If Compiled

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CONCEPTS QUESTIONS:
1) Gold Bullion Standard:
The basis of money remains a fixed weight of gold but the currency in circulation consist
of paper notes with the authorities standing ready to convert unlimited amounts of paper
currency in to gold and vice-versa, on demand at a fixed conversion ratio. Thus a pound
sterling note can be exchanged for say ‘x’ ounces of gold while a dollar note can be
converted into say ‘y’ ounces of gold on demand.
2) Gold Exchange Standard:
Gold Exchange Standard was established in order to create additional liquidity in the
international markets. Hence the some of the countries committed themselves to convert
their currencies into the currency of some other country on the gold standard rather than
into gold.
The authorities were ready to convert at a fixed rate, the paper currency issued by them
into the paper currency of another country, which is operating a gold specie or gold
bullion standard. Thus, if rupees are freely convertible into dollars and dollars in turn into
gold, rupee can be said to be on a gold exchange standard.
3) The Gold Standard:
This is the oldest system which was in operation till the beginning of the First World War
and a for few years thereafter ie it was basically from 1870 - 1914. The essential feature
of this system was that the gouvernment gave an unconditional guarentee to convert their
paper money to gold at a prefixed rate at any point of time or demand.
4) Triffins Paradox:
The Bretton Woods System had some contradictions which were pointed out by Prof. R
Tryffin which were :- The system depended on the dollar performing and its role as a key
currency. Countries other than the U.S had to accumulate dollar balances as the dollar
was the means of International payment. This meant that the US had to run BOP deficits
so that other countries could build up a stock of claims on the US. When the US deficits
started mounting, other countries started losing faith in the ability of the US to convert
their dollar asset into gold.
5) Fixed exchange rate
As the name suggests, under fixed exchange rate system, the value of a currency in terms
of another is fixed. These rates are determined by governments or central banks of the
respective countries. The fixed exchange rates result from pegging their currencies to
either some common commodity or to some particular currency. The rates remain
constant or they may fluctuate within a narrow range. When a currency tends crossing
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over the limits, governments intervene to keep within the band. Normally countries pegs
its currency to the currency in which the major transactions are carried out or some
countries even peg their currencies to SDR.
For example
: - US dollar has 24 currencies pegged to itself whereas French franc has 14 currencies
and 4 currencies are pegged to SDRs. The major advantage of this system is that it
provides stability to international trade and exchange rate risk is reduced to some extent.
Because of the fixed exchange rate system, exporters and importers are clear how much
they have to pay each other on the due date. The disadvantage is that it is prone to
speculation i.e. a speculator anticipating devaluation of pound sterling will buy US
dollars at a forward rate so as to sell them when devaluation of the pound takes place.
6) Floating Exchange Rates:
When the relative price of currencies are determined purely by force of demand and
supply and when the authorities make no attempt to hold the exchange rate at any
particular level within a specific band or move it in a certain direction by intervening in
the exchange markets, it is referred to as Floating Exchange Rate.
7) Crawling Peg:
A crawling peg rate is a hybrid of fixed and flexible exchange rate systems. Under this
system, while the value of a currency is fixed in terms of a reference currency, this peg
keeps on changing itself in accordance with the underlying economic fundamentals, thus
letting the market forces play a role in the determination of the change in exchange rate.
There are several bases which could be used to determine the direction of change in the
exchange rate for example – the actual exchange rate ruling the market, t there is gradual
modifications with permissable variations around the parity restricted to a narrow band.
The change in parity per unit period is subject to a ceiling with an additional short term
constraint, e.g. parity change in a month cannot be more than 1/12th of the yearly ceiling.
Parity changes are carried out , based on a set of indicators. They may be discretionary,
automatic or presumptive. The indicators are : current account deficits, changes in
reserves, relative inflation rates and moving average of past spot rates. Countries such as
Portugal and Brazil have in the part adopted variants of Crawling Peg.
8) Adjustable Peg:
Adjustable Peg system was established which fixed the exchange rates, with the provision
of changing them if the necessity rose. Under the new system, all the members of the
newly set up IMF were to fix the par value of their currency either in terms of gold, or in
terms of US dollar. The par value of the US dollar was fixed at $ 35 per ounce. All these
values were fixed with the approval of the IMF, and were reflected in the change
economic and financial scenario in the countries engaged in international trade. The
member countries agreed to maintain the exchange rates for their currency within a band
of one percent on either sides of the fixed par value. The extreme points were to be
referred to as upper and lower support point, due to which requirement that the countries
do not allow the exchange rate to go beyond these points. The monetary authorities were
to stand ready to buy or sell the US dollar and thereby support the exchange rates. For this
purpose, a country which would freely buy and sell gold at the aforementioned par value
for the settlement of international transactions was deemed to be maintaining its exchange
rate within the one percent band.
9) Special Drawing Rights(SDRs):
The IMF created an asset called Special Drawing Rights by simply opening an account in
the name of each member country and crediting it with a certain amount of SDRs. The
total volume created has to be ratified by the gouverning board and its allocation among
the members is propotional to their quotas. The members can use it for settling payments
among themselves as well as for transactions with the fund. E.g. paying the reserve
tranch contribution of an increase in their quotas.
10) Devaluation :
The lowering of a country’s official exchange rate in relation to a foreign currency (or to
gold) so that exports compete more favourably in the overseas markets. Devaluation is
the opposite to revaluation.
11) Lerms:
An acronym for liberalization Exchange Management System that was introduced from
March 1, 1992 under which the rupee was made partially convertible. The objective was
to encourage exporters and induce a greater inflow of remittances through proper
channels as well as bring about greater efficiency in import substitution. Under the
system, percent of eligible foreign exchange receipts such as exports earnings or
remittances was to be converted at the market rate and the balance 40% at the official rate
of exchange. Importers could obtain their requirements of foreign exchange from
authorized dealers at the market rate. Because of certain weaknesses, this system was
replaced by a unified exchange rate in March 1993. This unification was recommended as
an important step towards full convertibility by the committee on balance of payments
under the chairmanship of C Ragranajan. Under the unified rate system all foreign
exchange transactions through authorized dealers out at market determined rate
exchange.
12) Custom Union:
Custom Union is a form of economic integration in which two or more nations agree to
free all internal trade amongst themselves while levying a common external tariff on all
non-member countries. The theory of custom unions and economic integration is
associated primarily with the work of Prof. Jacob Viner in the 1940’s. This theory mainly
focuses on optimum utilization of resources present in the member countries. Integration
provides the opportunity of industries that have not yet been established as well as for
those that have to take advantage of economies of large scale production made possible
by expanded markets.
13) Dirty float:
The authorities are intervened more or less intensely in the foreign exchange market in
which there are no officially declared parties, but there is official intervention that has
come to be known as managed or dirty float.
14) Gold Tranche:
Member countries have an absolute claim on the IMF upto the amountof gold
subscriptions they have made. In operational terms, they can draw this amount (= 25% of
their quota) from IMF any time. This is called ‘reserve tranche’ or “gold tranche” and is
treated as the reserve of the country concerned. However, this sum is reimbursed to the
IMF within a specified period varying from 3 months to 5 years.
15) Credit Tranches :
Any member can unconditionally borrow the part of its quota which it has contributed in
the form of SDRs or foreign currency. When it can borrow upto 100% of its quota in four
futher tranches it is called credit tranches. (Tranche means a ‘slice’)
16)International Liquidity :
It refers to the stock of means of international payment
17) Extended Fund Facility (EFF):

This facility was established in 1974 by the IMF to help countries address more
protracted balance-of-payments problems with roots in the structure of the economy.
Arrangements under the EFF are thus longer (3 years) and the repayment period can
extend to 10 years, although repayment is expected within 4½ -7 years.
18) FDI
FDI is the acquisition of a controlling interest in a foreign firm or affiliate (branch,

subsidiary, etc.). There are a variety of ways that FDI can occur, including building new
foreign facilities from scratch ("Greenfield investment"), merging with a foreign firm,
taking over a foreign firm, and entering a partnership with a foreign firm (Example; a
joint venture).
Horizontal FDI involves investing in a firm that is in the same industry. Vertical FDI
involves investing in a supplier or customer firm.
19) PI
Portfolio investments consist mainly of the holding of transferable securities or

guaranteed by the govt. of the capital importing country. Such holdings do not amount to
right to control the company. E.g. shares, debenture, bonds etc.
20) GDR
“Global Depositary Receipts mean any instrument in the form of a depositary receipt or
certificate (by whatever name it is called) created by the Overseas Depositary Bank
outside India and issued to non-resident investors against the issue of ordinary shares or
Foreign Currency Convertible Bonds of issuing company.”
They are negotiable certificates that usually represent a company’s publicly traded
equities and can be denominated in any freely convertible foreign currency.
They are listed on a European stock exchange, often Luxembourg or London. Each DR
represents a multiple number or fraction of underlying shares or alternatively the shares
correspond to a fixed ratio, for example, 1 GDR = 10 Shares.
21) ADR
A GDR issued in America is an American Depositary Receipt (ADR). An ADR

represents an ownership interest in foreign securities. It is a negotiable instrument issued
by an American Depository bank certifying that shares of a non-US issuing company are
held by the depository’s custodian bank abroad.
Each unit of ADR is called an American Depository Share (ADS). They are an ideal way
for foreign companies to raise funds to expand their international capital base and get
name and product exposure in the US. ADR could be listed on the New York stock
exchange, NASDAQ or could be issued as private placement securities under rule 144a in
the US.
21) ODA (Official Development Assistance)

Many developing countries continue to struggle under the grips of extreme poverty. The
trends in globalization and economic transition have had both a bright and dark side.
Certain countries have been left behind by or out of the entire process, and in others, the
gulf between the rich and poor has widened. As a result of this they are in a constant need
of funds and other forms of assistance to develop them. The assistance provided for this
purpose from one country to another is termed as ODA.
Previously it was granted to a country that needed to rebuild itself after the war. ODA
came in the form of infusions of aid from the international community, ODA is a vehicle
through which countries strive to cultivate a sound international environment and
promote ties of goodwill with other countries ODA was instrumental in helping lay
essential infrastructure and in other ways set the stage for the economic takeoff of
developing countries. ODA can serve as a vital diplomatic tool for to help create a
desirable international climate and promote closer ties with other states. The main goals
of ODA can be included in following points:
• Providing humanitarian assistance for the purpose of attaining global prosperity

and development.
• Tackling Global Issues such as global environmental degradation, the population
explosion, the food and energy crises, AIDS and other infectious diseases, to drug
abuse, terrorism, crimes against international society, and now financial turmoil.
• Creating a harmonious environment of security in terms of ensuring peace and
security for the human race and the world at large,
22) Foreign Aid
One of the important methods of financing trade is through aid. Larger trade is possible
through larger aid and it is in this context that a study of the mechanics of aid is relevant
in international finance. Movement of money from one country to another in the form of
aid is referred to as the foreign aid. The donor countries not only look into their own
capacity to grant aid but at the recipient country’s capacity to absorb aid. The latter is
judged by the efficiency and productivity in the resource allocation in the pattern of
planning and investment and in priorities of allocation, the methods of raising resources
and the overall performance of the economy.
Availability of foreign aid for the purpose of investment would accelerate growth by
helping the cooperating factors at home to be fully deployed and by accelerating the rate
of investment. This would enable the necessary technical innovation and accelerate the
entrepreneurial function. Foreign aid augments domestic economic growth. The pattern
of flows under foreign aid does not depend upon pure economic factors nor on pure
commercial considerations but more on politico-economic factors.
The effect of foreign aid on the foreign exchange market is to:

• increase the supply and ease the pressures of demand,
• to facilitate the transfer mechanism in the currency markets and
• to obviate the need for frequent changes in the exchange rates, pending the process
of structural adjustment in the domestic economy.
The inflow of foreign aid would however increase the money supply, which may not lead
to inflationary pressures so long as funds are efficiently and productively used in the
development process. The basic postulate is that foreign aids fills in the gaps make
available non-available and complimentary resources and augments the investment
process.
23) Multilateral Investment Guarantee
Multilateral Investment Guarantee is a non-commercial guarantee (insurance) for

investments made in developing countries. Such a guarantee protects investors against the
risks of transfer restriction (including convertibility), expropriation, war and civil
disturbance and breach of contract. MIG has a joint sponsorship by developed and
developing countries and multilateral character.
MIG supplements national and private agencies supporting foreign direct investment
through their own investment insurance programmes. The MIG encourages foreign
investments by providing viable alternatives in investment insurance against non-
commercial risks in developing countries thereby creating investment opportunities in
those countries. E.g. Investors who would like to invest in a developing country like
Africa would surely like to get a cover for their investments and can attain this insurance
through a Multilateral Guarantee and thus can invest jointly in such an investment
project.
24) Multilateral Aid
Multilateral means "many sides". Here organisations that involve many countries, give
help. This aid is run by groups such as the World Health Organisation (WHO) and United
Nations Educational, Scientific and Cultural Organisation (UNESCO) - both of which are
part of the United Nations (UN). Economic aid for development by the developed
countries is based on political affinities with the recipient country. Such an aid may be
bilateral or multilateral. Multilateral aid is through international financial institutions for
use in the import of goods and services from any country. Multilateral aid is usable
anywhere and hence its rate of utilization will be high.
25) Bilateral Aid
Bilateral means "two sides". This type of aid is from one country to another. An example
would be Britain giving money and sending experts to help build a dam in Turkey. Quite
often bilateral aid is also tied Aid. This is the most common type of aid. In this type of aid
the giving (or donor) country also benefits economically from the aid. This happens, as
the receiving country has to buy goods and services from the donor country to get the aid
in the first place. In building a dam, for example, the Britain may insist that their
companies, experts and equipment are used. Whether the aid is given may depend on the
receiving country agreeing to buy e.g. military jets from the donor. Bilateral aid is from
one government to the other. Generally bilateral aid constitutes the bulk of the total aid
granted to any country. It may be tied or untied.
26) Petro Dollar

During the oil crises of 1973, the Capital markets have played a very important role. They
accepted the dollar deposits from oil exporters and channeled the funds to the borrowers
in other countries. This is called ‘recycling the petrodollars’.
27) Junk Bonds
A junk bond is issued by a corporation or municipality with a bad credit rating. In

exchange for the risk of lending money to a bond issuer with bad credit, the issuer pays
the investor a higher interest rate. "High-yield bond" is a nicer name for junk bond The
credit rating of a high yield bond is considered "speculative" grade or below "investment
grade". This means that the chance of default with high yield bonds is higher than for
other bonds. Their higher credit risk means that "junk" bond yields are higher than bonds
of better credit quality. Studies have demonstrated that portfolios of high yield bonds
have higher returns than other bond portfolios, suggesting that the higher yields more
than compensate for their additional default risk.
Junk bonds became a common means for raising business capital in the 1980s, when they
were used to help finance the purchase of companies, especially by leveraged buyouts,
the sale of junk bonds continued to be used in the 1990s to generate capital
28) Samurai Bonds

They are publicly issued yen denominated bonds. They are issued by non-Japanese
entities.
The Japanese Ministry of Finance lays down the eligibility guidelines for potential
foreign borrowers. These specify the minimum rating, size of issue, maturity and so forth.
Floatation costs tend to be high. Pricing is done with respect to Long-term Prime Rate.
29) Shibosai Bonds

They are private placement bonds with distribution limited to banks and institutions. The
eligibility criteria are less stringent but the MOF still maintains control.
30) Shogun / Geisha Bonds

They are publicly floated bonds in a foreign currency while Geisha are their private
counterparts.
31) Yankee Bonds

These are dollar denominated bonds issued by foreign borrowers. It is the largest and
most active market in the world but potential borrowers must meet very stringent
disclosure, dual rating and other listing requirements, options like call and put can be
incorporated and there are no restrictions on size of the issue, maturity and so forth.
Yankee bonds can be offered under rule 144a of Sec. These issues are exempt from
elaborate registration and disclosure requirements but rating, while not mandatory is
helpful. Finally low rated or unrated borrowers can make private placements. Higher
yields have to be offered and the secondary market is very limited.
32) Value Date:
The settlement of a transaction takes place by transfers of deposits between two parties.
The day on which these transfers are effected is called the Settlement Date or the Value
Date.
33) Spot Rate:

When the exchange of currencies takes place on the second working day after the date of
the deal, it is called spot rate.
34) Forward Transactions:

If the exchange of currencies takes place after a certain period from the date of the deal
(more than 2 working days), it is called a forward rate. A trader may quote a forward
transaction for any future date. It is a binding contract between a customer and dealer for
the purchase or sale of a specific quantity of a stated foreign currency at the rate of
exchange fixed at the time of making the contract.
35) Swap Transaction:

A swap transaction in the foreign exchange market is combination of a spot and a forward
in the opposite direction. Thus a bank will buy DEM spot against USD and
simultaneously enter into a forward transaction with the same counter party to sell DEM
against USD against the mark coupled with a 60- day forward sale of USD against the
mark. As the term ‘swap’ implies, it is a temporary exchange of one currency for another
with an obligation to reverse it at a specific future date.
36) Bid Rate:

The bid rate denotes the number of units of a currency a bank is willing to pay when it
buys another currency.
37) Offer Rate:

The offer rate denotes the number of units of a currency a bank will want to be paid when
it sells a currency.
38) Bid - Offer Rate:

The bid offer Rate is the rate which states both, the price which is the bank is willing to
pay to buy other currencies and the price the bank expects when it sells the same
currency. Bid and Ask will always be from a bank’s point of view. Thus (A/B)bid will
denote the number of units of A the bank will pay when it buys one unit of B and
(A/B)ask will mean the number of units of A the bank will want to be paid in order to sell
one unit of B.
39) European Quote:

The quotes are given as number of units of a currency per USD. Thus DEM1.5675/USD
is a European quote.
40) American Quotes:

American quotes are given as number of dollars per unit of a currency. Thus
USD0.4575/DEM is an American quote.
41) Direct Quotes:

in a country, direct quotes are those that give unit of the currency of that country per unit
of a foreign currency. Thus INR 35.00/USD is a direct quote in India.
42) Indirect Quote:

Indirect or Reciprocal Quotes are stated as number of units of a foreign currency per unit
of the home currency. Thus USD 3.9560/INR 100 is an indirect quote in India.
43) Arbitrage:
Arbitrage may be defined a san operation that consists in deriving a profit without risk
from a differential existing between different quoted rates. It may result from 2
currencies, also known as, geographical arbitrage or from 3 currencies, also known as,
triangular currencies.
Examine the transformation of the European Union from a political and economic
union to a monetary union.
Ans: - The basis of the European Monetary Union was to build a united Europe after the
World War II. This was initiated by when the European nations created the European
Coal and Steel community, with a view to freeing trade in these two sectors. The pricing
policies and commercial practices of the member nations of this community were
regulated by a supranational agency. In 1957, the Treaty of Rome was signed by
Belgium, France, Germany, Italy, Luxemburg and the Netherlands to form the European
Economic Community (EEC), whereby they agreed to make Europe a common market.
While they agreed to lift restrictions on movements of all factors of production and to
harmonize domestic policies, the ultimate aim was economic integration. The EEC
achieved the status of a customs union by 1968. In the same year, it adopted a Common
Agricultural Policy (CAP), under which uniform prices were set for farm products in the
member countries, and levies were imposed on imports from non- member countries to
protect the regional industry from lower external prices. In the European unification,
power was given to all member countries that they could veto any decision taken by other
members. This hindrance was removed when the members approved of the Single
European Act, in 1986, making it possible for a lot of proposals to be passed by weighted
majority voting. This paved way for the unifications of the markets for capital and labour,
which converted EEC practically into a market on January 1, 1993.
The Heads of State and governments of the countries of the EU decided at Maastricht on
9th and 10th December 1991 to put in place the European Monetary Union (EMU).
Adhering to the EMU meant irrevocable fixed exchange rates between different countries
of the Union. The setting up of the EMU had been a step forward towards the
introduction of a common currency in the member states of EU, as per the Maastricht
Treaty. It had been ratified by all 12 countries which constituted the union at that point of
time. The EMU completed the mechanism that started with the Customs Union of the
Treaty of Rome and the big Common Market of the Single Act.
The objectives of the EMU are:-
• Adoption of an economic policy, based on a close coordination between

economic policies of the member states.
• Fixing of irrevocable exchange rates leading to a single currency.
• Development of a single monetary policy having objective of price stability and
the support to the economic policies of the member states in general.
The primary advantage of EMU was that it helped in stabilizing exchange rates in the
currencies of member states. It also helped in elimination of transaction costs, greater
transparency in prices and greater credibility with respect to the world outside. Also,
EMU signified giving up a independent national monetary policy. There seemed to be an
agreement among the member states that the effect of the EMS would be beneficial for
the economic growth of Europe. However it was anticipated there would be some
problems in short and medium term. For instance, the programmes of structural
adjustment carried out by the countries like Italy, Spain, Germany to reduce public
deficits and inflation by a restrictive policy had negative effects on internal demand and
growth. This policy also had negative effects on neighboring countries in terms of
reduction of their international business. The countries which had not attained a required
level of economic convergence found it difficult for maintaining the currency within the
EMS.
Thus the transformation of the European Union from a political and economic union to a
monetary union has explained above along with the features of the EMU.
DISCUSS THE RELEVANCE / IMPORTANCE OF THE BOP STATEMENTS?
BOP statistics are regularly compiled, published and are continuously monitored by
companies, banks and government agencies. A set of BOP accounts is useful in the same
way as a motion picture camera. The accounts do not tell us what is good or bad, nor do
they tell us what is causing what. But they do let us see what is happening so that we can
reach our own conclusions. Below are 3 instances where the information provided by
BOP accounting is very necessary:
1. Judging the stability of a floating exchange rate system is easier with BOP as the
record of exchanges that take place between nations help track the accumulation of
currencies in the hands of those individuals more willing to hold on to them.
2. Judging the stability of a fixed exchange rate system is also easier with the same
record of international exchange. These exchanges again show the extent to which a
currency is accumulating in foreign hands, raising questions about the ease of
defending the fixed exchange rate in a future crisis.
3. To spot whether it is becoming more difficult for debtor counties to repay foreign
creditors, one needs a set of accounts that shows the accumulation of debts, the
repayment of interest and principal and the countries ability to earn foreign exchange
for future repayment. A set of BOP accounts supplies this information. This point is
further elaborated below.
The BOP statement contains useful information for financial decision makers. In the short
run, BOP deficit or surpluses may have an immediate impact on the exchange rate.
Basically, BOP records all transactions that create demand for and supply of a currency.
When exchange rates are market determined, BOP figures indicate excess demand or
supply for the currency and the possible impact on the exchange rate. Taken in
conjunction with recent past data, they may conform or indicate a reversal of perceived
trends. They also signal a policy shift on the part of the monetary authorities of the
country unilaterally or in concert with its trading partners. For instance, a country facing
a current account deficit may raise interest to attract short term capital inflows to prevent
depreciation of its currency. Countries suffering from chronic deficits may find their
credit ratings being downgraded because the markets interpret the data as evidence that
the country may have difficulties its debt.
BOP accounts are intimately with the overall saving investment balance in a country’s
national accounts. Continuing deficits or surpluses may lead to fiscal and monetary
actions designed to correct the imbalance which in turn will affect exchange rates and
interest rates in the country. In nutshell corporate finance managers must monitor the
BOP data being put out by government agencies on a regular basis because they have
both short term and long term implications for a host of economic and financial variables
affecting the fortunes of the company.
Futures
A futures contract is an agreement between two parties to buy or sell an asset at a certain
specified time in future for certain specified price. In this, it is similar to a forward
contract. However, there are a number of differences between forwards and futures.
These relate to the contractual features, the way the markets are organized, profiles of
gains and losses, kinds of participants in the markets and the ways in which they use the
two instruments.
Futures contracts in physical commodities such as wheat, cotton, corn, gold, silver, cattle,
etc. have existed for a long time. Futures in financial assets, currencies, interest bearing
instruments like T-bills and bonds and other innovations like futures contracts in stock
indexes are a relatively new development dating back mostly to early seventies in the
United States and subsequently in other markets around the world.
Major Features Of Futures Contracts
The principal features of the contract are as follows:
Organized Exchanges
Unlike forward contracts which are traded in an over-the-counter market, futures are
traded on organized exchanges with a designated physical location where trading takes
place. This provides a ready, liquid market in which futures can be bought and sold at any
time like in a stock market.
Standardization
In the case of forward currency contracts, the amount of commodity to be delivered and
the maturity date are negotiated between the buyer and seller and can be tailor-made to
buyer's requirements. In a futures contract both these are standardized by the exchange on
which the contract is traded. Thus, for instance, one futures contract in pound sterling on
the International Monetary Market (IMM), a financial futures exchange in the US, (part
of the Chicago Board of Trade or CBT), calls fore delivery of 62,500 British Pounds and
contracts are always traded in whole numbers i.e. you cannot buy or sell fractional
contracts. A three-month sterling deposit on the London International Financial Futures
Exchange (LIFFE) has March, June, September, December delivery cycle. The exchange
also specifies the minimum size of price movement (called the "tick") and, in some cases,
may also impose a ceiling on the maximum price change within a day. In the case of
commodity futures, the commodity in question is also standardized for quality in addition
to quantity in a single contract.
Clearing House
The exchange acts as a clearinghouse to all contracts struck on the trading floor. For
instance, a contract is struck between A and B. Upon entering into the records of the
exchange, this is immediately replaced by two contracts, one between A and the clearing
house and another between B and the clearing house. In other words, the exchange
interposes itself in every contract and deal, where it is a buyer toe very seller and a seller
to every buyer. The advantage of this is that A and B do not have to undertake any
exercise to investigate each other's creditworthiness. It also guarantees the financial
integrity of the market. The exchange enforces delivery for contracts held until maturity
and protects itself from default risk by imposing margin requirements on traders and
enforcing this through a system called "marking to market".
Margins
Like all exchanges, only members are allowed to trade in futures contracts on the
exchange. Others can use the services of the members as brokers to use this instrument.
Thus, an exchange member can trade on his own account as well as on behalf of a client.
A subset of the members is the "clearing members" or members of the clearinghouse and
non-clearing members must clear all their transactions through a clearing member.
The exchange requires that a margin must be deposited with the clearinghouse by a
member who enters into a futures contract. The amount of the margin is generally
between 2.5% to 10% of the value of the contract but can vary. A member acting on
behalf of a client, in turn, requires a margin from the client. The margin can be in the
form of cash or securities like treasury bills or bank letters of credit.
Marking To Market
The exchange uses a system called marking to market where, at the end of each trading
session, all outstanding contracts are repriced at the settlement price of that trading
session. This would mean that some participants would make a loss while others would
stand to gain. The exchange adjusts this by debiting the margin accounts of those
members who made a loss and crediting the accounts of those members who have gained.
This feature of futures trading creates an important difference between forward contracts
and futures. In a forward contract, gains or losses arise only on maturity. There are no
intermediate cash flows. Whereas, in a futures contract, even though the gains and losses
are the same, the time profile of the accruals is different. In other words, the total gains or
loss over the entire period is broken up into a daily series of gains and losses, which
clearly has a different present value.
Actual Delivery Is Rare
In most forward contracts, the commodity is actually delivered by the seller and is
accepted by the buyer. Forward contracts are entered into for acquiring or disposing off a
commodity in the future for a gain at a price known today. In contrast to this, in most
futures markets, actual delivery takes place in less than one percent of the contracts
traded. Futures are used as a device to hedge against price risk and as a way of betting
against price movements rather than a means of physical acquisition of the underlying
asset. To achieve this, most of the contracts entered into are nullified by a matching
contract in the opposite direction before maturity of the first.
Types of futures
As is evident from the previous discussion, trading in futures is equivalent to betting on
the price movements in futures prices. If such betting is used to protect a position - either
long or short - in the underlying asset, it is termed as hedging. On the other hand, if the
activity is undertaken only with the objective of generating profits from absolute or
relative price movements, it is termed as speculation. It must be noted that speculators

provide liquidity to the markets by their willingness to enter open positions.
We shall briefly look at currency, interest rate and stock index futures. There are others
like commodity futures as well which are not covered under this section.
Currency Futures
We shall look at both hedging and speculation in currency futures. Corporations, banks
and others use currency futures for hedging purposes. The underlying principle is as
follows:
Assume that a corporation has an asset e.g. a receivable in a currency A that it would like
to hedge, it should take a futures position such that futures generate a positive cash
whenever the asset declines in value. In this case, since the firm in long, in the underlying
asset, it should go short in futures i.e. it should sell futures contracts in A. Obviously, the
firm cannot gain from an appreciation of A since the gain on the receivable will be eaten
away by the loss on the futures. The hedger is willing to sacrifice this potential profit to
reduce or eliminate the uncertainty. Conversely, a firm with a liability in currency A e.g. a
payable, should go long in futures.
In hedging too, the corporation has the option of a direct hedge and a cross hedge. A
British firm with a dollar payable can hedge by selling sterling futures (same effect as
buy dollar futures) on the IMM or LIFFE. This is an example of a direct hedge. If the
dollar appreciates, it will lose on the payable but gain on the futures, as the dollar price of
futures will decline.
An example of a cross hedge is as follows:
A Belgian firm with a dollar payable cannot hedge by selling Belgian franc futures
because they are not traded. However, since the Belgian franc is closely tied to the
Deutschemark in the European Monetary System (EMS). It can sell DM futures.
An important point to note is that, in a cross hedge, a firm must choose a futures contract
on an underlying currency that is highly positively correlated with the currency exposure
being hedged.
Also, even when a direct hedge is available, it is extremely difficult to achieve a perfect
hedge. This is due to two reasons. One is that futures contracts are for standardized
amounts as this is designed by the exchange. Evidently, this will only rarely match the
exposure involved. The second reason involves the concept of basis risk. The difference
between the spot price at initiation of the contract and the futures price agreed upon is
called the basis. Over the term of the contract, the spot price changes, as does the futures
price. But the change is not always perfectly correlated - in other words, the basis is not
constant. This gives rise to the basis risk. Basis risk is dealt with through the hedge ratio
and a strategy called delta hedging.
A speculator trades in futures to profit from price movements. They hold views about the
future price movements - if these differ from those of the general market, they will trade
to profit from this discrepancy. The flip side is that they are willing to take the risk of a
loss if the prices move against their views of opinions.
Speculation using futures can be in the either open position trading or spread trading. In
the former, the speculator is betting on movements in the price of a particular futures
contract. In the latter, he is betting on the price differential between two futures contracts.
An example of open position trading is as follows:
$/DM Prices
Spot 0.5785
March Futures 0.5895
June Futures 0.5915
September Futures 0.6015
These prices evidently indicate that the market expects the DM to appreciate over the
next 6-7 months. If there is a speculator who holds the opposite view - i.e. he believes
that the DM is actually going to depreciate. There is another speculator who believes that
the DM will appreciate but not to the extent that the market estimates - in other words,
the appreciation of the DM will fall short of market expectations. Both these speculators
sell a September futures contract (standard size - DM 125,000) at $ 0.6015.
On September 10, the following rates prevail:
Spot $/DM - 0.5940, September Futures - 0.5950
Both speculators reverse their deal with the purchase of a September futures contract. The
profit they make is as follows:
$(0.6015-0.5950) i.e. $0.0065 per DM or $(125000 x 0.0065) i.e. $ 812.5 per contract.
A point to be noted in the above example is that the first speculator made a profit inspite
the fact that his forecast was faulty. What mattered therefore, was the movement in
September futures price relative to the price that prevailed on the day the contract was
initiated.
In contrast to the open position trading, spread trading is considered a more conservative
form of speculation. Spread trading involves the purchase of one futures contract and the
sale of another. An intra-commodity spread involves difference in prices of two futures
contract with the same underlying commodity and different maturity dates. These are also
termed as time spreads. An inter-commodity spread involves the difference in prices of
two futures contracts with different but related commodities. These are usually with the
same maturity dates.
Interest Rate Futures

Interest rate futures is one of the most successful financial innovations in recent years.
The underlying asset is a debt instrument such as a treasury bill, a bond or time deposit in
a bank. The International Monetary Market (IMM) - a part of the Chicago Mercantile
Exchange, has futures contracts on US Government treasury bonds, three-month Euro-
dollar time deposits and medium term US treasury notes among others. The LIFFE has
contracts on euro-dollar deposits, sterling time deposits and UK Government bonds. The
Chicago Board of Trade offers contracts on long term US treasury bonds.
Interest rate futures are used by corporations, banks and financial institutions to hedge
interest rate risk. A corporation planning to issue commercial paper can use T-bill futures
to protect itself against an increase in interest rate. A treasurer who is expecting some
surplus cash in the near future to be invested in some short term investments may use the
same as insurance against a fall in interest rates. Speculators bet on interest rate
movements or changes in the term structure in the hope of generating profits.
A complete analysis of interest rate futures would be a complex exercise as it involves
thorough understanding and familiarity with concepts such as discount yield, yield-to-
maturity and elementary mathematics of bond valuation and pricing.
Stock Index Futures
A stock index futures contract is an obligation to deliver on the settlement date an amount
of cash equivalent to the value of 500 times the difference between the stock index value
at the close of the last trading day of the contract and the price at which the futures
contract was originally struck. For example, if the S&P 500 Stock Index is at 500 and
each point in the index equals $ 500, a contract struck at this level is worth $ 250,000
(500 * $500). If, at the expiration of the contract, the S&P 500 Stock Index is at 520, a
cash settlement of $ 10,000 is to be made [ (520 - 510) * $500].
It must be noted that no physical delivery of stock is made. Therefore, in order to ensure
that sufficient funds are available for settlement, both parties have to maintain the
requisite deposit and meet the variation margin calls as and when required.
Options
A options agreement is a contract in which the writer of the option grants the buyer of the
option the right purchase from or sell to the writer a designated instrument for a specified
price within a specified period of time.
The writer grants this right to the buyer for a certain sum of money called the option
premium. An option that grants the buyer the right to buy some instrument is called a call
option. An options that grants the buyer the right to sell an instrument is called a put
option. The price at which the buyer an exercise his option is called the exercise price,
strike price or the striking price.
Options are available on a large variety of underlying assets like common stock,
currencies, debt instruments and commodities. Also traded are options on stock indices
and futures contracts – where the underlying is a futures contract and futures style
options.
Options have proved to be a versatile and flexible tool for risk management by
themselves as well as in combination with other instruments. Options also provide a way
for individual investors with limited capital to speculate on the movements of stock
prices, exchange rates, commodity prices etc. The biggest advantage in this context is the
limited loss feature of options.
Types Of Options
As mentioned earlier, the underlying asset for options could be a spot commodity or a
futures contract on a commodity. Another variety is the futures-style option.
An option on spot foreign exchange gives the option buyer the right to buy or sell a
currency at a stated price (in terms of another currency). If the option is exercised, the
option seller must deliver or take delivery of a currency.
An option on currency futures gives the option buyer the right to establish a long or short
position in a currency futures contract at a specified price. If the option is exercised, the
seller must take the opposite position in the relevant futures contract. For example,
suppose you had an option to buy a December DM contract on the IMM at a price of $
0.58 / DM. You exercise the option when December futures are trading at $ 0.5895. You
can close out your position at this price and take a profit of $ 0.0095 per DM or, meet
futures margin requirements and carry a long position with $ 0.0095 per DM being
credited to your margin account. The option seller automatically gets a short position in
December futures.
Futures style options are a little bit more complicated. Like futures contracts, they
represent a bet on a price. The price being betted on, is the price of an option on spot
foreign exchange. Simply put, the buyer of the option has to pay a price to the seller of
the option i.e. the premium or the price of the option. In a futures style option, you are
betting on the changes in this price, which, in turn depends on several factors including
the spot exchange rate of the currency involved. For instance, a trader feels that the
premium on a particular option is going to increase. He buys a futures-style call option.
The seller of this call option is betting that the premium will go down. Unlike the option
on the spot, the buyer does not pay the premium to the seller. Instead, they both post
margins related to the value of the call on spot.
Options Terminology
To reiterate, the two parties to an options contract are the option buyer and the option
seller, also called the option writer. For exchange traded options, as in the case of futures,
once the agreement is reached between two traders, the exchange (the clearing house)
interposes itself between the two parties becoming buyer to every seller and seller to
every buyer. The clearing house guarantees performance on the part of every seller.
Call Option
A call option gives the option buyer the right to purchase currency Y against currency X,
at a stated price X/Y, on or before a stated date. For exchange traded options, one contract
represents a standard amount of the currency Y. The writer of a call option must deliver
the currency if the option buyer chooses to exercise his option.
Put Option
A put option gives the option buyer the right to sell a currency Y against currency X at a
specified price on or before a specified date. The writer of a put option must take delivery
if the option is exercised.
Strike Price (also called exercise price)
The price specified in the option contract at which the option buyer can purchase the
currency (call) or sell the currency (put) Y against X.
Maturity Date
The date on which the option contract expires is the maturity date. Exchange traded
options have standardized maturity dates.
American Option
An option, call or put, that can be exercised by the buyer on any business day from
initiation to maturity.
European Option
A European option is an option that can be exercised only on maturity date.
Premium (Option price, Option value)

The fee that the option buyer must pay the option writer at the time the contract is
initiated. If the buyer does not exercise the option, he stands to lose this amount.
Intrinsic value of the option
The intrinsic value of an option is the gain to the holder on immediate exercise of the
option. In other words, for a call option, it is defined as Max [(S-X), 0], where s is the
current spot rate and X is the strike rate. If S is greater than X, the intrinsic value is
positive and is S is less than X, the intrinsic value will be zero. For a put option, the
intrinsic value is Max [(X-S), 0]. In the case of European options, the concept of intrinsic
value is notional as these options are exercised only on maturity.
Time value of the option
The value of an American option, prior to expiration, must be at least equal to its intrinsic
value. Typically, it will be greater than the intrinsic value. This is because there is some
possibility that the spot price will move further in favor of the option holder. The
difference between the value of an option at any time "t" and its intrinsic value is called
the time value of the option.
At-the-Money, In-the-Money and Out-of-the-Money Options
A call option is said to be at-the-money if S=X i.e. the spot price is equal to the exercise
price. It is in-the-money is S>X and out-of-the-money is S<X. Conversely, a put option is
at-the-money is S=X, in-the-money if S<X and out-of-the-money if S>X.
Option Pricing
Black & Scholes, in their celebrated analysis on option pricing, reached the conclusion
that the estimated price of a call could be calculated with the following equation:
Pc = [Ps][N(d1) – [Pe][antilog (-Rft)[N(d2)]
Where:
Pc - market value of the call option
Ps - price of the stock
Pe - strike price of the option
Rf - annualized interest rate
t - time to expiration in years
antilog – to the base e
N(d1) and N(d2) are the values of the cumulative normal distribution, defined as follows:
d1 = Ln (Ps / Pe) + (Rf + 0.5 s 2)t
sÖt
d2 = d1 - (s Ö t)
where:
Ln (Ps / Pe) is the natural logarithm of (Ps / Pe)
s 2 is the is the variance of continuously compounded rate of return on stock per time
period.
Admittedly, the definitions of d1 and d2 are difficult to grasp for the reader as they involve
complex mathematical equations. However, the basic properties of the Black-Scholes
model are easy to understand. What the model establishes is that the estimated price of
options vary directly with an option’s term to maturity and with the difference between
the stock’s market price and the option’s strike price. Further, the definitions of d1 and d2
indicate that option prices increase with the variance of the rate of return on the stock
price, reflecting that the greater the volatility, higher the chance that the option will
become more valuable.
Relationship Between The Option Premium And Stock Price
It is obvious that the option premium fluctuates as the stock price moves above or below
the strike price. Generally, option premiums rarely move point for point with the price of
the underlying stock. This typically happens only at parity, in other words, when the
exercise price plus the premium equals the market price of the stock.
Prior to reaching parity, premiums tend to increase less than point per point with the stock
price. One reason for this are that point per point increase in premium would result in
sharply reduced leverage for the option buyers – reduced leverage means reduced
demand for the option. Also, a higher option premium entails increased capital outlay and
increased risk, once again reducing demand for the option.
Declining stock prices also do not result in a point per point decrease in option premium.
This is because, even a steep decline in the stock price in a span of a few days has only a
slight effect on the option’s total value – its time value. This term to maturity effect tends
to exist as the option is a wasting asset.
Option Strategies
This section deals with some of the most basic strategies that can be devised using
options. The idea is to familiarize the reader with the flexibility of options as a risk
management tool. In order to keep matters simple, we make the following assumptions:
• We shall ignore brokerage, commissions, margins etc.

• We shall assume that the option is exercised only on maturity and not prematurely
exercise - in other words, we assume that we are only dealing with European
options
• All exchange rates, strike prices and premia will be in terms of dollars per unit of
a currency and the option will be assumed to be on one unit of the currency.
Call Options
A call option buyer's profit can be defined as follows:
At all points where S<X, the payoff will be -c
At all points where S>X, the payoff will be S-X- c, where
S = Spot price
X = Strike price or exercise price
c = call option premium
Conversely, the option writer's profit will be as follows:
At all points where S<X, the payoff will be c
At all points where S>X, the payoff will be -(S-X- c)
To illustrate this, let us look at an example and construct the payoff profile.
Consider a trader who buys a call option on the Swiss Franc with a strike price of $ 0.66
and pays a premium of 1.95 cents ($0.0195). The current spot rate is 0.6592. His gain or
loss at time T when the option expires depends upon the value of the spot rate at that
time.
For all values of S below 0.66, the option buyer lets the option lapse since the Swiss
francs can be bough in the spot market at a lower price. His loss then will be limited to
the premium he has paid. For spot values greater than the strike price, he will exercise the
option.
Let us look at the payoff profile of the call option buyer.
Spot Rate Gain (S-X-c) Loss (-c)
0.6000 - -0.0195
0.6500 - -0.0195
0.6600 - -0.0195
0.6700 - -0.0195
0.6795 - -
0.6800 0.0005 -
0.6900 0.0105 -
0.7000 0.0205 -
Similarly, we can construct the payoff profile for the call writer. This will be as follows:
Spot Rate Gain (c) Loss (S-X-c)
0.6000 0.0195 -
0.6500 0.0195 -
0.6600 0.0195 -
0.6700 0.0195 -
0.6795 - -
0.6800 - -0.0005
0.6900 - -0.0105
0.7000 - -0.0205
Put Option
A put option buyer's profit can be defined as follows:
At all points where S<X, the payoff will be X-S-p
At all points where S>X, the payoff will be -p, where
S = Spot price
X = Strike price or exercise price
p = put option premium
Conversely, the put option writer's profit will be as follows:
At all points where S<X, the payoff will be -(X-S- p)
At all points where S>X, the payoff will be p
For example, let us take the case of a trader who buys a June put option on pound sterling
at a strike price of $1.7450, for a premium of $0.05 per sterling. The spot rate at that time
is $ 1.7350.
For all values of S greater than $1.7450, the option will not be exercised as the sterling
has a higher price in the spot market. For values between $1.6950 and $ 1.7450, the
option will be exercised, though there will still be a loss. Here the option buyer is trying
to minimize the loss. For values of spot rate below $ 1.6950, the option will be exercised
and will lead to a net profit.
At expiry, the put option buyer's payoff profile can be depicted as follows:
Spot Rate Gain (X-S-p) Loss (-p)
1.6600 0.0350 -
1.6800 0.0150 -
1.6900 0.0050 -
1.6950 - -
1.7400 - -0.0450
1.7500 - -0.0500
1.7800 - -0.0500
1.8000 - -0.0500
Similarly, we can construct a payoff profile for the put option writer. His gains and losses
will look as follows:
Spot Rate Gain (p) Loss -(X-S-p)

1.6600 - -0.0350
1.6800 - -0.0150
1.6900 - -0.0050
1.6950 - -
1.7400 0.0450 -
1.7500 0.0500 -
1.7800 0.0500 -
1.8000 0.0500 -
Spread Strategies
Spread strategies with options involve simultaneous sale and purchase of two different
option contracts. The objective in these strategies is to realize a profit if the underlying
price moves in a fashion that is expected and to limit the magnitude of loss in case it
moves in an unexpected fashion. Evidently, these are speculative in nature. However,
these strategies are such that they provide limited gains while also ensuring limited
losses.
Spread strategies involving options with same maturity but different strike prices are
called vertical spreads or price spreads. The types of vertical spread strategies are bullish
call spreads, bearish call spreads, bullish put spreads and bearish put spreads. The
expectation when going in for these strategies is that the underlying rate is likely to either
appreciate or depreciate significantly.
Horizontal or time spread strategies involve simultaneous buying and selling of two
options which are similar in all respects except in maturity. The basic idea behind this is
that the time value of the short maturity option will decline faster than that of the long
maturity option. The expectation when going for this strategy is that the underlying price
will not change drastically but the difference in premia will over time.
Vertical Spread Strategies
A bullish call consists of selling the call with the higher strike price and buying the call
with the lower strike price. The expectation is the underlying currency is likely to
appreciate. The investor however, would like to limit his losses.
Since a lower priced call is being bought i.e. higher premium is paid and a higher priced
call is being sold i.e. lower premium is received, the initial net investment would be the
difference in the two premia. The maximum profit potential will be the difference in the
strike prices minus the initial investment. The maximum loss is the initial investment.
This strategy thus yields a limited profit if the currency appreciates and a limited loss if
the currency depreciates.
On the other hand, if the investor expects the currency to depreciate, he can go in for the
bearish call spread. This is the reverse of the bullish spread i.e. the call with the higher
strike price is bought and that with the lower strike price is sold. The maximum gain will
be the difference in the premia. The maximum loss will be the difference is premia minus
the difference in the strike prices.
A bullish put spread consists of selling a put option with higher strike price and buying a
put option with a lower strike price. In this case, if there is a significant appreciation in
the underlying rate, neither put will be exercised and the net gain will be the difference in
premia. Maximum loss will be the difference in strike prices minus the difference in
premia. A bearish put spread is the opposite of a bullish put spread.
An extension of the idea of vertical spreads is the butterfly spread. A butterfly spread
involves three options with different strike prices but same maturity. A butterfly spread is
bought by purchasing two calls with the middle strike price and selling one call each with
the strike price on either side. The investor's expectation is that there will be a significant
movement in the underlying rate - he is, however, unsure of the direction of this
movement. This strategy yields a limited profit if there is a significant movement in the
underlying rate - appreciation or depreciation. But if the movements are moderate or not
very significant, it tends to result in a loss.
Selling a butterfly spread involves selling two intermediate priced calls and buying one
on either side. As opposed to the buyer of a butterfly spread, the seller here is betting on
moderate or non-significant movements. He does not expect drastic movements either
way. Therefore, this strategy yields a small profit if there are moderate changes in the
exchange rate and a limited loss if there are large movements on either side.
Horizontal Or Time Spreads
As mentioned earlier, horizontal or time spread strategies involve simultaneous buying
and selling of two options which are similar in all respects except in maturity. The basic
idea behind this is that the time value of the short maturity option will decline faster than
that of the long maturity option.
Straddles And Strangles
A Straddle strategy consists of buying a call and a put both with identical strikes and
maturity. If there is a drastic depreciation, the investor gains on the put i.e. by exercising
the option to sell. If there is a drastic appreciation, the investor exercises the call and
purchases at the lower price. However, if there is a moderate movement either way, the
investor will suffer a loss.
A strangle is similar to a straddle. It consists of buying a call with strike above the current
spot rate and a put with a strike price below the current spot. Like the straddle, it yields a
profit for drastic movements and a loss for moderate movements.
Currency options thus, provide the corporate treasurer a tool for hedging foreign
exchange risks arising out of the firm's operations. Unlike the forward contracts, options
allow the hedger to gain from favorable exchange rate movements while being protected
against unfavorable movements
Swaps
Financial swaps are a funding technique, which permit a borrower to access one market
and then exchange the liability for another type of liability. The global financial markets
present borrowers and investors with a wide variety of financing and investment vehicles
in terms of currency and type of coupon - fixed or floating. Floating rates are tied to an
index which could be the London Interbank borrowing rate (LIBOR), US treasury bill
rate etc. This helps investors exchange one type of asset for another for a preferred stream
of cash flows.
It must be noted that swaps by themselves are not a funding instrument; they are a device
to obtain the desired form of financing indirectly. The borrower might otherwise have
found this too expensive or even inaccessible.
A common explanation for the popularity of swaps concerns the concept of comparative
advantage. The basic principle is that some companies have a comparative advantage
when borrowing in fixed rate markets while other companies have a comparative
advantage in floating rate markets. This may lead to some companies borrowing in fixed
markets when the need is of a floating rate loan and vice versa. Swaps are used to
transform the fixed rate loan into a floating rate loan.
Types Of Swaps
All swaps involve exchange of a series of periodic payments between two parties. A swap
transaction usually involves an intermediary who is a large international financial
institution. The two payment streams are estimated to have identical present values at the
outset when discounted at the respective cost of funds in the relevant markets.
The two most widely prevalent types of swaps are interest rate swaps and currency
swaps. A third is a combination of the two to result in cross-currency interest rate swaps.
Of course, a number of variations are possible under each of these major types of swaps.
Interest Rate Swaps
An interest rate swap as the name suggests involves an exchange of different payment
streams which fixed and floating in nature. Such an exchange is referred to as a exchange
of borrowings or a coupon swap. In this, one party, B, agrees to pay to the other party, A,
cash flows equal to interest at a predetermined fixed rate on a notional principal for a
number of years. At the same time, party A agrees to pay party B cash flows equal to
interest at a floating rate on the same notional principal for the same period of time. The
currencies of the two sets of interest cash flows are the same. The life of the swap can
range from two years to over 15 years. This type of a standard fixed to floating rate swap
is also called a plain vanilla swap in the market jargon.
London Inter-bank Offer Rate (LIBOR) is often the floating interest rate in many of the
interest rate swaps. LIBOR is the interest rate offered by banks on deposits from other
banks in the Eurocurrency markets. LIBOR is determined by trading between banks and
changes continuously as the economic conditions change. Just as the Prime Lending Rate
(PLR) is used as the benchmark or the peg for many Indian floating rate instruments,
LIBOR is the most frequently used reference rate in international markets.
Usually, two non-financial companies do not get in touch with each other to directly
arrange a swap. They each deal with a financial intermediary such as a bank who then
structures the plain vanilla swap in such a way so as to earn them a margin or a spread. In
international markets, they typically earn about 3 basis points (0.03%) on a pair of
offsetting transactions.
At any given point of time, the swap spreads are determined by supply and demand. If
more participants in the swap markets want to receive fixed rather than floating, swap
spreads tend to fall. If the reverse is true, the swap spreads tend to rise.
In real life, it is difficult to envisage a situation where two companies contact a financial
institution at exactly the same time with the proposal to take opposite positions in the
same swap. Most large financial institutions are therefore prepared tow are house interest
rate swaps. This involves entering into a swap with a counterparty, then hedging the
interest rate risk until an opposite counterparty us found. Interest rate future contracts are
resorted to as a hedging tool in such cases.
Currency Swaps
Currency swaps involves exchanging principal and fixed rate interest payments on a loan
in one currency for principal and fixed rate interest payments on an approximately
equivalent loan in another currency.
Suppose that a company A and company B are offered the fixed five-year rates of interest
in U.S. dollars and sterling. Also suppose that sterling rates are generally higher than the
dollar rates. Also, company A enjoys a better creditworthiness than company B as it is
offered better rates on both dollar and sterling. What is important to the trader who
structures the swap deal is that difference in the rates offered to the companies on both
currencies is not the same. Therefore, though company A has a better deal in both the
currency markets, company B does enjoy a comparatively lower disadvantage in one of
the markets. This creates an ideal situation for a currency swap. The deal could be
structured such that company B borrows in the market in which it has a lower
disadvantage and company A in which it has a higher advantage. They swap to achieve
the desired currency to the benefit of all concerned.
A point to note is that the principal must be specified at the outset for each of the
currencies. The principal amounts are usually exchanged at the beginning and the end of
the life of the swap. They are chosen such that they are equal at the exchange rate at the
beginning of the life of the swap.
Like interest rate swaps, currency swaps are frequently warehoused by financial
institutions that carefully monitor their exposure in various currencies so that they can
hedge their currency risk.
Other Swaps
A swap in its most general form is a contract that involves the exchange of cash flows
according to a predetermined formula. There is no limit to the number of innovations that
can be made given this basic structure of the product.
One innovation is that principal in a swap agreement can be varied throughout the term of
the swap to meet the needs of the two parties. In an amortizing swap, the principal
reduces in a predetermined way. This could be designed to correspond to the amortization
schedule on a particular loan. Another innovation could be the deferred or forward swaps
where the two parties do not start exchanging interest payments until some future date.
Another innovation is the combination of the interest and currency swaps where the two
parties exchange a fixed rate currency A payment for a floating rate currency B payment.
Swaps are also extendable, where one party has the option to extend the life of the swap
or puttable, where one party has the option to terminate the swap before its maturity.
Options on swaps or Swaptions, are also gaining in popularity.
A constant maturity swap (CMS) is an agreement to exchange a LIBOR rate for a swap
rate. Foe example, an agreement to exchange 6-month LIBOR for the 10-year swap rate
every six months for the next five years is a CMS. Similarly, a constant maturity treasury
swap (CMT) involves swapping a LIBOR rate for a treasury rate. An equity swap is an
agreement to exchange the dividends and capital gains realized on an equity index for
either a fixed or floating rate of interest.
These are only a few of the innovations in swaps that exist in the financial markets. The
above have been mentioned to underscore the fact that swaps and other derivatives that
have been dealt with in this module are all born out of necessity or needs of the many
participants in the international financial market.

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1) Gold Bullion Standard:

2) Gold Exchange Standard:

3) The Gold Standard:

5) Fixed exchange rate

6) Floating Exchange Rates:

9) Special Drawing Rights(SDRs):

12) Custom Union:

13) Dirty float:

14) Gold Tranche:

15) Credit Tranches :

It refers to the stock of means of international payment

17) Extended Fund Facility (EFF):

FDI is the acquisition of a controlling interest in a foreign firm or affiliate (branch,

Portfolio investments consist mainly of the holding of transferable securities or

A GDR issued in America is an American Depositary Receipt (ADR). An ADR

21) ODA (Official Development Assistance)

• Providing humanitarian assistance for the purpose of attaining global prosperity

22) Foreign Aid

The effect of foreign aid on the foreign exchange market is to:

23) Multilateral Investment Guarantee

Multilateral Investment Guarantee is a non-commercial guarantee (insurance) for

24) Multilateral Aid

25) Bilateral Aid

26) Petro Dollar

27) Junk Bonds

A junk bond is issued by a corporation or municipality with a bad credit rating. In

28) Samurai Bonds

29) Shibosai Bonds

30) Shogun / Geisha Bonds

31) Yankee Bonds

33) Spot Rate:

34) Forward Transactions:

35) Swap Transaction:

36) Bid Rate:

37) Offer Rate:

38) Bid - Offer Rate:

39) European Quote:

40) American Quotes:

41) Direct Quotes:

42) Indirect Quote:

The objectives of the EMU are:-

• Adoption of an economic policy, based on a close coordination between

DISCUSS THE RELEVANCE / IMPORTANCE OF THE BOP STATEMENTS?

relative price movements, it is termed as speculation. It must be noted that speculators

An example of open position trading is as follows:

Interest Rate Futures

Premium (Option price, Option value)

• We shall ignore brokerage, commissions, margins etc.

Let us look at the payoff profile of the call option buyer.

Spot Rate Gain (S-X-c) Loss (-c)

Spot Rate Gain (c) Loss (S-X-c)

Spot Rate Gain (X-S-p) Loss (-p)

Spot Rate Gain (p) Loss -(X-S-p)

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