Money Market Flashcards
Q7. Discuss the ways in which a company can reduce its exposure to exchange rate risk.
Foreign exchange risk management techniques can be divided into internal and external techniques. Internal techniques are mainly used as part of a company’s risk management strategy which aims to minimize the companies exposure to exchange rate risk.
1.Netting - offset of intra-group payments and receipts in the same or different currencies.
- Matching - a company matches its foreign currency inflows with its foreign currency outflows in respect of amount and approximate timing
- Leading and Lagging - adjusting the timing of receipts\payments cycles so as to facilitate netting.
- Invoicing in the home currency - FX risk is transferred to the other party in the business transaction. However the other party may charge a higher price to compensate for the extra risk undertaken
- Currency diversification - Spread transactions over a large number of currencies. Because probability of adverse movements in large number of currencies is very small
- Mark-ups - increasing price, however Competition is a constraint to this strategy
- Counter-trade and currency offsets - The exchange of product for product, rather then currency-based buy or sell contracts
External Risk Management
is about hedging against possible exchange rate exposure.The main external exposure management techniques are:
Forward Exchange Contracts
Currency Futures
Currency Swaps
Currency Options
Forward exchange contracts refer to agreements of exchange rate on future date. The exchange rate in a forward is agreed in advance and so there is no foreign exchange rate risk.
+ contract is flexible, can be decided by 2 parties any date and any exchange rate.
- it is an obligation not an option
- OTC risk, credit risk
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Currency future is a future delivery of a standardized amount of foreign exchange at a fixed time, place and price
A swap that involves the exchange of principal and interest in one currency for the same in another currency.
Currency options
Advantages
Large trades are possible
Strike price, expiration dates and other features can be tailored to meet an individuals need
Risk is limited to option premium
Its not an obligation
Protected against adverse movements in the exchange rate but can benefit if the exchange rate moves in your favour.
Disadvantages The cost
Q9. Compare and contrast the following: •Future contracts and forward contracts •Forwards Rate Agreements and future contracts •Swaps and Future contracts •Option contracts and forward contracts
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What is Money Market?
It is a market delaing with short term securities and transfer needs, with maturity of less than a year. Ex:
T bill
Commercial paper
Shor term Bank Deposits
Capital Market covers long term instruments
What is yield on a security depend on?
- maturity
- Credit risk
- Liquidity
the higher these risks the higher the yield
What factors affect the shape of the yield curve?
There are 5 factors:
Economic performance - is an expectation indicator of future rates, hence directly affect current longer term rates also are affected market expectations of future inflation.
CB operations - CB intervention changes availability of securities of different maturities.
Borrowing demand - demand change can drive the yield of particular maturity bond.
Liquidity preference - if there is no advantage of investing in longer term securities ( no higher yield) investors prefer short term since they are more liquid.
Market segmentation - Bank investors tend to invest short term, whereas institutional investors prefer longer term, resulting fewer demand in the medium term. In the absense of any other factors this would display humped yield curve shape.
A dealer takes a fixed deposit of Euro 5 million from a customer for 73 days at 4.63%. What does he pay at maturity?
5,046,300 ( 365 days in a year)
A CD is issued with face value USD 3 million, a coupon of 5.25% and a term of 91 days. A dealer buys this CD in the secondary market, when it has only 30 days left to maturity and the yield is quoted as 5.17%. How much does he pay for it?
If the yield at which the dealer purchased the CD were 5.08% instead of 5.17%. How much would he pay for it?
3,026,407 (365 days in a year)
3,026,630
Take commercial paper issued for 91 days with a face value of EUR 10 million. On maturity, the investor receives only the face value of EUR 10 million. If the yield on the Commercial Paper is 4.7%, How much is the investor willing to pay for the Treasury Bill if the yield is 4.17%?
9,884,179
What is a commercial paper?
It is an unsecured promissory note from Corporation to money market. Usually sold at discount because issuer pay only face value at the maturity. The term is usually 1-270 days
A dealer buys US dollar Euro-CP with a face value of USD 3 million at a yield of 5.17%, when it is issued with 30 day’s maturity How much does he pay for it?
Exam type question
2,987,306
7 days later, he sells it at a yield of 5.17%. It now has only 23 days to maturity. What price does he sell it for?
Exam type question
2,990,268
What return on his investment did he make over the 7 days?
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Futures vs Forward Rate agreement
1) Standardization vs flexibility
2) Margin vs credit risk - margin is paid or received each day to reflect the day’s loss or profit on contracts held
3)Settlement - A Forward Rate Agreement settlement is paid at the beginning of the forward period.
on the other hand The futures settlement-the profit or loss on the contract-is also all settled by the same date, via the variation margin payments made during the period from the transaction until the futures delivery date
4) Liquidity and spread: Standardization and transparency generally ensure a liquid market in futures contracts, together with narrower between bid and offer than in Forward Rate Agreements. For delivery dates far in the future there may be insufficient liquidity in the futures market, whereas a Forward Rate Agreement might be available.
5) Underlying commodity: Futures contracts are not available in all currencies, whereas a Forward Rate Agreement might be available however the price may not be attractive.
6) Taking a position: Forward Rate Agreements and Futures are in opposite directions. A buyer of a Forward Rate Agreement will profit if interest rates rise. A buyer of a futures contract will profit if interest rates fall.
What are the futures contract size for
Eur Dollar
Eur Sterling
Euro euro
Eurodollar futures: contract size is $1,000,000
Eurosterling Futures: contract size is £500,000
Euroeuro Futures: contract is 1,000,000 euro
A dealer expects interest rates to fall (futures to rise) and takes a speculative position. He therefore buys 20 Eur 1-month futures contracts at 95.27. He closes them out subsequently at 95.20. The contract amount is 3,000,000.
What is his profit or loss?
20x Contracts = 20 x 3,000,000 x (((100-95.2)-(100-95.27))/100) x 1/12 = euro3500
