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ACI DEALING

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:

Section 1 - Basic Interest Rate Calculations - 6 questions - 6 marks


Section 2 - Cash Money Market - 6 questions - 6 marks
Section 3 - Cash Money Market Calculations - 6 questions - 6 marks
Section 4 - Foreign Exchange - 12 questions - 12 marks
Section 5 - Foreign Exchange Calculations - 6 questions - 6 marks
Section 6 - FRAs, Money Market Futures & Swaps - 12 questions - 12 marks
Section 7 - Options - 6 questions 6 marks
Section 8 - Asset and Liability Management - 8 questions - 8 marks
Section 9 - Principles of Risk - 8 questions - 8 marks
Section 10 - The Model Code - 20 questions - 20 marks
Total maximum score 90 marks
The overall pass level is 60% (54 marks), assuming that the minimum score criteria for each of
the topic baskets is met.
There is a minimum score criteria of 60% for the Model Code section and 50% for each of the
other topic baskets.
(extract form the ACI website June 2013)
You may use any financial (or scientific) calculator in the examination as long as it is not TEXT
PROGRAMMABLE. Alternatively the Microsoft on-screen calculator is available on the test
screen. Our recommendation is the programmable HP17BII calculator as formulae for the
exam can be programmed into this calculator saving valuable time when writing the exam.
TTC 2013

The Financial Markets


Where is the market?
Location
Primary and secondary market

Participants in the market


Intermediation
disintermediation

TTC 2013

The Financial System


GOVERNMENT

INTERMEDIATION
FUNDS

FIRMS

FUNDS

FINANCIAL
INTERMEDIARIES

INSTRUMENTS

HOUSEHOLDS

INSTRUMENTS

FIRMS

FUNDS
HOUSEHOLDS

SURPLUS
UNITS

INSTRUMENTS

DISINTERMEDIATION

GOVERNMENT

DEFICIT
UNITS
TTC 2013

The Market Development


Markets are where traders and brokers, are involved
Traders work for banks, stockbrokers, Central banks
Inter-dealer brokers act as agents facilitating trades

between market participants


Market has evolved significantly in the last 30 years
Products traded include:
Currencies
Bonds
Money Market Assets
Commodities
Equities
Derivatives
TTC 2013

The ACI Financial markets Association


Formerly known as the Association Cambiste Internationale
Established in 1955 to bring together forex traders in major

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

ACI has a council of Presidents


AACI has an executive committee
TTC 2013

The Role of the ACI


The ACI Model Code updated in 2013
It contains best practice for ethics and code of conduct as

well as best practice for dealing and operations in the OTC


financial markets
It does not deal with legal matters or technicalities
It aims to set out the manner and spirit in which business is
conducted
The committee for Professionalism - CFP is an ACI body
that is willing to arbitrate disputes between market
participants where all avenues have been exhausted to try
and resolve the dispute between themselves.

TTC 2013

Section 1

Basic Interest Rate


calculations
TTC 2013

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.

One question basket 6 questions


TTC 2013

Day Base Conventions


NOTE: Not all currencies calculate interest using the same day
base convention.
Domestic money markets use:
ACT/365 or ACT/360
The 365 day base currencies referred to in the exam are
GBP,AUD, NZD, HKD, SGD. All other currencies given in
the exam use a 360 day base convention.
NOTE: Euroyen is the only exception which is ACT/365
ACT refers to the actual number of days in the investment
period. You will always be given the days, but NOT the day
base in the exam.
Since 1999 USD Treasury bonds, Euro Denominated
Treasury bonds, GBP Treasury bonds all use ACT/ACT
convention for accrued interest calculations.
TTC 2013

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).

NB: All these benchmarks are quoted to at


least 2 decimal places, but not more than 5.
TTC 2013

Overnight Index Benchmarks

NOTE: All these benchmarks are WEIGHTED AVERAGE


RATES unlike LIBOR and EURIBOR which are simple
average rates
Sterling Overnight Index Average (SONIA) for GBP
Euro overnight index average (EONIA) for EUR
Fed Funds Effective rate for USD
TOIS for CHF . This is a Tom/next rate not an overnight
rate
TONAR Tokyo overnight average rate for Japanese Yen
These rates are used for fixing overnight index swaps OISs
in each of the respective currencies.
TTC 2013

Rates format and basis points


Fractions
Most rates in the exam will be expressed as a
fraction. Therefore they will quote a rate as
4.% which is 4.25%. To calculate the decimal
divide the numerator by the denominator for
example, % is 3 divided by 4 which is 0.75%.
Basis points
1 basis point is 0.01% or 0.0001 as a decimal.

TTC 2013

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Simple Interest Calculations

Interest Earned, Future Value, Present Value,


Yield or Holding period return

Y
ieldinterstintalprincpalxdaybaseactualdysx10
Amount at maturity
Yield
Amount at inception

or

day basis
- 1 x
x 100
day count

TTC 2013

Exercises Simple Interest


1. Invest USD 5,000,000 at 2.50% for 273 days What interest
is due?
2. You invest GBP 1,000,000 at 3.50% for 180 days. What do
you receive back (capital and interest) at maturity?
3. You invest EUR at 2.75% for 60 days and receive 1,025,000
back at maturity. What amount of EUR did you originally
invest?
4. You received 75,000 in interest on EUR5,000,000 invested
for 180 days. What yield did you receive on your
investment?
TTC 2013

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Bond and Money market basis

Given a 360 day rate (Bond basis) calculate the


equivalent 365 day (Money Market Basis) rate

Given a 365 day (Money Market Basis) rate


calculate the equivalent 360 day (Bond basis) rate

TTC 2013

Bond and MM basis - Explained


A bond will pay a round amount of interest as its coupon.
Therefore a $100,000 bond with an annual coupon of 5% will
pay $5,000 in interest at the end of the year (irrespective of the
number of days in the year).
However, a $100,000 money market deposit at 5% for a year
with actual days of 365 will pay interest calculated as follows:
100,000 x 0.05 x 365 360 = $5,069.44
Therefore the a 5% interest rate would offer you a better return
in the money market than the bond market because of the
more favourable day base convention in the money market.
The Money market equivalent of a 5% Bond rate will be
LOWER than 5%.

NB: The MM basis rate will always be LOWER than its


BB Rate equivalent
TTC 2013

Convert semi-annual to annual rate


Formula given in exam

annual rate

semi - annual rate


1

-1

Convert a semi-annual rate of 4.65% to an annual


equivalent:

0.0465
1

- 1 0.04704 or 4.704%

TTC 2013

Convert annual to a semi-annual rate


Formula given in exam

Semi annual rate

1 annual rate - 1 x 2

Convert an annual rate of 4.704% to a semi- annual


equivalent:

1 0.04704 - 1 x 2 0.046499 or 4.65%


TTC 2013

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

The Interest rate expectations theory is used to explain an


inverse yield curve.
TTC 2013

Yield Curves
Humped Yield Curve
Rate

Maturity

The Market segmentation theory is used to


describe a humped yield curve.

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

Menu steps Program the HP 17 BII


Push EXIT key until this menu appears
FIN

BUS

SUM

TIME

SOLVE

CURRX

choose SOLVE and the menu below will appear


CALC

EDIT

DELET

NEW

Choose NEW and the then start typing your equation using the alpha

characters and the numerals and brackets


The equation must have an equal number of these brackets ( as those
brackets) otherwise the equation will be rejected
Once you have completed typing the equation, push EXIT key until it
asks you if you want to save the equation push YES and then CALC. If
the formula is accepted, it will show you the formula menu. If it is
unsuccessful, it will beep you and return to the formula for editing.

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

Cash Money Market


and Calculations
TTC 2013

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.

Two question baskets 6 theory and 6


calculations
TTC 2013

Money Market Instruments


Interest-Bearing

or YIELD Instruments

Deposits-call

and term
Certificates of Deposit (CDs)
Discount

Instruments

Treasury Bills
Bankers Acceptances

referred to as eligible bills


in the UK. (GBP denominated)
Promissory Notes
Commercial Paper
Not

all these instruments are issued by banks, and all are


unsecured. However Treasury Bills are seen as risk free as
they are issued by Governments
TTC 2013

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

Maturities in the Money Market


Trading days must be working days in the centre
where the funds are cleared
Periods of trading deposits:
Up to 4 weeks are classified as short dates
from 1 month to 1 year is classified as fixed dates
Over 1 year in medium term

Domestic deposits trade out of today or tomorrow,


whereas euro deposits usually trade out of spot.
Month end deposits will mature on the last dealing
date of the month and this is known as the end-end
convention.
Turn of the month is a deal done out of the last
working day of the month maturing on the first
working day of the next month.
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

Offer for assets


Bid for cash
TTC 2013

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)
TTC 2013

Discount Instrument Calculations


To calculate the discount or purchase price of
a discount instrument you need:
The face value
The discount rate
The days to maturity
The day count convention i.e. 365 or 360

The purchase price is the face value minus


discount

TTC 2013

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Discount Paper ACI Formulas

To calculate the discount

To calculate consideration or purchase price

NB: To calculate the purchase price of the DISCOUNT


instrument you can simply deduct the discount amount
from the face value

TTC 2013

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Converting a Discount rate to a Yield

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considerat ion x actual days

Converting a Yield to a Discount Rate


(not required for the exam)

or

discount amount x day basis


x 100
face value x actual days

TTC 2013

Treasury Bill Exercise


A USD Treasury bill with a face value of 100
is issued at a discount rate of 9.25% p.a. for
90 days
Calculate the discount amount
Calculate the purchase price
calculate the equivalent yield

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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NB: This Formula not given in exam

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

1. Calculate the maturity proceeds of the CD


2. Calculate the consideration of the CD in the
secondary market
3. Calculate the holding period return for the
investor
TTC 2013

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120x10
TTC 2013

Calculating the profit/loss on CD


When calculating the profit or loss on a CD, you need to
consider the difference between the original purchase price
plus the accrued interest to date of disposal against the
consideration received at sale.
In our example accrued interest is:
1,000,000 x 0.065 x 120 360 = 21,666.67
The dirty price received at sale was 1,022,277.23
Subtract the accrued interest from the dirty price:
1022,277.23 21,666.67 = 1,000,610.56 clean price
Subtract the original purchase price from the clean price:
1,000,610.56 1,000,000 = $610.56 profit.
This makes sense because the HPR is HIGHER than the
original yield expected.
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

Yield to discount Exercise


A 91 day Sterling Treasury Bill with a
face value of GBP 10m is quoted at a
yield of 6.75% p.a.
calculate the purchase price (secondary
market proceeds)
calculate the discount rate on the bill
TTC 2013

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TTC 2013

The Repo Market - 1


Repo is short for repurchase agreement
One party lends securities (usually Government
bonds) in return for borrowing funds
The lender of money has a SECURED deposit,
which usually attracts a lower interest rate than
normal money market deposits
The two main transaction types are:
All in or Classic Repo one transaction two legs.
This can be a fixed dated or done on a call basis
referred to as open-ended.
Sell/Buy Back two separate deals one spot and
one forward. This CANNOT be open-ended.
TTC 2013

The Repo Market - 2


The repo can either be special where a specific bond is
required or General collateral - GC where any
acceptable bond can be given as collateral. GC repo
rates are usually higher than special repo rates.
The lender of bonds (repo) bears the MARKET RISK on
the bond during the life of the repo.
The lender of cash (reverse repo) bears the CREDIT
RISK during the repo.
Under a classic repo there can be substitution (GC not
special) of bonds, haircut and margining during the repo,
whereas under a sell/buy back, substitution and
margining is unusual by can be done by cancelling the
buy back leg and entering a new transaction with the new
details.
TTC 2013

The Repo structure


At inception - settlement date
Repo
seller

bond

Cash

Repo
buyer

At Maturity
Repo
seller

Cash plus repo interest

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

The All in or classic Repo - 1


One party sell bonds (the repo) to another (the reverse
repo) while simultaneously agreeing to repurchase them
on a future date at a specified price.
If you do the repo (lend bonds), you BORROW cash on
the offer side of the market quote
If you do the reverse (borrow bonds), you LEND cash at
the bid.
The sale and repurchase price are the same except for
the repo interest which is simply added to obtain the
amount of money due on expiry. This is why a classic
repo is considered to be ONE transaction with two legs.
Any coupons paid during the life of the repo which is paid
to the buyer by the issuer, must be paid back to the seller
immediately.
TTC 2013

The All in or classic Repo - 2


The collateral is exchanged for cash at an agreed rate of
interest for a fixed period or it can be open ended
An initial margin may be charged by the LENDER of cash.
The lender of cash may take collateral which exceeds the
value of the amount of cash loaned. This is referred to as the
haircut.
Margin calls during the life of the repo ensure the cash lender
that the value of the security never falls below the current
value of cash advanced. The current value is calculated as
the cash lent plus the interest earned to date.
Margin calls can be provided either in the form of additional
security or the cash equivalent by the repo seller.
BOTH the REPO and the REVERSE REPO are subject to
margin calls during the life of the repo.
TTC 2013

The All in or classic Repo - 3


Factors influencing the size of the margin are:
The longer the term of the repo the greater the chance of
default
The longer the collateral has to maturity, the greater the
change in the collateral value because of a change in
interest rates.
The creditworthiness of the counterparty providing collateral
The liquidity of the collateral
The legal agreement (or lack thereof) covering the
transaction.

Flat basis is a repo done with no margin.

TTC 2013

Delivery under a classic repo


Delivery of security needs to be considered. The
collateral (bonds) can be held in custody by the repo
seller. The danger under this arrangement is that the
collateral may be used twice to raise cash. This is known
as double dipping.
A tri-party repo is one where both counterparts use the
same custodian. Segregated accounts will be opened by
the custodian for the express purpose of the repo
transaction. This kind of repo allows comfort to the buyer
as no double dipping can occur and is subject to a legally
binding agreement signed by all three parties.

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

Calculating the haircut


Fixed bond amount calculate the start money
Bonds market value (dirty price) divided by (100 plus the
haircut)
Example
-Dirty price 995,000
-Haircut 2%
995000/102%
= $975,490.20 cash against bond value at start of repo
Fixed cash amount calculate the bond value at start
Cash amount x (100 plus the haircut)
Example
-Cash $1m
-Haircut 2%
1,000,000 x 102% = 1,020,000 bond value at start of repo
TTC 2013

Dealing the repo rate


1. when doing the REPO (lending or selling bonds), you are borrowing
cash, so you would deal on the OFFER side of the repo rate
2. when doing the REVERSE REPO (borrowing or buying bonds), you are
lending cash, so you would deal on the BID side of the repo rate
3. The repo done Tom/Next or overnight is 1 day. One week and spot/week
are 7 days and two weeks is 14 days.
You need to answer 5 questions when facing a Repo calculation question:
4. Am I doing the repo or reverse repo?
5. How long is the repo term?
6. What is the repo rate and am I borrowing or lending cash?
7. What is the collateral worth?
8. Is there a haircut?

Repo rate 1.75/80


When doing the reverse Repo
you deal at the bid

When doing the Repo


you deal at the offer
TTC 2013

Classic Repo Example


FLAT BASIS REPO
A bank wishes to place out USD50 million Eurodollar bonds (doing the repo).
The bond has a coupon of 5,50% and mature on 12/04/2015. The repo rate
is 6.50/6.60 for 7 days. The bond collateral value is $51,633,700.
By doing the repo, you are going to borrow funds at 6.60%
Determine repo interest and final consideration
$51,633,700 x 0.066 x 7/360 = 66,263.25 repo interest (MM convention)
51,633,700 + 66,263.25 = $51,699,963.25 final cash (Buy back price)
REPO WITH HAIRCUT (using the same details as above)
If there was a 2% haircut on the repo, then the start money would be
different.
51,633,700/102% = $50,621,274.50 is the start money
Determine the repo interest and final consideration
$50,621,274.50 x 0.066 x 7/360 = 64,963.97 repo interest
$50,621,274.50 + 64,963.97 = $50,686,238.47 final cash (buy back price)
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.

Two question baskets 12 theory and 6 calculations


TTC 2013

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

quote- if USD/HKD = 7.2500 then the reciprocal


rate is 1/7.25 = HKD/USD 0.1379
Forward exchange rate - the rate agreed today for the
exchange of one currency for another at some date in the
future other than spot
Swap - a purchase for value one date with a simultaneous
sale for a different value date
(Sale With A Purchase)
Outright - the purchase or sale of forex for a future value
date
Overnight O/N - rolling out a position from today into
tomorrow
tom/next T/N - rolling out a position from tomorrow into the
spot date
Spot Next S/N - rolling out of spot into the next day
TTC 2013

Dealing in Spot FX Markets


Consider

how you would deal in your own currency


against the USD or other major currencies
Always look at what you are doing in the base currency
If you have a QUOTED currency amount, you will
DIVIDE by the exchange rate to get the BASE currency
amount
If you have a BASE currency amount, you will MULTIPLY
by the exchange rate to get the QUOTED currency
amount
NOTE: As a market user receiving several quotes:
You buy the base currency at the LOWEST offer
You sell the base currency at the HIGHEST bid
TTC 2013

Cross rates
An

exchange rate which is derived from two other


quoted exchange rates is called a cross rate.
(The stronger currency usually becomes the base
currency in a cross quote)
EXAMPLE: Deriving a cross rates by using two
dollar based or direct quotes.
Given the following calculate the CHF/HKD
exchange rate:
1USD = HKD 7.2500
1USD = CHF 1.5000

TTC 2013

Cross rates
We

can deduce mathematically therefore that


CHF 1.5000 = HKD 7.2500
To find out how many HKD = 1CHF we need to
divide both sides by 1.5000 (to arrive at 1CHF on
the left-hand side)

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

Rules for cross rates


TWO DIRECT (OR INDIRECT) QUOTES
Cross and divide (divide high number by low number).
For example to determine the CHF/HKD given

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

Rules for cross rates


A DIRECT AND INDIRECT QUOTE (different base
currency)
Straight down and Multiply
For example to determine the GBP/HKD given

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

Cross Rate Exercise


1. Given the following calculate the
GBP/HKD exchange rate:
USD/HKD 7.7550/75
GBP/USD 1.8325/35
2. Given the following calculate the
HKD/JPY exchange rate:
USD/HKD 7.7550/75
USD/JPY 114.25/30
TTC 2013

Forward foreign exchange


Forward

foreign exchange is used to hedge against


adverse currency movements
Forward exchange rates can be quoted for any
currency pair.
Both spot and forward exchange rates are
influenced greatly by current expectations of future
events
Arbitrage will occur where quoted forward points
move too far away from the implied fair value
forward points
Interest rate parity theorem The forward points
are equal to the difference between the interest
rates of the two currencies for the period of an
TTC 2013

Forward foreign exchange


AN EXAMPLE (positive Points)
Assume that the exchange rate (SPOT) between USD
and CHF is 1.25 (USD 1 = CHF 1.25). Let us also
assume that the interest rate for one year in USD is 3%,
and the interest rate for CHF for one year is 5%
Using the information given:
The USD/CHF one year
forward rate is:
3%
5%
1.3125 1.03 = 1.2743
The forward points are:
1.2743 - 1.25 = 0.0243
USD1.03 CHF 1.3125
OR
243 Points
USD 1

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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Forward FX formula example

Using the info from the previous example:

TTC 2013

Forward foreign exchange


AN EXAMPLE (Negative Points)
Lets assume that the exchange rate (SPOT) between USD and
CHF is 1.2500 (USD 1 = CHF 1.25). Let us also assume that
the interest rate for one year in USD is 5%, and the interest rate
for CHF for one year is 1%.
USD 1 CHF 1.25

1 YR

5%

1%

USD1.05 CHF 1.2625

Using the information given:


The USD/CHF one year
forward rate is:
1.2625 1.05 = 1.2024
The forward points are:
1.2024 - 1.2500 = - 0.0476
OR
negative 476 Points
TTC 2013

Forward FX Positive points


NOTE: The higher interest rate currency will be at a
forward discount to the lower interest rate currency.
Where the base currency interest rates are lower than
the variable currency, then the variable currency is
trading at a discount to the base currency in the forward
market. The points will then be POSITIVE.
Positive points benefit the seller of the base currency on
the forward dates and points would be described as in
your favour.
TTC 2013

Forward FX- negative points


NOTE: The lower interest rate currency will be at a
forward premium to the higher interest rate currency.
Where the base currency interest rates are higher than
the variable currency, then the variable currency is
trading at a premium to the base currency in the forward
market. The points will then be NEGATIVE.
Negative points can be identified when the bid is
HIGHER than the offer in the price quoted. This is a
common question type in the exam, so check the points
before you do the calculation.
Negative points benefit the buyer of the base currency
on the forward date.
TTC 2013

How do we know if points are


Negative or positive?
Points Negative

Quoted currency
Interest rates
Are higher than

Quoted currency
interest rates

The gap represents the


points i.e. the interest rate
differential

Are higher than

The gap represents the


points i.e. the interest rate
differential

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

Change in forward points


The forward points will change because of two factors:
A change in the spot but this will not change the points
significantly unless the move is big.
A change in the interest rates of the two currencies This
will have a much more significant effect on the forward
points.
Question: how will the points change when:
1. USD I/rates are higher than EUR I/rates and EUR
rates fall?
2.USD I/rates are higher than JPY I/rates and USD rates
fall?
3. GBP I/rates are higher than USD I/Rates and USD
rates fall?
TTC 2013

Forward foreign exchange


Calculating

forward points given the spot and


outright:
Bid
Offer
3 month Outright = 179.07 179.42
minus
Spot GBP/JPY
= 181.31 181.62
Forward points
= -2.24
-2.20
OR
224
220
Points are NEGATIVE (bid higher than offer). GBP
interest rates are therefore higher than JPY interest
rates. JPY Premium and GBP discount.
TTC 2013

Outright Forward Exchange


This

is a transaction with one leg for a forward date


other than spot. These transactions are usually
referred to as Forward Exchange Contracts - FECs
For example, a exporter in the South Africa has
USD receivables in 3 months and wishes to secure
a rate today for delivery in 3 months time. The
bank quotes 3-month bid at 2000 pips and the spot
is 9.0000. The customer will receive 9.2000 for his
USD in 3 months time irrespective of the prevailing
spot. The bank in turn will use the FX swap market
and the spot market to hedge the customer deal.
In this example, the bank will buy and sell 3
months and sell USD/ZAR spot.
TTC 2013

FX time Options
Banks

offer outright foreign exchange contracts to


their customers on the following basis:

Fixed dated This is the most common form of FX


outright forward contract. This is a contact where the
customer can only take up the contract on the expiry
date. The customer can however shorten or extend this
contract through the use of a FX swap at their own cost.
2. Time options this is an FX outright contract where the
customer has flexibility on the drawdown date of the
contract. Time options can be offered in two ways:
a. Partly optional This is a contract which can be drawn
down only after a certain time has elapsed but must be
taken up by the expiry date.
b. Fully optional this is a contract that can be taken up at
anytime from inception but must be taken up at expiry.
1.

TTC 2013

FX time Options - Pricing


If the contract is partly optional, the customer will sell the base currency to
the bank at the bid side of the points for the start of the forward period which
will be added to the bid of the spot. If they wish to buy the base currency,
they pay the offer side of the points for the full term of the contract added to
the offer of the points.
If the contract is fully optional, the customer will sell the base currency to the
bank at the bid side of the spot. If they wish to buy the base currency, they
pay the offer side of the points for the full term of the contract added to the
offer side of the spot.
Example
Spot USD/ZAR is 8.5075/85
1-mth points
200/210
2-mth points
425/435
3 mth points
550/570
a. A 3-month partly optional contract where the contract can be taken up
after 1 month would be quoted as USD/ZAR 8.5275/8.5655 ( bid:
8.5075+0.0200 offer: 8.5085+0.0570).
b. A 3-month fully optional contract where the contract can be taken up at
anytime in the 3 months would be quoted as USD/ZAR 8.5075/8.5655 ( bid:
8.5075 offer: 8.5085+0.0570).
TTC 2013

Forward exchange swaps


This

transaction involves TWO legs namely


A spot leg AND a forward leg.
Assuming the dealer wants to buy USD against the
CHF 3 months, he will then sell and buy. This
means he will sell USD/CHF in the spot market and
buy the 3 months USD/CHF with the same
counterparty simultaneously. Deals are usually
interbank.
The spot price is agreed immediately between the
buyer and seller when the deal is done and the points
are added to the spot. (if the points are negative, then
the forward rate will be LOWER than the spot). The
spot agreed is usually the mid rate of the current
TTC 2013
bid/offer.

Cross forward fx - An Example


USD/NOK spot is 7.8350/60
USD/NOK 3 mth Fwd pts 340/380
GBP/USD spot is 1.5400/05
GBP/USD 3 mth Fwd pts 70/65
Step1- calculate 3 mth fwd for each
currency pair
3 month USD/NOK outright
7.8350
7.8360
+0.0340 +0.0380
7.8690
7.8740
3 month GBP/USD outright
1.5400
1.5405
-0.0070
-0.0065
1.5330
1.5340

Step 2 calculate the cross


GBP/NOK 3 mth outright
(Direct and indirect quote use
straight down and multiply rule
stronger currency is the base)
USD/NOK

7.8690

7.8740

GBP/USD

1.5330

1.5340

GBP/NOK
12.0632
3mth outright

12.0787

TTC 2013

Forward Forward swaps


This is a Fx Swap starting at a future date other than spot.
For example, a dealer wants to do a FX Swap for 3 months
starting in 3 months time. This is described as a 3x6 swap.
RULE: Take the far bid and subtract the near offer to get the
fwdfwd bid and take the far offer and subtract the near bid to
get the fwd fwd offer.
An example A dealer wants to buy the 3s and sell the 6s
USD/CHF 3 mth Fwd pts 80/85
USD/CHF 6 mth Fwd pts 140/145
Spot is 1.7500
He buys 3 months at 1.7500 + 0.0085 = 1.7585
And sells 6 months at 1.7500 + 0.0140 = 1.7640
He has sold the 3x6 at 55 points.
The 3 x 6 bid/offer is 55/65. (use the rule to check)
TTC 2013

A Typical Bank Forward Points Quote Page


EUR/USD FORWARDS
Period BidOffer
O/N
23
T/N
3.5 4
S/N
1.5 2
1WK
10 11
1MTH
40 43
2MTH
80 85
3MTH
115
6MTH
220
9MTH
310
1YR
405

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

NDFs - Non-Deliverable Forwards


NDFs are currency contracts for difference CFDs. Like
FRAs are to interest rates, so NDFs are to foreign
exchange rates.
They are traded in countries where there is no formal
forward exchange market or an illiquid forward market.
They can be used for hedging and speculation.
They are like forward outright FX deals where a future rate
of exchange is agreed between the parties but only the
DIFFERENCE between the exchange rate fixing at expiry
and the NDF contract rate is settled in foreign currency.
If at fixing the prevailing exchange rate is higher that the
NDF rate, then the seller pays the buyer the difference. If
the prevailing exchange rate is lower, then the buyer pays
the seller.
There is never an obligation to take or make delivery of the
notional contract amount.
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

Forward foreign exchange


Value tomorrow theoretical price convention
switch the points-change the sign-add to spot
For example:
The spot rate USD/HKD is 7.2500/7.2515
The T/N points are 25/26
What is the theoretical bid/offer rate for tomorrow?
7.2500 7.2515
+
+
-0.0026 -0.0025

Tom price for USD/HKD = 7.2474/7.2490


TTC 2013

The precious metals market


ISO codes for precious metals
Gold XAU
Platinum XPT
Palladium XPD
Silver XAG
The four major gold coins traded are: Kruger Rand, American Eagle,
British Sovereign all have a gold purity of 22 carats or 0.9167.
The Canadian Maple leaf with a purity of 24 carats or 0.9999
The LIBOR Rate for gold is the GOFO rate. This is the lending rate for
gold loans in the London market
LOCO account is the equivalent of a Nostro account for gold.
There may be questions on the above points in the foreign exchange
section in the exam. Read the section in the study guide for more detail.
TTC 2013

Section 4

Forward Interest
Rates, FRAs, Futures,
and Swaps
TTC 2013

Section Objectives
To understand the mechanics of and how to use

money market interest rate derivatives to hedge


interest rate risk.
One question basket 12 questions

TTC 2013

Derivatives Why Use Them?


Hedging
Direct hedges e.g. Forward cover
Indirect hedges e.g. Currency hedges

for motor

manufacturers

Speculation
Gearing

or leverage (the main cause of large derivative

losses)
Big market moves

Simulation
Creating

a synthetic portfolio

Arbitrage
To take

advantage of mispricing between markets


TTC 2013

Forward forward rates


Forward forward interest rates are prices
which pertain today to deposit periods
commencing in the future
What is the rate
for this period?

0 Borrow funds for 3 months

Short funds for 3 months

Lend for six months


TTC 2013

F
R
SLD/BXLSR -1 XLD
1

B
-S
D

The forward forward


pricing Formula

Where
FR = forward rate
LR = long rate
SR = short rate
SD = short days
DB = day base
LD = long days

TTC 2013

3-Month LIBOR forward interest rate


Calculate the fair value for a USD 3-month
LIBOR Interest rate starting in 3 months time
(a 3x6) given the following information:
6-month LIBOR rate (LR) = 4% (0.04)
3-month LIBOR rate (SR) = 3.50% (0.035)
SD =90 days
LD =180 days
DB = 360

TTC 2013

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3-Month LIBOR forward interest rate

TTC 2013

Checking the formula An example


Lend 1m @ 4% for 180 days results in interest payable of
$20,000 (1mx0.04x180/360)
Borrow 1m @ 3.5% for 90 days results in interest receivable
of $8,750 (1mx0.035x90/360)
Difference in interest is $11,250 (20,000 8,750)

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ardperiod

To calculate the fair value interest rate for the remaining 90


days, the rate calculated must utilize the capital plus interest
after the first 90 days to achieve the amount repayable at the
end of 180 days.
Calculated as follows:

TTC 2013

What does this forward rate mean?


This is the rate at which the forward period borrowing or
lending must be done to breakeven.
In other words:
If I borrowed (long cash) for 3 months at 3.50% and lent
for 6 months (short cash) at 4.00%,
Then,
4.461% is the rate at which I must borrow cash for 3
months in 3 months time (3x6) to breakeven on my
money market book.
This forward forward rate calculation is the methodology
applied to identify the interest rates for mismatches in the
money market books of a bank and is the basis for FRA
pricing.
TTC 2013

Forward Rate Agreements


Definition
An FRA is an agreement between two parties, a
Buyer and a Seller that sets (fixes) the level of an
interest rate for a specific time in the future on a notional value.
For example 3 months starting 6 months from now.
In 6 months time the FRA rate will be compared to the 3 month
market benchmark such as EURIBOR or LIBOR and the
DIFFERENCE will be settled based on the notional principal.
FRAs are therefore referred to as CFDs (contracts for
difference).
FRAs are the ideal short-term derivative to hedge
mismatches in the money market funding book of a bank.
FRA prices are derived using the forward forward model.
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!

NOTE: Fixing and settlement are on the SAME DAY in


domestic FRA markets e.g. GBP FRAs in London fix
and settle on the SAME DAY.
Foreign currency FRAs settle T+2 e.g. USD FRAs in
London fix TWO working days before settlement occurs.
TTC 2013

Buying or Selling an FRA


The Buyer of the FRA
The buyer of an FRA is a potential future borrower and exposed to
interest rates rising (short cash in the forward period)
Buying the FRA is like borrowing money at a fixed rate for a future
period.
The buyer will receive the difference between the FRA and the 3 month
LIBOR at fixing if the LIBOR rate is ABOVE the FRA rate, and pay if the
LIBOR rate is BELOW the FRA rate.

The Seller of the FRA


The seller of an FRA is a potential future investor, and is exposed to
rates falling (long cash in the forward period)
Selling the FRA is like lending money at a fixed rate for a future period.
The seller will receive the difference between the FRA and the 3 month
LIBOR at fixing if the LIBOR rate is BELOW the FRA rate, and pay if the
LIBOR rate is ABOVE the FRA rate.
TTC 2013

Buying an FRA to hedge


Borrower has a USD 50m floating rate loan priced at 3-month LIBOR. She
thinks rates will rise in the next three months.
Market rates today
Borrows and
Fixes FRA and
Borrowing
3-mth LIBOR 5.75%
buys FRA

borrows again

matures

3X6 FRA 6.00%


3x6 FRA period
Transactions today
Borrows at 5.75% FOR 90 days
t
3
Buys 3x6 FRA at 6.00%
3 months time
2 scenarios 3-month LIBOR fixes at 6.25% or 5.75%
Scenario 1
Repays loan and borrows 50m at current LIBOR 6.25%
LIBOR is above FRA rate so receives difference 0.25%
Therefore effective cost of funding 6.00% for 3 months
Scenario 2
Repays loan and borrows 50m at current LIBOR 5.75%
LIBOR is below FRA rate so pays difference
0.25%
Therefore effective cost of funding 6.00% for 3 months
NOTE: IRRESPECTIVE of LIBOR rate borrowing cost is 6.00%

TTC 2013

Selling an FRA to hedge


A large bank needs to lend USD 100m for 6 months in 6 months time linked
to LIBOR. They think interest rates will fall in the next 6 months. They want to
lock in the investment rate for that period today.
Sells FRA
Fixes FRA and
Investment
FRA rate today
6X12 FRA 4.25%
Transactions today
Sells 6x12 FRA at 4.25%

invests cash

matures

6x12 FRA period

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

Forward Rate Agreements - Summary


The agreement is a reciprocal compensation
agreement between the two counterparts
If at settlement the reference rate > FRA rate,
then
the Seller pays compensation to the Buyer
If at settlement the reference rate < FRA rate,
then
the Buyer pays compensation to the Seller

TTC 2013

Calculation of Settlement Amount


Settlement
Amount

( iL - i F ) x N x
1+

Where:
iL
iF
N
d
B

=
=
=
=
=

iL x

d
B

d
B

reference interest rate (LIBOR)


contract (FRA) rate
notional principal amount
actual number of days in the forward period
day count convention
(e.g. 360 for USD, 365 for GBP)

TTC 2013

Calculation of Settlement Amount


Example
FRA USD 50million (B or day base is 360)
FRA rate 5.375%
3-month USD LIBOR Fixed at 6.25%
FRA period 90 days
Settlement
=
Amount

(0.0625 - 0.05375) x 90/360 x 50,000,000


1

0.0625 X 90/360

= 109,375/1.015625
= 107,692.31 paid by FRA seller to buyer
TTC 2013

Futures Contracts - A Definition


A future contract is a standardised contract between two
parties to exchange a standard quantity of a specified
underlying asset on a predetermined future date at a price
agreed today, traded on an organised Exchange guaranteed
by the exchange
The price of a futures contract can be divided into three
main elements:
The spot price of the underlying asset
The financing cost which includes storage and insurance
cost for the underlying asset in certain cases
Cash flow generated by the underlying asset (if any)

TTC 2013

Pricing Futures - An Example


Given the following calculate the future price of gold
The current gold price is $865 per ounce.
The 1-year financing cost is 5%p.a. and
The storage and insurance cost is $5 p.a.
The futures price= $865+($865 x 0.05)+$5 = $913.25
NOTE: this is the fair value or no arbitrage futures
price (ignoring transaction cost).
The 1-year gold futures contract may well trade above
(contango) or below (backwardation) the spot price.

TTC 2013

Short Term Interest Rate Futures Price


The formula used for pricing short term interest rate
is the forward-forward pricing formula. This method
applies to FRA and STIR futures fair value interest
rates.
However, unlike FRAs, STIR futures are quoted as
a PRICE rather than an interest rate
The price is arrived at by deducting the interest rate
from 100
For example, a rate of 3,75% will be 100 3.75 =
96.25
Futures prices can be quoted to 3 decimal places
96.255 which = 3.745%
TTC 2013

Interest Rate Futures Specifications


3-month Euronext Eurodollar futures are quoted as price and
have a nominal value of $1,000,000. Minimum tick 0.5 or
0.25 for near contract on CME
3-month Euronext Eurosterling futures are quoted as price
and have a nominal value of 500,000. Minimum Tick 0.5
3-month Euroyen futures are quoted as price and have a
nominal value of 100,000,000 Minimum Tick 0.5
3-month Euronext EUR futures are quoted as price and have
a nominal value of 1,000,000 Minimum Tick 0.5
3-month Euronext Euroswiss futures are quoted as price and
have a nominal value of CHF 1,000,000 Minimum Tick 1
Contract months are known as IMM (International Monetary
Market) months. March, June, September and December.
The near month contract is the most liquid.
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

Margining and settlement


Initial Margin is the amount that is put up to open a futures

position on an exchange and will be held by the exchange


until the contract expires or is closed out. This is usually
sufficient to cover a single day loss on an open position.
The exchange determines the amount of initial margin
required.
Variation margin is payable (receivable) daily in cash based
on the contracts revaluation through a process called
marking-to-market (M-T-M). The mark to market price is
usually determined by an weighted average price calculated
using prices (usually the last 5 trades) traded during a
period prior to the close of the trading day.
Settlement and trading is guaranteed by the exchange and
margins are usually payable between 10h00 and 12h00 on
the day following the trade or mark-to-market.
TTC 2013

Calculating variation Margin


Near 3-mth Euro$ futures

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

Long10 contracts at 94.65

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

STIR Futures vs FRAs


FUTURES

FRAs
Sell FRAs if you

Buy futures if you


believe rates will FALL believe rates will FALL
Sell futures if you
Buy FRAs if you
believe rates will RISE believe rates will RISE
Note: Buying FRAs is the same as selling futures
Selling FRAs is the same as buying futures
SO
To hedge a long FRA position BUY futures
To hedge a short FRA position SELL futures
THIS SLIDE IS IMPORTANT TO REMEMBER!!!!
TTC 2013

Interest Rate Swaps - IRSs


An interest rate swap (IRS) can be defined as an exchange of
one set of cash flows for another based on a notional
principal amount or an exchange for differences on a given
set of cash flows.
The concept of a basic IRS is very similar to that of an FRA.
The difference is that the FRA is applied to a single period
cash flow, and a swap is applied to cash flows over a longer
period of time.
The important concept to remember is that the buyer of an
IRS (also known as the Fixed rate payer) is protected against
rising interest rates and the seller (the Fixed Rate receiver) is
protected against declining interest rates.
TTC 2013

Typical Reuters IRS Screen


Absolute quotation

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%

Reset quarterly against


3-monthLIBOR

Reset quarterly against


3-month LIBOR

TTC 2013

Interest Rate Swaps Structures


Plain vanilla swap This is a fixed for floating rate swap with a
fixed notional value for the life of the swap. This is by far the
most common IRS done.
Accreting swap - A swap, which has a notional value that
increases over the life of the swap.
Amortizing swap - A swap, which has a notional value that
decreases over the life of the swap.
Rollercoaster swap - A swap, which has a notional value that
increases and decreases during the life of the swap.
Basis swap A swap where one floating rate is swapped for
another floating rate. An example would be a 6-month LIBOR
against 3-month LIBOR swap.

TTC 2013

The Swap Mechanism


A PAYS fixed to B

PARTY B

PARTY A
A RECEIVES floating from B

The rates exchanged can be a fixed rate for a floating rate or


floating for floating rate.
The counterparties will only exchange the difference between
the rates based on a Notional Principal amount
There will always be a start date, expiry date, fixing dates, and
settlement dates agreed on the swap
Day count convention is calendar rolls modified following CRMF
TTC 2013

Coupon or Plain Vanilla Swaps

Over 75% of all swaps are plain vanilla


Fixed rate vs. floating rate cash flows
Notional Principal amount never exchanged
Principal is constant for the life of the swap
Reference index - JIBAR, LIBOR, etc.

3Month is the most common benchmark


Swaps subject to ISDA documentation. ISDA = International
Swap and Derivatives Association
Fixing in advance with Settlement in arrears
Settlement is done on a netting basis which reduces the
counterparty risk
Payer, receiver quotation convention
Absolute Vs. spread quotation in overseas markets
TTC 2013

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

The swap has a notional principal of USD 50 million


The fixed rate is 5.75% on the swap
The first 3month LIBOR fix is 5.25% done on the start date of the swap
i.e. at 0 on the timeline above.
Amount to be paid on second fixing is calculated as follows:
50,000,000 x (0.0575-0.05250) x 90/360 = $62,500 paid by the buyer (fixed
rate payer) to the seller (floating rate payer) on the second fixing date.
This process is repeated over the life of the IRS
TTC 2013

Overnight Index Swap (OIS)


an OIS is a fixed/floating interest rate swap
floating leg is a daily overnight or tom/next reference rate
floating leg interest is compounded daily
the interest difference is exchanged as a single amount at
maturity of the swap
settlement is made net with no exchange of principal
Sterling Overnight Index Average (SONIA) is the benchmark in
GBP
Euro overnight index average (EONIA) used for EUR overnight
index swaps
Fed Funds Effective rate used for USD overnight index swaps
All overnight index rates are weighted average rates unlike
LIBOR and EURIBOR which are simple averages.
TTC 2013

Cross Currency Interest Rate Swap


Differs from a normal IRS in that there is an exchange of
principal and the interest rates swapped are in TWO
DIFFERENT CURRENCIES.
This exchange of principal can be done at the start of the
swap, but there MUST ALWAYS be an exchange of principal
at the end of the swap.
The spot rate used for the principal exchange at expiry of the
CIRS is ALWAYS the same as the spot which was prevailing
at inception (and which may have been used at inception).
These swaps can be floating for floating and are referred to
as a basis swap and are the most common currency swap.
They can also be fixed for floating
They are the ONLY swap which can offer fixed for fixed.
These swaps are used primarily to hedge long term Foreign
Exchange exposure.
TTC 2013

Section 5

Options

TTC 2013

Section Objectives
To understand the fundamentals of options. To

recognise the principal classes and types, and


understand the terminology, how they are quoted
in the market, how their value changes with the
price of the underlying asset and the other
principal factors determining the premium, how the
risk on an option is measured and how they are
delta hedged. To recognise basic option strategies
and understand their purpose.
One question basket 5 questions

TTC 2013

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.

TTC 2013

Types of Option Contracts


A Call option gives the holder the right but not the
obligation to buy the underlying asset at some time
in the future.
A Put option gives the holder the right but not the
obligation to sell the underlying asset at some time
in the future.
NOTE: Options can either be American - exercisable
at any time up to expiry- or European -exercisable
only at expiry. Options can also be styled Asian or
Bermudan (see workbook for definition)
TTC 2013

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
TTC 2013

Valuing Option Contracts


The value of an option is the premium which someone is
prepared to pay for the option.
Intrinsic value represents the money you would make
between the exercise price and the market price if you were
to exercise the option you are holding immediately Intrinsic
value can only be POSITIVE.
Time value reflects the amount of premium in excess of the
intrinsic value that someone would be prepared to pay in the
hope that the option will be worth exercising before it expires

TTC 2013

Pricing Option Contracts


The

further out-of-the-money the exercise price,


the cheaper the option
The longer the time to expiry, the more expensive
the option is
The fair value price of an option is dependent on:
the strike price
the term of the option
the underlying asset price (spot)
the prevailing risk free interest rate
the volatility of the underlying asset price
The pricing model used is usually based on the
Black and Scholes options pricing model.
TTC 2013

Valuing Options
Call values Put values

when

Rise

Fall

Price of underlying rise

Fall

Rise

Price of underlying fall

Rise

Rise

Volatility rises

Fall

Fall

Volatility falls

Fall

Fall

Time to expiry reduces

Rise marginally

Fall marginally

Interest rates rise

Fall marginally

Rise marginally

Interest rates fall

TTC 2013

Option Contract Expiry Profiles


Profit

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

TTC 2013

Option Contract Expiry Profiles


LONG PUT

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

TTC 2013

Short Straddle Expiry Profile


Profit

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
TTC 2013

Long Straddle Expiry Profile


Profit

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
TTC 2013

Option short Strangle


Profit

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
TTC 2013

Option Long Strangle


Profit

Asset Price

Loss

Buy a call at and a put with different strike prices same


expiry date and notional amount.
This is a strategy to benefit from high volatility
TTC 2013

A synthetic long asset position


Synthetic
Long asset

Profit

Short Put

0
Long Call

Spot Asset Price

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.
TTC 2013

A synthetic short asset position


Synthetic
short asset

Profit
short Call

0
E

Spot Asset Price


Long Put

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.
TTC 2013

The Option Greeks

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
TTC 2013

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.
TTC 2013

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.
TTC 2013

The Option Greeks


Gamma
Gamma measures the change in the delta
resulting from a change in the price of the
underlying asset
Gamma ranges between 0 and 1. The gamma will
be most sensitive to change when the option strike
is at-the-money close to expiry. Gamma exposure
can only be offset by buying or selling) options
opposite to those already bought (or sold).

TTC 2013

The Option Greeks


Theta
Theta measures the change in the option premium
resulting from a change in the time to expiry of the
option
The decay of time will result in the option loosing
value, all other factors remaining equal.
Time value decays slowly at first and then
increases as the option approaches expiry.
Theta is positive for options writers and negative for
option buyers.
TTC 2013

The Option Greeks


Vega
Vega measures the change in the option premium
resulting from a change in the volatility of the
underlying asset price
The more volatile the underlying asset price, the
more likely the option will expire in the money. So if
volatility increases, the value of the option will also
increase, all other factor remaining equal.
Volatility measures change but not the direction of
prices
TTC 2013

The Option Greeks


Rho
Rho measures the change in the option premium
resulting from a change in the risk free interest rate
Rho is the least important of the Greeks. If the
underlying asset is extremely sensitive to the
change in interest rates, then the option value will
change, all other factors remaining constant.

TTC 2013

Interest Rate Options


CAPS
A Cap is an agreement whereby the buyer buys the
right to pay a predetermined fixed rate (strike rate)
on a notional principal amount if LIB|OR rises
above the strike rate. (used by borrowers)
FLOORS
A Floor is an agreement whereby the buyer buys
the right to receive a predetermined fixed rate
(strike rate) on a notional principal amount if LIBOR
falls below the strike rate. (used by lenders)

TTC 2013

Interest Rate Options


COLLARS
A Collar is the simultaneous purchase of a cap (floor) and sale
of a floor (cap) with different strike rates, same notional value
and expiry date.
This can be used by both lenders and borrowers where they
reduce the cost of a hedge by limiting the upside benefit.
Borrowers collar BUY the cap and SELL the floor. Lenders
collar BUY the floor and SELL the cap.
Borrowers are guaranteed a worse case rate - the strike on
the cap - and will limit the benefit of a favourable market move
- the strike on the floor.
Lenders are guaranteed a worse case rate - the strike on the
floor - and will limit the benefit of a favourable market move the strike on the cap.
TTC 2013

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.
TTC 2013

Section 6

Principles of Asset
and Liability
Management
TTC 2013

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.

One question basket 8 questions


TTC 2013

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.
TTC 2013

What is the function of the ALM team?


Banks have 3 main
sources of funds:
1.
2.
3.

Deposits from clients


Interbank deposits
Shareholders equity

Banks invest in 5 main assets:


1.
2.
3.
4.
5.

Reserves with the central bank


Loans
Interbank loans
Bonds
Fixed assets

The ALCO comprises the CEO and heads of business


units in Credit, retail, corporate and Treasury.
The ALM team or ALCO (asset and Liability Committee)
controls profit and risk. They primarily consider the
Interest rate risk created by the mismatch of the asset
and liability maturities of the banks balance sheet.
TTC 2013

Principals of the BASEL Committee


1. Board and senior management oversight of interest rate
risk
2. Adequate risk management policies and procedures
3. Risk measurement and monitoring
4. Internal controls
5. Information for supervisory authorities
6. Capital adequacy
7. Disclosure of interest rate risk
8. Supervisory treatment of interest rate risk in the banking
book
These guidelines set by the Basel committee have prompted a
significant evolution in systems used by banks for
managing interest rate risk, which have gradually become
more comprehensive and accurate.
TTC 2013

Return on equity
There are five key variables driving ROE
Earnings on assets (EOA)

ROE

Margin (EOA COD)


Operating expenses (OE)
Leverage (debt/equity)
Tax (t)

Leverage (debt/equity) can have a major impact on the ROE of a bank,


so banks could be tempted to increase debt while leaving equity
unchanged. Central banks are aware of this danger and therefore
control the level of debt to equity through the imposition of capital
adequacy regulations.
TTC 2013

Capital Adequacy

The Basel accord is the main capital adequacy


structure that bank supervisors use.
Basel covers aspects of capital, risk weighting of
assets and the required capital ratio to meet the
banks product mix. The basic Capital Adequacy
Directive - CAD - sets the minimum capital required at
8% of total risk-weighted assets. (This is known as
the Cooke Ratio)
The three pillars of the BASEL Accord:
1. Minimum Capital Requirements
2. The Supervisory Process
3. Market Discipline
TTC 2013

Capital Adequacy under Basel II


Refers to the adequacy of a banks capital in relation to risk arising from:
Assets (loans, negotiable paper)
Dealing operations
Off-balance sheet transactions
Other business risk
Equity Capital enables a bank to bear risk and absorb unexpected
losses

Regulatory Capital Prescribed by the regulatory


authorities in the country. This is split into two main
categories namely Tier 1 (core) and Tier 2.
Economic capital this is the amount of capital needed to
cover the risk being faced by a bank (usually in excess of
Regulatory Capital). This is the capital specifically allocated
to a branch of a bank. It can also be defined as capital at risk
(CaR) and can be measured using VaR
TTC 2013

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

Risk weighted assets

Trading Risk
Operational Risk

Credit Risk Weighting


Two approaches: standardized approach which relies on
external ratings; that is ratings given by rating agencies such
as Moodys and Standard and Poor or Fitch-IBCA
The second approach which has received the most attention
all over the world is the Internal Rating Based (IRB) approach
(available under two options: foundation or advanced)
We will examine each approach; the Standardised approach
and the foundational approach for IRB.

TTC 2013

Credit Risk Weighting


Standardized Approach
The Standardized approach is one where a weighting will be
related to the riskiness of the transaction, as identified by the
rating of external rating agencies.
AN EXAMPLE
AAA - AA- A+ - A- BBB+ - BBB- and below
Corporate 20%
50% 100%
A loan made to a A+ would be rated at 50% therefore a loan of
$100 would attract capital of 8% x ($100 x 50%) = $4
Under Basel I this loan would have simply had a risk weighting
of 100% and attracted capital of $8.
Remember unrated loans STILL attract a weighting of 100%
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Credit Risk Weighting


Internal Ratings-Based (IRB) Approach
In the IRB approach, the banks have to calculate the probability of
default of a corporate client over a 1-year time horizon. That is
lending to a client today, what is the likelihood of default by the
borrower in one years time? This probability of default is referred to
as the PD.
NOTE: to apply the IRB approach you need two pieces of
information: the PD and the maturity of the loan.
With retail loans (small amounts), a similar PD can be calculated for
a portfolio of loans. Basel Committee of Bank Supervision (BCBS)
formula to calculate the capital charge contains the following
factors:
1. The probability of default (PD)

2. The exposure at default (EAD)


3. The loss given default (LGD)
Also; Effective maturity (M)
M = maturity; b(PD) = maturity adjustment
R = correlation between defaults

TTC 2013

Credit risk mitigation - Securitisation


Securitization is where bonds are issued which have the backing of an
income producing asset, typically bank debt in the form of long-term debit
instruments such as mortgages or short-term debt instruments, such as
credit card receipts.
This is a popular way of banks freeing up capital and transferring credit
risk.
There are usually different classes of bonds issued in a single
securitisation based on the credit of the underlying securitised asset.

Issuing Bank

Removes assets

Balance sheet

Frees up capital
Assets against which the
bonds are issued

Trust or SPV

Issues bonds of differing


classes based on the
underlying credit

Bond Market

TTC 2013

Credit risk mitigation- credit derivatives


Credit derivatives are a relatively new phenomenon, and
have really only become prominent in the mid to late 90s
A credit derivative is a privately negotiated contract whose
value is derived from the credit risk of a bond, bank loan, or
some other credit instrument. Credit derivatives allow the
market participant to separate default risk from the other
forms of risk, such as interest rate and currency risk
Three basic structures
Credit Default Swap CDS this bases the payoff on a
specific credit event, such as a bond down grading or
default. .
A total return swap - Links a stream of payments to the
total return on a specific asset.
Credit spread options - Ties the payoff to the credit spread
on a specific bank loan or bond.

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Credit Derivative triggers


The standard ISDA documentation for credit swaps defines a set of credit
events which trigger the Credit Derivative. A credit event could be one of the
following:
Payment default on an agreed-upon public or private debt issue (the
reference asset)
Debt rescheduling
A filing for bankruptcy
Or some other specified event to which the two parties agree.
As a general rule, the credit event must be an objectively measurable event
involving real financial distress; technical defaults are usually excluded. The
reference credit is usually a corporation, a government, or some other debt
issuer or borrower to which the credit protection buyer has some credit
exposure.
The contract will contain a materiality clause which will:
Call for a significant move of the reference credits underlying stock or
bond price
Ensure that the market recognizes the credit event for what is
Prevent an unnecessary trigger due to a default caused by legal questions
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Operation Risk Weighting


Standardized Approach and Advanced
Measurement (AMA) approach
Remember operational risk refers to losses incurred due to human
or systems error.
The standardized approach this is straight forward:
The capital charge is simply a multiple of the gross revenue of an
activity, averaged over the last three years.
Gross revenue is the sum of net interest margin and non-interest
income (such a fee charged).
The capital charge under this method is the same for all banks
irrespective of their operational control processes.
The Advanced Measurement Approach (AMA) under this
approach, the banks themselves estimate statistically what could be
the worst operational losses, for a confidence level of 99.9%. This
requires estimation of two factors:
The number (frequency) of operational losses over a years, and the
potential magnitude of these operational losses
TTC 2013

Interest rate risk management


Gap concept
Interest rate risk is identified as the possible changes in net
interest income . The gap is a concise measure of the interest
rate risk that links changes in market interest rates to
changes in the net interest income (NII)of the bank. The gap
over a given period is defined as the difference between the
amount of rate sensitive assets and rate sensitive liabilities.
A positive gap is one where rate sensitive assets exceed
rate sensitive liabilities.
A negative gap is one where rate sensitive liabilities exceed
rate sensitive assets.
A positive gap benefits from rising interest rates
A negative gap benefits from falling interest rates.
TTC 2013

Basel III liquidity risk


Liquidity Coverage Ratio - LCR
The Basel II rules insist that a bank maintains a high liquidity coverage ratio.
This rule requires banks to have enough cash or near-cash to survive a 30day market crisis.

Net Stable Funding Ratio NSFR (1 year time horizon)


This ratio is applied to reduce the banks dependency on short-term funding
and is longer term in nature to limit over-reliance on short-term wholesale
funding.

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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Funds Transfer Pricing


The main aims of internal funds transfer pricing system:
1. To transfer interest rate risk from the various units in the bank to one
central unit usually the Treasury. The Treasury can correctly evaluate
and manage this risk and where necessary apply the relevant hedging
policies
2. To evaluate the actual profitability of this activity by assigning interest
rate risk management to a single centralized unit
3. To remove the need for each division from dealing with the funding of
their loans or the investment of surplus deposits
4. To provide a more accurate assessment of the contribution of each
operating unit to the banks overall profitability.

. The bank can either apply a single internal transfer rate


-ITR (usually a floating benchmark like LIBOR) or it can
apply multiple ITRs reflective of the maturity profile of
deposits and loans.
TTC 2013

Section 7

Principles of
Risk
TTC 2013

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.

One question basket 8 questions

TTC 2013

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
TTC 2013

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.
TTC 2013

Minimum Control Standards


For Credit Risk
Good credit assessment
Credit limits imposed and monitored by
management
By counterparty
By industry
By country

Credit enhancement Credit Derivatives


Default management ISDA and ICMA
documentation
Termination clauses used in the IRS market
Payment netting bilateral and multilateral
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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
TTC 2013

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
TTC 2013

Minimum Control Standards


For Market Risk
Transaction approval
Measurement
Regular marking to market of open positions
Gap analysis for interest rate exposure
Risk identification using Value at Risk modeling (VaR)

Risk reporting
Risk system development good revaluation
Limit approval
Timeous inputting of deals
Matching of hedges with the hedged instrument
TTC 2013

Measuring Market Risk - VaR


Value at Risk VaR is a method of assessing
market risk characterised by three key elements:
1. It indicates the MAXIMUM potential loss that a
position or portfolio can suffer
2. Within a certain confidence level (lower than 100%)
3. Limited to a certain time horizon that the position
will remain constant
. Basel Accord recommends a 99% confidence level
over a 10 day holding period using historical data of
no less than 12 months.
TTC 2013

Value at Risk Models


The models most often used to measure VaR are:
1. Variance covariance method
2. Monte Carlo simulation
3. Historical simulation
Limitations of the VaR
4. It assumes normal distribution of prices
5. It requires an explicit volatility and correlation estimate
6. It assumes a linear payoff hypothesis
7. It provides no measure of the excess loss if the actual loss
is greater than the expected loss. One of the ways to
overcome this is to apply another risk measure referred to
as the Expected Shortfall.
Expected shortfall - is defined as the expected value of all
losses in excess of VaR.
TTC 2013

Dealing Room Limit Structures


Market risk and credit risk are only limited by the
imposition of LIMITS.
Credit limits these are used to control credit risk
and are set OUTSIDE of treasury. A dealer must
strictly keep within the limits set. Credit limits will be
set by counterparty, market sector, and country.
Dealing limits these are limits used to control
market risk. Limits will be set per instrument, currency,
dealer, desk, and dealing room.
LIMITS DO NOT CHANGE unless management adjust
them.
TTC 2013

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
TTC 2013
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

TTC 2013

Minimum Control Standards


For Operational Risk
Timeous transaction processing
Constant Position reconciliation
Timeous input and confirmation
Good Cash management
Security for environment and systems
Proper customer service
Policy and procedure adherence everyone must
understand the mechanics of the transactions
Strictly controlled database management
Good control and management on the introduction of new
products
Good management information systems / exceptions
reports

TTC 2013

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
TTC 2013

Documentation in current use


ISDA - International Swap and Derivatives
Association documentation covers all treasury
instruments except Repos
GMRA - Global Master Repurchase Agreement encompassing the International Capital Market
Association ICMA (previously ISMA) and The
Bond Markets Association - TBMA
ICOM international Currency Options Market
(Previously LICOM)
FEOMA Foreign Exchange and Options Master
Agreement
TTC 2013

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
TTC 2013

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)
TTC 2013

Netting-3
Multilateral netting is much more complex and is
easiest to understand when examining the structure
of a CLEARING HOUSE.

ONE PAYMENT, PER CURRENCY, PER DAY


There are several participants in the netting process
and there is normally a redistributing of default risk.
Continuous linked settlement (CLS) is the most
effective initiative to deal with settlement or default
risk.

TTC 2013

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

TTC 2013

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
TTC 2013

Nostro and Vostro accounts


Nostro account is our foreign exchange account held with
an overseas correspondent bank e.g. from London Bank
perspective, their USD account held with Citibank NY
Vostro account is a local currency account held on behalf of
an overseas client bank e.g. from Citibank NY perspective, the
London Bank USD account held with themselves. Sometimes
also referred to as a Loro account.
Note: A Nostro and Vostro account are the same account.
A Loco account is an account for gold in London. It can be
described as a nostro account for gold.
TTC 2013

Straight Through Processing


Three main factors that help streamline STP:
Front-end (dealing) data capture
SSIs
Immediate matching of confirmations
Together with Automated payment systems, these
have become the building blocks that have taken
the concept of STP from theory to practice. Deals
can now go from initiation to settlement without
ANY manual intervention.
TTC 2013

Continuous linked settlement


CLS eliminates the settlement risk in cross currency payment
instruction settlement through CLS Bank linking the local
central bank Real Time Gross Settlement (RTGS) systems.
This occurs during a five-hour window of their overlapping
business hours: in this window, settlement instructions for a
particular date are settled and funds are requested to be paid
in and are paid out by CLS Bank.
CLS Bank is based in New York and is a multi-lateral netting
system for currency settlement.
Only currencies which are part of CLS can settle through the
system.
Only counterparties in countries which are part of CLS can
use the system.
Currency pair and counterparty determine whether a deal can
settle through CLS.
TTC 2013

Section 10

The ACI
Model Code
TTC 2013

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

One question basket 20 questions


TTC 2013

Introduction to the Model Code - 1

The model code was authored by the ACI. It was

constructed with reference to a number of existing


local codes in affiliated countries, Central Banks of
some OECD countries, the FSA, and other
regulators.
The objective was to establish a universal code
which would transcend the customs and practices of
the individual countries and produce a code which
promotes ethics and a code of conduct expected of
participants in dealing in the markets covered by the
ACI financial markets association irrespective of the
centre in which deals are being concluded.
TTC 2013

Introduction to the Model Code - 2


The code does not deal with legal matters or
technicalities, but it aims to set out the manner and
spirit in which business is conducted.
Regulators have accepted the model code as the
basis for the conduct and ethics of its dealers,
brokers, and treasury operations staff.
A party who has a dispute with another
counterparty which remains unresolved, can
present a request for arbitration to the ACI
Committee For Professionalism the CFP. The
CFP ruling is not legally binding, but does offer
aggrieved parties a professional ruling on the
dispute.
TTC 2013

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.
TTC 2013

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.
TTC 2013

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.
TTC 2013

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.

TTC 2013

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
TTC 2013

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.
TTC 2013

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.
TTC 2013

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.
TTC 2013

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
TTC 2013

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!!

TTC 2013

Your Top Five


Take-Outs
Shukriah!

TTC 2013

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