Professional Documents
Culture Documents
Notes
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Table of Contents
2. They enable price discovery of the financial assets by bringing buyers and
sellers together.
3. They provide liquidity for financial assets so that an investor can buy or sell
a financial asset at any time.
Capital markets include equity markets and debt markets, in which equity and
debt instruments and their derivatives are traded. Commodity markets facilitate
the trading of commodities. Money markets facilitate short-term debts and
financing. Foreign exchange markets provide a facility through which foreign
exchange and their derivatives can be traded.
Depository institutions have a banking license and are governed by the country’s
banking laws. They transform liquid liabilities, such as savings accounts, into
relatively illiquid assets such as home mortgages, car loans, business loans, and
credit card balances. Depository institutions also operate the payment systems
through which bank balances are transferred between parties. This occurs
through checks, wire transfers, and credit and debit card transactions, eliminating
the risk of carrying cash. They also offer foreign exchange services, such as the
conversion of one currency into another, thereby facilitating international trade.
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o The amount of leverage that a hedge fund can take is not controlled
by the regulators.
Adverse Selection
Adverse selection is an instance of market failure that is rooted in the asymmetry
of information between the buyers and sellers that exist in the market.
Adverse selection occurs when a seller has more information on the value of the
object being sold than the buyer and is unwilling to sell it at a lower price than the
value they know it holds. The buyer, however, does not have enough information
to accurately assess the value of the object. As such, he or she undervalues it due
to the possibility that it is defective. This asymmetry of information prevents the
transaction from taking place. If both the seller and the buyer had similar
information, they would be willing to trade at a mutually agreed price. If both had
insufficient information, they would trade at the expected price, in which case
both parties would consider the possibility of the item being defective. When
there is an imbalance of information between the buyer and the seller, they are
unable to arrive at a mutually acceptable price.
While the good firms will not accept the offer because it undervalues their stock,
the bad firms will readily accept it as it overvalues their stock. This adverse
selection inappropriately inflates poor stock while deflating quality stock and is,
thus, considered a failure in the market.
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Moral Hazard
Moral hazard, like adverse selection, is another instance of market failure that is
rooted in the asymmetry of information between buyers and sellers in the
market.
Moral hazard describes a market failure situation in which one of the parties
involved in a transaction undertakes excessive risk knowing that they do not have
to pay the consequences of that risk.
When lending to a customer, a bank expects the money to be paid back with
interest. Moral hazard is the risk that the borrower will not use the money as
intended, take unnecessary risks, or fail to take adequate steps to reduce risk.
Similarly, a company that sells stock to investors is expected to use the money in
the shareholders’ interests. If the shareholders do not have sufficient information
about or control over how the company spends funds, the management is free to
use the money as it pleases. The management may use the money in risky
activities or wasteful expenditure since any consequences will be borne by the
shareholders.
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Regulatory Framework
A financial institution can become insolvent if it suffers a large sudden loss or a
sustained period of smaller losses. A seemingly solvent bank can turn out to be
insolvent if examiners find hidden losses (assets that have been overvalued or
liabilities that have not been recognized). Solvency regulations seek to prevent
financial institutions from becoming insolvent. That is, they protect depositors
against losses when normal regulations fail to prevent a financial institution’s
insolvency. This is achieved by the means of deposit insurance, which protects
depositors against losing all their savings in the event that an institution fails.
Deposit insurance assures depositors of the safety of their deposits in the event of
an adverse shock to the system and, thereby, prevents “bank runs.” This
guarantee of government protection, however, also carries a risk of “moral
hazard.” That is, the insured or guaranteed institution may make higher-risk bets
because severe losses from losing bets will fall on taxpayers, while profits from
winning bets will go to the owners and managers.
Governments also seek to prevent any liquidity crises, such as bank runs, on
otherwise solvent banks by using the central bank as a lender of last resort. That
is, the central bank is ready to lend to an illiquid bank when no one else will,
provided the bank has collateral in the form of high-quality assets.
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To control risk taking, regulations limit the amount of high-risk assets financial
institutions can hold. Banking regulations also encourage the diversification of
assets as a means of reducing risk.
Central banks are financial institutions that determine the money supply and key
interest rates. They also regulate and monitor other financial institutions,
especially banks.
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Central Banks
Central banks issue currency and are found in almost every country. They monitor
credit conditions and create money to keep the market fluid and deter difficulties
in performing basic transactions.
Central banks attempt to control the key interest rates of very liquid markets.
They trade their deposits back and forth with the Federal Reserve banks. The
Federal banks will add or drain liquidity to keep the interest rates in line with
target levels.
The central bank may ration credit or encourage loans. They regulate and monitor
financial institutions. They may not always have full authority, but they work
closely to ensure they are solvent.
A central bank’s goal is to keep currency stable; however, they will reduce or
increase the value of their currency to stimulate or restrain the economy. They
also accomplish this by managing the foreign exchange market, which can be
extremely large in some countries.
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Central banks, along with other regulators, help stabilize the bank system. They
accomplish this by:
regulating capital,
As a lender of last resort, the central bank may offer loans to institutions that are
having difficulties or close to failing. International central banks have agreed upon
how much capital they should have and have established a specific amount they
must maintain. They enforce diversification of assets to protect against a shock
causing a crash.
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While central banks regularly inspect the financial health of banks through
examination and disclosures, a bank’s financial health may rapidly decline in the
case of rapid trading losses. To monitor this, banks are required to implement
stringent internal controls and robust risk management processes to ensure live
monitoring of any mounting risks. Stress testing and VaR calculations are also
adopted to calculate the worst possible losses under adverse scenarios.
In the U.S., the Federal Reserve is the regulator for banks and bank holding
companies. The Federal Deposit Insurance Corporation (FDIC) provides deposit
insurance, guaranteeing the safety of a depositor's accounts in each insured bank.
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Treasury bills are short-term debt obligations that are backed by the U.S.
government and have a maturity of less than one year. Treasury notes are debt
securities, and they mature between 1 and 10 years. Treasury bonds are
marketable debt securities that have a fixed interest and a maturity of more than
10 years.
Government bonds are considered riskless because the government has the
option to increase taxes or print the money required to repay bonds.
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Term Structure
Yield Curves
Based on the spread between maturities, the yield curve can be classified as one
of the following:
A normal yield curve results when the short-term interest rates are lower than
the long-term interest rates. The normal yield curve is the most commonly
observed of all yield curve shapes. It has a positive slope, which implies that
the market expects growth in the economy and a rise in inflation in the future.
Under normal conditions, long-term interest rates are kept higher to
compensate for future market uncertainty and the potential of increased
inflation rates.
An inverted yield curve results when the long-term interest rates are lower
than the short-term interest rates. This negatively sloped curve is observed
when the market expects the economy to slow down and perform poorly in
the future. So, instead of demanding a higher rate of interest in long-term
securities, investors prefer to lock their returns on short-term securities,
expecting that the central bank will reduce interest rates to stimulate the
economy.
The steep yield curve is a normal yield curve with a wide spread between the
short-term and long-term interest rates. This curve is usually observed during
an expansion phase of an economy, during which the demand for credit is
likely to be high.
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The flat yield curve is a yield curve that tracks similar yields for different
maturities. The spread in a flat yield is almost negligible. The flat yield curve is
a transitional stage between the normal and inverted curves. It is normally
observed when the market is unsure about the movement of the economy and
the future of inflation.
The humped yield curve, also known as the bell-shaped curve, is observed
when medium-term interest rates are higher than both short-term and long-
term maturities. The humped yield curve is a transitional state between a
normal yield curve and an inverted yield curve. Not all humped yield curves
result in the onset of an inverted yield curve.
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The spread is a summary measure of the yield curve. It can be defined as the
difference between the strike price and the market value.
The normal yield curve has an upward slope and is the most common yield curve.
It is defined as a short-term debt security that has a lower yield than the long-
term debt securities of the same credit worth. This is referred to, and considered
to be, “normal” because investors generally expect more compensation for
greater risk. Long-term bonds are riskier. The normal yield curve is seen as growth
and trend inflation.
The inverted yield curve is basically the exact opposite of the normal yield curve.
It is defined as identifying an environment in which long-term debt security has a
lower yield than short-term debt (of the same credit worth).
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This is the rarest of the yield curve types and investors know it typically means a
recession or slowdown in the economy.
The flat yield curve is just that: A flat line with no difference between investing in
short-term or long-term securities and no difference in the interest rates of the
same credit worth. It is usually seen in the transition time between a normal and
an inverted curve. This is unfavorable because the investor doesn’t stand to
benefit from holding the bond for 30 years; as such, he or she may as well sell it
immediately rather than incurring risk by holding it for a longer period of time.
The humped yield curve follows a very similar path to the flat yield; however, it
will drop at some point in the future. If an investor holds a 30-year bond, the
closer he sells the bond during the up time of the hump, the better. Holding on to
the bond to maturity is very risky. The humped yield curve indicates a slowdown
in the economy.
Credit spread is the difference in the yield amount between two bonds that have
similar maturity but different credit quality. For instance, the Treasury is expected
to be able to pay its bonds. An A-rated industrial company that offers a bond has
a chance of going out of business or otherwise not being able to pay. Therefore,
they must offer greater returns on their bonds to make the risk worthwhile to
investors. The credit spread measures the difference between what investors are
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willing to pay for a riskless bond and a bond that is associated with risks. The
higher the credit rating, the lower the credit spread.
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Credit spread is the additional yield an investor earns above the risk-free rate
when investing in a risky bond. The additional yield compensates the investor for
the credit risk they bear when investing in a corporate debt. The value of the
spread depends on the credit rating of the corporate issuing the debt. The higher
the credit rating, the lower the credit spread.
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Bond Returns
Bond returns are measured by calculating current yield. The yield is the simplest
calculation, and it indicates the return you will get on your investment. This is
calculated as:
Bond investors prefer to calculate this as yield to maturity (YTM). This is a more
advanced calculation than current yield and shows the total of the return you will
receive if you hold on to the bond until its maturity date. However, as bond prices
increase, bond yields fall.
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Yield to maturity (YTM) is the rate of return investors would earn if they were to
buy the bond today at the current market price. It is the discounted rate at which
the sum of all future cash flows equates to the current market price of the bond if
all the cash flows from the bond are made on schedule, the bond is held until
maturity, and the cash flows received are reinvested at YTM.
If the YTM of a bond is equal to its coupon rate, the bond is selling at par.
If the YTM of a bond is less than its coupon rate, the bond is selling at a premium.
If the YTM of a bond is more than its coupon rate, the bond is selling at a
discount.
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Interest rates and bond prices have an inverse relationship. When interest rates
go down, new bond issues pay lower coupon rates, thus increasing the demand
and price for the earlier, higher coupon-rate bonds. When interest rates go up,
new bond issues have higher coupon rates, thereby decreasing the demand and
price of earlier bonds.
If an investor has bought a bond with the intention of holding it until maturity,
there is no interest rate risk, as the redemption value and coupon rate are fixed
and, therefore, unaffected by changing interest rates. If, on the other hand, the
investor buys a bond with the intention of selling it before maturity, the rise in
interest rates will adversely affect the price of the bond.
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Duration
Duration
𝑃𝑉
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑡
𝑉
Modified Duration
Modified duration helps to calculate how the price of a bond will change in
response to a change in interest rates. Modified duration is the percentage
change in the price of the bond for every unit (basis point) of change in interest
rate. It is calculated as follows:
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 (𝑀𝐷) =
𝑌𝑇𝑀
(1 + 𝑛 )
Modified duration helps to calculate the changes in bond prices that result from
changes in the yield curve. A bond with longer maturity and a lower coupon rate
will have a higher duration than one with a shorter maturity and higher coupon
rate. However, duration analysis suffers limitations as it fails to take into
consideration the following:
Credit is measured by credit rating agencies. These provide people and investors
with the information necessary to determine if an issuer of debt will be able to
pay what is owed. Credit ratings are issued in ratings; the higher the rating, the
more confidence investors will have. Individual investors generally use credit
rating agencies to get a rating they feel comfortable with; for example, the AAA
rating.
Institutional investors want to know how much credit risk they are taking. They
prefer a full investigation to know the risk they are taking before they purchase a
bond. Some investors may not select bonds by type, but by a predetermined
credit rating for the company selling it.
State and local governments sell bonds that are federally tax exempt, giving the
investor more incentive to purchase them. In these cases, investors depend on
credit rating agencies to verify corporate debts. Asset-backed securities are an
alternative method by which investors can invest in corporate debts.
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Primary Markets are for investors who want the first chance to exploit new
investments. These companies or individuals may buy up new stock and retain it
as privately held without it ever hitting the public market. The main reason for a
company to issue stock is to:
There are several reasons why an institution may issue securities in the primary
market:
To pay back outstanding debt and fund it with proceeds from the issue
of equity shares.
Governments, private sector companies, and public sector companies raise funds
by issuing securities, such as shares and debentures, to both the public at large
and institutional investors.
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Venture capital companies and other private companies often choose the public
offering route instead of a private placement investment. A public offering
involves selling themselves or going public and issuing their own shares on the
market. Going public means they issue shares in the company at a predetermined
price and receive funds in return.
Public offerings initially require the securities to be documented with the terms
and conditions. These documents must be registered and approved by the SEC or
other regulating body depending on the country. The rules vary widely from
country to country. The U.S. is considered to be extremely strict in terms of the
requirements that govern a company’s ability to go public, and the SEC is
renowned for being very thorough. This gives investors throughout the world
more confidence in the company’s stock.
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After the securities are allocated, trading in the secondary market begins. The first
day of trading can vary greatly from expectations and may require adjustments.
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Public Offerings
When a private company “goes public” (offers shares to the public for the first
time) the offering is called an initial public offering (IPO). An IPO gives the
company better access to capital markets and, therefore, to funds at a lower
price. It also allows the promoters to liquidate their holdings directly through the
exchange. When securities other than shares are issued to the public, this is not
classified as an IPO.
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Securities issued in the primary markets are traded in the secondary market. The
issuer of the securities is no longer a party to the transaction, and transactions
involving the purchase or sale of securities are executed between two investors
through a centralized exchange market or through over-the-counter (OTC) deals.
In a small number of cases, trades may be executed through dark pools.
Dark pools are a means for brokers to cross-sell stocks among their own
customers. The majority of these are handled away from the central exchanges.
The name dark pool comes from the fact the exchanges are hidden from the
public. The brokers often have their own rules as to who gets to trade what and
how fast. They are required to make the fact that a trade took place public, but
they don’t have to share all the details.
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Stock dealers are people or firms who make a business of buying and selling
stocks for their own account, either via a broker or otherwise. They tend to deal
with less liquid stocks that don’t trade frequently. Therefore, if a company
wanted to sell a rare stock they would sell it to the dealer, and the dealer would
hold it until they found someone to buy it.
Fast markets are exchanges that try to compete by bring a sale to the front more
rapidly than other markets. They do this by investing in faster electronic systems.
The main problem with this approach is that a flood of transactions can occur in a
rush with only a few of them being executed. This puts a strain on the systems
and can cause dealers to shut down because they are overwhelmed by the
volumes. The Flash Crash of May 2010 is an example of this phenomenon in
action.
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The liquidity of a market directly influences the efficiency with which deals take
place. A functional secondary market is a prerequisite for a functional primary
market; investors would not subscribe to new issues in the primary market
without a secondary market in which to liquidate investments.
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Hard commodities include metals that are either mined or extracted such
as gold, copper, brass, silver, etc.
Derivative contracts are financial instruments that derive their value from an
underlying asset. The most common derivative contracts are forwards, futures,
swaps, and options.
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Futures markets buy and sell contracts for delivery on a future date. Those trading
in commodities also trade in commodity derivatives. In the 1980s, people began
to trade financial futures on interest rates, stock indexes, and other key variables.
Today, both commodity and financial products are traded on the futures markets.
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Commodities Markets
Commodity markets are markets in which primary products are traded such as
gold, metals, energy, wheat, and corn. Financial products are traded on
exchanges and over-the-counter (OTC) markets. OTCs are flexible in terms of
delivery dates and dealers trade OTC stocks within a network via computer or
phone.
Forwards markets are OTC markets that set the prices for financial instruments,
stocks, bonds, or other assets with a future delivery. The price is set in a contract,
and the contracts are binding on all parties. This type of market is customizable
and carries a high default risk.
In comparison, futures markets have contracts to buy or sell, but are standardized
and have little-to-no default risk. The futures markets have standardization, which
helps to create liquidity in the marketplace. Forwards markets have some credit
risk, but futures markets do not because a clearinghouse guarantees against
default risk. Futures markets are sufficiently well-structured to survive times in
which other markets fail.
Future contracts are standardized contracts traded on exchanges. The trades are
guaranteed by a clearinghouse and this offsets counterparty risk. The OTC
markets have also adopted the use of clearinghouses for trades in certain
products. The terms of a contract, such as the trade date, place of delivery, and
the underlying quality and quantity of a commodity, are all pre-fixed. The only
variable parameter in a future contract is the future price, which converges into
the spot price on the expiry date.
Speculators are the major participants in the commodity markets. They normally
exit their position before the expiry date. Only about 2% of futures contracts
result in delivery at the expiry.
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No-Arbitrage Principle
When trade is taking place in different markets, if the prices are lower in one
market than another, the demand will shift and level the prices again. Arbitrage is
defined as two entities purchasing and selling a financial security to profit from a
difference in the price between two markets. The profit on the trade is made by
exploiting the difference between the price of the same (or extremely similar)
financial securities on different markets. Market inefficiencies result in arbitrage.
This offers a means by which traders can make sure prices do not deviate
substantially, for a prolonged period, from the fair value.
The more the market levels, the less money there is to be made. Thus, the no-
arbitrage principle states that when unequal pricing situations arise, the normal
trading of the markets will take care of this situation quickly. These are not
opportunities that are available often; however, arbitrage can take place between
markets and across time.
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Pricing by No-Arbitrage
According to the no-arbitrage principle, the price of the one-year zinc forward
must be $10.20.
If the price of the forward was less than $10.20 (say $10.05), then an arbitrageur
could buy a one-year zinc forward (take a long position in the commodity
forward), borrow a unit of zinc from someone today and sell it (short-sell the
commodity), invest the proceedings from the short sale in risk-free deposits for a
year, and make a riskless profit of $0.15. The actual cash flows are given below.
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Similarly, if the price of the forward was more than $10.20 (say $10.40), then the
arbitrageur could short-sell the forward, take a loan of $10, use it to buy a unit of
zinc today, and lend out that zinc to make a riskless profit of $0.20.
As we can see, the no-arbitrage principle, therefore, sets the correct price of the
one-year zinc forward at $10.20.
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There are many ways to invest in commodity markets. Investors can directly
invest in commodity markets by entering into futures markets or taking a forward
position. There are also many indirect ways of investing in commodity markets to
help diversify a portfolio. Investors can buy mutual funds, exchange-traded funds,
or invest in the stocks of companies that specialize in agriculture, mining, or
energy.
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The spot exchange rate pertains to spot transactions and immediate (two-
day) exchanges of bank deposits denominated in two given currencies.
Interest rate parity simply implies that the expected returns are the same on both
domestic and foreign assets. It describes an equilibrium condition for the foreign
exchange market.
Where:
For example, suppose banks in the USA offer 1% annual interest per dollar
deposits, while banks in Britain offer 5% per pound sterling deposits. The GBP-
USD spot exchange rate is 1.7, meaning one can buy 1 GBP for 1.7 USD right now.
According to interest rate parity, the forward exchange rate of GBP-USD would be
less than 1.7, meaning it would be less expensive to buy pounds in a one-year
forward contract than it is right now.
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Consider an example in which the interest rate parity of British and US currency is
disturbed. Let’s say that the USD interest rate is 1%, the GBP interest rate is 5%,
and both the spot and one-year forward rate for GBP-USD are 2. This deviation
would give an opportunity for covered interest arbitrage. An American bank can
borrow $1,000,000 at 1% for one year. It will then owe $1,010,000 (principal +
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interest) after that year. It can subsequently sell the $1,000,000 to buy £500,000.
It can then lend the pounds for one year at a rate of 5%, a transaction that would
yield a £525,000 return after one year. Simultaneously, it can enter into a one-
year forward contract to sell £525,000 after one year at the forward GBP-USD
exchange rate of 2. One year later, it receives $1,050,000. It pays back $1,010,000
to its obligors, thus netting a profit of $40,000.
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Triangular Arbitrage
Triangular arbitrage is a foreign exchange arbitrage strategy that takes advantage
of the price discrepancy between three currency pairs. The opportunity for
triangular arbitrage emerges when market imperfections cause a mispricing
between the currency pairs. Traders can then exploit this price discrepancy by
executing a cyclic trade in the three currency pairs.
Let the market quoted exchange rates for A-B, B-C, and A-C be denoted by
(A/B)m,(B/C)m, and (A/C)m respectively.
Let (A/C)I be the implicit cross rate of A and C determined from (A/B) m and (B/C)m,
such that (A/B)m x (B/C)m = (A/C)I.
Occasionally, however, the quoted rate may differ from the implicit rate. This
mispricing can be exploited by quickly converting the first currency to the second,
converting the second to the third, and finally converting the third back to the
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first. The opportunities for triangular arbitrage are rare. When they do emerge,
they quickly disappear as arbitrageurs seek to exploit the mispricing.
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EUR-USD is 1.3399
EUR-GBP is 0.802
GBP-USD is 1.6833
The implicit cross rate of EUR-GBP is 0.796, which differs from the market quote
of 0.802.
Finally, it can sell the GBP to buy $1,007,543, netting a profit of $7,543.
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Carry Trade
Currency carry trade, also called open interest arbitrage, is another arbitrage
strategy that takes advantage of the difference between the interest rates of two
different currencies. In a currency carry trade, investors borrow in the low-
interest currency and convert it into the high-interest currency. They then lend in
the high-interest currency. On maturity, they buy back the low-interest currency.
The profit is the difference between the interest rates of the two currencies.
The biggest risk in a currency carry trade is exchange rate risk. Fluctuations in the
exchange rate can cause losses if the low-interest currency becomes more
expensive when buying back.
The carry trade is not an arbitrage, but a strategy used by currency traders. They
borrow in one currency with a low interest rate and then use the funds to buy a
different currency that is paying a higher interest rate. In addition to earning an
interest rate differential due to the difference between the two currencies, there
is also a chance that the currency they purchased will appreciate. However, this
strategy can be risky because the trader’s profit depends on the exchange rate
remaining the same until the transactions are completed.
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For example, suppose the annual interest rate on US dollars is 1%, the interest
rate on British pounds is 5%, and the exchange rate of GBP-USD is 1.6833. An
arbitrageur can borrow $1,000,000 at 1%, convert it to £594,071, and then buy a
one-year GBP bond that yields 5%. On maturity, the bond will return 623,775
GBP. Assuming the exchange rate is constant, he can then sell the pounds to buy
$1,050,000. After paying back the $1,000,000 million with 1% interest, he would
have a $40,000 profit.
For a carry trade to be profitable, the exchange rate must not move adversely
against the currency with the higher interest rate. In the above example, if the
GBP-USD exchange rate decreases, (i.e., the USD becomes more expensive) the
carry trade will be less profitable.
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Options Overview
An option is a financial derivative representing a contact that is sold by one party
to another. The contact gives the party the right to buy or sell a security, but they
are not obligated to buy or sell it. The contract outlines an agreed price and time
or end date.
A call option is a contract for the right to buy a bond, stock, commodity or any
other security at a given price, on or before a given date.
A put option is a contract for the right to sell a bond, stock, commodity or any
other security at a given price, on or before a given date.
The long put option, or taking a long position, involves buying a security with the
expectation the security will rise in value.
Option Styles
The option style depends upon the dates on which the option can be exercised.
Options that can be exercised on any day before the expiration date are known as
American style. Options that can be exercised only on the expiration date are
known as European style. American and European style options, known as vanilla
options, are the most common. The payoff of other, “exotic options,” is calculated
differently.
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C = max(0,S – K)
P = max(0,K – S)
Long Call
A trader buys a call option on stock ABC with a strike price of $60 and one month
to expiry. The buyer pays the seller an upfront premium of $5. The stock is
currently trading at $60; as such, upon expiry, the buyer will yield a positive
payoff if the stock price exceeds $65. If the stock price does not go above $60, the
buyer may choose not to exercise the option and will lose the $5 paid as a
premium to the option seller.
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Short Call
The payoff for the option writer is exactly opposite to the payoff of the option
buyer.
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A trader buys a put option on stock ABC with a strike price of $90 and one month
to expiry. The buyer pays the seller an upfront premium of $8. The stock is
currently trading at $90. Upon expiry, the buyer will have positive payoff if the
stock price falls below $82. If the stock price does not fall below $90, the buyer
may choose not to exercise the option and will lose the $8 paid as a premium to
the option seller.
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The payoff for the option writer is exactly opposite to the payoff of the
option buyer.
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Option Strategies
There are various option strategies through which an investor can take a bullish or
bearish view on the underlying security. To maximize the payoff, these strategies
require simultaneous buying and selling of various options of the same
underlying.
Unlimited profit,
Long call Buy call option
limited loss
Limited profit,
Short put Sell put option
unlimited loss
Limited profit,
Covered call Buy stock and sell call option
Bullish unlimited loss
Limited profit,
Short call Sell call option
unlimited loss
Unlimited profit,
Long put Buy put option
limited loss
Bearish
Sell put option; buy another put
option at a higher strike price
Limited profit,
Bear spread (or)
limited loss
Sell call option; buy another call
option at a higher strike price
Long Unlimited profit, Buy call and put option at the same
straddle limited loss strike price
Long condor Limited profit, Sell put and buy put at higher
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Short Limited profit, Sell call and put option at the same
straddle unlimited loss strike price
Range
Buy put and sell put at higher strike
Bound price;
Limited profit,
Short condor
limited loss Sell call and buy call at higher strike
price
Greek Letters
“Greeks” are a measure of the risks involved with taking a position in an option.
The risk variable is the results of a relationship or the assumption of the option
with another underlying variable.
There are five Greeks: delta, gamma, theta, vega, and rho.
in the price of the underlying asset. Delta and Gamma are used by people who are
trying to hedge positions in options.
Theta options have a limited time frame and, because of this, the time value
portions of their prices decay as the expiration date moves closer. Time sensitivity
itself changes the value of the option.
RHO is the rate of change between an options values and the interest rate. In
other words, sensitivity to the interest rate.
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Vega is the rate of change of the value of the option with respect to the
volatility of the underlying asset.
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Rho is the rate of change of the value of the option with respect to the
change in the interest rate.
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Black-Scholes Model
S = sport price
o = implied volatility
The value of delta for any non-exotic option lies between -1 and +1.
Implied volatility, strike price, interest rate, and time to maturity are known
variables of the model and are assumed to be constant. As the spot price is the
only stochastic variable taken into consideration in the Black-Scholes model, it is
known as a “single factor” model. It calculates European-style call or put options
prices based on the assumption that the stock does not pay dividends.
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The function N(x) is the cumulative probability distribution function for the
standardized normal distribution (mean = 0 and standard deviation = 1). In other
words, it is the probability that a variable with standard normal distribution N(0,
1) will be less than x.
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Example
The prices of European-style call and put options are calculated as:
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C = Option premium
The value of delta for any non-exotic option lies between -1 and +1.
If a call option has a delta of 0.6, this means that when the price of the underlying
asset changes by a small amount, the option price changes by 60% of that
amount.
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In the above diagram, the stock price corresponds to point A, and the option price
corresponds to point B. Thus, the delta will be the slope of the line indicated in
the diagram.
Delta Hedging
For example, suppose the price of a stock is $100, and the price of a call option of
the same stock is $10, with a delta 0.6. An investor has sold 20 call options,
assuming each contract represents 100 shares of the underlying stock. The
investor’s options position can be hedged by buying 0.6*100*20=1200 shares.
The gain (loss) on the options position would then tend to be offset by loss (gain)
on the stock position.
If the stock price goes up by $1, the result is a gain of $1,200 on the stock
purchases. The price of the sold call option goes up by 0.6*$1=$0.6, producing a
loss of $1,200 on the written options position.
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If the stock price goes down by $1, the result is a loss of $1,200 on the stock
purchases. The price of the sold call option goes down by 0.6*$1=$0.6, resulting
in a gain of $1,200 on the written options position.
For the example above, the delta of the option position is 0.6*20*100=1200. In
other words, the investor loses 1200*ΔS on the short option position when the
stock price increases by ΔS.
The delta of the stock is 1.0. So, for a long position of 1200 shares in the stock, the
delta will be 1200.
In this case, the delta of the investor’s overall position is zero. The delta of the
stock position offsets the delta of the options position. A position with a delta of
zero is known as “delta neutral.”
Continuous changes in the option's delta value mean that the investor’s position
remains delta-hedged for only a short period of time, and the hedge needs to be
adjusted periodically. This is known as position rebalancing.
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Dynamic delta hedging is the process by which the delta is periodically adjusted in
response to movement in the underlying asset prices.
Continuing from the above example, let’s say that, at the end of two days, the
stock price increases to $110. An increase in the stock price leads to an increase in
the delta. The delta increases from 0.6 to 0.65, and an extra 0.05 delta would
require an extra 0.05*2000=100 shares to be purchased for the delta to be
hedged.
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The binomial option pricing model (BOPM) is extensively used for option pricing
because it can value options over time. This makes BOPM a very useful tool for
valuing American-style and exotic options that can be exercised before the expiry
date.
The BOPM starts with the current stock price as the initial node and generates a
price tree based on the expected up move (u) and down move (d) at various time
intervals. The subsequent prices of the underlying assets are calculated using the
up move and down move factor, the volatility of the underlying asset, and
passage of time between two steps. The up move and down move factors are
calculated as:
The binomial value is calculated at each node for a risk-neutral portfolio. The
portfolio value from the up move of the underlying must be equal to the value
from the down move of the underlying under a no-arbitrage condition. Solving
the equation and discounting it to the present value provides the current value of
the riskless portfolio. The present value of the portfolio is equal to the delta unit
of the stock minus the value of the call option.
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Example
The value of the portfolio at up move is $110 Δ - 5, and the value of the portfolio
at down move is $90 Δ. The value at both the nodes of the binomial tree must be
equal. Hence Δ = 0.25. The future value of the riskless portfolio is $22.5. The
present value of the portfolio is $22.2205, calculated by discounting the future
value of the portfolio using the risk-free rate. The present riskless portfolio is $100
Δ - call option = $ 22.2205. The value of the call option calculated using BOPM,
with three months to expiry, is $2.7795.