INSURANCE NOTES

IC-33 Key Notes Combined by Ravneet Kaur on Scribd

FOREX NOTES

302370_1007476_2_forex_question_cci by Ravneet Kaur on Scribd

SWAPS

Swap – Meaning
 A Swap is an agreement between two counter parties to exchange cash flows in the future.
 Terms like the dates when the cash flows are to be paid, the currency in which to be paid and the mode of payment are determined and finalized by parties.
 Calculation of cash flows involves the future values of one or more market variables. Evolution of swap market
 Financial experts agree that the origin of the swap markets can be traced back to 1970s when many countries imposed exchange regulations and restrictions in order to control cross border capital flows.  Experts are of the opinion that swap markets owe their origin to the exchange rate instability that followed the demise (failure) of Bretton Wood System during the years 1971 to 1973.
 Most of the borrowers and investors at the international level wishing to diversify their assets and liabilities compositions in varied currencies in order to control losses arising due to fluctuations in exchange rate.
 In 1980s a few countries liberalize their exchange regulatory measures, as a result, some of the MNCs treasurers structured their portfolios and brought out a new financial product, known as swaps.  Replaced their existing contracts like parallel(similar, comparable) and back-to-back loans ,with the swap deals which found them more flexible and suitable due to simpler documentation and single jurisdiction. (authority, power).
 Swap were found to lower financing cost and tax differences.
 In 1980s, most of the MNCs and other corporate borrowers were approaching to the investors directly rather than through banks, also encourage them to make financial arrangement through swaps.
 First swap contract was negotiated in 1981 between Deutsche Bank and an undisclosed counter party.
 Bankers were only acting as brokers in the swap markets to match the complimentary requirement of the counter parties.
 Emergence of the large bank and performed as aggressive market makers specifically in dollar interest rate swaps.
 Provide bid/ offer quotes for both interest rate and currency swaps.
 The banks started to find out a counter party with exactly or nearly matching requirement to hedge the original swap by entering into a matching swap.
 The formation of the international Swap Dealers Association (ISDA) in 1984 was a significant development to speed up the growth in the swap market by standardizing swap documentation.
 In 1985, the ISDA published the first standardized swap code.. This code was revised in 1986 and in 1987, published its standard form agreements.
 Currency swaps were first introduced in late 1970s, and then interest rate swap in 1981, equity and commodity swap in mid 1980s and credit derivatives in 1990, were floated. Features of Swaps
 Counter parties:
 Swap involve the exchange of a series of periodic payment between at least two parties.
 Example, a firm having a loan of ten crore payable at ten percent fixed coupon rate for five years, wants to exchange for a floating interest rate with that party who is also interest to exchange its liability from floating to fixed.
 Facilitators:
 Swap agreements are arranged through an intermediary which is usually a large international financial institution/ bank having network of its operation in major countries.
 These intermediaries plays a significant role in bringing closer the various parties for such deals.
 Facilitator will note down the requirement of the parties and try to match and fulfill these with other parties.
 Swap facilitators can be classified into two :
 Brokers -- -function as agent that identify and bring the counter parties on the table for the swap deal.
 Initiate the counter parties to finalize the swap deal according to their respective requirement.
 Swap dealers – they themselves become counter parties and takeover the risk.
 Swap dealer are the part of the swap deal, they face two problems .
 First, how to price swap to provide for his service. Second problem is to manage this portfolio.
 Cash flows:
 Swap deal is an exchange of two financial obligation in future, both the parties would desire to have same financial liabilities as before the swap deal.
 In swap deal, the present value of future cash streams are examined, and then appropriate decision is taken.
 Documentations:
 Swap transaction may be set up with great speed , their documentations and formalities are much less in comparable to loan deals.
 It is an evaluation of various future cash stream arisen out in various contract done in past.
 The terms of different contract suit the interested firms requirements, the deal will be enacted.
 Transaction cost:
 It is observed that the transaction cost are relatively low in swap in comparison to loan agreement.  Unlikely to exceed half percent of the total sum involved in the swap agreement.
 Benefits to parties:
 Swap agreement will be done only when the parties will be benefited by such agreement, otherwise such deals will not be excepted.
 Termination:
 Swap is an agreement between two parties, it cannot be terminated at one’s instance.
 Termination also requires to be accepted by counter parties.
 Default risk:
 Swap deals are bilateral agreement, the problems of potential default by either of the counter party exist.

Interest rate swaps -- Meaning
 An interest rate swap is a financial agreement between the two parties who wish to change the interest payment or receipts in the same currency on assets or liabilities to a different basis.
 No exchange of principal amount in this swap.
 This is also known in the market as plain vanilla swap.
 Principal amount applies only for the purpose of calculating the interest to be exchanged under interest rate swap.
 Maturities range from a year to over 15 years.
 Feature of interest rate swaps:
 Notional principal:
 Interest amount whether fixed or floating is calculated on a specified amount borrowed or lent.
 Parties do not exchange this amount at any time., it remains constant throughout the life of the swap.
 Fixed rate:
 This is the rate, which is used to calculate the size of the fixed payment.
 Banks or financial institutions who make market in interest rate swap quote the fixed rate, they are willing to pay if they are fixed rate payers in a swap (bid swap rates) , they are willing to receive if they are floating rate player in a swap (ask swap rate). Fixed payment =( P ) x (Rfp) x (Ffp) Where P is the notional payment, Rfp is the fixed price, Ffp is the fixed day count fraction.
 Floating rate:
 Floating rate as one of the market indexes like LIBOR (London Inter Bank Offer Rate).
 Treasury Bill rate, primary rate, etc. on which basis the floating interest rate is determined in the swap agreement.
 Floating payment = (P) x (Rfe) x (Ffe)
 Where P is notional payment, Rfe is the floating rate set on the reset date, Ffx is the floating rate day count fraction.
 Trade date, effective date, reset date, payment date:
 Trade date:
 Fixed rate payment are normally paid semi-annually or annually. For example, it may be March 1, September 1 etc.
 Trade date may be defined as such date on which the swap deal is concluded.
 Effective date:
 Effective date is that date from which the first fixed and floating payment start to accrue.
 For example, a 5- year swap is traded on August 30, 2002 the effective date may be September 1, 2002, and ten payment dates from March 1, 2003 to September 1, 2007.
 Example for calculation of fixed and floating interest rate: Let us assume Party X on a semi-annual basis, pays 7 per cent rate of interest on the notional amount and receives from the Party Y LIBOR + 30 basis points . The current six- month LIBOR rate is 6.30 per cent per annum. The notional principal is Rs. 35 crore. Amount to be paid as per fixed rate: Notional principal x (Days in period/365) ( Interest rate/100) 350000000 x (182/365) x ( 7/100) = Rs. 1221644 Amount to be paid as per floating rate: Notional principal x (Days in period/365) ( Interest rate + base/100) 350000000 x (182/365) x ( 6.30 + .30/100) = Rs. 1167833 In a swap, the payments are netted. In this case, Party X pays Party Y the net difference. Rs. 1221644 - Rs. 1167833 = Rs.53810
 Types of interest rate swaps:
 Plain vanila swap:
 It is also known as fixed-for-floating swap.
 One party with a floating interest rate liability is exchanged with fixed rate liability.
 Period ranges from 2 years to over 15 years for a predetermined notional principal amount.
 Zero coupon to floating:
 Holders of zero-coupon bonds get the full amount of loan and interest accrued(accumulate) at the maturity of the bound.
 The fixed rate player makes a bullet payment at the end and floating rate player makes the periodic payment through out the swap period.`
 Alternative floating rate:
 Floating reference can be switched to other alternatives as per the requirement of the counter party.  These alternatives include three-month LIBOR, one-month commercial paper, T-Bill rate etc.
 Alternative floating interest rates are charged in order to meet the exposure of other party.
 Floating-to-floating:
 One party pays one floating rate, say, LIBOR while the other counter party pays another, say, prime for a specified time period.
 These swap deals are mainly used by the non-US banks to manage their dollar exposure.
 Forward swap:
 This swap involves an exchange of interest rate payment that does not begin until a specified future point of time.
 Swaptions:
 Swaptions are combination of the features of two derivative instruments i.e. option and swap.
 Option interest rate swaps are referred as swaptions.
 Buyer of the swaption has the right to enter into an interest rate swap agreement by some specified date in the future.
 Swaption will specify whether the buyer of the swaption will be a fixed rate receiver or a fixed rate payer.
 Buyer exercises the option then the writer of the option will become the counter party.
 Equity swap:
 Equity swap involves the exchange of interest payment linked to the change in the stock index.
 Example , an equity swap agreement may allow a company to swap a fixed interest rate of 6 per cent in exchange for the rate of appreciation on a particular index say BSE or NSE index. Currency Swap -- Meaning
 In currency swap, the two payment streams being exchanged are denominated in two different currencies.
 Example , a firm which has borrowed Japanese yen at a fixed interest rate ‘can swap’ away the exchange rate risk by setting up a contract whereby it receives yen at a fixed rate in return for dollars at either a fixed or a floating interest rate.
 In currency swap three basic step are involved
 1.Initial exchange of principal amount – at an agreed rate of exchange. This rate is based on the spot exchange rate.
 2.Ongoing exchange of interest – after establishing the principal amount, the counter parties exchange interest payment on agreed date based on the outstanding principal amount at the fixed interest rates agreed at the outset of the transaction.
 3.Re-exchange of principal to principal – agreement on this enables the counter parties to re-exchange the principal sums at the maturity date. Types of currency swaps
 Fixed-to-fixed currency swap:
 Currencies are exchanged at fixed rate.
 One firm raises a fixed rate liability in currency X, say US dollar while the other firm raises fixed rate funding in currency Y say pound.
 Principal amount are equivalent at the current market rate of exchange.
 In swap deal, first party will get pound where the second party gets dollars.
 The first party will make periodic get (pound) payment to the second, in turn gets dollar computed at interest at a fixed rate on the respective principal amount of both currencies.
 Floating-to-floating:
 The counter parties will have payments at floating rate in different currencies.
 Fixed-to-floating currency swap:
 It is a combination of a fixed-to-fixed currency swap and floating swap.
 One party makes the payment at a fixed rate in currency, say, X while the other party makes the payment at a floating rate in currency, say Y.
 Contract without the exchange and re-exchange of principals do exist.
 A financial intermediary (a swap bank) structures the swaps deal and routes the payment from one party to other party. Debt-Equity swap
 In debt-equity swap, a firm buy’s a county debt on the secondary market at a discount and swaps it into local equity.
 Debts are exchanged for equity by one firm with the other.
 Enable the investors to purchase the external debts of such underdeveloped countries to acquire equity or domestic currency in those same countries.
 For example, a multinational firm wants to invest in, say, brazil, hires an intermediary (normally a bank) to buy brazil loans in the secondary market.
 MNC (again through a middleman) presents the loans, denominated in dollar as, to the brazil central bank, which redeems them for brazil currency. The central bank, which redeems them at face value more than the loans trade in the secondary markets. Motivation underlying swaps
 Swap are important techniques or technology for transforming the characteristics of financial claim.
 There is a different risk perception between markets. Example, bond market and bank credit market evaluate the companies differently because their credit assessment is subjective.
 A company can raise the fund in particular market at lower cost where it receives better evaluation, which it can swap into the desired type of instrument.
 I t relates with regulation of issuers and investors concerning the respective governments.
 Government regulation that seeks to limit the amount of debt issue by the foreign companies to protect domestic investors from increased risks and preventing to borrow from local markets.
 Government regulation makes certain markets more attractive to particular companies (usually domestic) than others.
 There is subsidized financing available in certain type of business , for example export financing.  A currency swap may allow a company to take advantage of such situation.
 The availability of funds in different markets changes due to temporary supply/ demand imbalances.
 Lowering reserve requirement for bank will result in increase of supply of funds in the bank credit and rates fall down.
 The borrower will desire to go in such market where the supply is in excess.
 It is related to balance-sheet position of the counter parties.
 Swapping provides better opportunities to determine the type of assets and liabilities it wants to carry.
 Example, a banking company’s assets are the loans issued to the customers.
 I t is observed that changes overtime may effect the differences between markets and the prevailing rates may be changes.

FOREIGN EXCHANGE PLUS

Q.1 : Define Foreign Exchange and Explain the Functions of Foreign

Exchange Market. (M.2011)

Ans. A) FOREIGN EXCHANGE

                Foreign Exchange refers to foreign currencies possessed by a country for making payments to other countries. It may be defined as exchange of money or credit in one country for money or credit in another. It covers methods of payment, rules and regulations of payment and the institutions facilitating such payments.

A.       FOREIGN EXCHANGE MARKET

        A foreign exchange market refers to buying foreign currencies with domestic currencies and selling foreign currencies for domestic currencies. Thus it is a market in which the claims to foreign moneys are bought and sold for domestic currency. Exporters sell foreign currencies for domestic currencies and importers buy foreign currencies with domestic currencies.

            According to Ellsworth, "A Foreign Exchange Market comprises of all those institutions and individuals who buy and sell foreign exchange which may be defined as foreign money or any liquid claim on foreign money". Foreign Exchange transactions result in inflow & outflow of foreign exchange.

B.       FUNCTIONS OF FOREIGN EXCHANGE MARKET

            Foreign exchange is also referred to as forex market. Participants are importers, exporters, tourists and investors, traders and speculators, commercial banks, brokers and central banks.

            Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are the important foreign exchange instruments used in foreign exchange market to carry out its functions.

            The Foreign Exchange Market performs the following functions.

1.             Transfer Of Purchasing Power I Clearing Function

            The basic function of the foreign exchange market is to facilitate the conversion of one currency into another i.e. payment between exporters and importers. For eg. Indian rupee is converted into U.S. dollar and vice-versa. In performing the transfer function variety of credit instruments are used such as telegraphic transfers, bank drafts and foreign bills. Telegraphic transfer is the quickest method of transferring the purchasing power.

2.             Credit Function

            The foreign exchange market also provides credit to both national and international, to promote foreign trade. It is necessary as sometimes, the international payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required.

            For eg. Mr. A can get his bill discounted with a foreign exchange bank in New York and this bank will transfer the bill to its correspondent in India for collection of money from Mr. B after the stipulated time.

3.             Hedging Function

A third function of foreign exchange market is to hedge foreign exchange risks. By hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange rates. Under this function the foreign exchange market tries to protect the interest of the persons dealing in the market from any unforseen changes in exchange rate. The exchange rates under free market can go up and down, this can either bring gains or losses to concerned parties. Hedging guards the interest of both exporters as well as importers, against any changes in exchange rate.

Hedging can be done either by means of a spot exchange market or a forward exchange market involving a forward contract.

Q. 2 : Explain the dealers or participants in foreign exchange market. (M.2011)

Ans. A) PARTICIPANTS I DEALERS IN FOREIGN EXCHANGE MARKET

            Foreign exchange market needs dealers to facilitate foreign exchange transactions. Bulk of foreign exchange transaction are dealt by Commercial banks & financial institutions. RBI has also allowed private authorised dealers to deal with foreign exchange transactions i.e buying & selling foreign currency. The main participants in foreign exchange markets are

1.        Retail Clients

            Retail Clients deal through commercial banks and authorised agents. They comprise people, international investors, multinational corporations and others who need foreign exchange.

2.        Commercial Banks

            Commercial banks carry out buy and sell orders from their retail clients and of their own account. They deal with other commercial banks and also through foreign exchange brokers.

3.    Foreign Exchange Brokers

            Each foreign exchange market centre has some authorised brokers. Brokers act as intermediaries between buyers and sellers, mainly banks. Commercial banks prefer brokers.

4.        Central Banks

            Under floating exchange rate central bank does not interfere in exchange market. Since 1973, most of the central banks intervened to buy and sell their currencies to influence the rate at which currencies are traded.

            From the above sources demand and supply generate which in turn helps to determine the foreign exchange rate.

B.            TYPES OF FOREIGN EXCHANGE MARKET

            Foreign Exchange Market is of two types retail and wholesale market.

1.        Retail Market

            The retail market is a secondary price maker. Here travellers, tourists and people who are in need of foreign exchange for permitted small transactions, exchange one currency for another.

2.    Wholesale Market

The wholesale market is also called interbank market. The size of transactions in this market is very large. Dealers are highly professionals and are primary price makers. The main participants are Commercial banks, Business corporations and Central banks. Multinational banks are mainly responsible for determining exchange rate.

3.        Other Participants

a)        Brokers

         Brokers have more information and better knowledge of market. They provide information to banks about the prices at which there are buyers and sellers of a pair of currencies. They act as middlemen between the price makers.

b)        Price Takers

                     Price takers are those who buy foreign exchange which they require and sell what they earn at the price determined by primary price makers.

c)        Indian Foreign Exchange Market

         It is made up of three tiers

     i.        Here dealings take place between RBI and Authorised dealers (ADs) (mainly   

      commercial  banks).

    ii.        Here dealings take place between ADs

   iii.        Here ADs deal with their corporate customers.

Q. 3 : Define I Explain I Write note on spot and forward exchange rates.

Ans. A)  EXCHANGE RATE

                     Transactions in exchange market are carried out at what are termed as exchange rates. In foreign exchange market two types of exchange rate operations take place. They are spot exchange rate and forward exchange rate.

1)             Spot Exchange Rate :-

            When foreign exchange is bought and sold for immediate delivery, it is called spot exchange. It refers to a day or two in which two currencies are involved. The basic principle of spot exchange rate is that it can be analysed like any other price with the help of demand and supply forces.

            The exchange rate of dollar is determined by intersection of demand for and supply of dollars in foreign exchange. The Remand for dollar is derived from country’s demand for imports which are paid in dollars and supply is derived from country’s exports which are sold in dollars.

            The exchange rate determined by market forces would change as these forces change in market. The primary price makers buy (Bid) or sell (ask) the currencies in the market and the rates continuously change in a free market depending on demand and supply. The primary dealer (bank) quotes two-way rates i.e., buy and sell rate.

(Bid) Buy Rate 1 US $ = ` 45.50

(Ask) Sell Rate 1 US $ =  ` 45.75

            The bank is ready to buy 1 US $ at Rs. 45.50 and sell at Rs. 45,75. The difference of Rs.0.25 is the profit margin of dealer.

2)             Forward Exchange Rate

            Here foreign exchange is bought or sold for future delivery i.e., for the period of 30, 60 or 90 days: There are transactions for 180 and 360 days also. Thus, forward market deals in contract for future delivery. The price for such transactions is fixed at the time of contract, it is called a forward rate.

            Forward exchange rate differs from spot exchange rate as the former may either be at a premium or discount. If the forward rate is above the present spot rate, the foreign exchange rate is said to be at a premium. If the forward rate is below the present spot rate, the foreign exchange rate is said to be at a discount. Thus foreign exchange rate may be at forward premium or at forward discount.

            For Eg. an Indian importer may enter into an agreement to purchase US $ 10,000 sixty days from today at 1 US $ = Rs. 48. No amount is paid at the time of agreement, except for usual security margin money of about 10% of the total amount. 60 days form today, the importer will get 10,000 US $ in exchange for Rs. 4,80,000 irrespective of the Spot exchange rate prevailing on that date.

a)        Factors Influencing Forward Exchange Rate

i)         Interest rates.

ii)        Degree of speculation in foreign exchange market.

iii)       Inflation rate.

iv)       Foreign investor’s confidence in domestic country.

v)        Economic situation in the country.

vi)       Political situation in the country.

vii)     Balance of payments position etc.

b)        Need For Forward Exchange Rate Contracts

            To overcome the possible risk of loss due to fluctuations in exchange rate, exporters, importersand investors in other countries may enter in forward exchange rate contracts.

                     In floating or flexible exchange rate system the possibility of wide fluctuation in exchange is more. Thus, both exporters and importers safeguard their position through a forward arrangement. By entering into such an arrangement both parties minimize their loss.

Q. 4 : Write note on Arbitrage.                                         O R

         Write note on Interest rate and Arbitrage.

Ans. A.  ARBITRAGE

                        Arbitrage is the act of simultaneously buying a currency in one market and selling it in another to make a profit by taking advantage of exchange rate differences in two markets. If the arbitrages are confined to two markets only it is said “two-point” arbitrage. If they extend to three or more markets they are known as “three-point” or “multi-point” arbitrage. Those who deal with arbitrage are called arbitrageurs.

            A Spot sale of a currency when combined with a forward repurchase in a single transaction is called “Currency Swap". The Swap rate is the difference between spot and forward exchange rates in currency swap.

            Arbitrage opportunities may exist in a foreign exchange market.. Suppose the rate of exchange is 1 US $ = `. 50 in US market and 1 US $ = `. 55 in Indian Markets, then an arbitrageur can buy dollars in US market and sell it in Indian market and get a profit of `. 5 per dollar..

            In today’s modern well connected and advanced markets, arbitrageurs (which are mainly banks) can spot it quickly and exploit the opportunity. Such opportunities vanish over a period of time and equilibrium is again maintained.

For Eg.

                     Bank A       ` / $ = 50.50 / 50.55

                     Bank B       ` / $ = 50.40 / 50.45

The above rates are very close. The arbitrageur may take advantage and he can purchase $ 1,00,000 from Bank B at `. 50.45 / a dollar and sell to it to Bank A at `. 50.50, thus making a profit of 0.05. The total profit would be (1,00,000 x 0.05) = `. 5,000. The profit is earned without any risk and blocking of capital.

B.   ARBITRAGE.AND INTEREST RATE

            Interest arbitrage refers to differences in interest rates in domestic market and in overseas markets. If interest rates are higher in overseas market than in domestic market, an investor may invest in overseas market to take the advantage of interest differential.

Interest arbitrage may be covered and uncovered.

1)             Uncovered Arbitrage

            In this system, arbitrageurs would take a risk to earn profit by investing in a high interest bearing risk free securities in a foreign market. His earnings would be according to his calculations if the currency of foreign market where he invested does not depreciate. If depreciation is equal to the difference in interest rate, the investor would not incur loss. However, if depreciation is more than interest rate, then the arbitrageur will incur loss.

            For Eg. In New York interest rate on 6 month Treasury Bill is 6% and in Spain it is 8%. An US investor may convert US dollars in EURO and invest in Spain, thereby taking an advantage of +2% interest rate. Now when bill matures, US investor will convert EURO into dollars. However, by that time EURO may have depreciated the US investor will get less dollars per EURO. If EURO depreciates by 1%, US investor will gain only +1% (+2 – 1%). If EURO depreciates by 2% or more, US investor will not gain anything or incur loss. If EURO appreciates, US investor will gain, +2% and interest rate differential

2)             Covered Arbitrage

International investors would like to avoid the foreign exchange risk, thus interest arbitrage is usually covered. The investor converts the domestic currency for foreign currency at the current spot rate for the purpose of investment. At the same time, investor sells forward the amount of foreign currency which he is investing plus the interest that he will earn so as to coincide with maturity of foreign investment.

The covered interest arbitrage refers to spot purchase of foreign currency to make investment and offsetting simultaneous forward sale of foreign currency to cover foreign exchange risk. When treasury bills mature, the investor will get the domestic currency equivalent of foreign investment plus interest without a foreign exchange risk.