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All financial instruments can be visualized as bundles of cash flows Allow market participants to trade cash flows that have different characteristics and different risks
Payment or receipt of cash at:
a specific time in a specific currency with a certain credit risk
Special characteristics that can be represented as attributes
Cash Flows of a Loan $100 A loan from borrower’s point of view… t0 t1 Time Borrower receives 100 at t0 and pays 100 plus interest at t1 -$(100 + 5) The same cash flows from lender’s point of view $(100 + 5) t0 -$100 t1 Time …lender pays 100 at t0 and receives 100 plus interest at t1 .
$100 cash lent …if borrower defaults A defaultable deposit… t1 No partial recovery of the principal .Cash Flows with a Default Possibility + $105 If no default occurs t0 .
Cash Flow Attributes Currency Time Market risk Credit risk Sensitivity to risk factors .
Cash Flows in Different Currencies 100 et (EUR) 0 t0 .100 (USD) t1 .
Cash Flows with Timing Differences USD100 t0 -USD95 t1 .
Lt1 N Decided here .Cash Flows with Different Market Risks Determined at t0 Ft0 N t0 t1 t2 .
Pay defaulted amount -$100 Fee t0 t1 .Cash Flows with Different Credit Risks Here there are two possibilities No payment if no default If default…..
04 0.02 0.5 Bond Price 95 92.5 0 0.2 Price of a 2-year default-free discount bond 100 97.08 0.5 85 82.02 0.Different Sensitivities to Market Risk Factor Price of a 30-year default-free discount bond 100 80 70 60 50 40 30 20 Bond Price 10 0 0.2 Yield .08 0.5 90 87.04 0.06 0.1 0.1 0.06 0.
t1) t1 Synthetic.. all EUR Denominated cash flows cancel.00 USD Sell EUR forward at price Ft0 Adding vertically.. Par value $1..Synthetic USD Bond Receive EUR Buy EUR denominated bond t0 Pay EUR t1 Receive EUR t0 Pay USD t1 +1. default-free USD discount bond.EUR + 1.00 .00 USD Buy spot Euro t0 t1 ... t0 -B(t0.
Engineering a Currency Forward Applicable to engineering any linear instrument Begin with target cash flow Detach the individual component cash flows at different dates to represent them as stand alone cash flows Add or subtract new cash flows at chosen dates to convert the detached stand alone cash flows to meaningful financial contracts Ensure that vertical addition of cash flows result in the newly added/subtracted cash flows canceling out and obtaining the original target cash flow .
) Receive 100 currency X t0 This can be decomposed into two cash flows…… t1 Pay (100/Ft0) currency Z t0 t1 Pay (100/Ft0) currency Z Receive 100 currency X t0 t1 .Engineering a Currency Forward (contd.
) Add a positive currency Z cash flow CtZ 0 t1 Pay (100/Ft0) currency Z (original cash flow) Receive 100 currency X (original cash flow) t0 t0 C X t0 t1 Add a negative currency X cash flow CtX (This cancels the newly added currency X cash flow at t0) 0 t0 t1 CtZ (This cancels the newly added currency Z cash flow at t0) 0 .Engineering a Currency Forward (contd.
Contractual Equation for Synthetic Currency Forward FX forward Buy currency X against currency Z at t1 Loan Borrow = currency Z at t0 for maturity t1 Spot Operation Buy currency X + against currency Z Deposit Lend + currency X at t0 for maturity t1 .
Contractual Equation for Synthetic Currency Forward using Discount Bonds FX forward Buy currency X against currency Z at t1 Sell Z-denominated = bond at t0 with maturity t1 Spot Operation Buy currency X + against currency Z Buy X-denominated + bond at t0 with maturity t1 .
Creating a Synthetic T-bill Motivation – to avoid withholding of tax on a T-bill in a given currency as per tax rules of the corresponding government Create a synthetic T-bill in that currency using a T-bill in another currency where corresponding government does not withhold tax .
Contractual Equation for Synthetic Currency Forward written in terms of T-bill Short Z = Denominated T-bill Spot Operation + Buy currency X against Z Buy X + Denominated T-bill FX forward Buy X against Z .
Denominated = + Buy X against Z T-bill Spot Operation Buy currency X against Z Buy X + Denominated T-bill .Contractual Equation for Synthetic T-bill Short Z FX forward .
Contractual Equation for Synthetic T-bill (contd.) Long Z Denominated = T-bill FX forward + Buy Z against X Spot Operation Buy X + Denominated Buy currency X against Z T-bill .
Buy X-denominated T-bill… t1 (1+r*) X t0 -X … and buy Z forward t1 100 Z t0 Adding vertically.(1+r*) X Receive 100 Z t0 -Z (Present value of 100Z) t1 . Par value 100Z t1 ...Engineering a Synthetic T-bill X Buy X against Z .. gives a long T-bill in Z currency. t0 -Z ….
Creating a Synthetic Loan Motivation – loan in desired currency not available or very expensive Was true for Japanese banks wanting USD loans after the collapse of the Hokkaido Takushoku Bank in 1997 Create a synthetic loan in the desired currency by taking a loan in another currency .
Contractual Equation for Synthetic USD/JPY Forward FX forward Loan Spot Operation Sell USD against = Borrow USD with + Buy JPY against JPY for time t1 maturity t1 USD at t0 Deposit + Lend JPY for maturity t1 .
Contractual Equation for Synthetic USD Loan FX forward Loan Sell USD against Borrow USD with = JPY for time t1 maturity t1 Spot Operation Buy JPY against USD at t0 Deposit .Lend JPY for maturity t1 .
) USD Loan FX forward Spot Operation Borrow USD with Sell USD against = + Buy USD against maturity t1 JPY for time t1 JPY at t0 Loan + Borrow JPY for maturity t1 .Contractual Equation for Synthetic USD Loan (contd.
Engineering a Synthetic USD Loan Receive Yen A forward contract of Yen against USD t0 + Yen A loan in Yen t1 Pay USD t0 + t1 ..Yen with interest t0 Adding vertically. we get a loan in USD …. t1 Spot purchase of USD t0 t1 .
Creating a Synthetic Currency Spot Contract Motivation – capital controls in a country not allowing spot purchase of a foreign currency (say USD) beyond a certain limit Create a synthetic spot contract for purchasing USD by using a USD forward contract and a USD loan .
Contractual Equation for Synthetic USD Spot Contract FX-Forward Spot Operation Sell X against = Buy USD against X USD for time t1 Loan in USD + Borrow USD at t0 for maturity t1 Deposit in X + Lend X at t0 for maturity t1 .
Engineering a USD Spot Contract Receive USD Forward purchase of USD t0 + t1 Pay X t0 + t1 … a deposit in X t0 t1 … a loan in USD Adding vertically. we get a synthetic USD spot purchase… Receive USD t0 Pay X t1 .
Creating a Synthetic Cross Currency Rate Motivation – Insufficient liquidity and higher expense of currency transactions not involving USD (say CHF and INR) Create a synthetic cross currency rate by using USD/CHF and USD/INR contracts .
Contractual Equation for Synthetic CHF/INR Cross Rate Spot Operation Buy CHF against INR = Spot Operation Buy USD against INR + Spot Operation Sell USD against CHF .
CHF/INR…… + CHF t0 .USD t1 Adding vertically. results in the cross.INR + CHF + t1 t0 .Engineering a Synthetic CHF/INR Cross Rate + USD t0 .INR t1 .
FX Swaps Can be modeled in terms of a loan in one currency and a deposit in another currency No interim interest payments on loan or deposit Results initially in exchange of two currencies followed later by a reverse exchange of the two currencies with interest .
Modeling an FX Swap in terms of a Loan and a Deposit + EUR t0 .USD t1 . we get the FX-Swap… + EUR + USD with interest t1 + USD with interest .USD Adding.EUR with interest t1 t0 .EUR with interest t0 .
Contractual Equation for FX Swap FX Swap EUR Loan plus USD Deposit = Loan in EUR + Deposit USD .
.EUR t1 .EUR t1 Equals forward purchase of USD exchanged at Ft0.USD t1 Plus Spot Operation + USD t0 .Engineering a Currency Forward using an FX Swap + EUR + USD with interest FX .EUR with interest t0 . + USD t0 ..swap .
Contractual Equation for Forward Contract using FX Swap FX Swap Exchange EUR Loan for USD Deposit FX Forward Buy USD against EUR = + Spot Operation Buy USD against EUR .
credit risk and capital requirements . liabilities.Why Banks use FX Swaps? Interbank instruments Low credit risk Does not entail buying/selling of bonds/deposits/loans Does not move prices Off balance sheet items Minimal impact on assets.
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