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Introduction to Financial Markets

Financial Markets Education


Financial Markets Education
Financial Markets Education provides instruction on all aspects
of banking and finance for UBS employees and for our top
clients.

Europe United States APAC

Joe Troccolo Joe Bonin Onn Chan


London Stamford Singapore
+44 20 7568 0735 +1 203 719 6507 +65 6836 5708
joe.troccolo@ubs.com joe.bonin@ubs.com onn.chan@ubs.com

Walter Braegger Kai-Hing Lum


London Tokyo
+44 20 7568 8938 +81 352 08 6494
walter.braegger@ubs.com kai-hing.lum@ubs.com

Spencer Morris
London
+44 20 7568 8938
spencer.morris@ubs.com

1
This class

♦ Introduction
♦ Issuers & Investors
♦ Equities and Indexes
♦ Fixed Income Markets
♦ Foreign Exchange Markets
♦ All About UBS

2
Markets

♦ Market: an institution joining buyers and sellers


[need not be “a” location]
♦ Who are the buyers and sellers?
♦ Financial markets are mechanisms for the flow of
– money
– risk

3
Markets: the buyer, the seller & the price

♦ How much would you pay for this ticket?

♦ What is its fair value?

4
Value and price – the official definition

♦ Fair market value. Fair market value is the price that [property] would sell
for on the open market. It is the price that would be agreed on between a
willing buyer and a willing seller, with neither being required to act, and both
having reasonable knowledge of the relevant facts.

5
A market price

6
A stock market, then

“Sshh!”

“Buy! Sell! Buy! Sell!”

7
And now (the information processor)

8
Who are the players?

♦ Who are the players in the financial markets?

9
And what do they do?

♦ Why do they need to be involved in the financial markets?

10
Financial Markets – a model
Liabilities

Individuals Corporates Governments

Mortgages Debt and Risk


Commercial equity
and personal transformation
loans issuance
loans products

Securities & money


Banks markets ‘Hedging’ Markets
-commercial and retail banks -cash, CP, bonds, equities -foreign exchange
-deposit-taking institutions -primary and secondary markets -interest rates derivatives
-(inc. building societies in UK) -disintermediation of banks -equity derivatives
-origination and distribution
-brokers and dealers
Debt and Risk
equity transformation
Deposits purchases products

Asset Managers
-pension funds
-insurance companies
-mutual funds / unit trusts (CIVs)

Assets

Individuals Corporates Governments

11
What is a Bank?

♦ Retail banking - cheque drawing account


♦ Private banking - for wealthier clientele
♦ Commercial banking - business accounts
♦ Investment banking
– Raising capital/Issuing securities
– Brokerage/execution
– Advisory services

12
Products: Banking Finance

♦ Loans
– term loans
– revolving facilities

13
Products: Money and securities Markets

♦ Cash
♦ Treasury Bills
♦ Commercial paper
♦ Government Bonds
♦ Corporate Bonds
♦ Ordinary shares
♦ Preference shares
♦ Convertible Bonds and other ‘Equity-linked’
♦ Structured Products

14
‘Hedging’ markets

♦ Foreign Exchange
– spot
– forward
– options
– exotics

♦ Interest rates
– FRAs, futures and swaps
– interest rate options
– bond forwards, futures and options

♦ Equities
– equity swaps
– stock options
– index swaps
– index options

15
Financial markets: Who are the players?

♦ Companies ♦ Investment funds


♦ Governments ♦ Hedge funds ‘Fund
♦ Municipals ♦ Brokers managers’

♦ Agencies ♦ Dealers ♦ Pension funds

♦ Supranationals ♦ Market-makers ♦ Private Equity funds & “sponsors”

♦ Financial ♦ Insurance companies


Institutions ♦ Commercial banks
♦ Central banks (increasingly)
♦ Private banks
♦ Regulators
♦ Charities
♦ Exchanges
♦ Individuals (through Private Banking)
♦ Central banks

16
Issuers & Investors
Financial Markets Education
Introduction

♦ Issuers ♦ Investors
♦ Those who want to raise ♦ They are “lending” or investing
capital are the issuers
♦ They buy
♦ They “issue” – Money market instruments
– Loans – Bonds, share etc DIRECTLY and
– Bonds – Through funds – pools of money
– Preferred Stock
♦ They are concerned with
– Equity
– Return
– Convertible Bonds
– Preservation of capital
♦ They are concerned with – Risks
– Amount – Market
– Maturity for loans and bonds – Credit
– Cost
– Fraud
– Market value
– Share price
– Credit rating
– Investor base

1
Issuers - Companies
What do companies do?

Bond Debt
holder Assets
capital

Share Share
holder capital

Profits

3
Corporate clients - Shareholder value

Shareholder Value
Shareholder
– measures business activities by the Value
value they add to the owners of
the company
– framework for analysing our own Return on
activities and those of our clients Cost of Capital
Capital
– other business drivers serve to
achieve this one

“ “... any investment project and its


concomitant financing plan must
pass only the following test: Will the

“ “We raise capital to make concentrate


project, as financed, raise the market
value of the firm’s shares? If so, it is
and sell it at an operating profit then worth undertaking; if not, its return
we pay the cost of capital.Share-holders is less than the marginal cost of
pocket the difference” capital to the firm.”

Roberto Goizueta, former Chairman & CEO,


” Merton Miller and Franco Modigliani

Coca-Cola Company 1958
Corporate activity & shareholder value

Improve operating Measure and Reduce


performance cost of capital
– Sales growth – Capital structure
– Operating performance – Tax structure
– Investment decisions – Dividend policy
– Sensible Management – Financial management

Buying Raising, repaying


companies Debt or refinancing
or divisions debt
Assets
Selling Raising or
companies Equity buying back
or divisions equity

5
Example - M & A

6
Example - Selling a Company

7
From Debt to Equity

Typical “single A” corporate capital structure

Debt Equity

Loans Bonds Preference


shares

Senior debt

8
Source: UBS DCMG
Debt equity Spectrum

♦ In a bankruptcy, holders of subordinated debt are repaid after the senior bank
lenders

Secured Debt

Unsecured Debt
Subordinated Debt
Seniority

Cost
Hybrid
Preferred Shares
Common Shares

♦ Holders of subordinated debt rank above equity investors


♦ Equity investors only have a residual claim

9
Disney Bonds

10
Disney Bond

11
High-Yield Ford Bond

12
Ford Bond

13
Why do people issue equity?

Funding M&A /
major expansion

Need cash to pay


down debt

Selling stakes in
companies
they own (privatisation)

Giving a
subsidiary autonomy

Exit from a
financial or strategic
investment

14
Initial Public Offering (IPO)

15
Initial Public Offering (IPO)

16
Equity issuance

Follow-on
IPO
(Marketed)

Block /
Equity-linked Accelerated
trades

17
Tesco - Case Study
Case Study - TESCO

♦ Largest retailer in the UK


♦ More than 30% market share UK

Source: Reuter’s 26/07/2006

19
TESCO

20
TESCO Strategy

21
UK Business

22
Market Rewards Performance

23
TESCO Shares are a Popular Investment

24
Lend £ to TESCO?

25
Debt Financing
O n B a la n c e S h e e t D e b t M a t u r it ie s
T h is in f o r m a t io n w a s c o r r e c t a s a t 2 6 t h F e b r u a r y 2 0 0 5

800

700

600

500
Millions (£)

400

300

200

100

0
6

2
-0

-0

-1

-1

-1

-1

-1

-2

-2

-2

-2

-2

-3

-3
eb

eb

eb

eb

eb

eb

eb

eb

eb

eb

eb

eb

eb

eb
F

F
Y e a r to F e b ru a ry
D e b t M a tu r i n g i n Y e a r C ash

26
TESCO’s Credit Rating

27
Investors - Funds
The theory behind

WHAT THE THEORY SAYS WHAT THE ASSET MANAGER ADDS


♦ Capital asset pricing theory ♦ What is the market
♦ The optimal portfolio is part risk free ♦ Who creates the market portfolio
asset and part market portfolio
♦ Should incorporate superior information
♦ The proportions depend on how risk
averse you are ♦ Harvesting the asset premium is good
♦ Adding superior market information is
better
♦ The two words: Beta & Alpha
♦ The quant adds: Tracking Error

29
What is Equity Risk?

30
Diversification – How to earn an asset premium

♦ The higher the number of different stocks in the portfolio, the more company-
specific risks are eliminated

Risk

Market- AND company-specific


risk of the portfolio

Company-
specific risk
Market Risk
Number of Stocks Owned

31
The FTSE 100 Index

32
Diversification

Diversification works better in quiet times

33
SECTION 4

The Fund Industry


You are an investor

♦ With 100m to invest


♦ What will you buy?

35
Some Possibilities

♦ Deposit the money with the Government


♦ Deposit the money with a bank
♦ Buy Government bonds
♦ Buy commercial paper
♦ Buy corporate bonds
♦ Lend money to one company
♦ Buy equities
♦ Buy private equity
♦ Build your own wind turbine in Scotland
♦ Buy 100m lottery tickets

36
Some Fund types

♦ Money-market funds ♦ Pension Funds


♦ Government bond funds ♦ Life funds
♦ Corporate bond funds ♦ Hedge funds
♦ High yield bond funds
♦ Emerging market bond funds
♦ Index tracking equity funds
♦ Small-cap equity funds
♦ Equity ‘growth’ funds
♦ Private equity funds

37
Spoilt for Choice

38
Many Alternatives

39
Funds

♦ Collect assets together – economies of scale


♦ Have performance objectives
– Benchmarks or Absolute
– Risk
– Return

♦ Are sold to various clients


– Retail funds – to individuals
– Institutional funds - to pension funds, endowments
– Hedge Funds – typically to institutions and HNW individuals

40
Investment Funds

♦ Open ended collective investments


♦ Investors participate by buying shares in the funds
♦ US - Mutual Funds
♦ UK – OEICs & Unit Trusts
– subject to the same regulation
– OEIC is more flexible and simplified alternative
– OEIC has 'Umbrella' fund structure
– many 'sub-funds' with different investment objectives.
– Easier to move between different OEICs in the same management group

41
Investment Funds

♦ Traditional Funds are organised around styles:


– sectors
– growth
– value
– large, small, mid cap

♦ Traditional funds have:


– benchmarks
– economies of scale

♦ Traditional Funds
– try to minimise fees and costs to stay competitive

♦ Are easily accessible and mostly open to new investors

42
Case Study: UBS (Lux) Equity Fund

♦ Investment objective
– Achieve high growth and adequate earnings
– Due considerations to capital security and liquidity of assets
– Minimum investment in equities: 70%

♦ Fund type:open-end investment fund


♦ Domicile of fund:Luxembourg
– Portfolio management:UBS Asset Management
– Management Company:UBS Equity Fund Management Company S.A.
– Custodian bank:UBS (Luxembourg)S.A.

43
Example UBS (Lux) Equity Fund - Legal

♦ Entire assets of each subfund are undivided property of all investors in


subfund
– Equal rights in proportion of units hold

♦ Fund assets are separate from the assets of the Management Company.
♦ Assets of subfund can only be used to offset liabilities of subfund
♦ Assets are managed by the Management Company in the interest and for the
account of the unitholders.

44
UBS (Lux) Equity Fund – EURO STOXX 50

♦ Benchmark: STOXX 50 ♦ Fund’s assets (Dec 04)


– EUR 1,270,360,000
♦ Fund weightings not necessarily identical
with benchmark
♦ Weightings determined by
– Strategic orientation
– Market position
– Quality of Management
– Soundness of earnings
– Growth potential
– Shareholder value potential

♦ Dividends reinvested
♦ All-in fee: 1.2% p.a.

45
UBS (Lux) Equity Fund - the structure

♦ Management Company ♦ Administrative agent


– management of the Fund – UBS Fund Services (Luxembourg) S.A.,
– issue and redeem of units Luxembourg
– general administrative duties
♦ Portfolio management
– calculation of the net asset value per
– UBS AG, UBS Global Asset Management unit
– Portfolio Advice – Fund’s accounts
♦ Custodian Bank and main paying agent – Reporting
– holds all the liquid assets and securities
♦ Sales agencies
– performs all customary banking duties
– UBS (Luxembourg) S.A and other sales
– routine administrative work in connection agencies in various countries
with the Fund’s assets

46
The Structure

UBS (LUX) EQUITY Fund

Service Subfund Subfund Subfund Service

Subfund Subfund Subfund


Subfund

Money Service

Fund Manager

Money

Administrative Portfolio
Custodian Bank
Agent Management

47
Performance Measures – the numbers

48
Performance Measures – the pictures

49
Mutual Funds & Banks – the services

♦ research
– equity research
– quantitative research
– credit research
– strategy
– economic research

♦ advice
– portfolio advice
– execution advice
– risk management advice

♦ market-making & execution


♦ financing
– especially leveraged funds services

50
How do we make money?

♦ How we make money


– Commissions on trades
– Income from trading volumes (bid / offer)
– Fees for operational services
– Fees for advice

♦ Broker review process:


– Institutional investors measure the services that are provided
– research
– execution
– added services
– voting process to assign commissions
– fund managers / traders / research analysts have votes
– commissions allocated accordingly

51
Hedge Funds
Why hedge funds are in vogue …

Source: UBS AIS Report (J. Johansen, July 2004)

53
European hedge fund industry

♦ 298 hedge fund managers domiciled in Europe (Dec’ 03)


♦ Managing around US$125 billion
– around 15% of the global assets under management of US$817 billion.

♦ Growth rate of the European hedge fund industry between 1995 and 2002 was around
50% (but from a very low base)
♦ United Kingdom is the dominant location
– Market share of around 73% based on assets under management
– Market share of around 62% based on number of managers.

♦ Strategies related to equities are dominant


– European long/short equity had a market share of 36% based on managers and 30% based on
assets under management.

♦ The median manager in Europe has a 1.5% management fee and a 20% performance
fee.
♦ Europe’s market share in fund of funds land is around 40%

54
Hedge funds and traditional funds

♦ Traditional Funds are organised around ♦ Hedge Funds are organised around
styles: strategies:
– sectors – convertible arbitrage
– growth – equity long/short
– value – equity market neutral
– large, small, mid cap – event driven
– relative value
– global macro

♦ Traditional funds have: ♦ Hedge Funds


– benchmarks – try to achieve absolute not relative returns
– economies of scale – have dis-economies of scale

♦ Hedge Funds
♦ Traditional Funds – charge aggressive fees - although their ability
– try to minimise fees and costs to stay to do this may diminish
competitive
♦ Hard to get information
♦ Are easily accessible and mostly open to – close quickly
new investors

55
Long Google / short Yahoo

♦ Google has just gone public ♦ Systematic versus company specific risk
♦ You like Google and you think that Market
Leverage
Google should do better than Yahoo Exposure
0 0%

♦ Buying Google shares?


3 1 75% 25%
25%
– You are exposed to the overall market
performance 2 50%

♦ Why not just buy the difference between ♦ Returns will be correlated to the market
Google & Yahoo only because of the “non-hedged”
♦ Buy Google & Sell Yahoo exposure
♦ Likely to under-perform in strong bull
markets

56
Long / Short Equity Historical Returns 94 – 04
Market
Exposure
0%

75% 25%
25%

50%

Long Short

Source: CSFB/Tremont Advisers

57
Comparison to traditional strategies

Traditional Fund Hedge Fund


Return ♦ Relative to benchmark ♦ Absolute, positive returns
Characteristics (capture asset class (exploit investment
premium) opportunity)
♦ Return volatility tracks ♦ Return volatility dictated by
market volatility manager’s approach to risk

Risk Attributes ♦ Market risk ♦ Liquidity risk


♦ Credit risk ♦ Mark to market risk
♦ Change of strategy risk
♦ Human risk

Transparency ♦ High ♦ Low

Regulation ♦ High ♦ Low

Performance ♦ Market performance ♦ Sustainable investment skills


Driver ♦ Asset allocation decision ♦ Sound risk management

Fee Structure ♦ Management Fee < 1% ♦ Management Fee (1-2%)


♦ Incentive Fee (10-25%)

58
Hedge Fund industry – Not only equity

6% 3% 8%
8%
8% 3 8%

10%
19 %

Lon g / Short Equity Eve n t Drive n G loba l Ma cro Con ve rtible A rbitra g e
Equity Ma rk e t Ne utra l Fixe d In com e A rbiutra g e Ma n a g e d Future s Othe rs

Composition in 2002

Source: TASS Research

59
Case Study: Man Multi-Strategy Fund

60
What do they do and why?

61
Investment Allocation

62
Performance

63
Banks & Hedge Funds - Prime Brokerage

♦ All services an in-house trader would receive including:


– stock loan
– financing
– leverage
– clearing
– balance sheet / position management
– reporting

♦ Funds select Prime Brokerage based on following priorities


– service and responsiveness
– securities lending capabilities
– financing / leverage
– systems / product sophistication
– cross margining

64
Equity Financing - Short Selling Example

♦ Suppose a hedge fund sells short to the market 10,000 shares of


IBM at US$85

♦ To cover, he borrows from AFund

Trade date Security Borrowing & Lending

Collateral
Hedge Fund AFund
10,000 IBM

Short
10,000 US$850,000
sale IBM

Market

65
Closing Trade

♦ Suppose we close the position 1 week later.


♦ The new IBM price is US$84.50

1 week later Security Borrowing & Lending

Collateral
Hedge Fund AFund
10,000 IBM + Fee

Close
10,000 US$845,000
short IBM

Market

66
Equity & Equity Indices
Financial Markets Education
Types of Products

Same Issuer as Underlying Shares Third Party Issuer


♦ Shares ♦ Investment Funds
♦ Depository Receipt ♦ Indexes
♦ Preferred Shares ♦ Futures / Forwards
♦ Convertible Bonds ♦ Equity (Asset) Swaps
♦ Warrants ♦ Exchange Traded Funds
♦ Options
♦ Exchangeables
♦ Equity-Linked Notes

1
Shares

♦ Trading: Exchange (or Listed) vs. OTC


♦ Voting Rights
– May have multiple votes, one vote, no votes

♦ May pay dividends, may not pay dividends


– Many stocks generate this sort of income
– Amount often not strongly correlated with earnings

♦ May be on the whole enterprise or part


♦ May have ownership restrictions
– Registered vs Bearer
– Foreign Ownership
Div Div Div Div Div Div Div Div Div Div
– Qualified Ownership
– Short Sales

Price

2
Share Characteristics

♦ Assets have costs and benefits


associated with them.
♦ Assets have risk associated with
them
♦ Characteristics of an asset
– Price (Market Value)
– Income (Dividend, Coupon)
– Non-financial benefits (voting
rights)
– Risk (Price Risk)

Price Voting Dividend Price


Rights Benefits Risk

Economic
Exposure
3
Being long and being short
Trader starts with no position, and:

♦ Buys 1000 shares ♦ Sells 1000 shares


♦ Has a position which: ♦ Has a position which:
♦ makes money when share price goes up ♦ loses money when share price goes up
♦ loses money when share price goes down ♦ makes money when share price goes
down

Value of position
Value of position

LONG SHORT

0 share price 0 share price

4
Being long and being short – financing position
Trader starts with no position, and:

♦ Buys 1000 shares ♦ Sells 1000 shares


♦ Trader needs to ♦ Trader needs to
– borrow money – borrow shares
– (and could lend the shares out) – (and could lend the money out)

♦ Will receive dividends ♦ Will pay dividends

5
Tesco benefits – Dividend History

Source: Bloomberg
6
TESCO - description

7
Preferred Shares

♦ Fixed dividend (like a coupon), usually no voting rights


♦ May have a redemption date and price
♦ Hybrid of shares and bonds
♦ Rank above common shares, but below all other forms of debt, therefore yield
is better than straight debt
♦ If cumulative, then any dividend arrearage must be settled before common
shares can earn a dividend
♦ Trade like bonds; prices usually don’t move with stock
♦ Terms vary, may be listed on different exchange from the common shares;
usually thinly traded

9
Stock Exchange

♦ Organisation that provides a marketplace to trade stocks


♦ Sets rules to ensure that market operates efficiently and fairly
♦ Only the exchange members can directly trade on the exchange
♦ General public needs to place the order with an exchange member
♦ To be accepted for trading on an exchange a security has to meet certain
listing requirements
♦ To be listed on the NYSE a company must have
– issued at least a million shares of stock worth $100 million
– earned more than $10 million over the last three years

10
NYSE: We Are There

11
London Stock Exchange listing requirements

♦ Three-year record of accounts


♦ Independent revenue earning business
♦ The directors and senior management must have collectively appropriate
expertise and experience
♦ Directors must be free of conflict between duties to the company and private
interests and other duties.
♦ If there is a 30% or more shareholder, the company must be capable of
operating and making independent decisions
♦ Sufficient working capital for at least the next 12 months
♦ Minimum 25% in public hands

12
Exchange

Clearing Mechanism

Client A Exchange Exchange Exchange Client B


wants to Member matches Member wants to
buy (Bank A) orders (Bank B) sell

♦ standardised (price is the only variable)


♦ liquid (easy to close position and hedge)
♦ transparent
♦ no Credit Risk (clearing)

13
Over The Counter (OTC)
– Client negotiates the price and the other
Bank A characteristics of a product with a bank
directly
Client needs a
specific
– Might involve brokers
product
Bank B

♦ tailor made
♦ often no secondary market (more difficult to close position)
♦ no transparency
♦ credit risk

14
Depositary Receipt

♦ Relate to single equities


♦ Depositary Receipts (‘DRs’) are re-packaged equities
♦ DRs convert foreign equities into products which are readily available to
investors in terms of trading and settlement.
♦ Approximate linear exposure to the underlying equity.
♦ DRs are legally transferable products

15
US Invests in Europe Through ADRs

Source: Bank of New York

16
BASF ADR

Source: Bank of New York

17
TESCO: A Good Investment Anywhere!

18
SECTION 3

World Indices
Indexes

♦ Was the market up or down yesterday?


♦ Reflect the value of a “basket” of stocks
♦ Calculation
– capitalisation weighted, price weighted
– usually not dividend adjusted

♦ Can you buy a “cash” FTSE 100 instrument?


♦ Index Types: sector, wide market, global
♦ Related Investments
– Futures, Forwards, Options, Equity Linked Notes, Tracking Baskets, . . .

20
World Equity Indices

21
P/E of World Equity Indices

22
They all seem to be similar but …

♦ Nikkei 225
– Index for the Tokyo stock market
– 225 Stocks in Index
– Price-weighted index
– Price change of a small company has same effect as a price change of a large
company
– Index includes many old-line manufacturing firms, which are less important for the
economy than they used to be. Name % Weight
– Record high of 38,915 (Dec 29 1989) in the Index
1 Advantest Corp 3.156
2 TDK Corp 2.72
3 Kyocera Corp 2.72
4 Fanuc Ltd 2.522
5 Tokyo Electron Ltd 2.182
6 Honda Motor Co Ltd 2.006
7 Canon Inc 1.962
8 KDDI Corp 1.915
9 Takeda Pharmaceutical Co Ltd 1.794
10 Softbank Corp 1.79
11 CSK Corp 1.713
12 Trend Micro Inc 1.71
13 Shin-Etsu Chemical Co Ltd 1.497
14 Toyota Motor Corp 1.486
15 Secom Co Ltd 1.486
23
Dow Jones industrial average

♦ Most widely recognised index ♦ Does not truly represent US market


– Only 30 companies
♦ Started with 12 stocks in 1896 (GE only
survivor) – Price weighted

♦ Price-weighted index ♦ ETF that tracks DJ: Dow Diamonds


– Stocks with high prices have bigger weighting

♦ 30 largest publicly traded companies


in US
– Low diversification
Name % Weight Last Price
♦ Only industrial companies (no transport in the Index
and utility stocks) United Technologies Corp
International Business Machines Corp
7.004
6.573
100.02
93.86
Caterpillar Inc 6.311 90.12
♦ Included Microsoft and Intel in 1999 3M Co 5.888 84.08
American International Group Inc 4.674 66.74
Johnson & Johnson 4.581 65.42
Altria Group Inc 4.476 63.91
American Express Co 3.974 56.75
Exxon Mobil Corp 3.73 53.27
Procter & Gamble Co 3.702 52.87

24
S&P500 Index

♦ 500 leading US companies from ♦ Tracked by many funds


different sectors – Most liquid ETF: S&P SPDRs
♦ Diverse index – Known as Spyder (Spider)

♦ 70% of total market cap of all US stocks


♦ Capitalisation weighted
♦ Only large cap stock in Index
Name % Weight
in the Index
♦ Only profitable stocks in index 1 General Electric Co 3.461
2 Exxon Mobil Corp 3.101
♦ Started in 1923 with 233 stocks 3 Microsoft Corp 2.589
4 Citigroup Inc 2.317
5 Wal-Mart Stores Inc 2.01
6 Johnson & Johnson 1.752
7 Bank of America Corp 1.701
8 Pfizer Inc 1.621
9 American International Group Inc 1.569
10 International Business Machines Corp 1.41
11 Intel Corp 1.291
12 Procter & Gamble Co 1.21
13 JPMorgan Chase & Co 1.205
14 Altria Group Inc 1.184
15 Cisco Systems Inc 1.077

25
Nasdaq

♦ National Association of Securities Dealers Automated Quotations


♦ World largest electronic stock market
♦ Created in 1971 to provide better market for OTC stocks
♦ Stocks listed stocks on NYSE
– Larger, older
– More established
– Floor traded

♦ Stocks listed on Nasdaq tend to be


– Smaller, newer
– Often technology
– More volatile
– Electronically traded

26
Nasdaq Indices

♦ Nasdaq Composite Index ♦ Nasdaq 100 Index


– 4,000 stocks traded on Nasdaq (about every – 100 largest stock in Nasdaq
stock traded on the exchange) – Modified market weightings to prevent
– Market Cap weighted largest caps from being too dominant
– About 65% technology – No stock more than 24% of index
– Top 10 stocks about 30% of Index – Top 10 stocks about 40% of index
– Often cited in Financial press – Heavily weighted towards technology
– Not that actively traded – Very volatile
– ETF: Fidelity Nasdaq Composite Index Fund – Very actively traded
– ETF: Nasdaq 100 Trust
– Symbol QQQ

27
Nasdaq Index Composition

♦ Nasdaq Composite ♦ Nasdaq 100

Name % Weight Name % Weight


in the Index in the Index
1 Microsoft Corp 9.247 1 Microsoft Corp 7.797
2 Intel Corp 4.615 2 Qualcomm Inc 5.696
3 Cisco Systems Inc 3.85 3 Intel Corp 3.971
4 Dell Inc 3.335 4 Apple Computer Inc 3.456
5 Amgen Inc 2.561 5 Cisco Systems Inc 3.394
6 Oracle Corp 2.258 6 Nextel Communications Inc 3.229
7 Qualcomm Inc 1.947 7 eBay Inc 3.016
8 eBay Inc 1.666 8 Dell Inc 3.002
9 Yahoo! Inc 1.541 9 Amgen Inc 2.92
10 Comcast Corp 1.385 10 Comcast Corp 2.392
11 Nextel Communications Inc 1.026 11 Starbucks Corp 2.37
12 Apple Computer Inc 1.005 12 Oracle Corp 2.306
13 Applied Materials Inc 0.898 13 Yahoo! Inc 1.879
14 Comcast Corp 0.856 14 Biogen Idec Inc 1.857
15 Fifth Third Bancorp 0.85 15 Electronic Arts Inc 1.588
16 Costco Wholesale Corp 0.71 16 Genzyme Corp 1.43
17 Starbucks Corp 0.698 17 Maxim Integrated Products Inc 1.415
18 Biogen Idec Inc 0.696 18 IAC/InterActiveCorp 1.364
19 Electronic Arts Inc 0.641 19 Symantec Corp 1.363
20 Amazon.Com Inc 0.559 20 Bed Bath & Beyond Inc 1.299

28
Nasdaq Composite versus Nasdaq 100 - Volatility

29
Nasdaq Composite versus Nasdaq 100 - Level

30
DAX & CAC40

♦ Deutscher Aktien Index – DAX ♦ CAC40


– Performance based Index – Tracks stocks on Paris Bourse
– Dividends etc. reinvested – 40 largest & most liquid stocks
– Benchmark for Shares traded on the – Float-weighted index
Frankfurt stock Exchange – Only public outstanding shares are
– 30 stocks in Index (largest and most liquid) counted
– Capitalisation weighted – Started in 1987 with a base of 1000
– Started in 1984 (base 1000)

Name % Weight Name % Weight


in the Index in the Index
1 Siemens AG 11.214 1 Total SA 13.734
2 E.ON AG 10.363 2 Sanofi-Aventis 9.617
3 Deutsche Telekom AG 9.271 3 BNP Paribas 7.02
4 Deutsche Bank AG 7.766 4 France Telecom SA 5.387
5 Allianz AG 6.933 5 Societe Generale 5.141
6 DaimlerChrysler AG 6.448 6 AXA SA 4.277
7 BASF AG 6.235 7 Vivendi Universal SA 3.962
8 SAP AG 5.112 8 Carrefour SA 3.509
9 RWE AG 4.349 9 Suez SA 3.099
10 Bayer AG 3.872 10 L'Oreal SA 2.919

31
DJ STOXX 50

♦ Dow Jones STOXX indices


– Index family that represents the price development of European shares
– market capitalization of the free float of the company
– calculated as price & performance indices.
– The shares on which the indices are based are converted into euros or dollars

♦ Dow Jones STOXX 50


– Capitalisation weighted index of 50 European blue chips stocks

♦ Dow Jones Euro STOXX 50


– Capitalisation weighted index of 50 European blue chips stocks in the euro area

32
DJ STOXX 50

♦ DJ STOXX 50 ♦ DJ Euro STOXX 50


Name % Weight Name % Weight
in the Index in the Index
1 BP PLC 6.629 1 Total SA 6.365
2 HSBC Holdings PLC 5.541 2 Royal Dutch Petroleum Co 6.097
3 Vodafone Group PLC 5.077 3 Telefonica SA 3.918
4 GlaxoSmithKline PLC 3.944 4 Banco Santander Central Hispano SA 3.633
5 Total SA 3.927 5 Sanofi-Aventis 3.593
6 Royal Dutch Petroleum Co 3.761 6 Nokia OYJ 3.562
7 Novartis AG 3.636 7 Siemens AG 3.253
8 Nestle SA 3.226 8 E.ON AG 3.05
9 Royal Bank of Scotland Group Plc 3.168 9 ENI SpA 3.041
10 Shell Transport & Trading Co PLC 2.617 10 BNP Paribas 2.959
11 UBS AG 2.608 11 Banco Bilbao Vizcaya Argentaria SA 2.829
12 Telefonica SA 2.417 12 ING Groep NV 2.762
13 Banco Santander Central Hispano SA 2.244 13 Deutsche Telekom AG 2.729
14 Nokia OYJ 2.194 14 Deutsche Bank AG 2.284
15 Barclays PLC 2.174 15 ABN AMRO Holding NV 2.266
16 Roche Holding AG 2.17 16 France Telecom SA 2.203
17 Siemens AG 2.007 17 Societe Generale 2.186
18 HBOS PLC 1.902 18 Allianz AG 2.041
19 E.ON AG 1.881 19 DaimlerChrysler AG 1.897
20 ENI SpA 1.877 20 Unilever NV 1.88

33
How do you “buy” an index ?

♦ Tracking baskets
♦ Funds
♦ ETFs
♦ Index linked Notes
♦ Futures
♦ Options ...

Shares Investm ent ETF Index Futures


. Fund OEIC linked
Note
Price discovery Continuous Once a day Continuous Continuous Continuous
Exchange traded YES NO YES Some YES
Expiry (Settlem ent) NO NO NO YES (Cash) YES (Cash)
Short Sale YES NO YES NO YES
Dividend YES YES YES NO NO

34
Equity Portfolios

♦ Index Tracking Mutual Funds


– “track” publicly traded market index
– High degree of correlation or exact replication
– Low management fees (under 20 bp per year)

♦ Exchange Traded Funds


– Portfolio of shares
– Buyer of the fund is the beneficial owner of the shares
– Trade continuously during the day
– For many investors they are tax advantaged since they do not distribute capital gains
– Replicate or track an index
– Market Index
– Sector Index
– Country Index (priced in home currency)
– Style Index

35
Exchange Traded Funds (ETFs)

♦ Like Open-Ended Mutual Funds, but trade intra-day


♦ Combines advantages of index funds with advantages of listed shares
♦ Liquidity is “big”
– (QQQs have traded over $5.3 billion in a day)

♦ Buy / sell any time during trading day


♦ Can be sold short
♦ Sector ETFs on the rise

36
SPDRs

37
Why?

♦ Entire index in one security


♦ Low maintenance fees and expenses
♦ Tax efficient
♦ Dividends
♦ All day trading
♦ Buy on margin
♦ Sell short

38
What is a Spider?

39
More on Spider

40
Even more on Spider

41
QQQQ

42
“Primary” and Secondary Market

ETF Fund Company

Share
B ETF
Share
Buy / Sell A
Share

Buy / Sell
C

Market
Investor A
Maker
Buy / Sell
Borrow

Lend

Investor B

43
SECTION 4

Equity Derivatives
Futures

♦ Exchange traded contract to buy or sell an asset or collection of assets


at a future date at a price agreed upon today
♦ Futures can be written on shares and indexes
♦ In the US, single name stock futures are “new”
♦ Settlement may be physical or cash
♦ Forwards are the OTC analogue

45
Derivative - Future versus Spot

♦ A Future has a risk profile which is very similar to that of the underlying
Value of a share

Value of a future
0 0
share price share price share price
today

Price Risk Price Risk


Capital

46
Why futures?

♦ Economic Rationale ♦ Practical considerations


♦ Equivalent economic exposure to ♦ Liquidity – often more liquid than the
underlying underlying
♦ Asset allocation / rebalancing made easy ♦ Transaction costs – trade the entire index
with one bid/offer, low commissions
♦ Access to foreign markets
♦ Offset – trade out of position easily
♦ Less exposure to currency than
investment in the underlying ♦ Cash settlement – no need to transact
underlying shares
♦ Mark to market – realise daily P/L

47
What does this say?

48
Word Equity Futures

49
Equity swaps

♦ In a swap two parties agree to exchange cash flows from different


investments.
♦ In the equity world generally one side pays an interest rate while the other
pays a equity return.
♦ An equity swap is a contract between two counterparties to exchange the
economic performance of one asset (e.g. cash) for the economic performance
of another asset (e.g. equities).

USD LIBOR +/- spread


PARTY A PARTY B
Price Return of a Equity
Index

50
Equity swap: Example

♦ Investor would like to have exposure to the S&P but can not invest directly.
♦ Investor asks the bank to invest $100 for them.
♦ Investor accepts both the potential gain and loss in the market.
♦ How much will that cost?
♦ The bank needs to borrow money to buy the stock and has to pay interest
(LIBOR).
♦ Therefore, assuming there are no other costs, the cost of a swap will be my
borrowing costs (LIBOR) plus my profit margin.

51
SECTION 5

Certificates
Certificates

♦ Redemption amount equal to spot price of underlying at maturity


– One for one exposure
– Tracks the performance of an asset or strategy

♦ Usually, no coupons are paid to holder


♦ Cost efficient way to execute investment strategy not easily achieved with
traditional investments
♦ Wholesale and retail investor dealing sizes
♦ Certificates are usually cash settled
– Cash settled at the price of the underlying on expiry
– No stamp duty in UK, Switzerland, Germany

53
Certificates

♦ Fixed maturity or open ended


– Fixed term usually 3-5 years
– Issuer has the right to stipulate expiry of open-end certificates once a year

♦ Often listed on stock exchanges


– Fast and transparent exposure to investment products
– Simple execution similar to share dealing
– Traded through stock broker
– Liquid (market making is required by exchange)
– Low cost, minimal bid/offer spread

♦ Also called
– Tracker certificates
– Benchmark certificates
– Performance linked notes

54
Open-end Certificate on DAX
Deutsche Börse: Certificate

Deutsche Börse: DAX

55
Diverse range of underlyings

♦ Country Index
– DAX, CAC40, FTSE, S&P500, Nasdaq,…

♦ Multinational Index PERLES


– DJ Euro Stoxx 50, DJ GlobalTitans, …

♦ Sector Certificates
– DJ Stoxx sectors, FTSE Global sectors, …
– Biotech basket, fuel cell basket, data highway basket, EU enlargement basket

♦ Pre-determined investment strategy


– Issuer acts as calculation agent
– Clear investment policy, non manager reliant
– Growth, Value, PEG
– Long/short

56
Diverse investment strategies
“The Euro PEG 20 Certificate has a clearly defined and disciplined
investment strategy…
Every quarter, 20 companies with the lowest Price-Earnings-to-growth
(PEG-ratio) from DJ STOXX Index are selected.”

DJ Islamic Market Titans 100 Index Open End Certificate


“The Dow Jones Islamic Market Indexes were created for people who
wish to invest according to Islamic investment guidelines. The
indexes track Shari`ah compliant stocks from around the world,
providing Islamic investors with comprehensive tools based on a
truly global investing perspective.”

Open End Certificate on FTSE4GOOD EUR 50


“The FTSE4Good Europe 50 is a price-index for socially responsible
investment. The criteria for the relevant selection are the
environmental sustainability, social issues and human rights. The
FTSE4Good Europe 50 Index is designed with the support of UNICEF,
the United Nations Childrens’s Fund, and uses data provided by
EIRIS, the Ethical Investment Research Service. Index Reviews occur
on a semi-annually basis in March and September.”

57
Selling an Index “short” - UBS Shorty

♦ Similar to short SMI future ♦ Speculate on a decline in the index


– Fixed notional
♦ Add to a portfolio to effective way to
– Leverage about 5.5 at issuance hedge against market weakness
– Easy and transparent

“Initial Margin”

“Trade is
closed when
this level is
reached”

Short Term:
No asset premium
to collect

58
SECTION 6

Equity Options
Derivative - Calls versus Puts

♦ Calls and puts represent different aspects of the price risk


– Options allow us to separately trade the upside and downside risk

ATM Options OTM Call, ITM Put

Value
Value

Long Call Share


price
Share
“good risk” today
price 0
today
strike
0 price
Strike
price

Short Put
“bad risk”

Short Long
Put Call Price Risk

60
Options

♦ Call ♦ Put
♦ A buyer’s option ♦ A seller’s option
♦ Right to buy ♦ Right to sell
♦ An underlying (DAX, VOD, FTSE) ♦ An underlying
♦ at a fixed price (4500, 100 , 5000) ♦ at a fixed price
♦ on (European) ♦ on (European)
♦ or before (American) ♦ or before (American)
♦ fixed time (19/12/07) ♦ fixed time

61
Why Options?

♦ Economic Rationale ♦ Common uses:


♦ Price and Transfer risk ♦ Owner of IBM shares:
– Sells call options and / or
♦ Price mainly determined by the risk of the
underlying – Buys put options

♦ Options are “naturally” leveraged ♦ Investor


– Buys Calls or Puts
♦ Price = small % of underlying
– Benefits from increase ordecrease in share
♦ Speculators like leverage price
– Limited loss
♦ Investors can use it to reduce risk

62
Example

♦ IBM = USD95
♦ Investor owns shares
– Sells 3 month 100 Call for USD3
– If IBM trades above 100 in 3 months investor has earned 8% return for 3 months

♦ Or
♦ Investor owns shares
– Has a profit since they were bought at 80
– Buys the 3 month 90 Put for USD2
– Locks in 10% gain (90 – 80 – 2 = 8 = 10% of 80)
– Allows the investor to “stay long”

63
Options – They’re a BIG Business!

64
Summary

♦ From the issuer’s point of view equity is a way to finance the company’s
operations and assets
♦ From the investor’s point of view equity is a way to earn a return from the
success of a company’s business
♦ Theory says that only market risk is rewarded so investors should diversify
their equity investments
♦ The financial markets provide many ways for investors to “get long” or short
and to target exactly the risk they are willing to take on

65
Fixed Income Markets
Introduction to Financial Markets
SECTION 1

Bonds
Bonds are securities

♦ They are (like) pieces of paper,


– which represent money that has been borrowed by the issuer

♦ Whilst the issuer may raise $500m


– an investor may buy $100,000 of the bond.

♦ This is one distinction between bonds and loans


– bonds are divided up into smaller, more liquid, pieces

2
Bond Markets

♦ Issuance – primary market


– CP / ECP
– MTNs / EMTNs
– Eurobonds
– Global Bonds
– High Yield
– Emerging Market

♦ Secondary trading
– Providing liquidity
– Credit analysis and research
– Providing indices

3
EuroSterling Bonds

4
Bond Characteristics

♦ Issue Size
♦ Currency of issue (may not be the same as the issuer’s home currency)
♦ Maturity
♦ Coupon Rate
♦ Coupon Frequency

♦ Price versus Face Amount


– represented as a price or as a yield

5
Bonds

100
01/07/2006

5 01/07/2004 5 01/07/2005 5 01/07/2006


♦ Just a series of cash flows over time

6
Tesco - securities

7
Tesco - bonds

8
Tesco - bond

9
Why invest?

♦ Why would an investor buy these bonds rather than the comparable Gilt?
♦ What are they getting?
♦ What risks are they taking?

10
Bond Price and Yield

♦ The bond’s price is the price of a fixed set of a future cashflows


♦ How can you compare 2 bond investments?
♦ Is it better to pay 100 or 107 per cent of face?

11
Two Bonds – same borrower

♦ BOND A ♦ BOND B

♦ 3 year maturity ♦ 3 year maturity


♦ Price = 107 ♦ Price = 100

Which one is the better investment?

12
Two Bonds – same borrower

♦ BOND A ♦ BOND B

♦ 3 year maturity ♦ 3 year maturity


♦ Price = 107 ♦ Price = 100
♦ Coupon = 7.25% ♦ Coupon = 4.00%

13
Two Bonds – same borrower

♦ BOND A ♦ BOND B

♦ 3 year maturity ♦ 3 year maturity


♦ Price = 107 ♦ Price = 100
♦ Coupon = 7.25% ♦ Coupon = 4.00%
♦ Yield = 4.5% ♦ Yield = 4.0%

14
SECTION 2

Government Bonds - for comparison


UK Gilt

16
Gilt price performance

17
Gilt yield

18
The yield curve: 3 year yield has hardly moved!

19
World Bond Mkts

20
US Govt bonds
♦ From June 2004:

21
World Bond Curves

22
Quality of issuer/borrower

♦ Who would you be more comfortable lending £1,000 to; UBS AG or me?
♦ How would you make it clear to me you felt this way?
♦ How about UBS AG vs UK Treasury?
♦ Rates market can be segmented:
– LIBOR (London InterBank Offer Rate) / EURIBOR
– deposits
– futures
– swaps
– Government
– T-bills
– Treasury bonds/notes
– Credit
– Tesco
– UBS AG
– etc
23
Ratings
S&P Moody's
AAA Aaa
AA+ Aa1
AA Aa2
AA- Aa3
A+ A1 Investment
A A2 Grade
A- A3
BBB+ Baa1
BBB Baa2
BBB- Baa3
=============================
BB+ Ba1
BB Ba2 Non
BB- Ba3 Investment
B+ B1 Grade
B B2
B- B3

24
SECTION 3

Back to Tesco Bonds


Tesco bond price

26
Tesco bond yield

27
Tesco bond spread

28
Forecasting performance

♦ If you want to forecast how an investment in these Tesco bonds will perform
(over the next 1 year, say), what factors would you be thinking about?

29
Related Fixed Income Markets

♦ Deposits
– Cash deposits
– Deposit cash vs bond collateral (repo market)

♦ Futures (& options)


– on deposit rates
– on bond prices

♦ Interest rate swaps


♦ Credit derivatives
– Credit default swaps

30
SECTION 4

Interest Rates
The Money Market

♦ Market for short-dated money


– Money (short term) rather than capital (tends to be longer term)
– Sometimes called STIR: short term interest rates

♦ Deposits
– LIBOR

♦ Commercial paper often included


♦ Plus
– FRAs
– Short term interest rate futures
– FX swaps

32
Types of interest rates

33
Time horizon and currencies

♦ If you believed interest rates are likely to rise would you charge the same
interest rate to a 1-year borrower and a 2-year borrower?
♦ What if rates are ‘likely’ to fall?
♦ Different countries have very different borrowing costs in their own currency:
– JPY (¥)
– USD ($)
– MXN

34
Deposit rates

♦client site

35
Deposit Index Rates

♦ LIBOR - London Inter-Bank offered rate


– index of deposit rates polled from 16 London based international banks at 11am
(London time) each day
– remove top 4 and bottom 4 and average the remaining 8
– published for maturities up to 1year
– used for USD, GBP, JPY, CHF

♦ For Euros
– tend to use Euribor - Euro Interbank Offered Rate
– about 50 prime banks polled for their rate for euro interbank term deposits within
the euro zone
– Also there is Eonia (Euro OverNight Index Average) which is an effective overnight
rate computed as a weighted average of all overnight unsecured lending transactions
in the interbank market

36
SECTION 5

Interest Rates Swaps


What are swaps?

♦ OTC agreements
– not securities

♦ Interest Rate swap


– agreement to exchange:
– a series of cashflows based on a fixed interest rate
for
– a series of cashflows based on a periodically adjusting (floating) deposit market
interest rate

38
What is an interest rate swap?

LIBOR3
LIBOR2 LIBOR5
LIBOR1 LIBOR4

1 2 3 4 5

Fixed rate – SWAP rate

♦ Exchange of cashflows
♦ Fixed rate (the swap rate) for floating rate (LIBOR deposit rates)
♦ LIBOR is known at the beginning of each period, and paid at the end.

39
But why?

40
Some interest rate swap terminology

♦ Swap rate (price)


♦ Paying and receiving (not buying and selling)
♦ Effective date
♦ Maturity date
♦ Notional
♦ Tenor

41
Hedging debt issuance - liability swap

♦ XYZ Corp (due to name recognition) can issue a five year


fixed coupon 9% bond, but it wants floating debt
♦ In the Floating Rate market, XYZ can fund at LIBOR + 0.50%
♦ Swap Market: 8.52-8.54
♦ Issue the bond and receive on the swap
♦ Cost of Floating Funding = LIBOR + 48

8.52%
9% Swap
Bond XYZ
LIBOR

42
Liability swap

Issue fixed rate bond (borrow at fixed rates)

and
Receive fixed on swap

has cashflows that look like


Issuing a floating rate note (borrow at variable rates)

43
SECTION 6

Credit Derivatives
Credit Derivatives

♦ Contracts based on credit exposure


– exposure to borrowers not paying debts (interest / principal)

♦ Allow isolation and trading of credit risk between counterparties


♦ Allow trading of credit risk without trading the underlying assets (bonds and
loans) which have those risks.
♦ Changes the nature of ‘credit risk management’
– becoming more ‘actively’ managed

♦ Like any derivatives, used for


– hedging
– taking exposure
– yield enhancement

45
Global Credit Derivatives Market
US $ bn
5000
4500
4000
3500
3000
2500
2000
1500
1000
500
0
1997 1998 1999 2000 2001 2002 2004
Source: BBA Credit Derivatives Report 2001/2002

46
Global Credit Derivatives Market—the products

CLNs and
Asset swaps
Repacks
12%
9% Credit Spread
options
Synthetic 3%
Securitisations
26%

Credit Default
Basket default Swaps
swaps 45%
5%

Source: Risk, February 2001

47
Credit Default Swaps

♦ Credit (Default) swaps - most common type of credit derivative


♦ OTC agreement
♦ One party buys credit protection from the other, on a particular entity, on
a certain face amount,
♦ for a certain period
– typically 1-10 years

♦ Premium paid quarterly (quoted in bps per annum)


♦ If a credit event occurs,
– trade terminates
– the protection seller will
– buy deliverable obligation (bond or loan) at par

48
Credit Default swap

Before default
Periodic payment
Protection Protection
Buyer Seller
Credit Protection

On default
Periodic payment

Protection Protection
Deliverable Obligation
Buyer Seller
Par

49
Some CDS prices

Cost in b.p. for protection:

50
Foreign Exchange Markets
Financial Markets Education
What does drive the FX Market?

1
What does drive the FX Market?

2
FX market ticks differently

♦ Market participants who lack a profit motive


– Central banks manage exchange rates through market intervention
– Corporations hedge cash flows and earnings
– Equity managers exchange currencies to fund foreign equity transactions
– Tourists buy foreign exchange to travel

♦ Estimate of the proportion of market participants who are price-takers is 90%


(Mercer Investment Consulting, 2004)
♦ Largest and most liquid market in the World
– Average daily turnover is $1.9 trillion (BIS Triennial Survey 2004)
– 15 times average daily turnover of Global Equity markets ($130 billion – World
Federation of Exchanges, 2003)
– 40 times the average daily turnover of the NYSE ($46 billion, NYSE 2004)

3
FX and Risk Premium

♦ Underlying asset class expected to yield “good returns”


– Pays coupon or dividend
– Long term positive return (positive risk premium)
– Is a strategic investment
– Being long is generally good

♦ Investors are in general willing to take risk because they expect positive return
(risk premium)
♦ Many investors do not have strong convictions about future currency
movements
– They do not expect a positive long term return on currency
– No “safe” strategy in FX, long term trends unexpectedly reverse

♦ Currency often considered a “zero sum game”


– Currency movements create additional risk which is not remunerated by a positive
risk premium

4
Risk Premium

1000
Dividends not included

200

100

50

10
81 83 85 87 89 91 93 95 97 99 01 03 05

UKX SPX TPX GBP JPY CHF

5
What is the “True Value” of a US Dollar ?

♦ What is the correct value of a US Dollar?


♦ What does it say on every piece of US currency, coin and note?

♦ Purchasing Power Parity

USD 3000 = = CHF 3480


Law of One Price & Purchasing Power Parity (PPP)

♦ Law of one price


– Price of identical goods are equal once converted into the same currency
– Exchange rates ensure the “same price tag” on each good
– The location of where a good is traded is irrelevant

♦ Purchasing Power Parity – the naïve form


– Every investor consumes same basket of goods
– Law of one price holds for all assets

7
Does Purchasing Power Parity hold?

The Economist, Jun 9th 2005: “Economists lost some


faith in PPP as a guide to exchange rates in the 1970s,
after the world's currencies abandoned their anchors to
the dollar. By the end of the decade, exchange rates
seemed to be drifting without chart or compass. Later
studies showed that a currency's purchasing power does
assert itself over the long run. But it might take
three to five years for a misaligned exchange rate to
move even halfway back into line.”

8
Fast food and strong currencies

The Economist, Jun 9th 2005: “Our index shows that


burger prices can certainly fall out of line with each
other. If he could keep the burgers fresh, an ingenious
arbitrageur could buy Big Macs for the equivalent of
$1.27 in China, whose yuan is the most undervalued
currency in our table, and sell them for $5.05 in
Switzerland, whose franc is the most overvalued
currency. The impracticality of such a trade highlights
some of the flaws in the PPP idea. Trade barriers,
transport costs and differences in taxes drive a wedge
between prices in different countries.”

9
The Big Mac Index – 2005

10
PPP & exchange rate

♦ If PPP holds between two countries then the exchange rate is determined by
the rate of inflation in the two countries
♦ The growth rate of FORDOM is (inflationDOM – inflationFOR)
♦ If PPP holds and there is no inflation, then FX rates should not change
♦ IF PPP holds and inflation equals the risk-free rate the current FX forward will
be the future FX spot

11
FX spot and PPP

180
♦ You have to be patient!
160
♦ You might have to wait some
140 years
120

100

80
86 88 90 92 94 96 98 00 02 04

USDJPY USDJPY assuming PPP


1.95
1.85
1.75
1.65
1.55
1.45
1.35
1.25
88 90 92 94 96 98 00 02 04

GBPUSD GBPUSD assuming PPP

12
FX talk – Technical Analysis

13
Drivers of the Foreign Exchange Market

♦ Demand and Supply (the volume of cross-border trade is insufficient to


account for the magnitude of foreign exchange transactions each year)
♦ Economics (Trade Flows, Current Account Deficits, Foreign Direct
Investment,...)
♦ International Trade
♦ Global Investing
♦ Political News and Events
♦ Central Bank Involvement
♦ Hedge Funds
♦ Expectations
♦ Rumours (The Premature Demise of Alan Greenspan)
Overview of the Foreign Exchange Market

♦ Open and Active 24 hours


♦ Average Daily Volume estimated in excess of USD 1.5 Trillion (versus USD
35.5 Billion daily average on the NYSE).
Commercial Banks Investment Banks
Central Banks Corporations
Major participants Fund Managers Hedge Funds
Arbitrageurs Speculators
HNW Individuals

Where (UBS) Zurich, New York, Singapore

What Spot, Forwards, Options

15
FX information

News
♦ Fundamental
♦ Technical
♦ Dealing Floor
Products
♦ Spot
♦ Forward
♦ Options

16
FX Products
Snapshot of FX market

18
What’s out there?

♦ Most important currencies - the MAJORS:

USD EUR JPY GBP CHF


$ € ¥ £

19
Spot Exchange Rates

♦ A “Spot” Exchange Rate is simply the “current” price of one currency in


terms of another currency
♦ In other product areas, they speak of “cash prices”, but that would be too
confusing with foreign exchange

20
What is Spot “Dollar-Swiss”

♦ If someone says Dollar-Swiss, denoted USD|CHF, is 1.2190

This means the price of


1 _________ is 1.2190 _________

♦ If someone says USD|CHF = 1.2190 it is interpreted as

USD 1 = CHF 1.2190

21
What is “Cable”?

♦ “Cable” refers to Sterling|Dollar (GBP|USD)


♦ If someone says GBP | USD is 1.8561

This means the price of


1 _________ is 1.8561 _________

♦ Sometimes USD is the asset (“Swissy”)


♦ Sometimes the price of the asset is quoted in USD (“Cable”)
♦ Which is the “American” Quote?
♦ Which is the “European” Quote?

22
Can really quote either way - reciprocity

♦ Typically the exchange rate between US Dollars and Swiss Francs is


quoted in ‘European’ terms

USD|CHF = 1.2190 which means


USD1 = CHF 1.2190

But can quote in ‘American’ terms:


USD 0.8203 = CHF 1

♦ The quoting system is not applied on a consistent, universal basis


♦ In the InterBank market, USD | CHF is always quoted in European terms

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Spot Quotes

♦ Everything in foreign exchange revolves around the


“SPOT” quote
♦ Generally, a SPOT transaction refers to a two day forward trade (ie, it settles
in two good business days in the future) ... except Canadian Dollar and
Mexican Peso which, in North America, are (often) 1 day trades

24
The Typical Timing of Spot Trades

NOW TOMORROW SPOT

DAYS
0 1 2

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Marketmaker Spot Quotes and Terminology
The “figure” or
“big figure”
♦ EUR|AUD:

1.6257 |1.6259 “pips”

BID ASK/OFFER

♦ EUR|AUD:

1.62 57 | 59

The “handle”

26
Spot Quotes

USD | CHF = 1.2190

If USD | CHF changes to 1.2191 it has gone


up one pip

♦ A “pip” is the smallest quoted unit of the spot price

27
Spot Quotes (continued)

USD | CHF = 1.2190

If USD | CHF rises to 1.2290 it is said to have


risen by 1 “big figure”

28
Spot Quotes (continued)

♦ Most currencies are quoted to four decimal places (5 digits in total)


USD|CHF = 1.2190
GBP|USD = 1.8561
♦ But some currencies only look out two decimal places:
(like the small ones vs. the Dollar - e.g., Yen)
USD|JPY = 105.56

What is a “big figure” here?

What is “the handle” here?

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Market Jargon

One Dollar, 3 Bucks = One Million Dollars, Three Million Dollars


Notation for 1 Million = MM, Mio
Two Yards of Yen = Two Billion Yen

♦ Say in USD|CHF, quote = 1.1640-50


♦ If you (as a customer) buy Dollars , you would
Yours, Mine say “mine” (at 50)
♦ If you (as a market-taker) sell Dollars, you
would say “yours”

♦ If you hear a broker’s market, 40-50, and


then hear given, it means someone just gave
Given, Paid (sold) USD for (hit) the bid (40)
♦ Similarly, if someone paid, they’ve bought
(and paid) at the offer

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FX Forwards and Options –
Corporate Hedging
Japanese hedger

♦ A Japanese car manufacturer just sold 1,000 cars to a European wholesaler for
10 million Euro
♦ The car manufacturer will receive the 10 million Euro in 3 months.
♦ A car costs 1.2 million JPY to produce
♦ The manufacturer gets 10,000 Euro per car in 3 months

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How to hedge the FX risk?

♦ EURJPY Spot is 135


♦ An exchange rate of 135 results in a 12.5% margin and is acceptable
♦ The company believes that the minimal (operating) margin to satisfy the
shareholders is 7.5%, but the company believes that they should get more out
of this trade
♦ Does the company have any FX risk?
♦ If yes, what should the company do?

33
How to get rid of FX risk - Currency Forwards

♦ An FX spot trade done today settles in 2


business days
♦ Trades that settle on any day later than
the spot date are called forward trades
♦ An FX-forward trade is an agreement to
exchange a fixed amount of one currency
for a fixed amount of another currency at
a fixed later date

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What’s the intuition?

♦ Spot reflects the current value of EUR 1 in terms of JPY

EUROs are growing at 2.2%


Yens are growing at 0.1%

♦ EUROs are becoming relatively more abundant. When supply goes up, price
goes down

Forward is lower than Spot


(There is a net benefit to carrying EUROs)

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Forward Points

♦ In our example,

Spot trades at 134.92


3-month Forward trades at 134.19
Forward is lower than Spot
(There’s a net benefit to holding EUROs)

♦ Forward Points are defined as Forward - Spot


♦ The Forward Points are -0.73 JPY
♦ more often reported as -73 (pips)
♦ and generally often the “-” is missing with 2-way markets
♦ The Market usually quotes Forward Points not Outright Forwards

36
Outrights versus Pips

37
(Short) Forward versus Put

♦ In our example the Japanese car manufacturer could sell 3-months 10 mm


Euros 3-months forward at a price of 134.27 Jen per Euro
♦ He would trade away his exposure to the EURJPY exchange rate
♦ His operating margin goes to 11.89%
♦ What if the car manufacturer has a strong view that the EURO currency will
strengthen in the next 3 months?
♦ A EURJPY exchange rate of 138 would yield an operating margin of 15%!
♦ But if he does not hedge and the market goes against him he might not make
the 10% margin he needs

38
3 month 130 EUR put JPY call -

♦ Buy insurance!
♦ 3 month standard 130 strike EUR put JPY call costs
– 0.69% of EUR face
– 0.93 JPY per EUR
– 9,300,000 JPY (EUR face 10,000,000)
– this results in a worst-case margin of 7.56%

4.1

-0.9 125 130 140

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