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FINS1612:
Financial Institutions,
Instruments and Markets

Chapters 13, 15, 16, 18 & 19

Chapter 13: An Introduction to IR Determination & Forecasting

Macroeconomic Context of Interest Rate Determination:

The Reserve Bank determines interest rates in order to stabilise the currency, maintain
full employment and to maximise the economic prosperity and welfare of the people
of Australia.

A central bank may increase interest rates (tighten monetary policy) if there
is:
- Inflation above target range
- Excessive growth in GDP
- A large deficit in the balance of payments (= too much debt)
- Rapid growth in credit and debt levels
- Excessive ‘downward’ pressure on FX markets

This will result in:

- The increase of long-term rates

- Slowing down consumer spending
- The reduction of inflation and demand for imports
- Decreasing the size of the current account
- Possibly attracting foreign investment causing the domestic currency
to appreciate

Three effects of changes in interest rates:

1. Liquidity effect
- The affect of the RBA’s market operations on the money supply and
system liquidity
- e.g. RBA increases rates (i.e. tightens monetary policy) by selling CGS
2. Income effect
- This is a flow-on effect from the liquidity effect and dictates that if interest
rates rise, economic activity will slow – allowing rates to ease
- Increased rates reduce spending levels and income levels
3. Inflation effect
- As the rate of growth in economic activity slows, demand for loans also
slows
- This results in an easing of the rate of inflation
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Economic indicators:

1. Leading indicators
- Economic variables that change before a change in the business cycle

2. Coincident indicators
- Economic variables that change at the same time as the business cycle
changes

3. Lagging indicators
- Economic variables that change after the business cycle changes

Difficulties exist with knowing the extent of the timing lead or lag of such indicators
and also with consistently performing indicators (e.g. rates of growth in money
measures were once lead indicators and are now lagging indicators).

Loanable Funds Approach to Interest Rate Determination:

LF: the funds available in the financial system for lending

Uses the supply and demand of money to explain rates  preferred method of
explaining and forecasting interest rates (assumes a downward-sloping demand curve
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and an upward-sloping supply curve). This means that as interest rates rise demand
falls and as interest rates rise supply increases. Therefore, changes in the positions of
the demand and supply curves will result in changes in the rate of interest.

Supply of loanable funds - comprised of 3 principal sources:

- Savings of household sector (S)
- Changes in money supply (M)
- Dishoarding (∆D)
o Hoarding is the proportion of total savings in economy held as
currency
o Dishoarding occurs (i.e. currency holdings decrease) as interest rates
rise and more securities are purchased for the higher yield available
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Equilibrium in the LF market:

In Figure 13.9 equilibrium is point E and the equilibrium rate is i0. E is a temporary
equilibrium because the supply and demand curves are not independent and the
dynamic variables will continue to change.
- The level of dishoarding (currently ab) will change once portfolios have been
reallocated from holding currency in this figure and the dishoardign process
will cease, moving the S curve upwards.
- The money supply is unlikely to increase proportionately in subsequent
periods. Therefore, the S + ∆M component of the supply curve would change.
- A change in business and/or government demand would inevitably change the
position of these curves.

Therefore, the LF approach is problematic because the supply and demand curves are
not independent of each other, meaning a final equilibrium interest rate can not be
determined.

Impact of disturbances on rates:

Expected increase in economic activity:

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- When businesses increase their investment in inventories and capital

equipment, they will borrow and sell financial instruments to obtain funds
(demand curve moves to the right = higher interest rate)
- Initial effect is that businesses sell securities, yields increase (price decreases)
meaning some savers will rearrange their portfolios by giving up cash and
buying securities meaning dishoarding occurs

Inflationary expectations
- The demand shifts to the right (companies realise they need more funds in
order to maintain their investment plans) and the supply curve shifts to the left,
resulting in higher interest rates and unchanged equilibrium quantity

Term and Risk Structure of Interest Rates:

Yield is the total return on an investment, comprising interest received and any
capital gain (or loss) and a yield curve is a graph – at a point in time – of yields on an
identical security with different terms to maturity.

The term structure of interest rates is the relationship between interest rates and term
to maturity for debt instruments in the same risk class.

Different types of yield curves:

Normal or positive yield curve

- Longer-term interest rates are higher than shorter term rates

Inverse or negative yield curve

- Short-term interest rates are higher than longer-term rates

Humped yield curve

- Shape of yield curve changes over time from normal to inverse

Three theories have been advanced to explain the shape of the yield
curve:
- Expectations theory
- Market segmentation theory
- Liquidity premium theory

Expectations Theory:

- The current short-term interest rate and expectations about future short-term
interest rates are used to explain the shape and changes in shape of the yield
curve
- Longer-term rates will be equal to the average of the short-term rates expected
over the period
- The theory is based on assumptions, e.g.
o Large number of investors with reasonably homogenous expectations
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o No transactions costs and no impediments to interest rates moving to

their competitive equilibrium levels
o Investors aim to maximise returns and view all bonds as perfect
substitutes regardless of term to maturity
Example: The rate on a one-year instrument is 7% per annum. The investor expects to
obtain 9% per annum on a one-year investment starting in one year’s time. What is
the current two-year rate?

Explanations for the shape of yield curves:

Inverse yield curve

- Will result if the market expects future short-term rates to be lower than
current short-term rates

Normal yield curve

- Will result from expectations that future short-term rates will be higher than
current short-term rates

Humped yield curve

- Investors expect short-term rates to rise in the future but to fall in subsequent
periods

Market Segmentation Theory:

The essence of this theory is its emphasis on the behaviour of market participants in
seeking to minimise the riskiness of their portfolios, rather than profit maximisation.

Assumes that securities in different maturity ranges are viewed by market participants
as imperfect substitutes (i.e. investors will operate within some preferred maturity
range). This means it rejects two assumptions of the expectations theory.
- Preferences of participants are motivated by reducing the risk of their
portfolios, i.e. minimising exposure to fluctuations in prices and yields
- This states that certain institutions will purchase securities with different
maturity dates and liquidity levels in order to minimise risk. For example, a
life insurance office mainly has long term liabilities, so it will purchase assets
that match the cash-flow characteristics of their liabilities.

The shape and slope of the yield curve are determined by the relative demand and
supply of securities along the maturity spectrum.
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For example, if the central bank increases the average maturity of bonds by
purchasing short-term bonds and selling long-term bonds, segmented markets theory
suggests:
- Short-term yields decrease and long-term yields increase
- Although financial system liquidity is unchanged, economic activity is
affected because areas of expenditure sensitive to
o Short-term interest rates will expand
o Long-term interest rates will contract

Expectations theory suggests that there would be no effect on expectations about

future short-term interest rates, and therefore no effect on the economy.

Liquidity premium theory:

Assumes investors prefer shorter-term instruments, which have greater liquidity and
less maturity and interest rate risk and, therefore, require compensation for investing
longer term.

The liquidity premium can be included in the expectations theory equation

0i2= (0i1+ E1i1 + L)/2

(L is the size of the liquidity premium)

Risk Structure of Interest Rates:

- Default risk is the risk that the borrower (i.e. issuer) will fail to meet its
interest payment obligations
- Commonwealth Government bonds are assumed to have zero default risk –
offer a risk-free rate of return
- Some borrowers may have greater risk of default (i.e. state government or
private sector firms)
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- Investors will require

compensation for bearing
the extra default risk

Chapter 15: Foreign Exchange: The Structure and Operation of the FX Market

Nature of Global FX Markets:

- FX Markets comprise all financial transactions denominated in foreign

currency – currently estimated to be nearly USD2000 billion per day.
- Facilitate exchange of value from one currency to another
- Internationally adopted FX market conventions to improve market
functionality

Discuss Participants in the FX Markets:

FX market participants can be classified as:

- FX dealers and brokers
- Central banks
- Firms conducting international trade transactions
- Investors and borrowers in the international capital markets
- Foreign currency speculators
- Arbitrageurs

FX Dealers and Brokers:

- FX dealers
o Are financial institutions, typically commercial banks and investment
banks, that quote two-way (i.e. buy and sell) prices and act as
principals in the FX market
o Usually licensed or authorised by the central banks of the countries in
which they operate

- FX brokers
o Transact almost exclusively with FX dealers, obtain the best prices in
global FX markets matching FX dealers’ buy and sell orders for a fee
o Also provide anonymity to participants until a transaction is carried out
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Central Banks:

Enter FX market to
- Purchase foreign currency to pay for Government purchases of imports, or pay
interest on, or redeem, government debt
- Change the composition of holdings of foreign currencies in managing official
reserve assets
- Influence the exchange rate

Firms Conducting International Trade Transactions:

- Exporters receive foreign currency for the sale of their goods and services
- Exporters use the FX market to sell foreign currency and buy AUD
- Importers use the FX market to buy foreign currency (sell AUD) for
purchasing imports

Investors and Borrowers in the International Capital Markets:

- Commercial bank foreign borrowings are usually converted into the home
currency
o Payment of interest and principal need to be made in the denominated
currency of the loan
- Corporations and financial institutions investing overseas
o Need to purchase FX in order to make investments
o Dividends or interest payments received from overseas investments
will be denominated in a foreign currency

Speculative Transactions:

- Businesses and financial institutions may attempt to anticipate future exchange

rate movements to make a profit
- There is a risk involved that the exchange rate will move
o In the opposite direction to that anticipated
o In the anticipated direction but by less than expected

For example…

If, today:
Spot rate: USD1= AUD1.75
Exchange rate expected today + n days:
USD1= AUD1.70

Then, today:
Buy USD1 at a cost of AUD1.75
Then, at today + n days:
Sell USD1 and obtain AUD1.70

Arbitrage Transactions:

- Profit is made through FX transactions that involve no FX risk exposure

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- Types of arbitrage
o Geographic—where two dealers in different locations quote different
rates on the same currency
o Triangular—occurs when exchange rates between 3 or more currencies
are out of perfect alignment

Example:

Triangular arbitrage
USD1 = AUD1.80
USD1 = SGD1.80
AUD1 = SGD 0.98

Arbitrage strategy
Sell AUD1.80 and receive USD1
Sell USD1 to receive SGD1.80
Sell SGD1.80 to receive AUD1.8367

Describe the Functions and Operations of FX Markets:

The FX Market consists of a vast and highly sophisticated global network of

telecommunications systems that provide the current buy and sell rates for various
currencies in dealing rooms located around the globe. To facilitate transactions, it is
essential that dealing rooms around the world have access to the same information at
the same time.

Outline Instruments Traded in FX Markets:

FX market instruments are typically:

- Spot transactions
o Have maturity date two business days after the FX contract is entered
into (e.g. used if an Australian importer has an account in USD to pay
within the next few days)

- Forward transactions
o Have maturity date more than two days after FX contract is entered
into (e.g. used if Australian importer has to pay a USD liability in 2
months, and covers or hedges against an appreciation of the USD)

tod value transactions: An FX contract with settlement and delivery today

tom value transactions: An FX contract with settlement and delivery tomorrow
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Explain Conventions for Quotation and Calculation of Exchange Rates and

Forward Exchange Rates, and Complicating Factors:

When asking for a quotation, there are certain conventions that govern the quotation.
For example:
- The price of currency is expressed in terms of another currency – so when
asking for a quotation it needs to be specified which currencies you are
referring to (e.g. USD in terms of Yen)
- Also, the order in which the currencies are expressed is significant. The first
currency mentioned is the price being sought (also called base currency or the
unit of quotation) and the second currency is the terms currency ( for example,
USD/AUD is the price of USD1 in terms of AUD)

For example: Australian dollar/euro may be expressed as EUR/AUD1.6155–1.6165,

usually abbreviated to EUR/AUD1.6155–65:

- The two numbers indicate the dealer’s buy (bid) and sell (offer) price
- A dealer quoting both bid and offer prices is a price-maker
o The dealer will buy EUR1 for AUD1.6155
o The dealer will sell EUR1 for AUD1.6165

(Dealer ‘buys low’ and ‘sells high’)

= difference between the buy

and sell price (spread)

Transposing Spot Equations:

Example: Given a quotation of EUR/AUD1.6155–1.6165 the AUD/EUR quotation

can be determined by transposing the quotation, i.e. ‘reverse and invert’

1. Reverse the bid and offer prices: 1.6165–1.6155

2. Take the inverse (divide both numbers into 1)
1.000 1.000
1.6165 1.6155
AUD/EUR0.6186–0.6190

Calculating cross-rates:

- All currencies are quoted against the USD

- There are two ways currencies can be quoted against the USD and the method
of cross-rate calculations depends on whether the quote is direct or indirect
o Direct quote—the USD is the base currency
o Indirect quote—the USD is the terms currency and the other currency
is the base currency
- When FX transactions occur between two currencies, usually where neither
currency is the USD, the cross-rate needs to be calculated
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- Method of cross-rate calculations depend of whether the quote is direct or

indirect

Direct/Direct crossover:
1. Place the currency that is to become the unit of quotation first
2. Divide opposite bid and offer rates
3. Divide the base currency offer into the terms currency bid (gives the bid rate)
4. Divide the base currency bid into the terms currency offer (gives offer rate)

Direct/Indirect crossover:
1. Multiply the two bid rates (gives the bid rate)
2. Multiply the two offer rates (gives the offer rate)

Indirect/Indirect Crossover:
1. Place the currency that is to become the unit of quotation first
2. Divide opposite bid and offer rates
3. Divide the terms currency offer rate into the base currency bid rate (gives the
bid rate)
4. Divide the terms currency bid rate into the base currency offer rate (gives the
offer rate)

(Lectures give no completed examples so look at T/B page 613-614 for examples if
confused )

Forward points and forward exchange rates:

- The forward exchange rate is the FX bid/offer rates applicable at a specified

date beyond the spot value date
- The forward exchange rate varies from the spot rate due to interest rate parity
o Interest rate parity is the principle that exchange rates will adjust to
reflect interest rate differentials between countries – this is the
principle behind the variance.

Forward exchange rates are quoted as forward points either above or below the spot
rate
- Forward points represent the forward exchange rate variation to a spot rate
base
- If the forward points are rising, then add them to the spot rate (i.e. base
currency is at a forward premium; interest rate of the base currency is lower)
- If the forward points are falling, then subtract them from the spot rate (i.e.
base currency is at a forward discount; interest rate of the base currency is
higher)

Example: Given AUD/USD (spot)

0.7830–0.7840

and six-month forward points:

0.0032–0.0027
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Then, since the forward points are falling, subtract them from the spot rate to obtain
the six-month forward rate of:
0.7798–0.7813

Example: A company approaches a FX dealer for a forward quoteon the USD/CHF

with a 3-month (90-day) delivery. The spot rate is USD/CHF1.1560. The dealer needs
to calculate the forward points. Assume the 3-month eurodollar interest rate is 3.00%
per annum and the 3-month euroSwiss franc interest rate is 4.00% per annum

Substitute into equation above -

Points = 29 points

The 3-month forward rate is USD/CHF1.1589. The points are added to the spot rate as
the interest rate of the base currency is lower
Complicating Factors:

Sometimes, modifications to the equation and example are required because different
borrowing and lending rates apply in the euromarkets where interest rates are
generally taken. This means an FX dealer will need to adjust the formula to account
for the different interest rates and may also charge a margin for costs and perhaps
some points to reflect their relationship with the company and market competition.

A forward exchange contract:

- Locks in an exchange rate today for delivery of foreign currency at a specified
future date
- FX dealers quote forward points on standard delivery dates, usually monthly
out to 12 months, of a specified amount of one currency against another
- As the dealer does not know what the spot rate will be on a future date, they
will carry out the FX transaction today even though delivery will not occur
until the future date, i.e.
o Borrow funds in one market and purchase the foreign currency that
will be needed at a future date
o Invest the purchased foreign currency in that market until delivery is
due
o The difference between the cost of borrowed funds and the return
received on the invested foreign currency will be adjusted against the
spot rate today

Recognise Important FX Impacts of EMU:

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- The European Monetary Union is changing the structure of the FX markets

because 12 currencies have disappeared and have now been replaced by the
Euro (EUR) – it is expected other countries will join in the future
- This currency is widely used in FX markets (it has become a hard currency).
Other hard currencies include USD, the pound sterling (GBP) and the Yen
(JPY)

Chapter 16: The FX Market

Explain how an equilibrium exchange rate is determined

A floating exchange rate regime is one in which the value of the currency is
determined by demand and supply conditions whereas a pegged exchange rate regime
is one where a domestic currency is locked into a specified multiple of another
currency such as the USD, e.g. Hong Kong dollar.

Demand Curve:

- To purchase Australian goods and services foreigners must buy AUD

- Downward-sloping demand curve occurs as the devaluation of AUD results in
a greater demand by foreigners
o For foreigners, a fall in the price of the AUD is equivalent to a
reduction in the price of everything in Australia

Supply Curve:

- Upward-sloping supply curve occurs as the quantity of AUDs supplied to the

FX market increases as the price of the AUD increases
- As the AUD appreciates, the price of foreign currency falls, making foreign
goods cheaper for Australian residents
- The demand for foreign currency increases and, therefore, so does the supply
of AUD

Describe the Factors Responsible for Movements in the Exchange Rate:

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Main factors influencing exchange rate movements:

- Relative inflation rates

- Relative national income growth rates
- Relative interest rates
- Exchange rate expectations
- Government or central bank intervention

Relative inflation rates:

- Relative inflation rates influence the price and, therefore, the demand for
foreign goods by residents
- The change in demand for imported goods, in turn, affects the demand for
foreign currency used to buy these goods
o This view of the determination of the value of a currency is called
purchasing power parity (PPP)

Relative national income growth rates:

Example: Australian income growth rates rise relative to the US making Australian
demand for imports increases, increasing the supply of AUD, which, in turn, causes
the AUD to depreciate
- A secondary effect could be an increase in foreign investment in Australia,
increasing the demand for AUD, causing the AUD to recover some value

Relative interest rates:

Example: if Australian interest rates rise relative to the US

- Effect for US residents
o US residents and companies may redirect some of their cash into
Australian interest-bearing instruments, increasing the demand for the
AUD

- Effect for Australian residents

o Australian investors and businesses are more likely to keep their
surplus funds invested in Australia, causing a decrease in the supply of
the AUD

The net effect is that the AUD will appreciate

- The analysis has ignored whether a change in the nominal interest rate is due
to a change in the:
o Real rate of return
Or
o Inflation expectations premium
inom = r + pe

Example: if nominal interest rates rise due to an increase in the inflation expectations
premium –
- The currency may not appreciate, and could depreciate due to:
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o The effect of inflationary expectations (PPP theory)

o Businesses and individuals seeking to invest cash holdings in overseas’
securities to avoid a loss of value

Example: if nominal interest rates rise due to an increase in the real rate of return
- The currency may appreciate due to an inflow of funds from the rest of the
world

Exchange rate expectations:

- Motivation for turnover in the FX market

- Only part of the turnover in the FX market is accounted for by transactions
associated with exports, imports and financial assets
- A significant portion of turnover is motivated by changes in exchange rate
expectations
- Exchange rate expectations are based on expectations about future changes in
o Relative inflation
o Relative income growth
o Relative interest rates

Example: AUD expected to depreciate

- Effect for Australian residents
o Seek to buy foreign currency before AUD falls
o Increasing supply of AUD on FX markets
- Effect for foreign residents
o Defer purchases of the AUD
o Reduces demand for AUD
- Net effect
o AUD depreciates as expected

Government or central bank intervention:

- Policies by foreign and/or domestic governments may affect the relative rate
of inflation, income growth or interest rates between countries
- Also, the market participants’ expectations that the government will alter its
policy affecting these variables in the future

A central bank may also influence the currency by

- Intervening in international trade flows (intervention aimed at increasing
exports and/or reducing imports) by using subsidies to exporters, making
exports more competitive. This increases demand for Australian exports and
demand for AUD. Intervention on the import side could be in the form of a
tariff, quota or embargo.
- Intervening in foreign investment flows (Governments alter the exchange rate
by altering the flow of investment funds between countries). They do this by
imposing prohibitions on the outflow of funds from a country or imposing
penalty taxes on residents who earn income offshore and non-residents’
interest income earned in the home country.
- Directly intervening in the FX market (involves purchases or sales of
currency). There are two motivations for doing this. The first is smoothing,
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where the RBA tries to remove volatility in the currency caused by speculators
and the second is exchange rate targeting where the RBA tries to push the
equilibrium exchange rate to some level.

Chapter 18: Futures Contracts and Forward Rate Agreements

Consider the Nature and Purpose of Derivative Products:

- Derivatives are risk management products that derive their value from an
underlying commodity or instrument. The two main types of derivative
contracts are:
o Commodities (e.g. gold, wheat, cattle)
o Financial (e.g. shares, government securities and money market
instruments)
- Derivative contracts enable investors and borrowers to protect assets and
liabilities against the risk of changes in interest rates, exchange rates and share
prices
- Hedging involves transferring the risk of unanticipated changes in prices,
interest rates or exchange rates to another party

- A futures contract is the right to buy or sell a specific item at a specified future
date at a price determined today
- The change in the market price of a commodity or security is offset by a profit
or loss on the futures contract

Example: A farmer wants to sell wheat in a couple of months, but is concerned that
the price is going to fall in the meantime. How can the farmer hedge this price risk?

The solution is to enter into a wheat futures contract to sell meaning:

- If wheat prices fall, the futures contract will rise in value, offsetting the loss in
the physical market from the fall in the wheat price
- If wheat prices rise, the futures contract will fall in value, offsetting the gain in
the physical market from a rise in the wheat price

Outline Features of Futures Contracts and Forward Rate Agreements and

Market Operating Procedures:

- Although futures contracts are highly standardised, variations between

countries exist due to:
o The types of contract being based on the underlying security traded in
that country
o Differences in the quotation convention

Orders and agreement to trade:

Futures contracts are highly standardised and an order normally specifies:
- Whether it is a buy or sell order
- The type of contract (varies between exchanges)
- Delivery month (expiration)
- Price restrictions (if any) (e.g. limit order)
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- Time limits on the order (if any)

Margin requirements:

- Both the buyer (long position) and the seller (short position) pay an initial
margin, held by the clearing house, rather than the full price of the contract
- Margins are imposed to ensure traders are able to pay for any losses they incur
due to unfavourable price movements in the contract
- A contract is marked-to-market on a daily basis by the clearing house (i.e.
repricing of the contract daily to reflect current market valuations)
- Subsequent margin calls may be made, requiring a contract holder to pay a
maintenance margin to top-up the initial margin to cover adverse price
movements

Closing out of a contract:

- Involves entering into an opposite position

Example: Company S initially entered into a ‘sell one 10-year treasury bond contract’
with company B
- Company S would close out the position by entering into a ‘buy one 10-year
treasury bond contract’ for delivery on the same date, with a third party, e.g.
company R
o The second contract reverses or closes out the first contract and
company S would no longer have an open position in the futures
market

Contract delivery:

- Most parties to a futures contract manage a risk exposure or speculate and do

not wish to actually deliver or receive the underlying commodity/instrument
and close out of the contract prior to the delivery date
- SFE requires financial futures in existence at the close of trading in the
contract month to be settled with the clearing house in one of two ways
o Standard delivery—delivery of the actual underlying financial security
o Cash settlement

Identify why Participants use Derivative Markets and how Futures are used to
hedge price risk:

Futures markets can be established for virtually any commodity or financial asset that
has the following attributes:
- It is traded freely, generally without direct government controls over the prices
- There is, at times, a considerable degree of price volatility
- There is a universally accepted standard for quality
- There is a plentiful supply of the commodity or security or cash settlement is
possible

Commodities:
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Mineral—silver, gold, copper, petroleum, zinc

Agricultural—wool, coffee, butter, wheat and cattle

Financial:

- Currencies—pound sterling, euro, Swiss franc

- Interest rates
o Short-term instruments—US 90-day treasury bills, 3-month eurodollar
deposits, Australian 90-day bank-accepted bills
o Longer-term—US 10-year T-notes, Australian 3-year and 10- year
Commonwealth Treasury bonds
o Share price indices — All Ordinaries

Four main categories of participants

- Hedgers
- Speculators
- Traders
- Arbitragers

These participants provide depth and liquidity to the futures market,

improving its efficiency

Hedgers:

- Attempt to reduce the price risk from exposure to changes in interest rates,
exchange rates and share prices
- Take the opposite position to the underlying, exposed transaction
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Example: An exporter has USD receivable in 90 days. To protect against fall in USD
over next 3 months, the exporter enters into a futures contract to sell USD

Speculators:

- Expose themselves to risk in the attempt to make profit

- Enter the market in the expectation that the market price will move in a
favourable direction for them

Example: Speculators who expect the price of the underlying asset to rise will go
long and those that expect the price to fall will go short

Traders:

- Special class of speculator

- Trade on very short-term changes in the price of futures contracts (i.e. intra-
day changes)
- Provide liquidity to the market

Arbitragers:

- Simultaneously buy and sell to take advantage of price differentials between

markets
- Attempt to make profit without taking any risk

Example: Differentials between the futures contract price and the physical spot price
of the underlying commodity

Explain how using derivatives to manage one risk may create a new risk
exposure:

Futures contracts may be used to manage identified financial risk exposures such as:
- Hedging the cost of funds (borrowing hedge)
o This is where borrowers are exposing themselves to the risk of an
increase in the cost of funds (IR increases)
- Hedging the yield on funds (investment hedge)
o This is where an investor is attempting to hedge interest rate risk
exposure when planning to make an investment
- Hedging a foreign currency transaction
o There is risk involved in foreign exchange markets. Investors often
hedge to reduce the risk involved when currencies
appreciate/depreciate.
- Hedging the value of a share portfolio
o Investors are also exposed to risk in changes in share prices over time.

- A hedger needs to consider the physical market risk exposure to be managed

and the necessary transactions to be carried out in the futures market,
including the transaction conducted today and the closing out of that position
at maturity date.
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- Basic hedging rule: conduct a transaction in the futures market today that is
the same as the transaction to be carried out in the physical market at a later
date (at which time the open futures position is closed out)

The risks of using the futures markets for hedging include the
problems of:
- Standard contract size
- Margin risk
- Basis risk
- Cross-commodity hedging

Standard contract size:

- Due to contract size the physical market exposure may not exactly match the
futures market exposure, making a perfect hedge impossible

Margin payments:

- Initial margin required when entering into a futures contract

- Further cash required if prices move adversely (i.e. margin calls)
- Opportunity costs associated with margin requirements

Basis risk:

Two types of basis risk:

- Initial basis
o The difference between the price in the physical market and the futures
market at commencement of a hedging strategy

- Final basis
o The difference between the price in the physical market and the futures
market at completion of a hedging strategy

A perfect hedge requires zero initial and final basis risk.

Cross-commodity hedging:

- Use of a commodity or financial instrument to hedge a risk associated with

another commodity or financial instrument
o Often necessary as futures contracts are available for few commodities
or instruments
- Selection of a futures contract that has price movements that are highly
correlated with the price of the commodity or instrument to be hedged

Explain and illustrate the use of an FRA for hedging interest rate risk:

The Nature of the FRA:

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An FRA is an over-the-counter product enabling the management of an interest rate

risk exposure:
- It is an agreement between two parties on an interest rate level that will apply
at a specified future date
- Allows the lender and borrower to lock-in interest rates
- Unlike a loan, no exchange of principal occurs
- Payment between the parties involves the difference between the agreed
interest rate and the actual interest rate at settlement

The FRA specifies:

- Trade or contract date
- Notional principal amount
- Contract period in which the FRA interest rate will be based
- FRA agreed rate
- FRA settlement reference rate
- FRA start date

Main advantages of FRAs

- Tailor-made, over-the-counter contract, providing great flexibility with respect
to contract period and the amount of each contract
- Unlike a futures contract, an FRA does not have margin payments

Main disadvantages of FRAs

- Risk of non-settlement (credit risk)
- No formal market exists and concern about difficulty to close out FRA
position is overcome by entering into another FRA opposite to the original
agreement
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Settlement amount = FRA settlement rate - FRA agreed rate

A futures contract:
- Is an agreement between two parties to buy or sell a specified commodity or
instrument at a specified date in the future, at a price specified today
- May be used as a hedging strategy by opening a position today that requires a
closing transaction that is the reverse of the exposed transaction in the physical
market
- Limitations include margin calls, imperfect hedging due to basis risk, and
availability

FRAs:
- Are over-the-counter contracts specifying an agreed interest rate to apply at a
future date
- Advantages include
o Flexibility—they are tailor-made
o No margin calls
- Disadvantages include
o Non-settlement or credit risk
o Lack of formal market

Chapter 19: Options

Examine the nature of options contracts and markets:

- Options differ from futures because they provide asymmetric cover against
price movements
- Options limit the effects of adverse price movements without reducing profits
from favourable price movements
- Options involve the payment of a premium by the buyer to the seller (writer)
- An option gives the buyer the right, but not the obligation, to buy or sell a
specified commodity or financial instrument at a predetermined price (exercise
or strike price), on or before a specified date (expiration date)
- An option will only be exercised if it is in the buyer’s best interest

Describe the types of options contracts available:

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- Types of options
o Call options – give the option buyer the right to buy the commodity or
instrument at the exercise price
o Put options – give the buyer the right to sell the commodity or
instrument at the exercise price
- Options can be exercised either
o Only on expiration date (European)
o Any time up to expiration date (American)

A premium is the price paid by an option buyer to the writer (seller) of the option and
the exercise price or strike price is the price specified in an options contract at which
the option buyer can buy or sell.

Explain the profit and loss payoff profiles of options contracts:

Profit and Loss Payoff Profiles: are the potential gains/losses available to the buyers
and writers of an option.
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Example: a call option for shares in a listed company at a strike or exercise price (X)
of $12, and a premium (P) of $1.50
- Figure 19.1 indicates the profit and loss profiles of a call option for (a) the
buyer or holder (long call) and (b) the writer or seller (short call)
- The critical break points of the market price of the share (S) at expiration date
are <$12, $12 to $13.50 and >$13.50
- If S (market price of asset) > X (i.e. > $12) , option is ‘in-the-money’

Example: a put option for shares in a listed company at a strike or exercise price (X)
of $12, and premium (P) of $1.50
- Figure 19.2 indicates the profit and loss profiles of a put option for (a) the
buyer or holder (long put) and (b) the writer or seller (short put)
- The critical break points of the market price of the share (S) at expiration date
are <$10.50, $10.50 to $12 and >$12
- Buyer exercises option if S < X (i.e. < $12)

 DON’T KNOW/THINK THIS PART (REST OF THIS POINT WILL BE IN

THE EXAM – BUT I PUT IT IN ANYWAYS!)

Covered and uncovered options:

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- Unlike futures, the risk of loss for a buyer of an option contract is limited to
the premium
- However, sellers (writers) of options have potentially unlimited risk and may
be subject to margin requirements unless they write a covered option
o i.e. the writer of an option holds the underlying asset or provides a
financial guarantee
- The writer of a call option has written a covered option if either
o The writer owns sufficient of the underlying asset to satisfy the option
contract if exercised, or
o The writer is also the holder of a call option on the same asset, but with
a lower exercise price
- The writer of a put option has written a covered option if the writer is also the
holder of a put option on the same asset, but with a higher exercise price

Organisation of the Market:

Option markets are categorised as:

- Over-the-counter
- Exchange-traded
o These are recorded through a clearing-house
o Clearing-house acts as counterparty to buyer and seller, thus creating
two options contracts through the process of ‘novation’
o The clearing-house allows buyers and sellers to close out (i.e. reverse)
their contracts

Types of options traded on the Australian options markets:

- Options on futures contracts
- Share options
- Low-exercise-price options
- Warrants
- Over-the-counter options

Options on futures contracts:

- Traded on the Sydney Futures Exchange (SFE)

- Buyer of options contract has the right to buy (call) or sell (put) a futures
contract
- Options on futures available for
o 90-day bank-accepted bills
o SFE/SPI200index futures contract
o 3-year and 10-year Commonwealth Treasury bonds
o Overnight options on the above Treasury bond and share price index
futures contracts

Share options:

- Traded on the ASX

- Based on ordinary shares of specified listed companies
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- Usually 3 or more options contracts for each company, each with identical
expiration dates but different exercise prices
- The options clearing-house maintains a system of deposits, maintenance
margins and a share scrip depository

Low exercise price options (LEPOs)

- Traded on the ASX since 1995

- A highly leveraged option on individual stocks, with an exercise price between
1 and 10 cents, and a premium similar to the price of the underlying stock
- Exercisable only at expiration date (i.e. European)
- Available over a range of high-liquidity stocks listed on the ASX

Warrants:

- An options contract (i.e. contractual right but not obligation to buy or sell an
underlying asset)
- Two classes of warrants
o Equity warrants attached to debt issues made by companies raising
funds through primary market debt issues
 Option to convert debt to ordinary shares of the issuing
company (discussed in Chapter 5)
o Warrants issued as financial products for investment and to manage
risk exposure to price movements in the market
 Issued by financial institutions
 American- or European-type contracts
 Traded on CLICK XT, the ASX’s electronic trading system
 Settlement of contracts through ASX options clearing-house
- Warrants issued as financial products
o Fractional warrants
 Cover only a part or a fraction of a listed share
 Thus may require two or more fractional warrants to be
exercised to buy a share
o Fully covered warrants
 Underlying shares lodged in trust by issuer as guarantee
 Shares held as a guarantee of the issuer’s capacity to deliver the
stock if the holder exercises warrant
 Price involves initial specified instalment and second
instalment based on market value of share

Over the counter options:

- Are a very flexible risk management product – can be tailored to meet

individual needs in terms of the amount, term, interest rate and price
- Banks are significant providers of these types of options.

Explain the factors affecting the price of options:

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Option price (or premium) is influenced by four key factors

- Intrinsic value
- Time value
- Price volatility
- Interest rates

Intrinsic value:

- The market price of the underlying asset relative to the exercise price
- The greater the intrinsic value, the greater the premium, i.e. positive
relationship
- Options with an intrinsic value
o Positive are ‘in-the-money’ and the buyer is able to exercise contract at
a profit
o Negative are ‘out-of-the-money’ and the buyer will not exercise
o Zero are ‘at-the-money’

Time value:

- The longer the time to expiry, the greater the possibility that the option will be
able to be exercised for a profit (‘in-the-money’), i.e. positive relationship
- If the spot price moves adversely, the loss is limited to the premium

Price volatility:

- The greater the volatility of the spot price, the greater the chance of exercising
the option for a profit, or a loss
- The option will only be exercised if the price moves favourably
- The greater the spot price volatility, the greater the option premium, i.e.
positive relationship

Interest rates:

- Interest rates have opposite impacts on put and call options

o Positive relationship between interest rates and the price of a call
 Benefit of present value of deferred payment if exercised >
lower present value of profit if exercised
o Negative relationship between interest rates and the price of a put
 Opportunity cost of holding asset
 Lower present value of the profit if exercised
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Develop options strategies for hedging price risk:

Single-option strategies:

Example: long asset (i.e. bought) and bearish (negative) about future asset price
- Strategy
o Limit downside risk by writing (selling) a call option, i.e. short-call
o Figure 19.5 and Table 19.4 in textbook illustrate the profit profile of
this strategy

Combined-options strategies (cont.)

Example: expectation of asset price stability

- Strategy
o Take opposite position to long straddle and long strangle
o Strategy I: Short straddle
 Sell call and put options with same exercise price
o Strategy II: Short strangle
 Sell call and put options, both out-of-the-money
 Figure 19.13 in textbook illustrates the profit profiles

In conclusion, the potential gains and losses to buyers and sellers of futures contracts
are different from that of options because options provide one-sided price protection
that is not available through futures and the option buyer limits losses and allows
profits to accumulate. However, the premium may be quite high.