision, it is

apprehended that the derivatives contracts, particularly the index futures which are
essentially cash-settled, may be construed as speculative transactions and therefore
the
losses, if any, will not be eligible for set off against other income of the assessee and
will
be carried forward and set off against speculative income only up to a maximum of
eight
years .As a result an investors losses or profits out of derivatives even though they are
of
hedging nature in real sense, are treated as speculative and can be set off only against
speculative income.

1. Which of the following contract terms is not set by the futures exchange?
a. the price
b. the deliverable commodities
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c. the dates on which delivery can occur

d. the size of the contract
e. the expiration months

2.

Find the forward rate of foreign currency Y if the spot rate is $4.50, the
domestic interest rate is 6 percent, the foreign interest rate is 7 percent, and the
forward contract is for nine months.

a. $5.104
b. none are correct
c. $4.458
d. $4.532
e. $4.468

3. Margin in a futures transaction differs from margin in a stock transaction

because
a. stock transactions are much smaller
b. delivery occurs immediately in a stock transaction
c. no money is borrowed in a futures transaction
d. futures are much more volatile

4. Most futures contracts are closed by

a. exercise
b. offset
c. default
d. none are correct
e. delivery
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5. Which of the following is not a forward contract?

a. an automobile lease non-cancelable for three years
b. none are correct
c. a signed contract to buy a house in six months
d. a long-term employment contract at a fixed salary
e. a rain check
6. One of the advantages of forward markets is
a. none are correct
b. the contracts are private and customized
c. trading is conducted in the evening over computers
d. performance is guaranteed by the G-30
e. trading is less costly and governed by more rules

7. Which of the following best describes normal contango?

a. none are correct
b. the futures price is less than the spot price
c. the cost of carry is negative
d. the expected spot price is less than the futures price
e. the spot price is less than the futures price

8. Suppose you sell a three-month forward contract at $35. One month later, new
forward contracts are selling for $30. The risk-free rate is 10 percent. What is the
value of your contract?
a. $4.55
117

b. $4.96
c. $4.92
d. $5
e. none are correct

9. Futures prices differ from spot prices by which one of the following factors?
a. the systematic risk
b. the risk premium
c. the spread
d. none are correct
e. the cost of carry

10. Suppose there is a risk premium of $0.50. The spot price is $20 and the futures
price is $22. What is the expected spot price at expiration?
a. $21.50
b. none are correct
c. $24.50
d. $22.50
e. $20.50
References
Fabrizi, P., G. Forestieri and P. Mottura (2002), Gli strumenti e i servizi finanziari,
Milano: Egea
Hull, J.C. 2003. Opzioni, futures e altri derivati, Milano: Finanza e Mercati
Pozzoli, S. 2008. Doppia trasparenza sui contratti derivati, Il Sole 24Ore
Tenuta, P. 2007. Crisi finanziaria e strumenti di previsione del risk
management nelle aziende pubbliche locali, Milano: Franco Angeli
118

Tenuta, P. 2008. Las fuentes de financiacin y el impacto de los derivados

en la estabilidad econmico-financiera de los entes locales italianos, Revista
de Estudios de la Administracin Local y Autonmica, 306

119

Module IV

Forward and
Futures

120

After reading this module, you will be able to understand:

Introduction
Delivery And Settlement Of A Forward Contract
Default Risk And Forward Contracts
Termination Of A Forward Contract
The Structure Of Global Forward Markets
types Of Forward Contracts
History Of Futures Markets
Definition Of Futures
Difference Between Futures And Forwards
Organization Of Exchange
Development Of Organized Exchanges,
Clearing House,
Clearing House Mechanism,
Contract Specifications For Futures,
Types Of Margins,
Orders In Futures Market,
Settlement Procedures,
The Relationship Between Futures Price And Cash Price,
Basis, Cost-Of-Carry, Contango And Backwardation,
Motives Behind Using Futures,
Types Of Futures

121

Chapter 6

Introduction to forward Contracts

1 Background
From the 1970s financial markets became riskier with larger swings in interest rates
and equity and commodity prices. In response to this increase in risk, nancial
institutions looked for new ways to reduce the risks they faced. The way found was the
development of exchange traded derivative securities. Derivative securities are assets
linked to the payments on some underlying security or index of securities. Many
derivative securities had been traded over the counter for a long time but it was from
this time that volume of trading activity in derivatives grew most rapidly.
The most important types of derivatives are futures, options and swaps. An option
gives the holder the right to buy or sell the underlying asset at a specified date for a
pre-specified price. A future gives the holder the
obligation to buy or sell the underlying asset at a specified date for a pre-specified
price. Swaps allow investors to exchange cash ows and can be regarded as a portfolio
of futures contracts.
Options and futures are written on a range of major stocks, stock market indices, major
currencies, government bonds and interest rates. Most options and futures in the UK
are traded on the London International Financial Futures Exchange (http://www.li
e.com/) and most options and futures in the US are traded on the Chicago Board of
Trade (http://www.cbot.com/). It is also possible to trade futures contracts on a range
of

different

individual

stocks

from

across

the

world

at

Euro

next

(http://www.universal-stockfutures.com/). Such exchange traded derivatives might be

described as o -the-peg or generic as the details of the derivative are specified by the
Exchange House. Other derivatives are traded over the counter. They are tailor-made
and designed specifically to meet the needs of individual traders, the party and counter
party.
Derivatives allow investors a great deal of flexibility and choice in determining their
cash flows and thus are ideal instruments for hedging of existing risk or speculating on
122

the price movements of the underlying asset. Thus for example it is possible to o set
the risk that a stock will fall in price by buying a put option on the stock. It is possible to
gain if a large change in the price of the underlying asset is anticipated even if the
direction of change is unknown. It is also possible by using an appropriate portfolio of
options to guarantee that you buy at the lowest price and sell at the highest price | a
trader's dream made reality.
2 Forward Contracts
Forwards and futures contracts are a special type of derivative contract. For-ward
contracts were initially developed in agricultural markets. For example an orange
grower faces considerable price risk because they do not know at what price their
crops will sell. This may be a consequence of weather conditions (frost) that will affect
aggregate supply. The farmer can insure or hedge against this price risk by selling the
crop forward on the forward orange con-centrate market. This obligates the grower to
deliver a specific quantity of orange concentrate at a specific date for a specified price.
The delivery and the payment occur only at the forward date and no money changes
hands initially. Farmers can, in this way, eliminate the price risk and be sure of the
price they will get for their crop. An investor might also engage in such a forward
contract. For an example an investor might sell orange concentrate forward for
delivery in March at 120. If the price turns out to be 100, the investor buys at 100 and
delivers at 120 making a pro t of 20. If the weather was bad and the price in March is
150, the investor must buy at 150 to fulfill her obligation to supply at 120, making a
loss of 30 on each unit sold. The farmer is said to be a hedger as selling the orange
concentrate forward reduces the farmer's risk. The investor on the other hand is taking
a position in anticipation of his beliefs about the weather and is said to be a speculator. This terminology is standard but can be misleading. The farmer who does not
hedge their price risk is really taking a speculative position and it is difficult to make a
hard and fast distinction between the two types of traders.
Why trade forward?
For an investor the forward market has both pros and cons. The advantage is that
there is no initial investment. That is it costs nothing now to buy or sell forward. The
disadvantage is that there is a change of suffering a large loss.
The price of a forward contract
123

Let's consider a forward contract for a particular underlying asset, e.g. IBM stock, with
a maturity date of T . The price of such a forward contract is easy to determine. In the
absence of any transactions or storage cost the price of the forward contract is the
future value of the current spot price.

Position

Cost Now

Payoff at Maturity

(1)

Long Underlying

S0

ST

(2)
(3)

Long Forward
Short Forward

(ST F )
(F ST )

0
0
F

(4) Long Discount Bond

(1+r
)

Table 1: Forward Price

Let F be the forward price and S0 be the current spot price and let r0T be the risk-free
rate of interest from now until the maturity date T , then
F = (1 + r0T )S0:
To simplify the notation denote r0T simply by r. Then F = (1 + r)S0. To see that this
formula is correct, let's consider the payoff and cost of the positions that can be taken
on the stock, the forward contract and a risk-free discount bond with a face value of F
and a maturity date of T . If we take a long position in the stock, the cost now is S 0 and
the payoff at the maturity date is ST . We don't know what ST will be since the payoff to
the asset is uncertain. If we take a long position in the forward contract, the cost now
is zero and the payoff at maturity is ST F . That is we are obligated to buy at F and the
underlying asset can be sold for ST . If ST > F , then we buy at F and can immediately sell
at ST for a pro t of ST F . If on the other hand ST < F then we must buy at F but can only
sell at ST so we have a loss since ST F < 0. In addition suppose we buy the discount
bond. It costs F=(1 + r) now and pays out the face value F at maturity. We can
summarise all this information in Table 1.
Now consider the following trading strategy: go long in the forward con-tract and buy
the discount bond. The payoff to the forward contract is (ST F ), you are committed to
buy at F but can sell for ST , and the payoff to the bond is simply F , so the total payoff
is ST . Thus this trading strategy replicates the payoff to the underlying asset. We then
invoke the arbitrage principle that since this trading strategy has the same payoff at
maturity as the underling asset, it must cost exactly the same as buying the underlying
asset itself. The strategy costs F=(1 + r) as the forward contract involves no
124

Position

Cost Now

Payo at Maturity

(1) + (3) = (4)

S0
F

(2) + (4) = (1)

(1+r
)

Table 2: Forward
initial outlay, therefore it must be the case that F=(1 + r) = S0 or
F = (1 + r)S0:
That is, the forward price is simply the future value of the stock. The long position in
the stock (1) is equivalent to a portfolio of a long position in the forward and a long
position in the discount bond (2) + (4).
As an alternative suppose you go long in the stock and short on the forward contract,
that is a portfolio of (1) and (3). The overall payoff at maturity is ST + (F ST ) = F . The
cost of this strategy is S0 but has the same payoff as a risk-free bond with face value of
F and is thus equivalent to position (4). Thus as before F=(1 + r) = S 0. This is summarized
by Table 2.
As yet another possibility consider buying the underlying stock and going short on the
discount bond with face value of F (that is borrow an amount F=(1 + r)). At maturity
one has an asset worth ST but and obligation to repay F and thus a net worth of ST F.
This is exactly the same as the long forward contract. Since the payoff s are the same
we are said to have synthesized or replicated the forward contract. The cost of this
synthetic forward contract is the cost of the stock now S 0 less what we borrowed, F= (1
+ r), so that the net cost is
F
S
0

:
(1 + r)

The payoff is the same as the forward contract. Yet the forward contract involves no
exchange of money upfront. So the cost of the synthetic forward must be zero too:
F
S
=0
0
(1 + r)
which again the delivers the same conclusion that F = (1 + r)S0.

Exercises:
125

Exercise 1: If F > (1+r)S0 identify a arbitrage opportunity. Put together a portfolio which
gives you money now and only o setting obligations at the maturity date.
Exercise 2: If F < (1+r)S0 identify a arbitrage opportunity. Put together a portfolio which
gives you money now and only o setting obligations at the maturity date.
Exercise 3: If the stock pays out a dividend D at the maturity date T , so the total payo
to holding the stock is ST + D, calculate the forward price if the interest rate is r
Forward Value
The forward contract is initially negotiated so that there is no initial outlay. That is the
delivery price on the forward contract is chosen so that the value of the contract is
zero. However, as maturity approaches the price of the underlying asset changes but
the delivery price does not. Thus as time progresses the forward contract may have a
positive or negative value. Let K be the delivery price and let St denote the price of the
underlying asset at time t with time T t left to maturity. The forward price is F t = St(1 +
rtT ) where rtT is the risk-free interest rate from t until T .
The same argument can be used above can now be used to find how the value of the
forward contract changes as the time moves to maturity. Let this value be v t. Consider
the portfolio of one long forward contract and the purchase of a discount bond with
face value of K and maturity date of T. The payoff to the forward contract is (ST K) but
the payoff to the bond is
K leaving a net payoff of ST . The cost of this portfolio is vt +

K
. Since
T
(1+rt )

it replicates exactly the underlying (which has a price of S t) we have

K
v =S
t

=
t

(1 + rtT )

(F

K)

(1 + rtT )

126

where the last part follows since St = Ft=(1 + rtT ). To check that this makes
sense rst consider what happens at t = 0. At t = 0 the delivery price is chosen so
vt = 0, that is K = S0(1 + r0T ) = F0 and the forward price is equal to the delivery
price. Next consider t = T . Then rtT = 0 and we get vT = ST K which is just the
payo to the forward contract at maturity.
To presage what we will do subsequent, the value of the forward contract can
also be calculated by using the stochastic discount factor k.1 A forward
contract with a delivery price of K has a payo at maturity of ST K. Thus the value
of this payo is
K
v
t

= E[k

(S

K)] = E[k S

T]

KE[k] = S

(1 + rtT )

where the last part of the equation follows since E[k] measure the appropriately discounted payo of one unit of payo for sure and thus is equal to the
discount factor 1=(1 + rtT ).

Futures Contracts
So far we have used the terms forward and futures interchangeably and they
are equivalent if there is no interest rate uncertainty. There are however, some
differences between forward and futures contracts.
Forward contracts are normally traded over the counter and futures con-tracts
are generally exchange traded with futures prices reported in the - nancial
press. With a futures contract therefore the exchange provides a standardised
contract with a range of speci ed delivery periods. Thus a wheat futures
contract will be specify the delivery of so many bushels of wheat for delivery in
a particular month. The quality and delivery place will also be speci ed. The
exact day of delivery within the month is usually left to the discretion of the
writer of the contract.
1

We will study risk-neutral probabilities and the stochastic discount factor later
in the
course.

127

The key difference between forward and futures contracts is that forwards are
settled at maturity, whereas futures contracts are settled daily. This daily
settlement is done by requiring the investor to hold a margin account with the
exchange. Thus although the contract costs nothing initially, the investor is
required to deposit a certain amount of funds, the initial margin with the
exchange. This margin account is marked to market to re ect the daily gains or
losses on the contract. Thus for example if you buy a futures contract on
Wednesday for 250 and the following day the futures price has fallen to 240,
you will have su ered a loss of 10 and this amount will be deducted from your
margin account. In e ect the futures contract is closed out and rewritten every
day. The exchange will also specify a maintenance margin which is the amount
which must be maintained in the margin account, usually about 75% of the
initial margin. If the margin account does fall below the maintenance margin
the investor will be required to deposit extra funds, the variation margin, with
the exchange. Most futures contracts are closed out prior to maturity and don't
actually result in delivery of the underlying. Thus an investor will settle the
futures contract and withdraw the amount in the margin account on that day.
Traders on futures (and other types of exchange markets) can place conditional trade as well as trade orders. There are three main types of order that
can be executed. (i) A \Market" order will trade immediately at the current
market price once the order is made there is no turning back! (ii) \Limit" orders
are used to set a price at which the trader is prepared to trade. For example if
the prices are currently high, the trader can input a price a bit lower than the
current o er, and place a conditional order to buy. The order will now move
into a working orders account and will be executed if the o er price falls to the
limit level speci ed. (iii) \Stop" orders enable the trader to limit losses in his/her
portfolio. This involves setting a conditional price at which to sell the asset if
the market moves too much in the wrong direction. The trader speci es a price
and volume at which to sell. The order will again be placed in the working
orders account and will be executed if the price falls to the level speci ed.

128

Day Position

Futures Price

Gain/loss

Future Value

Long

(1+r)T

G0

1
Long

(1+r)T

G1 GT0
(1+r)
1

G1

1
Long

G1G0

G1 G0
(1+r)T
(1+r)T

G2
G

1
T
T

Long

(1+r)

1 Long 1
T
0

T 2

T 1
GT

T 2 GT
3
2
G (1+r) G
T 1 T
2
(1+r)
G
T GT 1

G2G1
G
T 2 T 3

T 1GT 2
G
T GT 1

Table 3: Equivalence of Futures and Forward Prices

Although futures are settled daily we now show that the forward price and the
futures price are the same if interest rates are known even if the forward
contract cannot be traded. For simplicity suppose that the interest rate is
constant and let r denote the daily interest rate and suppose that the futures
contract matures on date T and let G0; G1; G2; : : : ; GT 1; GT denote the futures
price on each of the trading days. Suppose that we have a position
1
1
t 1
on day t. Thus initially our position is (1+r)T 1and we increment
our position on a daily basis. The change in the value of our position on day
1 is
G
G
1
0 :
(1 + r)T 1
of

(1+r)T

To calculate the future value of this gain or loss compounded to date T we

multiply by (1+ r)T 1 as there are T 1 days to go. Thus the future value is
simply G1 G0. The positions and future value on each day is summarised in Table
3.
Overall the future value from this portfolio is GT G0. Since the futures price at
maturity must equal the spot price, GT = ST , the future value is ST G0. If we
combine this portfolio with a the purchase of a risk-free asset at time zero with
a face value of G0 the portfolio has a payo of ST . Since the futures contracts
cost nothing to purchase the overall cost of the portfolio
129

is the cost of the risk-free asset, 1 T . Suppose that the forward contract
(1+r)
has a delivery price of F0. Since we have already seen that the forward contract
combined with a risk-free asset with face value of F0 gives at time

T a portfolio worth ST , these two portfolios must cost the same. Hence
G0

F0
(1 + r)T

or G0 = F0 and hence for any t, Gt

prices are equivalent.

(1 + r)T

= Ft. Thus the forward and futures

This argument can be replicated if the interest rate changes in a known way,
simply by choosing the appropriate positions so that the future value of the
gain or loss on the futures contract is Gt Gt 1 on date t.
There is however, a di erence between futures and forward prices if the
interest rate is uncertain. Suppose that there is a positive covariance between
the interest rate and the price of the underlying asset. Then if the price of the
asset rises the gains on the futures contract will tend to be valued at a high
interest rate and similarly losses on the futures contract will be valued at a low
interest rate. An investor holding a forward contract is not a ected by changes
in the interest rate if they cannot trade the forward. Hence if the covariance
between the interest rate and the underlying is positive, the futures price will
tend to be higher than the forward price. In practice even this di erence is likely
to be small for as most futures contracts are held for relatively short durations.
Thus for most practical purposes there is little di erence between the forward
and the futures price.
It is to be remembered too that although we've talked about the market price
there are really two prices, the bid price and the o er price.2 The o er price is
the price one can buy at (the market o ers the contract at this price) and the bid
price is the price one can sell at (how much the market is prepared to pay for
the asset). It must be the case that o er price bid price otherwise you could buy
at the o er price and sell at the bid price and make an immediate arbitrage pro
t. The di erence between the bid and o er prices is know as the bid-o er spread
and the cost of buying at the o er price as selling at the bid price is known as
the roundtrip cost.
130

The o er price is also known as the ask price, particularly in

the U.S.

131

Backwardation and Contango

We have shown that the forward price is just the future value of the underlying, F = (1 + r0T )S0. Perhaps surprisingly the expected value of the
underlying asset at time T , E[ST ] does not a ect the forward price at all. Yet it is
also clear that the forward price tends to the current spot price as the contracts
tends to maturity. To see this suppose that we are very close to the delivery
period. If the forward price were below the current spot price, then it would be
possible buy the forward contract, wait for delivery and sell almost surely at
the higher spot price. This will tend to drive the forward price up toward the
spot price. Similarly if the forward price were above the spot price one could
sell the forward contract, buy at the lower spot price and make the delivery
generating an almost sure pro t. With everyone doing this the forward price will
fall toward the spot price.
A situation where the forward price is below the expected spot price, F < E[S T ],
is called backwardation. A reverse situation where the forward price is above
the expected spot price is called contango. An interesting question, and one
that exercised Hicks and Keynes in the 1930s, is whether forward prices
normally exhibit backwardation or contango and why.
To consider the relationship between the forward price and the expected
future spot price it is necessary to consider the risk involved in holding a
forward or futures position. Consider an investor or speculator who holds a
long position in a forward contract. This obligates the investor to pay out F the
forward price at maturity in return for an asset that will be worth the unknown
amount ST . For simplicity suppose the investor F=(1 + r) in a risk-free
investment now which will deliver F at time T to o set his/her obligations. The
cash- ow is thus a certain F=(1 + r) now and an uncertain amount ST at time T .
The question that remains is how to value the risky future payo ST . As in
corporate nance we could evaluate this payo using a CAPM so that the

132

value of the future cash ow is

E[ST ]
(1 + r )
r) is the required rate of return, is the beta
where r = r + (rM
the underlying asset and rM is the expected rate of return on the market
portfolio. Then the value of the investors portfolio is
F

of

E[ST ]

+
:
(1 + r) (1 + r )

As the asset is priced so that S0 = E[ST ]=(1 + r ), if this term where positive or
negative, there would be an arbitrage opportunity. For example if F=(1 + r) >
E[ST ]=(1 + r ) then there would be an arbitrage opportunity to borrow F=(1 + r),
buy the underling asset at the price S0 = E[ST ]=(1 + r ) and short the forward
contract. This would create a net in ow of cash today and o setting cash ows at
the maturity date as illustrated in Table 4. Thus we must have that the forward
price satis es
(1 + r)

F = E[ST ]

(1 + r )

If the beta of the underlying asset were zero then r = r and the forward price
would be equal to the expected spot price. In these circumstances we would
say the the forward price is an unbiased predictor of the expected future spot
price. We do however, know that for most assets the beta of the asset is
positive and hence r > r. That is to say the asset has some systematic risk that
cannot be diversi ed away and hence an expected return higher than the riskfree rate is required to compensate. In this typical case
F < E[ST ]
and we have backwardation.3 If the returns on the market were negatively
correlated with the underlying asset then we would have < 0 and hence F >
E[St] and hence contango.
The same argument can also be made by using the stochastic discount fac-tor
and hence does not rely on a speci c pricing model such as the CAPM.
3

Since it is the typical case it is often referred to as normal

backwardation.

133

Position

Cost Now

Payoff at Maturity

Long Underlying
Short Forward
Short Discount Bond

S0 = E[ST ]=(1 + r )
0
(1+Fr)

ST
(F ST )
F

Table 4: Arbitrage Possibility

Since the current stock value reflects the appropriately stochastically discounted value of possible future values, S0 = E[k ST ]. Since F = S0(1 + r) we have
that F = (1 + r)E[k ST ]. Using the covariance rule
F = (1 + r)E[k ST ] = (1 + r)E[k]E[ST ] + (1 + r)Cov(k; ST ) = E[ST ] + (1 +
r)Cov(k; ST )
since E[k] = 1=(1 + r). It can be seen from the above equation that whether
there is backwardation or contango depends on the sign of cov(k; ST ). Typically, because individuals are risk averse, the demand will be for assets that o
er insurance and the price of returns in low payo states will be high. Thus for
most assets the covariance will be negative. Typically then F < E[ST ] and the
forward will exhibit backwardation.
Exercises:
Exercise 4: The current gold price is $500 per ounce. The forward price for
delivery in one year is $575 per ounce. The cost of storing an ounce of gold for
one year is $40 and this must be paid now in advance. The risk-free rate of
interest is 10% per annum. If you own ten ounces of gold, how can you exploit
an arbitrage opportunity to make $190?
Exercise 5: Consider a forward contract written on a non-dividend paying asset.
The current spot price is $65. The maturity of the contract is in 90 days and the
interest rate over this period is 1.1%. Determine the forward price. What is the
value of this contract? A corporate client wants a 90-day

134

forward contract with the delivery price set at $60. What is the value of this contract? (See Hull
p.108).
Exercise 6: Consider a one year futures contract on an underlying com-modity that pays no
income. It costs $5 per unit to store the commodity with payment being made at the end of the
period. The current price of the commodity is $200 and the annual interest rate is 6%. Find the
arbitrage-free price of the futures contract. (See Hull p.116).

135

CHAPTER 7

INTRODUCTION TO FUTURE

Future markets were designed to solve the problems that exist in forward markets. A future
contract is an agreement between two parties to buy or sell an asset at a certain time in the
future at a certain price. But unlike forward contracts, the future contracts are standardized
and exchange traded. To facilitate liquidity in the future contracts, the exchange specifies
certain standard features of the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that can be delivered,
(or which can be used for reference purpose in settlement) and a standard time of such
settlement. A future contract may be offset prior to maturity by entering into an equal and
opposite transaction. More than 99% of future transactions ate offset this way.
The standardized items in a future contract are:
Quantity of the underlying.
Quality of the underlying.
The date and the month of delivery.
The units of price quotation and minimum price change.
Location of settlement.
FEATURES OF A FUTURE CONTRACT
Future contracts are organized / standardized contracts, which are traded on the exchanges.
These contracts, being standardized and traded on the exchanges are very liquid in nature.
In futures market, clearing corporation/ house provides the settlement guarantee.

DISTINCTION BETWEEN FUTURE AND FORWARD CONTRACTS:

136

Future contracts are often confused with future contracts. The confusion is primarily because
both serve essentially the same economic functions of allocating risk in the presence of future
price uncertainty. However futures are a significant improvement over the forward contracts as
they eliminate counterparty risk and offer more liquidity.

FEATURES
Operational
Mechanism

FORWARD CONTRACT
Not traded on
exchange

FUTURE CONTRACT
Traded on exchange

Contract
Specifications

Differs from trade to

trade.

Contracts are
standardized
contracts.

Counterparty Risk

Exists

Exists, but assumed

by Clearing
Corporation/ house.

Liquidation Profile

Poor Liquidity as
contracts are tailor
maid contracts.

Very high Liquidity as

contracts are
standardized
contracts.

Price Discovery

Poor; as markets are

fragmented.

Better; as fragmented
markets are brought to
the common platform.

FUTURE TERMINOLOGY
Spot Price: The price at which an asset trades in the spot market.
Future Price: The price at which the future contracts trades in the market.
Contract Cycle: The period over which a contract trades. The index futures contracts on the
NSE have one-month, two-months and three-months expiry cycle, which expire on the last
Thursday of the month. Thus a January expiration contract would expire on the last Thursday of
January and a February expiration contract would cease trading on the last Thursday of

137

February. On the Friday following the last Thursday, a new contract having a three-month
expiry would be introduced for trading.
Expiry Date: It is the date specified in the future contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist.
Contract Size: The amount of asset that has to be delivered under one contract. For instance,
the contract size on NSEs futures market is 200 Nifties.
Basis: Basis is usually defined as the spot price minus the future price. There will be a different
basis for each delivery month for each contract. In a normal market, basis will be negative. This
reflects that futures prices normally exceed spot prices.
Cost of Carry: The relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus the interest
that is paid to finance the asset less the income earned on the asset.
Initial Margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.
Marking-to-Market: In the future market, at the end of each trading day, the margin account
is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is
called marking-to-market.
Maintenance Margin: This is somewhat lower than the initial margin. This is set to ensure that
the balance in the margin account never becomes negative. If the balance in the margin
account falls below the maintenance margin, investor receives a margin call and is expected to
top up the margin account to the initial level before trading commences on the next day.

DIFFERENCE BETWEEN FUTURES AND OPTIONS

138

At a practical level, the option buyer faces an interesting situation. He pays for the option in full
at the time it is purchased. After this, he only has an upside. There is no possibility of the
options position generating any further losses to him (other than the funds already paid for
option). This is different from futures, which is free to enter into, but can generate very large
losses. This characteristic makes options attractive to many occasional market participants, who
cannot put in the time to closely monitor their future options. Buying put option means that
you are buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the
full extent to which Nifty drops below the strike price of the put option. This is attractive to
many people, and to mutual funds creating guaranteed return products. The Nifty index fund
industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to
create a new kind of a Nifty index fund, which gives the investor protection against extreme
drops in Nifty.
Selling put option is selling insurance, so anyone who feels like earning revenues by selling
insurance can set himself up to do so on the index option market. More generally, option offer
nonlinear payoffs whereas futures only have linear payoffs. By combining futures and
options, a wide variety of innovative and useful payoff structures can be created.

PAYOFF FOR DERIVATIVES CONTRACT

Payoff is likely profit/loss that would accrue to a market participant with change in the price of
the underlying asset. This is generally depicted in the form of payoff diagrams, which show the
price of the underlying asset on the X-axis and the profit/losses on the Y-axis.
Payoff for Futures:
Future contracts have linear payoffs. It means that the losses as well as profits for the buyer
and the seller of a future contract are unlimited. These linear payoffs are fascinating as they can
be combined with options and the underlying to generate various complex payoffs.
Payoff for buyer for futures: Long Futures
The payoff for a person who buys a futures contract is similar to the payoff for a person who
holds an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who buys a two-month Nifty index futures contract
when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the
index moves down it starts making losses

139

PROFIT

0
LOSS

1220
NIFTY

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contracts is similar to the payoff for a person who
shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who sells a two-month Nifty index futures contract
when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the
index moves down, the short future position starts making profits, and when the index moves
up, it starts making losses.
PROFIT

1220
0
NIFTY

140

LOSS

USING INDEX FUTURES

There is always risk involved when we trade in a stock market. The risk cannot be eradicated
fully but can be minimized up to some extent. Following are the types of risks that can be
minimized through futures:
Basic objective of introduction of futures is to manage the price risk.
Index futures are used to manage the systemic risk, vested in the investment in securities.
Basically there are eight basic modes of trading on the index futures
market;
Hedging
H1 Long stock, short Nifty futures
H2 Short stock, long nifty futures
H3 Have portfolio, short Nifty futures
H4 Have funds, long Nifty futures
Hedge Terminology:
Long hedge- When you hedge by going long in futures market.
Short hedge - When you hedge by going short in futures market.
Cross hedge - When a futures contract is not available on an asset, you hedge your position in
cash market on this asset by going long or short on the futures for another asset whose prices
are closely associated with that of your underlying.
Hedge Contract Month- Maturity month of the contract through which hedge is
accomplished.
Hedge Ratio - Number of future contracts required to hedge the position.
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Speculation
Speculation is all about taking position in the futures market without having the underlying.
Speculators operate in the market with motive to make money. They take:
- Position in any future contract.
- Opposite positions in two future contracts. This is a conservative
speculative strategy. Speculators bring liquidity to the system, provide insurance to the
hedgers and facilitate the price discovery in the market.
S1 Bullish index, long Nifty futures
S2 Bearish index, short Nifty futures

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HEDGING
H1: long stock, short Nifty futures
A person who feels that the stocks will be intrinsically under evaluated or the profits and the
quality of the company will make it more worth as compared to the market will always like to
take a long position on the cash market. While doing so he will have to face the following kinds
of risks:
1. His understanding can be wrong, and the company is really not worth more than the market
prices.
2. The entire market moves against him and generate losses even though the underlying idea
was correct. The second outcome happens all time. A person may buy Reliance at Rs.190
thinking hat it would announce good results and the stock price would rise. A few days later,
Nifty drops, so he makes losses, even if his understanding of Reliance was correct. There is a
peculiar problem here. Every buy position on a stock is simultaneously a buy position on Nifty.
This is because a, LONG RELIANCE position generally gains if Nifty rises and generally losses if
Nifty drops. In this sense, a LONG RELIANCE position is not a focused play on the valuation of
Reliance. It carries a LONG NIFTY position along with it, as incidental baggage. The stock picker
may be thinking that he wants to be LONG RELIANCE but a long position on Reliance effectively
forces him to be LONG RELIANCE + LONG NIFTY. If we think that WIPRO is under evaluated, the
position LONG WIPRO is not purely about WIPRO; it is also partly about Nifty. Every trader who
has a LONG WIPRO position is forced to be an
index speculator, even though he may not have no interest in the index.
Those who are bullish about the index should just buy Nifty futures; the need not trade
individual stocks.
Those who are bullish about WIPRO do wrong by carrying along a long position on Nifty
as well. There is a simple way out. Every time we adopt a long position on a stock, we
should sell some amount of Nifty futures. This will help in offsetting the hidden Nifty
exposure that is every long-stock position. Once this is done, we will have a position
which will be purely about the performance of the stock. The position LONG WIPRO +
SHORT NIFTY is a pure play on the value of WIPRO, without any risk from fluctuation of
the market index. When this will be done the stockpicker has hedged away his index
143

exposure. The basic point of this hedging strategy is that the stockpicker proceeds with
his core skill, i.e. picking stocks, at the cost of lower risk.
NOTE: hedging does not remove losses. The best that can be achieved by using hedging is the
removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profit
than the un-hedged position, half the time. One should not enter into a hedging strategy
hoping profit for sure; all that can come out of
hedging is reduced risk.
H2: Short stock, long Nifty futures
If a person feels that the stock is over evaluated or the profits and the quality of the company
made it worth a lot less as compared to what the market thinks, he can take a short position on
the cash market. This will give rise to two types of risks:
1. His understanding can be wrong, and the company is really worth more than the market
price.
2. The entire market moves against him and generates losses even though the underlying idea
was correct. The second outcome happens all time. A person may sell Reliance at Rs.190
thinking that Reliance would announce poor result and the stock price would fall. And if after
few days if the Nifty rises, he will incur loss, even if the intrinsic understanding of Reliance was
correct. There is a peculiar problem here. Every sell position on a stock is simultaneously a sell
position on Nifty. This is because a SHORT RELIANCE position generally gains if Nifty falls and
generally loses if Nifty rises. In this sense, a SHORT RELIANCE position is not a focused play on
the valuation of Reliance. It carries a SHORT NIFTY position along with it, as incidental baggage.
The stock picker may be thinking he wants to be SHORT RELIANCE, but a short position on
Reliance on the market effectively forces him to be SHORT RELIANCE + SHORT NIFTY.
Even if we think that WIPRO is overvalued, the position SHORT WIPRO is not purely about
WIPRO; it is also about the Nifty. Every trader who has a SHORT WIPRO position is forced to be
an index speculator, even though he may not have any interest in the index.
individual stocks.

well.

144

There is a simple way out. Every time we adopt a short position on a stock, we should buy some
amount of Nifty futures. This will help in offsetting the hidden Nifty exposure that is every
short-stock position. Once this is done, we will have a position, which will be purely about the
performance of the stock. The position SHORT WIPRO + LONG NIFTY is a pure play on the value
of WIPRO, without any risk from fluctuation of the market index. When this will be done the
stockpicker has hedged away his index exposure. The basic point of this hedging strategy is
that the stockpicker proceeds with his core skill, i.e. picking stocks, at the cost of lower risk.
H3: Have Portfolio, short Nifty futures
Some of us might have experienced the feeling of owing an equity portfolio, and then one day,
we become uncomfortable about the overall stock market. Sometimes we have a view that the
stock prices will fall in the near future. At other times, we may see that the market is in for a
few days or weeks of massive volatility, and we do not have an appetite for this kind of
volatility. The best example of this volatility is the union budget. Market positions become
volatile for one week before and two weeks after the budget. Many investors want to eradicate
this three weeks volatility. This becomes a peculiar problem if we are thinking of selling the
shares in the near future, for example, in order to finance a purchase a house. This planning can
go wrong if by the time we sell shares, Nifty has dropped sharply.
There are two main alternatives, when one faces this type of problem:
1. Sell shares immediately. This sentiment generates panic selling which is rarely optimal for
the investor.
2. Do nothing, i.e. suffer the pain of volatility. This leads to political pressure for government to
do something when stock prices fall. Here in this case, with the index futures market, a third
and a remarkable alternative becomes available
3. Remove your exposure to index fluctuations temporarily using index futures. This will allow
rapid response to market conditions, without panic selling of shares. It will allow an investor
to be in control of his risk, instead of doing nothing and suffering the risk. The idea here is that
every portfolio contains a hidden index exposure. This statement is true for all portfolios,
whether a portfolio is composed of index stock or not. In the case of portfolios, most of the
portfolio risk is accounted for by index fluctuations. Hence a
position LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG
PORTFOLIO position. Is suppose we have a portfolio of Rs.1 billion, which is having a beta of
1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures.
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H4: Have funds, buy Nifty futures

A person may be in a situation where he is having funds, which needed to be invested in equity,
or he may be expecting to get funds in future to be invested in equity. The following can be the
occurrences in the above conditions:
-end fund, which just finished its initial public offering, has cash, which is not yet
invested.

complete. It takes several weeks from the date that it becomes sure that the
funds will come to the date that the funds are actually are in hands.
-ended fund has just sold fresh units and has received funds. To get oneself invested
in equity sounds quite easy but it involves the following problems:
1. A person may need time to research stocks, and carefully pick stocks that are expected to do
well. This process of research takes time. For that time the investor is partly invested in cash
and partly invested in stocks. During this time, he is exposed to the risk of missing out if the
overall market index goes up.
2. A person may have made up his mind on what portfolio he seeks to buy, but going to the
market and placing the market order would generate large impact cost. The execution would
be improved substantially if he could instead place a limit orders and gradually accumulate the
portfolio at favorable prices. This takes time, and during this time, he is exposed to the risk of
missing out if the Nifty goes up.
3. In some cases, such as land sale above, the person may not simply have cash to immediately
buy the shares, hence he is forces to wait even if he feels that Nifty is unusually cheap. He is
exposed to the risk of missing out if Nifty rises.
The three alternatives that are available with an investor are as follows:

A person who expects to obtain Rs.5 million by selling land would immediately enter into a
position LONG NIFTY worth Rs.5 million. Similarly a close-end fund, which has just finished its
initial public offering and has cash, which is not yet
146

invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested into
equity. The index futures market is likely to be more liquid than individual
stocks so it is possible to take extremely large position at a low impact cost.
-end fund can gradually acquire stocks. As and when shares are
obtained, one would scale down the LONG NIFTY position correspondingly. No matter how
slowly the stocks are purchased, this strategy would fully capture a rise in Nifty, so there is no
risk of missing out on a broad rise in the stock market while this process is taking place. Hence,
this strategy allows the investor to take more care and spend more time in choosing stocks and
placing aggressive limit orders.

VALUATION OF A FORWARD CONTRACT

Valuation of an ASSET that provides no income
The valuation of an asset that provides no income such as non-dividend paying stocks, zerocoupon bonds or gold is obvious:

F0 = the forward price

S0 = the current price of the asset
r = continuous compounding risk free rate
T = time to maturity
At time T the customer will pay F0 (fixed at time t=0) to get the asset.
Based upon the discussion on the forward market efficiency (where S0 = 10$, T = 1 year and the
fair F0 = 10.45$), we would have:
If
asset.
If
that asset.

, arbitrageurs would buy the asset and short forward contracts on that
, arbitrageurs would sell the asset and enter a long forward contracts on
147

Valuation of an ASSET that provides a fixed income

The fixed income could be a coupon that the bond owner will receive before the maturity. Lets
note I the present value of that income. In a way, due to that income the investor will pay
less than S0 to purchase the asset. The amount I has to be subtracted from the current price
of the asset so that we have

F0 = the forward price

S0 = the current price of the asset
r = continuous compounding risk free rate
T = time to maturity
I = present value of the known income
For example if the asset is a bond:
current value S0 = 1000$,
coupon = 20$ paid in 5 months,
T = 9 months,
risk free continuous rate from today to 5 months is 3%
risk free continuous rate from today to 9 months is 4%
with
Valuation of an ASSET that provides a known yield
Suppose an asset that is expected to provide a yield of 6%p.a.. For instance, this could mean
that
Yield
income is paid once a year and is equal to
6% of the asset price at the time it is paid

6% annual compounding
148

income is paid twice a year and is equal to

3% of the asset price at the time it is paid

6% semi-annual compounding

Lets imagine that a stock index is supposed to give a continuous dividend yield of 0.2%
p.month. in the first coming month and 0.3% p.month. in the second month.
the total dividend yield is such that :
p.a.
Lets note q the average yield p.a. with continuous compounding, on the asset during the life of
a forward contract
It can be shown that

Valuation of a FORWARD CONTRACT of an asset that provides no income

Lets first consider a forward contract of an asset that provides no income :
At the initial time t=0 when the contract is signed , we have

with
S0 = the initial value of the Asset
K = the delivery price agreed at the origin of the contract (t=0)
T = maturity time when the asset will be delivered
rini = continuous compounding risk free rate applicable from initial time to maturity

149

As time passes, there can be changes in the value of the asset and also in the value of the risk
free rate.
Lets consider a time t, such that t < T .
Since it is a given fact that the investor (the short) will receive K at time T, if we discount back
that amount K to the time t we have
with
r = continuous compounding risk free rate applicable from that time t to maturity
We can compare both the asset value at time t ( = St ) and the amount K at the same time t. This
is the value f at time t of the short forward contract:

since we agreed to say that the value of an instrument is related to a long position we have:

equation 1
If the investor would sell a new forward contract for the same asset to be delivered at time T
the price Ft would be:
equation 2
from equation 2 above we have

in equation 1 this gives the value f, at time t, of a long forward contract based upon the price
Ft of an equivalent forward contract concluded at that same time t:

equation 3
Note: the value of a short forward contract is -f
150

At time t = 0 we have F0 = K so that f = 0 which means that the contract has no value (this is also
demonstrated using an arbitrage reasoning in appendix A5 page 218).
At maturity time t = T we have FT = ST so that f = ST -K
Valuation of a FORWARD CONTRACT of an asset that provides a fixed income
By the same reasoning we have the value f at time t of the long forward contract (concluded
some times ago) of an asset that provides a fixed income:

or

St = the value of the Asset at time t

K = the delivery price agreed at the origin of the contract (t=0)
T = maturity time when the asset will be delivered
t = time elapsed since the contract was signed
I = present value of the known income
r = continuous compounding risk free rate applicable from that time t to maturity
Ft = price of an equivalent forward contract for the same asset concluded at time t
Note: the value of a short forward contract is -f
Valuation of a FORWARD CONTRACT of an asset that provides a known yield
By the same reasoning we have the value f at time t of the long forward contract (concluded
some times ago) of an asset that provides a known yield:

151

or

St = the value of the Asset at time t

K = the delivery price agreed at the origin of the contract (t=0)
T = maturity time when the asset will be delivered
t = time elapsed since the contract was signed
q = the average yield p.a. with continuous compounding, on the asset during the remaining life
of a forward contract
r = continuous compounding risk free rate applicable from that time t to maturity
Ft = price of an equivalent forward contract for the same asset concluded at time t
Note: the value of a short forward contract is -f
Valuation of a FORWARD CONTRACT of currency
We will show in section "valuation of futures contracts on currencies" that a currency is an
asset that provides a known yield. Therefore we just need to replace q with r B and r with rA in
the formula just above.
We have the value f at time t of the long forward contract (concluded some times ago) of an
asset that provides a known yield:

rA = the continuous risk free rate of currency A

rB = the continuous risk free rate of currency B
SA/1B = the spot exchange rate at time t such that SA/1B amount of currency A = 1 currency B
K = the delivery exchange rate agreed at the origin of the contract (t=0)

152

Module V:
Introduction to
Options and swaps

153

After reading you will be able to understand the following:

Introduction to options
Option terminology
Options pay offs
Factors influencing option prices
Elementary Investment Strategies
Options Clearing Corporation
Other Options
Trading Strategies of Options
Put-Call Parity
Binomial Option Pricing Model
Black-Scholes Option Pricing Model
Introduction to swaps
Interest Rate Swaps and
Currency Swaps

154

CHAPTER 8

INTRODUCTION TO OPTIONS

Definition:
Derivatives are deferred settlement contracts which derive their value from the underlying.
Derivatives in Indian Context are divided into two parts which are further sub divided as shown in the
figure below:
Figure 1.5

Balance Sheet

Swaps

Foreign Currency
Denominated
INR
Denominated

Derivative
s
Vanilla
Profit & Loss

Options

The Swaps which affects the balance sheets of the companies

Exotic

include the

Term Exposures i.e. loans taken in foreign currency or in Indian rupee denomination. Whereas the
derivatives which affect the P/L A/c are the options which help in mitigating the risk involved in the Sales
and Purchases.
Options:
Simply stated, an option is a choice. The buyer of an option acquires the right and not the obligation, to
buy or sell an underlying asset under specific conditions in exchange for the payment of a premium. It is
entirely up to the buyer whether or not to exercise that right; only the seller of the option is obligated to
perform.
Thus, a currency Option is characterised by underlying currency on which the option is based.
Options Terminologies:
155

Following are some of the concepts and terminologies which are essential in understanding the
fundamentals of Options:
Call Option: A call option conveys on the option buyer the right to buy the underlying asset at a
predetermined price. If the buyer of the call exercises his right, i.e., he decides to buy the underlying
asset, then the seller of the call has to oblige, i.e., he has to sell the underlying asset.
Put Option: A put option gives the buyer the right to sell the underlying asset at a predetermined price.
If the buyer of the put option exercises his right, i.e., he decides to sell the underlying asset, then the
seller of the put, he has to buy the underlying asset.

Figure 1.6
Diagrammatically,
Call Option

Buy

Right to
Buy

Put Option

Sell

Obligation
to Sell

Buy

Right to
Sell

Sell

Obligation
to buy
156

Spot Rate: Simply put, it is the current market rate of the currency. For instance, if the spot rate of
USD/INR is 40.80, it means that corporate would have to pay 40.80 for every US Dollar purchased.
Strike rate: This is the rate at which an Option contract has been entered into.
Expiration Date: This is the date at which the option expires.
In The Money, At The Money, Out Of Money: These concepts are very important as far as Options Go. It
is essential to understand that what holds true for the Call option, exactly the reverse holds true for the
Put option. The following table gives a clear idea as regards these concepts.

Table 1.1

In The Money (ITM)

Call Option

Put Option

When the price of the

When the price of the

underlying is greater than the

underlying is lower than the

strike price

strike price.
When the strike rate is equal to

At the Money (ATM)

Out Of Money (OTM)

When the strike rate is equal to

the price of the underlying

the price of the underlying

When the price of the

When the price of the

underlying is lower than the

underlying is higher than the

strike rate

strike rate

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All the above mentioned concepts are very important as they play a major role in understanding the
concepts of Option Pricing which takes into account various factors i.e. Strike Price, Volatility, Time,
Price of Underlying, Interest Rate Differential and Option Premium which affects the option pricing.
Types of Options:
Options can be bifurcated on the following basis:
On the basis of their exercisability American or European:
An American option gives the buyer the right to exercise his option at any point of time during the
option period. The European option is inflexible in this regard as the buyer can exercise his right only
on the maturity date. As the American option offers more flexibility, it commands a higher premium
in comparison to its European counterpart.
On the basis of the parameters on which the option is structured Plain Vanilla or Exotic:
Factors like the Strike rate, Spot date, Date of expiry, Volatility influence the Option premium. An
Option which considers only these factors is called as Plain Vanilla Option. An option which
incorporates any other parameter than those mentioned above is called as Exotic Option. An
Exotic Option may include some barriers. The advantage of such options is that it helps to reduce
the amount payable as option premium to a great extent.
However, it is to be noted that Exotic Options are not permitted in USD/INR trade by the Central
Bank in India. Only European Options are permitted in case of INR structures.
Options v/s Forwards:
To understand the advantages of Options in a better manner, an attempt has been made to distinguish
between the two:
Table 1.2
Options

Forwards
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An option gives a right and not an obligation to

Forward contracts obligate the parties to

the option buyer.

honour the transactions.

Options, thus offer the buyers an unlimited

gain potential while at the same time, limiting
their losses.
Barring USD/INR options, the buyer can

Forwards help in capping the losses at the cost

of limiting the gain potential.
Forwards, in this regard, are inflexible.

choose from a variety of exotic options.

Due the flexibility which they offer, Options

command a higher premium compared to a
Forward contract. This premium is generally
paid upfront at the time of writing an option.

An option gives best of both the worlds.

Factors like the Spot Rate, Strike Rate,
Volatility, etc. are crucial in determining the
price of an Option.

Forward rates are calculated after

incorporating the interest rates of the
countries to prevent arbitrage.

Forward affirms the opportunity loss.

Forwards are generally considered as a

function of interest rate differential between
two countries. In India however, Forwards are
influenced by Demand and Supply.

The derivative structures which are presented to corporate by the banks comes to us for analysing the
same and find out whether the structure forwarded can be entered or not under the current scenario
and minimise the risk involved in the structure by way of reducing the premiums or increasing the profit
margin for the clients. These structures are unique to foreign currency derivatives. One of the reasons
why they are unique is because these structures have been created for some specific purpose by the
banks. Another interesting fact to be noted is that even the names of these structures may be

159

recognised only by the Indian Banks! The same structures may be known by a totally different name
elsewhere in the world!
The following are the renowned option structures which are quite frequently used:
In case of Plain Vanilla Options:
1) Sea Gull Structure
2) Range Forward Structure
3) Zero Cost Structure
In case of Exotic Options:
Barrier Options could be Single Barrier options or Double Barrier Options.
It may also be noted that both the barrier options can further be classified into Knock-In Option and
Knock-Out Option.
Sea Gull Structure:
Term Sheet:
Buy USD Put INR Call 1 Mio @ 43.65
Sell USD Call INR Put 1 Mio @ 44.00
Sell USD Put INR Call 1 Mio @ 43.25

Table 1.3

Sea Gull

160

Buy USD put INR Call

Duration

USD 5 Mio @ 43.65

6
months

Sell USD call INR put

USD 5 Mio @ 44.0000
Sell USD put INR call
USD 5 Mio @ 43.2500

Spot on Maturity
Spot Rate

Payoff

Spot

Payoff

Rate

Spot

Payoff

Rate

Spot

payoff

rate

44.01

-0.01

43.64

0.01

43.66

-0.34

43.24

0.4

44.02

-0.02

43.63

0.02

43.67

-0.33

43.23

0.4

44.03

-0.03

43.62

0.03

43.68

-0.32

43.22

0.4

44.04

-0.04

43.61

0.04

43.69

-0.31

43.21

0.4

44.05

-0.05

43.6

0.05

43.7

-0.3

43.2

0.4

44.06

-0.06

43.59

0.06

43.71

-0.29

43.19

0.4

From the above spreadsheet, it can be seen that for depreciation of every paisa above the 44.00 levels,
we incur an additional loss to the extent of 1 paisa.
Likewise, at all levels between the 43.25 and 43.65 level, we incur an additional gain to the extent of 1
paisa.
Similarly, at all levels between the 43.65 and 44.00 level, we incur a loss to the extent of:
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(Higher strike Middle Strike) - (Spot Rate Middle Rate)

In this illustration, it is (44.00 43.65) (43.66 43.65) = 0.34 and so on.
At all levels below the 43.25 levels, the gain is to the extent of 40 Paisa.
Thus, in the context of the above example, it can be said that the Best Rate that we would be able to sell
our Dollars is 44.00. At the same time, we can also infer that the Worst Rate would be Spot Rate + 40
Paisa.
OPTION PRICING TECHNIQUES:
The Black and Scholes Model:
The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out
working to create a valuation model for stock warrants. This work involved calculating a derivative to
measure how the discount rate of a warrant varies with time and stock price. The result of this
calculation held a striking resemblance to a well-known heat transfer equation. Soon after this
discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing
model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved
version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of
Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the
risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding
investor's risk preferences.

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In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the
expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the
change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second
part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration
day. The fair market value of the call option is then calculated by taking the difference between these
two parts.
Assumptions of the Black and Scholes Model:
1) The stock pays no dividends during the option's life
Most companies pay dividends to their share holders, so this might seem a serious limitation to the
model considering the observation that higher dividend yields elicit lower call premiums. A common
way of adjusting the model for this situation is to subtract the discounted value of a future dividend
from the stock price.
2) European exercise terms are used
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European exercise terms dictate that the option can only be exercised on the expiration date. American
exercise term allow the option to be exercised at any time during the life of the option, making american
options more valuable due to their greater flexibility. This limitation is not a major concern because very
few calls are ever exercised before the last few days of their life. This is true because when you exercise
a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the
end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.
3) Markets are efficient
This assumption suggests that people cannot consistently predict the direction of the market or an
individual stock. The market operates continuously with share prices following a continuous It process.
To understand what a continuous It process is, you must first know that a Markov process is "one
where the observation in time period t depends only on the preceding observation." An It process is
simply a Markov process in continuous time. If you were to draw a continuous process you would do so
without picking the pen up from the piece of paper.
4) No commissions are charged
Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay
some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial
and can often distort the output of the model.
5) Interest rates remain constant and known
The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality
there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with
30 days left until maturity is usually used to represent it. During periods of rapidly changing interest
rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the
model.
6) Returns are lognormally distributed
This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable
for most assets that offer options.
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The Black and Scholes Model:

Delta:

Delta is a measure of the sensitivity the calculated option value has to small changes in the share price.
Gamma:

Gamma is a measure of the calculated delta's sensitivity to small changes in share price.
Theta:

Theta measures the calcualted option value's sensitivity to small changes in time till maturity.
Vega:

Vega measures the calculated option value's sensitivity to small changes in volatility.
Rho:

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Graphs of the Black and Scholes Model:

This following graphs show the relationship between a call's premium and the underlying stock's price.
The first graph identifies the Intrinsic Value, Speculative Value, Maximum Value, and the Actual
premium for a call.

The following 5 graphs show the impact of deminishing time remaining on a call with:
S = $48
E = $50
r = 6%
sigma = 40%
Graph # 1, t = 3 months
Graph # 2, t = 2 months
Graph # 3, t = 1 month
Graph # 4, t = .5 months
Graph # 5, t = .25 months

166

Graph #1

Graph #2

167

Graph #3

Graph #4

168

Graph #5

Graphs # 6 - 9, show the effects of a changing Sigma on the relationship between Call
premium and Security Price
S = $48
E = $50
r = 6%
sigma = 40%
Graph # 6, sigma = 80%
Graph # 7, sigma = 40%
Graph # 8, sigma = 20%
Graph # 9, sigma = 10%

Graph #6

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Graph #7

Graph #8

170

Graph #9

CHAPTER 9

INTRODUCTION TO SWAPS
INTRODUCTION

Swaps have been growing at a mind boggling rate. The market is designing creative and
complex structures to provide tailor-made solutions. The regulators are unable to design
systems to effectively assess risks involved in these transactions. Today the term swap
financing is used to describe a funding and a currency exposure management technique. It
enables corporations, agencies and institutions to cope with the problems of fluctuating rates,
imperfect capital markets, restrictive exchange control regulations and accounting standards.
Swaps are derivatives, which involve a private agreement between two parties to exchange
cash flows in the future according to a prearranged formula. The underlying instruments are
liabilities or assets with interest expenses or incomes. Swap is essentially a derivative used for
hedging and risk management.
Historically, swaps had been arranged opportunistically when two companies had requirements, which
are exactly equal and opposite. The first recorded swaps were negotiated in 1982. Since then, the
markets have grown very rapidly. The expansion in the swap market has occurred in response to the
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challenging phenomena, which have characterized financial markets today arbitrage opportunities, tax
regulations, capital controls, etc., as a result of market imperfection, need for protection against interest
rate and exchange rate risk, improvements in computer technology and increasing integration of world
capital markets. Thus, swaps are powerful tool propelling global capital market integration.
The diverse requirements of corporate treasurers, bank liability managers, finance minister and portfolio
manage account for the rapid growth of the swap market. A currency swap involves exchange of
principal and interest payments in two different currencies between two different parties. Swaps are
privately negotiated customized transactions; swaps are off balance sheet transactions and have grown
at a phenomenal rate. In a currency swap, one party agrees to exchange principal and make regular
interest payments in one currency to a counter party for principal and periodic interest payments in
another currency. Swaps are useful in hedging exchange rate and interest rate risks by taking
advantages of arbitrage opportunities that arise due to the prevailing imperfections in the capital
market.
The interest rate swap market, in which borrowers contract to exchange interest rate payments, has
grown substantially in recent years. These instruments are used by financial managers to reduce
borrowing costs, increase asset returns, or hedge interest rate risk. Major market participants include
commercial and investment banks, which both use and deal in swaps, securities firms, savings and loan
institutions, corporations and government agencies.

BACKGROUND
Many literatures has demonstrated that gaps which are computed as functions of the duration
of assets and liabilities are more meaningful and useful measures of interest rate risk exposure
for depository institutions than are the simpler and more commonly used maturity gaps.
Bierwag and Kaufman (1992) derived duration gaps for depository institutions for economic net
worth of economic net income, and book value interest income. They extended duration gaps
to off balance sheet accounts including futures contracts and swap agreements and show the
sensitivity of the market value of net worth and income measures to interest rate fluctuations.
Bierwag, Kaufman, and Toeys (1983) reviewed the historical development of duration and it
uses in summarizing in one variable the cash flow characteristics of bonds, approximating the
price sensitivity of bonds, and developing bonds portfolio strategies, particularly those that
attempt to immunize against interest rate risk. In all these uses, duration has shown to be
superior to term to maturity. By the Macaulay measures, duration performs reasonably well in
comparison to its more sophisticate counterparts and, because of its simplicity appears to be
cost-effective. For portfolio managers who wish to immunize portfolios of bonds against
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interest rate risk, or who wish use duration in formulating active strategies single factor models
should outperform nave maturity models while matching the performance of more complex
multifactor models.
Yawitz, Kaufold, Macirowki, and Smirlock (1987) examined the pricing and duration of floating rate
bonds that have experienced changes in credit risk. They showed that the price of a floater whose credit
risk has changed can be viewed as equal to the face value of the bond minus an annuity the investor is
short if credit risk has increased and vice-versa.

In the general, larger companies are more active in the swaps market than smaller ones, and
treasures are more likely to transact swaps than accountants. Most companies tend to transact
swaps fairly regularly as business circumstances change, such as cash flow profiles, the funding
structure and business strategies. Once a company has transacted one swap, the many uses of
the market normally result in a company transacting many more, with about 60 per cent of
companies having transacted more than ten swaps.
Interest-rate swaps are used more than currency swaps, partly because the foreign exchange
market can sometimes be used instead of the currency swaps market. Non-users of the market
are often newly established enterprises where it is more important to get markets and products
right rather than treasury policy. Most non-users, however, agree with users that there are
positive benefits to be gained from using the market.
Table 1
Size comparison
No. of swaps
Type of swap
No. with master
agreements
Never revalue
Sector
Problems

Small
2-10
Interest rate swap (IRS)
57%

Large
Over 10
IRS and currency swap
91%

57%
Capital goods/properly
Complicated/legal

15%
Consumer
Tax/counterparty risk

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Most companies have ISDAs (master agreements with standard terms and conditions) agreed
with banks, from just one bank to as many as 30 to 40 banks. This makes it very easy to transact
a swap, as just a phone call is required to arrange the swap. Normally three quotes are
obtained from banks by companies before entering into a swaps contract, to ensure that prices
are reasonable and the deal is transacted with the cheapest bank. Counterparty credit is of
some concern and for a swap of less than about ten years; a bank with an AA or better credit
ratings is normally required.
There is an enormous difference in the sophistication of different users in the market. Very
active participants speak to each bank at least once a month and very often will speak to five or
six banks a day. These participants are maintaining relationship and are also obtaining
information on how aggressive each bank is to receive or pay a fixed rate of interest or
currency. Thus, when the company needs to do a swap it has already engaged in an extensive
pre-marketing campaign and will contact those banks which it already knows will be in a
position to offer a competitive price. These users often find the prices quoted by banks are very
close, with perhaps just one or even no basis points difference between them. Less frequent
users of the market, however, find that prices can vary quite widely between banks. This may
be because these companies are not aware of how each banks swaps book is placed to know
which banks to phone for favorable prices, and maybe also the banks try to earn an extra basis
point or two from infrequent and less sophisticated users. In general, though, whether a
company is a small or a large user, it pays to shop around to obtain several prices before
determining which bank to deal with. After phoning for a quote, companies normally expect to
be called back within about 10 to 25 minutes with a price. For very complex structures deals a
price may be expected early the next day. It is normally good practice to complete a swap
before 4 pm as the swaps market is not so efficient after the futures market closes.
Although the majority of participants transact only plain vanilla deals, A plain vanilla deal is a
simple, straightforward deal with no complexities as one stated we believe in the KISS (keep it
simple, stupid) approach, 28 per cent have done exotic swaps, such as amortizing and zero
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coupon swaps, which were by far the most commonly cited exotic swaps used by respondents.
The general view is that it is better to use plain vanilla instruments and to build up the required
hedge using a number of vanillas. Beware of banks salesmen trying to sell new financial
products! However, using plain vanillas can be less convenient and so exotics are very useful in
certain circumstances. Banks price exotics by building up all the vanilla elements themselves
and a company should understand the breakdown of the exotic and all the possible outcomes
of the transaction under a number of different scenarios. This may be of interest rates
doubling, trebling, halving or not changing or of there being a dramatic movement in exchange
rates. Sterling suffered in the ERM crisis of September 1992 and rates went from /DM
2.95down to about /DM 2.2 today. Some companies have stories to tell of ding swaps and
fixing their interest payments when rates were at 15 per cent and expected to rise. The
transactions at the time were done for very sensible commercial reasons, but there has to be
awareness that rates may change dramatically from the levels expected! As one financial
manager stated, Swaps and other derivatives are very risky if accompanied by inadequate back
office controls and systems, poor understanding by senior management of risk management
policy and a failure to articulate a clear policy and strategy to guide the actions of the treasury
department.
Generally, companies do not have any problems about using the swaps market. They do not
consider there to be any legal, accounting, regulatory or tax problems and they do not think
that they are costly, complicated or difficult to arrange. Counterparty risk is not a problem,
provided that swaps are transacted with reputable financial institutions.
Interest rate swaps are thought to be very efficient and the pricing is realistic. There are lots of
quotes available in a very competitive market, and there is certainty of the outcome of swap
transactions. The minimum size of a swaps transaction has declined in size from 5m just a few
years ago to no minimum size at all now. This reduction in the minimum size of swaps has
therefore attracted some smaller companies into the market. Interest-rate risk management

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and are the preferred product to use by many companies. Interest rate swaps are also off
balance sheet.
Other derivative instruments are used by corporations, especially options, FRAs and foreign
exchange forwards. Futures are not used as regularly. There were very mixed views about
options, some companies thought that they were very cheap and others that they were too
expensive.
Bierwag, Kaufman, and Toeys (1983) reviewed Factor analysis, using a principal components
approach, revealed that there are essentially five reasons for doing swaps. First, there are the
sophisticated uses such as exposure management and synthetics. Second are sues involved in
a new issue of finance, such as the ability to do a swap immediately and to obtain a cheaper
funding cost. The third factor was related to restructuring the existing debt profile of the
company, such as switching from fixed to floating rate finance, unlocking high coupon debt and
that a swap is cheaper than refinancing. The fourth reason related to exploiting market
imperfections or arbitrage strategies. Finally, there was risk separation, enabling the
separation of risks such as interest rate risk from their own risk premium and unbundling the
funding decision from the payment decision. As one commented, Probably (one of) the most
important inventions to come out of the financial community in the last 15 year is the ability to
separate interest rate risk from debt maturity. Its a godsend to treasurers. Table 2 summarizes
the use of swaps. Using swaps to match asset and liability cash flows and managing the balance
sheet better is by far the most important. Most financial managers use the market for interest
rate risk management and matching asset and liability cash flows.
Ten companies were selected in ten different industrial sectors and different geographical
areas. They included two non-users, seven users and one who stated that it would not use
swaps again. There were three subsidiaries and seven head offices, highly geared companies
and lowly geared companies and six users of exotic swaps. Table 3 summarizes the findings
from these visits.
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Table 2 Uses of swaps

Managing the balance sheet and matching asset and liability cash flows
Obtaining finer terms in raising new finance
Restructuring the balance sheet around existing asset and liability structures
Exploiting arbitrage opportunities
Separating risks to enable more effective risk management of the individual risk
components

The swaps market has seen enormous growth since its inception in 1981 because financial
managers have found many uses of the market and do not think there are any major problems.
As one treasurer explained, As in individual who was a treasurer before swaps existed, the
contrast in the before and after is quite extraordinary. How did we do our job without their
existence?

The BCG growth-share matrix displays the various business units on a graph of the market growth rate
vs. market share relative to competitors:

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BCG Growth-Share Matrix

Relative Market Share

High

Low

High
Indian Swap Market

Market Growth Rate

International Swap Market

Low

Resources are allocated to business units according to where they are situated on the grid as
follows:
Cash Cow - a business unit that has a large market share in a mature, slow growing
industry. Cash cows require little investment and generate cash that can be used to
invest in other business units.
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Star - a business unit that has a large market share in a fast growing industry. Stars may
generate cash, but because the market is growing rapidly they require investment to
maintain their lead. If successful, a star will become a cash cow when its industry
matures.
Question Mark (or Problem Child) - a business unit that has a small market share in a
high growth market. These business units require resources to grow market share, but
whether they will succeed and become stars is unknown.
Dog - a business unit that has a small market share in a mature industry. A dog may not
require substantial cash, but it ties up capital that could better be deployed elsewhere.
Unless a dog has some other strategic purpose, it should be liquidated if there is little
prospect for it to gain market share.

According to this growth matrix International Swap market can be placed at Stars Position as it
large market share in a fast growing industry. As market is growing rapidly they require
investment to maintain their lead. If successful,
Similarly Indian Swap Market can be placed at Question mark position as it has a small market
share in a high growth market. it require resources to grow market share, but whether they will
succeed and become stars is unknown.
In India there are certain factors which are forcing the market upwards and certain obstacles
which prevent the market to grow. The situation of India can be explained through Deriving
and restraining forces with the help of Kurtin Lewin Model which is explained to show the
driving forces and restraining forces. These are the pairs of opposites in which driving forces
push the growth of ones market forward and on the other hand restraining forces push the
growth backward.
In the context of swap market in India following can be summarized in Kurtin lewin model:

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Driving forces
1. Creates link between distinct
Markets or firms with differential

Restraining Forces
1. Non availability of
acceptable bench mark.

access to fund sources.

2. Provide a way to reduce total funding

cost of debt.

3. Flexible and convenient way for companies

to manage balance sheet.

4. Minimize the cost of regulation and tax

2. Lack of developed
term Money Market

3. Lack of active market

for floating loans

4. Non availability of
variety of acceptable

yield curves

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Types of Swap:

Interest Rate Swap (IRS)

Coupon Only Swap (COS)
Principal Only Swap (POS)
Currency Coupon Interest Rate Swap (CCIRS)

Swap Mechanism:

Swap involves exchange of a floating to fixed interest rate or fixed to floating interest rate.
Figure 1.8
Plain

Pays Fixed Rate

Corporate

Bank
Receives Floating Rate

Vanilla
Interest
Rate Swap:

The corporate has taken a loan of $ 1 mio at 6 month LIBOR rate for 3 years. So in order to minimise the
cost, the corporate enters into a Swap. The client enters into an agreement to receive 6 month LIBOR
and pay a fixed rate of 3.50% per annum for 3 years on a notional principal of $ 1 mio.

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Table 1.6
Cash Flow in an IRS:

Corporate
Date

Corporate Pays

Net Flow

Receives
15-Oct-06

5.22%

3.50%

1.72%

15-Apr-07

5.40%

3.50%

1.90%

15-Oct-07

5.14%

3.50%

1.64%

15-Apr-08

4.78%

3.50%

1.28%

15-Oct-08

4.83%

3.50%

1.33%

15-Apr-09

4.77%

3.50%

1.27%

15-Oct-09

4.85%

3.50%

1.35%

So, eventually the client ends up paying only 3.50% on $ 1 mio for the tenor of the underlying. In this
way, the cost of borrowing can be reduced by entering into a Swap transaction.

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CURRENCY SWAPS

A currency swap can be looked upon as any transaction undertaken to eliminate (or hedge) either
partially or fully, the financial consequences of movements in foreign exchange rates or to substitute
exposure to one currency for exposure to another. These consequences relate either to the assets and
liabilities of the institution or to its revenues and expenses. The need for currency swaps derives from
foreign exchanges risks, which can be, identified under two main headingsi) Accounting /Translation Exposure
ii) Transaction Exposure.

Accounting Exposure also known as translation exposure arises because MNCs may wish to translate
financial statements of foreign affiliates into their home currency in order to prepare consolidated
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financial statements or to compare financial results. As investors all over the world are interested in
home currency values, the foreign currency balance sheet and income statement are restated in the
parent countrys reporting currency. For example, foreign affiliates of US companies must restate the
franc, sterling or mark statements into US dollars so that the foreign values can be added to the present
US dollar denominated balance sheet and income statement. This accounting process is called
translation.
Translation exposure measures the effect of an exchange rate change on published financial statements
of a firm. Assets and liabilities that are translated at the current exchange rate are considered to be
exposed, as the balance sheet will be affected by fluctuations in currency values over time; those
translated at a historical exchange rate fluctuations. So, the difference between exposed assets and
exposed liabilities is called translation exposure.
Under the generally accepted US accounting principles, the net monetary asset position of a subsidiary
is used to measure its parents foreign exchange exposure. The net monetary asset position is monetary
assets such as cash and accounts receivable minus monetary liabilities such as account payable and
long-term debt.

Translation Exposure = Exposed Assets Exposed Liabilities

Four methods of foreign currency translation have been developed in various countries.
1. The current rate method
2. The monetary/non-monetary method
3. The temporal method
4. The current/non-current method
Transaction exposure arises whenever a company is committed to a foreign currency denominated
transaction entered into before the change in exchange rate. Transaction exposure measures the effect
of an exchange rate change on outstanding obligations, which existed before the change, but were
settled after the exchange rate change. Transaction exposure, thus, deals with changes in cash flows
that result from existing contractual obligation due to exchange rate changes.
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Of the four categories to be discussed below, straight currency swaps and exchange of borrowings are
what constitute the modern form of the swap. A currency swap structure also allows for interest rate
differential between the two currencies via periodic payments rather than the lump sum reflected by
forward points used by the foreign exchange market. This enables the swap structure to be customized
to fit the counter parties exact requirements at attractive rates. For e.g. the cash flows often underlying
bond issue may be matched exactly and invariably at much finer rates then those available on the
foreign exchange market.

The currency swap can take the form of the

Parallel or back-to-back loans
Straight currency swap
Long-term forward exchange contract cover
Exchange of borrowings

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MULTIPLE CHOICE QUESTIONS

i.

The value of an option depends on the stock's price, the risk-free rate, and the

a. Exercise price.
b. Variability of the stock price.
c. Option's time to maturity.
d. All of the above.
e. None of the above.

ii.

An option which gives the holder the right to sell a stock at a specified price at some time in the
future is called a(n)

a. Call option.
b. Put option.
c. Out-of-the-money option.
d. Naked option.
e. Covered option.

iii. There are call options on the common stock of XYZ Corporation. Which of the following best
describes the factors affecting the value of these call options?

a. The price of the call options is likely to rise if XYZs stock price rises.
b. The higher the strike price on the call option, the higher the call option price.
c. Assuming the same strike price, a call option which expires in one month will sell for a
higher price than a call option which expires in three months.
d. All of the answers above are correct.
e. None of the answers above is correct.

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iv.

Which of the following statements is correct?

a. Put options give investors the right to buy a stock at a certain exercise price before a
specified date.
b. Call options give investors the right to sell a stock at a certain exercise price before a
specified date.
c. Options typically sell for less than their exercise value.
d. LEAPS are very short-term options which have begun trading on the exchanges in recent
years.
e. Option holders are not entitled to receive dividends unless they choose to exercise their
option.

v.

An investor who writes call options against stock held in his or her portfolio is said to be selling
___________ options.

a. in-the-money
b. put
c. naked
d. covered
e. out-of-the-money

vi.

Suppose you believe that Du Pont's stock price is going to decline from its current level of
$82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put option
giving you the right to sell 100 shares at a price of $83.00 per share. If you bought a 100-share
contract for $510.25 and Du Pont's stock price actually dropped to $63.00, you would make

a. $1,950.00
b. $1,439.75
c. $1,489.75
d. $2,000.00
e. $2,435.00
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vii. Which of the following statements about interest rate and reinvestment rate risk is correct?

a. Variable, or floating rate, securities have a high degree of interest rate (price) risk.
b. Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while
reinvestment rate risk is the risk of earning less than expected when interest payments or
debt principal are reinvested.
c. Price risk can be eliminated by purchasing zero coupon bonds.
d. Reinvestment rate risk can be eliminated by purchasing variable, or floating, rate bonds.
e. All of the statements above are correct.

viii. A commercial bank estimates that its net income suffers whenever interest rates increase. The
bank is looking to use derivatives to reduce its interest rate risk. Which of the following
strategies best protects the bank against rising interest rates?

a. Buying inverse floaters.

b. Entering into an interest rate swap where the bank receives a fixed payment stream, and in
return agrees to make payments that float with market interest rates.
c. Purchase principal only (PO) strips that decline in value whenever interest rates rise.
d. Enter into a short hedge where the bank agrees to sell interest rate futures.
e. Sell some of the banks floating rate loans and use the proceeds to make fixed rate loans.

ix.

Company A can issue floating rate debt at LIBOR + 1 percent and can issue fixed rate debt at 9
percent. Company B can issue floating rate debt at LIBOR + 1.4 percent and can issue fixed rate
debt at 9.4 percent. Suppose A issues floating rate debt and B issues fixed rate debt. They
engage in the following swap: A will make a fixed 7.95 percent payment to B, and B will make a
floating rate payment equal to LIBOR to A. What are the resulting net payments of A and B?

a. A pays a fixed rate of 9 percent, B pays LIBOR + 1.5 percent.

b. A pays a fixed rate of 8.95 percent, B pays LIBOR + 1.45 percent.
c. A pays LIBOR plus 1 percent, B pays a fixed rate of 9.4 percent.
d. A pays a fixed rate of 7.95 percent, B pays LIBOR.
e. None of the answers above is correct.

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x.

Deeble Construction Co.s stock is trading at $30 a share. There are also call options on the
companys stock, some with an exercise price of $25 and some with an exercise price of $35. All
options expire in three months. Which of the following best describes the value of these
options?

a. The options with the $25 exercise price will sell for $5.
b. The options with the $25 exercise price will sell for less than the options with the $35
exercise price.
c. The options with the $25 exercise price have an exercise value greater than $5.
d. The options with the $35 exercise price have an exercise value greater than $0.
e. If Deebles stock price rose by $5, the exercise value of the options with the $25 exercise
price would also increase by $5.

xi.

Which of the following are not ways in

management can increase the value of a company?

which

risk

a. Risk management can increase debt capacity.

b. Risk management can help a firm maintain its optimal capital budget.
c. Risk management can reduce the expected costs of financial distress.
d. Risk management can help firms minimize taxes.
e. Risk management can allow managers to maximize their bonuses.

xii. A swap is a method for reducing financial risk. Which of the following statements about swaps,
if any, is incorrect?

a. A swap involves the exchange of cash payment obligations.

b. The earliest swaps were currency swaps, in which companies traded debt denominated in
different currencies, say dollars and pounds.
c. Swaps are generally arranged by a financial intermediary, who may or may not take the
position of one of the counterparties.
d. A problem with swaps is the lack of standardized contracts, which limits the development of
a secondary market.
e. All of the statements above are correct.
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xiii. Which of the following statements is most correct?

a. One advantage of forward contracts is that they are default free.

b. Futures contracts generally trade on an organized exchange and are marked to market daily.
c. Goods are never delivered under forward contracts, but are almost always delivered under
futures contracts.
d. Answers a and c are correct.
e. None of the answers above is correct.

xiv. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80-07. If
annual interest rates go up by 1 percentage point, what is the gain or loss on the futures
contract (assume $1,000 par value)?

a. Loss of $78
b. Gain of $78
c. Loss of $145
d. Gain of $145
e. None of the above

190

191