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quantity & timing of settlement -.Operations of derivatives market Exchange traded v. Highly standardised Unlimited access Physical delivery is very rare Margin required Daily settlement in cash More liquid Example would be a futures contract mechanism & differences settled Settlement at end of maturity delivering of underlying Less liquid Example would be a forward contract . OTC derivatives OTC derivatives Privately negotiated derivative contract in which two parties agree to settle a financial trade / agreement at a future date Tailored to meet needs of parties Limited access Made with intention of delivery Margin requirements do not exist period by Exchange-traded derivatives Standardised contract with a standard underlying instrument.
type & date of settlement of futures contract sizes Smallest movement in price of exchange Tick Smallest movement in price of an eXChang~ traded derivative contract Every tick has an equal value ] "'tick'" types Smallest movement in rates interest rates Tick value (for interest rate contract) = No.Derivatives terminology r---------------------------------------~ Contract where terms of contract are standardised in nature Terms specify amount. of trading units x one basis point x time to expiry Clearing mechanism • • • Clearing house acts as mediator in futures contract Sells for the buyer Buys for the seller Eliminates counterparty risk Monitors solvency of its members by specifying solvency norms • • Digitized by Google .
client can withdraw cash from margin account with broker In case of losses.Futures contracts require payment of margin. client may be asked to deposit additional margin Required by clearing house as collateral against trader's open position Calculated by comparing daily settlement price of futures contract with previous day's settlement price Initial investment = initial margin required of minimum VM Requires maintenance Interest rate charged higher than market rate Not all underlying assets (UA) qualify to be bought on margin . which is comparable to a security deposit Variation / mark-to-market margin (VM) If price settlement results in profit.
Basis I Basis = futures price .. risk exposure Forward contract Forward exchange contract (FEe) Agreement made today to exchange a specified instrument SR = price of UA for immediate delivery for specified quantity Forward rate (FR) & spot rate (SR FR> SR FR Currency traded at premium Currency traded at par Currency traded at discount Underlying instrument could be • • • Currency Security Commodity = SR FR < SR Digitized by Google .spot price I [ ...< = .Contango futu res price spot price Basis terms I .Convergence Basis risk = risk of variation in value of basis in hedged position = > Backwardation futu res price spot price = process of basis approaching zero Hedging strategy: underlying position &.
of units of domestic currency (DC) required to buy one unit of foreign currency (FC) IRULE: BUY LOW. SELL HIGH Indirect quote Denotes no. of units of Fe required to buy one unit of De ~ IRULE: BUY HIGH.Quotes used in FEe Direct quote Denotes the no. SELL LOW [ Bid price (buying rate) Rate for buying FC in exchange for DC Terms in FEe • + I Offer price (selling rate) Rate for selli ng FC in exchange for DC • + I J Spread • + Range forward contract: agreement to buy or sell currency at an exchange rate which lies within the agreed range of values Participating forward contract: agreement that allows a company to cap its downside currency risk through a worst case exchange rate Difference between bid & offer price FOREX could be delivered Client could request cancellation of forward contract Client could request extension of forward contract .
the notional amount of currencies does not change hands profits or losses on a notional principal amount are settled in cash at the end of the contract Digitized by Google .Forward market hedge (FMH) &. money market hedge (MMH) &. a company can sell the expected net inflow of foreign currency and buy the expected net outflow of foreign currency Currency required at end of contract period The total receipts (principal plus interest) after liquidating the foreign currency investment are then used to make business payments Currency required immediately used as replacement for forward contracts in those currency markets where currencies are not freely convertible due to cash settlement. SAFEs FMH Company enters into a binding contract with a bank • • • to buy or sell certain quantity of FOREX at predetermined exchange rate at agreed future date MMH Process of: • borrowing in money market of one country • converting funds borrowed at spot exchange rate of beneficiary country • investing in second country Using forward currency rates.
Futures contract Futures contract (Fe) commitment to buy a commodity. security or currency at predetermined future date at price agreed upon today Exchange-traded currency futures contract (FC) entails delivery of one or more foreign currencies Derivative contract which at predetermined future date at price agreed upon today Construction of a futures hedge 1 Identification of underlying CUT) to be hedged transaction Contract cycle: the period over which a future contract trades Expiry date: the date specified in the futures contract Contract size: the amount of asset that has to be delivered under one contract Cost of carry: summary of relationship between futures prices and spot prices .
which involves simultaneous purchase (or sale) of a call option & a put option at the same strike price and time to expiry Buy position Sell position Strangle Derivative position which involves the simultaneous purchase (or sale) of a call option and a put option with the same time to expiry but with different strike prices Buy position Sell position Meaning Long Short - Concept Long straddle Action Buy put & call at same strike price Profit potential Unlimited Limited 1Unlimited Limited Loss potential Limited - Short stradd Ie Long stra ng Ie Short stradd Ie -- Sell put & sell call at same strike price Buy put & call at different strike prices strike prices - Unlimited Limited Unlimited - Sell put & sell call at different Digitized by Google .Currency straddles and strangles Straddle Derivative position.
.Swaps ... over a period of time resulting in an exchange of a series of future cash flows exchange a specific amount of two different currencies contract in which two counterparties exchange interest payments in the two currencies over the term of swap Advantages of swaps: • • • • • Cost reduction Hedging for longer time periods Restructuring of debt profile Access to international markets Cheaper than forwards Exchange of fixed interest obligations for fixed interest obligations Exchange of fixed rate obligations for floating rate obligations Disadvantages of swaps: • • • Cost reduction may not be possible if there are adverse movements in exchange rates Possibility of default by counterparty May turn risky if government imposes restrictions Digitized by Google .... a bilateral OTC agreement.
of currencies Digitized by Google .FOREXswap (FS) Principal exchanged at start & re-exchanged at end of swap No exchange of interest payments Currency options (CO) American option: can be exercised on any business day up to & including expiry date European option: can be exercised only on expiry date of option Advantages of CO: • • • Protect company against adverse currency fluctuations Hedge against FOREX risk Provide effective currency hedge Disadvantages of CO: on / before predetermined future date • • Option premium paid whether or not option exercised Exchange-traded currency options available in limited no.
11 Process under which debit balances are netted off against credit balances.Treasury & Advanced Risk Management Techniques Netting Netting Meaning Objective E2. so that only the net amounts remain to be paid in actual currency flows To offset expected loss in one currency exposure by likely gain in another - Netting between two parties Lower balances netted off against higher balances Remainder amount paid / received Does not require intervention of central treasu ry unit Netting between more than two parties Coordinated by group's treasury operations department Digitized by Google .
Advantages & Disadvantages of netting: Advantages Reduces banking transaction costs Has legal risk Exchange control restrictions may be imposed Disadva ntages ~ Reduces credit risk and liquidity risk Dates of settlement of contracts & foreign currency involved may not match - Digitized by Google .
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