A hedge fund is a lightly regulated investment partnership that
uses a range of investment techniques and invests in a wide array of assets
to generate a higher return for a given level of risk than what’s expected of
normal investments. In many cases, but hardly all, hedge funds are managed
to generate a consistent level of return, regardless of what the market does.
Sunday 19 December 2010
Directional funds
Directional funds are hedge funds that don’t hedge — at least not fully. Managers of directional funds maintain some exposure to the market, but they try to get higher-than-expected returns for the amount of risk that
they take. Because directional funds maintain some exposure to the stock market, they’re said to have a stock-like return. A fund’s returns may not be steady from year to year, but they’re likely to be higher over the long run than the returns on an absolute-return fund.
Directional funds are the glamorous funds that grab headlines for posting double or triple returns compared to those of the stock market. The fund managers may not do much hedging, but they have the numbers that get
potential investors excited about hedge funds.
A directional strategy is most appropriate for aggressive investors willing to take some risk in exchange for potentially higher returns.
they take. Because directional funds maintain some exposure to the stock market, they’re said to have a stock-like return. A fund’s returns may not be steady from year to year, but they’re likely to be higher over the long run than the returns on an absolute-return fund.
Directional funds are the glamorous funds that grab headlines for posting double or triple returns compared to those of the stock market. The fund managers may not do much hedging, but they have the numbers that get
potential investors excited about hedge funds.
A directional strategy is most appropriate for aggressive investors willing to take some risk in exchange for potentially higher returns.
A “non-directional fund" OR an absolute-return fund
Absolute-return fund is designed to generate a steady return no matter what the market is doing. Alfred Winslow Jones managed his pioneering hedge fund with this goal, although the long-short strategy that he used was just one of several methods that snagged him consistent return.
Although absolute-return funds are close to the true spirit of the original hedge fund, some consultants and fund managers prefer to stick with the label absolute-return fund rather than “hedge fund.” The thought is that hedge funds are too wild and aggressive, and absolute-return funds are designed to be slow and steady.
In truth, the label is just a matter of personal preference. An absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. That falls in category of portfolio management.
Hedge fund managers can use many different investment tools within an absolute-return strategy.
Some say that absolute-return funds generate a bond-like return, because like bonds, absolute-return funds have relatively steady but relatively low returns.
The return target on an absolute-return fund is usually higher than the long-term rate of return on bonds, though. A typical absolute-return fund target is 8 percent to 10 percent, which is above the long-term rate of return on bonds and below the long-term rate of return on stock.
Although absolute-return funds are close to the true spirit of the original hedge fund, some consultants and fund managers prefer to stick with the label absolute-return fund rather than “hedge fund.” The thought is that hedge funds are too wild and aggressive, and absolute-return funds are designed to be slow and steady.
In truth, the label is just a matter of personal preference. An absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. That falls in category of portfolio management.
Hedge fund managers can use many different investment tools within an absolute-return strategy.
Some say that absolute-return funds generate a bond-like return, because like bonds, absolute-return funds have relatively steady but relatively low returns.
The return target on an absolute-return fund is usually higher than the long-term rate of return on bonds, though. A typical absolute-return fund target is 8 percent to 10 percent, which is above the long-term rate of return on bonds and below the long-term rate of return on stock.
Hedging vs speculating
Hedging is the process of reducing risk. Speculating is the processof seeking a high return by taking on a greater-than-average amount of risk.
Although hedging and speculating are opposing strategies, many hedge funds today use both.
Although hedging and speculating are opposing strategies, many hedge funds today use both.
Saturday 18 December 2010
Wednesday 15 December 2010
Accounts - Introduction
What is Accounting?
Accounting is the art of identifying, recording, and reporting financial information relating to a particular entity to interested parties. The main way of communicating this financial information is through financial statements, such as the balance sheet and income statement. There are two main streams of accounting:- Managerial accountingThis form of accounting provides accounting information to help managers make decisions to manage the business. Financial information is used by managers to set budgets, analyze the costs of the different products, control and monitor work in progress, and so on.
- Financial accounting
This form of accounting is used to prepare accounting information for people outside the organization or not involved in the day-to-day running of the company. Here we are mainly concerned with financial accounting.
1. Shareholder / Investors
2. Tax authorities
3. Lenders to company
4. Financial analysts
5. Suppliers
6. Employees
Organization forms
Monday 13 December 2010
Elements of financial statements
The 3 components of financial statements are :
1. Assets
2. Equity
3. Liability
Assets
Asset is economic resource which the entity owns or controls.
These can be fixed ( like property, plant ) with life of more than 1 year
OR
current ( like cash, inventory, accounts )
Liability
Liability is obligation of enterprise which will result in outflow of economic resources in future.
It can be current (like accounts payable or bank overdrafts ) or long term(like bank loan) with life more than year.
Equity or net assets
Equity = Assets - liability
Some other terms
Revenue or income represents the income that a business generates
Expenses - costs associated with running the business like wages, electricity bills
Gain - Increase in equity arising from the transactions outside of an entity's normal operating.
Loss - Opposite of gain
1. Assets
2. Equity
3. Liability
Assets
Asset is economic resource which the entity owns or controls.
These can be fixed ( like property, plant ) with life of more than 1 year
OR
current ( like cash, inventory, accounts )
Liability
Liability is obligation of enterprise which will result in outflow of economic resources in future.
It can be current (like accounts payable or bank overdrafts ) or long term(like bank loan) with life more than year.
Equity or net assets
Equity = Assets - liability
Some other terms
Revenue or income represents the income that a business generates
Expenses - costs associated with running the business like wages, electricity bills
Gain - Increase in equity arising from the transactions outside of an entity's normal operating.
Loss - Opposite of gain
Organizational Forms and the Business Goal
Financial accounting is important within all types of business organizations, the major forms of which are introduced here:
In sole proprietorships and partnerships, the owners and managers of the business are generally the same people. In companies, the owners (that is, the shareholders) do not necessarily manage the business. This separation of ownership and control, while having many advantages such as knowledge and experience in particular areas, often creates a conflict of interest. Owners or shareholders pay managers to run the business in their best interests. The manager's prime responsibility is to make decisions in the best interests of maximizing shareholder wealth, but managers may sometimes neglect their obligations to the shareholders.
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In sole proprietorships and partnerships, the owners and managers of the business are generally the same people. In companies, the owners (that is, the shareholders) do not necessarily manage the business. This separation of ownership and control, while having many advantages such as knowledge and experience in particular areas, often creates a conflict of interest. Owners or shareholders pay managers to run the business in their best interests. The manager's prime responsibility is to make decisions in the best interests of maximizing shareholder wealth, but managers may sometimes neglect their obligations to the shareholders.
Wednesday 28 July 2010
Legal documentation for reducing settlement failures
There have been several attempts by regulatory bodies within the financial industry to reduce settlement failures. One of the methods put forward was to create more generic documentation structures. For some markets, where each deal is unique, this can be extremely difficult. Eg. consider the case of documentation of OTC derivatives.
Standard documentation of OTC derivatives
In the over-the-counter (OTC) market, each deal is negotiated between two parties depending on their particular circumstances. Asking both parties to use some form of generic documentation to record the deal can be unworkable especially if the details of their deal are unusual.
The International Swaps and Derivatives Association (ISDA) and the British Bankers’ Association (BBA) are two regulatory bodies that developed standard documentation for OTC derivatives.
There are now master agreement forms for many financial products that create a common legal framework that can be understood by all market participants. These master agreements cover most, if not all, of the major legal points that should be agreed as part of documenting the transactions to which they relate.
Master agreements cover how the parties will conduct themselves in the event of the early termination of the contractual agreements because of credit default or other unforeseen events. In particular, the agreements specify how the exposures for more than one transaction under the master agreement will be netted against each other if one or more transactions have positive exposure and other transactions have negative exposure.
In addition to the master agreements, individual transactions are tied to the master agreements with confirmation documents containing the specific terms of each transaction. The master agreements should ideally be negotiated prior to any individual transaction being agreed but, in many cases, they are only negotiated as a consequence of the first transaction.
The International Swaps and Derivatives Association (ISDA) and the British Bankers’ Association (BBA) are two regulatory bodies that developed standard documentation for OTC derivatives.
There are now master agreement forms for many financial products that create a common legal framework that can be understood by all market participants. These master agreements cover most, if not all, of the major legal points that should be agreed as part of documenting the transactions to which they relate.
Master agreements cover how the parties will conduct themselves in the event of the early termination of the contractual agreements because of credit default or other unforeseen events. In particular, the agreements specify how the exposures for more than one transaction under the master agreement will be netted against each other if one or more transactions have positive exposure and other transactions have negative exposure.
In addition to the master agreements, individual transactions are tied to the master agreements with confirmation documents containing the specific terms of each transaction. The master agreements should ideally be negotiated prior to any individual transaction being agreed but, in many cases, they are only negotiated as a consequence of the first transaction.
Operational Risk
Operational risk was initially defined in the negative as any form of risk that is not market or credit risk. This negative definition is rather vague as it does not tell us much about the exact types of operational risks faced by banks today, nor does it provide banks with a proper basis for measuring risk and calculating capital requirements.
A better definition is provided by the Basel Committee, who define operational risk as:
"The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."
This definition includes legal risk, but excludes strategic and reputational risk. However, because operational risk is a term that has a variety of meanings, banks are permitted to adopt their own definitions, provided the minimum elements in the Committee's definition are included.
Operations Risk Vs. Operational Risk
There exists an important distinction between operations risk and operational risk.
Operations risk relates to the activities carried out by the operations or back office department of a bank. The back office is the area of a bank that looks after most of the administrative side of any trades undertaken by the front office. It is therefore responsible for the accurate and timely settlement of all transactions in accordance with trade deadlines.
Operational risk is a much broader concept incorporating not just the activities of back office departments, but also many other possible risk events across the whole organization. In its 2003 paper on 'Sound Practices for the Management and Supervision of Operational Risk', the Basel Committee (in conjunction with the banking industry) identified seven loss event categories that can potentially result in substantial operational losses.
1. Internal fraud
2. External fraud
3. Employment practices and workplace safety
4. Clients, products, and business practices
5. Damage to physical assets
6. Business disruption and system failures
7. Execution, delivery, and process management
A better definition is provided by the Basel Committee, who define operational risk as:
"The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."
This definition includes legal risk, but excludes strategic and reputational risk. However, because operational risk is a term that has a variety of meanings, banks are permitted to adopt their own definitions, provided the minimum elements in the Committee's definition are included.
Operations Risk Vs. Operational Risk
There exists an important distinction between operations risk and operational risk.
Operations risk relates to the activities carried out by the operations or back office department of a bank. The back office is the area of a bank that looks after most of the administrative side of any trades undertaken by the front office. It is therefore responsible for the accurate and timely settlement of all transactions in accordance with trade deadlines.
Operational risk is a much broader concept incorporating not just the activities of back office departments, but also many other possible risk events across the whole organization. In its 2003 paper on 'Sound Practices for the Management and Supervision of Operational Risk', the Basel Committee (in conjunction with the banking industry) identified seven loss event categories that can potentially result in substantial operational losses.
1. Internal fraud
2. External fraud
3. Employment practices and workplace safety
4. Clients, products, and business practices
5. Damage to physical assets
6. Business disruption and system failures
7. Execution, delivery, and process management
Tuesday 27 July 2010
Ongoing trade managent
Funding or financing?
The need for funding or financing depends on the nature of the OTC derivative product. Currency forwards do not require the borrowing or lending of funds unless the forward is part of a strategy involving the requirement of the currency itself. A currency swap, in which funds are borrowed from a foreign bank as a loan, is a form of financing. Only OTC derivatives that involve the exchange or movement of actual principal require financing, or can be used for funding other efforts.
Many OTC derivatives are settled by the delivery of an actual asset.
The need for funding or financing depends on the nature of the OTC derivative product. Currency forwards do not require the borrowing or lending of funds unless the forward is part of a strategy involving the requirement of the currency itself. A currency swap, in which funds are borrowed from a foreign bank as a loan, is a form of financing. Only OTC derivatives that involve the exchange or movement of actual principal require financing, or can be used for funding other efforts.
Many OTC derivatives are settled by the delivery of an actual asset.
OTC derivatives
1. OTC (Over The Counter)
OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement.
Few OTC derivatives include forwards and swaps.
The responsibility for trade accuracy lies in the front office.
OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement.
Few OTC derivatives include forwards and swaps.
The responsibility for trade accuracy lies in the front office.
Forwards
A forward contract is the simplest of the Derivative products. It is a mutual agreement between two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the seller at a future date. The Price of the contract does not change before delivery. These type of contracts are binding, which means both the buyer and seller must stay committed to the contract. This means they are bound to deliver or take delivery of the product on which the forward contract was agreed upon. Forwards contracts are very useful in hedging.
Example. The forward FX transaction
Important Characteristics of Forwards Contracts:
1. They are Over the counter (OTC) contracts
2. Both the buyer and seller are bound by the contractual terms
3. The Price remains fixed
Using forwards
An airline company that needs to purchase an amount of jet fuel in six months' time can enter into a forward transaction which fixes the price today. Whether the market price rises (or falls) in the interim is irrelevant; the company can budget around a predetermined level of fuel expenditure.
From forwards to futures
While many forward transactions are customized affairs, negotiated bilaterally between two parties, there is also a large market in standardized, fungible, forward agreements - futures contracts. A futures contract is based upon a particular type of forward transaction; the number of assets involved, the quality of those assets, and the days on which future transactions can be executed are all standardized. The standardization allows easy transferability, and positions can be liquidated simply by reversing the trade. Indeed, the vast majority of futures transactions (over 90%) are unwound before the pre-agreed delivery dates. One attraction of a futures transaction relative to an immediate transaction in an underlying asset is that initial outlay is usually much lower – a participant usually needs to post margin equivalent to only a small proportion of the underlying value of an asset. (In the case of a forward trade no margin at all may be necessary – assuming that the parties can agree on credit risk).
*In this sense, futures contracts are similar to securities, but it would be wrong to call a futures contract a security.
Example. The forward FX transaction
Important Characteristics of Forwards Contracts:
1. They are Over the counter (OTC) contracts
2. Both the buyer and seller are bound by the contractual terms
3. The Price remains fixed
Using forwards
An airline company that needs to purchase an amount of jet fuel in six months' time can enter into a forward transaction which fixes the price today. Whether the market price rises (or falls) in the interim is irrelevant; the company can budget around a predetermined level of fuel expenditure.
From forwards to futures
While many forward transactions are customized affairs, negotiated bilaterally between two parties, there is also a large market in standardized, fungible, forward agreements - futures contracts. A futures contract is based upon a particular type of forward transaction; the number of assets involved, the quality of those assets, and the days on which future transactions can be executed are all standardized. The standardization allows easy transferability, and positions can be liquidated simply by reversing the trade. Indeed, the vast majority of futures transactions (over 90%) are unwound before the pre-agreed delivery dates. One attraction of a futures transaction relative to an immediate transaction in an underlying asset is that initial outlay is usually much lower – a participant usually needs to post margin equivalent to only a small proportion of the underlying value of an asset. (In the case of a forward trade no margin at all may be necessary – assuming that the parties can agree on credit risk).
*In this sense, futures contracts are similar to securities, but it would be wrong to call a futures contract a security.
Hedging
One main use of Derivatives is as a tool for transferring/reducing risk on a commodity/item. Say you are a manufacturer who uses Rice as the ingredient in your product. You would not want the price or availability of Rice to affect your production in any way. You can decide to enter into a contract with a Rice farmer to buy a specified quantity of Rice in a future date say after 3 months at a specified price. Here you are hedging to reduce your risk of availability. The farmer would also be avoiding a risk of lack of prospective buyers. By entering into agreement with you, he has reduced that risk and he has a buyer who would be buying his product on the agreed date at the agreed price. Of course there are some external factors that may cause the agreement to become null. For e.g., if due to a flood all his crops are destroyed, you cannot expect the farmer to honour the agreement. Similarly if you go bankrupt the farmer would have to find a new buyer for his products. So Derivatives can act as a tool to mitigate risk but it cannot help us avoid it altogether. Also this risk reduction will happen only between the two parties who are entering into the agreement. Any other manufacturer may end up without rice supplies or any other farmer may end up without buyers.
How futures trade work?
The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically.
Risks involved
We have already seen the example of wheat being bought by us. See here if not yet seen.
Now suppose instead of you buying 5,000 kgs of wheat there is trade between wheat producer and the Hotel. In Economy there is a principle - As the demand of the commodity rises, the price also rises.
Risk involved with wheat seller
This explains the risk that wheat seller faces the risk like if demand falls price falls or may have worries about next season. So he may be trying to secure a selling price for next season's crop.
Risk involved with wheat buyer or Hotel manager
The wheat buyer / Hotel manager may be trying to secure a buying price to determine how much chapatis / chapatiss can be made and at what profit.
So what should they do?
So the farmer and the hotel manager may enter into a futures contract requiring the delivery of 5,000 kg's of grain to the buyer at a price of Rs.4 per kg in say June. By entering into this futures contract, the farmer and the hotel manager secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain(or any physical commodity) - that can then be bought and sold in the futures market.
Strategies in Futures Market
So, a futures contract is an agreement between two parties:
a short position - the party who agrees to deliver a commodity - and
a long position - the party who agrees to receive a commodity.
In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the hotel manager would be the holder of the long (agreeing to buy).
In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5000 kgs of grain at a price of Rs.4 per kg.
Transactions
DAY 1 : The price of the grain rises to Rs. 5 from Rs. 4
The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the futures contracts for wheat increases to Rs.5 per kg the day after the above farmer and hotel manager enter into their futures contract of Rs.4 per kg. The farmer, as the holder of the short position, has lost Rs.1 per kg because the selling price just increased from the future price at which he is obliged to sell his wheat.
The hotel manager, as the long position, has profited by Rs.1 per kg because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.
On the day the change occurs, the farmer's account is debited Rs.5,000 (Rs.1 per kg X 5,000 kgs) and the hotel manager's account is credited by Rs.5,000 (Rs.1 per kg X 5,000 kgs). As the market moves every day, these kinds of adjustments are made accordingly.
Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.
As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market.
Note that futures are not always deliverable in cash when the futures contract expires. Eg. the gold futures require the delivery of 100 troy ounces of gold per contract. Others like index futures and currency futures settle in cash.
Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at Rs.5 per kg, the farmer would lose Rs.5,000 on the futures contract and the hotel manager would have made Rs.5,000 on the contract.
But after the settlement of the futures contract, the hotel manager still needs wheat to make chapatis, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for Rs.5 per kg (a total of Rs.25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the hotel manager's futures profits of Rs.5,000 go towards his purchase, which means he still pays his locked-in price of Rs.4 per kg (Rs.25,000 - Rs.5,000 = Rs.20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at Rs.5 per kg but because of his losses from the futures contract with the hotel manager, the farmer still actually receives only Rs.4 per kg. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is referred to as hedging.
Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a hotel manager. In such a case, the short speculator would simply have lost Rs.5,000 while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires.)
Taking out Credit :
Also the person who gets credit can take out the profit from the account he holds. Eg. The hotel owner had the profit of Rs. 5000. He can take it out keeping the initial margin in the account intact. Or if there are more number of transaction, he can take out all the money but keeping the account at initial margin.
Entering into Contract - Some terms
Initial margin
So the farmer and the hotel manager may enter into a futures contract requiring the delivery of 5,000 kg's of grain to the buyer at a price of Rs.4 per kg. But both have to pay for the risk that involves as the price of the wheat changes. This amount will be a small percentage of the total contract. This amount is called the initial margin. Suppose 1 future contracts = 100 kg of wheat. Also for entering into 1 future contract, Rs. 100 are to be paid. Now what is the initial margin?
Initial margin = (price per contract X number of contracts)
In our case number of contracts = 5000/100 = 50
So initial margin = 50 X 100 = Rs. 5000
VARIATION MARGIN
As we see that as the price of commodity rises, the seller is debited with the loss and buyer is credited with profit. In case of fall, it is opposite. So this brings variation margin.
MAINTENANCE MARGIN
If the futures contract continues to go against the client, the client's account is debited, and the initial margin of the client's account continues to fall. It will reach the minimum point where the exchange member that carries the account call on the client to deposit more funds such that the account again reaches at the minimum point.
Importance of Futures
Futures markets though risky but still serves purpose for some people.
Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market is informed of continuous change of price through various factors.
Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This was shown in example above.
Risks involved
We have already seen the example of wheat being bought by us. See here if not yet seen.
Now suppose instead of you buying 5,000 kgs of wheat there is trade between wheat producer and the Hotel. In Economy there is a principle - As the demand of the commodity rises, the price also rises.
Risk involved with wheat seller
This explains the risk that wheat seller faces the risk like if demand falls price falls or may have worries about next season. So he may be trying to secure a selling price for next season's crop.
Risk involved with wheat buyer or Hotel manager
The wheat buyer / Hotel manager may be trying to secure a buying price to determine how much chapatis / chapatiss can be made and at what profit.
So what should they do?
So the farmer and the hotel manager may enter into a futures contract requiring the delivery of 5,000 kg's of grain to the buyer at a price of Rs.4 per kg in say June. By entering into this futures contract, the farmer and the hotel manager secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain(or any physical commodity) - that can then be bought and sold in the futures market.
Strategies in Futures Market
So, a futures contract is an agreement between two parties:
a short position - the party who agrees to deliver a commodity - and
a long position - the party who agrees to receive a commodity.
In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the hotel manager would be the holder of the long (agreeing to buy).
In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5000 kgs of grain at a price of Rs.4 per kg.
Transactions
DAY 1 : The price of the grain rises to Rs. 5 from Rs. 4
The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the futures contracts for wheat increases to Rs.5 per kg the day after the above farmer and hotel manager enter into their futures contract of Rs.4 per kg. The farmer, as the holder of the short position, has lost Rs.1 per kg because the selling price just increased from the future price at which he is obliged to sell his wheat.
The hotel manager, as the long position, has profited by Rs.1 per kg because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.
On the day the change occurs, the farmer's account is debited Rs.5,000 (Rs.1 per kg X 5,000 kgs) and the hotel manager's account is credited by Rs.5,000 (Rs.1 per kg X 5,000 kgs). As the market moves every day, these kinds of adjustments are made accordingly.
Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.
As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market.
Note that futures are not always deliverable in cash when the futures contract expires. Eg. the gold futures require the delivery of 100 troy ounces of gold per contract. Others like index futures and currency futures settle in cash.
Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at Rs.5 per kg, the farmer would lose Rs.5,000 on the futures contract and the hotel manager would have made Rs.5,000 on the contract.
But after the settlement of the futures contract, the hotel manager still needs wheat to make chapatis, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for Rs.5 per kg (a total of Rs.25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the hotel manager's futures profits of Rs.5,000 go towards his purchase, which means he still pays his locked-in price of Rs.4 per kg (Rs.25,000 - Rs.5,000 = Rs.20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at Rs.5 per kg but because of his losses from the futures contract with the hotel manager, the farmer still actually receives only Rs.4 per kg. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is referred to as hedging.
Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a hotel manager. In such a case, the short speculator would simply have lost Rs.5,000 while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires.)
Taking out Credit :
Also the person who gets credit can take out the profit from the account he holds. Eg. The hotel owner had the profit of Rs. 5000. He can take it out keeping the initial margin in the account intact. Or if there are more number of transaction, he can take out all the money but keeping the account at initial margin.
Entering into Contract - Some terms
Initial margin
So the farmer and the hotel manager may enter into a futures contract requiring the delivery of 5,000 kg's of grain to the buyer at a price of Rs.4 per kg. But both have to pay for the risk that involves as the price of the wheat changes. This amount will be a small percentage of the total contract. This amount is called the initial margin. Suppose 1 future contracts = 100 kg of wheat. Also for entering into 1 future contract, Rs. 100 are to be paid. Now what is the initial margin?
Initial margin = (price per contract X number of contracts)
In our case number of contracts = 5000/100 = 50
So initial margin = 50 X 100 = Rs. 5000
VARIATION MARGIN
As we see that as the price of commodity rises, the seller is debited with the loss and buyer is credited with profit. In case of fall, it is opposite. So this brings variation margin.
MAINTENANCE MARGIN
If the futures contract continues to go against the client, the client's account is debited, and the initial margin of the client's account continues to fall. It will reach the minimum point where the exchange member that carries the account call on the client to deposit more funds such that the account again reaches at the minimum point.
Importance of Futures
Futures markets though risky but still serves purpose for some people.
Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market is informed of continuous change of price through various factors.
Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This was shown in example above.
Futures Contract
A futures contract is an agreement to buy or sell an asset at a certain time in the future at a specific price. The Contractual terms of the futures contracts are very clear. The Futures market was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are traded ONLY in organized exchanges rather than physical exchange. They also use a clearing house that provides the necessary protection to both the buyer and the seller. The price of the futures contract can change prior to delivery. Hence, both participants must settle daily price changes as per the contract values.
If the contract option remains open until the delivery dae, the seller must deliver and the buyer must receive the underlying trade asset at the price that was agreed upon on the original trade date.
An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/- per tonne at some date say in December 2008. If no interim payments are made and if the price of Steel moves violently, a considerable credit risk could build up. To avoid this a margin system is used by the exchanges. As per the margin system, both parties must deposit a small sum with the exchange. This amount will be a small percentage of the total contract. This amount is called the initial margin. As the steel value changes, the contract value also changes. If the contract value changes, the margin must be topped up by an amount corresponding to the change in price of steel. The margin money is the property of the person who deposits it and would be returned to them if the contract gets cancelled /completed.
Characteristics of Futures contract:
1. They are traded in organized exchanges
2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract with the clearing house.
3. Both the buyer and seller are bound by the contract terms and are expected to honour their end of the contract.
4. The settlement cycle differs from 1 product to another, and takes several delivery months.
See here how future market works.
If the contract option remains open until the delivery dae, the seller must deliver and the buyer must receive the underlying trade asset at the price that was agreed upon on the original trade date.
An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/- per tonne at some date say in December 2008. If no interim payments are made and if the price of Steel moves violently, a considerable credit risk could build up. To avoid this a margin system is used by the exchanges. As per the margin system, both parties must deposit a small sum with the exchange. This amount will be a small percentage of the total contract. This amount is called the initial margin. As the steel value changes, the contract value also changes. If the contract value changes, the margin must be topped up by an amount corresponding to the change in price of steel. The margin money is the property of the person who deposits it and would be returned to them if the contract gets cancelled /completed.
Characteristics of Futures contract:
1. They are traded in organized exchanges
2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract with the clearing house.
3. Both the buyer and seller are bound by the contract terms and are expected to honour their end of the contract.
4. The settlement cycle differs from 1 product to another, and takes several delivery months.
See here how future market works.
Futures markets or exchanges
Futures are traded on exchanges. These exchanges may be electronic, floor-based, or a combination of both.
Futures exchanges generally specialize in a particular group of products.
For example, the Intercontinental Exchange (ICE) trades petroleum futures such as Brent crude, natural gas, and electricity futures. The Chicago Board of Trade (CBOT) trades agricultural, interest rate, and metals futures.
In those markets that maintain a trading floor, generally one product trades in one pit. The participants in the pits are mainly brokers, traders, hedgers, and spreaders. The different delivery months offered by each product are dependent on the deliverable product.
Many exchanges (for example, ICE and Euronext.liffe) have developed electronic trading. These platforms match buyers and sellers and report the execution to the clients, the entering member firm, and the clearing facility.
Futures exchanges generally specialize in a particular group of products.
For example, the Intercontinental Exchange (ICE) trades petroleum futures such as Brent crude, natural gas, and electricity futures. The Chicago Board of Trade (CBOT) trades agricultural, interest rate, and metals futures.
In those markets that maintain a trading floor, generally one product trades in one pit. The participants in the pits are mainly brokers, traders, hedgers, and spreaders. The different delivery months offered by each product are dependent on the deliverable product.
Many exchanges (for example, ICE and Euronext.liffe) have developed electronic trading. These platforms match buyers and sellers and report the execution to the clients, the entering member firm, and the clearing facility.
Monday 26 July 2010
Option Exchanges
Euronext.liffe, with its LIFFE CONNECT electronic trading platform, is a fully electronic exchange, as is the International Securities Exchange (ISE) in the US.
The Chicago Board Options Exchange (CBOE) and the American Stock Exchange (Amex) operate from a trading floor, although their 'open outcry' system is augmented by electronic order routing and reporting systems.
The Chicago Board Options Exchange (CBOE) and the American Stock Exchange (Amex) operate from a trading floor, although their 'open outcry' system is augmented by electronic order routing and reporting systems.
Options
An options contract is nothing but the right to buy or sell something at a specified price within a period of time. The feature of the options contract for a buyer is that, the buyer has the right to buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyers maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the options contracts for sellers is an obligation. If a seller enters into an agreement, he has to deliver the asset on the specified date and the price agreed upon. Thus the loss for a seller could be much worse.
Terminologies
1. CALL and PUT
The right to buy is called a "CALL" option while the right to sell is called a "PUT" option.
right to buy - CALL (learning bc - buy call)
right to sell - PUT
Please note that an option is only a right to do something. It is not an obligation to carry out the action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.
For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy 1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The total value of the contract would sum up to 10,00,000/- (10 lacs) As part of getting into the contract you make an initial payment of say 2% of the contract value to the merchant. You make a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the buyer and the merchant is the seller.
Change of Price of Asset
Now take the above example on gold.
1. Assuming on 1st December the price of gold is Rs. 1050/- per gram, then to buy thousand grams of gold you would need Rs. 10,50,000/- rupees which is Rs. 50,000/- more than your options contract. Hence if you exercise your right to buy, you stand to make a profit of Rs. 50,000/- At the same time, the seller has an obligation since he has agreed on the contract and he has to sell the gold to you at a loss of Rs. 50,000/- when compared to the market rate.
2. Assuming on 1st December the price of gold is Rs. 950/- per gram, then to buy thousand grams of gold you would need Rs. 9,50,000/- which is Rs. 50,000/- less than your options contract. Hence if you exercise your right to buy, you stand to lose Rs. 50,000/- You can buy the same quantity of gold in the market at a lesser price. Hence you can choose to let your contract expire and limit your losses to only Rs. 20,000/- The Seller on the other hand does not make any transaction but still stands to keep the Rs. 20,000/- you paid him to form the contract.
In above example 1 thing is clear, that why option is called derivative because option is a contract that deals with an underlying asset like gold, property, stock the value of which changes.
Another point we get is when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment (the initial one), which is the money you used to pay for the option.
The initial 2% charged is because the buyer don't give full money to the seller in advance. This is like interest or security.
2. STRIKE / EXERCISE PRICE, OPTION PREMIUM, EXPIRY DATE, SERIES
This 1000 rupees per gram that you agreed upon with the merchant is called the "STRIKE OR EXERCISE" Price.
The initial deposit of Rs. 20,000/- you paid him is called the "Option premium".
EXPIRY OR EXPIRATION MONTH = when the option contract terminates
SERIES = expiration month and exercise price
We will cover more terminology as we go through this tutorial.
Partcipants in an Options market:
1. Buyers of Calls
2. Sellers of Calls
3. Buyers of Puts
4. Sellers of Puts
People who buy options are called "HOLDERS" and (learning way bh of bhu )
those who sell options are called "WRITERS"
Eg. in case of stock market.
Buyers of calls hope that the stock will increase substantially before the option expires. Buyers of puts hope that the price of the stock will fall before the option expires.
Call Holders and Put Holders (The Buyers) are not obligated to buy or sell. They have the right to do so if they wish. Similarly Call writers and Put Writers (The Sellers) are obliged to buy or sell. This means that they need to buy or sell if the Call holder decides to exercise his right to buy.
Characteristics of Options Contracts:
1. Unlike other derivative products that are price fixing contracts, options are price insurance type of contracts
2. Options have been basically OTC products. But of late, due to its popularity, exchange traded options are also being widely used.
3. The options are very favourable to the Holders or the Buyers.
Widely used terms in Options contracts:
In-the-Money - An ITM option is one that would lead to a positive cash flow to the holder if it were exercised immediately. For e.g., If you have an options contract to buy shares of XYZ limited at Rs. 100/- per share and it is currently trading at Rs. 120/- per share then your options contract is said to be In the Money.
At-the-Money - An ATM option is when the prevailing price of the asset and your option price are more or less same.
Out-of-the-Money - An OTM option is when the prevailing price of the asset is lesser than the option price.
An Example call Option with respect to the Share Market:
You buy 10 call options for the company XYZ pvt ltd, at the strike price of Rs. 325/- at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.
Two things can happen here:
1. You can make a profit:
Say on the date of expiry the share of XYZ pvt ltd is trading at Rs. 380/- per share, then you can opt to exercise your call option. Hence you would be getting 10 shares of XYZ ltd at Rs. 325/- which you can sell at Rs. 380/-
Your Input cost per share = 325
Premium per share = 10
Market value during Selling = 380
Your Profit per share = 380 - (325+10) = Rs. 45 /-
Net Profit = Rs. 450/-
Here Rs. 325 is the Strike price and Rs. 380 is the spot price.
2. You can incur a Loss:
Say on the date of expiry the shares of XYZ pvt ltd is trading at Rs. 275/- per share, then you can opt to let the contract expire. Since you are the buyer or the call holder you can opt to either buy or let the contract expire. Since the share is available in the market at a lesser price than the strike price, it is not wise to exercise the option. Hence you ignore it.
Your input cost = Rs. 10/- (The premium you paid per option)
Loss incurred = Rs. 100/- (Because you do not make any other payment apart from the premium)
Loss you would have incurred if you had exercised the option:
Cost per share = 325
Premium per share = 10
Market value during selling = 280
Your loss per share = (325+10) - 280 = Rs. 55/-
Net Loss: Rs. 550/-
Incurring a loss of Rs. 100/- is better than incurring a loss of Rs. 550/- hence your decision of letting the contract expire was a wise decision.
An Example Put Option with respect to the Share Market:
You buy 10 put options for the company XYZ pvt ltd, at the strike price of Rs. 300 per share at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.
Two things can happen here:
1. You can make a profit:
Say on the date of expiry, the shares of XYZ is trading at Rs. 265/- per share, then you can opt to exercise your contract. You can buy 10 shares of XYZ from the market and then sell your shares to the option writer since he has an obligation to buy if you intend to sell.
Your premium = 10
Your input cost per share = 265
Price at which the Put option is exercise = 300
Profit per share = 300 - (265 + 10) = 25
Net Profit = Rs. 250/-
2. You can make a Loss:
Say on the date of expiry, the shares of XYZ is trading at Rs. 325/- per share, then you can opt to let the contract expire. Since the share is trading at a price more than the option price, you can choose to let the contract expire.
Your premium = 10
Loss incurred = Rs. 100/- (The premium paid)
Even in this case, this loss would be compensated by the fact that you can sell off the shares that you have in the market at a higher price than the option strike price.
Effect of markets
ETD markets
Options specification and nomenclature is set by the exchange at the time of listing. In the case of equity options, the specifications are only changed by the corporate actions.
OTC markets (Over the counter)
The terms of OTC options are negotiated between the buyer and the seller and are therefore customized.
# American form = exercisable on any business day during its life
# European form = exercisable only at the end of its life
# Exercise of equity options = physical settlement in trading lots
# Exercise of index options = cash settlement in exchange set lots
# Exercise of currency options = cash settlement in country of underlying currency
# Exercise of interest rate options = deliverable set by exchange
Terminologies
1. CALL and PUT
The right to buy is called a "CALL" option while the right to sell is called a "PUT" option.
right to buy - CALL (learning bc - buy call)
right to sell - PUT
Please note that an option is only a right to do something. It is not an obligation to carry out the action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.
For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy 1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The total value of the contract would sum up to 10,00,000/- (10 lacs) As part of getting into the contract you make an initial payment of say 2% of the contract value to the merchant. You make a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the buyer and the merchant is the seller.
Change of Price of Asset
Now take the above example on gold.
1. Assuming on 1st December the price of gold is Rs. 1050/- per gram, then to buy thousand grams of gold you would need Rs. 10,50,000/- rupees which is Rs. 50,000/- more than your options contract. Hence if you exercise your right to buy, you stand to make a profit of Rs. 50,000/- At the same time, the seller has an obligation since he has agreed on the contract and he has to sell the gold to you at a loss of Rs. 50,000/- when compared to the market rate.
2. Assuming on 1st December the price of gold is Rs. 950/- per gram, then to buy thousand grams of gold you would need Rs. 9,50,000/- which is Rs. 50,000/- less than your options contract. Hence if you exercise your right to buy, you stand to lose Rs. 50,000/- You can buy the same quantity of gold in the market at a lesser price. Hence you can choose to let your contract expire and limit your losses to only Rs. 20,000/- The Seller on the other hand does not make any transaction but still stands to keep the Rs. 20,000/- you paid him to form the contract.
In above example 1 thing is clear, that why option is called derivative because option is a contract that deals with an underlying asset like gold, property, stock the value of which changes.
Another point we get is when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment (the initial one), which is the money you used to pay for the option.
The initial 2% charged is because the buyer don't give full money to the seller in advance. This is like interest or security.
2. STRIKE / EXERCISE PRICE, OPTION PREMIUM, EXPIRY DATE, SERIES
This 1000 rupees per gram that you agreed upon with the merchant is called the "STRIKE OR EXERCISE" Price.
The initial deposit of Rs. 20,000/- you paid him is called the "Option premium".
EXPIRY OR EXPIRATION MONTH = when the option contract terminates
SERIES = expiration month and exercise price
We will cover more terminology as we go through this tutorial.
Partcipants in an Options market:
1. Buyers of Calls
2. Sellers of Calls
3. Buyers of Puts
4. Sellers of Puts
People who buy options are called "HOLDERS" and (learning way bh of bhu )
those who sell options are called "WRITERS"
Eg. in case of stock market.
Buyers of calls hope that the stock will increase substantially before the option expires. Buyers of puts hope that the price of the stock will fall before the option expires.
Call Holders and Put Holders (The Buyers) are not obligated to buy or sell. They have the right to do so if they wish. Similarly Call writers and Put Writers (The Sellers) are obliged to buy or sell. This means that they need to buy or sell if the Call holder decides to exercise his right to buy.
Characteristics of Options Contracts:
1. Unlike other derivative products that are price fixing contracts, options are price insurance type of contracts
2. Options have been basically OTC products. But of late, due to its popularity, exchange traded options are also being widely used.
3. The options are very favourable to the Holders or the Buyers.
Widely used terms in Options contracts:
In-the-Money - An ITM option is one that would lead to a positive cash flow to the holder if it were exercised immediately. For e.g., If you have an options contract to buy shares of XYZ limited at Rs. 100/- per share and it is currently trading at Rs. 120/- per share then your options contract is said to be In the Money.
At-the-Money - An ATM option is when the prevailing price of the asset and your option price are more or less same.
Out-of-the-Money - An OTM option is when the prevailing price of the asset is lesser than the option price.
An Example call Option with respect to the Share Market:
You buy 10 call options for the company XYZ pvt ltd, at the strike price of Rs. 325/- at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.
Two things can happen here:
1. You can make a profit:
Say on the date of expiry the share of XYZ pvt ltd is trading at Rs. 380/- per share, then you can opt to exercise your call option. Hence you would be getting 10 shares of XYZ ltd at Rs. 325/- which you can sell at Rs. 380/-
Your Input cost per share = 325
Premium per share = 10
Market value during Selling = 380
Your Profit per share = 380 - (325+10) = Rs. 45 /-
Net Profit = Rs. 450/-
Here Rs. 325 is the Strike price and Rs. 380 is the spot price.
2. You can incur a Loss:
Say on the date of expiry the shares of XYZ pvt ltd is trading at Rs. 275/- per share, then you can opt to let the contract expire. Since you are the buyer or the call holder you can opt to either buy or let the contract expire. Since the share is available in the market at a lesser price than the strike price, it is not wise to exercise the option. Hence you ignore it.
Your input cost = Rs. 10/- (The premium you paid per option)
Loss incurred = Rs. 100/- (Because you do not make any other payment apart from the premium)
Loss you would have incurred if you had exercised the option:
Cost per share = 325
Premium per share = 10
Market value during selling = 280
Your loss per share = (325+10) - 280 = Rs. 55/-
Net Loss: Rs. 550/-
Incurring a loss of Rs. 100/- is better than incurring a loss of Rs. 550/- hence your decision of letting the contract expire was a wise decision.
An Example Put Option with respect to the Share Market:
You buy 10 put options for the company XYZ pvt ltd, at the strike price of Rs. 300 per share at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.
Two things can happen here:
1. You can make a profit:
Say on the date of expiry, the shares of XYZ is trading at Rs. 265/- per share, then you can opt to exercise your contract. You can buy 10 shares of XYZ from the market and then sell your shares to the option writer since he has an obligation to buy if you intend to sell.
Your premium = 10
Your input cost per share = 265
Price at which the Put option is exercise = 300
Profit per share = 300 - (265 + 10) = 25
Net Profit = Rs. 250/-
2. You can make a Loss:
Say on the date of expiry, the shares of XYZ is trading at Rs. 325/- per share, then you can opt to let the contract expire. Since the share is trading at a price more than the option price, you can choose to let the contract expire.
Your premium = 10
Loss incurred = Rs. 100/- (The premium paid)
Even in this case, this loss would be compensated by the fact that you can sell off the shares that you have in the market at a higher price than the option strike price.
Effect of markets
ETD markets
Options specification and nomenclature is set by the exchange at the time of listing. In the case of equity options, the specifications are only changed by the corporate actions.
OTC markets (Over the counter)
The terms of OTC options are negotiated between the buyer and the seller and are therefore customized.
# American form = exercisable on any business day during its life
# European form = exercisable only at the end of its life
# Exercise of equity options = physical settlement in trading lots
# Exercise of index options = cash settlement in exchange set lots
# Exercise of currency options = cash settlement in country of underlying currency
# Exercise of interest rate options = deliverable set by exchange
Types of orders in options
Apart from orders mentioned here, there are other types of orders in options.
Spread orders
Here there is simultaneous purchase and sale of equal number of puts or calls having the same underlying issue but different series. Spread order can be market or limit order. Limit orders are entered at the difference between the buy leg and the sell leg of the trade. If the buy side has greater value, the price will be a net debit price. If the sell side has greater value, the order will be entered with a net credit price.
Straddle orders
Here there is simultaneous purchase or sale of equal number of puts and calls having the same underlying issue but same series.
Difference between spread and straddle is clear in terms of and & or.
Combination orders
It is variation of straddle order but is composed of different series like spread orders.
Spread orders
Here there is simultaneous purchase and sale of equal number of puts or calls having the same underlying issue but different series. Spread order can be market or limit order. Limit orders are entered at the difference between the buy leg and the sell leg of the trade. If the buy side has greater value, the price will be a net debit price. If the sell side has greater value, the order will be entered with a net credit price.
Straddle orders
Here there is simultaneous purchase or sale of equal number of puts and calls having the same underlying issue but same series.
Difference between spread and straddle is clear in terms of and & or.
Combination orders
It is variation of straddle order but is composed of different series like spread orders.
Sunday 25 July 2010
Settlement Failures in FX markets
Repercussions of Settlement Failure
Although the party that causes the failure typically has to compensate the other counterparty for any interest income lost due to the non-receipt of currency, this failure can have serious repercussions.
Apart from the (cost of) time wasted trying to resolve the issue, such failures can erode a bank’s reputation quite quickly. Also, the party causing the failure will typically have to compensate the other counterparty for any interest income lost due to the non-receipt of currency. A settlement failure may also have a snowball effect in that the receiving bank may have needed the funds to pay another obligation. Additionally, market regulators often apply fines and sanctions to banks that cause settlement failure.
One method to prevent failure in FX market settlement is netting. See in detail here.
Although the party that causes the failure typically has to compensate the other counterparty for any interest income lost due to the non-receipt of currency, this failure can have serious repercussions.
Apart from the (cost of) time wasted trying to resolve the issue, such failures can erode a bank’s reputation quite quickly. Also, the party causing the failure will typically have to compensate the other counterparty for any interest income lost due to the non-receipt of currency. A settlement failure may also have a snowball effect in that the receiving bank may have needed the funds to pay another obligation. Additionally, market regulators often apply fines and sanctions to banks that cause settlement failure.
One method to prevent failure in FX market settlement is netting. See in detail here.
Netting
Netting is one of the most effective ways of reducing settlement risk in FX trades. Payment (or settlement) netting is defined as an arrangement between two or more counterparties to net all payments in a single currency owed between them on a given value date.
Regulatory authorities encourage netting arrangements because they reduce the amount of payments that have to be made.The lower the number of payments, the lower the probability that there will be a default. In addition, because netting reduces the number of payments, both the opportunity for human error and the charges levied per payment are reduced.
Ideally, the process of payment netting should be supported by a legal agreement. This can take the form of a brief document that only supports netting, or it can be a settlement netting provision that is included in a master agreement.
Calculating netted amounts correctly is important to ensure accurate settlement monies. Market participants should automate the actual netting calculation, if possible, so that errors introduced by manual calculations are reduced. Counterparties should confirm the net payment amount with each other at a predetermined cut-off time prior to settlement.
Types of Netting
Netting of payments between counterparties take place through different methods.
Bilateral Netting
The netting of payments between two counterparties is known as bilateral settlement netting.
Example
Invest Bank is due to make five payments to Finance Bank for a total of GBP 100 million. However, Finance Bank is due to make three payments to Invest Bank for a total of GBP 95 million.
If the two banks use bilateral settlement netting then they need not make eight separate payments totaling GBP 195 million. Instead, Invest Bank can simply make one payment to Finance Bank for GBP 5 million.
The one drawback with bilateral netting is that although it reduces the number of payments a bank has to make, the actual reduction is often rather small in practice. The reason for this is that a bank may not have reciprocal deals with all the banks that it deals with. In such situations, bilateral netting cannot bring the maximum benefit of netting.
Multilateral Netting
Netting by Novation
Payment netting reduces the number of settlement payments flowing between counterparties and therefore reduces settlement risk. However, it does not reduce credit risk as the contracts giving rise to the obligations being netted remain in effect, and both counterparties remain legally obliged to settle for the gross amount of their obligations.
Netting by novation is the process whereby a number of contracts are canceled and replaced by one single contract. This new contract is legally binding and aggregates and nets all of the payment obligations of the previous contracts.
Novation netting, unlike payment netting, refers not only to the payments due under transactions, but also to the transactions themselves – it is arranged not at settlement but when a contract is entered into, and it has the effect of lowering counterparty credit risk.
Close-Out Netting
In addition to payment netting, master agreements may also provide for close-out netting. This is an agreement to settle all contracted claims and obligations by one single payment, upon the occurrence of default by one party (or if some other termination event occurs).
Close-out netting differs from netting by novation in that the latter is accomplished prior to a default or bankruptcy occurring (when the transaction takes place), whereas the former type of agreement occurs in the event of default (that is, a contract is signed but only retrieved in the event of default).
Regulatory authorities encourage netting arrangements because they reduce the amount of payments that have to be made.The lower the number of payments, the lower the probability that there will be a default. In addition, because netting reduces the number of payments, both the opportunity for human error and the charges levied per payment are reduced.
Ideally, the process of payment netting should be supported by a legal agreement. This can take the form of a brief document that only supports netting, or it can be a settlement netting provision that is included in a master agreement.
Calculating netted amounts correctly is important to ensure accurate settlement monies. Market participants should automate the actual netting calculation, if possible, so that errors introduced by manual calculations are reduced. Counterparties should confirm the net payment amount with each other at a predetermined cut-off time prior to settlement.
Types of Netting
Netting of payments between counterparties take place through different methods.
- Bilateral netting
- Multilateral netting
- Netting by novation
- Close-out netting
Bilateral Netting
The netting of payments between two counterparties is known as bilateral settlement netting.
Example
Invest Bank is due to make five payments to Finance Bank for a total of GBP 100 million. However, Finance Bank is due to make three payments to Invest Bank for a total of GBP 95 million.
If the two banks use bilateral settlement netting then they need not make eight separate payments totaling GBP 195 million. Instead, Invest Bank can simply make one payment to Finance Bank for GBP 5 million.
The one drawback with bilateral netting is that although it reduces the number of payments a bank has to make, the actual reduction is often rather small in practice. The reason for this is that a bank may not have reciprocal deals with all the banks that it deals with. In such situations, bilateral netting cannot bring the maximum benefit of netting.
Multilateral Netting
Netting by Novation
Payment netting reduces the number of settlement payments flowing between counterparties and therefore reduces settlement risk. However, it does not reduce credit risk as the contracts giving rise to the obligations being netted remain in effect, and both counterparties remain legally obliged to settle for the gross amount of their obligations.
Netting by novation is the process whereby a number of contracts are canceled and replaced by one single contract. This new contract is legally binding and aggregates and nets all of the payment obligations of the previous contracts.
Novation netting, unlike payment netting, refers not only to the payments due under transactions, but also to the transactions themselves – it is arranged not at settlement but when a contract is entered into, and it has the effect of lowering counterparty credit risk.
Close-Out Netting
In addition to payment netting, master agreements may also provide for close-out netting. This is an agreement to settle all contracted claims and obligations by one single payment, upon the occurrence of default by one party (or if some other termination event occurs).
Close-out netting differs from netting by novation in that the latter is accomplished prior to a default or bankruptcy occurring (when the transaction takes place), whereas the former type of agreement occurs in the event of default (that is, a contract is signed but only retrieved in the event of default).
Settlement and payment systems in FX markets
Settlement of FX transactions usually involves the use of secure international and domestic payment system networks. Let us study three of these networks in detail.
Con
Con
Continuous Linked Settlement (CLS)
Continuous Linked Settlement is a real-time system that by which a number of the world's largest banks manage settlement of foreign exchange amongst themselves (and their customers and other third-parties), irrespective of time zones.
It has 17 eligible currencies under it right now. These are:
The process is managed by CLS Group Holdings AG and its subsidiary companies and include a settlement bank regulated by the Federal Reserve Bank of New York. The Group was formed in 1997 and the settlement system has been operational since 2002. As of February 2009, there were 73 shareholders and 62 settlement members as well as 4,576 Third Party participants (411 banks, corporates and non-bank financial institutions and 4,165 investment funds) that participate in the system.
CLS settles transactions on a payment versus payment basis, also known as PVP. When a foreign exchange trade is settled, each of the two parties to the trade pays out (sells) one currency and receives (buys) a different currency; PVP ensures that these payments and receipts happen simultaneously. Without PVP there is a (small, but with potentially devastating financial consequences) chance that one or more parties could pay away funds to another institution but not receive any reciprocal funds due (generally for reasons of credit-related default)—this is known as settlement risk, or Herstatt risk.
An additional benefit of the CLS system is the increased straight through processing capabilities.
Other services like CLS , there is TARGET and EBA.
It has 17 eligible currencies under it right now. These are:
- Australian Dollar
- Canadian Dollar
- Danish Krone
- EUR Euro
- Hong Kong Dollar
- Israeli new shekel
- Japanese Yen
- Mexican Peso
- New Zealand Dollar
- Norwegian Krone
- Singapore Dollar
- South African Rand
- South Korean Won
- Swedish Krona
- Swiss Franc
- Pound Sterling
- United States Dollar
The process is managed by CLS Group Holdings AG and its subsidiary companies and include a settlement bank regulated by the Federal Reserve Bank of New York. The Group was formed in 1997 and the settlement system has been operational since 2002. As of February 2009, there were 73 shareholders and 62 settlement members as well as 4,576 Third Party participants (411 banks, corporates and non-bank financial institutions and 4,165 investment funds) that participate in the system.
CLS settles transactions on a payment versus payment basis, also known as PVP. When a foreign exchange trade is settled, each of the two parties to the trade pays out (sells) one currency and receives (buys) a different currency; PVP ensures that these payments and receipts happen simultaneously. Without PVP there is a (small, but with potentially devastating financial consequences) chance that one or more parties could pay away funds to another institution but not receive any reciprocal funds due (generally for reasons of credit-related default)—this is known as settlement risk, or Herstatt risk.
An additional benefit of the CLS system is the increased straight through processing capabilities.
Other services like CLS , there is TARGET and EBA.
TARGET
TARGET( Trans-European Automated Real-time Gross Settlement Express Transfer System) was an interbank payment system for the real-time gross settlement (RTGS) of cross-border transfers throughout the European Union. It included 17 national real-time gross settlement (RTGS) systems and the ECB payment mechanism (EPM). TARGET provided access to more than 1,000 direct participants and more than 48,000 credit institutions (including branches and subsidiaries). In November 2007 it was replaced by TARGET2.
Euro Banking Association (EBA)
The Euro Banking Association (EBA) is an industry forum for the European payments industry with over 200 member banks and organisations from the European Union and across the world aimed at fostering and driving pan-European payment initiatives. Through its EURO1, STEP1 and STEP2 systems, EBA offers clearing and settlement services to wide community of banks in the European Union, and continues to be a key contributor to the creation of a standardised Single Euro Payments Area (SEPA).
3 systems
The 3 systems are run by EBA CLEARING. The EBA Clearing Company was founded in June 1998 by 52 banks.
Euro1
EURO1 is a real-time net clearing and settlement system for individual financial and commercial payments and is owned and operated by EBA CLEARING. It is open to banks that have a registered address or branch in the European Union and fulfill a number of additional requirements.
Step1
It is a payment system for commercial transactions in EURO.
Step2
It the first and so far only pan-European Automated Clearing House (PE-ACH) , which processes mass or bulk euro payments ( upto EUR 50,000 per transaction ) for banks from 32 European countries.
Those payment are processed that bears an International Bank Account Number, IBAN, and a Bank Identifier Code (BIC)) as well as payments that comply with the Scheme Rulebooks and Implementation Guidelines for the Single Euro Payments Area (SEPA) as they have been issued by the European Payments Council.
Once a year, the EBA brings together its member banks and organisations as well as other stakeholders in the market for a pan-European payments conference entitled EBAday. The EBA also runs a payments portal providing news and information on ongoing topics in the market.
3 systems
The 3 systems are run by EBA CLEARING. The EBA Clearing Company was founded in June 1998 by 52 banks.
Euro1
EURO1 is a real-time net clearing and settlement system for individual financial and commercial payments and is owned and operated by EBA CLEARING. It is open to banks that have a registered address or branch in the European Union and fulfill a number of additional requirements.
Step1
It is a payment system for commercial transactions in EURO.
Step2
It the first and so far only pan-European Automated Clearing House (PE-ACH) , which processes mass or bulk euro payments ( upto EUR 50,000 per transaction ) for banks from 32 European countries.
Those payment are processed that bears an International Bank Account Number, IBAN, and a Bank Identifier Code (BIC)) as well as payments that comply with the Scheme Rulebooks and Implementation Guidelines for the Single Euro Payments Area (SEPA) as they have been issued by the European Payments Council.
Once a year, the EBA brings together its member banks and organisations as well as other stakeholders in the market for a pan-European payments conference entitled EBAday. The EBA also runs a payments portal providing news and information on ongoing topics in the market.
Foreign exchange transactions
Spot deal
A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.
Notes:
Most spot deals take T+2 days
For Canadian dollar and Mexican peso settle on T+1 days,
South African rand, Thai baht with T+3 days
Saudi riyal (SAR) cannot be settled on friday due to religious reasons. So if you have USD/SAR trade on wednesday it will be settled on monday.
Forward
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties. and foreward contract is a negotiated and agreement between two parties.
FX swap
In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).So 1st transaction is spot deal where where 2 parties agree to exchange 2 currencies on spot date. 2nd transaction is forward transaction where currencies are re-exchanged at an agreed forward rate.
Non-deliverable Forward
A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.
Notes:
Most spot deals take T+2 days
For Canadian dollar and Mexican peso settle on T+1 days,
South African rand, Thai baht with T+3 days
Saudi riyal (SAR) cannot be settled on friday due to religious reasons. So if you have USD/SAR trade on wednesday it will be settled on monday.
Forward
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties. and foreward contract is a negotiated and agreement between two parties.
FX swap
In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).So 1st transaction is spot deal where where 2 parties agree to exchange 2 currencies on spot date. 2nd transaction is forward transaction where currencies are re-exchanged at an agreed forward rate.
Non-deliverable Forward
Trade settlement in FX market
Standard settlement instructions (SSIs) need to be exchanged where possible as they minimize the chances of incorrect/incomplete instructions being exchanged.
One day prior to settlement or on the settlement date (up to a cut-off time), payment instructions are sent to the nostro bank for all the amounts owed. These instructions advise the nostro bank of the counterparty’s nostro agent’s name, SWIFT address, and account numbers if applicable.
Settlement and payment systems in FX markets
Settlement Failures in FX markets
One day prior to settlement or on the settlement date (up to a cut-off time), payment instructions are sent to the nostro bank for all the amounts owed. These instructions advise the nostro bank of the counterparty’s nostro agent’s name, SWIFT address, and account numbers if applicable.
Settlement and payment systems in FX markets
Settlement Failures in FX markets
Nostro Account
Every bank has accounts for each currency held in correspondent banks in the country of origin of the currency. These accounts are known as nostro accounts. For example, a bank located in New York will have a nostro account in a correspondent bank in Japan to receive yen. It will also have a nostro account in a correspondent bank in the UK to receive sterling.
Since euro can be received in any country within the euro area, banks can have euro-denominated nostro accounts in correspondent banks in Paris, Frankfurt, and so on.
A nostro account to one bank must simultaneously be a vostro account to another bank.
For example, if UK Bank maintains a dollar account with USA Bank in New York, the account would be a USD-denominated nostro account to UK Bank, but a vostro account in its home currency to USA Bank.
Similarly, if USA Bank maintains a GBP account with UK Bank in London, this would be a vostro account to UK Bank, but a nostro account to USA Bank.
Since euro can be received in any country within the euro area, banks can have euro-denominated nostro accounts in correspondent banks in Paris, Frankfurt, and so on.
A nostro account to one bank must simultaneously be a vostro account to another bank.
For example, if UK Bank maintains a dollar account with USA Bank in New York, the account would be a USD-denominated nostro account to UK Bank, but a vostro account in its home currency to USA Bank.
Similarly, if USA Bank maintains a GBP account with UK Bank in London, this would be a vostro account to UK Bank, but a nostro account to USA Bank.
Standard settlement instructions (SSIs)
Standard settlement instructions (SSIs) need to be exchanged where possible as they minimize the chances of incorrect/incomplete instructions being exchanged. If SSIs are not used, then the settlement instructions may be recorded at the time of trade execution.
Eg. in case of FX markets, such instructions should be sent by the close of business on the trade date (for a spot deal) or at least one day before settlement (for a forward deal).
Eg. in case of FX markets, such instructions should be sent by the close of business on the trade date (for a spot deal) or at least one day before settlement (for a forward deal).
Some ISO Currency Codes
USD (US dollar)
EUR (euro)
GBP (sterling)
JPY (Japanese yen)
CHF (Swiss franc)
CAD (Canadian dollar)
AUD (Australian dollar)
HKD (Hong Kong dollar)
INR (Indian Rupee)
EUR (euro)
GBP (sterling)
JPY (Japanese yen)
CHF (Swiss franc)
CAD (Canadian dollar)
AUD (Australian dollar)
HKD (Hong Kong dollar)
INR (Indian Rupee)
Trading systems in FX
The most commonly used trading systems are Reuters and EBS ( Electronic broking system ).
Markets Trading system
spot market Reuters Dealing 3000 Spot matching service , EBS
forward market Reuters Dealing 3000 Forward matching service
Hybrid Tullet-Prebon
Reuters and EBS provide anonymity.
EBS is screen-based working 24X7 throughout weeks.
Markets Trading system
spot market Reuters Dealing 3000 Spot matching service , EBS
forward market Reuters Dealing 3000 Forward matching service
Hybrid Tullet-Prebon
Reuters and EBS provide anonymity.
EBS is screen-based working 24X7 throughout weeks.
Foreign exchange transactions
Spot deal
A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.
Notes:
Most spot deals take T+2 days
For Canadian dollar and Mexican peso settle on T+1 days,
South African rand, Thai baht with T+3 days
Saudi riyal (SAR) cannot be settled on friday due to religious reasons. So if you have USD/SAR trade on wednesday it will be settled on monday.
Forward
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties. and foreward contract is a negotiated and agreement between two parties.
FX swap
In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).
Transaction 1 : Spot deal on 2 currencies where 2 parties agree to exchange on spot date
Transaction 2 : A forward transaction where teh currencies are re-exchanged at a forward date and at an agreed forward rate.
NDF (Non-deliverable funds )
A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.
Notes:
Most spot deals take T+2 days
For Canadian dollar and Mexican peso settle on T+1 days,
South African rand, Thai baht with T+3 days
Saudi riyal (SAR) cannot be settled on friday due to religious reasons. So if you have USD/SAR trade on wednesday it will be settled on monday.
Forward
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties. and foreward contract is a negotiated and agreement between two parties.
FX swap
In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).
Transaction 1 : Spot deal on 2 currencies where 2 parties agree to exchange on spot date
Transaction 2 : A forward transaction where teh currencies are re-exchanged at a forward date and at an agreed forward rate.
NDF (Non-deliverable funds )
Some trading services
SETS (Stock Exchange Electronic Trading Service) is the London Stock Exchange's trading service for UK blue-chip securities. It is an electronic order book that executes hundreds of trades every second.
Ex-dividend date
Entitlement to a dividend payment depends on the relationship between the trade date and the ex-dividend date.
The record date is the day by which investors must be the owners of the shares so that they are entitled to receive the dividend on the payment date.
Ex-dividend date is a fixed number of days before the record date. The ex-dividend date is set by the local stock exchange (where the stock is listed) rather than by the issuer.
If the trade date is within the cum-dividend (or with-dividend) period, that is, the period between the dividend announcement date and the ex-dividend date, then the buyer of the stock is entitled to receive the dividend (and the seller loses their entitlement to the dividend).
If the trade date is within the period beginning with the ex-dividend date and including the record date, then the buyer is not entitled to a dividend. However, the seller of the stock will receive a dividend payment.
Ex - ex dividend date
Cd - cum-dividend date
Rd - Record date
Ad - Announcement date
Td - trade date or value date
time-line ---->
Ad Cd Ex Rd
Td buyer gets the dividend
Td seller gets the dividend
So if Td is before Ex, buyer gets dividend otherwise seller.
The record date is the day by which investors must be the owners of the shares so that they are entitled to receive the dividend on the payment date.
Ex-dividend date is a fixed number of days before the record date. The ex-dividend date is set by the local stock exchange (where the stock is listed) rather than by the issuer.
If the trade date is within the cum-dividend (or with-dividend) period, that is, the period between the dividend announcement date and the ex-dividend date, then the buyer of the stock is entitled to receive the dividend (and the seller loses their entitlement to the dividend).
If the trade date is within the period beginning with the ex-dividend date and including the record date, then the buyer is not entitled to a dividend. However, the seller of the stock will receive a dividend payment.
Ex - ex dividend date
Cd - cum-dividend date
Rd - Record date
Ad - Announcement date
Td - trade date or value date
time-line ---->
Ad Cd Ex Rd
Td buyer gets the dividend
Td seller gets the dividend
So if Td is before Ex, buyer gets dividend otherwise seller.
Funding or financing
Funding refers to financing investment through obtaining obtaining cash at the lowest possible borrowing rates or maximizing the benefits of lending cash of other entities.
Assume for example that a trading institution has just settled the final the single purchase of shares at its custodian, resulting in positive securities position and negative cash positions in custodians accounts.
Security position and cash position
Lend share
Use shares as collateral
Use shares to clean-up another sale
Do nothing
Assume for example that a trading institution has just settled the final the single purchase of shares at its custodian, resulting in positive securities position and negative cash positions in custodians accounts.
Security position and cash position
Lend share
Use shares as collateral
Use shares to clean-up another sale
Do nothing
buy-in or sell out
Buy-in occurs when buyer issues a notice to the seller that unless the shares are delivered by a specified date, thn a buy-in will be executed whereby the buyer will purchase the share from another counterpaty at the market price and any losses occurs to the buyer will be paid by the seller. This means that even if original trade is dead, the seller still has to pay for any loss occurring to buyer.
Sell-out occurs when the seller of shares issues a notice to the buyer that unless the cash is paid by a specified date, the seller may sell shares to some other counter-party at the market price and any loss occuring to the seller will be paid by the buyer.
Sell-out occurs when the seller of shares issues a notice to the buyer that unless the cash is paid by a specified date, the seller may sell shares to some other counter-party at the market price and any loss occuring to the seller will be paid by the buyer.
Settlement Failure
Once a value date is reached, settlement should occur otherwise it is failed.
Reasons of failure
- Unmatched settlement instructions at the deadline time imposed by the custodian
- Insufficient securities/cash in the counter-party's account at the custodian
Repercussions
The repercussions are :
In case when there are insufficient securities from seller's side and the buyer has to wait, the legal ownership of shares moves from the seller to the buyer upon the trade's legal settlement date regardless of when the trade actually settles. Here buyer receives interest till he gets his stocks from seller as a penalty.
In case when seller waits, the then seller faces a loss in interest + principal amount.So buyer has to that interest and that cash in case he is late to pay it earlier. Till he pays principal , buyer has to pay interest a well.
The repercussions are :
In case when there are insufficient securities from seller's side and the buyer has to wait, the legal ownership of shares moves from the seller to the buyer upon the trade's legal settlement date regardless of when the trade actually settles. Here buyer receives interest till he gets his stocks from seller as a penalty.
In case when seller waits, the then seller faces a loss in interest + principal amount.So buyer has to that interest and that cash in case he is late to pay it earlier. Till he pays principal , buyer has to pay interest a well.
Prevention
In some markets, regulators impose fines/penalties on parties that cause settlement failure. Trading counteraparties can also implement a number of methods to avoid failures.
Egs.
Seeking acknowledgement from custodians for receipt of settlement instructions,
Prioritizing any actions relating to settlement instructions according to the value date of trades.
For markets that remain open after their value date may be buy-in or sell out procedure.
In some markets, regulators impose fines/penalties on parties that cause settlement failure. Trading counteraparties can also implement a number of methods to avoid failures.
Egs.
Seeking acknowledgement from custodians for receipt of settlement instructions,
Prioritizing any actions relating to settlement instructions according to the value date of trades.
For markets that remain open after their value date may be buy-in or sell out procedure.
Trade related functions
For any entity involved in trading in the fixed income markets, there are a number of ongoing position and trade-related functions that must be carried out:
Funding / Financing
Reconciliation
Corporate actions
Safe custody
Accounting
Funding / Financing
Reconciliation
Corporate actions
Safe custody
Accounting
Trade reporting
The practice of announcing the trade or issue of a security to the appropriate regulator. Trade reporting is mandatory and serves to increase transparency in the market.It should be done within some time frame limit.
By checking that trades are conducted in a fair and orderly manner and in accordance with market rules, regulators are able to meet their objectives of ensuring investor protection and safeguarding the reputation and integrity of the marketplace.
Trade reporting can be conducted via a number of mechanisms, such as:
Regulators analyze trades in an attempt to identify any possible cases of market manipulation, insider trading, or other breaches of market rules and regulations. Due to the sheer volume of transactions, many markets have automated systems in place that attempt to detect dubious trading patterns.
By checking that trades are conducted in a fair and orderly manner and in accordance with market rules, regulators are able to meet their objectives of ensuring investor protection and safeguarding the reputation and integrity of the marketplace.
Trade reporting can be conducted via a number of mechanisms, such as:
- the automatic forwarding of trade details from computerized exchange trading systems
- transmission of messages via systems such as TRAX and Omgeo, which also act as transaction reporting systems
- transmission of messages via NCSDs, who then forward the trade details to the regulatory authority
Regulators analyze trades in an attempt to identify any possible cases of market manipulation, insider trading, or other breaches of market rules and regulations. Due to the sheer volume of transactions, many markets have automated systems in place that attempt to detect dubious trading patterns.
Confirmation / Affirmation or comparison matching
Confirmation and affirmation
Sending trade confirmation guarantees that trade details are correct.
Methods of confirmation / affirmation in case of bonds
Sending trade confirmation guarantees that trade details are correct.
Methods of confirmation / affirmation in case of bonds
- Banks - A bank trading on behalf of client may issue a trade confirmation to the client say via SWIFT, email etc. or may utilize a trade affirmation facility. Omgeo, a global joint venture between the Depository Trust & Clearing Corporation (DTCC) and Thomson Financial, offers trade confirmation and affirmation services and has users in over 40 countries.
- Exchange firms - Stock exchange firms in case of stocks, Options exchange members in case of Options.
- Broker dealer firms
These firms use some registered clearing agent or vendor for confirming / affirming trades.
Eg. in case of stocks - In US, there is National Securities Clearing Corporation (NSCC) and Fixed Income Clearing Corporation(FICC).
Eg. in case of options - In US, listed options trades are compared on exchange and then sent to Option clearing Corporation ( OCC ) for settlement. UK options traded on Euronext.liffe clear at LCH.Clearnet. Options traded in Japan settle through Japan Securities Clearing Corporation (JSCC).
Trade Enrichment
Trade enrichment is the process of applying relevant information to the trade that is necessary to settle the trade correctly.
It has following elements:
In an automated environment, trade enrichment can be primarily achieved from the static data repository (this is referred to as static data defaulting). If any static data items are missing, the trade is treated as an exception with processing halted until the necessary information is added to the static data repository.
It has following elements:
- Trade figuration, that is, calculating trade cash values
- Trade comparison requirements and validation for counterparties; for example, some trades may not require confirmations to be sent if other trade agreement methods are in place. Trade confirmations to clients carry full details of the trade including fees, commission, and net money. The counterparty's information is not included on the client's confirmation
- The selection of the relevant custodian details
- The transmission of settlement instructions, for example, by SWIFT or fax
- The reporting of trades to stock market regulators
In an automated environment, trade enrichment can be primarily achieved from the static data repository (this is referred to as static data defaulting). If any static data items are missing, the trade is treated as an exception with processing halted until the necessary information is added to the static data repository.
Trade validation
Errors can arise when data is placed in electronic format, either from manual keying, scanning, or optical character recognition. For example, with manual input:
Even if data is correctly entered in electronic form, computer hardware or software can subsequently introduce errors. For example, the bank may pay more (or receive less) than the market value of the securities purchased (or sold). Therefore, in order to facilitate the timely settlement of trades and minimize operational risk, there should be a final check for errors before any trade details are sent externally. The drawback of this activity is the additional processing time, but the downstream impact in terms of both time and cost usually makes it worthwhile.
The checks to be performed on various trades can be classified as fundamental checks, special trades and exception handling. These are cleared here 1 by 1.
- bid and offer prices can be reversed
- incorrect share prices may be entered
- decimal places can be omitted or entered incorrectly
Even if data is correctly entered in electronic form, computer hardware or software can subsequently introduce errors. For example, the bank may pay more (or receive less) than the market value of the securities purchased (or sold). Therefore, in order to facilitate the timely settlement of trades and minimize operational risk, there should be a final check for errors before any trade details are sent externally. The drawback of this activity is the additional processing time, but the downstream impact in terms of both time and cost usually makes it worthwhile.
The checks to be performed on various trades can be classified as fundamental checks, special trades and exception handling. These are cleared here 1 by 1.
- FUNDAMENTAL CHECKS -This includes checking of trade date, value date, quantity and other checks.
- Trade date must be a business day and before value date
- Value date must be a business day and after trade date on T+3 or T+1 depending on equities or bonds or depending on different countries.
- Quantity - must be whole numbers
- Others - Securities must be identifiable, and in case of rights or warrants they must be 'alive'.
- SPECIAL TRADES
Further trade validation may need to be performed on some trades, for instance:- trades that are deemed to be large, that is, the settlement value is above a specified minimum threshold
- trades in a specific security/market, for example, a new market or a stock that trades infrequently
- trades with a specific counterparty, for example, a new broker or bank
- trades with a value date in the past (note however that 'as of' trades, that is, trades processed after their actual trade date, are valid trades)
- trades with prices outside a specified range, for example, 5% above or below the current market price for the stock; this can, for instance, identify trades that traders have mistakenly entered at off-market prices or where the trader has dealt in the wrong stock
- trades settling on a free of payment (FOP) basis
Much of the trade validation process can be handled on an automated basis by rules-based error checking and exception reporting, that is, setting up specific rules within the settlement system to mark any trades that fail validation tests as exceptions. - EXCEPTION HANDLING
Trades that are subject to exception handling are routed to the appropriate person/department for investigation. If the issue is resolved, the data is updated and the trade is released again for settlement. Some trades might need to be amended or canceled, in which case they may need to be returned to the front office. Other trades may not be resolved within an acceptable period of time, in which case they may be escalated to a more experienced or knowledgeable member of the middle office or operations area.
Trade figuration
It is to figure out how much cash is required in the trade.
It can be due to
It can be due to
- Gross trade cash value
Eg. one buys 3000 shares of market value Rs. 10, it will cash him R. 30,000. - CommissionCommission charged by broker/dealer.
- Other factorsOther factors may be stamp duties, purchase and sales tax, securities registration fees, transaction fees imposed by regulatory bodies.
Bank Organizational Structure
The bank has 3 sections :
1. Front office
2. Middle office
3. Back office
Front office
Trades that have been executed and entered into the front office trading system should flow through to the back office immediately in an automated environment.
Middle office
It deals with risk management.
Back office
To ensure that all trades have successfully arrived in the back office settlement system, a trade-by-trade reconciliation should take place to identify any potential missing trades. This type of reconciliation can occur though an acknowledgment sent by the settlement system to the trading system within a specified time-frame or by the settlement system detecting non-consecutive/missing trade reference numbers. Procedures for dealing with any missing trades should be in place.
Upon receiving a trade, the back office should immediately validate the trade details against external market data feeds supplied by securities data vendors. Validation should also include checking static data items for potential problems, such as unknown counterparty or security. Problematic trades may require correction and are treated as 'exceptions' as they require manual intervention to correct the issue before processing can continue.
Once the trade details have been validated by the back office, the trade is accepted for settlement and assigned a reference number within the settlement system.
1. Front office
2. Middle office
3. Back office
Front office
Trades that have been executed and entered into the front office trading system should flow through to the back office immediately in an automated environment.
Middle office
It deals with risk management.
Back office
To ensure that all trades have successfully arrived in the back office settlement system, a trade-by-trade reconciliation should take place to identify any potential missing trades. This type of reconciliation can occur though an acknowledgment sent by the settlement system to the trading system within a specified time-frame or by the settlement system detecting non-consecutive/missing trade reference numbers. Procedures for dealing with any missing trades should be in place.
Upon receiving a trade, the back office should immediately validate the trade details against external market data feeds supplied by securities data vendors. Validation should also include checking static data items for potential problems, such as unknown counterparty or security. Problematic trades may require correction and are treated as 'exceptions' as they require manual intervention to correct the issue before processing can continue.
Once the trade details have been validated by the back office, the trade is accepted for settlement and assigned a reference number within the settlement system.
Saturday 24 July 2010
Reconciliation
An accounting process used to compare two sets of records to ensure the figures are in agreement and are accurate. Reconciliation is the key process used to determine whether the money leaving an account matches the amount spent, ensuring that the two values are balanced at the end of the recording period.
Trade by trade reconciliation
Trading position reconciliation
Open trades reconciliation
Custodian position reconciliation
Trade by trade reconciliation
Trading position reconciliation
Open trades reconciliation
Custodian position reconciliation
Mergers and Acquisitions
A merger occurs when two or more companies combine into one while all parties involved mutually agree to the terms of the merge. The merge usually occurs when one company surrenders its stock to the other. If a company undergoes a merger, it may indicate to shareholders that the company has confidence in its ability to take on more responsibilities. On the other hand, a merger could also indicate a shrinking industry in which smaller companies are being combined with larger corporations. For more information, see "What happens to the stock price of companies that are merging together?"
In the case of an acquisition, however, a company seeks out and buys a majority stake of a target company's shares; the shares are not swapped or merged. Acquisitions can often be friendly but also hostile, meaning that the acquired company does not find it favorable that a majority of its shares was bought by another entity.
A reverse merger can also occur. This happens when a private company acquires an already publicly-listed company (albeit one that is not successful). The private company in essence turns into the publicly-traded company to gain trading status without having to go through the tedious process of the initial public offering.Thus, the private company merges with the public company, which is usually a shell at the time of the merger, and usually changes its name and issues new shares.
In the case of an acquisition, however, a company seeks out and buys a majority stake of a target company's shares; the shares are not swapped or merged. Acquisitions can often be friendly but also hostile, meaning that the acquired company does not find it favorable that a majority of its shares was bought by another entity.
A reverse merger can also occur. This happens when a private company acquires an already publicly-listed company (albeit one that is not successful). The private company in essence turns into the publicly-traded company to gain trading status without having to go through the tedious process of the initial public offering.Thus, the private company merges with the public company, which is usually a shell at the time of the merger, and usually changes its name and issues new shares.
Spin offs
A spin off occurs when an existing publicly-traded company sells a part of its assets or distributes new shares in order to create a newly independent company. Often the new shares will be offered through a rights issue to existing shareholders before they are offered to new investors (if at all). Depending on the situation, a spin-off could be indicative of a company ready to take on a new challenge or one that is restructuring or refocusing the activities of the main business.
Safe Custody
Many institutions provide safe custody services for their clients, that is, they agree to hold and manage securities (and cash) for their clients. Such services may be provided not only by custodian banks, but also by brokerage operations. Securities owned by clients but managed by entities providing custodial services must be held in segregated accounts at the relevant custodian.
Fundamental safe custody services provided for clients’ securities accounts include:
For cash accounts, services include the provision of safe custody for cash in different currencies, receipt and payment of cash, and the updating of cash accounts for accrued interest.
The fee charged to a client for custodial services may be based on the size of the client’s bond portfolio or the number of movements in and out of the portfolio.
Fundamental safe custody services provided for clients’ securities accounts include:
- safe custody of bond positions
- receipt and delivery of bonds
- valuation of bond holdings
- updating holdings due to corporate actions
- issuing statements of holdings
For cash accounts, services include the provision of safe custody for cash in different currencies, receipt and payment of cash, and the updating of cash accounts for accrued interest.
The fee charged to a client for custodial services may be based on the size of the client’s bond portfolio or the number of movements in and out of the portfolio.
Corporate actions
A corporate action is an event initiated by a public company that affects the securities (equity or debt) issued by the company.
Splits, dividends, mergers and acquisitions,rights issue and spinoffs are all examples of corporate actions.
Type of Impact
Some corporate actions such as a dividend (for equity securities) or coupon payment (for debt securities (bonds)) or call (early redemption) of a debt security may have a direct financial impact on the shareholders or bondholders; Other corporate actions such as stock split may have an indirect impact, as the increased liquidity of shares may cause the price of the stock to rise. Some corporate actions such as name change have no direct financial impact on the shareholders.
How are corporate actions processed?
The details of all possible corporate actions need to be recorded. Corporate actions processing is a complicated, non-standardized, and, to a large extent, manual process. In cases where benefits are predictable at the outset from the static data repository, it’s important that the data is accurate, whether it is sourced from the issuer’s prospectus, the custodian, or data providers. Some institutions utilize third parties to provide them with independent notification at the time a benefit is due from an unpredictable announced event, while others rely on their custodians to provide the detail. Despite this, processing failures can arise in the corporate action chain due to problems with the flow of downstream information (from issuers to investors) or upstream information (from investors to issuers).
Types
Corporate actions are classified as Voluntary, Mandatory and Mandatory with Choice corporate actions.
Mandatory Corporate Action : A mandatory corporate action is an event initiated by the corporation by the board of directors that affects all shareholders. Participation of shareholders is mandatory for these corporate actions. An example of a mandatory corporate action is cash dividend. All holders are entitled to receive the dividend payments, and a shareholder does not need to do anything to get the dividend. Other examples of mandatory corporate actions include stock splits, mergers, pre-refunding, return of capital, bonus issue, asset ID change, pari-passu and spinoffs. Strictly speaking the word mandatory is not appropriate because the share holder per se doesn't do anything. In all the cases cited above the shareholder is just a passive beneficiary of these actions. There is nothing the Share holder has to do or does in a Mandatory Corporate Action.
Voluntary Corporate Action : A voluntary corporate action is an action where the shareholders elect to participate in the action. A response is required by the corporation to process the action. An example of a voluntary corporate action is a tender offer. A corporation may request share holders to tender their shares at a pre-determined price. The shareholder may or may not participate in the tender offer. Shareholders send their responses to the corporation's agents, and the corporation will send the proceeds of the action to the shareholders who elect to participate.
Sometimes a voluntary corporate action may give the option of how to get the proceeds of the action. For example in case of a cash/stock dividend option, the shareholder can elect to take the proceeds of the dividend either as cash or additional shares of the corporation. Other types of Voluntary actions include rights issue, making buyback offers to the share holders while delisting the company from the stock exchange etc.
Mandatory with Choice Corporate Action : This corporate action is a mandatory corporate action where share holders are given a chance to choose among several options. An example is cash/stock dividend option with one of the options as default. Share holders may or may not submit their elections. In case a share holder does not submit the election, the default option will be applied.
Splits, dividends, mergers and acquisitions,rights issue and spinoffs are all examples of corporate actions.
Type of Impact
Some corporate actions such as a dividend (for equity securities) or coupon payment (for debt securities (bonds)) or call (early redemption) of a debt security may have a direct financial impact on the shareholders or bondholders; Other corporate actions such as stock split may have an indirect impact, as the increased liquidity of shares may cause the price of the stock to rise. Some corporate actions such as name change have no direct financial impact on the shareholders.
How are corporate actions processed?
The details of all possible corporate actions need to be recorded. Corporate actions processing is a complicated, non-standardized, and, to a large extent, manual process. In cases where benefits are predictable at the outset from the static data repository, it’s important that the data is accurate, whether it is sourced from the issuer’s prospectus, the custodian, or data providers. Some institutions utilize third parties to provide them with independent notification at the time a benefit is due from an unpredictable announced event, while others rely on their custodians to provide the detail. Despite this, processing failures can arise in the corporate action chain due to problems with the flow of downstream information (from issuers to investors) or upstream information (from investors to issuers).
Types
Corporate actions are classified as Voluntary, Mandatory and Mandatory with Choice corporate actions.
Mandatory Corporate Action : A mandatory corporate action is an event initiated by the corporation by the board of directors that affects all shareholders. Participation of shareholders is mandatory for these corporate actions. An example of a mandatory corporate action is cash dividend. All holders are entitled to receive the dividend payments, and a shareholder does not need to do anything to get the dividend. Other examples of mandatory corporate actions include stock splits, mergers, pre-refunding, return of capital, bonus issue, asset ID change, pari-passu and spinoffs. Strictly speaking the word mandatory is not appropriate because the share holder per se doesn't do anything. In all the cases cited above the shareholder is just a passive beneficiary of these actions. There is nothing the Share holder has to do or does in a Mandatory Corporate Action.
Voluntary Corporate Action : A voluntary corporate action is an action where the shareholders elect to participate in the action. A response is required by the corporation to process the action. An example of a voluntary corporate action is a tender offer. A corporation may request share holders to tender their shares at a pre-determined price. The shareholder may or may not participate in the tender offer. Shareholders send their responses to the corporation's agents, and the corporation will send the proceeds of the action to the shareholders who elect to participate.
Sometimes a voluntary corporate action may give the option of how to get the proceeds of the action. For example in case of a cash/stock dividend option, the shareholder can elect to take the proceeds of the dividend either as cash or additional shares of the corporation. Other types of Voluntary actions include rights issue, making buyback offers to the share holders while delisting the company from the stock exchange etc.
Mandatory with Choice Corporate Action : This corporate action is a mandatory corporate action where share holders are given a chance to choose among several options. An example is cash/stock dividend option with one of the options as default. Share holders may or may not submit their elections. In case a share holder does not submit the election, the default option will be applied.
Settlement
Settlement (of securities/bonds or in FX market) is a business process whereby securities or interests in securities are delivered, usually against (in simultaneous exchange for) payment of money, to fulfill contractual obligations, such as those arising under securities trades.
Nature of Settlement -
There are 2 ways of payment in case of settlement.
1. Delivery versus payment(DVP) in which transfer of security takes place for payment or any other financial asset.
2. Free of payment (FOP) - Here first delivery of securities takes place and later on payment is done. Here 1 party takes risk of not getting anything at all.
Settlement cycles
US and UK have T+3 days for Equities but for bonds they have T+1 days for bonds.
Japan has T+3 days for both bonds and Equities.
Germany T+2 days
Greater the number of business days, greater the risk.
In case of FX market it takes T+2 day mainly.
Settlement date
Settlement date
Transfer of legal ownership of a bond/shares move from the seller to the buyer on the intended settlement date. This should be before value date.
Trade settlement process
Step 1: Settlement instructions
Although agreement may have been confirmed on a trade with the client, the actual process of exchanging bonds/cash cannot take place until a settlement instruction has been issued to the custodian. Its better if standard settlement instructions (SSIs) are used. The settlement instructions are generally transmitted from bank's settlement system via a secure method such as SWIFT.
Step 2: Settlement process
Upon receipt or ack of settlement instructions, the custodian tries to match the instruction sent by the counterparty to its custodian. It then returns the settlement status.
Step 3 : Settlement status
Depending on the settlement status, either the settlement is done or there is settlement failure.
In case some problem occurs there is settlement failure due to settlement not done till value date. See here for more on settlement failure.
Settlement status
There are various pre-value date settlement status:
- Matched settlement instructions - If custodian finds everything in order, then status is matched. Then both parties are advised of the status and instructions are kept by custodian till value date.
- Unmatched settlement instructions - If custodian finds any discrepancies, the status is advisory and this is issued to both parties. These are investigated immediately with priority given to those close to value date or having higher net cash value settlement amounts.
- Advisory settlement instructions
- Settled instructions
Settlement Process
Upon receipt (and acknowledgement) of the settlement instruction, the custodian tries to match the instruction with the instruction sent by the counterparty to its custodian. The process of comparing counterparties to a trade can be accomplished in various ways:
Whichever process is used, there are a number of different pre-value date settlement statuses that can arise following such action.
- in the marketplace in which the trade occurs (for example, locked-in trades)
- through custodians
- through clearing firms
- on a trade-by-trade basis
Whichever process is used, there are a number of different pre-value date settlement statuses that can arise following such action.
Settlement instructions
Settlement instructions are normally transmitted from bank's settlement system via some secure method like SWIFT.
System Used
Rather than using transmitting settlement instructions to the custodian from counterparty's system, it can send in an automated way by the authorized third party directly to custodian. This reduces risk of issuing any wrong settlement instruction of trade.
Content of Instruction include
Names - of issuer, issuer's custodian, counter-party, counter-party's custodian
Dates - value/settlement date
Account numbers - of both custodian in deal
Settlement basis - DVP or FOP
Quantity of bonds and net cash settlement value
Information related to securities - security identifier, iso code of currency
System Used
Rather than using transmitting settlement instructions to the custodian from counterparty's system, it can send in an automated way by the authorized third party directly to custodian. This reduces risk of issuing any wrong settlement instruction of trade.
Content of Instruction include
Names - of issuer, issuer's custodian, counter-party, counter-party's custodian
Dates - value/settlement date
Account numbers - of both custodian in deal
Settlement basis - DVP or FOP
Quantity of bonds and net cash settlement value
Information related to securities - security identifier, iso code of currency
Static data involved with fixed income securities (or bonds)
These are the type of static data included as the part of the bond grouping are:
- Day count basis :
Eg. actual/actual for UK, 30/360 for US corporate bonds - Settlement cycle :
T+1 for US treasuries, T+3 for Eurobonds - Location of Settlement
Fedwire Securities services for US treasuries, ICSDs(Euroclear/Clearstreams) for Eurobonds, CREST for UK Corporate bonds
Formal recording of trade : Trade capturing
All executed bond trades must be formally recorded. In case of electronic communication , these details are automatically captured.
Details of Trade execution
There can be various things involved in it:
Now the Bonds can be identified by unique in-house number or globally used 12-character alphanumerical code called ISIN number.
In it 1st 2 characters imply country eg. US for US bonds, XS for Eurobond
Next 9 characters represents national securities identification number.
Last character verifies the code.
Security identifier are stored as static data repository.
Flow of trade capturing
1. Trade execution - which is done in the front office.
2. Reconciliation - This is done to check if all the trading details have arrived in the back office from the front office. If some trade details is missing, they are requested again.
3. Validation - Validation of trade is done. If something is invalid is found it is dealt with manually. These are dealt with 'exception'.
4. Settlement - Once all the above steps are done, settlement is fixed and assigned a reference number in the settlement system.
Details of Trade execution
There can be various things involved in it:
- Type of instrument
- Price
- Transaction : buy or sell
- Counterparty details
- Trade date and time and value/settlement date
Now the Bonds can be identified by unique in-house number or globally used 12-character alphanumerical code called ISIN number.
In it 1st 2 characters imply country eg. US for US bonds, XS for Eurobond
Next 9 characters represents national securities identification number.
Last character verifies the code.
Security identifier are stored as static data repository.
Flow of trade capturing
1. Trade execution - which is done in the front office.
2. Reconciliation - This is done to check if all the trading details have arrived in the back office from the front office. If some trade details is missing, they are requested again.
3. Validation - Validation of trade is done. If something is invalid is found it is dealt with manually. These are dealt with 'exception'.
4. Settlement - Once all the above steps are done, settlement is fixed and assigned a reference number in the settlement system.
Primary Market - Syndicate Pricing and Underwriting
Pricing and Underwriting Practices
On the primary market, borrowers may entrust syndicates with the task of trading their bonds. Syndicates consist of large investment banks that agree to purchase the entire bond issue from the borrower and resell it to investors. In this way, the issuer avoids the risk of being left with unsold securities.
Fees and Expenses
Syndicate members buy the issue from the borrower at a discount. This discount represents the par value of the issue minus the underwriting fees. In this way, they make a profit when they sell the issue to investors at par.
The underwriting fees of a new bond issue can be flexible or fixed, depending on the type of deal and the market. Underwriting fees usually consist of:
Practices for pricing and underwriting a new bond
When pricing and underwriting a new bond issue, there are a number of practices followed by the syndicate members.
Traditional Open Pricing
In traditional open pricing, the underwriters have the ability to change the price and coupon any time up to the offering day – the day the bond is put on the market. This is to minimize any losses due to changes in market sentiment during the subscription period – i.e., the period from announcement day to offering day.
After analyzing the 'book', if it is found that there is more demand for the issue than supply, the price or coupon can be changed in the issuer's favor. If, prior to the offering day, the issuer is unhappy with pricing, the issue can be canceled.
Bought Deal
A bought deal is an offering in which the underwriters or syndicate purchase the entire bond issue and resell it. This only happens if underwriters are confident they can sell the bonds. The Eurobond market often operates on the bought deal basis.
The issuer approaches issuing houses giving details of the type of issue it wants and requesting bids at a fixed price. The period between the request and having to submit a bid is normally only a few hours.
After a bid has been accepted, the issuing house is the legal owner of the issue and is obliged to purchase the issue from the borrower at the quoted fixed price, even if market conditions change.
Often with the bought deal, the lead manager – usually a large global securities house – doesn't syndicate the issue. Instead, it places the entire issue itself. If it does syndicate the deal, it quickly spreads the risk between syndicate members. This process has made the market for new issues extremely competitive and concentrated.
In the case of the bought deal, there is no flexibility in the pricing of the issue during the subscription period. Fear of adverse market conditions can also result in the subscription period being brought forward.
Pre-Priced Deal
A pre-priced deal is very similar to a bought deal. In a pre-priced deal, the price is agreed between the underwriter and the borrower immediately prior to launch.
The issue is then syndicated in the same manner as an open priced issue except that there is generally no, or only a very short selling period.
Fixed Price Re-offer
Fixed price re-offer refers to a syndicate discipline, strongly enforced on the US market, where the underwriting banks agree to sell bonds to investors at no less than an agreed price. This method is mainly used to sell large issues to institutional investors.
The fixed price is usually maintained for 24 hours after the offering. This practice ensures transparency in the primary market – investors are assured that they cannot get the bonds cheaper from another dealer while the issue is in syndication.
For the issuer, the fixed price re-offer method has the advantage of lower underwriting fees.
Price Stabilization
Lead managers support trading in the primary market immediately after the offering. The issue price is stabilized using a stabilization fund that is taken account of in the fees charged to the issuer. The lead manager will buy back bonds that are under selling pressure and sell bonds to the market when there is excess demand.
The issue is only allowed to move within a certain price range over a given period. In order to achieve this, the lead manager allots bonds to the syndicate, either in excess of or falling short of the full issue amount.
By over-allotting the issue, going short, the lead manager must buy back bonds from the market to cover the short position. By going long, the lead manager will hold the remaining bonds for sale in the secondary market to satisfy excess investor demand. Through these activities the price is stabilized.
On the primary market, borrowers may entrust syndicates with the task of trading their bonds. Syndicates consist of large investment banks that agree to purchase the entire bond issue from the borrower and resell it to investors. In this way, the issuer avoids the risk of being left with unsold securities.
Fees and Expenses
Syndicate members buy the issue from the borrower at a discount. This discount represents the par value of the issue minus the underwriting fees. In this way, they make a profit when they sell the issue to investors at par.
The underwriting fees of a new bond issue can be flexible or fixed, depending on the type of deal and the market. Underwriting fees usually consist of:
- Management Fee
- Selling Concession
- Underwriting fee
- Legal Cost
- Printing Cost
Practices for pricing and underwriting a new bond
When pricing and underwriting a new bond issue, there are a number of practices followed by the syndicate members.
- Traditional open pricing
- Bought deal
- Pre-priced deal
- Fixed price re-offer
- Pot deal
- Price stabilization
Traditional Open Pricing
In traditional open pricing, the underwriters have the ability to change the price and coupon any time up to the offering day – the day the bond is put on the market. This is to minimize any losses due to changes in market sentiment during the subscription period – i.e., the period from announcement day to offering day.
After analyzing the 'book', if it is found that there is more demand for the issue than supply, the price or coupon can be changed in the issuer's favor. If, prior to the offering day, the issuer is unhappy with pricing, the issue can be canceled.
Bought Deal
A bought deal is an offering in which the underwriters or syndicate purchase the entire bond issue and resell it. This only happens if underwriters are confident they can sell the bonds. The Eurobond market often operates on the bought deal basis.
The issuer approaches issuing houses giving details of the type of issue it wants and requesting bids at a fixed price. The period between the request and having to submit a bid is normally only a few hours.
After a bid has been accepted, the issuing house is the legal owner of the issue and is obliged to purchase the issue from the borrower at the quoted fixed price, even if market conditions change.
Often with the bought deal, the lead manager – usually a large global securities house – doesn't syndicate the issue. Instead, it places the entire issue itself. If it does syndicate the deal, it quickly spreads the risk between syndicate members. This process has made the market for new issues extremely competitive and concentrated.
In the case of the bought deal, there is no flexibility in the pricing of the issue during the subscription period. Fear of adverse market conditions can also result in the subscription period being brought forward.
Pre-Priced Deal
A pre-priced deal is very similar to a bought deal. In a pre-priced deal, the price is agreed between the underwriter and the borrower immediately prior to launch.
The issue is then syndicated in the same manner as an open priced issue except that there is generally no, or only a very short selling period.
Fixed Price Re-offer
Fixed price re-offer refers to a syndicate discipline, strongly enforced on the US market, where the underwriting banks agree to sell bonds to investors at no less than an agreed price. This method is mainly used to sell large issues to institutional investors.
The fixed price is usually maintained for 24 hours after the offering. This practice ensures transparency in the primary market – investors are assured that they cannot get the bonds cheaper from another dealer while the issue is in syndication.
For the issuer, the fixed price re-offer method has the advantage of lower underwriting fees.
Price Stabilization
Lead managers support trading in the primary market immediately after the offering. The issue price is stabilized using a stabilization fund that is taken account of in the fees charged to the issuer. The lead manager will buy back bonds that are under selling pressure and sell bonds to the market when there is excess demand.
The issue is only allowed to move within a certain price range over a given period. In order to achieve this, the lead manager allots bonds to the syndicate, either in excess of or falling short of the full issue amount.
By over-allotting the issue, going short, the lead manager must buy back bonds from the market to cover the short position. By going long, the lead manager will hold the remaining bonds for sale in the secondary market to satisfy excess investor demand. Through these activities the price is stabilized.
Quote driven and order driven
In quote driven markets, the market makers continuously quote binding bids and offer prices for certain bonds.
Eg. Nasdaq
With order driven markets, buy and sell orders are compared and matched in order book. Large order deals generally take place on phone.
Eg. London Stock Exchange’s SETS trading service
Eg. Nasdaq
With order driven markets, buy and sell orders are compared and matched in order book. Large order deals generally take place on phone.
Eg. London Stock Exchange’s SETS trading service
Primary bond market
There is a certain process of offering these bonds for the first time in the primary bond market. The process of offering bonds to the public are similar to the offering of the stock. For the purpose of offering bond in the primary market, a company or a firm needs to take help of an investment bank.
The investment bank provides all the necessary experience and expertise for the purpose. The investment bank provides its suggestions regarding the creation of the issue. At the same time, the bank also provides an estimate of the expected yield from the issue. The maturity period of the bond is also suggested by these banks. The bank also helps in selling the bonds in the primary bond market. At the same time, the bank may also purchase the whole issue through firm commitment underwriting.
For the marketing of the new issue in the primary bond market, the investment bank uses its own network. The bank forms a syndicate or at certain times, forms a selling group, to sell the bonds to the investors through the primary bond market. The institutional investors or the individual investors lends their money to the particular company through these bonds. Once these are purchased from the primary bond market, these can be further traded in the secondary bond market.
These bonds provide a fixed income source to the investor. At the same time, the offering companies or the government also gets the very necessary money for their projects.
Issuing of bonds:
The issuing methods for government and non-government bonds differ considerably on the primary market.
In general,
Public Placement
Public placement is when an issue of bonds is offered to institutional and individual investors through a securities house.
Private Placement
Private placement is when an issue of bonds is offered to a limited number of investors.
Issuing Government Bonds
Issue Form
Most government bonds are issued in book-entry form. This means that there is no certificate of ownership. Instead, transactions are recorded in the issuer's and investor's accounts or by a clearing house.
Issue Method
Government bonds are generally issued by auction. Auctions are typically dominated by specialist government bond dealers, whose job it is to distribute government bonds on the primary market and make secondary markets.
There are two types of auction:
Single price
Some primary markets issue government bonds in single-price auctions. In traditional auctions, prices rise and items are sold to the highest bidders. In single-price auctions, prices fall and bonds are sold to all bidders at the same price – the highest accepted yield bid or the lowest accepted price bid that will clear the auction.
In a single-price auction, the authority in charge of selling government bonds sets an exceptionally high price per bond. It then lowers the price until someone bids. It continues to lower the price until someone else bids, and so the process continues until the entire issue has been spoken for.
Bidders are allocated the bonds for which they bid. However, they all pay the lowest bid price per bond – the price submitted by the last bidder.
Example
Let's say the first bidder bid USD 99 per bond, the second bidder bid USD 98.80 per bond, and the last bidder bid USD 98.75 per bond.
All bidders would be sold the bonds at USD 98.75 regardless of how much they bid.
Multiple price
Most government bonds are issued in multiple-price auctions.
In a multiple price auction, the issuer accepts the best bids until the issue is fully allocated. Bidders are awarded bonds at the price they bid. The prices bid by other participants and the minimum price are not known. In this way, multiple price auctions encourage higher bids.
At multiple-price auctions, bids can be placed on a price basis or on a yield basis and can be competitive or non-competitive.
Issuing Non-Government Bonds
SMALL ISSUES
On the primary market, small issues of non-government bonds are usually sold by private placement. With private placement, the issuer, or an agent acting on behalf of the issuer, offers the bonds to a limited number of investors.
Private placements are less expensive than public placements and avoid delays and legal complications.
LARGE ISSUES
On the primary market, large issues of non-government bonds are generally sold by public placement. With public placement, issues are distributed to an unlimited number of investors by one or more investment banks acting on behalf of the issuer.
Most bonds on the primary market are issued by public placement.
STAGES IN ISSUANCE OF NON-GOVT BONDS
The investment bank provides all the necessary experience and expertise for the purpose. The investment bank provides its suggestions regarding the creation of the issue. At the same time, the bank also provides an estimate of the expected yield from the issue. The maturity period of the bond is also suggested by these banks. The bank also helps in selling the bonds in the primary bond market. At the same time, the bank may also purchase the whole issue through firm commitment underwriting.
For the marketing of the new issue in the primary bond market, the investment bank uses its own network. The bank forms a syndicate or at certain times, forms a selling group, to sell the bonds to the investors through the primary bond market. The institutional investors or the individual investors lends their money to the particular company through these bonds. Once these are purchased from the primary bond market, these can be further traded in the secondary bond market.
These bonds provide a fixed income source to the investor. At the same time, the offering companies or the government also gets the very necessary money for their projects.
Issuing of bonds:
The issuing methods for government and non-government bonds differ considerably on the primary market.
In general,
- government bonds are issued by auction, and
- non-government bonds are issued by public placement or private placement .
Public Placement
Public placement is when an issue of bonds is offered to institutional and individual investors through a securities house.
Private Placement
Private placement is when an issue of bonds is offered to a limited number of investors.
Issuing Government Bonds
Issue Form
Most government bonds are issued in book-entry form. This means that there is no certificate of ownership. Instead, transactions are recorded in the issuer's and investor's accounts or by a clearing house.
Issue Method
Government bonds are generally issued by auction. Auctions are typically dominated by specialist government bond dealers, whose job it is to distribute government bonds on the primary market and make secondary markets.
There are two types of auction:
Single price
Some primary markets issue government bonds in single-price auctions. In traditional auctions, prices rise and items are sold to the highest bidders. In single-price auctions, prices fall and bonds are sold to all bidders at the same price – the highest accepted yield bid or the lowest accepted price bid that will clear the auction.
In a single-price auction, the authority in charge of selling government bonds sets an exceptionally high price per bond. It then lowers the price until someone bids. It continues to lower the price until someone else bids, and so the process continues until the entire issue has been spoken for.
Bidders are allocated the bonds for which they bid. However, they all pay the lowest bid price per bond – the price submitted by the last bidder.
Example
Let's say the first bidder bid USD 99 per bond, the second bidder bid USD 98.80 per bond, and the last bidder bid USD 98.75 per bond.
All bidders would be sold the bonds at USD 98.75 regardless of how much they bid.
Multiple price
Most government bonds are issued in multiple-price auctions.
In a multiple price auction, the issuer accepts the best bids until the issue is fully allocated. Bidders are awarded bonds at the price they bid. The prices bid by other participants and the minimum price are not known. In this way, multiple price auctions encourage higher bids.
At multiple-price auctions, bids can be placed on a price basis or on a yield basis and can be competitive or non-competitive.
Issuing Non-Government Bonds
SMALL ISSUES
On the primary market, small issues of non-government bonds are usually sold by private placement. With private placement, the issuer, or an agent acting on behalf of the issuer, offers the bonds to a limited number of investors.
Private placements are less expensive than public placements and avoid delays and legal complications.
LARGE ISSUES
On the primary market, large issues of non-government bonds are generally sold by public placement. With public placement, issues are distributed to an unlimited number of investors by one or more investment banks acting on behalf of the issuer.
Most bonds on the primary market are issued by public placement.
STAGES IN ISSUANCE OF NON-GOVT BONDS
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