An overview of Fx Market Basics

With the advent of International Trade, Foreign exchange assumed importance over time. Today the economies are so much interdependent that its impossible to say if any country or its currency is neutral of some other countries inflation or interest rate!
Lets make a move to understand some critical aspect of FX in global financial markets. Most of the people do not understand the notion of expression USD/EUR correctly. By the way, if you are being told USD/EUR = .8534 ; what can you make out of this expression? Lets say you want to Buy 100 EUR how much USD should you spend? Worry not, I am intending to make it simple for you.
First thing first:

When you See USD/EUR or JPY/GBP, you see one currency in numerator and another in denominator. We call the currency in Numerator as 'Base' Currency and Currency in denominator as 'Quote' Currency.
In simple terms 1 unit of  Base currency is bought by paying certain units of Quote Currency.

Reiterating above, whenever you see any expression like X/Y= Z , You should understand it as Buying 1 unit of X currency after selling Z unit of Y currency.
So If USD/EUR = .8534 then I am buying 1 USD after paying .8534 EUR.

Similarly, If the question is I want to buy 100 EUR, then ? Lets inverse both sides of USD/EUR = .8534 . This means, EUR/USD = 1.171783, Now this means To Buy 1 unit of EUR , 1.171783 USD have to be spent or 100 EUR = 117.1783 USD have to be spent.

So Does this help you?.
Do note that,  Fx market quotes currencies to 4  or max 5 decimal places, so 1 EUR = 1.0345 USD or 1.03452 USD

Concept of PIP: I first came across PIP is Charles Dickens novel 'The Great expectation'. What a character was he? So many shades; constantly changing with situation!! there PIP was protagonist and his full name was Philip Pirrip.
Ok, In FX world ..Percentage of change is referred to as PIP. This is somewhat like basis points which is part of 100. For bps (basis points), when  Stock market ( say NASDAQ) has % Change of .23 , we say 23 bps movement. On the same lines , PIP is absolute change in currency after decimal places.
When USD/GBP =1.03452 and next day USD/GBP = 1.3456, we can say a change of 4 pip. So , its actually difference in places after decimal which is 03456-03452 =4  or 4 pip.

What are Major and Crosses: Major are currency pairs where highly liquid currencies, mostly USD and sometimes EUR, are present in either numerator or denominator of currency pair,  . When there is no major in the pair , the pair is called as cross. So a pair of INR/JPY is a cross and INR/USD is a major.

Introduction to IFRS and Overview of IAS 39: Recognition and measurement of Financial instrument

IFRS - International Financial Reporting standards are standards/principles adopted by International Accounting Standards Board (IASB). Earlier IFRS were also known by the name IAS (international Accounting Standard). IFRS are increasingly adopted by more and more countries to bring parity in accounting standards owing to increase in global trades and to bring transparency in reporting financials.

Most of the countries in US and India are converging to IFRS. While Security exchange Commission is rather slow in moving towards IFRS from US GAAP, India is expected to cross the full compliance deadline of 2014. Originally it was expected India will shift to IFRS in three phases stating 1st April 2011.

As per IAS 39, IFRS makes it mandatory to classify securities in three buckets based on their intention/purpose to hold the security for banks and other financial concerns as below:

Held for Trading: Debt and Equity held for trading securities are valued at market price and any unrealized gain/loss is routed through income statement.

Held Till Maturity: Debt securities held till maturity are reported at amortized book cost and no mark to market is done for such securities.

Available for Sale: Available for sale securities are those which are neither 'Held till Maturity' not 'Held for Trading'. Any unrealized gain/ loss on such position is routed through Accumulated other Comprehensive income as a component of Equity in Statement of financial Positions.

Decision to classify a securities not only impacts the performance reporting(Income statement) for an financial insitutional but can also be important for complying with Capital Adequacy norms prescribed for Banks and such Financial institutions.

Its to be noted that reclassification of securities is also possible under IFRS.

Further, IFRS Financials require presentation of below information as per IAS 1:

1)      Statement of Financial position

2)      Statement of Comprehensive Income and/or Income Statement

3)      Statement of Change in equity

4)      Cash Flow statement

5)      Notes including significant accounting policies.

1) Statement of Financial position: Statement of financial position is the balance sheet and depicts position of Assets, Liabilities and Equity on a specified date.

B) Statement of Comprehensive Income: Total Comprehensive Income = Income/Loss reported in Income Statement +/- AOCI (Accumulated Other Comprehensive income)

Accumulated Other comprehensive Income is balance of unrealized gain/loss on available for sale securities, gains/Loss from translating foreign subsidiaries to local currency, Changes in revaluation surplus, Actuarial gains and losses in defined benefit plans recognition and gains/losses from derivative held as cash flow hedge.

AOCI is shown under Equity head under the subhead Accumulated Other Comprehensive income as below:

C) Statement of Changes to Equity: This statement shows the below information as per IFRS requirements:

a)      Total Comprehensive income for the period.

b)      Reconciliation between opening and closing balances for each component of equity head of balance sheet. Separately disclosing

(i)                  Income/loss

(ii)                Each item of AOCI

(iii)             Transactions with owners showing issues/buyback to/from owners and changes in ownership of subsidiaries that do not result in loss of control.

However, dividend distribution should be shown in Notes instead of showing in statement of changes in equity.

D) Cash flow Statement: Cash flow statement aims at reconciling Opening cash balance and closing cash balances by classifying the cash flows during the year under the below heads.

·        Cash flow from Operating activities

·        Cash flow from investing activities

·        Cash flow from financing activities

Cash flow can be prepared using direct or indirect method. Direct and indirect method only impacts method of calculation of cash flow from operating activities.

Indirect method aims at adding back unpaid expenditures and subtracting accrued incomes along with taking into account impact of changes in working capital.

IASC recommend using indirect method, however also allows direct method of reporting cash flow:

E) Notes, including summary of significant accounting policies. Disclosing intention to hold securities up to maturity and their classification based on held to maturity, held for trading or Available for sale. Method to value inventory and charge amortization and depreciation etc.

*Please note that above is not detailed discussion on respective standards and a thorough reading and interpretation is needed to fully understand the implication of compliance. 

IRS Compression: Cleaning Books and Making Sense

IRS portfolio compression is built on a simple idea. As dealer firms continue to trade swaps with each other, trades can begin to be removed without impacting the interest rate risk profile of the swap portfolio.

For example, Dealer A may have written a swap with Dealer B such that it is receiving fixed rate cash flows from Dealer B with a maturity slightly longer or shorter than five years. Suppose a new swap is written for the same notional amount where Dealer A pays fixed rate cash flows to Dealer B for five years. In this case, the macro interest rate risks have been largely offset. Dealer B is paying fixed in the first swap while Dealer A is paying fixed in the second swap. The notional principal is the same. All the dealers need to do is determine the difference in value between the two swaps caused by the mismatch in dates and in the fixed rate payments. If the parameters for valuing these mismatches are agreed, there is no reason why the swaps cannot literally be torn up – this is what is meant by the term compression in a bilateral context.

This type of exercise had been going on in an ad hoc manner for years between dealers as a means of reducing notionals, cleaning up portfolios and reducing operational costs. ISDA reports that an exercise similar to compression was used in 1999 to tear up nearly $1 trillion of interest rate swaps at Long Term Capital Management.

The examples used in this appendix require dealers to tear up and rewrite swap contracts. It may sound simple in concept but it involves considerably more negotiation among dealers than the successful process currently in use managed by TriOptima.

Multi-Lateral Compression

The benefits of compression between two dealers are obvious. To achieve meaningful reductions in notional outstanding, however, bilateral compression is a cumbersome exercise. If applied across the dealer community, meaningful results for the industry would involve literally hundreds of compression exercises per currency. Multi-lateral compression, on the other hand, can produce tremendous results in a very efficient manner provided there is widespread acceptance by market participants. This is the approach adopted by TriOptima in its triReduce service.

Consider, for example, a closed world where there are only four dealers: A, B, C and D. Consider as well their interdealer swaps in five years are as follows

As can be seen, the total Net Amounts of Rs are 100 and the total Net Amounts of Ps are 100. This is a closed system. All the swaps among the four have to net to zero. In a bilateral compression world, the dealers will not be able to compress any trades because in this simple world they only have one swap with each other dealer.

In a multi-lateral compression world, all the work can be done at once. Dealer A needs to receive fixed for 25 and Dealer B needs to receive fixed for 75. C and D need to pay fixed for 50 each. The compression will result in A receiving 25 from C and B receiving 25 from C and 50 from D. We started with 400 of notional and are down to 100.

This was a very simple example but it shows the value of increasing participants in compression.

LIBOR RIGGGGGED!!!!!!!!

James Griffith, an officer working in  Financial crimes cell of London Police, was having business as usual over a cup of coffee in his office till he got a call from his senior which moved the earth beneath his feet and his eyes were about to pop out as he muttered in his bewilderment  ’Oh my!!!! Go..........d!” It was bigger than anything he had handled earlier and his imagination failed to gauge the impact of reason of this amazement. To quote very conservatively it is a 15 digit number; 350,000,000,000,000, precisely 350 trillion USD and this humongous amount was riding on a rigged benchmark. Yes, It was none other than LIBOR the most prominent benchmark used globally on which the best of Investment banks and Hedge funds quote their Floating rates and premier banks fix their lending rates. This did not happen anytime soon but as early as 2006. This was indeed scandalous than many other recent scandals!

Read the below:

These are some of the mails between traders who betted on LIBOR and submitters who submitted LIBOR to British bankers Association (BBA) daily.

“WE HAVE TO GET KICKED OUT OF THE FIXINGS TOMORROW!! We need a 4.17 fix in 1m (low fix) We need a 4.41 fix in 3m (high fix)” (November 22, 2005, Senior Trader in New York to Trader in London);

“You need to take a close look at the reset ladder. We need 3M to stay low for the next 3 sets and then I think that we will be completely out of our 3M position. Then its on. [Submitter] has to go crazy with raising 3M Libor.” (February 1, 2006, Trader in New York to Trader in London); 

“Your annoying colleague again … Would love to get a high 1m Also if poss a low 3m … if poss … thanks” (February 3, 2006, Trader in London to Submitter); 

“This is the [book's] risk. We need low 1M and 3M libor. PIs ask [submitter] to get 1M set to 82. That would help a lot” (March 27, 2006, Trader in New York to Trader in London);… 

“Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the lib or fixing at 5.39 for the next few days. It would really help. We do not want it to fix any higher than that. Tks a lot.” (September 13, 2006, Senior Trader in New York to Submitter)…” 

The fundamental principle underlying floating rates is to allow the market to determine borrowing costs. Customers who borrow on a floating-rate basis, if they are sensible, and institutions that loan money on a floating-rate basis, if they are ethical, therefore expect two things from a benchmark interest rate. First, the benchmark should reflect actual conditions in the financial markets. That means no random fluctuations -- money costs what it is worth. Second, the benchmark rate should not be easy to manipulate. No rational, informed borrower would borrow money at a variable rate of interest and then empower the lender to determine when and how the interest rate changed in the future.

So it is startling that Libor, the financial world's most important number, satisfies neither of these requirements. Libor is computed by the British Bankers' Association (BBA), a powerful trade association based in London that represents more than 250 financial institutions. These banks are located in 50 countries and have operations in just about every corner of the globe. But instead of using actual market rates, big banks estimate the interest rate that they think they would have to pay if they borrowed money from other institutions. That is different than reporting the actual interest rate at which they are really borrowing from other banks.

Each day, the BBA sets Libor rates for 15 loan maturities in ten different currencies. In the case of the dollar, 18 banks submit their hypothetical borrowing costs. The BBA discards the four highest and the four lowest submissions considered as outliers distorting the calculation, and then averages the remaining ten to come up with the Libor number. Thompson Reuters calculates all of these rates for the BBA, and then publishes the results, usually around 11:45 AM (CET).  

Rate setting desk were acceding to the traders request and sending the artificial low or high rates to BBA. A low rate quoted to BBA is aimed at keeping the rate so low that it’s taken as outlier and excluded from average rates. This resulted in a lower number forming part of average which would otherwise would have been excluded. Therefore the overall rate was lower than what it could have been with fair play. Though the average was impacted by few basis points, yet the mammoth magnitude of money riding on LIBOR made the outcome substantial.

There are plenty of reasons why banks would like to manipulate Libor rates. During the height of the financial crisis, regulators foolishly looked to Libor to determine the market's perception of the health of big banks. A big bank reporting a low Libor rate was thought to be able to borrow money from other banks cheaply and, therefore, was seen as a safe place to invest. Banks worried about attracting the attention of regulators may have submitted low Libor rates in order to try to deflect regulatory scrutiny. 

More nefariously, banks also manipulated Libor to make money or avoid losses on their trading portfolios. For example, when U.S. traders at Barclays wanted Libor to rise in order to draw a bigger profit on some of their financial products, they simply asked their colleagues at the rate-setting desk in London to push the numbers up or down to suit their needs. Barclays would then submit artificial bids and persuade their counterparts at other banks to do the same.

EURO ZONE CRISIS : NutShell

The euro zone is an economic and monetary union of 17 European Union member states that have adopted the euro (€) as their common currency. The euro zone currently consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.
Monetary policy of the zone is the responsibility of the European Central Bank (ECB) which is governed by a president and a board of the heads of national central banks. The principal task of the ECB is to keep inflation under control.
Over the past few months, the European debt crisis has become more prominent and has been dominating headlines as the region’s sovereign debt issues continue to cause concern for the EU and potentially other global economies. The debt crisis basically came about because several Euro zone countries have lost control of their finances since the global recession, borrowing and spending more than they could realistically afford. The crisis was triggered by the worldwide financial collapse that began in 2008 and has been exacerbated by poor financial management.
The problem originated in Greece when it was realised that Greece’s deficit was twice as high as originally thought (12.7 per cent of GDP). It has since spread to other countries such as Spain, Ireland, and Portugal. Investors have since become less confident about Greece's ability to repay them and they demanded Greece pay higher interest rates on their bonds. This had a spiral effect as the more Greece had to pay bondholders in interest, the more it had to borrow, which in turn drove up interest rates even more. Greece's debt problems led investors who owned bonds issued by other peripheral Euro zone countries to lose confidence, especially because banks in France, Germany and the UK owned over $56bn worth of Greek government bonds. As a result of the crisis, other European countries have had to bail Greece out. This has cost billions of Euros. Greece was the first country to accept a bailout in May 2010, followed by Ireland and Portugal. However, before these bailouts were approved, the Governments of these countries had to agree to adopt 'austerity measures' to show they were doing what they can to tackle their economic problems themselves. This has led to mass public protests in Greece, with many people demonstrating against more job losses and tax rises as a result. A major concern is that if Greece is unable to keep repaying what it owes to other countries, the country could effectively go bankrupt which would have flow on affects on other countries. The uncertainty surrounding the Euro debt crisis has caused havoc in major world financial markets. This can be reflected in the CBOE volatility index. The Chicago Board of Options Exchange (CBOE) gives a standardised estimate of the market's expectation of future volatility. The index spiked upwards in August to the highest level since the global financial crisis. Over the past few weeks it has become more subdued as EU leaders begin to work out a possible solution to the EU debt crisis. In recent weeks, it appears that the Euro zone has inched closer to a resolution of its crisis. A debt-wracked Italy has come under pressure to introduce new reforms to tackle their own levels of debt. If Italy, the EU zone’s third largest economy, were to default, the bailout fund would become rapidly depleted and ineffective. Options are being explored on ways to scale up the EU’s 440 billion Euro war chest in the case that a larger economy such as Italy or Spain are dragged into the debt mire. One way of doing this is providing insurance to investors so that their losses would be recovered in the event of a debt default. Another option would be to create a separate fund and entice international investors and institutions to match EU commitments, thereby increasing the amount of cash available for potential future bailouts. By using such financial inventiveness, leaders hope to leverage the fund up to as much as a trillion Euros, which they hope will be enough to reassure volatile financial markets. In order to address the crisis, Greece's debt burden needs to be reduced so that the country can eventually stand on its own, banks need to raise more money so they can ride out the financial storm, and show that their European bailout fund is big and nimble enough to prevent larger economies from being dragged into the crisis. This criteria was met in the debt crisis plan which was unveiled in late October. A “Comprehensive” Debt Crisis Plan On the 27th October, 2011, the Euro zone leaders announced a “comprehensive and solid” response to the European debt crisis. The agreement has plans to: Begin negotiations on a nominal 50 per cent cut in bond investments to reduce Greece's debt burden by €100 billion. This would have the affect of cutting Greece’s debts from 160 per cent of GDP to 120 per cent of GDP by 2020. As well as the deal on deeper private sector participation in Greece, Euro zone leaders also agreed to scale up the European Financial Stability Facility (EFSF). The EFSF is Europe’s €440 billion bailout fund which was set up last year. The fund has already been used to provide help to other heavily in debt countries such as Portugal, Ireland and Greece, leaving around €290 billion available. An estimated €250 billion of that will be leveraged four to five times, producing a headline figure of around €1trillion, which will be deployed in a variety of ways. The EFSF will be boosted via both risk insurance and a special vehicle that will buy bonds. Further resources would come from co-operation with the IMF and sovereign wealth funds, including China. The fund would be tasked with ensuring financial stability in the Euro zone. These announcements have provided a degree of relief for international economies and share markets as it appears a tourniquet has been wrapped around the crisis for the time being. A recent announcement by the Prime Minister for Greece (George Papandreou) could undo a lot of the positive outcomes that came out of the debt crisis plan. The Prime Minister has called a referendum on accepting a second bailout plan. This move has renewed fears that Greece could default on its debt and that the Euro zone government debt crisis could deepen. This has shown that the debt crisis plan is only a movement in the right direction in trying to solve the crisis and that it is far from being laid to rest.

Differential Interest Rate Fix (DIRF)

DIFFERENTIAL INTEREST RATE FIX

DESCRIPTION

A Differential Interest Rate Fix (DIRF) is a contract that moves with reference to the SLOPE of a yield curve. The DIRF is meant for those who wish to profit from a steepening or flattening of one yield curve. The DIRF is customised with defined settlement dates, a defined value per basis point, and two defined points on the yield curve.

EXAMPLE

Assume an investor believes that the Italian yield curve will flatten over the next year more than that implied in the market. The client would enter into a flattening DIRF, say 2 years versus 7 years, for settlement in one year. The investor selects the amount per basis point they wish to transact, say ITL 1,000,000 per point. The DIRF price is given in terms of basis points. If at maturity the difference between the 2yr and 7yr ITL Swap rates has flattened below the DIRF level, the investor will receive ITL 1,000,000 for every basis point lower. If the difference is higher than the DIRF level, i.e. the curve has steepened, the investor will lose ITL 1,000,000 per basis point.

PRICING

The entry price is calculated by taking the difference between the implied forward rates for the two yield curve points chosen. This means in the above example, we calculate the one year forward 2yr rate and the one year forward 7 yr rate. The DIRF price is the difference. Investors who BUY the DIRF look to see the curve steepen, investors who SELL the DIRF look to see the curve flatten.

TARGET MARKET

This is a product for people who wish to take a position on the SLOPE of the yield curve without taking an outright position on a curve.

ADVANTAGES

·         Available in all major currencies

·         Can utilise any two points on the yield curve

·         Can be reversed at any time with reference to the then prevailing implied rates

·         Investor determines amount per point sensitivity

·         Settlement at maturity is against independent mid rate quoted on Telerate

·         No Exposure to parallel movement in yield curve

DISADVANTAGES

·         The attractiveness of DIRFs is dependent on the Implied Forward, rates not the spot rates, therefore expected movements can already be built in.

PRODUCT SUITABILITY

Simple Aggressiv

Credit Default Swap: Basics

A CDS is a contract that provides protection against the risk of a credit event by a particular company or country. The company is known as the reference entity and a default by the company is known as a credit event. The buyer of the insurance obtains the right to sell a particular bond issued by the company for its par value when a credit event occurs. The bond is known as the reference obligation and the total par value of the bond that can be sold is known as the swap's notional principal. The buyer of protection makes periodic payments to the protection seller until the occurrence of a credit
event or the maturity date of the contract, whichever is first. If a credit event occurs the buyer is compensated for the loss (possibly hypothetically) incurred as a result of the credit event.
A credit event usually requires a nal accrual payment by the buyer. The swap is then settled by either physical delivery or in cash. If the terms of the swap require physical delivery, the swap buyer delivers the bonds to the seller in exchange for their par value.
When there is cash settlement, the calculation agent polls dealers to determine the midmarket price, Q, of the reference obligation some specified number of days after the credit event. The cash settlement is then $(100 − Q)% of the notional principal.

The valuation of a credit default swap requires estimates of the risk-neutral probability that the reference entity will default at di erent future times. The prices of bonds issued by the reference entity provide the main source of data for the estimation. If we assume that the only reason a corporate bond sells for less than a similar Treasury bond is the possibility of default, it follows that:
Value of Treasury Bond - Value of Corporate Bond = Present Value of Cost of Defaults

By using this relationship to calculate the present value of the cost of defaults on a range of different bonds issued by the reference entity, and making an assumption about recovery rates, we can estimate the probability of the corporation defaulting at di erent future times. If the reference entity has issued relatively few actively traded bonds, we can use bonds issued by another corporation that is considered to have the same risk of default as the reference entity. This is likely to be a corporation whose bonds have the same credit rating as those of the reference entity and ideally a corporation in the same industry as the reference entity.
We start with a simple example. Suppose that a ve-year zero-coupon Treasury bond with a face value of 100 yields 5% and a similar ve-year zero-coupon bond issued by a corporation yields 5.5%. Both rates are expressed with continuous compounding. The value of the Treasury bond is
100 x e^(−0.05×5) = 77.8801
and the value of the corporate bond is 100 x e^(−0.055×5) = 75.9572. The present value of the cost of defaults is, therefore
77.8801 − 75.9572 = 1.9229
Define the risk-neutral probability of default during the five-year life of the bond as p. If we make the simplifying assumption that there are no recoveries in the event of a default, the impact of a default is to create a loss of 100 at the end of the five years. The expected loss from defaults in a risk-neutral world is, therefore, 100p and the present value of the expected loss is
100 x p x e^(−0.05×5)
It follows that: 100 x p x e^(−0.05×5) = 1.9229
so that p = 0.0247 or 2.47%.
There are two reasons why the calculations for extracting default probabilities from bond prices are, in practice, usually more complicated than this. First, the recovery rate is usually non-zero. Second, most corporate bonds are not zero-coupon bonds. When the recovery rate is non-zero, it is necessary to make an assumption about the claim made by bondholders in the event of default.