1 FinancialPrincAndInstruments

Introduction to Financial Principles and Instruments
Reval 100 Broadway, 22nd Floor New York, NY 10005
Copyright 2008 Reval. All rights reserved. The enclosed material is proprietary to Reval, and is therefore copyrighted. This document may not be disclosed in any manner to anyone other than the addressee and the employees of the addressed firm who are directly responsible for the evaluation of its contents. This document may not be used in any manner other than for the purpose that it was distributed. Any unauthorized use, reproduction or transmission in any form is strictly prohibited. The recipient of this document should not construe any information furnished herein as any legal, tax, accounting, investment or risk-management opinion, recommendation, strategy or advice. Trademarks Reval, HedgeRx, FAS 133 Doctor, and IAS 39 Doctor are registered trademarks of Reval. CICA 3865 DoctorTM is a trademark of Reval. Other product names mentioned in this document may be trademarks or registered trademarks and are hereby acknowledged.
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Table of Contents 1 About this Course and Document ..........................................................................4 1.1 Document History ...........................................................................................4 1.2 Conventions used in this manual....................................................................4 1.3 Course Description and Objectives ................................................................5 1.4 Pre-requisites for this Course .........................................................................5 1.5 Course Agenda...............................................................................................5 2. What is Treasury Management?............................................................................7 2.1. What are Cash and Liquidity Management?...................................................8 3. What is Risk Management? .................................................................................11 3.1. What is Hedging? .........................................................................................11 3.2. How do Firms Hedge? ..................................................................................12 3.3. What are Derivatives? ..................................................................................13 4. Financial Concepts ..............................................................................................16 4.1. What is the Time Value of Money?...............................................................16 4.2. What is an Index? What is a Benchmark? ...............................................20 4.3. What Types of Pricing can be used in Transactions?...................................20 4.4. How is interest calculated? ...........................................................................20 4.5. How is Net Present Value (NPV) / Fair Value (FV) calculated?....................22 4.6. What is an Exchange trade versus an Over-the-Counter one? ....................22 4.7. What are Stress Testing and Scenarios? .....................................................23 5. What are the Front, Middle and Back Offices responsible for?............................26 6. What are Interest Rates? .....................................................................................27 6.1. What are Interest Rate Swaps?....................................................................28 6.1.1 How is an interest rate swaps value calculated? ..................................30 7. What is Foreign Exchange?.................................................................................33 7.1. What are Foreign Exchange Forwards? .......................................................35 7.2. What is the value of a Foreign Exchange Forward? .....................................35 7.3. When are Foreign Exchange Forwards used for hedging?...........................39 7.4. What are Foreign Exchange Swaps? ...........................................................39 8. Commodities........................................................................................................49 8.1. What are Commodity Futures and Forwards? ..............................................49 8.2. Similarities and Differences of Futures and Forwards ..................................51 8.3. What are Commodity Swaps? ......................................................................52 9. Investments .........................................................................................................56 10. Glossary ...........................................................................................................58
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1 About this Course and Document
1.1
Document History The following table shows the revision history of this manual.
Date
05-08 07-08
Version
1.0 2.0
Description
Workbook for Introduction to Hedge Accounting course Revised based on class feedback
Author
PIT-A PIT-A
1.2
Conventions used in this manual The following table shows conventions used in this manual. Convention Bold wording Italics wording Eyeglasses bullet Definition Field reference or key term Screen/window reference Note to reader Calculation or exercise to perform Hands-on exercise to complete Computer icon Review Microsoft Excel spreadsheet showing calculations 1. Green background and book icon Main chapter heading
Calculator icon
1.1 Blue background and highlighted book icon
Lesson/sub-chapter within main chapter heading
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1.3
Course Description and Objectives The Introduction to Financial Principles and Instruments course will introduce participants to basic financial and hedge accounting topics. By the completion of this course, the participant will be able to: Explain treasury management, risk management and hedge accounting Discuss why firms hedge Explain various financial and hedge accounting terminology Define asset classes: foreign exchange, interest rate, and commodities Perform calculations for various products.
1.4
Pre-requisites for this Course There are no pre-requisites for this course. The knowledge gained from this course is a pre-requisite for the Introduction to HedgeRx course.
1.5
Course Agenda The agenda for this course follows. Please note that it is subject to change. Introduce treasury management Describe risk management and how firms hedge risk Examine asset classes, related products and valuations o Financial Concepts: Time value of money Pricing Curves/indexes and Benchmarks Interest calculation and zero coupon rates Net present value/mark-to-market Exchange traded versus over-the-counter Stress testing and scenarios
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o Interest rate Swaps o Foreign exchange Forwards Swaps o Commodities Forwards Swaps o Investments Held to Maturity (HTM) Available for Sale (AFS) Trading
Revals Hedging Management Solution
Market Data
Asset Classes
Commodity Financial
Interest Rates Foreign Exchange Energy Metal Agricultural
Front Office
Pricing Analytics Deal Capture Portfolio Allocations Term Sheet s
Middle Office
Market Exposure Risk What-if Analysis Mark-toMarket
Back Office
Inventory P/L Reset s Payment Option Expiry Audit Reports
FAS 133/IAS 39
Documentation Hedge Designation Analytics Reporting FAS 133 DoctorTM
Client Support
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2. What is Treasury Management? Reval provides web-based treasury and risk management solutions and services to corporations and financial institutions. Reval blends finance, technology, software, and operations expertise to deliver effective and rapidly deployable solutions that bring immediate return on investment to clients.
Treasury management is at the financial core of an organization handled by the treasury department. The department is responsible for managing the firms assets and liabilities: issuing new shares, receiving assets, borrowing and/or investing money, etc. The department deals with internal and external issues such as: Internal issues Wages Benefits Bonuses Consultant and/or liaison to other departments External issues Financial markets Investors Creditors Rating agencies Debt issuers
Treasury management affects risk. It is involved in: Cash management Liquidity management Risk management. Today, organizations have more financial obligations than in years past. There are more regulations to abide by. Organizations are more global and need to control risk factors external to the business that effect international activities. Also, organizations are more volatile. Changes in exchange rates, interest rates, and commodity prices are rapid and can adversely affect a company. The size of the treasury department is usually correlated to revenue size:
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Source: Treasury Strategies 2003 Corporate Treasury Survey
Larger companies generally have: Greater exposures/risk management needs Bigger treasury department Greater number of derivative trades.
2.1. What are Cash and Liquidity Management?
Cash management is the key role of treasury departments. It is the efficient movement of cash to maximize revenue opportunities. Cash management includes: Forecasting and protecting cash and assets Controlling cash receipts and distributions Investing excess cash and managing debt, when needed. Cash management starts with a forecast of cash flows, present and future. There are various methods to forecast cash flows: Scheduling: Schedule large-volume inflows or outflows (e.g., wire transfers) Distribution: Forecasting multiple distributions as one (e.g., check clearings or trade receivables) Statistical Analysis: Regression analysis creates a formula that attempts to explain the link between an event and related, dependent cash flows. The R-squared statistic shows the strength of this relationship.
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Liquidity is the ability of an organization to meet its short-term financial responsibilities. Organizations must be able to take advantage of opportunities that arise, such as funding an acquisition. Treasury management is responsible for maintaining cash balances and, thus, making sure the organization has liquid funding available.
Note: While cash management focuses on methods used to manage cash, liquidity management focuses on the balances that result from the cash management transactions.
Liquidity is managed using a variety of financial instruments: Money markets: Short-term, fixed-income securities Government securities: Including treasury bills (discount obligations issued by the U.S. Treasury of one-year or less durations), bonds issued by government agencies (e.g., Federal National Mortgage Association, Fannie Mae), and municipal bonds (issued by city and community governments) Bankers Acceptances (BAs): Issues of corporate debt that have been accepted/guaranteed by a bank Foreign Exchange Swaps (FX swaps): Consists of a spot transaction with a simultaneous forward transaction. Currencies are exchanged both at the spot and forward dates; the rates are set at the beginning of the transaction so their difference reflects the interest differential between the two currencies over the length of the swap. FX swaps may be entered into the same day (cash value), the next business day (tom-next) or two business days (spot next).
Scenario: ABC Company has excess Euros that it would like to invest for the next six months. It would like U.S. dollars in the interim to pay off expenses. After the six month interval, ABC will exchange the U.S. dollars back for Euros. Solution: ABC enters into an FX swap today with XYZ selling 1,000,000 Euros for 1,560,000 U.S. dollars (exchange rate of 156 U.S. dollars per Euro). ABC and XYZ also agree to a swap for value six months from today - XYZ will sell back the 1,000,000 Euros for 1,500,000 U.S. dollars. The difference is a result of the interest rate differential between the two currencies for the six months. Result: ABC Company has invested Euros for six months and gained U.S. dollars.
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TREASURY MANAGEMENT REVIEW
1. Define treasury management. ________________________________________________ ________________________________________________
2. Define cash management. ________________________________________________ ________________________________________________
3. Define liquidity management. ________________________________________________ ________________________________________________
4. Name three issues treasury management must monitor. ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________
5. What is the main difference between cash management and liquidity management? ________________________________________________ ________________________________________________
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3. What is Risk Management? Risk management is the responsibility of the treasury department to react to the uncertainties of the financial markets. It deals with the possibility that some future event will cause harm to the company. It provides strategies, techniques, and approaches to recognize and confront any threat to the organization. It must identify the source(s), measure and address the risk. There are various types of risk that need to be monitored such as: Interest rate risk: risk that the value of an interest-bearing asset (e.g., loan or bond) will decline due to an increase in interest rate, can be hedged with an interest rate swap. Currency risk: risk that arises from the change in price of one currency against another; when companies have assets or business across borders, they may be exposed to currency risk. Currency risk may be hedged by taking an off-setting position. Credit risk: risk that a borrower will not pay money owed; lenders generally charge a higher rate for higher risk customers. Liquidity risk: risk that a firm will not be able to sell an asset or meet financial obligations; liquidity risk is difficult to isolate as it impacts credit risk, market risk, etc. Commodity price risk: risk associated with price volatility of the commodity.
Types of risk
3.1. What is Hedging?
The term hedging is derived from the phrase hedging your bets used in gambling. For example, within the game of roulette, placing a hedge bet is one where the chips cover the lines between two numbers on the table. The bet covers all numbers involved at a reduced stake. The term now is used within risk management to cover a range of riskreduction activities such as various investments. A hedge investment reduces or cancels risk in another investment, similar to an insurance policy against a negative event. Hedging is the strategy designed to mitigate exposure to unwanted risk, so if the negative event occurs the damage is minimized. Hedging is used to reduce exposure to potential risks.
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Hedging uses instruments in the marketplace to strategically offset risk of adverse price movements. In other words, companies hedge one investment by entering into another. The goal of the hedge is not to make money but to mitigate risk. While the companys profits may be reduced in an upside, so will their losses in a downside.
Example hedge: A company has outstanding fixed-rate debt and believes that interest rates will decrease. They enter into a receive fixed, pay floating rate swap to hedge the fluctuation in interest rates.
3.2. How do Firms Hedge?
There are many hedging strategies that an organization can use. Hedging generally involves the use of derivatives, such as futures and options. Usually the derivative trade moves in the opposite direction of the initial investment: a loss in the investment will cause a gain in the derivative and vice-versa. Companies may hedge all or part of their risk. Definition: Companies hedge price changes in physical material by offsetting the risk in the futures market. About the company: Southwest Airlines originally served three cities in Texas: Dallas, Houston and San Antonio. They are now the largest airline in the United States and in the world measured by the number of passengers carried per year. About the hedge: Southwest is dependent on jet fuel. They have hedged fuel prices for years. In 2000, Southwest said it had adjusted its hedging strategy to utilize financial derivative instruments...it appears that the Company can take advantage of historically low jet fuel prices. Southwest used a combination of options and swaps to lock in low historical prices. Southwest hedged for forward years: 2008 is 65% hedged at $49/barrel, 2009 is 50% hedged at $51/barrel, 2010 is over 25% hedged at $63/barrel. The hedging strategy continues until 2012. Result: Risk managers have suggested that Southwest was speculating on energy prices, without a formal rationale for hedging the business risk. At present, Southwest has enjoyed a strong financial boost from its energy trading. Whether a volatility hedge or just a speculative one, Southwest has reaped the benefits of hedging. (At the time this was written in 2008, jet fuel cost 158.60 USD per barrel, over a 109 USD savings for Southwest Airlines).
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There are many different types of options and futures contracts. Companies can hedge against almost anything: commodities, stock, interest rate, currency, weather, etc. Every hedge has a cost. Similar to insurance, the benefit of the hedge may never be recognized; however, the cost is still there. Companies need to decide if the potential benefits justify the cost. The goal of the hedge is not to profit, but to offset risk and decrease potential losses. The company must consider the cost of the hedge in light of the implicit cost of not hedging to correctly evaluate the cost of the hedge.
3.3. What are Derivatives?
Derivatives are financial instruments whose value is derived from changes in the value of an underlying asset such as a commodity, debt instrument, interest rate or unit of currency. According to FAS 133, a derivative is an instrument with all three of the following characteristics: Derivatives definition 1. Underlying or either a notional amount of payment provision or both 2. Relatively small initial net investment 3. Net settlement or its equivalent. Derivatives are used to manage risk and may require FAS 133 or IAS 39 accounting (discussed in later sections of this manual). The following chart shows some example derivatives.
Derivative Interest rate swap Currency forward Commodity future
Underlying Interest index Exchange rate Commodity price
Notional Amount Dollar amount Number of currency units Number of commodity units
Important terms when discussing derivatives include: Notional amount: Principal amount of the transaction, quantity Start Date: Beginning date of the transaction; effective date
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Maturity Date: End date of the transaction Trade Date: Date the trade was entered into Settlement Date: Date when the buyer must pay for the securities delivered Reset Date: Date a floating rate is set for a period of time Floating Rate: Variable rate based on an index such as LIBOR Fixed Rate: Set amount Day Count Factor: Determines the number of days between two interest payments for investments such as swaps, bonds, loans, etc. It determines the way interest is accrued over time. Specific day count factors are discussed within the How is interest calculated? section of the next chapter.
RISK MANAGEMENT REVIEW 1. Define risk management. _____________________________________________________ _____________________________________________________ _____________________________________________________
2. Name three types of risk that firms need to manage. _____________________________________________________ _____________________________________________________ _____________________________________________________
3. What are the similarities between a treasury management system and a risk management system? ________________________________________________ ________________________________________________ ________________________________________________
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4. What are the differences between a treasury management system and a risk management system? ________________________________________________ ________________________________________________ ________________________________________________
5. How can a company manage interest rate risk? _____________________________________________________ _____________________________________________________
6. Define the term hedging. _____________________________________________________ _____________________________________________________ _____________________________________________________
7. What is a derivative? _____________________________________________________ _____________________________________________________ _____________________________________________________
8. What is an underlying asset? _____________________________________________________ _____________________________________________________ _____________________________________________________
9. What is meant by the notional? _____________________________________________________ _____________________________________________________
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4. Financial Concepts There are various financial concepts that are universal to all instruments and asset classes. The following terms are highlighted in this section: Time value of money Types of pricing Curves / indexes / benchmarks Interest calculation Net present value / mark-to-market Exchange traded versus over-the-counter Stress testing and scenarios
4.1. What is the Time Value of Money?
Congratulations! Youre a winner! You have won $1,000,000 U.S. dollars. Would you like to receive it today or ten years from today? Most people would choose to take the money now! It can be invested, used to make a purchase or utilized for other things. If the winner chooses to invest the money at 8% for ten years, compounded annually, it will be worth approximately $2,158,925. Why take $1,000,000 in ten years when it could be worth $2,158,925 by that time?
A dollar today does not equal a dollar tomorrow. All else being equal, you would prefer to receive your payment today rather than the same payment at a future date. As illustrated in the above example, the winner or lender could invest the money to increase the future value. The following two boxes show the time value of money. The discount rate is the interest rate used to determine the present value of future cash flows.
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Time value of money example calculations
The calculation highlighted in turquoise illustrates the future value of $10,000 today compounded annually at a rate of 5%. The calculation highlighted in orange illustrates the present value of $16,288.95 in ten years from today, compounded annually at a rate of 5%.
$10,000 today equals
$16,288.95 ten years from now at a rate of 5%
Future Value = Amount * (1 + interest rate per period) number of periods Example: The future value of $10,000 in ten years, compounded annually at a rate of 5%, is approximately $16,288.95. 16,288.95 = 10,000 * (1 + .05)10
Present Va lue =
Future Value (1 + interest rate per period) number of periods
Example: The present value of $16,288.95 in ten years, compounded annually at a rate of 5%, is approximately $10,000. 10,000 = 16,288.95 / (1 + .05)10
Pr esent Value factor =
1 (1 + interest rate per period) number of periods
OR PVf = PV / FV
Example: The present value factor of an annual interest rate of 5%, is approximately .95238. . 95238 = 1 / (1 + .05)
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1. Using the exponential of (1.05)10 which equals 1.628895 will create a PVf of approximately .6139.
.6139 = 1 / (1.05)10
2. Multiplying .6139 by the $16,288.95 brings us back to the original $10,000 of the deal. 3. Another way of calculating the PVf is to divide the PV by the FV.
.6139 = 10,000 / 16,288.95
Zero coupon rate definition
Rates may be calculated similar to the calculation of zero coupon interest rates. Zero coupon interest rates mean that there is only one interest flow, interest is paid only at maturity (simple interest). In this example, there are no interim coupon payments between today and ten years; all interest flow (i.e., coupons) is paid at the end of the term of the deal. Actually, money market rates (with maturities of one year or less) are quoted as zero coupon interest rates. If the deal had a one-year maturity (as in money markets), all interest would have been paid at the end of the year. Deals with greater than one year maturity actually use swap rates to calculate PV factors. These swap rates derive the yield curve (discussed in a later section).
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ON-YOUR-OWN PRESENT AND FUTURE VALUE CALCULATIONS

1. Calculate the present value of $2,000,000 in ten years from today. Assume the interest rate is 5%.
_____________________________________________________ _____________________________________________________ _____________________________________________________ _____________________________________________________
2. Calculate the future value of $2,000,000 in five years with an interest rate of 7%.
_____________________________________________________ _____________________________________________________ _____________________________________________________ _____________________________________________________
3. If $10,000 equals $10,500 in one year, what is the present value factor?
_____________________________________________________ _____________________________________________________ _____________________________________________________ _____________________________________________________
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4.2. What is an Index? What is a Benchmark?
An index is a statistical composite that measures changes in financial markets. For example, the Consumer Price Index (CPI) moves up and down as the rate of inflation changes. Indexes within markets are used to reflect market prices of bonds, commodities, interest rates, etc. For example, there are different indexes for the natural gas locations. A benchmark is a standard or reference against which prices are compared or calculated. Benchmarks usually are used because a commodity exists in many forms that can be distinguished by different properties or quality. For example, the various natural gas indexes are compared to the NYMEX, the benchmark for natural gas prices.
4.3. What Types of Pricing can be used in Transactions?
There are two types of pricing used in transactions:

Fixed: Price is set; no matter what happens in the market the price of the deal (or leg) will remain the same Float: Price is variable; it fluctuates based off of an index. The price may be the index price plus/minus a spread or a percentage of the index. Interest adjustments are made periodically (e.g., semiannually, quarterly, etc.) at the reset date.
4.4. How is interest calculated?
Interest accrues between payments throughout the life of the deal. Accrued interest represents the amount of accumulated interest between the last payment and the sale of the fixed-income instrument.
Accrued Interest = (Coupon rate) X (# days since last payment) X (Principal )
Whether accrued interest is included in the price of the security depends on the pricing method used:
Clean price: Represents the price of the security without the accrued interest included Dirty price: Represents the price of the security with the accrued interest included.
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How the number of days since the last payment is calculated depends on the day count factor used in the transaction.
Day Count Factor = (# days between dates / # days in reference period)
Some day count factors are:

Actual/365F: The number of accrued days is equal to the actual number of days between d_e and d_t. This accrual is often used in the money market and in calculating accrued interest of bonds or swaps. Actual/360: Same as Actual/365(fixed). This accrual is often used in the money market and in calculating accrued interest of bonds or swaps. The year is assumed to have 360 days. Actual/Actual Swap: The accrual factor is the sum of the accrued days of the non-leap year divided by 365 and the accrued days of the leap year divided by 366. Actual/Actual Bond: This accrual method is primarily related to bonds. However, in the context of accrual factors, the time in years is calculated as follows: if the period is less than one year the accrual factor is equal to the actual number of days between d_e and d_t divided by the number of days in the period from (d_t 1 year) to d_t (either 365 or 366). If the period is greater than one year, the accrual factor is equal to the number of whole years plus the accrual of a stub period calculated as above. 30/360: Also known as 'bond basis'. This accrual method assumes 30 days per month and 360 days per year. However, if the first date of an accrual period is not the 30th or 31st, and the last date of the period is the 31st of the month then that month is considered to have 31 days. Hence, the accrual factor is simply the number of accrued days divided by 360. 30E/360: This is know as 30/360 European. It is a slightly simpler version of 30/360 in that if the first date or the last date of an accrual period is on the 31st of a month, then the date is set to the 30th. Hence, the accrual factor is simply the number of accrued days divided by 360. Actual/Actual ISMA: The accrual factor is the sum of the accrued days of the non-leap year divided by 365 and the accrued days of the leap year divided by 366.
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Actual/Actual: Each month and year is calculated using the actual number of days that have passed. This accrual method calculates the actual number of days between two dates and assumes the year basis to be 365 days for non-leap years and 366 for leap years. If a short stub period (< 1 year) contains a leap day, the number of days is divided by 366 otherwise the number of days is divided by 365.
The zero coupon rate is the discount rate implied by the market in valuing a single future payment, such as the redemption of a zero coupon bond. Zero coupon rates are used to value streams of cash flows, such as swaps. Zero coupon securities are ones sold at deep discounts but do not pay interest.
4.5. How is Net Present Value (NPV) / Fair Value (FV) calculated?
Net Present Value or Fair Value is the difference between cash inflows and cash outflows at todays value. NPV uses the discount factor to compute the dollar value today for all cash flows, present (cost of investment) and future.
NPV = (1 + interest rate per period) number of periods

t=0
Calculating NPV or MTM is often called mark-to-market or simply mark.
4.6. What is an Exchange trade versus an Over-the-Counter one?
An exchange is a central location or marketplace where trading occurs. Securities, commodities, derivatives and other financial instruments are traded on an exchange. The exchange ensures fair and orderly trading. Exchanges may be physical locations where traders meet to conduct business or an electronic platform. Example exchanges are the National Association of Securities Dealers Automatic Quotation System, New York Mercantile Exchange, and London Metals Exchange.
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Contracts traded on futures exchanges are standardized. Futures and options are examples of exchange traded instruments. In contrast, an over-the-counter (OTC) transaction is one that occurs directly between two counterparties. An OTC contract is agreed upon by two parties and is settled in the future. Forwards and swaps are examples of OTC instruments. Derivatives are usually governed by an International Swaps and Derivatives Association (ISDA) agreement and documented under master agreements. The following table highlights some differences between exchange trades and over-the-counter trades:
Exchanges Over-the-Counter
Central location or electronic platform Standardized contracts Futures and options
Occurs directly between two counterparties Settled in the future Forwards and swaps
4.7. What are Stress Testing and Scenarios?
A stress test determines how a portfolio or transaction will react to different financial situations. It assesses performance of the transaction or portfolio under certain market changes.
Scenarios are the different events that are tested within the stress test. For example, what would happen to the trade if the price increased by 10%? What would happen to the value of the portfolio if the price decreased by 10%? Stress testing often is called what-if analysis, assesses potential losses by looking at the value of an instrument(s) under different scenarios. Scenarios may involve one change such as a price increase or decrease or multiple changes such as a price change combined with a change in a foreign exchange rate.
Stress testing trades is a good way to assess a firms risk exposures. Proper actions can be in place should unacceptable exposures be determined. Proper planning may prevent poor performance.
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FINANCIAL CONCEPTS REVIEW
1. What are the similarities and differences between a fixed price and a float price? Give examples of each.
________________________________________________ ________________________________________________
2. What are the similarities and differences between an index and a benchmark? Give examples of each.
________________________________________________ ________________________________________________
3. What is/are the similarities and differences between an exchange trade and an over-the-counter trade?
________________________________________________ ________________________________________________
4. Define the terms stress testing and scenario.
________________________________________________ ________________________________________________
5. A firm wants to see what would happen to its portfolio if the LIBOR curve increased and decreased by 10%. What would the firm need to do to assess the risk?
________________________________________________ ________________________________________________ ________________________________________________

6. The start date of a security is January 1st. Interest is paid semi-annually at the rate of 5% on a $100,000 notional. Today is July 15th. How much interest has been accrued assuming a day count factor of Actual/360?
________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________
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7. The start date of a ten-year, $100,000 bond is January 1st. Interest is paid annually at the rate of 5% on a $120,000 notional. Today is June 30th of the first year of the life of the bond. What is the clean price and dirty price of the security?
Clean:___________________________________________ Dirty:____________________________________________ ________________________________________________ ________________________________________________

8. The cost of a ten-year security is $40,000. The security will distribute $500 each year to the owner, the prevailing discount rate is expected to be 10% over the ten years, and an additional $100,000 at maturity. Is this security a good investment?
________________________________________________ ________________________________________________ ________________________________________________

9. The cost of a thirty-year security is $300,000. The security will distribute $100 each year to the owner, the interest rate is expected to be 5%, and it will pay out $1,000,000 at maturity. Is this security a good investment?
________________________________________________ ________________________________________________ ________________________________________________

10. The cost of a five-year security is $60,700 with an interest rate of 10.5%. The security will pay out $100,000 at maturity. Is this security a good investment?
________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________
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5. What are the Front, Middle and Back Offices responsible for?
The front office is the term used to describe the trading responsibility of a financial company. The front office is the location within the organization where revenues are generated. Various trading desks (interest rate, foreign exchange, and commodity) are considered to be part of the front-office. The front-office has also been defined as the sales personnel. The middle office is the group of employees within an organization that is in charge of monitoring and managing risk exposures and setting credit limits. The middle office draws from the knowledge of both the front and back offices. It generally consists of the risk and credit departments and may include the information technology department, depending on the organization. The back office is responsible for the support functions of the financial services company, including the trade confirmation (written acknowledgement of a transaction between two parties), trade settlement (delivery of instrument in exchange for payment), record keeping, accounting and compliance/regulatory issues.
FRONT, MIDDLE AND BACK OFFICE REVIEW
1. Match the office on the left to the definition on the right. Back office _____ Front office _____ Middle office _____
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a. Set credit limits and manage exposures b. Confirmations, settlements and accounting c. Trading desks
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6. What are Interest Rates?
Interest rates reflect the price of money and are determined by supply and demand. A greater demand for money is likely to drive up the price of money, reflected in the interest rate. Demand depends on factors such as the nation's economic health, the level of government borrowing to support budgets, etc. Rates are adjusted upward in an attempt to slow the economy, and downward to act as a stimulus. Interest rate payments are the fees paid to the lender to borrow money since the lender is foregoing other useful investments that could have been paid with the financing. Generally, they are quoted annually, the annual rate of interest. The amount lent is called the principal or notional amount. Simple interest is paid only on the principal or what is remaining from the principal. Compound interest charges interest on the interest; interest is paid on both the principal and the interest.
Benchmark interest rates are often used such as treasury, Libor, and Fed Funds rates. Rates may be fixed or floating. As stated in the previous section, a fixed rate is set and does not change. Floating rates are indexed to a benchmark rate; for example, the Libor plus or minus a certain percentage.
The yield curve represents the relationship between interest rates and time to maturity of the deal. The yield curve is usually upward sloping and accounts for the time value of money, interest rates being higher in the future.
Yield (%)
Time to maturity
A dollar today does not equal a dollar tomorrow. All else being equal, a lender would prefer to receive payment today rather than the same payment at a future date. The lender could invest the money to increase its future value.
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6.1. What are Interest Rate Swaps?
A swap is a contract specifying the exchange of one cash flow for another at a future point in time. These cash flows are linked to interest rates. These agreements state the exchange of periodic interest payments on a predetermined principal amount (the notional amount). One party may pay a fixed rate and the other party may pay a floating, variable rate based on an index such as in a plain vanilla swap. An example swap is the exchange of the 3M Libor for 5% paid semi-annually for five years. Each payment stream is called a leg of the swap. The side of the swap that pays the fixed rate purchased the swap. The table below shows the sides and legs of a swap. Assuming four payment periods, the swap has two sides and four legs.
Pay Side Receive Side
Payment leg 1 Payment leg 2 Payment leg 3 Payment leg 4
Receive leg 1 Receive leg 2 Receive leg 3 Receive leg 4
Long swaps (buying a swap) pay fixed and receive floating. Short swaps (selling a swap) pay floating and receive fixed.
The fixed swap rate usually is set so that the present value of the swap is zero. A swap is used to mitigate risk, not make a profit. Swaps are over-the-counter transactions and require documentation standardized by the International Swaps and Derivatives Association (ISDA).
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Example Interest Rate Swap
Step 1: Training Inc. enters into an agreement with Lender to Receive a Loan and pay a Floating (variable) Rate. Training Inc. does not want to pay a Floating Rate but wants to pay a Fixed Rate so Step 2: Training Inc. enters into an agreement with Swap Co. to Pay a Fixed Rate and Receive a Floating Rate (an interest rate swap) End result: The Floating Rate passes through Training Inc. from Swap Co. to Lender and Training Inc. Receives the Loan from Lender and Pays Swap Co. the Fixed Rate.
Pay Fixed
Training Inc.
Step 2
Swap Co.
Receive Float Pay Float Receive Loan
Step 1
Lender
A basis swap occurs if both parties pay floating rates, as shown below.
Pay Float
Training Inc.
Receive Float
Swap Co.
Interest rate swaps are used by hedgers to manage their fixed or floating assets and liabilities. For example, a swap may be used to protect against a debt that has interest rate risk built in based on movements of the benchmark. Interest rate swaps are easy to price and are traded in the over-thecounter market so they can be structured to match the cash flows of the underlying. However, the interest payments are locked in and if the index does not go in the owners favor, the owner is obligated to pay the agreed upon interest rate.
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6.1.1 How is an interest rate swaps value calculated?
An interest rate swaps value is the difference between the present values of the swaps sides. For example, if the swap pays out a fixed rate and receives a floating rate, the value will be calculated by taking the present value of the floating side and subtracting the present value of the fixed side. The day count factor enters into the equation for each interest payment. The following formulas are from Wikipedia.com. The value of the fixed leg is the present value of the fixed coupon payments known at the start of the swap:
C = swap rate M = number of fixed payments P = notional amount ti = number of days in the period Ti = basis according to the day count factor dfi = discount factor
The value of the floating leg is the present value of the floating coupon payments determined at the agreed upon dates for each payment:
N = number of floating payments P = notional amount fj = floating rate tj = number of days in the period Tj = basis according to the day count factor dfj = discount factor
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Scenario: Company A purchases a swap from Bank B. Company A will pay a fixed-rate of 5% semi-annually. Bank B will pay the floating rate based off of the six-month USD Libor. The notional amount is one million USD. Assume the six-month Libor rate is known to be 4.8% and 5.2% when the reset periods come, the day count factor is Actual/360, and for simplicity, the actual number of days is 180 and the discount factor is 1.
The present value of the fixed side equals: = .05 * [(1,000,000 * (180/360) * 1) + (1,000,000 * (180/360) * 1)] = .05 * [500,000 + 500,000] = 50,000 The present value of the floating side equals: = [(1,000,000*.048*(180/360)*1)+(1,000,000*.052*(180/360)*1)] = 24,000 + 26,000 = 50,000
Conclusion: The present value of the swap equals zero. It is a breakeven swap.
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INTEREST RATE REVIEW
1. Define the following terms: Term Definition
Interest rate Simple interest Compound interest Yield curve

2. Party A enters into a swap with Party B, agreeing to pay the 3month Libor rate. Bank B agrees to pay Party A the 6-month Libor rate. What type of transaction is entered into?
________________________________________________ ________________________________________________
3. Party C purchases a one-year, ten-million USD swap from Bank B. Party C agrees to pay Bank B a fixed-rate of 10% and Bank B agrees to pay Party C a floating rate based on the 6-month Libor rate. Assume the Libor rate is known to be 7% and 11% at the dates of reset, the day count factor is Actual/360 (actual number of days is 180), and the discount factor is 1. What is the value of the swap?
________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________
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7. What is Foreign Exchange?
Foreign exchange trades occur for several reasons: to buy or sell a commodity in a foreign currency or country, take advantage of exchange rates, or to leverage activities of an organization. The date that the funds are exchanged is known as the settlement date or delivery date. Foreign exchange transactions may be:
Spot settlement: Immediate delivery; within two days after the trade is booked (T + 2). [Note: There are some exceptions to this such as the Canadian dollar and British pound sterling which have T + 1 settlement.] Spot exchange rates adjust to compensate for the relative inflation rates between the two countries. Forward: The exchange occurs at some specified date in the future, perhaps months into the future.
Foreign exchange rates are the prices of currencies relative to one another. As a result, they may be quoted as either currency relative to the other. Exchange rates fluctuate often. According to Wikipedia, the top ten traded currencies are:
Rank
Currency
ISO code
% daily share (4/04)
1 2 3 4 5 6 7 8 9 10
United States dollar Euro Japanese yen
USD ($) EUR () JPY ()
88.7% 37.2% 20.3% 16.9% 6.1% 5.5% 4.2% 2.3% 1.9% 1.4%
British pound sterling GBP () Swiss franc Australian dollar Canadian dollar Swedish krona Hong Kong dollar Norwegian krone CHF (Fr) AUD ($) CAD ($) SEK (kr) HKD ($) NOK (kr)
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The base currency (also called the local currency) does not change when the exchange rate changes. Most often, the U.S. dollar is used as the base currency. Exchange rates may be quoted as indirect or direct quotations:
Indirect quote: The number of units of a foreign currency that can be exchanged for one unit of a local currency. Exchange rates quoted with the U.S. dollar as the base currency. For example, 104.40 Japanese yen per U.S. dollar. Direct quote: The number of units of a local currency exchangeable for one unit of foreign currency. Exchange rates quoted with another currency, such as the British sterling, Australian dollar, euro, etc. as the base currency. For example, .0096 U.S. dollars per Japanese yen.
Indirect versus direct quotes
Given a direct quote, the indirect quote may be obtained (the reciprocal of the direct quote) and vice versa. Exchange rates where the U.S. dollar is not one of the currencies are called cross rates. Foreign exchange conventions standardize the ways quotes are given. Currency quotations are relative to the US dollar. Quoting in terms of the US dollar is called American terms and quoting in terms of the foreign currency is called European terms. Most currencies are quoted in European terms. The exceptions are: British pound Irish pound Australian dollar New Zealand dollar
American versus European terms
If the number of units of a foreign currency that can be obtained for one US dollar increases, the US dollar appreciates in value relative to the foreign currency and the foreign currency depreciates relative to the US dollar. The trader is exposed to foreign exchange risk as the movement of the foreign currency in relation to the local currency is uncertain. In the markets, currency names are abbreviated to three letter codes, developed by the International Organization for Standardization (ISO). Spot price represents the current market price. The interest rate differential between two currencies is expressed in exchange rate points. Forward points are added or subtracted from the spot rate to calculate the forward, outright or all-in rate.
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All-in rate
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7.1. What are Foreign Exchange Forwards?
A forward contract is an obligation. In a forward transaction, the seller promises to deliver a specific amount of goods to a buyer at a future date at a fixed price. In many ways, forward transactions are similar booking a trip. Many people prefer to lock in a price before they travel rather than purchasing a hotel room once they reach their destination. A foreign exchange forward is an agreement to buy or sell a specified amount of currency at a specified date for future delivery. Most FX forwards mature within one to two years. The price of the forward consists of the spot price plus or minus forward points (the interest rate differential between the two currencies). The total price is known as the all-in price. Time is money the price of a current trade and a future trade will be different.
7.2. What is the value of a Foreign Exchange Forward?
Would you agree to purchase an asset today for 50 USD and agree to sell it in one weeks time for 45 USD? Probably not. What if there was a premium of 5 USD paid to you? Maybe. In general, the forward price (F) is based on the spot price (S) plus the interest cost/cost to carry it minus the benefit of holding the asset (time value of money):
F = S + Cost - Benefit Example scenario:1
Assume an asset is trading at 45 USD. Interest rates are 5.00%. The period to hold the asset is one-year and in that time, it will pay a dividend of 0.25 quarterly. What is the one-year forward price? In this example: S = 45 USD Cost = 5.00% Benefit = .25 * 4 = 1.00
The scenarios and calculations are adapted from Foreign Exchange: A Practical Guide to the FX Markets by Tim Weithers. 2008; Reval. 35
Therefore: F = 45 + (45 * .05) 1.00 F = 45 + 2.25 1.00 F = 46.25
Relating this equation to FX, we need to convert one currency to the other one within the currency pair. Suppose, for example, we are exchanging the USD for CHF. Assume the exchange rate for USD/CHF is 1.10. From whose perspective is this deal and who benefits? What is the cost? Since CHF is the underlying asset (think of the underlying asset as the currency in the denominator), the perspective is of the Swiss Franc holder. What is the cost to the Swiss Franc holder of entering into this deal? He cannot put his money in a bank and earn interest or he has to pay to borrow the money, pay interest. Either way, the cost is the interest lost. So, if we put the above variables into the equation from before, the formula would be:
F = S + (S rCHF t) - (1 rUSD t)
The problem with this equation is that it compares Swiss Francs with US dollars (like comparing apples with oranges). The cost is written in CHF but the benefit (interest) is in USD. In addition, the Future and Spot prices are also in CHF. It makes sense to quote the Future and Spot prices in CHF, the same currency. Therefore, we can leave the cost as CHF and we need to adjust the benefit from USD to CHF. How do we do this? Multiplying the USD rate by the spot price will convert the interest payment to CHF. Therefore:
F = S + (S rCHF t) - S (1 rUSD t) F = S + (S rCHF t) - ( S rUSD t)
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F = S + S [(rCHF t) - ( rUSD t)] F = S + S [(rCHF) - (rUSD)] t F = S + S (rCHF - rUSD) t
The difference between the two interest rates is interest rate parity. As shown, if the Swiss and U.S. interest rates were the same, then the future price would equal the spot price. However, the US interest rate is realized in the future (at the end of the deal) and the Swiss interest rate is realized at spot. So, the spot price and future prices are not equal. Is there a price in todays money at which we can exchange USD for CHF at the point in the future? The answer is the forward price. So, the equation is:
F = S + (S rCHF t) - F (rUSD t) F = S (1 + rCHF t) F (rUSD t) F + F (rUSD t) = S (1 + rCHF t) F ( 1 + rUSD t) = S (1 + rCHF t) F = S (1 + rCHF t)
_________________
(1 + rUSD t)
1 F = (1 + r t) 2
S (1 + r t)
Example scenario:
If USD/JPY is trading in the spot market at 110.00, Japanese interest rates are 1.00% and US rates are 5.00%. What do you expect the oneyear USD/JPY forward price to be? In this example: F=? S = 110.00 R1 = 1.00 R2 = 5.00
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F = [110 (1 + (.01*1) )] / [ 1 + (.05*1) ] F = 110 (1.01) / (1.05) F = 111.1 / 1.05 F = 105.81
The majority of interest rate forwards are done under one year so simple interest rates, rather than compound interest rates, are used.
If the exchange rate is trading at a higher level than the current domestic futures spot rate for a maturity period, the forward is trading at a discount. The market expects the domestic currency to depreciate against the other currency. This may or may not happen.
Discount = Spot Rate Futures Rate
If the spot futures exchange rate, with respect to the domestic currency, is trading at a higher spot exchange rate than it is currently, the forward is trading at a premium. The market expects the domestic currency to appreciate against the other currency.
Premium = Futures Rate Spot Rate
Some parameters within a foreign exchange forward are: Spot price: The prevailing price in the spot market; current market price Forward points: Interest rate differential between two currencies expressed in exchange rate points All-in price: Rate at which contract is entered into today for settlement at a specified future date; Spot price + (forward points/10,000) Delivery Type: Deliverable (physical) or Non-deliverable (cash)
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7.3. When are Foreign Exchange Forwards used for hedging?
Currency hedgers use foreign exchange forwards for three reasons:

1. Secure the value of future investment returns (e.g., foreign currency denominated bond coupon payments) used by international portfolio managers 2. Manage liquidity (exchange one currency for another) used by banks 3. Protect against adverse movements in the FX markets used by corporations.
7.4. What are Foreign Exchange Swaps?
A FX swap consists of a spot transaction and a simultaneous reverse forward transaction: the currency that is bought in the spot transaction is sold in the forward transaction or vice-versa. FX swaps are considered to be spot-forward transactions and are used to manage currency exposures. Because the notional is an equal and opposite offsetting position, foreign exchange swaps result in interest rate risk and are often managed by the interest rate desk. A cross currency swap exchanges one currency for another. Interest payments are exchanged throughout the life of the swap. They are not netted, as in interest rate swaps, because they are exchanged in two different currencies. Also, the principal amounts are exchanged either at the swaps inception, maturity or both. The over-the-counter contracts typically are done at fair value, at the coupon rates that make up the up-front payments. However, they do incur both market and credit risk as the spot rate moves and the interest rates of both currencies change, thus changing the mark-to-market (so the swaps usually take on a negative or positive value). Suppose a U.S. company needs Canadian dollars and a Canadian company needs U.S. dollars. These two companies could enter into a currency swap by agreeing on an interest rate, amount and maturity date. The same concepts that apply to interest rate swaps apply to currency swaps. There are vanilla currency swaps, basis currency swaps, etc. Currency swaps are valued similarly to interest rate swaps. However, both sides must be valued in the same currency.
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Therefore, when valuing a currency swap, the valuation of one side of the swap will involve currency conversion.
USD Principal Exchange
USD Fix ABC EUR Float Dealer
EUR Principal Exchange
Example scenario:2
Assume a US multinational company wants to borrow 100,000,000 USD cheaply for five years. How does an FX swap come into play? The best rate the company can find within the United States is 5.00%. While the company may be able to borrow money within the United States, it thinks that it should get a better rate. The company looks abroad. A Swiss company knows the US company and is willing to loan the company Swiss Francs at 2.50% until maturity (but the discount rate is 3.00%). Is this a good deal? Should the company accept the 5.00% USD rate or the 2.50% CHF rate? While many companies like to borrow money on a long-term floating rate basis, we will assume, for simplicity of this example, the loan is of a fixed-rate. We will also assume that the USD/CHF spot rate is 1.2500. While usually not the case, we will assume that the Swiss rate is flat at 3.00% and the US rate is flat at 5.00% throughout the loan. The company can accept the loan in CHF and enter into a swap with Swap Company for USD. They will cover their coupon payments in CHF while allowing them to pay in USD.
The scenario and calculations are adapted from Foreign Exchange: A Practical Guide to the FX Markets by Tim Weithers.
2
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1.25M CHF
USD interest payments & principal
Swiss Company
CHF interest payments & principal
U.S. Company
CHF interest payments & principal
Swap Company
1. First, we need to calculate the interest payments for each of the five years. In order to do that, we need to calculate the value of the notional in CHF.
If the spot rate is 1.2500 and the USD notional is 100,000,000, what is the notional in CHF? CHF notional = 100,000,000 * 1.25 CHF notional = 125,000,000 So the company will receive 125,000,000 CHF from the swap and give the Swap company 100,000,000 USD.
2. Next, what are the cash payments of 125,000,000 CHF that the company will receive at the rate of 2.50%?
125,000,000 * .025 = 3,125,000 CHF

3. What amounts will be exchanged at the end of the swap? The same amounts at the beginning plus the final coupon.
140,000,000
120,000,000 Interest Payments in CHF
100,000,000
80,000,000
60,000,000
40,000,000
20,000,000
0 1 2 3 Year 4 5
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4. What are the payments for the 100,000,000 USD? Remember, the companys goal is to have an interest rate of less than 5.00%. What is the fair rate to charge for USD?
In order to answer this question, we need to know the present value of the Swiss Franc cash flows. Since the interest rate is 3.00% for the five years, the PV factors are:
Year Equation PVf
1 2 3 4 5
1 / (1.03) 1 / (1.03)2. 1 / (1.03)3 1 / (1.03)4 1 / (1.03)5
.9709 .9426 .9151 .8885 .8626
Now that we have the PV factors, we need to multiply them by each cash flow to get their present values.
Year Equation PV Cash Flows
1 2 3 4 5
.9709 * 3,125,000 .9426 * 3,125,000 .9151 * 3,125,000 .8885 * 3,125,000 .8626 * 128,125,000
Total Cash flow
3,033,980.58 2,945,612.22 2,859,817.69 2,776,522.02 110,521,750.50

122,137,683.01
Note: The company gained 125,000,000 CHF but the present value is only 122,137,683.01. The company saved 2,862,317.00 CHF (equal to 2,289,853.59 USD) from this swap compared to borrowing at 5.00% USD!
5. But, what is the fair coupon rate for the USD payments? The total payment should be valued at:
100,000,000 2,289,853.59 = 97,710,146.41 USD

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6. Next, we need to know the PV factors for the USD coupons. Keeping in mind that the interest rate is 5.00%: Year Equation PVf
1 2 3 4 5
1 / (1.05) 1 / (1.05) . 1 / (1.05)3 1 / (1.05)4 1 / (1.05)5

2
.9524 .9070 .8638 .8227 .7835
So, the coupon rate (c), will be multiplied by each payment to obtain the profit of 97,710,146.41 USD: 97,710,146.41 = .9524c + .9070c + .8638c + .8227c + .7835(c + 100,000,000) = c(.9524+.9070+.8638+.8227+.7835) + 78,350,000 = 4.3295c + 78,352,616.65 switching the two sides. 4.3295c = 97,710,146.41 78,352,616.65 4.3295c = 19,357,529.76 c = 4,471,101.53
OR 4.47110143% which much less than the 5.00% offered in the US! Going abroad to get the money was beneficial to the company.
7. So lets plot this out to show the payments and receipts in USD and CHF.
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150,000,000 135,000,000 120,000,000 105,000,000 90,000,000 75,000,000 60,000,000 45,000,000 30,000,000 15,000,000 0 -15,000,000 -30,000,000 -45,000,000 -60,000,000 -75,000,000 -90,000,000 -105,000,000 -120,000,000 1 2 3 4 5 USD payments CHF Payments
Another way to analyze this is to look at FX forward prices:
Note that given the time horizon of five years, we need to use the compounding interest rate formula, rather than the simple rate one:
F = S [ (1 + r1) / (1 + r2) ] t = S [(1 + rCHF) / (1 + rUSD)] t
Lets review the cash flows for each year:

Year CHF payment USD payment
1 2 3 4 5
3,125,000 3,125,000 3,125,000 3,125,000 128,125,000
-4,471,101.53 -4,471,101.53 -4,471,101.53 -4,471,101.53 -104,471,101.53
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1. Convert them all to USD using the given FX forward rates:
S = 1.25 r1 = 1.03 r2 = 1.05

Year Forward Rate 1.2262 CHF Payments in USD 2,548,523.8950 USD Payments
Year 1 Year 2 Year 3 Year 4 Year 5

Total
-4,471,101.53 -4,471,101.53 -4,471,101.53 -4,471,101.53 -104,471,101.53

-122,355,507.6424
1.2028 1.1799 1.1574
2,598,104.4230 2,648,529.5364 2,700,017.2801

123,340,868.2823
1.1354 112,845,693.1478
The receipts are definitely more than the USD payments and the company gains $985,360.64 in total. But, is it really almost one million USD? We need to calculate the present value of each cash flow to find out the true dollar amount in todays value.
2. Whats the present value of the difference in each payment? Difference -1,922,577.6335 PVf 0.9524 PV of Difference -1,831,026.3176
-1,872,997.1055 -1,822,571.9921 -1,771,084.2484 8,374,591.6193
0.9070 0.8638 0.8227 0.7835
-1,698,863.5877 -1,574,406.2128 -1,457,075.3942 6,561,711.6672

340.1549
Note: The differences in the above table are caused by rounding the PVf to four decimal places.
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3. What if the company took the loan at 5.00% USD? Working through this exercise again with the value of 5.00% USD interest would create payments of 5,000,000 annually. Year 1 2 3 4 5 CHF payment in USD Received USD payment Paid
2,548,523.89 2,598,104.42 2,648,529.54 2,700,017.28 112,845,693.15 123,340,868.28
-5,000,000.00 -5,000,000.00 -5,000,000.00 -5,000,000.00 -105,000,000.00 -125,000,000.00
Total in USD
4. And the PV of the difference between the two? PVf Difference PV of Difference
.9524 .9070 .8638 .8227 .7835 Total
-2,451,476.1050 -2,401,895.5770 -2,351,470.4636 -2,299,982.7199 7,845,693.1478
-2,334,739.1477 -2,178,590.0925 -2,031,288.5983 -1,892,201.4756 6,147,305.8754 -2,289,513.4387
The difference is 2,289,513.44 USD, which is close to the 2,289,853.59.00 USD difference calculated in step #4 of the previous set of steps (the inequality in the two numbers is caused by rounding).
Given that the company can borrow cheaper abroad, it pays to issue a bond abroad and do the cross-currency swap to eliminate or hedge the exchange rate risk.
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FOREIGN EXCHANGE REVIEW3
1. You enter into a spot-forward arbitrage given the following:
EUR/USD S = 1.2940 t = 1 year rUS = 3.00% rEUR = 4.00% Spot notional EUR = 100,000,000 What is the one-year forward rate? ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________
2. If a U.S. company issues a 3.00% annual coupon bond in CHF in Switzerland and does a cross-currency swap, show how it affectively will be borrowing at 5.00% in USD, given the following information:
USD/CHF S = 1.2500 rUS = 5.00% rCHF = 3.00% Notional (paid back at maturity) CHF = 100,000 PVf for the five years, as calculated in the section:
Exercises adapted from Foreign Exchange: A Practical Guide to the FX Markets by Tim Weithers. 47
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Year
CHF
USD
1 2 3 4 5
0.9709 0.9426 0.9151 0.8885 0.8626
0.9524 0.9070 0.8638 0.8227 0.7835
________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________
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8. Commodities
Commodities are physical items such as energy, electricity, metals, grains, textiles, food stock, etc. Commodity trades may be physical (delivery of the commodity) or financial (cash flow from one party to another at maturity of the contract, no exchange of the underlying commodity). Commodity prices are extremely volatile which results in hedging actions. As with interest rates, spot trading takes delivery immediately. All other transactions are included in the forward market. Various risks are associated with the commodities market:
Price risk: Fluctuation of the commodity cost Transportation risk: Something happens within the line of transporting the commodity from the seller to the buyer Delivery risk: Concerns the quality of the commodity delivered Credit risk: Counterparty default risk.
Commodity risks
8.1. What are Commodity Futures and Forwards?
A commodity forward contract is an agreement between two parties at day 0 to exchange a stated quantity of a commodity at a fixed future date for an amount defined at day 0.4 A commodity futures transaction has the same general features as a forward but has a standard contract size and is transacted through an exchange. The clearing house of the exchange takes away almost all of the credit risk associated with the transaction. Futures facilitate trading of commodities in the market. They also provide a method for hedging against price risk. They provide a way for traders or producers to guarantee a price at a specific point in time. Ideally, the price set in the contract will equal the spot price for the future date. The buyer, known as the long, agrees to take delivery of the commodity. The seller, known as the short, agrees to make delivery of the commodity. A small percentage of contracts traded are actually delivered. Most contracts are liquidated with an equal and opposite contract before expiration. The idea behind the liquidation with an offsetting contract is that a loss in one market should be offset by a gain in the other market.
4
Definition adapted from Commodities and Commodities Derivatives by Hlyette Geman 49
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Example commodity futures hedge: A producer of natural gas holds (long) 10,000 MMBTU of natural gas. The producer can hedge by selling (short) one natural gas futures contract.
P&L
Spot Future price
Long forward: when purchasing long, the profit and loss potential is infinite.
P&L Future price Spot
Short forward: when selling short, the profit and loss potential is limited to amounts before the price falls below spot.
Scenario: Oil producer fears a price decline
An oil producer wants to stabilize cash flow with a hedge on the futures market. On March 1st, the manager notices that they will have extra production for the next two months. The manager wants to capture the market prices now rather than wait for lower prices in April and May. In the futures market, the producer agrees to sell 10 contracts in April and May at $120 per barrel (1,000 barrels in a contract) in April and $125 per barrel in May. Assuming two pricing scenarios: prices increase to $122 and $126 in April and May in scenario 1 (shown in the table below in pink) and prices decrease to $118 and $124 in April and May in scenario 2 (shown in the table below in gray), the producer will loss or gain $30,000. The producer is obligated to deliver the commodity or settle the transaction in cash.
Profit/Loss = (Futures Price - Actual Price)

t=0
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Month
Scenario 1: Prices Increase
Scenario 1: Profit/Loss
Scenario 2: Prices Decrease
Scenario 2: Profit/Loss
April May
$122 $126
(120-122) * (10,000) = -20,000 (125-126) * (10,000) = -10,000 Total Loss of 30,000
$118 $124
(120-118) * (10,000) = 20,000 (125-124) * (10,000) = 10,000 Total Profit of 30,000
8.2. Similarities and Differences of Futures and Forwards
The following table shows similarities and differences of futures and forwards.
Characteristic Definition Futures Forwards
Seller is obligated to deliver specific amount of specific item at a specified future date Cash or physical settlement Standard contracts Exchange Typically closed out before contract matures by making an off-setting deal Offset risk (hedge with an equal and opposite trade) or speculate on change in price of item (offset losses).
Same
Settlement Contract Type Where traded Delivery date
Same Custom contracts Over-thecounter End of contract
Reason for transaction
Buy or sell item, physical or financial
Valuation
Marked-to-market daily; participants At the end of adjust positions regularly to keep the the contract value constant Dont know Known
Counterparty
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8.3. What are Commodity Swaps?
Swaps in the commodities market have the same definition as in the interest-rate markets and are a generalization of forward contracts. Interest payments are paid generally monthly, quarterly, semi-annually or annually. Interest payments equal a defined quantity multiplied by the current price (either fixed or floating based on an index). Commodity swaps allow purchasers to lock in the price of the commodity. For example, a one-year commodity swap paying quarterly payments would look like:
3 months
3 months
3 months
3 months
t= 0
Payment 1
Payment 2
Payment 3
Final payment (t+1year)
On the set interest dates, the buyer of the swap will pay the fixed price multiplied by the quantity and the seller will pay the floating price (based off an index) multiplied by the quantity. In our example above, the payments occur quarterly from the date of inception to the maturity date of the swap.
Fixed price payments
Buyer
Floating price payments
Seller
The value of the swap is the difference between the sums of each legs payments present value:
N Fixed N Floating
Value of swap =
(Price) (Quantity) (discount factor) t =0
(Price) (Quantity) (discount factor)

t =0
2008; Reval.
52
Scenario:
Mobility Gas Company enters into a commodity fixed-floating swap with Gogo Gas Company. Mobility will pay a fixed price of $11.30 per MMBTU (USD) and Gogo will pay a floating price based off of the NYMEX. The quantity is 100,000 MMBTU of natural gas each month. The deal will commence on January 1st and end on June 30th. Payments will be exchanged quarterly for cash settlement. Assume a discount factor of 1 and that the NYMEX has the following prices on the respective dates: March 31st: $11.35 June 30th: $11.25 What is the value of the commodity swap?
1. What information is given? We know:
Fixed price: $11.30 Floating prices: $11.35 and $11.25 Payments: calculated and paid every 3 months Quantity: 100,000 MMBTU/month (300,000/period) Discount Factor: 1
2. What are the values of the cash flows? Date Fixed Calculation Fixed Payment Floating Calculation Floating Payment
March 31 June 30
300,000 * 11.30 * 1 300,000 * 11.30 * 1

Total
-3,390,000 -3,390,000
-6,780,000
300,000 * 11.35 * 1 300,000 * 11.25 * 1
3,405,000 3,375,000
6,780,000
3. What is the difference between the leg totals?
Zero. Therefore, this is a break-even swap and it is a good hedge to pay fixed rate instead of a floating one.
2008; Reval.
53
COMMODITIES REVIEW
1. Today is January 1st of the current year and natural gas prices are $12.05 per MMBTU. Gogo Gas Company is concerned that prices are going to increase. Gogo enters into an agreement to purchase 100,000 MMBTU per month for the second quarter of the current year at $12.05 flat for all three months. What is the value of this transaction assuming the discount factor is 1 and the prices for the months are actually:
April: $11.75 May: $12.25 June: $12.15 ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________
2. Mobility Gas Company purchases a three-year swap, paying annually. The terms of the swap are:
Fixed price: $12.004 Floating prices: $12.15, $12.20, $11.65 Quantity: 100,000 MMBTU per month Discount Factor: Year 1 2 3 df .9975 .9750 .9525
What is the value of the swap?

2008; Reval. 54
________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________ ________________________________________________
2008; Reval.
55
9. Investments
Trading Accounting Method P&L Impact Financial Statement
Available for Sale (AFS)
Held to Maturity (HTM)
MTM Earnings Gains / Losses Income Statement
MTM OCI Balance sheet
Amortized cost No MTM None Interest on Balance Sheet
A security available for Trading is one that is you can buy today and sell tomorrow. The main reason for purchasing the security is for arbitrage reasons, to buy and sell constantly. As a result, according to FAS 115, it is marked-to-market and the MTM is required to flow through as earnings to profit and loss. Hence, the security is included on the income statement (as equity). For example, you purchase a 10-year bond with the intent to sell it next week and purchase a different security. An Available for Sale (AFS) security is one which you buy to own without the intent to trade it. If the right price comes along, you will sell it. However, the initial reason for purchase was to own the security. It is marked-to-market at fair value. The profit or loss is recorded as Other Comprehensive Income (OCI), not earnings. Hence, it is included on the equity side of the balance sheet. For example, you purchase a 10-year bond to redeems in 10 years but if the price increases, you will see your bond. A Held to Maturity (HTM) security is one that you purchase with the intent to hold it until its maturity. There is no impact on profit and loss. The amortized cost is included within the balance sheet and the only interest is recognized as earnings on the balance sheet. For example, you purchase a 30-year bond to redeem in 30 years from today.
2008; Reval.
56
Transfers between Categories Type of Transfer Trading to AFS Measurement Basis Transferred at fair value to AVS category and is the new cost basis of security Transferred at fair value at the date of transfer and becomes the new cost basis of security Transferred at fair value at the date of transfer Impact of Transfer on Stockholders Equity Unrealized gains / losses at date of transfer increase / decrease stockholders equity Unrealized gains / losses at date of transfer increase / decrease stockholders equity Impact of Transfer on Net Income Unrealized gains / losses at date of transfer are recognized in income Unrealized gains / losses at date of transfer are recognized in income
AFS to Trading
HTM to AVS
AVS to HTM
Transferred at fair value at the date of transfer
Unrealized gains / None losses at date of transfer increase / decrease a separate component of equity Unrealized gains / None losses at date of transfer is carried as a separate component of equity and is amortized over the remaining life of the security
57
2008; Reval.
10. Glossary Term Accrued interest Definition
Represents the amount of interest that has accumulated between the last payment and the sale of the fixed-income instrument. Responsible for the support functions of the financial services company, including the trade confirmation and settlement, record keeping, accounting and compliance/regulatory issues. Local currency; does not change when the exchange rate changes. Standard or reference against which prices are compared or calculated. Includes: cash forecasting, control of cash receipts and distributions, protecting assets from fraud or loss, investment of excess cash, and debt management when needed. Price of fixed-income instrument without accrued interest included. Agreement between two parties at day 0 to exchange a stated quantity of a commodity at a fixed future date for an amount defined at day Same general features as a forward but has a standard contract size and is transacted through an exchange. The clearing house of the exchange takes away almost all of the credit risk. Has the same definition as in the interest-rate markets and are a generalization of forward contracts. Risk that a borrower will not pay money owed; lenders generally charge a higher rate for higher risk customers. Exchanges one currency for another. Interest payments are exchanged throughout the life of the swap. They are not netted, as in interest rate swaps, because they are exchanged in two different currencies. Also, the principal amounts are exchanged either at the swaps inception, maturity or both. .
Back office
Base currency Benchmark Cash management
Clean price Commodity forward
Commodity futures
Commodity swap Credit risk
Cross currency swap
2008; Reval.
58
Currency risk
Risk that arises from the change in price of one currency against another; when companies have assets or business across borders, they may be exposed to currency risk. Currency risk may be hedged by taking an off-setting position. Determines the number of days between two interest payments for investments such as swaps, bonds, etc. Concerns the quality of the commodity delivered Financial instrument whose value is derived from changes in the value of an underlying asset such as a commodity, debt instrument, interest rate or unit of currency. The number of units of a local currency exchangeable for one unit of foreign currency. Exchange rates quoted with another currency, such as the British sterling, Australian dollar, euro, etc. as the base currency. For example, .0096 U.S. dollars per Japanese yen. Price of fixed-income instrument with accrued interest included. Interest rate used to determine the present value of future cash flows. Central location or marketplace where trading occurs. Also called Net Present Value; difference between cash inflows and cash outflows at todays value. Price is set. Price is variable. The exchange occurs at some specified date in the future, perhaps months into the future.
Interest rate differential between two currencies.
Day count factor Delivery risk Derivative
Direct quote
Dirty price Discount Rate Exchange Fair value Fixed price Floating price Forward Forward points Front office FX swap Hedging Index
Trading responsibility of a financial company. Consists of a spot transaction and a simultaneous reverse forward transaction. Mitigate exposure to unwanted risk, so if the negative event occurs the damage is minimized. Used to reflect market prices of stocks, bonds, commodities, interest rates, etc.
2008; Reval.
59
Indirect quote
The number of units of a foreign currency that can be exchanged for one unit of a local currency. Exchange rates quoted with the U.S. dollar as the base currency. For example, 104.40 Japanese yen per U.S. dollar. Difference between the future and spot interest rates. Risk that the value of an interest-bearing asset (e.g., loan or bond) will decline due to an increase in interest rate, can be hedged with an interest rate swap. Maintaining cash balances and, thus, making sure the organization has liquid funding available. Risk that a firm will not be able to sell an asset or meet financial obligations; liquidity risk is difficult to isolate as it impacts credit risk, market risk, etc. Process of calculating the NPV or FV. Employees in charge of monitoring and managing risk exposures and setting credit limits. Also called Fair Value; difference between cash inflows and cash outflows at todays value. Transaction that occurs directly between two parties. Fluctuation of the commodity cost. Creates a formula that attempts to explain the link between an event and related, dependent cash flows. Shows the strength of a relationship. Responsibility of the treasury department to react to the uncertainties of the financial markets. Events that are tested within the stress test. Delivery date; date that the funds are exchanged in an FX transaction. Immediate delivery; within two days after the trade is booked (T + 2). Spot exchange rates adjust to compensate for the relative inflation rates between the two countries. Assesses performance of the transaction or portfolio under certain market changes; what-if analysis. Something happens within the line of transporting the commodity from the seller to the buyer Financial center of an organization; responsible for managing the firms assets and liabilities.
Interest rate parity Interest rate risk
Liquidity management Liquidity risk
Mark-to-market Middle office Net Present Value Over-the-counter Price risk Regression R-squared Risk management Scenario Settlement date Spot settlement
Stress test Transportation risk Treasury Department
2008; Reval.
60

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Introduction to Financial Principles and Instruments

Reval 100 Broadway, 22nd Floor New York, NY 10005

Introduction to Financial Principles and Instruments

Introduction to Financial Principles and Instruments

Introduction to Financial Principles and Instruments

1 About this Course and Document

1.1 Blue background and highlighted book icon

Lesson/sub-chapter within main chapter heading

Introduction to Financial Principles and Instruments

Introduction to Financial Principles and Instruments

Revals Hedging Management Solution

Introduction to Financial Principles and Instruments

Introduction to Financial Principles and Instruments

Source: Treasury Strategies 2003 Corporate Treasury Survey

2.1. What are Cash and Liquidity Management?

Introduction to Financial Principles and Instruments

Introduction to Financial Principles and Instruments

TREASURY MANAGEMENT REVIEW

1. Define treasury management. ________________________________________________ ________________________________________________

2. Define cash management. ________________________________________________ ________________________________________________

3. Define liquidity management. ________________________________________________ ________________________________________________

Introduction to Financial Principles and Instruments

3.1. What is Hedging?

Introduction to Financial Principles and Instruments

3.2. How do Firms Hedge?

Introduction to Financial Principles and Instruments

3.3. What are Derivatives?

Derivative Interest rate swap Currency forward Commodity future

Underlying Interest index Exchange rate Commodity price

Introduction to Financial Principles and Instruments

RISK MANAGEMENT REVIEW 1. Define risk management. _____________________________________________________ _____________________________________________________ _____________________________________________________

Introduction to Financial Principles and Instruments

5. How can a company manage interest rate risk? _____________________________________________________ _____________________________________________________

6. Define the term hedging. _____________________________________________________ _____________________________________________________ _____________________________________________________

7. What is a derivative? _____________________________________________________ _____________________________________________________ _____________________________________________________

8. What is an underlying asset? _____________________________________________________ _____________________________________________________ _____________________________________________________

9. What is meant by the notional? _____________________________________________________ _____________________________________________________

Introduction to Financial Principles and Instruments

4.1. What is the Time Value of Money?

Introduction to Financial Principles and Instruments

Time value of money example calculations

$10,000 today equals

$16,288.95 ten years from now at a rate of 5%

Future Value (1 + interest rate per period) number of periods

Pr esent Value factor =

1 (1 + interest rate per period) number of periods

Introduction to Financial Principles and Instruments

.6139 = 10,000 / 16,288.95

Zero coupon rate definition

Introduction to Financial Principles and Instruments

ON-YOUR-OWN PRESENT AND FUTURE VALUE CALCULATIONS

_____________________________________________________ _____________________________________________________ _____________________________________________________ _____________________________________________________

_____________________________________________________ _____________________________________________________ _____________________________________________________ _____________________________________________________

_____________________________________________________ _____________________________________________________ _____________________________________________________ _____________________________________________________

Introduction to Financial Principles and Instruments

4.2. What is an Index? What is a Benchmark?

4.3. What Types of Pricing can be used in Transactions?

There are two types of pricing used in transactions:

4.4. How is interest calculated?

Introduction to Financial Principles and Instruments

Day Count Factor = (# days between dates / # days in reference period)

Some day count factors are:

Introduction to Financial Principles and Instruments

1. Define treasury management.

2. Define cash management.

3. Define liquidity management.

RISK MANAGEMENT REVIEW 1. Define risk management. ___________________________ _ ___________________________

5. How can a company manage interest rate risk? _ _

6. Define the term hedging. ___________________________ _ ___________________________

7. What is a derivative? ___________________________ _ ___________________________

8. What is an underlying asset? ___________________________ _ ___________________________

9. What is meant by the notional? _ _

___________________________ _ _ ___________________________

___________________________ _ _ ___________________________

___________________________ _ _ ___________________________

Clean:_ Dirty: ______

F = [110 (1 + (.011) )] / [ 1 + (.051) ] F = 110 (1.01) / (1.05) F = 111.1 / 1.05 F = 105.81