Intervention Strasbourg

INTRO TO CONVENTIONAL FINANCE
MR. HAFID AGOUZOUL

Strasbourg University
Master Islamic Finance - 2015/2016
INTRO TO CONVENTIONAL FINANCE INTERNAL USE ONLY
1
Overview of the Course
 Global Overview of conventional finance

 Introduction to Financial Markets
 Introduction to Money Markets
 Overview of the main IR products and their usage
 Overview of the main FX products and their usage
INTRO TO CONVENTIONAL FINANCE 2

Organisation of a Global Bank
Global Bank
Corporate & Investment

Retail banking Investment Solutions Functions
Banking
Fixed Income (Foreign Asset Management Risk Management

Exchange, Interest Rates
and Credit) Private Banking Internal Audit
Equities Securities Services Finance
Commodities Legal
Corporate Finance Human Resources
Structured Finance Communication
Coverage IT
INTRO TO CONVENTIONAL 3
FINANCE
Structure of a Global Bank
• Retail banking: Provides traditional services to Individual and Small & Medium
Enterprises (SME) (Current account management, Loans and savings accounts,
Forex transactions, Developing financial solutions for financing and Investment)
• Asset Management, Private banking and securities services: Combining
activities related to the collection, management, development and
administration of client savings and assets for all type of clients: individual,
corporate and institutional investors:
– Asset Management: provides a range of funds and serves different type of
clients.
– Private Banking: Offers wealth management solutions to entrepreneurs and
High Net Worth Individuals.
– Securities Services: provides a full range of post-trade solutions to all
investment cycle players: clearing services, custody services, liquidity
management, fund administration and fund distribution.

• Corporate & Investment Banking: Provides financing, advisory and capital markets
services to corporates, financial institutions and investment funds. It has a role of
intermediary between issuers and investors:
– Corporate Finance: Brings to its clients solutions on Mergers and
acquisitions, Primary equity capital markets transactions, Financial
engineering and balance sheet restructuring.
– Structured Finance: designs financing solutions for its client. It manages the
full spectrum from origination, structuring and underwriting to distribution
on the loan syndications markets. They provide a wide array of products
from short term trade loans to medium and long term facilities, from
corporate lending to sophisticated financial solutions.
– Coverage: It provides its corporate clients with day-to-day corporate banking
services (financing, cash management and trade solutions ) via Senior
Bankers and Customer Relationship Managers. This division provides the
whole range of products and tailor-made solutions from different businesses
of the Bank.
INTRO TO 5
CONVENTIONAL FINANCE
– Equities : offers equity products (derivatives and non derivatives), indices

and funds, as well as financing solutions and equity brokerage platform
– Fixed Income Unit: Provides the client with access to Fixed Income asset
classes. FI develops advisory, investment and risk management solutions for
the specific needs of each investor. The products covered by this unit involve
Foreign exchange products, Interest rates products and Credit products.
– Commodities Unit: Provides the customers access to commodity markets
either for investment or for hedging purposes

• Functions: These are the support or enablement units that support all the
business lines in their day-to-day business to ensure the bank activities are in line
with the board strategy, the shareholders expectation and the regulations in
place.
– Risk management: the role of this unit is monitor the risks taken by the bank
businesses to ensure that (a) they are in line with the risk appetite of the
bank and (b) they are reasonable and don’t expose the bank to a huge
financial risk
– Internal audit: this unit is generally mandated by the board directly. Its role
to ensure the all departments are operating to the highest standards and
detect any malfunction or wrongdoing within the bank.
– Finance: this unit is the one in charge of the accounting and the financial
statements of the bank. They have to ensure that the balance sheet of the
bank is well represented and balanced.
– Legal: this is the unit that will ensure that we respect all the compliance rules
either those internal or external ones. Their main role is that the bank
operates per the mandate and regulations imposed by their jurisdiction.

– Human resources: their role is fundamental in managing all staff –related

issues. The bank’s most valuable asset is their staff and HR department is
there to ensure (a) smooth/seamless experience for the staff in their day-to-
day job and (b) that the bank is adequately staffed to execute its strategy.
– Communication: they are in charge of both internal and external
communication. This latter involves talking to investors, credit agencies,
publishing the financial results, etc.
– IT: this unit is the “backbone” of the bank. They are in charge of all the
systems used in the bank from ATM machine to the most sophisticated
software used in the trading floor. They do both implementation and support
of the implemented solutions.
The focus on the rest of the course will be on the CIB unit activities

Dealing Room Organisation
Banks Front Office Client with

direct access
Trader Sales
Client trough
Brokers Structuring Coverage team
Quant

Dealing Room Organisation
Trader: takes and manages positions through purchases and sales of securities and
derivatives. She carries out position hedging and anticipates market movements.
Sales: promotes and sells products to his clients. He develops business with new
clients, expands relationships with existing ones, offers them tailored financial
solutions, and works with Structuring to create new products.
Structuring: is responsible to quote structures for all derivatives sales teams. She
defines and promotes new products tailored to the demands of investors. She
implements the quantitative analysis required for the sale of these products and she
analyses their risk profile.
Quantitative analyst: is involved in the design and development of pricing libraries

and tools. He brings up propositions to the business in terms of model design for
instance. He is in charge of testing and validating the proposed solutions. He is also
involved in the libraries’ implementation.

Intro to financial markets
What is a financial market?
A financial market is a place where the buyers and sellers of various financial
instruments/products come together to try to match their respective needs. The
range of instruments trades on such market is very wide and varies from simple loan
products to very complex exotic structures.
The sellers will be typically institutions/individuals with assets/cash they would like
to invest to generate high yield. On the opposite, the buyers will be
institutions/individuals who are in need of cash or asset for their business activities
(e.g. funding a specific project).
E.g. company A has an excess of cash of $10m. If it keeps in a normal deposit

account in a bank, this would pay an interest rate of 1%. To get a better return,
company A would prefer to lend money to a another company B that needs the
funds and is ready to pay a higher interest

What is a financial market? (contd)
The size of financial markets is huge, amounts to hundreds (or even thousands) of
trillion dollars, split over big global financial centres.
The below table is the ranking as of Sept 2015:


Because of their size and their close relationship to the real economy, the financial
markets are at the heart of the economy, which eventually led to the crisis that had
shaken (and still shaking) the world over the recent years.
The crisis the world experienced in the recent years started with difficulties/defaults
in the US subprime mortgages, which then led to unprecedented difficulties across
the global financial system. As a result, huge losses were incurred by many
institutions. The contagion effect took the crisis from US Subprime mortgage to
other products, leading to even more losses.
With losses mounting, banks were suspecting that their peer banks might have
more losses and thus they became fearful of lending to each other, which pushed to
a liquidity dry up, causing the bankruptcy of some institutions notably Lehman
Brothers.
For this reason, the regulations became very strict over the last years, the objective
being to ensure financial markets stability


Because of their size and their close relationship to the real economy, the financial
markets are at the heart of the economy, which eventually led to the crisis that had
shaken (and still shaking) the world over the recent years.
The crisis the world experienced in the recent years started with difficulties/defaults
in the US subprime mortgages, which then led to unprecedented difficulties across
the global financial system. As a result, huge losses were incurred by many
institutions. The contagion effect took the crisis from US Subprime mortgage to
other products, leading to even more losses.
With losses mounting, banks were suspecting that their peer banks might have
more losses and thus they became fearful of lending to each other, which pushed to
a liquidity dry up, causing the bankruptcy of some institutions notably Lehman
Brothers.
For this reason, the regulations became very strict over the last years, the objective
being to ensure financial markets stability

Who are the Market Participants?

• Reporting Dealers: This refers to broker/dealers that are market makers and
traditionally have been the main medium through which Equity, IR&FX trades are
conducted.
• Other Financial Institutions: This refers to financial institutions other than the
traditional financial dealer institutions. The category includes smaller banks that
do not act as dealers in the Equity, IR&FX market, institutional investors, hedge
funds, and proprietary trading firms.
• Non financial Institutions: This category includes corporations, governments,

and high net worth individuals (HNWIs). The trades undertaken by these parties
are incidental to their day-to-day activities. For example, many international
corporations earn revenues all over the world and need to convert these into
their reporting currency.

Types of transactions in financial markets
Type of transactions in a financial market

Transactions in financial markets can be split into 4 broad types:
1. Funding/investment transactions: the objective of these transactions is to

provide financing (funding) for those who are short cash and need to raise some
fund for their projects. The other side of such transaction is to get some
return/yield for those who have excess in cash.
2. “Operational” transactions: these are linked to the day-to-day operations of the
companies in areas such as trade finance or FX.
3. Hedging transactions: these are operations made by market participants to
hedge/cover the risks in the books. This is done mainly via trading derivative
products
4. “Speculative” transactions: these are operations that are not needed in the
day to day risk or business but where the objective is rather to make money
based on a directional view of the market

Funding/investment transactions
 In this type of transactions, you have two sides: a counterparty that needs to
raise cash to fund some their projects/expenditure and a counterparty that have
excess in cash and is ready to provide funds in exchange of a return higher the
base one.
 The company that needs to raise funds can do it in two ways:
 Equity funding: Issue shares/stocks
 Funding via debt : this covers both normal loans and debt securities
Equity funding:
 The company will increase its capital and issues new shares/stocks that will be
bought by some shareholders. However, this involves sharing the ownership of a
company with the new stockholder. This could also mean giving the new
shareholders voting rights in the company which would allow them –to some
extent- decide on the future strategy of the company.
 Under the equity funding, the value of the raised funds can go higher/lower
than their initial value depending on the market value of the shares.

Equity funding (contd):

 However, shares may generate dividends distributed to the stakeholders
 The principal value of the investment is never directly repaid back by the
company, so in order to recoup their investment stockholders must transfer the
equity to somebody else.
Funding via debt:

• The other form of raising funds is to do it via debt. The principle is
straightforward – one party borrows funds from another and agrees to repay the
borrowings at some future dates, together with the interest payments.
• Unlike the Equity funding where most equity dividends vary according to the
company’s economic health, debt/interest repayments are unaffected by the
company’s performance.

Funding via debt (contd):

• There are two big categories of debt funding:
 Getting loans from the counterparty: this is the simplest form of raising
funds but it is generally done at higher rate.
 Trading debt securities: these can be either short term or long term
securities. Unlike the loans, securities are usually transferable to other
parties. Let’s dwell a bit on that one.
 We have short-term debt securities and long term ones
 The short-term is for funding needs less than 12 months.
 The long-term is for funding beyond that and go up to 40/50years.
 The short-term securities are trades in the Money Market whereas the long-
term securities are traded in Capital markets

Money Market instruments
Securities in the money markets include treasury bills (T-bill), commercial paper (CP)
and certificates of deposit (CD). These securities are negotiable
instruments and can be traded in the secondary market.
Government bills:
 Governments borrow cash to fund the running of their economies. They borrow
by selling debt to investors (lenders). The majority of this debt is issued in the
form of marketable debt instruments whose maturities range from 3 months up
to 30 years.
• At the short end, maturities of less than 12 months, the government debt
instruments are known as treasury bills although individual countries have their
own terminology. Some examples include:
- Treasury bills/Tbills (US, UK, Singapore, and Canada)
- Treasury discount bills (Japan)
- Treasury discount paper/Bubills (Germany)

• Treasury bills are generally regarded as risk-free by investors since “governments

don’t go bust over a period less than 1y given that they can print their own
money”. These bills make up a significant amount of total government debt
issuance.
• Treasury bills are issued at a discount to par and then redeemed at par on
maturity.
Why Governments issue treasury bills?:
1- Meet short-term funding requirements

2- Influence liquidity and interest rates
3- Provide a pricing benchmark for other money markets instruments

Maturities of treasury bills:

Treasury bills are issued in a variety of maturities depending on borrowing
requirements. Typically we have:
- US: 1M, 3M, 6M and 12M
- UK: 1M, 3M, 6M and 12M
- Germany: 6M and 12M
Treasury bills are offered in Auction on regular basis (weekly for the US and the UK).
In the US they are managed by “Department of the Treasury” and in the UK, they are
managed by “Debt Management Office”

Commercial Paper (CP):

• Commercial paper (CP) is a promissory note issued at a discount by a company
that promises to repay the holder the par value at maturity.
• The holder of the paper earns a fixed rate of interest equal to the difference
between the par value and the discounted issue price.
• It is the corporate version of a treasury bill – it is also negotiable so it can be sold
to another investor during its life. In most cases, however, the investor will retain
the paper until maturity.
• As CP is issued by companies, it is considered to be riskier than T-bills therefore,
it is issued with a higher interest rate. This makes commercial paper particularly
attractive to short-term debt buyers (money market funds or financial
institutions trying to enhance their returns on cash investments).
• CP is the primary mode of short-term debt issuance for borrowers such as banks,
finance companies, corporates. The bulk of issuance is from borrowers that can
attract the highest credit ratings from the major institutions are the most
prominent issuers of CP in most markets.

Commercial Paper investors:

• Commercial paper investors include:
– Bank trust departments
– Pension funds
– Insurance companies
– Governments
• Please note that due to the high denomination size, private investors rarely
invest in commercial paper.
Commercial Paper issuers:
• The major CP issuers include:
– Financial Companies
– Bank Holding Companies: The holding companies of commercial banks issue
commercial paper to finance bank operating expenses and various nonbank
activities.
– Non-financial corporates: The CP is issued to cover operating expenses and
also provide “bridge financing” till a long term funding source is found

Certificate of deposit (CD):

• A certificate of deposit (CD) is a receipt issued by a licensed institution to a
depositor to acknowledge money deposited. Issued at par, the bank guarantees
to repay the principal plus interest at maturity. The interest rate is fixed at
inception.
• By issuing them for fixed periods, banks know precisely how long investors will
deposit cash with them. As a consequence, it can hinder cash management at a
bank if a depositor demands its cash back the maturity of the deposit.
• Depositors can break time deposits and request repayment before maturity but
this comes at a penalty fee. As many CDs are negotiable instruments, sellers can
find buyers in the market rather than breaking them prior to maturity.
• Similarly to CPs, CDs are riskier than T-bill and hence the interest rate
remunerated is higher.

Valuation of money market instrument
• The T-bill, CPs and CDs are form of loans and deposits. They guarantee the
payment of the nominal invested + some interest rate.
• In a loan/deposit of less than 1Y, the amount of money you will receive/pay is:
Notional*(1+AnnualRate*LoanTermExpressedAsFractionOfYear)
e.g. if you borrow 100$ for 3 months at a 4% annual rate, then you have to
pay 100$(1+*4%*1/4)=101$
• Now let’s spend some time on this: the rate that you will be paying/receiving is
known from the definition of the instrument. The notional is known as well. The
main ingredient in the fraction of the year on which you will borrow/lend.
• There are standardised rules how to calculate the fraction of the year that will be
used to computed the interest amount. These are known as day count fraction
rules.
• E.g. if the basis is “ACT/365”, then the fraction of the year that will serve as the
basis of calculation will be the number of days between two dates divided by
365. We can also have “ACT/360” when the division will be on 360. We also have
a “30/360” basis on the market where each month is considered to have 30 days.
The difference in calculation can lead to significant money difference (cf. Excel)

Valuation of money market instrument
• Because these products are redeemed at par, the initial price is:
Notional/(1+AnnualRate*LoanTermExpressedAsFractionOfYear)
• Now what happens after the initial issuance?
• These instruments are then traded in the secondary market that will define their
price based on the bid/ask quotes.
• The price will obviously change depending on market conditions and the new
price will reflect the new discounting factor for each contract

Capital Markets debt instrument: Bonds
Bonds:
• A bond, is a contract where the issuer of the bond (borrower) has committed to
pay certain cash flows in the future to the various bondholders (investors).
• The borrower delivers to the lender a title in exchange of money:
• The borrower has the obligation to repay the money he borrowed, on terms
agreed upon in advance, which may take the form of a cash flow schedule.
• A bond is characterized by:
– The issuer: the borrower of the funds. It can be a government or a corporate
or even individuals (although very rare)
– The nominal amount: also known as the face value or the principal. This is
the amount of funds borrowed initially and that need to be repaid at
maturity.
– The nominal interest rate: aka as the coupon. This is the annual interest rate
to be paid
– The maturity: This is the final exchange date
– The payment schedule of Coupons: the pay dates for interest and Nominal

Bonds:
• Bond Market Key Players:
- Governments: ~45%
- Financial Institutions: ~40%
- Corporates: ~ 15%
Description of OAT 2021 3.75% OAT 2021 Cash flows
8.00% 100%
90%
7.00%
80%
6.00%
Coupons
70%
Notional
5.00%
60%
4.00% 50%
40%
3.00%
30%
2.00%
20%
1.00%
10%
INTRO TO CONVENTIONAL FINANCE

0.00%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
29
2021
0%
Bonds:

Bonds (capital repayment):
120
100
Bullet reimbursement : The 80 Interest

Capital
principal is repaid in full at the end 60
40
20
0
1 2 3 4 5 6 7 8 9 10
16
Interest Capital
14
Equal reimbursement of 12
10
principal: Each year, the issuer 8
repays the same amount of 6

4
nominal (+ coupons) 2
0
1 2 3 4 5 6 7 8 9 10

Bonds (some terminology):

Capital Interest
. 14
12
Constant annuities: all 10
8
payments (principal + 6
interest) are equal. 4
0
1 2 3 4 5 6 7 8 9 10
120
100
Interest
Zero-coupon: There is only 80
Capital
one payment (principal + 60
interest) at the end 40
20
0
1 2 3 4 5 6 7 8 9 10

Bonds (some terminology):

• If the bond price is equal to the nominal value, we say that the bond is at par.
• The bond prices are quoted in percentage: a bond with a price of 99% on a face
value of $100m will cost $99m to buy.
• If the price is below 100% the bond is said at a “discount” – if it’s above, the
bond is said at “premium”
• Bonds are usually quoted on “Clean” Price basis.
• The “clean” price of a bond is the “dirty” price (full price) minus the “accrued
interest”
• “accrued interest” is the amount of interest due since the last coupon payment
date. When a bond is sold, the price must be adjusted at settlement to account
for any accrued interest earned by the seller. Accrued interest compensates the
seller for foregoing the next coupon payment despite holding the bond for part
of the period since the last coupon payment.
Example: an OAT 5% maturity 25/10/2020, the Accrued Interest on the 25/04/2015
is: (25/10/2012 - 25/04/2015) / 365 x 5% = 2.5%
• The dirty price is the full price of the bond
Pricing of Bonds:
• Discounting factor for maturity higher than 1Y:

You need 100 EUR in one year. A friend offers to lend you the equivalent of this
amount today. The one-year rate is 5%.
How much will you actually receive today? 100
𝑃= =95,24
1+5 %
Now if you need this money for 2 years, How much will you receive now?
100
𝑃= 2
=90,70
(1+5 % )
• The discount factor at 1Y=95.24% and at 2Y is 90.70%

Pricing of Bonds:
• Discounting factor for maturity higher than 1Y:

You need 100 EUR in one year. A friend offers to lend you the equivalent of this
amount today. The one-year rate is 5%.
How much will you actually receive today? 100
𝑃= =95,24
1+5 %
Now if you need this money for 2 years, How much will you receive now?
100
𝑃= 2
=90,70
(1+5 % )
• The discount factor at 1Y=95.24% and at 2Y is 90.70%
• In general, for a rate “r” and maturity “t”:
100
𝑃𝑉 = 𝑡
(1+𝑟 )
Pricing of Bonds:
• Cash flows must always be compared at the same date

– n = numbers of years
– PV = Present value of the bond
– C = Coupon of the bond
– r = interest rate per year
• Present value of the bond is the sum of discounted cashflows
n
C 100
PV   t 1 (1  r ) t

(1  r ) n
100+C
C C C C
Y1 Yn

Pricing of Bonds:
- Accrued interest: The interest that has accumulated since the previous interest
payment date.
- Between two coupon dates the price increases due to the time and not
necessary due to Interest rates movement.
- At the coupon date, the bond price falls by approximately the value of the
coupon.
- These price changes are unrelated to market changes. They make the price
monitoring difficult, so they must be removed.
- Clean price is the right one to look at in order to remove time effect. It is the
reference price for quotation.
100%
95% Dirty Price

Clean price
90%
Face Value
85%
80%
75%
70%
0 1 2 3 4 5 6 7 8 9 10
INTRO TO CONVENTIONAL FINANCE Maturity

37
Concept of Yield:
- The Yield To Maturity (YTM) is the interest rate that will make the present value of
the cash flows equals to the price of the bond.
- The YTM is computed in the same way as the Internal Rate of Return (IRR), the cash
flows are those that the investor would realize by holding the bond to maturity.
- It allows to compare the return of two bonds with different coupons and
maturities, where comparing their prices is not relevant.
n
Ct N
P  t 1 (1  y ) t

(1  y ) n
Where :
P = price of the bond
C = Coupon
N = Nominal
n = number of years
y = YTM

How to compare bonds based on their yield:
- If a bond is bought at par value, then the YTM is equal to the coupon rate.
- If a bond is bought at a discount, then the YTM will be higher than the coupon
rate.
- If a bond is bought at a premium, then the YTM will be lower than the coupon
rate.
Examples in Excel: the 25th October 2015, what is the YTM of a classic bond, coupon
rate 8.50 %, expiry date 25th October 2022 and price 117% ?
YTM = ?
Examples in Excel: the 25th October 2015, what is the YTM of a classic bond, coupon
rate 5 %, expiry date 25th October 2022 and price 99% ?
YTM = ?

Bonds yields: Core western countries

Bonds yields: PIIGS

Concept of Z-spread:
- What affects bond prices?: Bond prices change depending on the interest rates
change on the market and on the credit quality of the issuer
- The Yield To Maturity (YTM) can be seen as a measure of the credit quality of
the issuer.
- Another way to see it is to say that the discounting rate we are using is the sum
of two parts: risk-free rate at each pay date + spread. This spread is called Z-
spread
- Z spread is the amount by which the discount rate would need to exceed the
return of the benchmark bonds in order for the present value to equal the
market price
- Let R1,R2,..,Rn be the Zero Coupon rates of the benchmark curve
- Then Z spread Z is the rate so that :
C C C M
P  2
 ...  
(1  R1  Z ) (1  R2  Z ) (1  Rn  Z ) (1  Rn  Z ) n
n

Bonds Z-spreads: Z-spread 10Y vs German Benchamrk

Intro to FX markets
• The foreign exchange market is the global market for the exchange (or trading) of
individual currencies.
• The FX market is a very active market with wide range of trading hours (almost
24H a day – 7days a week)
• The FX market is an over-the-counter (OTC) market where banks and other
market participants trade currencies around the clock (except at weekends). The
size and liquidity of this market is enormous. The most recent Triennial Central
Bank Survey by the Bank for International Settlements (BIS) found that average
daily turnover in the FX market was in excess of USD 5.3 trillion (an average of
USD 220 billion every hour).
• To give this figure some perspective, the following charts show that the global FX
market is a multiple of the largest domestic markets, such as the US stock and
bond markets. Average daily turnover for the US equity market is around USD
130 billion, while that of the US bond market is just under USD 700 billion.
INTRO TO 44
Intro to FX markets
FX Market is a more active market
INTRO TO 45
FX non-optional products
FX SPOT:
A spot FX quote is the cost of one currency in terms of another currency. Using
euro/US dollar as an example, an FX quote will usually be written in the form of:
EUR/USD 1.1090/95. [FX usually quotes in 4 digits].
The first currency code, EUR in this case, is known as the foreign currency (or base
currency). The second currency code, USD in this case, is known as the domestic
currency (sometimes referred to as quoted or terms currency).
The first quote is the bid and the second one is the offer (or ask): If you want to buy
1EUR, you will have to pay 1.1095USD and if you sell 1EUR, you will get one
1.1090USD only.
A FX Spot transaction has always spot execution lag i.e. the time between the
transaction agreement and the effective exchange of flows. The spot lag is defined
per currency pair but it is usually 2 business days.
The date on which the effective exchange of cashflows happens is called Spot Date
INTRO TO 46
FX non-optional products (2)
FX FORWARD:
A FX forward is a transaction to exchange one currency against another on a specific

future date at an agreed price. It differs from an FX spot trade in that the value date
occurs after the spot date. Under a FX forward outright, two parties enter a deal
today, and agree on the currencies, price, and future exchange date under the
transaction. At the future date, the transaction takes place with the currencies being
exchanged at the price agreed on the trade date.
The tenors traded on the forwards generally range from overnight to 12M (we could
also find maturities up to 18M/2Y for some ccy pairs).
The FX Forward are quoted in swap points (also know as forward points). The swap
points are the difference between the FX Forward rate and the FX spot rate.
e.g. EURUSD 1M forward will quote at mid: 4.5 swap points. It means that the bid/ask
for EURUSD in 1M will be: Spot+4.5/10000
Please note that:

• The swap points are traded in bid/ask as well
• the swap points can be either positive or negative. The sign is driven by the
differential of the interest rates between the two currencies (cf. next slide). When
the swap points are positive, the forward is said to be at a premium and the swap
points are negative the forward is said to be at a discount.
INTRO TO 47
Other IR products
IR Derivatives Market :
INTRO TO 48
Main benchmark interest rates
LIBOR or ICE LIBOR (formerly known as BBA LIBOR) stands for London Interbank Offered
Rate: is the rate at which the most creditworthy banks are ready to lend (unsecured)
money to each other for a specified period of time. It is a benchmark rate produced for
five currencies (EUR, GBP, CHF, JPY and USD) with seven maturities quoted for each -
ranging from overnight to 12 months, producing 35 rates each business day. ICE
Benchmark Administration maintains a reference panel of between 11 and 18 contributor
banks for each currency calculated.
EURIBOR (European Interbank Offered Rate): It is based on the interest rates at which a
panel of European banks (~24) borrow funds from one another for a specific set of
maturities. In the calculation, the highest and lowest 15% of all the quotes collected are
eliminated. The average of the remaining rates is then published at about 11:00 am each
day, Central European Time.
FED FUND: the rate at which banks trade funds in USD overnight.
EONIA (Euro Overnight Index Average): is the average rate of overnight loan & deposit
between ~35 banks in EUR (the average is volume weighted).
INTRO TO 49
IR products: IR Swaps
IR Swaps (IRS):
A swap is an OTC derivative instrument involving the exchange of a series of future
cash flows between two parties over a period of time. This contract has offsetting
obligations – each party pays a series of cash flows at various future dates, while
receiving another series of cash flows in exchange. Note that the cash flows do not
need to be paid on the same dates. The cash flow amounts are either set in advance
or calculated before each payment with reference to some observed underlying
market variables.
The usual exchange of cash flows in a swap is fixed for floating, though other
structures (floating for floating or fixed for fixed) are also possible. Single currency
swaps are the most common type of swap and are often given the generic term
"interest rate swaps" (IRS). There is also a thriving market for cross-currency swaps,
where values are also dependent on interest rates. However, the biggest market (by
far) is that for interest rate swaps.
INTRO TO 50
IR products: IR Swaps (2)
IR Swaps (IRS): Example

Two parties agree to a five-year swap which sees them exchanging cash flows based
on a notional principal of USD 100 million. Payments are made using the Actual-360
day count convention. The floating rate is set at the beginning of the period and paid
at the end.
The payment schedule is as

follows:
Party A (the payer) pays a
fixed-rate of 1.25%
(annualized) every 3
months.
Party B (the receiver) pays a
floating rate based on the
observed level of 6-month
LIBOR.
INTRO TO 51
IR Swaps (IRS):
Swap payments are based on a notional principal (USD 100 million), but this amount
is never transferred between the two parties. Any payments to be made are
calculated as a percentage of this fixed underlying amount.
One way of viewing an IRS is to consider it as a pair of offsetting fixed rate and floating
rate loans. Each counterparty is simultaneously borrowing and lending the principal
amount. The net capital amount is zero, but the interest payments differ.
Although, IRSs are OTC derivatives but there are quite standardised:
INTRO TO 52
IR Swaps (IRS): Valuation & Quotation
A swap can be split into two legs:

Floating leg: when the exchanged flows are based on the floating rate
Fixed leg: where the exchanged flows are based on the fixed rate
Today T1 T2 Tn
Time
The present value of a swap is the sum of the present value of the two legs
A swap is said to be at-par if its present value is zero
The swaps are quoted as the fixed rate that makes the swap at-par i.e. that makes the
present value of the swap equal to zero
Numerical example:
INTRO TO
SwapValuation
53
IR products: Cross-currency Swaps
Cross-currency Swaps (x-ccy swaps):

A cross-currency swap is an OTC derivative instrument involving the exchange of a
series of future cash flows between two parties over a period of time in two different
currencies. This contract has offsetting obligations – each party pays a series of cash
flows at various future dates, while receiving another series of cash flows in exchange.
Note that the cash flows do not need to be paid on the same dates.
The main difference with the IRS is that in the x-ccy, there is a notional exchange at
the beginning and at the end of the swap.
A Cross currency Swap can be “floating to floating”, “fix to floating” or “fix to fix”

Cross-currency Swaps (x-ccy swaps):
Example of a Cross Currency Swap (EUR Vs USD)
EUR Notional at maturity date
EUR Notional at effective date
EUR Debt EUR Floating rate EUR Asset
US Corporate Bank
USD Asset
USD Floating rate USD Debt
USD Floating rate
USD Notional at effective date
Floating Rate note

USD Notional at maturity date

Who uses Cross-currency Swaps (x-ccy swaps)?:
- A European company has assets in USD but raises his money in EUR
- For example an aeronautical company who sell planes in USD but has a debt in EUR
- Its balance sheet is not equilibrated
- Cross currency swap can be used to transform EUR debt into USD one
Balance sheet of the company
Asset Liability Asset Liability
In USD In EUR In USD In USD

(planes) (Bond) (planes) (Bond)
CCY swap
transforming the
EUR debit into USD
one

Mechanics of Cross-currency Swaps:
Notional
Notional
in USD
in EUR
Libor Libor Libor
T1 T2 T(n-1)
Euribor+ Euribor+
Euribor Euribor+
Notional +spread spread spread Notional
in USD spread in EUR
- The x-ccy swaps are usually quoted versus the USD

- They are quoted as the spread to add to the non-USD rate so that the total NPV
of the x-ccy swap is zero. This is spread is called basis e.g Basis EUR-USD
- The basis represents the preference that investors have in one currency versus
the other. This can be motivated by their view on a specific economy or on the
future rate moves

Mechanics of Cross-currency Swaps:
- This EUR-SUD basis was very close to 0% before the crisis, and was almost
constant. At that time, traders were usually not hedging their basis risk.
- - However, after the crisis this spread was very volatile causing a lot of trouble
and losses to traders who were not hedged
3 months Euribor Vs. 3 month Libor USD basis on a 10 year maturity

IR products: Basis Swaps
Basis Swaps:
- A basis swap is an OTC derivative instrument involving the exchange of a

series of future cash flows between two parties over a period of time.
- The exchanged cashflows are in the same currency but refering to different
floating rates e.g. Libor 3M vs Libor 6M
- There is no exchange of notional
- These swaps are quoted as the spread to add to a benchmark rate to get a
zero PV e.g. it will be the spread to add to Libor 6M leg to offset the Libor 3M
leg

IR products: Basis Swaps
Basis Swaps:
- Similarly to the x-ccy basis, the basis spread was close to zero prior to the
crisis but became very volatile afterwards
3 months Euribor Vs 6 month Euribor basis on a 10y maturity

IR products: Reminder discounting/compounding
Discrete Compounding vs continuous Compounding:

If we deposit 100$ for 2Y that pays an interest R% every 6 months and keep re-investing
the interest amount, the value of our initial investment is worth after 2Y
100$*(1+R%/2)^4 compounding factor.
The compounding factor after x years is:

- For yearly paid interest (1+R%)^(x)
- For semi-annually paid interest (1+R%*(6/12))^(x*12/6)
- For quarterly paid interest (1+R%*(3/12))^(x*12/3)
- For monthly paid interest (1+R%*(1/12))^(x*12/1)
- For daily paid interest (1+R%*(1/365))^(x*365/1)
These are all discrete compounding
The continuous compounding corresponds to the “limit” case where the interest paid
and re-invested continuously  compounding for x years is exp (R%*x)

IR products: Forward Contract (1/2)
Forward Contract: An agreement between two parties to borrow/lend a specific

amount of money in the future over a specific period of time. E.g. Party B would agree
to lend 100$ to Party A in 1 year for a period of 2 years. The interest rate of this loan
is agreed on at the date of the agreement. The underlying rate of the contract is
called the Forward Rate.
How to define the par/fair forward rate?

Example: Assume a party A want to borrow money in 1 year for a period of 2
years. Party B is ready to lend money for 1 year (starting today) at 1% and for 3 years
(starting from today) at 3%.
Today
1% R%? 3 years
1 year
3%
INTRO TO 62
IR products: Forward Contract (2/2)
From Party B perspective, if I have 100$ to invest for a time horizon of 3 years, I can
either:
(1)- invest it today for 3 years
(2)- invest it today for 1 year and re-invest the proceeds for 2 years
In case (1), I expect to get 100$*(1+3%)^3=109.27$

In case (2), I expect to get 100$*(1+1%)=101$ at the end of first year that I would re-
invest between year 1 and year 3 to get 101$*(1+R%)^2
The fair rate R% should satisfy the following equation:

101*(1+R%)^2=109.27  R%=4%
A forward contract is used to “lock-in” the level of the interest rate to be

paid/received in the future and hence hedge the risk of interest rate variations.
INTRO TO 63
IR products: Forward Rate Agreement (FRA)
FRA: It is an agreement to exchange in the future a fixed rate coupon against a

floating rate coupon, that will be determined on a given date of a Libor rate of a given
maturity.
e.g.Party A and Party B enter into a FRA to exchange the prevailing LIBOR between 1Y
and 1Y3M against a fixed rate 1% for a notional of 100$.
The mechanics of such a FRA would be:
- After 1Y, the 3M-LIBOR for the period [1Y, 1Y3M] is determined/published.
Let’s say it’s 1.2%.
- In a normal exchange, at 1Y3M Party A would receive 100$*(1+1%/4) and
Party B would receive 100$*(1+1.2%/4) or equivalently Party B would
receive the difference CashFlow=100$*(1+0.2%/4)
- In FRA, the practice is to exchange at time=1Y, the present value of this
CashFlow:
Flow Exchanged in a FRA =
The FRA is quoted e.g. 12x15: starts in 12 months over a period of 3M. It can be used
to “lock-in” the level of the interest rate in the future and hence hedge the risk of
interest rate variations.
INTRO TO 64
IR products: Short Term Futures
Short Term Future: It is very similar to a forward contract. The main differences with
a forward contract are:
-The futures are exchange-traded unlike the forward that are more Over-The-Counter
(OTC) agreements. The major exchanges on which short term futures are traded are:
Chicago Mercantile Exchange (CME), Liffe (NYSE Euronext Group) and Eurex
-The underlying forward rate is a 3M rate: USD Libor 3M or EURIBOR3M.
-The quotation mode: the contract is quoted as 100*(1-rate) e.g. a quotation of 99.5
means an underlying rate of 0.5%
-The contract is subject to daily margin calls
-The future contract is standardised in terms of expiry, underlying rate and the
nominal amount per contract.
INTRO TO 65
IR products: Short Term Futures (2)
Short Term Future:

-The futures are very liquid and are widely used for hedging purposes
-Each party of the contract is facing a clearing house and hence less counterparty risk
-Thanks to the margin call mechanism, the settlement risk is lower.
-The futures quotes reflect the market sentiment/view on future rate hikes.
-Finally, it is to be noted that because of the margin calls mechanism, the rate implied
from the futures quotes is slightly different from the effective forward rate. This
difference is the so-called convexity adjustment of the futures. For simplicity, in all the
sessions, we consider that there is no convexity adjustment in the futures
INTRO TO 66
FX FORWARD (contd):
How to derive the fair FX forward rate?
Let’s look at the following example: EUR/USD spot is at 1.10 today. We would like to
derive the 1M par/fair forward rate. The 1M EUR interest rate is at 0.1% and the 1M
USD interest rate is at 0.5%.
If I have 110 USD today that I would like to exchange into EUR in 1M, I can either:
1- invest it in 1M USD deposit for 1M and convert the proceeds to EUR after 1M or
2- convert the money today into EUR and invest it in a 1M EUR deposit
In case (1), after 1M, I will get 110$*(1+0.5%/12) to be converted in EUR at the FX rate
in 1M. At the end, the amount in EUR I would get is 110*(1+0.5%/12)/FX1M
In case (2), I will get 100EUR today that will get me 100EUR*(1+0.1%/12) after 1M.
Because there should be no arbitrage, the expected value of FX1M should be:

FX FORWARD (contd):
So the Forward FX 1M can be written as:
Or more generally:
We can see that depending on the level of the rates in the two currencies, the FX
Forward can be either higher or lower than the FX Spot, and thus the swap points can
be either positive or negative.
FX SWAP:
In an FX swap, there are two legs – the near leg and the far leg. The exchange rate at
the near leg is the spot price and the rate applicable at the far leg is the forward rate.
INTRO TO 68
Vanilla options definition
Reminder: Option definition
An option is a contract that give its holder the right but not the obligation to buy or
sell an underlying asset in the future at a price that is fixed today (called strike).
A call option gives the right to buy the asset in the future at the strike price if it is
lower than the market price.
A put option gives the right to sell the asset in the future at the strike price if it is
greater than the market price
There are 3 types of options:

- European option: the right to buy/sell can only be exercised at a specific time in
the future
- American option: the option can be exercised anytime between today and the
maturity
- Bermudan option: the option has few exercise dates before the maturity (e.g. the
option can be exercised on monthly basis).
The buyer of an option pays a premium to purchase the contract. This is the only
payment that is made by the option buyer. The option seller maximum profit is
limited to the premium.
The buyer of the option can loose the premium and also the payoff at maturity if the
option seller defaults
INTRO TO 69
Vanilla options definition
Reminder: Option definition
INTRO TO 70
FX Vanilla options
Vanilla FX Call/Put:
A Vanilla FX option is a contract that allows its holder to exchange two currencies in
the future using a pre-defined exchange rate called the strike of the option.
A call (resp. put) FX option on a currency pair FOR/DOM is an option that allows you
to buy (resp. sell) FOR currency in the future at an exchange rate=strike.
e.g. a 1Y call option on EUR/USD at strike 1.05 on a notional of EUR1mm:

- At the expiry = 1Y, the option holder will check the level of EUR/USD on the market
- If it’s lower than the strike, then nothing happens
- If it’s greater than the strike (let’s say it’s 1.10), then the option holder will buy
EUR1mm and will pay only USD1.05mm for that. Whereas on the market the
EUR1mm is worth USD1.10mm.
INTRO TO 71
FX Vanilla options (2)
FX Call/Put relationship:
As seen in the previous example, a call option on EUR/USD allows you to buy EUR at a
pre-defined strike (1.05 for instance).
The mechanics of the call option can also be seen as selling the USD for a specific rate
because in order to get EUR, we paid the equivalent USD.
A call option on EUR/USD on a notional amount of EUR1mm can be seen as a put

option on EUR/USD when we are selling USD1.05mm for EUR1mm.
For this reason, when defining a call option on EUR/USD, we usually say “Call
EUR/Put USD”
INTRO TO 72
IR Vanilla options
Caplet:
A caplet is a call option on the Libor. It allows its holder to borrow money in the future
at a strike K instead of the prevailing Libor.
Let’s take the example of a caplet where the underlying Libor is 3M and the maturity
of the caplet is 1Y with a strike of 1%.
The mechanics of such caplet are as follows:
- At the expiry = 1Y, the caplet holder will check the value of the spot Libor3M (the
Libor that starts at that time for 3M)
- If this Libor rate is lower than the strike, then nothing happens
- If this Libor rate is greater than the strike, then the caplet holder can borrow
money for a period of 3M at a rate equal to the strike (instead of Libor). So at
1Y3M, the caplet holder will get:
- Please note the payout happens at 1Y3M and not 1Y i.e. in a Vanilla caplet the
payout happens at (expiry of the option + tenor of the underlying Libor) and not at
the expiry of the option
INTRO TO 73
IR Vanilla options
Floorlet:
A floorlet is a Put option on the Libor. It allows its holder to lend money in the future
at a strike K instead of the prevailing Libor.
Let’s take the example of a Floorlet where the underlying Libor is 3M and the maturity
of the caplet is 1Y with a strike of 1%.
The payout of such Floorlet at 1Y3M
- Please note the payout happens at 1Y3M and not 1Y i.e. in a Vanilla caplet the
payout happens at (expiry of the option + tenor of the underlying Libor) and not at
the expiry of the option
INTRO TO 74
IR Vanilla options
Cap/Floor:
Caps = a strip of caplets on the same underlying Libor, that pays over regular periods
the payout of the underlying caplets.
Floor = a strip of floorlets on the same underlying Libor that pays over regular periods
the payout of the underlying floorlets.
INTRO TO 75
IR Vanilla options
Swaption:
A swaption is the option to enter in a swap in the future at a specific strike. The strike
will be the fixed rate of the swap transaction.
For a swaptions, we don’t talk about Call and Put option but rather on Payer or
Receiver swaptions:
- A payer swaption is an option to enter a swap in which we will pay the fixed rate
and receive the floating rate
- A receiver swaption is an option to enter a swap in which we will receive the fixed
rate and pay the floating rate
There are 2 types of swaptions:

- Physical: at the expiry of the option, if the option holder decides to exercise the
option, then he enters into an effective swap where he exchanges the cashflows
with its counterparty till the end of the swap
- Cash-settled: at the expiry of the option, if the option holder decides to exercise
the option, then all the future cashflows are discounted (to the option expiry
date) and exchanged. In this case, there is only one cashflow exchange at the
expiry. The discounting factor of the future cashflow is done using a specific
formula that is market standard.
INTRO TO 76
IR Vanilla options
Swaption:
Finally, like other options, a swaption can have a different types of exercise: European,
American or Bermudan BUT the vanilla swaption are European.
Let’s consider a EUR Payer Phyiscal swaption with maturity 1Y and underlying swap
the 5Y swap. Let’s fix the strike at 2%.
The mechanics of a swaption are as follows:

- At the expiry = 1Y, the swaption holder will check the value of the spot 5Y-swap on
the market
- If the swap rate is lower than the strike, then nothing happens
- If the swap rate is greater than the strike then the option holder enters into a swap
with its counterpart where he will be paying 2% and receive the floating rate till
the end of the swap.
INTRO TO 77

Intervention Strasbourg

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INTRO TO CONVENTIONAL FINANCE

MR. HAFID AGOUZOUL

 Global Overview of conventional finance

INTRO TO CONVENTIONAL FINANCE 2

Corporate & Investment

Fixed Income (Foreign Asset Management Risk Management

Equities Securities Services Finance

Corporate Finance Human Resources

Structured Finance Communication

INTRO TO CONVENTIONAL FINANCE 4

– Equities : offers equity products (derivatives and non derivatives), indices

INTRO TO CONVENTIONAL FINANCE 6

INTRO TO CONVENTIONAL FINANCE 7

– Human resources: their role is fundamental in managing all staff –related

INTRO TO CONVENTIONAL FINANCE 8

Banks Front Office Client with

INTRO TO CONVENTIONAL FINANCE 9

Quantitative analyst: is involved in the design and development of pricing libraries

INTRO TO CONVENTIONAL FINANCE 10

What is a financial market?

E.g. company A has an excess of cash of $10m. If it keeps in a normal deposit

INTRO TO CONVENTIONAL FINANCE 11

What is a financial market? (contd)

INTRO TO CONVENTIONAL FINANCE 12

What is a financial market?

INTRO TO CONVENTIONAL FINANCE 13

What is a financial market?

INTRO TO CONVENTIONAL FINANCE 14

Who are the Market Participants?

• Non financial Institutions: This category includes corporations, governments,

INTRO TO CONVENTIONAL FINANCE 15

Type of transactions in a financial market

1. Funding/investment transactions: the objective of these transactions is to

INTRO TO CONVENTIONAL FINANCE 16

INTRO TO CONVENTIONAL FINANCE 17

Equity funding (contd):

Funding via debt:

INTRO TO CONVENTIONAL FINANCE 18

Funding via debt (contd):

INTRO TO CONVENTIONAL FINANCE 19

INTRO TO CONVENTIONAL FINANCE 20

• Treasury bills are generally regarded as risk-free by investors since “governments

Why Governments issue treasury bills?:

1- Meet short-term funding requirements

INTRO TO CONVENTIONAL FINANCE 21

Maturities of treasury bills:

INTRO TO CONVENTIONAL FINANCE 22

Commercial Paper (CP):

INTRO TO CONVENTIONAL FINANCE 23

Commercial Paper investors:

INTRO TO CONVENTIONAL FINANCE 24

Certificate of deposit (CD):

INTRO TO CONVENTIONAL FINANCE 25

INTRO TO CONVENTIONAL FINANCE 26

INTRO TO CONVENTIONAL FINANCE 27

INTRO TO CONVENTIONAL FINANCE 28

Description of OAT 2021 3.75% OAT 2021 Cash flows

INTRO TO CONVENTIONAL FINANCE

INTRO TO CONVENTIONAL FINANCE 30

Bonds (capital repayment):

Bullet reimbursement : The 80 Interest

repays the same amount of 6