Page 412 of Pattabiraman The letter by itself has no market value. However, as the air show draws closer the price of a ticket in the gray market is Rs 1300. Now, your letter has attained value [Rs 300 x 3]. If a week before the air show, the price of a ticket in the gray market is Rs 1500, the value of the letter shoots up. In case of bad weather, the day before the air show, the price in the gray market is Rs 900, the letter becomes value less.
Page 421 of Pattabiraman
Page 421 of Pattabiraman
Refer page 416 of pattabiraman Unique – it’s a one on one contract. Price risk is eliminated – both parties are sure of the price at which the deal with go through No margins – no deposit or premium required Illiquid – you cant retract from a forward contract except with the consent of the other party – you cannot sell your right or obligation to a third party. A forward contract is not tradable.
Refer page 416 of pattabiraman
Refer page 417 of pattabiraman Differences between forward and futures contract page 417 [forward – non-standardised , risk of default, illiquid and not marked to market]
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Web download It is simple to comprehend that futures contracts on interest rates would be called interest rate futures. Let us look at the Forward Rate Agreements (FRAs) being traded in the OTC market. In case of FRAs, contracting parties agree to pay or receive a specific rate of interest for a specific period, after a specific period of time, on a specified notional amount. No exchange of the principal amount takes place among the parties at any point in time. Now, think about bringing this contract to the exchange. If we bring this FRA to the exchange, it would essentially be renamed as a futures contract. For instance, Eurodollar futures contract (most popular contract globally) is an exchange traded FRA on 3 months Eurodollar deposits rates. To comprehend the product further, now think we are entering into an FRA on an exchange. First thing would be that we would trade this contract on the exchange in the form of a standard product in terms of the notional amount, delivery and settlement, margins etc. Having entered into the contract, we can reverse the transaction at any point of time. Indeed, having reversed, we can again enter into the contract anytime. Therefore, these exchange traded FRAs (futures contracts) would be very liquidity. Further, in this contract, clearing corporation / house would bear the counterparty risk. The transaction mentioned above is pretty simple. But, world does not trade the interest rate futures so simply. Indeed, product designs are much more complicated and they are different both at the long and short end of the maturity curve.
Page 431 Pattabiraman For example, Mr X who has taken a position in the spot market on ABC Limited stock. The current spot price is S o. On a subsequent date, the spot price could be S 1 . If X stays unhedged, his risk is the price risk, S 1 – S o. If X hedges his spot position by taking an opposite position in the futures market, his risk is the difference between the change in the prices in the futures market and the change in prices in the spot market, ie (F 1 – F o ) – (S 1 - S o ), where Fo is the present futures price and F1 is the futures price in time 1. the risk that X now faces is basis risk. This risk arises only when ABC Limited futures are not available and X buys index futures to hedge his position (ie makes a cross hedge). If the basis remains unchanged, X would have a perfect hedge. But because the basis does change X may not have a perfect hedge. To minimize risk, X hopes that the price changes of the cash asset and the price changes of the futures price will have a high degree of correlation. Higher the correlation, lower is the basis risk.
Page 431 Pattabiraman For example, Mr X who has taken a position in the spot market on ABC Limited stock. The current spot price is S o. On a subsequent date, the spot price could be S 1 . If X stays unhedged, his risk is the price risk, S 1 – S o. If X hedges his spot position by taking an opposite position in the futures market, his risk is the difference between the change in the prices in the futures market and the change in prices in the spot market, ie (F 1 – F o ) – (S 1 - S o ), where Fo is the present futures price and F1 is the futures price in time 1. the risk that X now faces is basis risk. This risk arises only when ABC Limited futures are not available and X buys index futures to hedge his position (ie makes a cross hedge). If the basis remains unchanged, X would have a perfect hedge. But because the basis does change X may not have a perfect hedge. To minimize risk, X hopes that the price changes of the cash asset and the price changes of the futures price will have a high degree of correlation. Higher the correlation, lower is the basis risk.
Refer page 423 of pattabiraman Refer page 429 – construction of index
Refer page 88 of fabozzi
Refer page 422 of pattabiraman
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Refer page 426 of pattabiraman
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Refer page 434 of pattabiraman
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Web download SEBI’s Circular No. SEBI/DNPD/Cir-26/2004/07/16 dated July 16, 2004 as per para 4 (i) (a), (b) (c) of the aforementioned SEBI circular
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Page 99 – fabozzi Despite the risk of rising interest rate, some lenders are willing to provide term loans with a fixed rate. There are two reasons for this. First, a lender such as an insurance company does not borrow funds to extend a loan. Such a lender is seeking to lock in an interest rate over some period of time. Second, as we see later in this chapter, a lender can use an interest rate swap to convert cash flows from a fixed rate to a floating rate or the other way around, from a floating rate to a fixed rate. What this enables a lender to do is loan funds on a fixed-rate basis and swap the interest payments from a fixed rate to a floating rate. By doing so, a lender that borrows on a floating-rate basis can provide a matching of the loan’s interest payments to its borrowing cost. Economic theory tells us that if markets are efficient then whether a corporation synthetically creates a fixed-rate bond by issuing a floating rate bond and using a swap or by just issuing a fixed-rate bond, the cost of funds will be the same to the issuer after transaction costs. Therefore, why not just issue a fixed-rate bond? The answer lies in an understanding of how markets operate. In the real world, institutional bond buyers impose constraints on the amount that they will invest in a particular issuer, or in fact, issuers in a particular sector of the bond market. Suppose a corporation has historically issued only fixed-rate bonds. When this corporation is contemplating a new bond offering, the chief financial officer will approach its investment banker about how much it will cost to raise the target amount of funds. The sales force of the investment banking firm will canvass its bond customers to assess what it will cost the issuer to issue a fixed-rate bond. Suppose that the banker’s sales force indicates that most fixed-rate bond buyers are not willing to purchase any additional fixed-rate bonds issued by this corporation because it has realized its maximum exposure. This may mean a higher cost for issuing the bond. The sales force, however, may indicate that institutional buyers of floating-rate bonds will be more receptive to the corporation since they do not have any credit risk exposure to the corporation. The investment banker would then determine what the cost of a synthetically created fixed-rate bond issue will be if the corporation issued a floating-rate bond and used an interest rate swap. If the cost is lower, the corporation may issue the floating-rate bond. Even if the cost is close to the same, the CFO may decide to synthetically create a fixed-rate bond just to increase its presence in the floating-rate market. It is for the same reason that corporations needing to issue bonds with a floating rate will issue a fixed-rate bond and enter into an interest rate. In this case, the corporation will agree to pay a floating rate and receive a fixed rate, thereby synthetically creating a floating-rate bond. Use of swap in designing bonds page 516 – fabozzi
Page 99 – fabozzi Explain a simpler example. Receivables in INR and USD – just swap the payments
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