Читать книгу The Trade Lifecycle - Baker Robert P. - Страница 34

In the previous chapter we described some common financial products. These products all have an underlying entity upon which the trade is based. These entities are generally grouped into common sets known as asset classes.

Traders are normally organised into desks, each desk trading the same class of assets. Processes that flow from these trades are also divided by their asset class.

Large parts of the trade lifecycle are generic: trades are executed, booked, confirmed and settled. But the actual implementation of these processes may vary from one class of assets to another. Here we discuss some common asset classes, their particular features and how they affect the trade processes. This chapter makes reference to products described in the previous chapter but there the emphasis was on comparing trades by looking at their cashflows whereas here we see other aspects of the trades and how they fit into their asset class.

4.1 Interest rates

Interest rates are based around the lending and borrowing of money in a particular currency.

The underlying market force affecting the pricing of interest rate products is the interest rate in that currency hence the name of the asset class.

Money can be borrowed for different periods of time (known as term) and the major set of financial products in interest rates are divided into three terms

■ short term (less than one year) are known as cash or money market trades

■ medium term (usually from one to two years) are futures

■ longer term (two or more years) are swaps.

Interest and the time value of money

Interest is paid to attract lenders to part with money which they could otherwise have used for purchasing other assets or kept for security. A person making a loan to someone else will therefore charge interest to compensate for the loss of opportunity to use his own money and because there is a reduction in his liquidity meaning that he has less ability to cope with sudden demands on his money such as to pay wages or fix broken machinery.

The result of charging interest when money is loaned causes an effect known as the ‘the time value of money’. In essence this effect means that money in the future is worth less than money now. This is not to be confused with inflation which is caused by price rises. (The two are similar and are correlated to each other but here we confine the discussion to interest rates.)

In mathematical terms,

So if I have 100 pounds and the interest rate is 5 % per annum then, in one year, my 100 pounds will be worth

So if I am expecting 100 pounds in one year with 5 % interest per annum then my present value of that future 100 pounds is

So we see that money is worth less over time. How much less depends on two facts.

■ prevailing interest rates – the higher the rate, the less money is worth

■ time – the longer the time period, the less money is worth.

Management of cash is vital to any organisation; too much cash is an under-utilisation of the organisation's assets, too little cash increases costs (due to having to borrow more money) and increases risk.

Since different organisations have continuously changing cash requirements there is a very active market in trading cash products. These products come into the asset class of interest rates.

Interest rate participants

We can divide the market on interest rate products into three groups of participants:

■ Central Banks (such as Bank of England, Federal Reserve) – these organisations inject cash into their country's money supply, set the lowest level of interest rate (known as the base rate) and are lenders of last resort

■ Banks (who are generally lenders of money)

■ Commercial organisations such as industrial companies (who generally need to borrow money).

All interest rates derive from the base rate. This is the rate the central bank will charge for secured overnight lending.

Banks will lend to each other at a slightly higher interest rate than this base rate. The average interest rates at which banks are currently lending is known as LIBOR (London Interbank Offer Rate).

Banks will charge a yet higher rate to commercial organisations and others. This rate will depend on the credit worthiness of the organisation and how much profit the bank is trying to make.

Let's now examine the interest rate asset class.

The asset class of interest rate products

Here we describe typical products which are commonly grouped into the asset class of interest rates.

Deposit

A deposit (or loan) is a simple instrument. One counterparty gives an amount of currency to another counterparty, expecting its return on a future date. At agreed regular intervals, interest will be paid by the receiver to the depositor.

A deposit can be unsecured or secured. When secured, the receiver has to provide some collateral to the depositor and in the event of default, the collateral will be forfeited.

The market for very short-term loans and deposits is known as the money market. Here money can be borrowed overnight, for a few days or for a few months.

A very secure form of short-term lending is known as the repo market (repo is short for repurchase). Here the borrower sells a highly secure bond such a US Treasury bond at an agreed price for repurchase at an agreed future price. The purpose of such a transaction is to borrow money more cheaply by using the bond as collateral.

Deposits oil the wheels of financial markets by ensuring participants can acquire cash and proceed with other trading. When short-term lending becomes expensive, as we saw in the credit crunch of 2008, raising money for all other trading is negatively impacted.

Future

As explained in the previous chapter, a future is an agreement to transact at some future time with the price decided now. If we speak about a future on aluminium, it is quite easy to see how that future is applied. Not so with a future on interest rates. Interest rate futures are very common products but what do they mean and how do they work?

An interest rate future is a means to trade on what interest rates will be in the future. They are priced as 100 − interest rate. So if interest rates are expected to be 5 % in March, the March future will be priced at 95.

An interest rate future is an agreement between buyer and seller to deliver in the future an asset which pays interest. The price of that underlying asset is locked in now.

For example, I need to borrow money in 6 months' time and I am worried that interest rates may rise between now and when the loan starts. If I sell an interest rate future now and buy it back at the time of the loan, I can mitigate (hedge) the negative effects of an interest rate rise. Suppose interest rates now are 3 % so I can sell a future today for 97 (100 − 3).

If rates rise to 5 % in 6 months, I will be able to buy the future back at 95 (100 − 3).

So I have made a profit on the two future trades (sell now at 97, buy later at 95) which will help to offset the increase in interest charges.

Futures are standard products traded on exchanges, as opposed to forwards which can be any over-the-counter (OTC) agreement between counterparties. (See section 5.1 for a fuller explanation of forwards and futures.)

Futures have standard contract sizes, tick sizes and contract months. For example, US Treasury five-year T-note futures are traded in lots with $100,000 notional at maturity.

Their contract months are set at March, June, September and December.

Their tick size is 1/32. This means that prices are always expressed as whole numbers plus a certain number of 32nds. You cannot quote a price with a fractional part less than 1/32, for example 1/64 or 1/100.

Swap

Technically, a swap is an agreement to exchange one asset for another, however when used without a qualifier it means interest rate swaps (as opposed to equity, foreign exchange (FX) or other asset class swaps). Within the same currency, swaps can be customised to the requirements of the counterparties, but the standard trades are float-for-fixed and float-for-float between different indices. Swaps have agreed fixing periods throughout their life when money is transferred.

Float for fixed

One counterparty pays fixed currency. The other pays a floating rate dependent on an agreed index such as LIBOR.

Float for float

One counterparty pays a floating rate based on one index (e.g. Euribor) and the other pays floating based on a different index (e.g. TIBOR)

Although there is an agreed notional for a swap trade, this is only a nominal figure used to calculate the amount owed at each fixing. Swaps are used when a counterparty wants to hedge his exposure across different indices, or when he wants to transfer his payment streams from fixed rate to floating or vice versa.

Example

Housebuilding Bank receives floating rate mortgage repayments (at LIBOR + 2 %) from its customers and needs to service the debt arising by means of a bond it has issued which has fixed coupon payments (5 %) (See Figure 4.1).

Figure 4.1 Motivation for a swap trade

Housebuilding enters into a swap trade with a counterparty (Countrybank).

Housebuilding receives 5 % from Countrybank and pays its bond holders.

Housebuilding pays LIBOR + 2 % to Countrybank which it receives from mortgage borrowers. Now, Housebuilding has removed his exposure (risk) to interest rate changes.

The combination of deposits, futures and swaps traded in one currency constitutes the market data necessary to produce an interest rate curve. This determines how much that currency will be worth in the future based on information available today. Interest rate curves are used extensively in the financial world. Most trades rely on the interest rate curves to discount future cashflows. The higher the future interest rates in a currency, the less money in that currency will be worth.

Interest rate products are traded in their own right by dedicated trading desks and are also traded as hedges for more complicated trades or cashflow scenarios (as in the swap example above). In most currencies they are very liquid products.

FRA

A forward rate agreement (FRA) is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. With this type of agreement, it is only the differential that is paid on the notional amount of the contract. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, dependent on the market convention for the particular currency. FRAs are OTC derivatives. An FRA differs from a swap in that a payment is only made once at maturity.

Many banks and large corporations will use FRAs to hedge future interest or exchange rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.

The discount curve

As well as being important in their own right, the class of interest rate products is vital for construction of the discount curve. We saw in the previous chapter that most trades give rise to cashflows in the future. If we are going to assess the worth of future cashflows we cannot take them at face value. Those due sooner are worth more than those due later because of the time value of money. Therefore we need a means to weight future cashflows according to their depreciation over time. This can be done in many ways; one of the most common is to construct a discount curve.