Currency swap: Contract that commits two counterparties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.
A currency swap has three stages:
An initial exchange of principal: the two counterparties exchange principal amounts at an agreed exchange rate. This can be a notional exchange since its purpose is to establish the principal amounts as a reference point for the calculation of interest payments and the re-exchange of the principal amounts.
Exchange of interest payments on agreed dates based on outstanding principal amounts and agreed fixed interest rates.
- Re-exchange of the principal amounts at a predetermined exchange rate so the parties end up with their original currencies.
- Again this may be done to hedge risk, to speculate on changes in exchange rates, or to attempt to lower the cost of borrowing by borrowing in the currency in which the most favourable interest rates are available and then swapping into the currency that the firm needs to carry out its business. Whether this will be cheaper will depend among other things on the bid—offer spread.
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A eurobond is a debt security handled internationally by syndicates, groups of bankers and/or brokers who underwrite and distribute new issues of securities or large blocks of outstanding issues. It is typically in bearer (non-registered form) and is issued outside the country of the currency in which it is denominated.
Borrowers and lenders are spread around the world, while the intermediaries are spread across Europe, with the majority of business being done from London. The market was founded in the early 1960s and has provided a competitive source of funding for borrowers who can tap discreet but important sources of finance. Japanese banks, pension funds and insurance companies have become important lenders in recent years and there are still plenty of wealthy individuals who prefer the anonymity offered by bearer securities. The eurobond market is the world’s second largest securities market after the US bond market in terms of trading volume and the third largest after the US and Japanese bond markets in terms of debt outstanding. Read the rest of this entry »
A major defence industry supplier, Death Mines plc, wishes to borrow £1 million for twelve years at a fixed interest rate to finance a new investment project. It could do so by issuing a straight eurobond but, as it is not well known in the market and does not have a high credit risk rating, would have to pay a coupon of 8 per cent which it regards as too high. The firm’s own bank is willing to lend Death Mines the required amount via a one-year floating rate note at a rate of 2 per cent over LIBOR, currently at 3.6 per cent.
Clearly, the floating rate loan is much cheaper at the moment, but LIBOR could easily rise over the period of the loan to such a level that Death Mines would finish up losing on the project. Thus, it enters into a contract with a swap bank, Border International, to pay to it 5 per cent on the principal, receiving in exchange LIBOR.
The position of Death Mines now is:
Pays to its own bank LIBOR + 2 per cent
Pays to Border 5 per cent
Receives from Border LIBOR
Net position — fixed rate loan at 7 per cent Read the rest of this entry »
You need to be concerned with the psychological aspects of investing in a managed futures program from two distinct points of view. First, what type of investment best meets your needs? And second, if you’re going to personally interview and select a CTA, what psychological characteristics should you be looking for?
The type of futures investment you are suited for depends on your attitude toward risk. If you are an aggressive risk-taker, you might be looking for an emerging CTA with a short, but incredible, track record. A moderate risk-taker might select a seasoned trader with a five- to ten-year track record in the moderate volatility range. Safety-conscious investors prefer to define their maximum risk in advance. They look for limited partnerships and “guaranteed” funds. We’ll have a discussion of the various types of offerings later in this text. Read the rest of this entry »
In an interest-rate swap, two parties (called counterparties) agree to exchange periodic interest payments. The dollar amount of the interest payments exchanged is based on a predetermined dollar principal, which is called the notional principal amount. The dollar amount that each counterparty pays to the other is the agreed-upon periodic interest rate times the notional principal amount. The only dollars that are exchanged between the parties are the interest payments, not the notional principal amount. In the most common type of swap, one party agrees to pay the other party fixed-interest payments at designated dates for the life of the contract. This party is referred to as the fixed-rate payer. The other party, who agrees to make interest rate payments that float with some reference rate, is referred to as the floating-rate payer. The frequency with which the interest rate that the floating-rate payer must pay is called the reset frequency. Read the rest of this entry »
A collateralized debt obligation (CDO) is backed by a diversified pool of one or more types of debt obligations (e.g., U.S. domestic investment-grade corporate bonds, high-yield corporate bonds, emerging market bonds, bank loans, asset-backed securities, and residential and commercial mortgage-backed securities). The funds to purchase the collateral assets are obtained from the issuance of bonds. There is a collateral manager responsible for managing the collateral of assets.
A CDO is classified as a cash CDO or a synthetic CDO. The adjective “cash” means that the collateral manager purchases cash market instruments. A synthetic CDO is so named because the collateral manager does not actually own the pool of assets on which it has the credit risk exposure. Stated differently, a synthetic CDO absorbs the credit risk, but not the legal ownership, of the reference obligations. A credit default swap allows institutions to transfer the credit risk, but not the legal ownership, of the reference obligations it may own. Read the rest of this entry »
A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the total return realized on a reference obligation or a basket of reference obligations. A total return payment includes all cash flows that flow from the reference obligations as well as the capital appreciation or depreciation of those reference obligations. When the reference obligation is a bond market index, the swap is referred to as a total return index swap.
The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver; the party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.
Notice that in a total return swap, the total return receiver is exposed to both credit risk and interest-rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates. Read the rest of this entry »
An investor who lends funds by purchasing a bond issue is exposed to three types of credit risk: (1) default risk, (2) credit spread risk, and (3) downgrade risk.
Traditionally, credit risk is defined as the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. This form of credit risk is called default risk. If a default does occur, this does not mean the investor loses the entire amount invested because the investor can expect to recover a portion of the investment. Read the rest of this entry »
One issue that has elicited different responses is the role of currency risk in overall risk and return. Currency risk has been accounted for in all of the evidence presented. So the existence of currency risk will not reduce the benefits of investing in foreign markets. Rather, the question is whether managing currency risk will improve the gains from international investing.
While the reduction of any kind of risk is good, there are two issues that must be considered with regard to currency risk. First, the correlation between currency risk and stock market risk is close to zero. That means that currency changes and stock returns are independent of one another. Though both currency risk and stock market risk contribute to the total risk of a portfolio of foreign stocks, the contribution of currency risk to the total risk is not very large because of the zero correlation. On average, currency risk contributes less than 20 percent of the total risk. Read the rest of this entry »
There are several reasons for the persistence of the forward rate bias. Arbitrageurs or other smart traders may not be able to trade on the forward rate bias due to transaction costs and risk of taking positions. Second, arbitrageurs may be wary of the forward rate bias due to the absence of a logical explanation. Third, limits on arbitrage exist, as currency markets are very large. Finally, the forward rate bias will continue to persist probably due to the structure of currency markets. Each reason for persistence is discussed in turn.
There is general consensus based on the evidence presented above that the forward rate is biased and a poor predictor of the future spot rate. Read the rest of this entry »
Nearly all of the mutual fund families offer multiple funds that are geared toward international investing. The different kinds of funds can be categorized into index funds, international funds, regional funds, country funds, emerging market funds, and global funds. International mutual funds have higher expense ratios than domestic mutual funds to cover higher trading costs and higher management fees. The funds also tend to have redemption fees to control frequent trading. Examples of funds offered by major mutual fund companies are given below.
* Index funds. These include Fidelity Spartan International Index Fund, Vanguard Developed Markets Stock Index, Vanguard Emerging Markets Stock Index, and Price International Equity Index Fund.
* International funds. These funds do not invest in the domestic market. Funds include Fidelity International Growth, T. Rowe Price International, Fidelity Overseas, Vanguard International Growth, Fidelity Diversified International, and so on.
* Global funds. These funds invest in all countries, including the domestic market, and include Templeton World, GT Global Worldwide, Dreyfus Global, Vanguard Global Equity, Price Global Stock, and so on. Read the rest of this entry »
Driven by a combination of management-initiated efforts to improve defined contribution plans and increasing employee bottom-up requests for a wider array and range of investment options, the average number of choices offered by Benefits, Inc. clients is now 10, compared to 3 or 4 choices 10 years ago. Indeed, many large companies offer 75 or more options. However, a concern is whether these additional options are being used properly. Read the rest of this entry »
The Class B structure creates challenging financial issues for the fund sponsor This structure carries inherent risk in that the fund’s NAV could decline substantially, decreasing the amount of 126-1 fees and CDSCs received by the sponsor, possibly below the amount it advanced to the broker-dealer. This is especially a risk for an equity fund sponsor, since equity assets are more volatile than other asset types. In recent years, many fund sponsors have sought relief from the risk that the CDSC arrangement entails by taking advantage of new methods of financial engineering developed by banks and investment banks. These methods enable fund sponsors to reduce or eliminate this risk by securitizing and selling the future cash flows from 12b-1 fees and CDSCs. For example, consider a fund sponsor that has just paid a broker a 4% commission for selling Class B shares of a growth find. Rather than wait to recoup this commission via 12b-1 fees and/or CDSCs, the sponsor may sell the rights to these future cash flows to an unrelated party in exchange for a modestly lower payment today. This sale effectively protects the sponsor against the risk associated with a possible downturn in the equities market and consequential decline in cash flows from 12b-1 fees and CDSCs. Read the rest of this entry »
What if a stock has run out of steam and we’re anticipating a period of consolidation or lower volatility for a period of time? What if we have identified a range-bound stock and we want to take advantage of this price pattern behavior? We can achieve this by trading low-risk, high-reward options strategies! The two strategies we’ll discuss in this chapter are the Butterfly and the Condor, both of which produce profits provided the price remains within a certain price range, determined by the Exercise prices we select.
Butterflies
The Butterfly involves the following steps (you can use all calls or all puts with the Butterfly—you cannot mix the two):
Butterfly with Calls
Step 1 Buy 1 lower strike (ITM) call
Step 2 Sell 2 middle strike ATM calls
Step 3 Buy 1 higher strike (OTM) call
There are two key points here:
- The ratio between buying the ITM call, selling the ATM calls, and buying the OTM call is 1:2:1.
- The distance between the three adjacent strikes must be equal, with the middle strike being ATM or as close to ATM as possible.
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Delta The speed of a Straddle’s position accelerates dramatically Near the Money. Delta is
negative when the stock price is very low and accelerates into,a positive value when the stock price is nearer and above the strike price. This shows us that when the stock price is lower than the strike price, further down movement is profitable, and when the stock price is higher than the strike price, continued up movement is required from the stock to make the Straddle profitable. Delta’s profile is somewhat “S’ shaped. Delta will generally be less than one (for one contract) when the stock price is ATM. This signifies that at that point, the value of the Straddle will vary with the stock price, but at a reduced speed.
Gamma Gamma is always positive with a long Straddle and peaks where delta is rising at its
steepest angle. This invariably occurs Near the Money, indicating that the Straddle is very sensitive to swings in the stock price at these levels.
Theta Time decay affects the Straddle detrimentally. Theta assumes a “V” shape and is almost
entirely negative, forming its trough At the Money. This makes total sense because with a long Straddle you are buying two options premiums and are heavily exposed to time decay. Where the stock price is far lower than the Straddle strike price, theta can have a fractional positive value.
Vega Vega is entirely positive and forms a mountain-top shape, peaking At the Money. With the
vega value peaking ATM this indicates to us that a small increase in volatility is going to increase the value of our Straddle position markedly. Read the rest of this entry »
Are you actively looking for the next Dell? Do you want to find a stock that is under $1 a share (as Dell was, split adjusted, prior to 1996) and ride it to $50 (which Dell reached in 2000)? If this is what your goal is, you are better off studying gambling techniques and visiting a casino. Trying to make a killing causes you to invest in stocks that carry a lot of risk and that have relatively low odds of rewarding the risks you take.
If you feel the urge to make a killing and you’re particularly vulnerable to sins such as greed and gluttony, here is a good way to follow this commandment. Tell yourself that if you want to make a killing, rather than searching for a rags-to-riches stock, your money would be better spent by taking a risk on:
- Opening a restaurant
- Starting an Internet grocery store
- Buying real estate
- Buying swamp land in Zimbabwe
I’m not suggesting you actually do these things, only that you should consider them and then realize how much risk is involved in trying to make a killing in the market.
The statistics presented earlier illustrate just how large is the number of mutual funds available. Each fund has specific investment objectives and investment policies, which determine the nature and level of risk; the greater the risk, the greater should be the potential reward. The range of funds available provides a wide spectrum, from very safe, low-risk funds investing in government securities to speculative, high-risk funds investing in new or smaller companies or emerging markets or being highly geared or utilising sophisticated techniques involving derivatives. Read the rest of this entry »
- for mortgage repayment a low-risk investment would
- be sensible, but, if the term is long enough, greater
- risk could be taken in the early years;
- similarly for pension or retirement provision; greater risk can be taken when the investor is young;
- if saving to provide a’start in life’ for children, lowto-meditun risk funds should perhaps be chosen;
- if investing a windfall, such as a legacy, a relatively high risk might be acceptable, on the basis that the funds arose unexpectedly, although hopefully without being reckless.
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