Professional Documents
Culture Documents
CERTIFICATE
WORKSHOP
Facilitated by
Andre Kurten
TTC 2013
Examination Procedure
The examination consists of a single paper of 2 hours duration divided into the following 9
topic baskets:
TTC 2013
INTERMEDIATION
FUNDS
FIRMS
FUNDS
FINANCIAL
INTERMEDIARIES
INSTRUMENTS
HOUSEHOLDS
INSTRUMENTS
FIRMS
FUNDS
HOUSEHOLDS
SURPLUS
UNITS
INSTRUMENTS
DISINTERMEDIATION
GOVERNMENT
DEFICIT
UNITS
TTC 2013
centre's
Its offices are based in Paris
Over 14,000 members in 79 countries
Four regions the Americas, Asia Pacific, Europe, and Middle
East/Africa
Mission Statement to be regarded within the business community, financial
services industry and by the authorities and media, as the leading association
representing the interests of the financial markets and to actively promote the
educational and professional interests of the financial markets and industry
TTC 2013
Section 1
Section Objectives
To understand the principles of the time value of money. To be
able to calculate short-term interest rates and yields, including
forward-forward rates, and to use these interest rates and yields
to calculate payments and evaluate alternative short-term
funding and investment opportunities. Candidates should know
what information is plotted in a yield curve, the terminology
describing the overall shape of and basic movements in a
curve, and the classic theories which seek to explain changes in
the shape of a curve. They should also know how to plot a
forward curve and understand the relationship between a yield
curve and forward curves.
Benchmark Rates
London Interbank Offered Rate LIBOR is calculated by the
BBA (British Bankers Association) and is a mean (average) of
all the rates collected from the 16 reference banks and
published by 11h00 UK time (GMT). This rate applies to ALL
currencies traded in London.
EURIBOR is the EUR Interbank Offered Rate calculated by
the EBA (European Bankers Association) and is a mean of all
the rates collected from the 57 reference banks (47 from
European countries) and published by 11h00 Central
European Time (CET).
TTC 2013
InterPFsruetsteanrrentveV
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Simple Interest Calculations
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Amount at maturity
Yield
Amount at inception
or
day basis
- 1 x
x 100
day count
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Bond and Money market basis
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annual rate
-1
0.0465
1
- 1 0.04704 or 4.704%
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1 annual rate - 1 x 2
Yield Curves
Classic or Normal Yield Curve
Rate
Maturity
This yield curve is gently upward sloping. A positive yield curve is steeply
upward sloping. The Liquidity preference theory is used to explain a
classic yield curve. A positive yield curve would be explained by the
interest rate expectations theory
TTC 2013
Yield Curves
Inverse or Negative Yield Curve
Rate
Maturity
Yield Curves
Humped Yield Curve
Rate
Maturity
TTC 2013
Yield Curves
Flat Yield Curve
Rate
Maturity
TTC 2013
Interpolation
You may be required to do straight-line interpolation in
the exam. This is finding a rate between two points
given the rates around that point. The assumption is
that it falls on a straight line between the two rates
given.
For example. Given the 3 month (90 day) rate of
3.50% and the 6 month (180 day) rate of 4.10%
calculate the 4 month (120 day) rate.
4.10-3.50 = 0.60. this is the amount by which the rate
increases on a straight line basis between 3 and 6
months. Divide 0.60 by 3 = 0.20. this is the rate
increase per month. Add 0.20 to 3.50 = 3.70% which is
the 4 month (120 day) rate.
TTC 2013
BUS
SUM
TIME
SOLVE
CURRX
EDIT
DELET
NEW
Choose NEW and the then start typing your equation using the alpha
TTC 2013
Formula programming
HP17BII Programmable calculator
Go to the solve function and follow the prompts to type in these formulae
Forward forward pricing for FRAs
FRA=((1+(LRxLDDB100))(1+(SRxSDDB100))-1)x(DB(LD-SD)x100)
Settlement amount of FRA
FRASET=(DAYSx(LIB-FRA)xAMTDB100) (1+(LIB100xDAYSDB))
Secondary market price for CDs
CD=FVx(1+(IDDBxCR100)) ((1+(RDDBxMR100))
Forward Points for forward FX
PIPS=(SPTx((1+(QCxDY100DBQ))(1+(BCxDY100DBB)))-SPT
Simple interest Present value formula
PV=FV(1+(IRxDAYSDB100))
Discount to yield
YLD=DR(1-(DR100xDAYSDB))
Effective rate
EFF=((1+(R1100xD1DB))x (1+(R2100xD2DB))x(1+(R3100xD3DB))x
(1+(R4100xD4DB))-1)x(DB(D1+D2+D3+D4)x100
TTC 2013
Formula abbreviations
Forward forward pricing for FRAs
FRA = forward forward rate LR = long rate LD = long days SR= short rate SD= short
days DB = day basis
Settlement amount of FRA
FRASET= FRA settlement amount DAYS = days in the forward period LIB = LIBOR (or
equivalent FRA= FRA rate AMT= notional DB = day basis
Secondary market price for CDs
CD = Secondary market proceeds FV = face value ID = initial days DB = day basis CR
= coupon rate RD= remaining days MR= market yield
Forward Points for forward FX
PIPS= Forward points SPT = Spot QC= quoted currency interest rate DY = days
DBQ= day basis for quoted currency BC= base currency interest rate DBB= Day basis
for base currency
Simple interest Present value formula
PV= present value FV= future value IR= interest rate DAYS = days in period DB= day
basis
Discount to yield
YLD= true yield DR= pure discount rate DAYS= days DB= day basis
Effective rate
EFF= annual effective rate R1 = rate 1 D1 = days in period 1 DB= day basis R2, R3
etc same as for R1 and D1
TTC 2013
Section 2
Section Objectives
To understand the function of the money market, the
differences and similarities between the major types of cash
money market instrument and how they satisfy the
requirements of different types of borrower and lender. To
know how each type of instrument is quoted, the quotation,
value date, maturity and payment conventions that apply
and how to perform standard calculations using quoted
prices. Given the greater inherent complexity of repo, a good
working knowledge is required of its nature and mechanics.
or YIELD Instruments
Deposits-call
and term
Certificates of Deposit (CDs)
Discount
Instruments
Treasury Bills
Bankers Acceptances
Interbank Deposits
Deposits made between banks and financial
institutions
Why do banks deal with each other in the
Interbank market?
How do we distinguish between a domestic
currency and a euro currency?
TTC 2013
Quotation of prices
Prices in the money market are ALWAYS quoted
as percentages per annum, either in decimals or
fractions
Two sides to every price BID and OFFER
Difference between bid and offer is known as the
SPREAD.
Most centers use Bid/Offer for cash.
NB: London market uses Offer/Bid for cash in other
words Bid/offer for assets.
Bid for assets
Offer for cash
5.25/5.15
Dealing on prices
Whenever you are quoted an interest rate or price
by the market, you will ALWAYS borrow (buy) at
the higher price and lend (sell) at the lower price.
When YOU are quoting a price to a customer they
will always borrow (buy) from you at the higher
price and lend (sell) to you at the lower price.
If the market quote for USD deposits is 5.25/15
then you would borrow at 5.25 and lend at 5.15.
This principle is VERY IMPORTANT as many
questions will test your ability to identify the side
on which you are dealing as part of the question.
TTC 2013
Discount Instruments
Issued at a discount to Face value
Has no coupon rate
Face value repaid at maturity date
Fixed maturity date
To compare the return on discount
instruments with interest bearing
instruments, you need to convert the
discount to a yield
Bankers acceptances (eligible Bills are
often referred to as two name paper)
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Discount Paper ACI Formulas
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TTC 2013
Certificates Of Deposit
Certificate issued in bearer form mostly
immobilized and held by custodians
Has a fixed maturity - usually up to Five
years, but liquid up to one year
Has a fixed interest rate - the Coupon rate
Interest paid at maturity
Tradable - secondary market
Unsecured like normal deposits
Only issued by banks
TTC 2013
Trading CDs 1
Issued at face value (denominated in millions)
Traded in Secondary Market at current market rates
To calculate secondary market price you need:
Face value or Par value of CD
Coupon or issue rate
Yield (Current rate at which CD is traded)
Days from issue to maturity
Days from settlement to maturity
TTC 2013
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TTC 2013
CD Exercise
Give the following information:
Face Value
= $1m
Issue Rate
= 6.50% p.a.
Full tenure
= 180 days
Remaining tenure = 60 days
Yield
= 6.00%
Date convention = ACT/360
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7x360
120x10
TTC 2013
Yield to Discount
Some discount instruments are quoted as a yield to
maturity, but are discount instruments.
The purchase price is calculated in the same way as CD
consideration by using the present value calculation.
Here we use the face value as the maturity value.
Euro currency commercial paper ECP and GBP
(Sterling) Treasury Bills are traded on a true yield rather
than a straight discount.
Please note that GBP Treasury Bills are issued for
91,182,or a maximum of 364 days.
US domestic commercial paper USCP trades on a
straight discount and cannot be issued for more than 270
days.
TTC 2013
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Exercise 4 - Solution
6.38%
TTC 2013
bond
Cash
Repo
buyer
At Maturity
Repo
seller
Bond
Repo
buyer
The party providing collateral at inception is known as the repo or the repo
seller and the party providing cash is known as the reverse repo or repo
buyer.
TTC 2013
TTC 2013
TTC 2013
Sell/Buy Back
Two separate bond market transactions; a sale (purchase) in
the spot market and a purchase (sale) in the forward market
Repo rate not explicit, but is implied in the forward price
The right to any coupon during the life of the repo accrue to
the BUYER of the securities. It will be refunded to the SELLER
in the buyback price.
Because full title passes in the spot leg from SELLER to
BUYER, ISMA documentation does not apply (although most
counterparties will have ISMA/GMRA agreements in place
with each other)
Margining is unusual with these repos and is usually done by
repricing the repo
Sell/buy backs CANNOT be open ended
TTC 2013
Section 4
Foreign Exchange
TTC 2013
Section Objectives
To understand and be able to apply spot exchange rate quotations. To
understand basic spot FX dealing terminology and the role of
specialist types of intermediary. To recognise the principal risks in spot and
forward FX transactions. To calculate and apply forward FX rates, and
understand how forward rates are quoted. To understand the relationship
between forward rates and interest rates. To understand time options. To
be able to describe the mechanics of outright forwards, FX swaps and
forward-forward FX swaps, explain
the use of outright forwards in taking currency risk and explain the use of
FX swaps in rolling spot positions, hedging outright forwards, creating
synthetic foreign currency assets and liabilities, and in covered interest
arbitrage. To display a good working knowledge and understanding of the
rationale for NDFs. To be able to recognise and use quotes for precious
metals, and demonstrate a basic
understanding of the structure and operation of the international market in
precious metals.
Forex Jargon
Value date - the date when delivery takes place on a currency
deal
Spot date - two business days after deal date
Bid- the rate at which the price maker is willing to buy the
BASE Currency
Offer - the rate at which the price maker is willing to sell the
BASE Currency
Spread - the price makers margin between the bid and offer
price
Direct quote - 1 unit of USD in relation to quoted currency e.g.
USD/JPY = 114.25/75
Indirect quote- 1 unit of currency other than the USD in
relation to USD e.g. EUR/USD 1.3925/45.
NOTE: The currencies quoted indirectly against the USD are
the EUR,GBP, AUD, NZD. All others are quoted directly.
TTC 2013
Forex Jargon
Reciprocal
Cross rates
An
TTC 2013
Cross rates
We
1.5000/1.5000 = 7.2500/1.5000
1CHF = HKD4.8333
or CHF/HKD= 4.8333
There are some simple rules which help!!!
TTC 2013
USD/HKD= 7.2515/7.2545
USD/CHF = 1.5030/1.5050
BID
= 7.2515/1.5050 = 4.8183
OFFER = 7.2545/1.5030 = 4.8267
CHF/HKD =4.8183/4.8267 (spread is 84 points)
TTC 2013
USD/HKD= 7.2515/7.2545
GBP/USD = 1.4030/1.4050
BID
= 7.2515x1.4030 = 10.1739
OFFER = 7.2545x1.4050 = 10.1926
GBP/HKD=10.1739/10.1926 (spread is 187 points)
TTC 2013
1 YR
CHF 1.25
TTC 2013
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Forward FX formula
Where:
TCIR = terms currency interest rate
BCIR = base currency interest rate
TCDB = terms currency day base
DCDB = base currency day base
TTC 2013
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TTC 2013
1 YR
5%
1%
Quoted currency
Interest rates
Are higher than
Quoted currency
interest rates
Base currency
Interest rates
Points Positive
Base currency
Interest rates
The currency with the higher interest rate in the quoted pair is at a forward
discount to the other currency irrespective of whether it is the base currency
or not.
It is cheaper to buy the discount currency in the forward market.
TTC 2013
FX time Options
Banks
TTC 2013
7.8690
7.8740
GBP/USD
1.5330
1.5340
GBP/NOK
12.0632
3mth outright
12.0787
TTC 2013
118
230
320
410
NOTE:
Always assume 4 decimal places
after the big figure when using
forward points. (except for JPY
where 2 decimal places apply) The
11 points in the 1 week will be
written as 0.0011. Where a comma
appears in the quote then any
figures after the comma are extra
decimal places. The 1.5 points in
the S/N is then written as 0.00015
Where point are shown as PAR it
means they are zero.
TTC 2013
NDF Example
3-month NDF in USD/CNY at 6.2500.
Notional principal USD 10 million
2 scenarios in 3 months time:
1. USD/CNY fixes at 6.2600.
Difference of 100 pips on USD 10m is CNY100,000.
Settlement occurs in USD so 100,000/6.2600 = USD
15,974.44 seller pays the buyer.
2. USD/CNY fixes at 6.2300.
Difference of 200 pips on USD 10m is CNY200,000.
Settlement occurs in USD so 100,000/6.2300 = USD
32,102.73 Buyer pays the seller.
If this contract was used to hedge, the hedgers effective
exchange rate will be the NDF rate provided they can
procure the additional USD at the fixing rate in the spot
market
TTC 2013
Section 4
Forward Interest
Rates, FRAs, Futures,
and Swaps
TTC 2013
Section Objectives
To understand the mechanics of and how to use
TTC 2013
for motor
manufacturers
Speculation
Gearing
losses)
Big market moves
Simulation
Creating
a synthetic portfolio
Arbitrage
To take
F
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Where
FR = forward rate
LR = long rate
SR = short rate
SD = short days
DB = day base
LD = long days
TTC 2013
TTC 2013
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TTC 2013
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TTC 2013
FRA - Terminology
Contract amount:- The Notional Principal Amount e.g. R50m used in the
settlement calculation
Contract currency:The currency in which the contract amount is
denominated
Contract rate:- The fixed interest rate agreed under the FRA agreement
Dealing (transaction) date:- The date on which the FRA deal is struck and
the FRA rate is agreed
Fixing date:- The date when the reference rate is determined (could be
different to the settlement date)
Settlement (value) date:- The date on which the notional borrowing or
lending commences and the date on which settlement on the FRA is
made
Maturity date:- The date on which the notional borrowing or lending
matures
TTC 2013
FRA - Terminology
Forward period:- The number of days between the settlement and the
maturity date of the FRA
Reference rate:- The market-based interest rate used on the fixing date to
determine the settlement amount payable/receivable e.g. 3 month LIBOR
Settlement amount:- The amount paid by one party to the other on the
settlement date of the agreement, based on the difference between the
contract rate and the reference rate, calculated on the notional amount of
the FRA. Interest is usually paid in arrears, but the settlement on the FRA is
paid at the start of the interest period (settlement date on the FRA). The
settlement is therefore discounted or net present valued by using LIBOR
fixing rate.
TTC 2013
FRA - Diagram
Contract period
(FRA can be closed out)
Deal Date
when FRA rate
is agreed
Fixing Date
when benchmark
is determined
Forward period
(notional borrowing period)
Settlement Date
when net payment
is made
Maturity Date
nothing
happens here!
borrows again
matures
TTC 2013
invests cash
matures
12
6 months time
2 scenarios 6-month LIBOR fixes at 3.75% or 4.50%
Scenario 1
Invests 100m at current 6-month LIBOR 3.75%
LIBOR is below FRA rate so they receive the difference 0.50%
Effective return on investment is 4.25% for 6 months (3.75 + 0.50)
Scenario 2
Invests 100m at current 6-month LIBOR 4.50%
LIBOR is above FRA rate so they pay the difference 0.25%
Effective return on investment is 4.25% for 6 months (4.50 0.25)
NOTE: IRRESPECTIVE of LIBOR rate their return is 4.25%
TTC 2013
TTC 2013
( iL - i F ) x N x
1+
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d
B
TTC 2013
0.0625 X 90/360
= 109,375/1.015625
= 107,692.31 paid by FRA seller to buyer
TTC 2013
TTC 2013
TTC 2013
Tick values
3-month USD, CHF, and EUR futures have a full tick value of
25 of the contract currency. For every 1 point move in price
(0.01%), the contract value will change by 25. (1m x 0.01% x
3 12).
3-month GBP futures have a full tick value of 12.50.
(500,000 x 0.01% x 3 12)
3-month JPY futures have a full tick value of 2500. (100m
x 0.01% x 3 12).
A tick is usually also used to described as the MINIMUM
price movement allowed on a contract. It has become
common however that contracts trade in half ticks or in the
case of the Eurodollar contract on the CME in 1/4 ticks on the
near contract. A half tick would be denoted in the price as
0.005 and quarter ticks by 0.0025. for example or 95.4275
would indicate that the contract price includes a quarter tick.
TTC 2013
Price
M-T-M
Margin due or
(owing) in USD
Buy 20 contracts
94.50
94.65
7,500
Buy 50 contracts
94.55
94.65
12,500
Sell 50 contracts
94.60
94.65
(6,250)
Buy 20 contracts
94.55
94.65
5,000
Sell 30 contracts
94.65
94.65
Margin due
to you
18,750
Note that the exchange MTM each trade, but settles the net amount due at the end
of the day. Although 170 contracts were traded, Initial margin will only be required on
the OPEN position at the end of the trading day i.e. on 10 contracts.
TTC 2013
FRAs
Sell FRAs if you
Term of
swap
Price at
which the
bank will
pay fixed
Spread quotation
Basis points
added to current
government
bond price to
arrive at
absolute swap
rate
Price at
which the
bank will
receive
fixed
Current
government
bond price
Period
Bid
Offer
Period
Bid
Offer
Govn
1 Yr
5.75
5.80
1 Yr
+2
+7
5.73%
2 Yr
5.80
5.85
2 Yr
+4
+9
5.76%
3 Yr
5.85
5.90
3 Yr
+3
+8
5.82%
4 Yr
5.87
5.92
4 Yr
+1
+6
5.86%
5 Yr
5.90
5.93
5 Yr
+3
+6
5.87%
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TTC 2013
PARTY B
PARTY A
A RECEIVES floating from B
Settlement calculation
1 year Plain vanilla IRS fixed against 3 mth LIBOR
0
Start date
First fixing
Second fixing
Settlement of
first fixing
6
Third fixing
Settlement of
second fixing
9
Fourth fixing
Settlement of
third fixing
12
Settlement of
fourth fixing
Swap matures
Section 5
Options
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Section Objectives
To understand the fundamentals of options. To
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Definition of an Option
An option is a contract that gives the holder (or
buyer) of the option the right, but not the
obligation to buy (or sell) a specified quantity
and quality of a certain asset within a specified
period or on a specific date, at a price agreed
when the contract was entered into. For this
right, the buyer pays a premium and the seller
is obliged to honour the contract if called on to
do so by the holder.
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Options Characteristics
The premium of an option is payable when the option is
traded. For currency options, the premium is payable value
spot. For caps and floors the premium can be paid at the
start or over the life of the option.
The exercise price of the option is known as the STRIKE
price.
When buying options the most you can lose is the premium.
NOTE: The CREDIT RISK on a long option position can be
GREATER than the premium paid.
Selling options carries far greater risk than buying options.
Only options which are in-the-money will be exercised at
expiry
Out-the-money options expire worthless
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Valuing Options
Call values Put values
when
Rise
Fall
Fall
Rise
Rise
Rise
Volatility rises
Fall
Fall
Volatility falls
Fall
Fall
Rise marginally
Fall marginally
Fall marginally
Rise marginally
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LONG CALL
Profit
SHORT CALL
Premium
B
Asset price
Premium
LONG CALL
Limited downside risk with
unlimited profit potential
Loss
Asset price
Loss
E = exercise price
B = breakeven
SHORT CALL
Unlimited downside risk with
limited profit potential
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Profit
E
0
Premium
Asset price
0
B
E
Premium
Loss
SHORT PUT
Profit
Asset price
Loss
LONG PUT
E = exercise price SHORT PUT
Limited downside risk with limited
Limited downside risk between
B = breakeven
profit potential between
breakeven and zero
breakeven and zero
with limited profit potential
Buy a put when you expect a fall in the underlying market price
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0
E
Loss
Sell both a call and put option with the same strike price, notional value,
and expiry date
Expect very low volatility during the life of the strategy
Maximum profit = premium earned, with unlimited downside
ATM Straddles are delta neutral
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0
E
Loss
Buy both a call and put option with the same strike price, notional value,
and expiry date
Expect volatility to be high during the life of the strategy
Maximum loss = premium paid, with unlimited upside
ATM Straddles are delta neutral
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0
A
Asset Price
Loss
Sell a call and a put with different strike prices same expiry date
and notional amount.
This is a strategy to benefit from low volatility
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Asset Price
Loss
Profit
Short Put
0
Long Call
Loss
Long call + Short put with same strike, notional, and expiry =
SYNTHETIC LONG ASSET POSITION
In theory the price of ATM puts and calls have the same premium and therefore the cost of
constructing a synthetic long asset should have little or no premium cost.
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Profit
short Call
0
E
Loss
Long put + Short call with same strike, notional, and expiry =
SYNTHETIC SHORT ASSET POSITION
In theory the price of ATM puts and calls have the same premium and therefore the cost of
constructing a synthetic short asset should have little or no premium cost.
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Delta
Delta measures the change in the option premium (price)
resulting from a change in the price of the underlying asset
The term delta neutral refers to the fact that the option writer
or buyer has sold (or bought) the exact proportion of
underlying asset to neutralize the effect that the underlying
price has on the option premium, all other factors remaining
the same.
Delta on long calls ranges between 0 and +1 and you SELL
the underlying to delta hedge
Delta on short calls ranges between 0 and -1 and you BUY
the underlying to delta hedge
Delta on long puts ranges between 0 and -1 and you BUY
the underlying to delta hedge
Delta on short puts ranges between 0 and +1 and you SELL
the underlying to delta hedge
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Delta Values - 1
Delta hedging is done to neutralize the change in the option
premium value.
For options that are at the money (ATM), the delta is usually
0.50 (50%). This means for a 1c move in the market, the
premium should change by 0.5c. To delta hedge a short
ATM USD/CHF call option in 10m USD, the dealer would
need to BUY 5m USD to be delta neutral. The effect is that
as the option goes in the money the option value would
increase and the option writer would be losing money but
because he has bought 5m USD, he will make money on
this position, thus neutralizing the loss on the option. If the
option goes out of the money, the option writer will make
money on the option, but lose on the delta hedge.
Dealers who trade an options curve will use delta hedging
as they are looking to make money from the volatility of
price and not the direction of price.
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Delta Values- 2
As call options go in the money, the holder (buyer) would needs to
sell the underlying to remain delta neutral. They are getting long of
the underlying through the option. The delta would range between
+0.50 and +1. The opposite is true for the person who has written
the call as they would be getting short of the underlying so their
delta would range between
-0.50 and -1 and they would need to buy the underlying to remain
delta neutral.
As put options go in the money, the holder (buyer) would needs to
buy the underlying to remain delta neutral. They are getting short
of the underlying through the option. The delta would range
between -0.50 and -1. The opposite is true for the person who has
written the put as they would be getting long of the underlying so
their delta would range between +0.50 and +1. they would need to
sell the underlying to remain delta neutral.
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Currency Options
Characteristics
A currency option is described as at the money
when it has a strike price EQUAL to the forward
exchange rate.
A Call on one currency is a Put on the other
currency.
For example, a USD/ JPY call option is a Call on
USD and a Put on JPY.
Currency option premiums are payable value spot
after the deal date as a percentage of the base
currency notional amount.
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Section 6
Principles of Asset
and Liability
Management
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Section Objectives
To understand the fundamentals of Asset & Liability
Management as a practice of managing and hedging risks that
arise due to mismatches between the asset side and the
liability side of the balance sheets of a
bank. To explain how main risk factors like funding and
liquidity risk, market risk (FX, Interest Rate, Equity,
Commodity, etc.), credit risk, leverage risk, business
risk and operational risk are interrelated and how they affect
the balance sheet of a financial institution. To describe
common risk management and hedging techniques which
help control these effects and to understand how these
techniques are used to set up a state-of-the-art ALM
approach.
What is ALM?
ALM Incorporates the modern techniques used in
profitability and risk management of commercial
banks. These involve the following:
Creating shareholder wealth
Profit centre management
Risk-adjusted performance management
Pricing of credit risk and loan provision
The management of interest rate and liquidity risks
As competition is reducing bank margins, the need for more
precise information and a complete asset and liability
management system is becoming an absolute necessity.
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Return on equity
There are five key variables driving ROE
Earnings on assets (EOA)
ROE
Capital Adequacy
Types of Capital
Three tiers of capital:
Tier 1 (going concern capital) common equity capital, declared reserves, current
years audited profits.
Under BASEL III there are new targets for capital.
The common equity in Tier 1 must be a minimum of 4.50% with a 2.50% conservation
buffer making a total of 7.00%
Tier 1 capital must be a minimum of 6.0% with a conservation buffer of 2.50% making
Tier 1 total 8.50%. Total capital must be 8% with a 2.50% conservation buffer making a
total of 10.50%
Tier 2 (gone concern capital) comprises undisclosed reserves of the bank and
subordinated term debt with a maturity of 5 years or longer , certain reserves and
general provisions. Tier 2 capital can NEVER be more than 100% of tier 1 capital.
Tier 3 Bonds issued to support the trading book of a bank and no longer used.
NOTE: Under BASEL III certain Tier 2 capital will go from being bonds to common
equity if the banks capital ratio falls below a certain level. These are referred to as
CoCos (contingent convertibles). Gone concern capital is where the Tier 2 bonds lose
their status and become common stock if the bank goes into liquidation.
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Capital Adequacy
Credit Risk
Trading Risk
Operational Risk
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Issuing Bank
Removes assets
Balance sheet
Frees up capital
Assets against which the
bonds are issued
Trust or SPV
Bond Market
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Stress testing
These are tools used to identify and manage situations which can cause
extra-ordinary losses. They can be based on the following:
1. Replication of the strongest market shocks which occurred in the past
2. Statistical measures with extreme multiple of historical volatility
3. Subjective assumptions such as a 100BP move up or down in the Yield
Curve
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Section 7
Principles of
Risk
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Section Objectives
To understand why risk is inherent in banks business models
and why effective risk management is a key driver for banks
success. Candidates will be able to describe major risk
groups: credit, market, liquidity, operational, legal, regulatory,
and reputation risk. They will understand the significance of
risk groups for different banking businesses and units.
Candidates will also get an overview about methods and
procedures needed to manage these risk types and extend
their understanding to different risk/return profiles of
shareholders, regulators and debt providers.
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Treasury Risk
Volatile exchange rates and interest rates together with a
market environment that has become increasingly complex,
makes risk management within the treasury a vital function.
Treasury risk management staff must have a trading
background or at least some technical skill to deal with the risk
control function within the treasury. Lack of expertise can
result in losses.
Segregation of duties and reporting is also vital within the
treasury environment
A professional standards review in addition to the conventional
audit is also recommended to review the conduct of treasury
officers
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Credit Risks - 1
Default Risk (counterparty risk) - Exposure to the
likelihood or possibility that a counterparty to an outstanding
transaction my not be able to settle due to bankruptcy or
liquidation. Such a loss leads to the product of the exposure at
default (EAD) and the loss given default (LGD).
Country Risk - Caused mainly by a currency crisis where
borrowers are unwilling or unable to settle outstanding
transactions. Political and economic factors play an important
role in the assessment of country risk. There are many reports
generated by industry bodies detailing current economic and
political events within countries.
Settlement Risk - Usually the risk that payment is effected
on a currency transaction without the receipt of payment in turn
from the counterparty to the transaction. In currency settlement
this risk is referred to as HERSTATT RISK. CLS Bank is the
safest way to mitigate settlement risk
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Credit Risks - 2
Replacement risk
This is the cost of replacing a deal which is in default. For
example, if you enter into a deal to purchase currency at a
forward date and the counterpart to the trade cannot deliver,
you can cancel the deal and enter into a new deal to replace the
exiting deal. Any price over and above the original price paid is
the replacement cost. So you will only lose money if there was a
positive unrealized P&L. The only time the full capital amount is
at risk is when delivery has already been effected and cannot
be revoked. The process of marking-to-market allows a bank to
assess the replacement risk on all outstanding deals on an
ongoing basis. Close out netting is the commonly used netting
where a counterparty is in default.
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Market Risks
Currency Risk (exchange rate risk) - The cost of closing
out open foreign exchange positions in currencies to which the
treasury is exposed. This can be as a result of FX or FX
derivative positions. A common benchmark for controlling risk
in this area is the maximum loss permissible for one day on
open positions. Real time feeds help to monitor the intra day
risk on open positions. Different currency exposure may result
from
Transaction exposure spot or forward transaction losses
money due to a change in the exchange rate
Translation exposure - value of foreign assets or profits of
multinational company due to a devaluation of currency
Economic exposure - business profits affected by a change
in the exchange rate for exporters or importers
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Market Risks
Interest Rate Risk
Exposure to the changes in interest rates for interest rate
products such as bonds, FRAs, IRSs, caps, floors, and Interest
rate futures. Banks also consider the risk of yield curve
changing relative to the mismatch between assets and
liabilities. Liquidity ladders should be managed to gauge
mismatches and monitor the banks liquidity position.
NB a vital risk which needs to be carefully managed!!
Equity Risk the risk that a market position is sensitive to
equity market performance (stocks, stock index futures,
options)
Commodity risk the market value of a position is
sensitive to commodity price changes
Volatility risk a market position is sensitive to the volatility
of prices in FX, interest rate, equity and commodity markets
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Risk reporting
Risk system development good revaluation
Limit approval
Timeous inputting of deals
Matching of hedges with the hedged instrument
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Other Risks
Legal Risk - Caused by ineffective contracts which result in the inability to enforce
them. Before dealing with a client, banks should be clear that all the necessary
documentation is in place.
Reputational risk - This is the risk arising from negative perception on the part of
customers, counterparties, shareholders, investors or regulators that can adversely
affect a banks ability to maintain existing, or establish new, business relationships
and continued access to sources of funding.
Reputational risk may give rise to credit, liquidity, market and legal risk all of
which can have a negative impact on a banks earnings, liquidity and capital
position.
Regulatory Risk - Caused by the banks non-compliance with regulation, reporting
and compliance required by the financial authorities and or the Central Bank. The
consequence can be the imposition of fines or in the worse case, the withdrawal of
the financial institutions license to operate.
Specific risk - is a risk that affects a very small number of assets. This is
sometimes referred to as "unsystematic risk". In a balanced portfolio of assets there
is a spread between general market risk and risks specific to individual components
of that portfolio. An example would be the risk of one bond in a portfolio losing value
because of a downgrade of the issuer.
Systemic risk - is the risk of collapse of an entire financial system or entire
market, as opposed to risk associated with any one individual entity, group or
component of a system. It can be defined as "financial system instability, potentially
catastrophic, caused or exacerbated by idiosyncratic events or conditions in
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financial intermediaries. Often referred to as a knock-on effect.
Operational Risk
This is broadly defined as the likelihood of a loss, as
measured by the value of the loss, on the transaction
processed. This is a risk which is CONTROLLABLE
by the bank.
Causes may be as a result of:
Lack of proper procedures
No segregation of duties
Lack of internal controls
Insufficient systems
Manual interventions
Payment authorizations
Unskilled or shortage of staff
Capacity
Disaster recovery policies
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Basic documentation
Basic documentation is necessary to
establish:
The business to be conducted
The limits on deal/transaction size
Who the authorised dealers are that can
bind the company
Who the authorised signatory/s are on
the confirmations
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Netting
What is payment netting?
An example would be where two banks have a
large volume of treasury transactions
outstanding. The net pay and receive amounts
for each could be much reduced if these were
netted off against each other.
Other forms of netting are usually applied when
there is default by a counterparty and open
positions exist. The main reason is to prevent
cherry picking by the liquidators
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Netting-2
Bilateral netting of payments
Agreed between two parties and they enter into
a contract. Very easy to implement from a legal
and systems point of view.
ONE PAYMENT, PER COUNTERPARTY, PER
CURRENCY, PER DAY
Standardised documentation has been set up for OTC
derivatives contracts by industry bodies such as the
International Swap and Derivatives Association (ISDA)
and ICMA (International Capital Market Association)
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Netting-3
Multilateral netting is much more complex and is
easiest to understand when examining the structure
of a CLEARING HOUSE.
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Netting-4
Netting by novation is a netting arrangement where the
existing contracts are netted out and cancelled and replaced
by a single new (nova) contract
Close out netting is applied by an area outside of treasury in
the instance of a bankruptcy. All open positions are marked to
market and a single payment is made to settle all outstanding
commitments. This is usually the type of netting applied in
ISDA and ISMA documentation in the case of a bankruptcy.
Payment netting does not however reduce BIS capital
adequacy guidelines, but does reduce the number of
payments required
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Reconciliation's
Internal recon's position keeping
External recons Nostro accounts
Position keeping electronic with manual
adjustments where required
reconciliation is based on exception
reporting.
Problems are investigated and swiftly handled
to avoid loss or interest penalties
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Section 10
The ACI
Model Code
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Section Objectives
For candidates to have a thorough knowledge of
the provisions of the Model Code and market
practices, with particular emphasis on high
standards of integrity, conduct and professionalism
as well as the monitor and
control mechanisms to be introduced to protect
individuals and their institutions from undue risks
and resultant losses.
Please note that the exam is now based on the new
Model Code
Chapter 1
Business Hours and Time-Zone related issues
1. After hours/off premises dealing proper management
guidelines should be in place to control the process of offsite or after hours dealing.
2. Stop loss orders a clear understanding of these
conditions and ramifications should be reached between
the two parties before a stop loss order is given or
accepted. It is very difficult to definitively determine the
market highs and lows in the case of a dispute on the
trigger of a stop loss order.
3. Position parking this is often done to disguise the risk
on a position. The ACI says that this practice should be
forbidden.
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Chapter 2
Personal conduct issues
1. Entertainment and gifts managements role is to control the
nature of gifts offered and accepted. Entertainment should not be
offered nor accepted where the host is not present.
2.Gambling betting between market participants this should be
strongly discouraged.
3.Personal account trading proper controls should be in place to
avoid conflicts of interest with the dealers job.
4. Customer relationship, advice and liability because of the
complex nature of some products it is incumbent on the dealer to
ensure the customer understands the deal.
5. Confidential information - RESPECT confidential information. Dont
front run orders! Dont place an order with a broker to find out who
the counterparty is so as to make direct contact to conclude a deal.
Dont pressure the broker to give you information which is improper
for them to divulge by threatening to cut off business if they refuse.
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Chapter 3
Back Office, Payments, and Confirmations
1. Confirmations - confirmations should be sent out as soon
as possible after the deal. Brokers should confirm all
transactions to both counterparties immediately by an efficient
and secure means of communication.
2. Verbal confirmations regular verbal check of deals done is
good practice. At least one near the end of the day is
recommended.
3. Payment instructions the use of SSIs is strongly
recommended by the ACI.
4. Netting once again the ACI recommends that where
practical, payment netting should be used to reduce settlement
risk.
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Chapter 4
Disputes, Differences, Mediations and Compliance
1. Disputes and mediation arise mainly due to failure of dealers to
use clear and unambiguous language. Management of both parties
should take prompt action to resolve or settle the issue quickly and
fairly with a high degree of integrity and mutual respect
2. Differences between principals where a disputed deal can result
in a loss it is recommended that one party (preferably with the
agreement of the other) square the position ASAP.
3.Difference with brokers and the use of points where a broker
quotes a price that is unsubstantiated, the bank is entitled to stick
the broker. Any difference between the price proposed and the actual
deal price must be made good by the broker. It is bad practice to
insist on a deal at the original price or to refuse a brokers cheque or a
reduction in the brokerage bill for the difference.
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Chapter 5
Authorization, Documentation and Call Taping
1.Authorisation and responsibility for dealing activity
management should clearly set out, in writing, the
authorizations and responsibilities within which the dealing and
support staff should operate. It is the responsibility of
management to ensure that all employees are adequately
trained and aware of their own and their firms responsibilities.
2.Terms and documentation the use of standard terms and
conditions contained in standardized documentation such as
ISDA and ICMA is strongly recommended.
3.Qualifying and preliminary procedures
4. Telephone recording
5. Use of mobile phones
6. Dealing room security
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Chapter 6
Brokers and Brokerage
1. Role of brokers and the dealer/broker relationship the
choice of brokers is the responsibility of senior management at
the bank. Brokers are to act purely as agent.
2. Brokerage to be agreed in writing between the both the
management of the bank and the brokerage. Failure to pay
brokerage bills promptly is not considered good practice. 3.
Passing of names by brokers brokers should not divulge the
names of principles prematurely, and certainly not until satisfied
that both sides display serious intent to transact. Dealers should
inform brokers, wherever possible, about names they cannot
see for whatever reason
4. Name switching used to close a deal where limits are a
problem for the two original banks.
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Chapter 7
Dealing Practice
1. Dealing at non-current rate and rollovers using historical or noncurrent rates should be avoided. Where it is necessary to do so, it
should be fully documented. It is highly unethical for one party to hold
another to an erroneously agreed rate when the quotation is
demonstrably and verifiably a big figure or more away from the
prevailing market rate.
2. Consummation of a deal broker calls off as bank hits the price =
NO DEAL DONE. Broker hits the bank as the bank calls off = DEAL
DONE! Holding brokers unreasonably to a price is viewed as
unprofessional and should be discouraged by management. Under no
circumstance should brokers inform dealers that a deal has been
concluded when in fact it has not.
3. Dealing reciprocity informal reciprocity arrangements are
unenforceable. However dealers should show integrity and honour.
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Chapter 7
Dealing Practice (continued)
4. Dealing quotations, firmness, qualification and reference the
market participants must ensure that they make it clear whether
the prices they are quoting are firm or just indicative. Brokers
prices should be firm in a marketable amount unless otherwise
stated. Dealers MUST take their prices off with brokers if they no
longer want to deal at the price shown. Brokers have a
responsibility to assist dealers by checking with them whether their
prices are still firm. Where a price is dealt on, then all other prices
in that currency and market are cancelled and the broker will need
to firm up all the bids or offers in that market.
If you cannot do a name offered, the broker can propose another
acceptable name if offered quickly. It is bad practice to revise a
price once dealt on if the name does not work.
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Chapter 8
Dealing Practice for Specific Transactions
1. Dealing using a connected broker where a banker has a
share in a broking firm it should be openly declared.
Chapter 9
14 General Risk Management Principles
The professional dealer must not only understand and manage
the market risk pertaining to a trading position, but should also
be aware of the credit, legal, liquidity and operational risks
related to the business.
1. Promote the highest standard of conduct and ethics
2. Ensure senior management involvement and supervision
3. Organizational structure ensuring independent risk
management and controls
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Chapter 9
General Risk Management Principles
4. Ensure the involvement of a thoroughly professional management
in all administrative processes
5. Provide appropriate systems and operational support
6. Ensure timely and accurate risk management
7. Control market risk exposure by assessing maximum likely
exposure under various market conditions
8. Always recognize importance of market and cash flow liquidity
9.Consider impact of diversification and risk return profiles
10. Accept only the highest standard and most rigorous client
relationship
11. Clients should understand transactions
12. Risk management based on sound legal foundations.
13. Ensure adequate expertise in the support area of risk taking
14. USE JUDGEMENT AND COMMON SENSE!!
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