You are on page 1of 29

What Does Hedge Mean? Making an investment to reduce the risk of adverse price movements in an asset.

Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge). What Does Hedge Fund Mean? An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

What Does Prime Brokerage Mean?

A special group of services that many brokerages give to special clients. The services provided under prime brokering are securities lending, leveraged trade executions, and cash management, among other things. Prime brokerage services are provided by most of the large brokers, such as Goldman Sachs, Paine Webber, and Morgan Stanley Dean Witter. Hedge funds were what started the prime brokerage option. Hedge funds place large trades and need special attention from brokerages

In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation. If a borrower does default on a loan (due to insolvency or other event), that borrower forfeits (gives up) the property pledged as collateral - and the lender then becomes the owner of the collateral. In a typical mortgage loan transaction, for instance, the real estate being acquired with the help of the loan serves as collateral. Should the buyer fail to pay the loan under the mortgage loan agreement, the ownership of the real estate is transferred to the bank. The bank uses a legal process called foreclosure to obtain real estate from a borrower who defaults on a mortgage loan obligation.

Concept of collateral
Collateral, especially within banking, may traditionally refer to secured lending (also known as asset-based lending). More recently, complex collateralization arrangements are used to secure trade transactions (also known as capital market collateralization). The former often presents unilateral obligations, secured in the form of property, surety, guarantee or other as collateral (originally denoted by the term security), whereas the latter often presents bilateral obligations secured by more liquid assets such as cash or securities, often known as margin. Another example might be to ask for collateral in exchange for holding something of value until it is returned (e.g., I'll hold onto your wallet while you borrow my cell phone). In many developing countries, the use of collateral is the main way to secure bank financing.[citation needed] The ease of acquiring a loan depends on the ability to use assets such as real estate as collateral.

Security interest
A security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt.[1] It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets. Such rights vary according to the type of security interest, but in most cases, a holder of the security interest is entitled to seize, and usually sell, the property to discharge the debt that the security interest secures.

A secured creditor takes a security interest to enforce its rights against collateral in case the debtor defaults on the obligation. If the debtor goes bankrupt, a secured creditor takes precedence over unsecured creditor in the distribution. There are other reasons that people sometimes take security over assets. In shareholders' agreements involving two parties (such as a joint venture), sometimes the shareholders will each charge their shares in favor of the other as security for the performance of their obligations under the agreement to prevent the other shareholder selling their shares to a third party. It is sometimes suggested that banks may take floating charges over companies by way of security - not so much for the security for payment of their own debts, but because this ensures that no other bank will, ordinarily, lend to the company, thereby almost granting a monopoly in favor of the bank holding the floating charge on lending to the company. Some economists question the utility of security interests and secured lending generally. Proponents argue that secured interests lower the risk for the lender, and in turn allow the lender to charge lower interest, thereby lower the cost of capital for the borrower. Compare, for example, interest rates for a mortgage loan and for a credit card debt. Detractors argue that creditors with security interests can destroy companies that are in financial difficulty, but which might still recover and be profitable. The secured lenders might get nervous and enforce the security early, repossessing key assets and forcing the company into bankruptcy. Further, the general principle of most insolvency regimes is that creditors should be treated equally (or pari passu), and allowing secured creditors a preference to certain assets upsets the conceptual basis of an insolvency. More sophisticated criticisms of security point out that although unsecured creditors will receive less on insolvency, they should be able to compensate by charging a higher interest rate. However, since many unsecured creditors are unable to adjust their "interest rates" upwards (tort claimants, employees), the company benefits from a cheaper rate of credit, to the detriment of these non-adjusting creditors. There is thus a transfer of value from these parties to secured borrowers. Most insolvency law allows mutual debts to be set-off, allowing certain creditors (those who also owe money to the insolvent debtor) a prepreferential position. In some countries, "involuntary" creditors (such as tort victims) also have preferential status, and in others environmental claims have special preferred rights for cleanup costs. The most frequently used criticism of secured lending is that, if secured creditors are allowed to seize and sell key assets, a liquidator or bankruptcy trustee loses the ability to sell off the business as a going concern, and may be forced to sell the business on a break-up basis. This may mean realizing a much smaller return for the unsecured creditors, and will invariably mean that all the employees will be made redundant. For this reason, many jurisdictions restrict the ability of secured creditors to enforce their rights in a bankruptcy. In the U.S., the creditor protection, which completely prevents enforcement of security interests, aims at keeping enterprises running at the expense of creditors' [5] rights, and is often heavily criticized for that reason. In the United Kingdom, an administration order has a similar effect, but are less expansive in scope and restriction in terms of creditors rights. European systems are often touted as being pro-creditor, but many European jurisdictions also impose restrictions upon time limits that must be observed before secured creditors can enforce their rights. The most draconian jurisdictions in favor of creditor's rights tend to be in offshore financial centres, who hope that, by having a legal system heavily biased towards secured creditors, they will encourage banks to lend at cheaper rates to offshore structures, and thus in turn encourage [6] business to use them to obtain cheaper funds.

Credit Derivatives
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.[1] This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.[2] Credit derivatives are bilateral [2] contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity. Stated in plain language, a credit derivative is a wager, and the reference entity is the thing being wagered on. Similar to placing a bet at the racetrack, where the person placing the bet does not own the horse or the track or have anything else to do with the race, the person buying the credit derivative doesn't necessarily own the bond (the reference entity) that is the object of the wager. He or she simply believes that there is a good chance that the bond or collateralized debt obligation (CDO) in question will default (go to zero value). Originally conceived as a kind of insurance policy for owners of bonds or CDO's, it evolved into a freestanding investment strategy. The cost might be as low as 1% per year. If the buyer of the derivative believes the underlying bond will go bust within a year (usually an extremely unlikely event) the buyer stands to reap a 100 fold profit. A small handful of investors anticipated the credit crunch of 2007/8 and made billions placing "bets" via this method. The parties will select which credit events apply to a transaction and these usually consist of one or more of the following:

y y y y y y

bankruptcy (the risk that the reference entity will become bankrupt) failure to pay (the risk that the reference entity will default on one of its obligations such as a bond or loan) obligation default (the risk that the reference entity will default on any of its obligations) obligation acceleration (the risk that an obligation of the reference entity will be accelerated e.g. a bond will be declared immediately due and payable following a default) repudiation/moratorium (the risk that the reference entity or a government will declare a moratorium over the reference entity's obligations) restructuring (the risk that obligations of the reference entity will be restructured)...

Where credit protection is bought and sold between bilateral counterparties, this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative. This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic CDOs; credit linked notes; single tranche CDOs, to name a few. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite.

Market size and participants

Credit default products are the most commonly traded credit derivative product and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations (see further discussion below). The ISDA reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion with a gross market value of $948 billion (ISDA's Website). As reported in The Times on September 15, 2008, the "Worldwide credit derivatives market is valued at $62 trillion". [5] Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of Europe having about 10%. The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporate.[3]
[3] [4] [3]

Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives. An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets. A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. The advantage of this to the protection buyer is that it is not exposed to the credit risk of the protection seller[6]. Unfunded credit derivative products include the following products:

y y y

Credit default swap (CDS) Total return swap Constant maturity credit default swap (CMCDS)

y y y y y y y y

First to Default Credit Default Swap Portfolio Credit Default Swap Secured Loan Credit Default Swap Credit Default Swap on Asset Backed Securities Credit default swaption Recovery lock transaction Credit Spread Option CDS index products

Funded credit derivative products include the following products:

y y y y

Credit linked note (CLN) Synthetic Collateralised Debt Obligation (CDO) Constant Proportion Debt Obligation (CPDO) Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)

Key unfunded credit derivative products


The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product represents over thirty percent of the credit derivatives market[3]. A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a third party called a reference entity: this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfill certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction. The relevant credit events specified in a transaction will usually be selected from amongst the following:

y y y y

The bankruptcy of the reference entity; Its failure to pay in relation to a covered obligation; It defaulting on an obligation or that obligation being accelerated; It agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation.

If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim, then the transaction will settle. This means that, in the case of a physically settled transaction, the protection buyer can deliver an amount of the reference entity's defaulted obligations to the protection seller, in return for their full face value (notwithstanding that they are now worth far less). In the case of a cash settled transaction, a relevant obligation of the reference entity will be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its current value (i.e. compensating the protection buyer for the decline in the obligation's creditworthiness). Credit default swaps have unique characteristics that distinguish them from insurance products and financial guaranties. The protection buyer does not need to own an underlying obligation of the reference entity. The protection buyer does not need to suffer a loss. Since the reference entity is not a party to agreement between the protection buyer and seller, the seller of protection has no inherent recourse to the reference entity in the event of default and no right to sue the reference entity for recovery. However, if the transaction were to be physically settled the seller of protection could derive a right to take action against the reference entity on the basis of the loan or securities acquired during the settlement process. The product has many variations, including where there is a basket or portfolio of reference entities, although fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of late: credit default swaps which relate to asset-backed securities.


Main article: Total return swap A total return swap (also known as Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other receives a specified fixed or floating cash flow that is not related to the

creditworthiness of the reference asset, as with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may be any asset, index or basket of assets. The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use of the balance sheet, and which allows the other to effectively "buy protection" against loss in value due to ownership of a credit asset. The essential difference between a total return swap and a credit default swap is that the credit default swap provides protection against specific credit events. The total return swap protects against the loss of value irrespective of cause, whether default, widening of credit spreads or anything else i.e. it isolates both credit risk and market risk.

Key funded credit derivative products Credit linked notes

In this example coupons from the bank's portfolio of loans are passed to the SPV which uses the cash flow to service the credit linked notes. A credit linked note is a note whose cash flow depends upon an event, which may be a default, change in credit spread, or rating change. The definition of the relevant credit events must be negotiated by the parties to the note. A CLN in effect combines a credit-default swap with a regular note (with coupon, maturity, redemption). Given its note like features, a CLN is an on-balance-sheet asset, in contrast to a CDS. Typically, an investment fund manager will purchase such a note to hedge against possible down grades, or loan defaults. Numerous different types of credit linked notes (CLNs) have been structured and placed in the past few years. Here we are going to provide an overview rather than a detailed account of these instruments. The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a less creditworthy risk. For example, a bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that country's default or convertibility risk. From the bank's point of view, this achieves the purpose of reducing its exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. However, from the point of view of investors, the risk profile is different from that of the bonds issued by the country. If the bank runs into difficulty, their investments will suffer even if the country is still performing well. The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an enhanced coupon. Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults. There are several different types of securitized product, which have a credit dimension. CLN is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.

Credit-linked notes CLN: Credit-linked note is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.

y y y

Collateralized debt obligation CDO: Generic term for a bond issued against a mixed pool of assets - There also exists CDO-squared (CDO^2) where the underlying assets are CDO tranches. Collateralized bond obligations CBO: Bond issued against a pool of bond assets or other securities. It is referred to in a generic sense as a CDO Collateralized loan obligations CLO: Bond issued against a pool of bank loan. It is referred to in a generic sense as a CDO

CDO refers either to the pool of assets used to support the CLNs or, confusingly, to the CLNs themselves.

Collateralized debt obligations (CDO)

Collateralized debt obligations or CDOs are a form of credit derivative offering exposure to a large number of companies in a single instrument. This exposure is sold in slices of varying risk or subordination - each slice is known as a tranche. In a cash flow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap. A synthetic CDO is also referred to as CSO. Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared.

Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.)

History of Credit Derivatives Author:

1975 -NYSE ended fixed commissions, leading to dropping commission rates and broker consolidation. -Large number of boutique investment banks. -Severe recession and oil price shock. -Collapse of New York City real estate market. -New York City defaults on its municipal bonds. -Major banks hover on the edge of bankruptcy and crush of non-performing loans. 1978 -Glass Steagel Act passed. -Mutual funds and money market funds start growing rapidly. -U.S. dollar declines. 1979 -Oil price boom. -Gold and precious metals prices on a huge bull run. -Political instability. 1980 -High inflation, Prime Rate at 20%+. -Iran conflict. -Inverted yield curve signaling future recession. -Approach = Buy and hold loans, mortgages, bonds. -Limited secondary credit trading. -No synthetic credit structures or credit risk transfer instruments. -Leveraged leasing is big business.
-Height of "relationship banking." Large loan syndication and private placement businesses (Chase, Citibank, Morgan Stanley).

-Long credit training programs (1-3 years long) required for fixed income bankers. -No counterparty risk -- bond issues are syndicated then sold off at the end of the syndication period. - Secondard trading in bonds almost exclusively a U.S. market. No market in the U.K. Some German government debt trading. -Products includ bankers acceptances, repos, commercial paper, Fed Funds interbank loans.

-U.S. investors heavily restricted -- pension funds, insurance companies, etc. cannot invest outside the U.S. or Canada. -U.S. banks begin lending to third world banks backed by sovereign debt guarantees and financing (Latin America, Poland). -Project Finance is a major business for U.S., U.K. and French banks (Lloyds, Societe Generale, etc.) -Interest rate swaps are born from high inflation, interest rate volatility, and foreign currency volatility. -Banks start seeking ways to transfer risk off their books, leading to the rise of the "trader bank." -Consolidation of the banking sector begins. 1981 -Product innovation accelerates with the first interest rate swaps, currency swaps, zero coupon bonds, and variable rate financing. -Secondary market expands to include short dated bank paper. -Savings and Loans borrow at 3% and lend at 6%, giving rise to the 3/6/3 Rule (borrow at 3%, lend at 6%, golf at 3:00). But this makes S&L's highly susceptible to interest rate volatility. -No ISDA standards for interest rate derivatives contracts. Transactions are highly customized. -Trading desks are formed to trade interest rate products, requiring capital to hold trading portfolios, and setting off a wave of bank consolidations. 1983 -Oil prices fall, causing rapid defaults of petroleum-backed loans. -Foreign emerging market governments "de facto default" by suspending payments (Eastern Europe, Latin America). U.S. banks refuse to write the loans off based on the theory that governments can always print money to pay off sovereign loans. -U.S. Savings & Loan Crisis begins. S&Ls begin defaulting en masse. -Mortgage Backed Securities (MBS) market starts at Solomon Brothers (read Liars Poker). -First pooling of credits sold to institutional investors. First synthetic credit comprised of repayments from MBS loan pool, rather than single borrowers. -Asset Backed Securities (ABS) market starts with credit card and auto loan portfolios. -Rise of Michael Millkin, junk bonds, and synthetic high yield debt. -Joel Stern & Stewart, University of Chicago, Economic Value Added: Quest for Value introduces the concept of EVA. Debt is treated like equity, encouraging companies to borrow as much as possible if the value generated is positive. Gives rise to the concept of unlimited capital and calculated use of leverage and aggressive capital structures. Increased leverage and risk follows. 1987 -U.S. banks forced to recognize losses on emerging markets loans (Argentina, Brazil, Poland, Chile, Asia). -Banks respond by creating new loan structures and trading and swapping bad debts (e.g. bad Chile for bad Argentina). Banks begin trading debt with their own foreign subsidiaries. -Marshall Carter at Chase Manhattan Bank pioneers foreign subsidiary debt transfer program. -New York and London banks try to get out of defaulted sovereign debt market, but also need to generate yields, so often re-lend to the same foreign defaulted borrowers. -BASEL I creates control over pricing and accounting for credit risk. -Future flow deals appear. The premise is "if the South African government is in default, loan directly to companies in South Africa (e.g. Anglo American) because the government would be crazy to interfere with the flow of hard asset exports to overseas markets." The strategy has varying success. -Rise of Synthetic Ratings -- belief that an "A" rating means the same regardless of whether the borrower is a corporate, municipal, or sovereign. All borrowers with the same rating are assumed to have the same risk of default. Strategy has varying levels of success. 1992 -Inflation gone. -U.S.S.R. falls and splits into many separate countries. -Rise of high yield products such as structured notes, inverse floaters. -Orange County default due to high leverage and misunderstanding of risk dynamics inherent in derivative instruments. Results in push for greater risk control and transparency. Many municipals and pension funds prohibit investment in derivatives. -FASB 133 requires mark-to-market of securities positions. Debate about whether mark-to-market is effective for investor protection or simply an added cost. 1995 -First Credit Default Swaps (CDS) and Collaterized Debt Obligation (CDO) structures created by JPMorgan, led by Blythe Masters. -JPMorgan leads industry transformation away from relationship banking towards credit trading. Goal is higher returns without assuming buy and hold risk. -Accounting and regulatory arbitrage generates significant revenues. -Shifting of credit risk off bank balance sheets by pooling credits and remarketing portfolios, and buying default protection after syndicating loans for clients. 1996 -Single name CDS market takes hold and starts to grow. -KMV model (quantitative correlation analysis) relates balance sheet debt vs. market value of debt vs. probability of default. In 2001 KMV model shows Enron is BBB-C rated when S&P rating shows AA. KMV model proves to be more accurate than preceding default models.

-Rise of Financial Guarantors. -New strategy = build portfolios of debt securities, then package and sell off tranches based on default probabilities. Slice and dice to generate revenue for bank, customized risk/return profiles for investors. -ABS, CDS, emerging market debt all wrapped and sold off in tranches. 1998-1999 -Basket portfolio trading begins. -Buying and selling the entire debt capital structure takes hold. -New CDS contracts allow hedging below-investment grade and high yield loans. -ISDA updates its CDS confirmation document and supplements to reflect market needs. -CDS market becomes increasingly standardized and volume increases significantly. 2000-2001 -Volume of CDS contracts trading ($100 billion) far exceeds volume of cash bonds ($30 billion), creating a risk of price squeeze on defaulted bonds used for physical delivery. -First cash settlement CDS terms used to avoid dangers of physical settlement. -End of boom causes waves of growth company defaults. Investors realize the increasing importance of credit protection. -Rating arbitrage strategies gain popularity, taking advantage of time delay in rating agency downgrades and upgrades using CDS contracts for speculation. -Credit Linked Note (CLN) market in Europe grows rapidly, paving the way for rapid CDS growth. 2002 -CDX index created by dealers. -JP Morgan and Morgan Stanley issue CDS indexes. -Creation of CDS on tradeable credit indices causes massive leap in transaction volumes (100%+ per year). -Internet revolution and the rise of distributed computing makes complex mathematics easier. Structured credit can now be done from anywhere on the planet, reducing capital demands and allowing smaller players and emerging markets to enter the sector. -Rise of Hedge Funds: Number of funds increases from 4000 in 2002 managing $2 trillion to 8000+ managing $4 trillion. This creates intense demand for new structured products with higher yields. -Quiet deconsolidation wave begins with "outsourcing" of risky strategies by investment banks to separate entities formed for the purpose of generating higher yields. Also exposes the industry to potential wave of credit default risk. -Greater number of products, but less liquidity means higher transaction revenues but potential liquidity crises ahead. -Questionable risk management of complex strategies, interlocking ownership, high leverage, and secrecy of hedge fund industry lays the groundwork for potential market shocks. 2003 -ISDA definitions now the market standard. -Collaterized Debt Obligation (CDO) market expands. -Fleet Bank middle market group first to package illiquid private company loans and sell off tranches to investors. Industry follows by packaging everything possible. -Accounting vs. Auditing vs. Sarbanes-Oxley (SOX) issues. -Systematic Risk becomes apparent: Huge restatements due to vendor/buyer revenue accounting, Enron balance sheet/special purpose vehicles used to securitize assets. FASB 113 Financial Insurance regulation leads to MBIA earnings restatement. 2005 -ISDA creates definitions on CDS of ABS. -Delphi default uncovers significant counterparty risk and problems with price squeeze on defaulted bonds used for physical delivery. Several hedge funds and broker-dealers take large losses as buying of defaulted bonds for physical delivery creates a "price squeeze". Back office processing and documentation failures cause long delays in settlement. Systematic risks become highly evident and fear of future financial crises rises. -U.S. Fed Chairman issues edict to major credit market players to clean up documentation and settlement procedures or face halt in trading. Industry responds with positive and intense efforts. -CDS contracts are still an over-the-counter (OTC) market only, except for limited retail market in Australia. -Dramatic rise in pooling, tranching and re-marketing risk using CDO, CDO-squared (CDO^2), Nth-to-Default, and other Special Purpose Vehicles. Extremely lucrative business for major broker-dealers and specialty fund managers. 2006-present -Industry-specific indexes developed: CMBS, ABS (ABX), High Yield (100 names) -Counterparty risk expands to include broker-dealers, multinational corporations, hedge funds, insurers. -Large money center banks with huge balance sheets no longer needed to anchor new debt issues due to the broad availability of credit derivative risk transfer products. -Credit derivative volume has expanded exponentially to roughly $26 trillion, according to ISDA. -BASEL II drives increasing compliance to minimize credit risk, market risk, and operational risk. -FASB 133 and IAS 39 compliance emphasizes high dependence on credit default models. -Consolidation of Guarantors drives up competition and drives down risk premiums in new bond issues.

-Increasing movement toward cash settlement/auction pricing of defaulted credits upon credit event to "avoid the squeeze." -Markit, CDX, and iTraxx are now standard pricing sources, further enabling broad trading of credit derivatives. -Chicago Mercantile Exchange (CME) considers listing standardized single name CDS contracts to create the first large retail market. -DTCC clearing system development increases speed of trade clearing and settlement, reduces costs and operational risks. -Notional value of single name CDS outstanding now $19-25 trillion versus $40 trillion in bonds. -Dura default and auction in November 2006 goes smoothly, showing the value of improved standardized industry procedures and clear documentation. -Hedge fund counterparty risk remains. Large broker-dealers still exposed, as they lend to hedge funds through their prime brokerage arms. -Permanent Capital Vehicles (PCVs) are formed to invest in credit markets. Investment money is locked up for 5 years or more, which allows managers to do longer term arbitrage, capital structure, and cycle plays.

In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of his counterparty (most often his broker or an exchange). This risk can arise if the holder has done any of the following:

y y y

borrowed cash from the counterparty to buy financial instruments, sold financial instruments short, or entered into a derivative contract.

The collateral can be in the form of cash or securities, and it is deposited in a margin account. On U.S. futures exchanges, "margin" was formally called performance bond.

Margin buying
Examples Jane buys a share in a company for $100, using $20 of her own money, and $80 borrowed from her broker. The net value (share - loan) is $20. The broker wants a minimum margin requirement of $10. Suppose the share goes down to $85. The net value is now only $5 (net value ($20) - share loss of ($15)), and Jane will either have to sell the share or repay part of the loan (so that the net value of her position is again above $10). Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the amount of one's own cash used. This difference has to stay above a minimum margin requirement, the purpose of which is to protect the broker against a fall in the value of the securities to the point that the investor can no longer cover the loan. In the 1920s, margin requirements were loose. In other words, brokers required investors to put in very little of their own money. Whereas today, the Federal Reserve's margin requirement limits debt to 50 percent, during the 1920s leverage rates of up to 90 percent debt were not [1] uncommon. When the stock market started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls. This was one of the major contributing factors which led to the Stock Market Crash of [1] 1929, which in turn contributed to the Great Depression , a troubling financial time in the 1930s. However, as reported in Peter Rappoport [2] and Eugene N. White's 1994 paper Was the Crash of 1929 Expected , all sources indicate that beginning in either late 1928 or early 1929, "margin requirements began to rise to historic new levels. The typical peak rates on brokers' loans were 40-50 percent. Brokerage houses followed suit and demanded higher margin from investors."

Types of margin requirements

The current liquidating margin is the value of a securities position if the position were liquidated now. In other words, if the holder has a short position, this is the money needed to buy back; if he is long, it is the money he can raise by selling it. The variation margin or maintenance margin is not collateral, but a daily payment of profits and losses. Futures are marked-to-market every day, so the current price is compared to the previous day's price. The profit or loss on the day of a position is then paid to or debited from the holder by the futures exchange. This is possible, because the exchange is the central counterparty to all contracts, and the number of long contracts equals the number of short contracts. Certain other exchange traded derivatives, such as options on futures contracts, are markedto-market in the same way.

The seller of an option has the obligation to deliver the underlying of the option if it is exercised. To ensure he can fulfill this obligation, he has to deposit collateral. This premium margin is equal to the premium that he would need to pay to buy back the option and close out his position. Additional margin is intended to cover a potential fall in the value of the position on the following trading day. This is calculated as the potential loss in a worst-case scenario. SMA and Portfolio margin offer alternative rules for US and NYSE regulatory margin requirements.

Minimum margin requirement

The minimum margin requirement is now the sum of these different types of margin requirements. The margin (collateral) deposited in the margin account has to be at least equal to this minimum. If the investor has many positions with the exchange, these margin requirements can simply be netted. Example 1 An investor sells a call option, where the buyer has the right to buy 100 shares in Universal Widgets S.A. at 90. He receives an option premium of 14. The value of the option is 14, so this is the premium margin. The exchange has calculated, using historical prices, that the option value won't go above 17 the next day, with 99% certainty. Therefore, the additional margin requirement is set at 3, and the investor has to post at least 14 + 3 = 17 in his margin account as collateral. Example 2 Futures contracts on sweet crude oil closed the day at $65. The exchange sets the additional margin requirement at $2, which the holder of a long position pays as collateral in his margin account. A day later, the futures close at $66. The exchange now pays the profit of $1 in the mark-to-market to the holder. The margin account still holds only the $2. Example 3 An investor is long 50 shares in Universal Widgets Ltd, trading at 120 pence (1.20) each. The broker sets an additional margin requirement of 20 pence per share, so 10 for the total position. The current liquidating margin is currently 60 in favour of the investor. The minimum margin requirement is now -60 + 10 = -50. In other words, the investor can run a deficit of 50 in his margin account and still fulfil his margin obligations. This is the same as saying he can borrow up to 50 from the broker.

Initial and maintenance margin requirements

The initial margin requirement is the amount required to be collateralized in order to open a position. Thereafter, the amount required to be kept in collateral until the position is closed is the maintenance requirement. The maintenance requirement is the minimum amount to be collateralized in order to keep an open position. It is generally lower than the initial requirement. This allows the price to move against the margin without forcing a margin call immediately after the initial transaction. On instruments determined to be especially risky, however, the regulators, the exchange, or the broker may set the maintenance requirement higher than normal or equal to the initial requirement to reduce their exposure to the risk accepted by the trader.

When the margin posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. The investors now either have to increase the margin that they have deposited or close out their position. They can do this by selling the securities, options or futures if they are long and by buying them back if they are short. But if they do none of these, then the broker can sell his securities to meet the margin call.

Price of stock for margin calls

The minimum margin requirement, sometimes called the maintenance margin requirement, is the ratio set for:

y y y y y

(Stock Equity - Leveraged Dollars) to Stock Equity Stock Equity being the stock price * no. of stocks bought and Leveraged Dollars being the amount borrowed in the margin account. E.g. An investor bought 1000 shares of ABC company each priced at $50. If the initial margin requirement were 60%: Stock Equity: $50 * 1000 = $50,000 Leveraged Dollars or amount borrowed: ($50 * 1000)* (100%-60%) = $20,000

So the maintenance margin requirement uses the above variables to form a ratio that investors have to abide by in order to keep the account active.

The point is, let's say the maintenance margin requirement is 25% - That means the customer has to maintain Net Value equal to 25% of the total stock equity. That means he has to maintain net equity of $50,000 * 0.25 = $12,500. So at what price would the investor be getting a margin call? Let P be the price, so 1000P in our case is the Stock Equity.

y y y y y

(Current Market Value - Amount Borrowed) / Current Market Value = 25% (1000P - 20000)/1000P = 0.25 (1000P - 20000)= 250P 750P = $20,000 P = $20,000/750 = $26.66 / share

So if the stock price drops from $50 to $26.66, investors will be called to add additional funds to the account to make up for the loss in stock equity.

Reduced margins
Margin requirements are reduced for positions that offset each other. For instance spread traders who have offsetting futures contracts do not have to deposit collateral both for their short position and their long position. The exchange calculates the loss in a worst case scenario of the total position.

Margin-equity ratio
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader's capital equal to the value of the futures contract itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative trader might hold a marginequity ratio of 15%, while a more aggressive trader might hold 40%.

Return on margin
Return on margin (ROM) is often used to judge performance because it represents the net gain or net loss compared to the exchange's perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The annualized ROM is equal to (ROM + 1)(1/trade duration in years) - 1 For example if a trader earns 10% on margin in two months, that would be about 77% annualized Annualized ROM = (ROM +1)1/(2/12) - 1 that is, Annualized ROM = 1.16 - 1 = 77% Sometimes, return on margin will also take into account peripheral charges such as brokerage fees and interest paid on the sum borrowed. The margin interest rate is usually based on the Broker's call.

Portfolio margin
Portfolio margin is a risk-based margin policy. Portfolio margin usually results in significantly lower margin requirements on hedged positions than under traditional rules. While margin requirement of Regulation T generally limit leverage on equity to 4:1, with portfolio margin, accounts may increase their leverage up to 6:1 or more. Portfolio margin calculates the total loss potential of the portfolio and not individual positions. NYSE Margin requirement are calculated using the Options Clearing Corporation's (OCC) risk model to stress the positions with valuation changes at plus and minus intervals between 3% and 15%. They require 15 percent collateral requirement for equities and can be less for hedged options. The NYSE began a pilot program in April 2007 offering portfolio margin to certain qualified accounts.

Nostro and Vostro accounts

Nostro and Vostro are accounting terms used to distinguish an account you hold for another entity from an account another entity holds for you. The entities in question are almost always, but need not be, banks.

It helps to recall that the term account refers to a record of transactions, whether current, past or future, and whether in money, or shares, or other countable commodities. Originally a bank account just meant the record kept by a banker of the money they were holding on behalf of a customer, and how that changed as the customer made deposits and withdrawals (the money itself probably being in the form of specie, such as gold and silver coin). Some customers will keep their own records of their transactions, for instance, so they can check for errors by the bank. That record kept by the customer is also an account, of the money the bank is holding for them. When that customer is another bank, since they also keep other accounts (of the money they are holding for their customers) there is a need to clearly differentiate between these two types of accounts. The terms nostro and vostro remove the potential ambiguity when referring to these two separate accounts of the same balance and set of transactions. Speaking from the bank's point-of-view:

y y

A nostro is our account of our money, held by you A vostro is our account of your money, held by us

Note that all "bank accounts" as the term is normally understood, including personal or corporate chequing, loan, and savings accounts, are treated as vostros by the bank. They also regard as vostro purely internal funds such as treasury, trading and suspense accounts; although there is no "you" in the sense of an external customer, the money is still "held by us".

A bank counts a nostro account with a credit balance as a cash asset in its balance sheet. Conversely, a vostro account with a credit balance (i.e. a deposit) is a liability, and a vostro with a debit balance (a loan) is an asset. Thus in many banks a credit entry on an account ("CR") is regarded as negative movement, and a debit ("DR") is positive - the reverse of usual commercial accounting conventions. With the advent of computerised accounting, nostros and vostros just need to have opposite signs within any one bank's accounting system; that is, if a nostro in credit has a positive sign, then a vostro in credit must have a negative sign. This allows for a reconciliation by summing all accounts to zero (a trial balance) - the basic premise of double-entry bookkeeping.

Typical usage
Nostro accounts are mostly commonly used for currency settlement, where a bank or other financial institution needs to hold balances in a currency other than its home accounting unit. For example: First National Bank of A does some transactions (loans, foreign exchange, etc.) in B$, but banks in A will only handle payments in A$. So FNB of A opens a B$ account at foreign bank Credit Mutuel de B, and instructs all counter-parties to settle transactions in B$ at "account no. 123456 in name of FNBA, at CMB, X Branch". FNBA maintains its own records of that account, for reconciliation; this is its nostro account. CMB's record of the same account is the vostro account. Now, FNBA sells A$1,000,000 to C (a counterparty who has an A$ account with FNBA, and a B$ account with CMB) for a net consideration of B$2,000,000. FNBA will make the following entries in its own accounting system: (Internal) FX A$ trading account 1,000,000 DR A$ Account in name of C 1,000,000 CR

B$ Nostro at CMB (FNBA's nostro) 2,000,000 DR (Internal) FX B$ trading account 2,000,000 CR

Over at CMB, they record the following transaction: B$ Account in name of C 2,000,000 DR B$ Account in name of FNBA (CMB's vostro) 2,000,000 CR

[This is somewhat simplified; in reality C may not have an account with FNBA's corresponding bank, and will make settlement by cheque or some form of EFT. In this case CMB will make entries on several other accounts, such as a Teller's receiving account, or a clearing account with the third bank that the cheque was written on.]

A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities - remember, buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators. The consensus in the investment world is that the futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break down how it functions. While futures are not for the risk averse, they are useful for a wide range of people. In this tutorial, you'll learn how the futures market works, who uses futures and which strategies will make you a successful trader on the futures market.

A Brief History
Before the North American futures market originated some 150 years ago, farmers would grow their crops and then bring them to market in the hope of selling their inventory. But without any indication of demand, supply often exceeded what was needed and unpurchased crops were left to rot in the streets! Conversely, when a given commodity - wheat, for instance - was out of season, the goods made from it became very expensive because the crop was no longer available. In the mid-nineteenth century, central grain markets were established and a central marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (spot trading) or for forward delivery. The latter contracts - forward contracts - were the forerunners to today's futures contracts. In fact, this concept saved many a farmer the loss of crops and profits and helped stabilize supply and prices in the off-season. Today's futures market is a global marketplace for not only agricultural goods, but also for currencies and financial instruments such as Treasury bonds and securities (securities futures). It's a diverse meeting place of farmers, exporters, importers, manufacturers and speculators. Thanks to modern technology, commodities prices are seen throughout the world, so a Kansas farmer can match a bid from a buyer in Europe.

How The Market Works

The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery. But don't worry, as we mentioned earlier, almost all futures contracts end without the actual physical delivery of the commodity.

What Exactly Is a Futures Contract?

Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices. That's how the futures market works. Except instead of a cable TV provider, a producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain per se - that can then be bought and sold in the futures market. So, a futures contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). We will talk more about the outlooks of the long and short positions in the section on strategies, but for now it's important to know that every contract involves both positions. In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The price of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel.

Profit And Loss - Cash Settlement

The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the futures contracts for wheat increases to $5 per bushel the day after the above farmer and bread maker enter into their futures contract of $4 per bushel. The farmer, as the holder of the short position, has lost $1 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the long position, has profited by $1 per bushel because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat. On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position. As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at $5 per bushel, the farmer would lose $5,000 on the futures contract and the bread maker would have made $5,000 on the contract.

But after the settlement of the futures contract, the bread maker still needs wheat to make bread, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the bread maker's futures profits of $5,000 go towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000 - $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at $5 per bushel but because of his losses from the futures contract with the bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is referred to as hedging. Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker. In such a case, the short speculator would simply have lost $5,000 while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires.)

Economic Importance of the Futures Market

Because the futures market is both highly active and central to the global marketplace, it's a good source for vital market information and sentiment indicators. Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrows estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery. Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market.

The Players
Hedgers Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks. The holders of the long position in futures contracts (the buyers of the commodity), are trying to secure as low a price as possible. The short holders of the contract (the sellers of the commodity) will want to secure as high a price as possible. The futures contract, however, provides a definite price certainty for both parties, which reduces the risks associated with price volatility. Hedging by means of futures contracts can also be used as a means to lock in an acceptable price margin between the cost of the raw material and the retail cost of the final product sold.

Example: A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already been advertised in an upcoming catalog with specific prices. But what if the price of silver goes up over the next six months? Because the prices of the earrings and bracelets are already set, the extra cost of the silver can't be passed on to the retail buyer, meaning it would be passed on to the silversmith. The silversmith needs to hedge, or minimize her risk against a possible price increase in silver. How? The silversmith would enter the futures market and purchase a silver contract for settlement in six months time (let's say June) at a price of $5 per ounce. At the end of the six months, the price of silver in the cash market is actually $6 per ounce, so the silversmith benefits from the futures contract and escapes the higher price. Had the price of silver declined in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very volatile, the silver maker was still sheltering himself from risk by entering into the futures contract. So that's basically what hedging is: the attempt to minimize risk as much as possible by locking in prices for future purchases and sales. Someone going long in a securities future contract now can hedge against rising equity prices in three months. If at the time of the contract's expiration the equity price has risen, the investor's contract can be closed out at the higher price. The opposite could happen as well: a hedger could go short in a contract today to hedge against declining stock prices in the future. A potato farmer would hedge against lower French fry prices, while a fast food chain would hedge against higher potato prices. A company in need of a loan in six months could hedge against rising interest rates in the future, while a coffee beanery could hedge against rising coffee bean prices next year.

Speculators Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and therefore maximize their profits. In the futures market, a speculator buying a contract low in order to sell high in the future would most likely be buying that contract from a hedger selling a contract low in anticipation of declining prices in the future. Unlike the hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts.

Trader The Hedger



Secure a price now to protect against future declining prices Secure a price now to protect against future rising prices Secure a price now in anticipation of rising prices

The Speculator Secure a price now in anticipation of declining prices

In a fast-paced market into which information is continuously being fed, speculators and hedgers bounce off of - and benefit from - each other. The closer it gets to the time of the contract's expiration, the more solid the information entering the market will be regarding the commodity in question. Thus, all can expect a more accurate reflection of supply and demand and the corresponding price.

Regulatory Bodies The U.S. futures market is regulated by the Commodity Futures Trading Commission (CFTC) an independent agency of the U.S. government. The market is also subject to regulation by the National Futures Association (NFA), a self-regulatory body authorized by the U.S. Congress and subject to CFTC supervision. A broker and/or firm must be registered with the CFTC in order to issue or buy or sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in order to conduct business. The CFTC has the power to seek criminal prosecution through the Department of Justice in cases of illegal activity, while violations against the NFA's business ethics and code of conduct can permanently bar a company or a person from dealing on the futures exchange. It is imperative for investors wanting to enter the futures market to understand these regulations and make sure that the brokers, traders or companies acting on their behalf are licensed by the CFTC.

In the unfortunate event of conflict or illegal loss, you can look to the NFA for arbitration and appeal to the CFTC for reparations. Know your rights as an investor!

In the futures market, margin has a definition distinct from its definition in the stock market, where margin is the use of borrowed money to purchase securities. In the futures market, margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses. When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. In other words, the amount in your margin account changes daily as the market fluctuates in relation to your futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised. The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount. Let's say that you had to deposit an initial margin of $1,000 on a contract and the maintenance margin level is $500. A series of losses dropped the value of your account to $400. This would then prompt the broker to make a margin call to you, requesting a deposit of at least an additional $600 to bring the account back up to the initial margin level of $1,000. Word to the wise: when a margin call is made, the funds usually have to be delivered immediately. If they are not, the brokerage can have the right to liquidate your position completely in order to make up for any losses it may have incurred on your behalf. Leverage: The Double-Edged Sword In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay (deposit into your margin account). It is said that in the futures market, more than any other form of investment, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss. Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market is useful but also very risky). The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. So for an initial margin of $5,000, you may be able to enter into a long position in a futures contract for 30,000 pounds of coffee valued at $50,000, which would be considered highly leveraged investments. You already know that the futures market can be extremely risky and,therefore, not for the faint of heart. This should become more obvious once you understand the arithmetic of leverage. Highly leveraged investments can produce two results: great profits or greater losses. As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. For example, say that in anticipation of a rise in stock prices across the board, you buy a futures contract with a margin deposit of $10,000, for an index currently standing at 1300. The value of the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000), meaning that for every point gain or loss, $250 will be gained or lost. If after a couple of months, the index realized a gain of 5%, this would mean the index gained 65 points to stand at 1365. In terms of money, this would mean that you as an investor earned a profit of $16,250 (65 points x $250); a profit of 162%! On the other hand, if the index declined 5%, it would result in a monetary loss of $16,250 - a huge amount compared to the initial margin deposit made to obtain the contract. This means you still have to pay $6,250 out of your pocket to cover your losses. The fact that a small change of 5% to the index could result in such a large profit or loss to the investor (sometimes even more than the initial investment made) is the risky arithmetic of leverage. Consequently, while the value of a commodity or a financial instrument may not exhibit very much price volatility, the same percentage gains and losses are much more dramatic in futures contracts due to low margins and high leverage.

Pricing and Limits

As we mentioned before, contracts in the futures market are a result of competitive price discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and so on). Prices on futures contracts, however, have a minimum amount that they can move. These minimums are established by the futures exchanges and are known as ticks. For example, the minimum sum that a bushel of grain can move upwards or downwards is a quarter of one U.S. cent. For futures investors, it's important to understand how the minimum price movement for each commodity will affect the size of the contract in question. If you had a wheat contract for 5,000 bushels, the minimum price movement would be $12.50 ($0.0025 x 5,000). Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price

change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day. Say that the price change limit on silver per ounce is $0.25. Yesterday, the price per ounce closed at $5. Today's upper price boundary for silver would be $5.25 and the lower boundary would be $4.75. If at any moment during the day the price of futures contracts for silver reaches either boundary, the exchange shuts down all trading of silver futures for the day. The next day, the new boundaries are again calculated by adding and subtracting $0.25 to the previous day's close. Each day the silver ounce could increase or decrease by $0.25 until an equilibrium price is found. Because trading shuts down if prices reach their daily limits, there may be occasions when it is NOT possible to liquidate an existing futures position at will. The exchange can revise this price limit if it feels it's necessary. It's not uncommon for the exchange to abolish daily price limits in the month that the contract expires (delivery or spot month). This is because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract. In order to avoid any unfair advantages, the CTFC and the futures exchanges impose limits on the total amount of contracts or units of a commodity in which any single person can invest. These are known as position limits and they ensure that no one person can control the market price for a particular commodity.

Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads.

Going Long When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase. For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September. By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit! Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Joe held the contract, the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit. Going Short A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator. Let's say that Sara did some research and came to the conclusion that the price of oil was going to decline over the next six months. She could sell a contract today, in November, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market. Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000. By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss. Spreads As you can see, going long and going short are positions that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called spreads. Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts. There are many different types of spreads, including:

Calendar Spread - This involves the simultaneous purchase and sale of two futures of the same type, having the same price,
but different delivery dates.

Intermarket Spread - Here the investor, with contracts of the same month, goes long in one market and short in another
market. For example, the investor may take Short June Wheat and Long June Pork Bellies.

Inter-Exchange Spread - This is any type of spread in which each position is created in different futures exchanges. For
example, the investor may create a position in the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).

How To Trade
At the risk of repeating ourselves, it's important to note that futures trading is not for everyone. You can invest in the futures market in a number of different ways, but before taking the plunge, you must be sure of the amount of risk you're willing to take. As a futures trader, you should have a solid understanding of how the market and contracts function. You'll also need to determine how much time, attention, and research you can dedicate to the investment. Talk to your broker and ask questions before opening a futures account.

Unlike traditional equity traders, futures traders are advised to only use funds that have been earmarked as pure "risk capital"- the risks really are that high. Once you've made the initial decision to enter the market, the next question should be How? Here are three different approaches to consider: Do It Yourself - As an investor, you can trade your own account without the aid or advice of a broker. This involves the most risk because you become responsible for managing funds, ordering trades, maintaining margins, acquiring research and coming up with your own analysis of how the market will move in relation to the commodity in which you've invested. It requires time and complete attention to the market. Open a Managed Account - Another way to participate in the market is by opening a managed account, similar to an equity account. Your broker would have the power to trade on your behalf, following conditions agreed upon when the account was opened. This method could lessen your financial risk because a professional would be making informed decisions on your behalf. However, you would still be responsible for any losses incurred as well as for margin calls. And you'd probably have to pay an extra management fee. Join a Commodity Pool - A third way to enter the market, and one that offers the smallest risk, is to join a commodity pool. Like a mutual fund, the commodity pool is a group of commodities which can be invested in. No one person has an individual account; funds are combined with others and traded as one. The profits and losses are directly proportionate to the amount of money invested. By entering a commodity pool, you also gain the opportunity to invest in diverse types of commodities. You are also not subject to margin calls. However, it is essential that the pool be managed by a skilled broker, because the risks of the futures market are still present in the commodity pool.

Derivatives contracts can be divided into two general families:1. 2. Contingent claims, i.e., options Forward claims, which include exchange-traded futures, forward contracts and swaps

A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps.

The Swaps Market

Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. (For background reading, see Futures Fundamentals and Options Basics.) The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than 15 times the size of the U.S. public equities market.

Plain Vanilla Interest Rate Swap

The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. (For related reading, see How do companies benefit from interest rate and currency swaps?) For example, on December 31, 2006, Company A and Company B enter into a five-year swap with the following terms:

Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million. LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011.

y y

At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On December 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount. Figure 1 shows the cash flows between the parties, which occur annually (in this example). (To learn more, read Corporate Use of Derivatives for Hedging.)

Figure 1: Cash flows for a plain vanilla interest rate swap

Plain Vanilla Foreign Currency Swap

The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated. For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (i.e., the dollar is worth $0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays 40 million. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

Figure 2: Cash flows for a plain vanilla currency swap, Step 1.

Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the eurodenominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 * 3.50% = 1,400,000 to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company D's payment equals $1,960,000, and Company C's payment would be $4,125,000. In practice, Company C would pay the net difference of $2,165,000 ($4,125,000 - $1,960,000) to Company D.

Figure 3: Cash flows for a plain vanilla currency swap, Step 2

Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Figure 4: Cash flows for a plain vanilla currency swap, Step 3

Who would use a SWAP?

The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (i.e., liabilities) and earns a fixed rate of interest on loans (i.e., assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities. Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing. For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less well known. It will likely receive more favorable financing terms in the US. By then using a currency swap, the firm ends with the euros it needs to fund its expansion.

Exiting a Swap Agreement

Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this. 1. Buy Out the Counterparty Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the

other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent. 2. Enter an Offsetting Swap For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate. Sell the Swap to Someone Else Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty. Use a Swaption A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2




The Basics of Single-Name Credit Default Swaps
To understand the credit event auction default process, it is helpful to have a general understanding of single-name credit default swaps. A single-name CDS is a derivative in which the underlying instrument is a reference obligation, or a bond of a particular issuer or reference entity. Credit default swaps have two sides to the trade: a buyer of protection and a seller of protection. The buyer of protection is insuring against the loss of principal in case of default by the bond issuer. Therefore, credit default swaps are structured so that if the reference entity experiences a credit event, the buyer of protection receives payment from the seller of protection. (For more on credit default swaps, see our article Credit Default Swaps.)

Credit Event
In the CDS world, a credit event is a trigger that causes the buyer of protection to terminate and settle the contract. Credit events are agreed upon at the time the trade is entered into and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers: reference entity bankruptcy, failure to pay, obligation acceleration, repudiation and moratorium.

Physical vs. Cash Settlement

When a credit event occurs, settlement of the CDS contract can be either physical or in cash. In the past, credit events were settled via physical settlement. This means that buyers of protection actually delivered a bond to the seller of protection for par. This worked fine if the CDS contract holder actually held the underlying bond. As CDSs grew in popularity, they were used less as a hedging tool, and more as a way to make a bet on certain credits. In fact, the number of CDS contracts written outstrips the number of cash bonds they are based on. This would create an operational nightmare if all CDS buyers of protection chose to physically settle the bonds. A more efficient way of settling CDS contracts needed to be considered. To that end, cash settlement was introduced to more efficiently settle single-name CDS contracts when credit events occurred. Cash settlement better reflects the intent of the majority of participants in the single-name CDS market, as the instrument moved from a hedging tool to a speculation, or credit-view, tool.

CDS Settlement Process Evolves

As CDSs had evolved into a credit trading tool, the default settlement process needed to evolve as well. The volume of CDS contracts written is much larger than the number of physical bonds. In this environment, cash settlement is superior to physical settlement. In an effort to make cash settlement even more transparent, the credit event auction was developed. Credit event auctions set a price for all market participants that choose to cash settle. The credit event auction under the International Swaps and Derivatives Association (ISDA) global protocol was initiated in 2005. When buyers and sellers of protection submit to adhere to the protocol of a particular bankrupt entity, they are formally agreeing to settle their credit derivative contracts via the auction process.

To participate, they must submit an adherence letter to ISDA via email. This occurs for every credit event. In other words, you would have to formally submit a letter for Fannie Mae (NYSE:FNM), a separate one for Lehman Brothers, a separate one for Washington Mutual (OTC:WAMUQ), etc. The auction process is described below.

Credit Default Auctions

Buyers and sellers of protection participating in the credit event auction have a choice between cash settlement and what is effectively physical settlement. Physical settlement in the auction process means you settle on your net buy or sell position - not every contract. This is superior to the previous method as it reduces the amount of bond trading needed to settle all of the contracts. There are two consecutive parts to the auction process. The first stage involves requests for physical settlement and the dealer market process where the inside market midpoint (IMM) is set. Dealers place orders for the debt of the company that has undergone a credit event. The range of prices received is used to calculate the IMM (for the exact calculation used, visit

In addition to the IMM being set, the dealer market is used to determine the size and direction of the open interest (net buy or net sell). The IMM is published for viewing and then used in the second stage of the auction. After the IMM is published, along with the size and direction of the open interest, participants can decide if they would like to submit limit orders for the auction. Limit orders submitted are then matched to open interest orders. This is the second stage of the process.

The Lehman Brothers Auction

The Lehman Brothers failure in September 2008 provided a true test of the procedures and systems developed to settle credit derivatives. The auction, which occurred on October 10, 2008, set a price of 8.625 cents on the dollar for Lehman Brothers debt. It was estimated that between $6 billion and $8 billion changed hands during the cash settlement of the CDS auction. Recoveries for Fannie Mae and Freddie Mac (NYSE:FRE) were 91.51 and 94.00, respectively. (To learn more, read How Fannie Mae And Freddie Mac Were Saved.) Recoveries were much higher for the mortgage-finance companies placed into conservatorship, as the U.S. government backed the debt of these companies. What does the price of 8.625 mean? It means that the sellers of protection on Lehman CDS will have to pay 91.375 cents on the dollar to buyers of protection to settle and terminate the contracts via the Lehman Protocol auction process. In other words, if you had held Lehman Brothers bonds and had bought protection via a CDS contract, you would have received 91.375 cents on the dollar. This would offset your losses on the cash bonds you held. You would have expected to receive par, or 100, when they matured, but would have only received their recovery value after the bankruptcy process concluded. Instead, since you bought protection with a CDS contract, you receive 91.375.

The CDS "Big Bang"

Further improvements and standardization of CDS contracts continue to be made. Together, the various changes being implemented have been called the "Big Bang". In 2009, new CDS contracts will begin trading with a fixed coupon of 100 or 500 basis points, with the upfront payment differing based on the perceived credit risk of the underlying bond issuer. Another improvement is to make the auction process a standard part of the new CDS contract. Under current contracts, the auction process is voluntary or an "opt-in" and investors have to sign up for each protocol individually, increasing administration costs. Investors will now have to "opt-out" of the protocol if they would like to settle their contracts outside of the auction process (using a preapproved list of deliverable obligations).

The Bottom Line

All of the changes to CDS contracts should make single-name credit default swaps more popular and easier to trade. This is representative of the evolution and maturity of any financial product. (To learn more about CDSs, check out Credit Default Swaps: An Introduction.)

What Does Swap Mean?

Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps. If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.

 Basis Rate Swap

What Does Basis Rate Swap Mean? A type of swap in which two parties swap variable interest rates based on different money markets. This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates. For example, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury Bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the T-Bill rate for the LIBOR rate, they eliminate this interest-rate risk.

 Bond Swap
A strategy in which an investor sells a bond and at the same time purchases a different bond with the proceeds from the sale. There are several reasons why people use a bond swap: to seek tax benefits, to change investment objectives, to upgrade a portfolio's credit quality or to speculate on the performance of a particular bond.

 Commodity Swap
What Does Commodity Swap Mean? A swap in which exchanged cash flows are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodity. The vast majority of commodity swaps involve oil. So, for example, a company that uses a lot of oil might use a commodity swap to secure a maximum price for oil. In return, the company receives payments based on the market price (usually an oil price index). On the other side, if a producer of oil wishes to fix its income, it would agree to pay the market price to a financial institution in return for receiving fixed payments for the commodity.

 Currency Swap
What Does Currency Swap Mean? A swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet. Investopedia explains Currency Swap For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. Currency swaps were originally done to get around exchange controls.

 Credit Default Swap (CDS)

What Does Credit Default Swap (CDS) Mean? A swap designed to transfer the credit exposure of fixed income products between parties. Investopedia explains Credit Default Swap (CDS) The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.

 Interest Rate Swap

What Does Interest Rate Swap Mean? An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based

on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap. Investopedia explains Interest Rate Swap Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate specifications) for another. Because they trade OTC, they are really just contracts set up between two or more parties, and thus can be customized in any number of ways. Generally speaking, swaps are sought by firms that desire a type of interest rate structure that another firm can provide less expensively. For example, let's say Cory's Tequila Company (CTC) is seeking to loan funds at a fixed interest rate, but Tom's Sports Inc. (TSI) has access to marginally cheaper fixed-rate funds. Tom's Sports can issue debt to investors at its low fixed rate and then trade the fixed-rate cash flow obligations to CTC for floating-rate obligations issued by TSI. Even though TSI may have a higher floating rate than CTC, by swapping the interest structures they are best able to obtain, their combined costs are decreased - a benefit that can be shared by both parties.

Non-Deliverable Swap - NDS

What Does Non-Deliverable Swap - NDS Mean? A swap that is similar to a non-deliverable forward, with the only difference being that settlement for both parties is done through a major currency. Non-deliverable swaps are used when the swap includes a major currency, such as the U.S. dollar, and a restricted currency, such as the Philippine peso or South Korean won. Investopedia explains Non-Deliverable Swap - NDS For example, assume two companies are entered into a swap, exchanging U.S. dollars and South Korean won. The Korean company is due to pay $110,000,000 won, and the U.S. company is due to pay $125,000 U.S. dollars. The fixed rate for the contract is taken as the spot rate for the day before the payment date. In this example, we will assume 929 won/dollar. The Korean company is then due to pay $118,406.89 ($110,000,000/929) U.S. dollars. A net payment is made on the payment date - for this example, the U.S. company pays $6,593.11 ($125,000 - $118,406.89) U.S. dollars to the Korean company. Non-deliverable swaps have allowed emerging markets with minor currencies to hedge against currency risk.

Total Return Swap

What Does Total Return Swap Mean? A swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment. Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it. These swaps are popular with hedge funds because they get the benefit of a large exposure with a minimal cash outlay. Investopedia explains Total Return Swap In a total return swap, the party receiving the total return will receive any income generated by the asset as well as benefit if the price of the asset appreciates over the life of the swap. In return, the total return receiver must pay the owner of the asset the set rate over the life of the swap. If the price of the assets falls over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price. For example, two parties may enter into a one-year total return swap where Party A receives LIBOR + fixed margin (2%) and Party B receives the total return of the S&P 500 on a principal amount of $1 million. If LIBOR is 3.5% and the S&P 500 appreciates by 15%, Party A will pay Party B 15% and will receive 5.5%. The payment will be netted at the end of the swap with Party B receiving a payment of $95,000 ($1 million x 15% - 5.5%).

Variance Swap
What Does Variance Swap Mean? A type of volatility swap where the payout is linear to variance rather than volatility. Therefore, the payout will rise at a higher rate than volatility

Investopedia explains Variance Swap Variance is the square of standard deviation. Because of this, a variance swaps' payout will be larger than that of a volatility swap, as these products are based upon variance rather than standard deviation.

Volatility Swap
What Does Volatility Swap Mean? A forward contract whose underlying is the volatility of a given product. Investopedia explains Volatility Swap This is a pure volatility instrument allowing investors to speculate solely upon the movement of a stock's volatility without the influence of its price. Thus, just like investors trying to speculate on the prices of stocks, by using this instrument investors are able to speculate on how volatile the stock will be.

What are buy-back offers and how to evaluate them

Buy-back of shares is opposite to the issue of shares by a company. Here instead of giving shares, the company offers to take back its own shares, which are owned by the investors, at a specified price, which is usually at a premium over the current market price. Buy-backs have gained considerable importance in the past 25 years or so all over the world. In India, the Buy-back of Securities Regulation, passed in 1999, brought about a spate of announcements in this area. Companies such as Crisil Ltd and Piramal Healthcare Ltd have been in the news for offering buy back schemes to investors. Why companies buy back shares Surplus cash: When the company has a significant amount of cash and there are not many viable projects on its table and it is also not interested in disbursing cash to the shareholders in the form of dividends, the way out for most of the managements is buying back its own shares. Internal difference: Sometime shareholders have a contrasting view from the company management. If they are in a majority, they may create an obstacle to the company's growth. Buy back is a way out for enhancing the controlling stake for the management within the company. The shares bought under this scheme does not go to the promoters, but are held by the company as treasury stock that could be later resold or even used for employees' stock option schemes. What it means for you High share value if you don't sell back: One of the most common way of measuring the performance of a company is through earnings per share (EPS). A higher EPS means the intrinsic value of the share is also high; this, in turn, increases the value held by the investor. By means of the repurchasing route (buy-back), the number of shares outstanding reduces and, thus boosts, the EPS. Let's understand through an example. If a company has 10,000 outstanding shares and profit after tax (PAT) of `1 lakh, the EPS would be `10 (PAT/number of shares). If the company buys back 3,000 shares from the market, the new EPS would be `14.29 since the number of shares in the market goes down to 7,000. This means that the shareholders who do not sell back shares to the company will see an increase in the intrinsic value of shares they hold. Tax shield if you sell: Buy-back offers provide a tax shield for investors. This is because if the company were to declare dividends, investors would have to pay a tax on that. Modes of buy-back There are primarily two modes of buy-back--fixed price tender offer and open market buy-back. In the fixed price offer, the company may present shareholders with a formal tender offer, whereby they have the offer to submit a portion of their shares within a certain period, at a certain price, which is normally at a 15-20% premium over the current market price. In the latter, the company announces a band price for buy-back and purchases the shares from the market at the market price, subject to specified rules. In India, the former is preferred because of the high amount of cash involved in buy-back transactions. How to evaluate buy-back offer price When should you sell: First, observe the share price movement just before the buy-back. If there is a significant rise, it means there's something fishy. Second, assess the debt-equity ratio of the firm. If debt is higher than the industry average, it signals that their free cash flow in the future is going to be tight. Third, firms that have raised funds recently and come for- ward for the buyback route are not good contenders. When should you keep shares: If the company has significant amount of cash reserves, you may not want to take the buy- back offer. Another pointer is when the company does not have a huge capital expenditure plan. You can also consider keeping the shares if the share prices do not show a significant upward movement post the buy-back announcement.

Please note that buy-back has no impact on the performance or fundamentals of the company. Hence, investors need to exercise caution while evaluating the buy-back offers.

REPO (Repurchase Agreement)

What Does Repurchase Agreement - Repo Mean?
A form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for the party on the other end of the transaction, (buying the security and agreeing to sell in the future) it is a reverse repurchase agreement. A Repurchase agreement, also known as a Repo, RP, or Sale and Repurchase Agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price will be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate. The party who originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest. A repo is equivalent to a cash transaction combined with a forward contract. The cash transaction results in transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between the forward price and the spot price is effectively the interest on the loan while the settlement date of the forward contract is the maturity date of the loan.

Structure and terminology

A repo is economically similar to a secured loan, with the buyer (effectively the lender or investor) receiving securities as collateral to protect against default of the seller - the party who initially sells the securities being effectively the borrower. Almost any security may be employed in a repo, though practically speaking highly liquid securities are preferred because they are more easily disposed of in the event of a default and, more importantly, they can be easily secured in the open market where the buyer has created a short position in the repo security through a reverse repo and market sale; by the same token, illiquid securities are discouraged. Treasury or Government bills, corporate and Treasury/Government bonds, and stocks may all be used as "collateral" in a repo transaction. Unlike a secured loan, however, legal title to the securities clearly passes from the seller to the buyer. Coupons (installment payments that are payable to the owner of the securities) which are paid while the repo buyer owns the securities are, in fact, usually passed directly onto the repo seller. This might seem counterintuitive, as the ownership of the collateral technically rests with the buyer during the repo agreement. It is possible to instead pass on the coupon by altering the cash paid at the end of the agreement, though this is more typical of Sell/Buy Backs. Although the underlying nature of the transaction is that of a loan, the terminology differs from that used when talking of loans because the seller does actually repurchase the legal ownership of the securities from the buyer at the end of the agreement. So, although the actual effect of the whole transaction is identical to a cash loan, in using the "repurchase" terminology, the emphasis is placed upon the current legal ownership of the collateral securities by the respective parties. That said, one of the most important aspects of repos is that they are legally recognized as a single transaction (especially important in the event of counterparty insolvency) but do not count as a disposal and a repurchase for tax purposes. The following table summarizes the terminology: Repo Reverse repo Borrower Lender Buyer Participant Seller Cash receiver Cash provider Near leg Far leg Sells securities Buys securities Buys securities Sells securities

Types of repo and related products

There are three types of repo maturities: overnight, term, and open repo. Overnight refers to a one-day maturity transaction. Term refers to a repo with a specified end date. Open simply has no end date. Although repos are typically short-term, it is not unusual to see repos with a maturity as long as two years. Repo transactions occur in three forms: specified delivery, tri-party, and held in custody. The third form is quite rare in developing markets primarily due to risks. The first form requires the delivery of a prespecified bond at the onset, and at maturity of the contractual period. Tri-party essentially is a basket form of transaction, and allows for a wider range of instruments in the basket or pool. Tri-party utilizes a tri-party clearing agent or bank and is a more efficient form of repo transaction.

Due bill/hold in-custody repo

In a due bill repo, the collateral pledged by the (cash) borrower is not actually delivered to the cash lender. Rather, it is placed in an internal account ("held in custody") by the borrower, for the lender, throughout the duration of the trade. This has become less common as the repo market has grown, particularly owing to the creation of centralized counterparties. Due to the high risk to the cash lender, these are generally only transacted with large, financially stable institutions.

Tri-party repo
The distinguishing feature of a tri-party repo is that a custodian bank or international clearing organization, the tri-party agent, acts as an intermediary between the two parties to the repo. The tri-party agent is responsible for the administration of the transaction including collateral allocation, marking to market, and substitution of collateral. In the US, the two principal tri-party agents are The Bank of New York Mellon and JP Morgan Chase. The size of the US tri-party repo market peaked in 2008 before the worst effects of the crisis at approximately $2.8 trillion and by mid 2010 was about $1.6 trillion. [1] As tri-party agents administer hundreds of billions of US$ of collateral, they have the scale to subscribe to multiple data feeds to maximise the universe of coverage. As part of a tri-party agreement the three parties to the agreement, the tri-party agent, the repo buyer and the repo seller agree to a collateral management service agreement which includes an "eligible collateral profile". It is this "eligible collateral profile" that enables the repo buyer to define their risk appetite in respect of the collateral that they are prepared to hold against their cash. For example a more risk averse repo buyer may wish to only hold "on-the-run" government bonds as collateral. In the event of a liquidation event of the repo seller the collateral is highly liquid thus enabling the repo buyer to sell the collateral quickly. A less risk averse repo buyer may be prepared to take non investment grade bonds or equities as collateral, these may be less liquid and may suffer a higher price volatility in the event of a repo seller default, making it more difficult for the repo buyer to sell the collateral and recover their cash. The tri-party agents are able to offer sophisticated collateral eligibility filters which allow the repo buyer to create these "eligible collateral profiles" which can systemically generate collateral pools which reflect the buyer's risk appetite.[2] Collateral eligibility criteria could include asset type, issuer, currency, domicile, credit rating, maturity, index, issue size, average daily traded volume, etc. Both the lender (repo buyer) and borrower (repo seller) of cash enter into these transactions to avoid the administrative burden of bi-lateral repos. In addition, because the collateral is being held by an agent, counterparty risk is reduced. A tri-party repo may be seen as the outgrowth of the due bill repo, in which the collateral is held by a neutral third party.

Whole loan repo

A whole loan repo is a form of repo where the transaction is collateralized by a loan or other form of obligation (e.g. mortgage receivables) rather than a security.

Equity repo
The underlying security for many repo transactions is in the form of government or corporate bonds. Equity repos are simply repos on equity securities such as common (or ordinary) shares. Some complications can arise because of greater complexity in the tax rules for dividends as opposed to coupons.

Sell/buy backs and buy/sell backs

A sell/buy back is the spot sale and a forward repurchase of a security. It is two distinct outright cash market trades, one for forward settlement. The forward price is set relative to the spot price to yield a market rate of return. The basic motivation of sell/buy backs is generally the same as for a classic repo, i.e. attempting to benefit from the lower financing rates generally available for collateralized as opposed to nonsecured borrowing. The economics of the transaction are also similar with the interest on the cash borrowed through the sell/buy back being implicit in the difference between the sale price and the purchase price. There are a number of differences between the two structures. A repo is technically a single transaction whereas a sell/buy back is a pair of transactions (a sell and a buy). A sell/buy back does not require any special legal documentation while a repo generally requires a master agreement to be in place between the buyer and seller (typically the SIFMA/ICMA commissioned Global Master Repo Agreement (GMRA)). For this reason there is an associated increase in risk compared to repo. Should the counterparty default, the lack of agreement may lessen legal standing in retrieving collateral. Any coupon payment on the underlying security during the life of the sell/buy back will generally be passed back to the seller of the security by adjusting the cash paid at the termination of the sell/buy back. In a repo, the coupon will be passed on immediately to the seller of the security. A buy/sell back is the equivalent of a "reverse repo".

Securities lending
In securities lending, the purpose is to temporarily obtain the security for other purposes, such as covering short positions or for use in complex financial structures. Securities are generally lent out for a fee and securities lending trades are governed by different types of legal agreements than repos. Repos have traditionally been used as a form of collateralized loan and have been treated as such for tax purposes. Modern Repo agreements, however, often allow the cash lender to sell the security provided as collateral and substitute an equivalent security at repurchase.[3] In this way the cash lender acts as a security borrower and the Repo agreement can be used to take a short position in the security very much like a security loan might be used.[4]

Reverse Repo
A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe it a "reverse repo". So "repo" and "reverse repo" are exactly the same kind of transaction, just described from opposite viewpoints. The term "reverse repo and sale" is commonly used to describe the creation of a short position in a debt instrument where the buyer in the repo transaction immediately sells the security provided by the seller on the open market. On the settlement date of the repo, the buyer acquires the relevant security on the open market and delivers it

to the seller. In such a short transaction the seller is wagering that the relevant security will decline in value between the date of the repo and the settlement date.

For the buyer, a repo is an opportunity to invest cash for a customized period of time (other investments typically limit tenures). It is short-term and safer as a secured investment since the investor receives collateral. Market liquidity for repos is good, and rates are competitive for investors. Money Funds are large buyers of Repurchase Agreements. For traders in trading firms, repos are used to finance long positions, obtain access to cheaper funding costs of other speculative investments, and cover short positions in securities. In addition to using repo as a funding vehicle, repo traders "make markets". These traders have been traditionally known as "matched-book repo traders". The concept of a matched-book trade follows closely to that of a broker who takes both sides of an active trade, essentially having no market risk, only credit risk. Elementary matched-book traders engage in both the repo and a reverse repo within a short period of time, capturing the profits from the bid/ask spread between the reverse repo and repo rates. Presently, matched-book repo traders employ other profit strategies, such as non-matched maturities, collateral swaps, and liquidity management.

United States Federal Reserve use of repos

Repurchase agreements when transacted by the Federal Open Market Committee of the Federal Reserve in open market operations adds reserves to the banking system and then after a specified period of time withdraws them; reverse repos initially drain reserves and later add them back. This tool can also be used to stabilize interest rates, and the Federal Reserve has used it to adjust the Federal funds rate to match the target rate.[5] Under a repurchase agreement ("RP" or "repo"), the Federal Reserve (Fed) buys U.S. Treasury securities, U.S. agency securities, or mortgage-backed securities from a primary dealer who agrees to buy them back, typically within one to seven days; a reverse repo is the opposite. Thus the Fed describes these transactions from the counterparty's viewpoint rather than from their own viewpoint. If the Federal Reserve is one of the transacting parties, the RP is called a "system repo", but if they are trading on behalf of a customer (e.g. a foreign central bank) it is called a "customer repo". Until 2003 the Fed did not use the term "reverse repo"which it believed implied that it was borrowing money (counter to its charter)but used the term "matched sale" instead.

While classic repos are generally credit-risk mitigated instruments, there are residual credit risks. Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities sold at the maturity date. In other words, the repo seller defaults on his obligation. Consequently, the buyer may keep the security, and liquidate the security in order to recover the cash lent. The security, however, may have lost value since the outset of the transaction as the security is subject to market movements. To mitigate this risk, repos often are overcollateralized as well as being subject to daily mark-to-market margining. Conversely, if the value of the security rises there is a credit risk for the borrower in that the creditor may not sell them back. If this is expected to happen then the borrower may negotiate a repo which is undercollateralized. [6] Credit risk associated with repo is subject to many factors: term of repo, liquidity of security, the strength of the counterparties involved, etc. Repo transactions came into focus within the financial press due to the technicalities of settlements following the collapse of Refco. Occasionally, a party involved in a repo transaction may not have a specific bond at the end of the repo contract. This may cause a string of failures from one party to the next, for as long as different parties have transacted for the same underlying instrument. The focus of the media attention centers on attempts to mitigate these failures.

In the US, Repos have been used from as early as 1917 when war time taxes made older forms of lending less attractive. At first Repos were used just by the Federal reserve to lend to other banks, but the practice soon spread to other market participants. The use of Repos expanded in the 1920s, fell away through the Great depression and WWII , then expanded once again in the 1950s, enjoying rapid growth in the 1970s and 1980s in part due to computer technology. [6]

Market size
The US Federal Reserve and the European Repo Council (a body of the International Capital Market Association) both try to estimate the size of their respective repo markets. At the end of 2004, the U.S. repo market reached US$5 trillion. The European repo market has experienced consistent growth over the past five years, from 1.9 billion in 2001 to 6.4 trillion by the end of 2006, and is expected to continue significant growth due to Basel II, according to a 2007 Celent report entitled The European Repo Market. Especially in the US and to a lesser degree in Europe, the repo market contracted in 2008 as a result of the financial crisis. But by mid 2010 the market had largely recovered and at least in Europe had grown to exceed its pre-crisis peak. Other countries including Chile, India, Japan, Mexico, Hungary, Russia, China, and Taiwan, have their own repo markets, though activity varies by country, and no global survey or report has been compiled.