Underlying Assets and Reference Indices

QF 301

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Contents
Section 1: Equities
– – – – –

Panaroma Ideas about stock prices Stock Exchanges Quotes and Orders Indices

Section 2: Currencies Section 3: Fixed Income Rates
– – –

Interest Rate Fundamentals In Practice Modelling Interest Rates

Section 4: Others Section 5: Epilogue

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Learning Objectives
To understand derivatives, which are officially first and foremost financial instruments to modify risk profiles of certain underlying assets or reference rates, we need to have an idea what those assets or reference rates are and the respective market mechanisms and factors affecting them This lecture shows you the tip of the iceberg It is hoped that the exposure will illuminate to you the significance of economic/financial/business news in the papers, on the internet and in magazines It is also hoped that the “noise” that is one component of derivatives pricing and hedging models compresses into several equations an huge area that is highly complex and interesting

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Section 1: Equities 4 .

Panorama 5 .

companies can raise capital to pursue business opportunities and meet its operational needs Owning shares is like owning a piece of the company. share owner shares risk with the other owners Shares can be bought and sold at will in the market 6 .The Concept of Equity By issuing shares.

hugovandermolen.One share of Disney 7 Source: www.php .nl/scripophily/Disney.

Types of Shares Common Stock – – Represent a share in the assets and earnings of a company Dividends are decided by the directors of the company Preferred Stock – – Differ from common stock in regards to voting rights.g.000 per piece) 8 .g. Berkshire Hathaway issues Class B stocks with 1/200 voting right and 1/30 ownership value to small investors (Class A stocks sell for over $100. when company is financially weak) Share Classes – – Different classes of common stock with different dividends and voting rights E. dividend payout (higher or guaranteed fixed rate of return). priority to obtaining assets in case of dissolution Issued to entice investors (e.

One of the most admired companies in the world 9 .

payment is carried out in order of hierarchy: – – – – Debt: junior/senior. secured/unsecured Equity: common/preferred Chapter 7 – Liquidation Chapter 11 . debt of business is debt of owner Partnership General: Partners manage business and are personally liable for its debt Limited: Certain limited partners give up ability to manage business in exchange for limited liability on debt Limited Liability: All partners have some form of limited liability – Corporation: Artificial legal entity.bankruptcy chapters in the US 10 . shareholders have limited liability Corporations have two ways to raise capital – – – Issue stocks (equity) Issue bonds (debt) The combination of equity and debt is called capital structure In the event of dissolution.Business Organization and Capital Structure Business Organization – – Sole proprietorship: Entity has no separate existence from owner.Reorganization Forms of bankruptcy .

despite that. Dutch auction is sometimes used Dutch auction – high asking price lowered until there is a buyer Google Dutch-auctioned its shares at IPO.Stock “mechanics”: IPO IPO (Initial Public Offering) – – – Company seeks listing on exchange Investment bank sought out to be underwriter Underwriter needs to set IPO price. takes responsibility to buy stocks if price sets too high to sell off into the market over time later How is the price determined? – IPO stock is often underpriced Con – Less capital raised Pro – Ensures stocks are sold – Auction To minimize underpricing. still rose 17% on first day 11 .

1% 12 .45 Hang Seng Index surged 1.The world’s largest IPO ever Fast Facts: IPO at US$0.39 rose to US$0.

2006 Source: Wikipedia 13 Trivia: Which of these banks are not results of mergers? .Top Banks .

com/?p=69 http://skorcareer.com/2008/07/22/10-world%E2%80%99s-largestbanks-in-2008/ .Top Banks .my/blog/10-worlds-largest-banks-list-in2008/2008/06/18/ http://jaggerkieth.2008 14 Source: http://financialranks.wordpress.com.

Stock “Mechanics” Follow-on Offering – – – Issuance of stock subsequent to IPO Dilutive: New shares are created. more shares therefore value per share is reduced (why do it?) Non-dilutive: Sale of shares by directors or insiders Primary Offering – Issuance of stocks by company Secondary Offering – Offer of stock by shareholder 15 .

it would now be about $160. value of each share is divided by 5 To make share accessible to investors. the company issues new shares of stock (call options differ in this respect) Often added to bond issue for enticement Employee stock options – – Call option that is issued to employee. so as to align their motivations with the company’s Strike price typically set at the company’s stock price on option grant day 16 . BH has policy not to split stock. prevent fall in liquidity Warren Buffett’s Berkshire Hathaway is the most expensive stock in the US. usually executives.000 per share Warrants – – – Gives right to purchase company stocks at a strike price on a specified future date When warrant is exercised.Stock “Mechanics”: Splits and Options Stock splits – – – 1:5 split = each share becomes 5 shares. if GE hadn’t split its stock 9 times since IPO in 1892.

wired.com/science/discoveries/news/2006/08/71533 .Backdating Scandal Why the concern? Who are the victims? 17 Source:http://www.

uk/2008/04/29/ann_mather_sec_filing_backdating/ Date: 29th April 2008 .theregister.co.Pixar options backdating scandal 18 Source: http://www.

it can – Buy back shares Equal access scheme: company offers to buy back shares prorata Selective buy-back: offers to buy back only from several shareholders Any other reason for share buy-back? – Issue dividends Frequency: can be regular/announced or irregular/special Forms of payment: Cash. Payment Dividend play: someone buys stock to collect dividend…smart move? 19 . property Dates: Declaration. Ex-dividend. stock. Record.Stock “Mechanics”: Buyback and Dividends When company has too much money and has no plan on investing it.

Ex-Dividend Date Price Behaviour Stock price level before Price falls on ex-dividend date By how much? Stock price level after Time Ex-Dividend Date 20 .

Taxes Fast Facts Capital Gains Tax: Tax levied on profit upon sales of capital asset Singapore: 0% USA: Long-term capital gains tax 15% France: 27% Dividends Tax: Singapore 0% USA: 15% for most individual taxpayers Source: Wikipedia Arguments against: Double Taxation (this and income tax) Arguments for: Different tax rates for income through active or inactive work For more detailed info: www.oecd.org 21 .

the Brazilian government imposed 0.38% tax on all financial transactions to raise revenue Institutional traders then traded Brazilian stocks as American depository receipts (ADRs) in New York to avoid the tax (owners have right to exchange ADRs for shares – they are issued by banks) Tax raised less revenue than expected and liquidity in Sao Paulo Bovespa dropped (trading volume from 1. the Brazilian government announced that stock transactions would be tax-exempt 22 .Snippet: Unintended Consequences In 1997.2b reais a day in 1997 to 350m reais a day in 2001) In Sept 2001.

timelessmyths.com/arthurian/gallery/gareth.Stocks “Dynamics”: M&A Mergers and Acquisitions – Friendly acquirer – Combine to add value/Empire building Consensual merger/acquisition or hostile takeover Poison pill White knight – – Cash merger/Stock merger/Acquire assets Leveraged Buyout (LBO) Company X 23 Source: http://www.jpg Hostile acquirer .

Poison Pill and White Knight Poison Pill - White knight - Target company makes its own stock less attractive to the acquirer in order to avoid takeover bids. A target company is facing a hostile takeover from another party.g: allows the existing shareholders (except bidding company) to buy more shares at a discount. e. - 24 . The white knight offers the target firm a way out with a friendly takeover.

Mittal Steel Company Mittal Steel Company – largest steel company in the world by volume 25 Source: Wikipedia .

Arcelor Mittal 26 .

White knight Arcelor Mittal 27 Started off hostile Poison pill .

Jan 27. 2006 .Arcelor Mittal 28 Source: Asia Times Online.

Merger (risk) Arbitrage Cash merger – – – Acquirer announces to purchase stocks of target company Stock price rises in anticipation of the sale but not to the purchase price level due to risk that deal may not go through or may be delayed Arbitrageur may buy shares hoping that she may sell the shares at the higher purchase price after the merger Stock merger – – Acquirer announces to exchange stocks of the target for its own stocks at a certain ratio Arbitrageur may go long in one and short in the other in the hope the profit may be reaped upon completion of the M&A What can affect the deal from going through? 29 .

more environmentally friendly Fund management companies may adopt activism approach In Singapore: Securities Investors Association (Singapore) or SIAS 30 .Minority Shareholders’ Rights A shareholder who owns a substantial amount of shares has a lot of say in the direction of the company Shareholder activism uses equity stake to put pressure on management during AGMs – – Change financing structure. cut cost.

owns 4. 2008 – Icahn confirmed to commerce a proxy fight to remove Yahoo's Board of Directors in response to their "irrational" actions in rejecting Microsoft's takeover bid.Icahn launched a proxy contest. Eight directors will stand for re-election while the remaining three seats will include Icahn and two nominees that Icahn will recommend.Minority Shareholders’ Rights Carl Icahn . 2008 . July 21.98 percent of Yahoo common stock May 13. According to the agreement. 31 . the Yahoo Board will expand by two directors to eleven members. May 15. 2008 Icahn agreed to join Yahoo's Board of Directors in a deal that would end the proxy fight.

led by junk bond king Michael Milken.Leveraged Buyout Gain control of company through acquiring equity via the use of debt Asset of acquired company used as collateral for debt Also known as bootstrap transactions Debt is obtained by issuing junk bonds Some notable names: – – – – Kohlberg Kravis Roberts & Co (KKR) Creates limited partnerships to acquire corporations Finance some with own funds. such as Drexel Burnham Lambert. BT reports that many firms in Asia were in danger of being taken over – not because they were operating badly. but because they were low in debt! 32 . helped raised funds for LBO At one point in 2007. the rest through the issuance of junk bonds Investment banks.

4.1.Credit Ratings Investment Grade Junk For details: http://www2.1148442391999.article/2.html 33 How does rating affect stock price of company? What criteria are applied? Who pays for the rating? .standardandpoors.com/portal/site/sp/en/ap /page.1.

Sovereign Ratings Source: www.pdf 34 .com/shared/sovereign_ratings_history.fitchratings.

Guess the ratings of the major financial institutions in Singapore DBS UOB OCBC Temasek Holdings GIC 35 .

Problems with Ratings companies Little problem when rating companies for straightforward debt issuance Problematic when rating complex instruments Raters from the rating companies were not paid directly by the debt issuing companies – no conflict of interest But raters of complex instruments sometimes were paid – conflict of interest Ratings companies can roil the market Their pronouncements are important But they are after all humans and are prone to errors in judgement 36 .

Ideas about Stock Prices 37 .

Price of stock and value of company Price of stock is what you read in the papers or off Bloomberg Value of company is a more subjective concept What affects one’s valuation of a company? – – – Management – how it funds itself. the investment the company makes The business it is doing and the business environment – the risk and opportunities The economy at large How do most in the market guess the price of the stock? – – – – Work out personal valuation of company Guess prevailing perception of company’s value Fundamental analysis Technical Analysis 38 .

Views of Stock Prices Forecaster’s View – – – Fundamental Analysis: company fundamentals. macroeconomic factors. politics. Technical Analysis: patterns in price history suggests future movements Result: (Strong) Buy/Sell recommendation 39 . etc.

so no point trying to use that sort of information in trying to beat the market Information: Financial data – Weak form All publicly available information – Semi-strong form All information – Strong form Sensitivity to market returns – Capital Asset Pricing Model (CAPM): Asset return Company’s stock return Risk premium E ( Ri ) = R f + β im ( E ( Rm ) − R f ) Market’s stock return beta 40 Security Market Line Risk-free rate .Views of Stock Prices Economist’s View – – Efficient Market Hypothesis (EMH): stock prices has already factored in information*.

the tools of statistics and probability can be used to say something definitive/on average about prices Discrete model: prices evolve per unit of time.Views of Stock Prices QF view – – – – – Stock prices evolve stochastically No point trying to guess with precision future price moves Instead. each move is either up or down with probability p Continuous model: prices evolve by the Geometric Brownian Motion 41 .

5X 42 Day 1 Day 2 .The Binomial Tree Model Toss a coin! $X 1 1/2 1/4 $2X Day i 4 2 1 Day i+1 $0.

Continuous limit Let dt -> 0… What do we see? 43 .

5 98 97.5 100 99.5 99 98.Random Walk – 5 steps 101 100.5 0 2 4 6 8 10 12 44 .

5 100 99.5 101 100.5 0 2 4 6 8 10 12 45 .5 102 101.Random Walk – 100 steps 103 102.

Random Walk – 1000 steps 103 102 101 100 99 98 97 0 2 4 6 8 10 12 46 .

The Random Walk Model $X Day i Day i+1 2 $X $(X+2) The normal distribution 47 .

The Brownian Motion As dt -> 0. the motion obtained is called the Brownian motion or Wiener process The limit is said to be continuous Commonly denoted Wt or Zt dt It is the basic building block for continuous price models in finance 48 .

Some basic continuous models

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Source: Options, Futures and other Derivative, John C. Hull

Geometric Brownian Motion
Two quantities declared as definitive characteristic of stock price
– –

Mean drift (measures company growth) Volatility (measures degree of price fluctuation/riskiness of company)

Geometric Brownian Motion – de facto model of stock price in finance

dSt = μdt + σdWt St
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Roughly, but not quite:

d ln St

Not as difficult as you think
Step 1: Discretize

S ( i +1) dt − Sidt Sidt

= μdt + σ (W(i +1) dt − Widt ) = μdt + σ dt Z

Step 2: Excel

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they are used because they are mathematically tractable and they come with parameters that we can empirically associate with intuitive/observable financial quantities (drift = growth. Levy models. they give an average sense of the future evolution of prices Stochastic models (GBM. etc.Ideas about Models Models have underlying assumptions Stochastic models such as the Geometric Brownian Motion are not meant for forecasting.) are used to price and hedge financial derivatives 52 . vol = riskiness).

use statistical models to describe price movements 53 Which style do you prefer? .Your preference? Fundamental analysts – Look at “fundamental reasons/stories” – things happening in the world Technical analysts – Look at patterns in price histories Financial engineers – Believe in statistics.

Stock Exchanges 54 .

Stock Markets Stock markets are concentrated at stock exchanges Oldest stock exchange: Amsterdam Stock Exchange – – Established 1602 by Dutch East India Company Merged with Brussels Stock Exchange and Paris Stock Exchange on Sept 22. 2000 to form Euronext 55 Traditional – open outcry system These days – electronic exchanges .

Stock Exchanges: Development 56 .

Stock Exchanges: Development 57 .

co.Stock Exchanges: Development 58 Source: http://news.bbc.uk/2/hi/business/5039412.stm .

Stock Exchanges: Development 59 How does an exchange make money? .

com/forums/SIN04/Presentations/Ein.marinemoney.pdf .Stock Exchanges: as a business 60 Source: http://www.

nsf/NEWDOCNAME/REITS_INTRO?OpenDocument .com/SGXWeb_ST.Stock Exchanges: as a business 61 http://info.sgx.

Stock Exchanges: Highly regulated 62 .

Deputy Managing Director.html .gov.mas. MAS.Stock Exchanges: Highly regulated 63 Excerpt from "Regulating The Capital Markets: Making Market Discipline Work“ Speech by Tharman Shanmugaratnam.sg/news_room/statements/2001/Regulating_The_Capital_Markets__Making_Market_Discipline_Work__16_Feb_2001. at the Investment Fund Awards 2001 Source: http://www.

nsf/NEWDOCNAME/Rulebooks_and_Manuals .com/SGXWeb_RMR.sgx.Trading rules 64 SGX Rulebooks and Manuals Source: http://info.

nsf/VwCPForm_SGX_ST_RULES?OpenView .Trading rules 65 SGX Trading Rules Source: http://info.com/SGXRuleb.sgx.

Damping down the activity Extreme volatility in the market can be prelude to crashes Regulatory responses to extreme volatility – – – – – – Trading halts: trading is stopped when prices have moved or will imminently move by some specified amount Price limits: all trade prices are required to be within a certain range on a given day Transaction taxes: restrict trading by taxing it Margin requirements and position limits: restrict sizes of positions that traders can accumulate Collars: restrict access to trading systems Uptick rule: short selling is only permitted following a trade which is an uptick 66 .

Trading Halt Following 1987 market crash. then no halt Level 3 halt – – Condition: DJIA drops by more than 30% from its value on the previous day Halt for the whole day Why halt? 67 . U.S. then no halt Level 2 halt – – – – Condition: DJIA drops by more than 20% from its value on the previous day Before 1pm: halt for 2 hours Between 1pm and 2pm: halt for 1 hour After 2pm: if there is no Level 3 halt. stock and futures exchanges adopted a set of coordinated trading halt rules Level 1 halt – – – – Condition: DJIA drops by about more than 10% from its closing value on the previous day Before 2:30pm: halt for an hour Between 2:30pm and 3:30pm: halt for half and hour After 3:30pm: if there is no Level 2 halt.

Operational Structure Dealers/Brokers Order-driven Investor Clearing Agent Settlement T+3 Custodians/ Depositories 68 .

if prices do not change in their favour. one short. they will soon be forced into actual bankruptcy When traders are in technical bankruptcy.Brazilian Straddle Straddle is a trading position in two different types of instruments. those who guarantee their trades will suffer the losses This strategy is called Brazilian straddle: large market position vs one-way air ticket to Brazil Clearing members check on these – – – – – 69 monitor traders who clear through them closely require frequent position report throughout the day. one long. they lose nothing by massively increasing their positions – – If prices change in their favour. risk-offsetting Technically bankrupt traders do not have sufficient wealth to settle their trades. require margin payments to be made when prices move against their customers prohibit customers who cannot settle from trading contractually allocate profits made by technically bankrupt customers to clearing firm if problem not reported . their financial woes are over If not.

Quotes and Orders 70 .

Stock Quotes Bid/Ask –Who’s buying/selling? 71 Source: The Business Times. 2007 . May 4.

Orders
The specifications of an order
– – –

Price Number of shares Order type
Market Limit Stop Market-if-touched

– – –

Validity/expiration instructions Quantity instructions Other instructions
Display instructions

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Market and Limit Orders
Market order is an instruction to trade at the best price currently available on the market

Market orders pay the bid-ask spread (price for being impatient)

Limit order:
– – – –

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Limit price Instruction to trade at the limit price or a price better than this If it’s a limit buy order at $5, you’re guaranteed to buy at that price Limit buy/sell is usually set lower/higher than market

Limit Order Book
Best prices

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Source: Trading & Exchanges – Market Microstructure for Practitioners, Larry Harris

Validity/Expiry. Quantity and Display Instructions Examples of validity/expiry instructions – – – – – Day orders: valid for trading day only Good-till-cancel: valid till trader expressly cancels Good-until: valid till a certain date Immediate-or-cancel Good-after: valid after a certain date Examples of quantity instructions – – All-or-none Minimum-or-none Display instructions – To show no more than some maximum quantity to avoid market moving away from them 75 .

Limit orders are options When trader issues a limit order. limit orders are valuable. little value How long order will stand: allow other traders to defer trading decision Price volatility: in volatile market. because probability of execution is increased 76 . he is in effect writing an option – gives the other traders the option to trade with him – – Limit buy order: like put option (because expecting price to fall) Limit sell order: like call option (because expecting price to rise) Factors affecting value of this option – – – Limit price: too far behind market.

in return.Option view explains some phenomena Bid/ask spreads are wide in volatile market – option valuable. they offer liquidity. set the limit price far from the market to reduce value of option they give away Fast traders have advantage over slow traders – they quickly take up the valuable options The nature of liquidity – – Liquidity is the ability to trade at low cost Traders give away options (limit orders). they are compensated with the potential to realize a better trading price Why do markets consolidate (traders like to trade in the same place)? – They offer lots of options as a whole 77 . traders don’t like to give away valuable options.

Other order types Stop order – – Stop price Stop buy/sell order price usually set higher/lower than market Market-if-touched order – – Touch price If market price becomes equal or better than touch price. the market-if-touched order becomes a market order 78 .

Stop orders and Liquidity Stop orders accelerate price changes Say a trader has a large stop sell order at $100…if best bid falls below $100…it’s activated…trader then contributes to the falling market by trying to sell the stock Stop orders add momentum to the market Momentum traders – – – Buy when prices are rising and sell when prices are falling May issue stop orders to brokers Destabilize prices Contrarian traders – – – 79 Buy when prices are falling and sell when prices are rising May issue limit orders to brokers Stabilize prices .

what should I bid next? Twice the current bid or half of it? Let’s see what the coin says… 80 The Trader Thinker ..Reflect on this… So is the dynamics/stochastics of stock prices akin to the toss of a coin? Hmm.

Indices 81 .

g. S&P 500 – What is STI? Indices are often used as performance benchmarks by mutual funds – “beat the market” 82 .Indices A market index represents the “health” of the market as a whole An index may be – Price-weighted: proportional to the sum of prices of the index components E.g. Nikkei 225 – Value (capitalization) -weighted: proportional to the sum of market capitalization (price x number) of index components E. DJIA.

Topix HK: Hang Seng Index Singapore: STI South Korea: KOSPI China: SSE Composite Asia: S&P Asia 50 Latin America: S&P Latin America 40 Europe: S&P Europe 350.org/wiki/List_of_stock_market_indices#Asia 83 . FTSE Euro 100 See http://en. Wilshire 5000 UK: FTSE 100 Brazil: Ibovespa Japan: Nikkei 225.Indices Some major indices – – – – – – – – – – – US: S&P 500.wikipedia. Russell 2000.

The science of indexing 84 .

Ideas about Indices Index gives an average view of the market – but “average” can have many dimensions – Market capitalization – Price – Growth Index represents market return and volatility Index represents diversification – Investing in an index? Index as an asset? – Option on S&P 500: right to buy 500 stocks? Many funds use index as a gauge of performance Hedge funds are also called absolute value funds – they don’t use index as gauge of performance 85 .

Index instruments: Options on Indices 86 Source: http://www.cboe.com/LearnCenter/workbench/products/sp500.htm .

vanguard.Index strategies: Index Fund 87 Source: https://flagship.com/VGApp/hnw/FundsSnapshot?FundId=0040&FundIntExt=INT .

vanguard.Index Tracking – not bad! 88 Source: https://flagship.com/VGApp/hnw/FundsPriceHistory?FundId=0040&FundIntExt=INT .

How did they do it? 89 .

One possible way

Total number of stocks Limit the number of shares of each stock 0 or 1 Upper bound on transaction cost Value of tracking portfolio

Units of stock i

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Source: An evolutionary heuristic for the index tracking problem, J.E. Beasley, N. Meade, T.-J. Chang

One possible way
Tracking error

Objective function Excess return

Index return Tracking portfolio return

What assumptions underlie these techniques?

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Source: An evolutionary heuristic for the index tracking problem, J.E. Beasley, N. Meade, T.-J. Chang

Buy an index?

Questions: Why does UBS want to buy AIG’s commodity index? What determines the success of an index?

Section 2: Currencies 93 .

nails. c. fish-hooks. tobacco. (Source: Economic History of the World) .Trading Money Money is traded due to demand and supply forces – – What’s the worth of money? What’s its function? What demand forces? What supply forces? A medium of exchange – – – – – Buying a good for S$100 (on the flip side: selling S$100!) How to buy a foreign good? One of the earliest currencies: Greek coins Basic human innovation: better than barter! What have been used as money? Sheep. wampum 94 Greek silver coin. face of Athena. shells. jewels. whale teeth. oxen. elephant tails.480B.C.

Trading Money A unit of account – – Measure value of goods relative to a currency: price tags A finance jargon meaning the same: numeraire A store of value – – Companies hold ready cash for daily transactions What affects currencies’ worth as store of value? Banana money – zero worth now Germany is known for conservative monetary policy and aversion to inflation – historical root? (fear of hyperinflation) 95 .

Hyperinflation German hyperinflation (c. In a hyperinflation. 1923) 1923-issue 50 million mark banknote. the value of money relative to goods reduce rapidly 96 . At the time. this sum would have been worth approximately $12 million nine years earlier. burning money was less expensive than buying firewood. Worth approximately $1 US when printed. The note was practically worthless a few weeks later due to continued inflation Source: Wikipedia Inflation 1923–24: a woman feeds her tiled stove with money.

South Africa. Ecuador. East Timor Useful link: https://www. mint coins – – – Careful about it as it can cause inflation Money is commonly accepted by fiat An avenue of national pride Singpaore’s National Coat of Arms First President of Singapore Yusof bin Ishak How many currencies are there around the world? – – There are slightly more than 200 currencies around the world Some countries do not have their own currencies. Panama.Currencies Governments print paper money. e.g.gov/cia/publications/factbook/ Trivia: What is the currency of 97 – Luxembourg.cia. Botswana .

third letter refers to currency name What is CHF? What’s the ISO code for Canadian Dollar? What about Mexican Peso? 98 .Major Currencies The United States Dollar (USD) The Euro (EUR) The Japanese Yen (JPY) The Great Britain Pound (GBP) (aka Sterling) The Swiss Franc (CHF) ISO 4217 Currency Code – – – – Usually first 2 letters refer to country.

Foreign Exchange turnover Source: BIS Triennial Central Bank Survey 99 .

The Foreign Exchange Market Has an average daily turnover of about USD 2 trillion (daily turnover at NYSE before merger with Euronext was about USD 40-50 billion) World’s largest financial market – – Some participants relatively larger than others But all small in the grand scale of things Largely unregulated OTC market 10 0 – Central banks monitor currencies together with interest rates (monetary policies) .

options. exotic options 10 1 .The Foreign Exchange Market Key instruments – – – – Spot Forwards Swaps Derivatives: futures.

fxstreet.com. market very liquid 10 2 . www.The Foreign Exchange Market FX market is close to 24-7 – – Opens in Wellington.dailyfx. online Quotes and information readily available (www. now etrades.com. New Zealand.forexnews. www. on their Monday at 7 am Closes on Friday evening in the US Used to be traded via telephone or telex.com ).

Spot Quotes USDCAD EUR|USD 10 3 Source: Bloomberg.com .

3582 It’s a price: price of 1 USD in terms of EUR European/indirect terms: USD|EUR American/direct terms: EUR|USD Nicknames: GBP|USD = “Cable”.g. EUR is quote currency First currency thought of as asset.Spot Quotes Currency pair: USDEUR or USD|EUR – – – – Read “Dollar Euro” USD is base currency. AUD|USD = “ Aussie”. NZD|USD = “Kiwi” 10 4 . e.3583 means that 1 Euro is worth USD 1. EURUSD 1.

2162 100 pips make 1 big figure 2 pips: smallest quoted unit Market lingo – – – – I buy dollar yen! A five-pip decline in EUR|USD Euro-Dollar is trading at one-twenty-eight ‘the figure’ USD|JPY rises one big figure from 111.Spot Quotes USD|CHF 1.00 10 5 .

894 Yen|USD 0.0083 Do you smell anything fishy? 10 6 .Triangular arbitrage USD|EUR 1.3583 EUR|Yen 162.

Triangular arbitrage USD|EUR 0. once. back in 1977” 10 7 . author of Foreign Exchange – A Practical Guide to the FX Markets.894 Yen|USD 0.0083 Still fishy? Tim Weithers. mentioned someone in class asking UBS’s FX spot dealers if they had ever done traingular arbitrage…”yes.7362 EUR|Yen 162. I did.

www.forex.g.7686|90 .Who’s quoting? Marketmakers – – stand ready to buy if client wishes to sell and vice versa Found in banks.com) Earn through bid-ask spread (buy low sell high) – – Measure of how liquid the market is (how easy it is to buy and sell) Measure of profit marketmaker makes The handle 10 8 Quote with bid/ask: EUR|AUD 1. brokerages (e.

50 The Economist’s Big Mac Index is a widely cited indicator of PPP . Big Mac costs S$3 in Singapore and US$2 in the US.g. e. so the exchange rate by PPP ought to be USD|SIN 1.What drives exchange rates? Who determines exchange rates? – Nobody – Floating exchange rate era (read history of foreign exchange) Equilibrium considerations – – 10 9 Purchasing Power Parity – exchange rates are determined by relative prices of similar baskets of goods.

happenings in other asset classes.What drives exchange rates? Theoretical conception: Equilibrium considerations – Interest rate parity: because one can exchange currencies and deposit at the corresponding interest rate. etc. 7% US GDP – spends more than earns Daily international funding is on the order of US$8b Looming fear that it will trigger a large and rapid decline in USD Japan’s almost zero interest rate encouraged the yen-carry trade 11 0 Monetary policies. country economics. . exchange rates and interest rates satisfy a no-arbitrage relationship Macroeconomic factors US current account deficits – – – About US$800b. political stability.

Snapshot: Thai baht 11 1 .

Snapshot: Argentine peso 11 2 .

Section 3: Fixed Income Rates 11 3 .

Certificate of Deposit (CD).Overview Investment that gives regular return Institution raises funds with it. Banker’s Acceptance (BA).Fixed Income . T-Bills. incurring debt 2 main market – – Money market (< 1yr) Capital market (longer term) Instruments – Notes and Bonds Corporate Government. Fed Funds. Repo. money market mutual funds . municipal – – – – – – 11 4 Floating rate note (FRN) Swaps Credit-linked products Asset-backed securities (ABS) Collateralized Debt Obligations (CDO) Money market instruments: Commercial Paper (CP). Eurodollar deposits.

Interest Rate Fundamentals 11 5 .

Basic Concepts in Fixed Income Discounting and Compounding Present Value (PV) Discounting Factor (f) Rate (r) $K What’s the Present Value? Today 11 6 N days Discounting: PV = K x f Compounding: K = PV / f f = 1/(1+r x DAYCOUNTFRAC)Compounding Number .

Basic Concept in Fixed Income Rates are stated annualized Day count convention Simple vs continuous 11 7 .

Annualized rates Interest rates are usually stated annualized In other words. what’s the interest at maturity? Interest = ½ x 5% x $100 = $25 11 8 . it describes the amount of interest earned in 1 year If $100 is deposited at 5% for 6 months.

2007 till 3 Mar. 2007? The interest earned is $100 x FRAC x 5%.Day count convention Slightly more generally. where FRAC is a fraction that depends on the particular daycount convention that is adopted Some common day count conventions: Actual/Actual. Actual/365. what is the interest earned on $100 at 5% if the term is from Jan 10. Actual/360 11 9 .

7123 Between Jan 10 and Mar 3.Day count convention Actual/Actual: – – – – 2007 has 365 days (not leap year) Between Jan 10 and Mar 3.7123 Between Jan 10 and Mar 3. there are 52 days FRAC = 52/365 Interest = $100 x 52/365 x 5% = $0.7222 Actual/365 – – – Actual/360 – – 12 0 – . there are 52 days FRAC = 52/365 Interest = $0. there are 52 days FRAC = 52/360 Interest = $0.

Day count convention Most common is Actual/360 and is used by USD and EUR What is FRAC for Actual/360 when the term is 1 year? Other conventions abound: – – 30/360: each month is treated as having 30 days ACT/252: common is South American instruments. 252 is the number of business days in a year 12 1 .

2007 Day count convention: Actual/360 Quoted interest rate: 7% What do you get on Jun 8.Day count convention $100 is deposited from Jan 4. 2007 to Jun 8. 2007? 12 2 .

6891 6m Jul 1.Compounding What is the interest earned on $100 at 5% if the term is from Jan 1.0253 =107. 2009 6m 6m 6m 12 3 Jan 1. 2007 .0253 100x1.0252 100x1. 2007 till Jul 1.025 100x1. the deposit’s interest is earned by compounding Suppose the compounding frequency is semi-annual If day count convention is not taken into account: 100 100x1. 2009? For such a long period.

2008: 182 days Jul 1. 2009 – Jul 1. Jul 1. 2008 – Jan 1. 2007 – Jul 1. say Actual/360. Jul 1.3249 . Jan 1. Jan 1. 2009: 181 days 12 4 Payoff at maturity = 100(1+181/360x5%)(1+184/360x5%)(1+182/360x5%) x (1+184/360x5%)(1+181/360x5%) = 113. 2008: 184 days Jan 1. 2008. 2009: 184 days Jan 1. 2009 in addition to the start and maturity – – – – – Jan 1. 2008 – Jul 1. 2007.Compounding If day count convention.g. is taken into account. 2007: 181 days Jul 1. 2007 – Jan 1. 2008. the actual compounding periods must be determined: e.

General form: Disregarding day count convention Interest rate: r Principal: N Compounding frequency: n times a year Term: m years The payoff at maturity is: Nx(1+r/n)m/n 12 5 .

General form: With day count convention If day count convention is taken into account. t2)r)…(1+FRAC(tk-1. the actual dates in the compounding periods must be noted Say: t0. …. tk )r) 12 6 . tk The payoff at maturity is: N(1+FRAC(t0. t1. t1)r) (1+FRAC(t1.

what is the equivalent annual rate? The interest earned in 1 year (on $1 principal) = (1+1/4 * 5%)4 – 1 = 0.050945 The equivalent annual rate is 5. what do you think is the equivalent annual rate when n is very large? 12 7 .Equivalent annual rate If rate = 5%.0945% If compounding frequency is n times a year. compounding frequency is quarterly.

05) = 1.051271 In fact. exp(0.051140 (1+1/100 * 5%)100 = 1.The exponential function Observe: – – – – (1+1/10 * 5%)10 = 1.051258 (1+1/1000 * 5%)1000 = 1.051271 Leonhard Euler (1707-1783) on CHF 10 Generally.051270 (1+1/10000 * 5%)10000 = 1. 12 8 .

rate = r.1271 Interest = 5.55x0.1271 What is the payoff after 2.5985 Generally. term = T years.05 = 105.55 years = 100e2.Interest with continuous rate If rate = 5% is continuous.05 = 113. principal = N => Payoff = NerT 12 9 .55 years? Payoff after 2. what is the interest on $100 deposit after 1 year? Payoff after 1 year = 100e0.

Difference between rates Principal = 1 Term = 1 year Rate = r Payoff if rate is continuous: er Payoff if rate is simple: 1+r Payoff if compounding frequency is quarterly: (1+r/4)4 Binomial expansion: (1+r/4)4 = 1+r+6(r/4)2+… Taylor series expansion: er = 1+r+r2/2+r3/6+… The payoffs are roughly equal provided r is small 13 0 .

908894% 13 1 .879016% What is the rate if compounding frequency is quarterly? 100(1+r4/4)4=105=>r4= ((105/100)1/4-1)x4 = 4.Equivalent rates You own Bank Smiley and you want to pay an interest of $5 for a 1-year deposit on $100 What is the simple rate (equivalent annual rate)? 100x(1+rsimple) = 105 => rsimple = 105/100 – 1 = 5% What is the continuous rate? 100exp(rcont) = 105 => rcont = ln(105/100) = 4.

000 deposit? 13 2 .Snap! 1) What rate of interest with continuous compounding is equivalent to 15% per annum with monthly compounding? 2) A deposit account pays 12% per annum with continuous compounding. but interest is actually paid quarterly. How much interest will be paid each quarter on a $10.

In Practice 13 3 .

Fixed Payment in fine (reset date and coupon date coincide)/in arrear (reset at beginning of coupon period) Day-count convention 13 4 Yield: a single number that describes the quality of the instrument Currency Issuer/Credit rating .Bonds terminology Notional Notional/Face Value Coupon Frequency Maturity Accrued interest Cash/dirty price // Quoted/clean price – Dirty Price = Clean Price + Accrued Interest Discount (Coupon) Rate – – – (Reference) Floating.

000 .10-yr US Treasury Note Settlement date: 1/18/2005 Current (trade) date: 1/17/2005 Maturity: 11/15/2014 Coupon rate: 4.000. + means 1/64 Bloomberg convention: M = 1.25% Coupon frequency: S/A Face value: 1.000 Quoted price: 100+10/32+1/64 = 100.328125 per 100 face Day count convention: act/act 11/15/2004-1/18/2005: 64 days 13 5 UST convention: -10 means 10/32.

25% x N/365 x Face Trade date Settlement date Issue date Interest accrues at 4.Cashflows in a Bond (fixed rate) Accrued interest belongs to seller Day count convention Face value + coupon Coupon = 4. nearest coupon only remaining fraction taken . Payment at end of period: in-arrear Maturity 13 6 Coupon frequency: SA Clean price: discount these cashflows to settlement date.25% for this period.

no accrued Interest for seller) tdy A … 6m 3m 3m 13 7 Dirty price = Clean price + accrued interest (part of A belongs to seller as he has been holding on to the bond for the first 3m of the coupon period) .Cash/Dirty vs Quoted/Clean Prices A tdy 6m 6m … Dirty price = Clean price (buyer receives full coupon A.

43 per hundred face Ask price = 100-2.57 = 97.44 per hundred face 13 8 .56 = 97.T-bill Bid > Ask ?! Free-lunch!? Bid price =100 – 2.

matures in a (moderately) long time FRNs: floating rate version of bonds Interest rate environment (the spot curve) changes over time – serves as prices of fixed income instruments and as expectations of future rate movements Which strategy do you choose – buy-and-hold-tillmaturity or opportunistic trading 13 9 . notes.Want to invest in fixed income? Think about it… Length of investment – bills. bonds Fixed or floating coupon – – Bonds: coupon rate is fixed.

market rates 14 0 .Many rates… LIBOR EURIBOR SIBOR Fed Funds rate Prime rate Overnight rate Swap rate Constant maturity swap rate (CMS) Overnight indexed swap rate (OIS) Spot rate Forward rate Par rate The above are equivalent to each other Short rate. instantaneous forward rates.

g.LIBOR and LIBOR Fixing One of the most widely watched/referenced rates – CME’s Eurodollar futures (most heavily traded short-term interest rate futures contract) are based on USD LIBOR3m London Interbank Offered Rate Interest rate at which a bank is willing to lend funds to another bank (inter-bank market) Terms: overnight. 1w. 2w. x (1 + L x ACT/360) . 1-12m How is it produced? – – – – BBA maintains a panel of 8 contributor banks Top and bottom quartile are disregarded Middle two quartiles are averaged Announced shortly after 11am each day 14 1 Usage of LIBOR rates is via simple compounding with ACT/360 convention: e.

Spot rate A spot rate of N years is the rate at which interest accrues if cash were deposited for N years from today The graph of the function t |-> r(t). is called the spot (rate) curve Curve “under normal conditions” looks like this: r 14 2 t . where t is time to maturity and r(t) is the corresponding spot rate.

What’s your mood.ncsu.edu/AboutCES/smp/19/smhap.ces.gif . Mr Banker? r t r t 14 3 Source: http://www.

1 The Fundamental Strategy of Finance: Buy Low. Sell High r t Low High 14 4 How to capture the discrepancy and realize it as profit? .Fundamentals of Finance .

lend long (term) Short term rate r – 1 + 1 year Long term rate R – 2 years Liability: [(1+r)-1] = r in first year.The Business of Commercial Banking Borrow short (term). r + r(1+r) = r2 + 2r in the second year Revenue: (1+R)2 – 1 = 2R + R2 in the second year 14 5 .

which began since 1973 oil price shocks Greenspan Put (lower rates to stimulate economy after Dot Com bust) .The interest rate environment – extended view Very low now: Bernanke at the helm in new financial territory 14 6 Volker stepping on the brakes to stop inflation.

Ideas about the spot curve (term structure) Expectations Theory – Long-term interest rates reflect expectation of future shortterm interest rates Market Segmentation Theory – Rate of a term indicate demand and supply for borrowing and lending for that term Liquidity Preference Theory – – – 14 7 – Investors like to deposit short-term for liquidity reasons Borrowers like to borrow long-term to lock in rates Banks will need to finance long-term loans with short-term deposits. any change in short-term environment will adversely affect the financing => excessive interest rate risk Banks therefore raise long-term rates to reduce demand for long-term borrowings relative to short-term depositions .

What affects rates? Government monetary policies US FOMC announcement of rate hike/rise – – Holds 8 regularly scheduled meetings each year Date of each meeting is confirmed at the meeting preceding it Happenings in other markets – Stock/commodity market red-hot indicative of inflation pressure 14 8 .

gov/fomc/fundsrate.federalreserve.Federal Reserve and Monetary Policy Take a look! 14 9 Source: http://www.htm .

Federal Reserve and Monetary Policy 15 0 .

2008 Monetary Policy Press Release This is unconventional 15 1 .Fed Dec 16.

schwab.Fed Funds Rate – Target vs Effective 15 2 Source: http://www.com/public/schwab/research_strategies/market_insight/todays_market/recent_commentary/unconventional_0_to_25_range.html .

What now? Nominal interest rate near zero – economists call this (near) liquidity trap That means: people would rather hold on to money than to spend it (or make short term investments rather than long term investments) Major central banks use interest rates as tool to stimulate economy (or cool it down) With rates near 0.give money directly to businesses. we’re all dead”) . and economy needs lots of stimulation – HOW? Various views – – 15 3 Helicopter Money . which is what the 2008 $700B US Govt Bailout Plan is supposed to do Deficit Spending – spend on infrastructural projects in recession and under deficit conditions to stimulate economy (the view is that short-term policies should weigh over long-term policies to get out of the present crisis…in Keynes’ words – “In the long run.

Snap! 1) LIBID vs LIBOR – – Guess what is LIBID Which is higher? 2) Why are US Treasury rates significantly lower than other rates that are close to riskfree? 15 4 .

Modelling Interest Rates 15 5 .

such as the USD LIBOR3m rate? 15 6 . what’s the difference between the price of a stock (assuming the company thrives and does not go bankrupt) and an interest rate.What do you think? In the long run.

Futures and other Derivatives. John C. Hull .Mean Reversion 15 7 Source: Options.

The Vasicek Model Vasicek’s model is mean reversion speed dr = a (b − r )dt + σdz r = r(t) short rate volatility reversion level Wiener process 15 8 .

Vasicek Model is tractable 15 9 Source: Options. John C. Hull . Futures and other Derivatives.

Futures and other Derivatives. John C. Hull .Term Structure according to the Vasicek Model 16 0 Source: Options.

the interest earned between the period (t.What is short rate? Suppose short rate is r(t) (0 <= t <= T) Then discount factor is ∫0 e − r ( t ) dt T Roughly. then the instrument is worth today at 16 1 ⎡ ∫0 E ⎢e ⎣ − r ( t ) dt T ⎤ fT ⎥ ⎦ (taken wrt risk neutral measure) . t+dt) is r(t)dt on $1 If short rate is stochastic. and if the (stochastic) payoff of an instrument (that pays at time T) is fT .

Interest rate modelling is more difficult than stock price modelling There’s only 1 stock price There’s a whole term structure of interest rates! Correlation exists between rates: e. 1-year spot rate is correlated with 2-year spot rate Why is the Vasicek Model simplistic from this perspective? 16 2 .g.

Section 4: Others 16 3 .

relative to? Financial derivatives are financial instruments that stipulate cashflows in the future whose sizes depend on the prices of certain underlying assets or the magnitudes of certain reference indices Vanilla European option – – Call option : Payoff Max(ST – K.g. 8% .UNDERLYING assets/REFERENCE indices.ST. semi-annually) of a certain percentage of a notional amount What certain percentage? – Max(0. 0) at maturity T Inverse Floater – – 16 4 A note that pays coupons periodically (e. 0) at maturity T Put option : Payoff Max(K .LIBOR3m) x DayCountFraction .

Inflation index Index used is Consumer Price Index Inflation derivatives – – – – Inflation cap Inflation swap Inflation swaption Inflation bond Inflation cap payoff: 16 5 .

200.000 per degree day If cumulative HDD = 820.000 .000 = 1. payoff = (820-700) x 10.A-65) Example of a weather derivative: – – – 16 6 – Call option on cumulative HDD during February 2005 Strike price 700 Rate of $10.65-A) A day’s CDD := max(0.Temperature HDD: Heating degree days CDD: Cooling degree days A = average of highest and lowest temperature during the day at a specified weather station A day’s HDD := max(0.

com/fen51/one_time_articles/weather-derivatives/weather-derivatives.html .fenews.Temperature 16 7 Source: http://www.

fenews.com/fen51/one_time_articles/weather-derivatives/weather-derivatives.Temperature 16 8 Source: http://www.html .

Volatility

16 9

Source: CBOE’s website

Volatility

17 0

Source: CBOE’s website

Hmm…
Property derivatives are making inroads into the mainstream finance world – they are based on property indices Interesting thought…how do writers of exotic derivatives on indices hedge their risks?

17 1

Section 5: Epilogue 17 2 .

interest rates are often used in derivative contracts as reference rates. currencies and commodities. 17 3 .The Points Financial derivatives are contracts that refer to an underlying asset or a reference index or rate Some of the major asset classes which have commonly served as underlying assets for derivatives are the equities. The significance of being an underlying of a derivative is that the derivative attempts to alter the risk profile of the underlying asset. From the fixed income world.

This results in qualitatively different price and return histories. 17 4 . Financial engineers have improved the modelling by adopting more complicated models of price/rate/return stochastics. This is important as one fundamental piece of the theory of derivatives pricing is the mathematically assumed model of the underlying price/rate/return stochastics.The Points Prices from different asset classes and different rates are driven by a complicated web of factors. The Geometric Brownian Model is the de facto model of returns stochastics in finance. even though it is far from being accurate. This lecture describes the complexities that make up each asset class to highlight the simple-minded nature of the mathematical models.