Intervention Strasbourg
Intervention Strasbourg
Global Bank
Commodities Legal
Coverage IT
INTRO TO CONVENTIONAL 3
FINANCE
Structure of a Global Bank
• Retail banking: Provides traditional services to Individual and Small & Medium
Enterprises (SME) (Current account management, Loans and savings accounts,
Forex transactions, Developing financial solutions for financing and Investment)
• Asset Management, Private banking and securities services: Combining
activities related to the collection, management, development and
administration of client savings and assets for all type of clients: individual,
corporate and institutional investors:
– Asset Management: provides a range of funds and serves different type of
clients.
– Private Banking: Offers wealth management solutions to entrepreneurs and
High Net Worth Individuals.
– Securities Services: provides a full range of post-trade solutions to all
investment cycle players: clearing services, custody services, liquidity
management, fund administration and fund distribution.
• Corporate & Investment Banking: Provides financing, advisory and capital markets
services to corporates, financial institutions and investment funds. It has a role of
intermediary between issuers and investors:
– Corporate Finance: Brings to its clients solutions on Mergers and
acquisitions, Primary equity capital markets transactions, Financial
engineering and balance sheet restructuring.
– Structured Finance: designs financing solutions for its client. It manages the
full spectrum from origination, structuring and underwriting to distribution
on the loan syndications markets. They provide a wide array of products
from short term trade loans to medium and long term facilities, from
corporate lending to sophisticated financial solutions.
– Coverage: It provides its corporate clients with day-to-day corporate banking
services (financing, cash management and trade solutions ) via Senior
Bankers and Customer Relationship Managers. This division provides the
whole range of products and tailor-made solutions from different businesses
of the Bank.
INTRO TO 5
CONVENTIONAL FINANCE
Structure of a Global Bank
• Functions: These are the support or enablement units that support all the
business lines in their day-to-day business to ensure the bank activities are in line
with the board strategy, the shareholders expectation and the regulations in
place.
– Risk management: the role of this unit is monitor the risks taken by the bank
businesses to ensure that (a) they are in line with the risk appetite of the
bank and (b) they are reasonable and don’t expose the bank to a huge
financial risk
– Internal audit: this unit is generally mandated by the board directly. Its role
to ensure the all departments are operating to the highest standards and
detect any malfunction or wrongdoing within the bank.
– Finance: this unit is the one in charge of the accounting and the financial
statements of the bank. They have to ensure that the balance sheet of the
bank is well represented and balanced.
– Legal: this is the unit that will ensure that we respect all the compliance rules
either those internal or external ones. Their main role is that the bank
operates per the mandate and regulations imposed by their jurisdiction.
The focus on the rest of the course will be on the CIB unit activities
Client trough
Brokers Structuring Coverage team
Quant
Trader: takes and manages positions through purchases and sales of securities and
derivatives. She carries out position hedging and anticipates market movements.
Sales: promotes and sells products to his clients. He develops business with new
clients, expands relationships with existing ones, offers them tailored financial
solutions, and works with Structuring to create new products.
Structuring: is responsible to quote structures for all derivatives sales teams. She
defines and promotes new products tailored to the demands of investors. She
implements the quantitative analysis required for the sale of these products and she
analyses their risk profile.
A financial market is a place where the buyers and sellers of various financial
instruments/products come together to try to match their respective needs. The
range of instruments trades on such market is very wide and varies from simple loan
products to very complex exotic structures.
The sellers will be typically institutions/individuals with assets/cash they would like
to invest to generate high yield. On the opposite, the buyers will be
institutions/individuals who are in need of cash or asset for their business activities
(e.g. funding a specific project).
The size of financial markets is huge, amounts to hundreds (or even thousands) of
trillion dollars, split over big global financial centres.
The below table is the ranking as of Sept 2015:
The crisis the world experienced in the recent years started with difficulties/defaults
in the US subprime mortgages, which then led to unprecedented difficulties across
the global financial system. As a result, huge losses were incurred by many
institutions. The contagion effect took the crisis from US Subprime mortgage to
other products, leading to even more losses.
With losses mounting, banks were suspecting that their peer banks might have
more losses and thus they became fearful of lending to each other, which pushed to
a liquidity dry up, causing the bankruptcy of some institutions notably Lehman
Brothers.
For this reason, the regulations became very strict over the last years, the objective
being to ensure financial markets stability
The crisis the world experienced in the recent years started with difficulties/defaults
in the US subprime mortgages, which then led to unprecedented difficulties across
the global financial system. As a result, huge losses were incurred by many
institutions. The contagion effect took the crisis from US Subprime mortgage to
other products, leading to even more losses.
With losses mounting, banks were suspecting that their peer banks might have
more losses and thus they became fearful of lending to each other, which pushed to
a liquidity dry up, causing the bankruptcy of some institutions notably Lehman
Brothers.
For this reason, the regulations became very strict over the last years, the objective
being to ensure financial markets stability
• Other Financial Institutions: This refers to financial institutions other than the
traditional financial dealer institutions. The category includes smaller banks that
do not act as dealers in the Equity, IR&FX market, institutional investors, hedge
funds, and proprietary trading firms.
In this type of transactions, you have two sides: a counterparty that needs to
raise cash to fund some their projects/expenditure and a counterparty that have
excess in cash and is ready to provide funds in exchange of a return higher the
base one.
The company that needs to raise funds can do it in two ways:
Equity funding: Issue shares/stocks
Funding via debt : this covers both normal loans and debt securities
Equity funding:
The company will increase its capital and issues new shares/stocks that will be
bought by some shareholders. However, this involves sharing the ownership of a
company with the new stockholder. This could also mean giving the new
shareholders voting rights in the company which would allow them –to some
extent- decide on the future strategy of the company.
Under the equity funding, the value of the raised funds can go higher/lower
than their initial value depending on the market value of the shares.
Securities in the money markets include treasury bills (T-bill), commercial paper (CP)
and certificates of deposit (CD). These securities are negotiable
instruments and can be traded in the secondary market.
Government bills:
Governments borrow cash to fund the running of their economies. They borrow
by selling debt to investors (lenders). The majority of this debt is issued in the
form of marketable debt instruments whose maturities range from 3 months up
to 30 years.
• At the short end, maturities of less than 12 months, the government debt
instruments are known as treasury bills although individual countries have their
own terminology. Some examples include:
- Treasury bills/Tbills (US, UK, Singapore, and Canada)
- Treasury discount bills (Japan)
- Treasury discount paper/Bubills (Germany)
Treasury bills are offered in Auction on regular basis (weekly for the US and the UK).
In the US they are managed by “Department of the Treasury” and in the UK, they are
managed by “Debt Management Office”
• The T-bill, CPs and CDs are form of loans and deposits. They guarantee the
payment of the nominal invested + some interest rate.
• In a loan/deposit of less than 1Y, the amount of money you will receive/pay is:
Notional*(1+AnnualRate*LoanTermExpressedAsFractionOfYear)
e.g. if you borrow 100$ for 3 months at a 4% annual rate, then you have to
pay 100$(1+*4%*1/4)=101$
• Now let’s spend some time on this: the rate that you will be paying/receiving is
known from the definition of the instrument. The notional is known as well. The
main ingredient in the fraction of the year on which you will borrow/lend.
• There are standardised rules how to calculate the fraction of the year that will be
used to computed the interest amount. These are known as day count fraction
rules.
• E.g. if the basis is “ACT/365”, then the fraction of the year that will serve as the
basis of calculation will be the number of days between two dates divided by
365. We can also have “ACT/360” when the division will be on 360. We also have
a “30/360” basis on the market where each month is considered to have 30 days.
The difference in calculation can lead to significant money difference (cf. Excel)
• Because these products are redeemed at par, the initial price is:
Notional/(1+AnnualRate*LoanTermExpressedAsFractionOfYear)
• Now what happens after the initial issuance?
• These instruments are then traded in the secondary market that will define their
price based on the bid/ask quotes.
• The price will obviously change depending on market conditions and the new
price will reflect the new discounting factor for each contract
Bonds:
• A bond, is a contract where the issuer of the bond (borrower) has committed to
pay certain cash flows in the future to the various bondholders (investors).
• The borrower delivers to the lender a title in exchange of money:
• The borrower has the obligation to repay the money he borrowed, on terms
agreed upon in advance, which may take the form of a cash flow schedule.
• A bond is characterized by:
– The issuer: the borrower of the funds. It can be a government or a corporate
or even individuals (although very rare)
– The nominal amount: also known as the face value or the principal. This is
the amount of funds borrowed initially and that need to be repaid at
maturity.
– The nominal interest rate: aka as the coupon. This is the annual interest rate
to be paid
– The maturity: This is the final exchange date
– The payment schedule of Coupons: the pay dates for interest and Nominal
Bonds:
• Bond Market Key Players:
- Governments: ~45%
- Financial Institutions: ~40%
- Corporates: ~ 15%
8.00% 100%
90%
7.00%
80%
6.00%
Coupons
70%
Notional
5.00%
60%
4.00% 50%
40%
3.00%
30%
2.00%
20%
1.00%
10%
Bonds:
120
100
16
Interest Capital
14
Equal reimbursement of 12
10
principal: Each year, the issuer 8
nominal (+ coupons) 2
0
1 2 3 4 5 6 7 8 9 10
12
8
payments (principal + 6
interest) are equal. 4
0
1 2 3 4 5 6 7 8 9 10
120
100
Interest
Zero-coupon: There is only 80
Capital
20
0
1 2 3 4 5 6 7 8 9 10
Pricing of Bonds:
Pricing of Bonds:
Pricing of Bonds:
100+C
C C C C
Y1 Yn
Pricing of Bonds:
- Accrued interest: The interest that has accumulated since the previous interest
payment date.
- Between two coupon dates the price increases due to the time and not
necessary due to Interest rates movement.
- At the coupon date, the bond price falls by approximately the value of the
coupon.
- These price changes are unrelated to market changes. They make the price
monitoring difficult, so they must be removed.
- Clean price is the right one to look at in order to remove time effect. It is the
reference price for quotation.
100%
85%
80%
75%
70%
0 1 2 3 4 5 6 7 8 9 10
Concept of Yield:
- The Yield To Maturity (YTM) is the interest rate that will make the present value of
the cash flows equals to the price of the bond.
- The YTM is computed in the same way as the Internal Rate of Return (IRR), the cash
flows are those that the investor would realize by holding the bond to maturity.
- It allows to compare the return of two bonds with different coupons and
maturities, where comparing their prices is not relevant.
n
Ct N
P t 1 (1 y ) t
(1 y ) n
Where :
P = price of the bond
C = Coupon
N = Nominal
n = number of years
y = YTM
- If a bond is bought at par value, then the YTM is equal to the coupon rate.
- If a bond is bought at a discount, then the YTM will be higher than the coupon
rate.
- If a bond is bought at a premium, then the YTM will be lower than the coupon
rate.
Examples in Excel: the 25th October 2015, what is the YTM of a classic bond, coupon
rate 8.50 %, expiry date 25th October 2022 and price 117% ?
YTM = ?
Examples in Excel: the 25th October 2015, what is the YTM of a classic bond, coupon
rate 5 %, expiry date 25th October 2022 and price 99% ?
YTM = ?
Concept of Z-spread:
- What affects bond prices?: Bond prices change depending on the interest rates
change on the market and on the credit quality of the issuer
- The Yield To Maturity (YTM) can be seen as a measure of the credit quality of
the issuer.
- Another way to see it is to say that the discounting rate we are using is the sum
of two parts: risk-free rate at each pay date + spread. This spread is called Z-
spread
- Z spread is the amount by which the discount rate would need to exceed the
return of the benchmark bonds in order for the present value to equal the
market price
- Let R1,R2,..,Rn be the Zero Coupon rates of the benchmark curve
- Then Z spread Z is the rate so that :
C C C M
P 2
...
(1 R1 Z ) (1 R2 Z ) (1 Rn Z ) (1 Rn Z ) n
n
• The foreign exchange market is the global market for the exchange (or trading) of
individual currencies.
• The FX market is a very active market with wide range of trading hours (almost
24H a day – 7days a week)
• The FX market is an over-the-counter (OTC) market where banks and other
market participants trade currencies around the clock (except at weekends). The
size and liquidity of this market is enormous. The most recent Triennial Central
Bank Survey by the Bank for International Settlements (BIS) found that average
daily turnover in the FX market was in excess of USD 5.3 trillion (an average of
USD 220 billion every hour).
• To give this figure some perspective, the following charts show that the global FX
market is a multiple of the largest domestic markets, such as the US stock and
bond markets. Average daily turnover for the US equity market is around USD
130 billion, while that of the US bond market is just under USD 700 billion.
INTRO TO 44
CONVENTIONAL FINANCE
Intro to FX markets
FX Market is a more active market
INTRO TO 45
CONVENTIONAL FINANCE
FX non-optional products
FX SPOT:
A spot FX quote is the cost of one currency in terms of another currency. Using
euro/US dollar as an example, an FX quote will usually be written in the form of:
EUR/USD 1.1090/95. [FX usually quotes in 4 digits].
The first currency code, EUR in this case, is known as the foreign currency (or base
currency). The second currency code, USD in this case, is known as the domestic
currency (sometimes referred to as quoted or terms currency).
The first quote is the bid and the second one is the offer (or ask): If you want to buy
1EUR, you will have to pay 1.1095USD and if you sell 1EUR, you will get one
1.1090USD only.
A FX Spot transaction has always spot execution lag i.e. the time between the
transaction agreement and the effective exchange of flows. The spot lag is defined
per currency pair but it is usually 2 business days.
The date on which the effective exchange of cashflows happens is called Spot Date
INTRO TO 46
CONVENTIONAL FINANCE
FX non-optional products (2)
FX FORWARD:
The tenors traded on the forwards generally range from overnight to 12M (we could
also find maturities up to 18M/2Y for some ccy pairs).
The FX Forward are quoted in swap points (also know as forward points). The swap
points are the difference between the FX Forward rate and the FX spot rate.
e.g. EURUSD 1M forward will quote at mid: 4.5 swap points. It means that the bid/ask
for EURUSD in 1M will be: Spot+4.5/10000
IR Derivatives Market :
INTRO TO 48
CONVENTIONAL FINANCE
Main benchmark interest rates
LIBOR or ICE LIBOR (formerly known as BBA LIBOR) stands for London Interbank Offered
Rate: is the rate at which the most creditworthy banks are ready to lend (unsecured)
money to each other for a specified period of time. It is a benchmark rate produced for
five currencies (EUR, GBP, CHF, JPY and USD) with seven maturities quoted for each -
ranging from overnight to 12 months, producing 35 rates each business day. ICE
Benchmark Administration maintains a reference panel of between 11 and 18 contributor
banks for each currency calculated.
EURIBOR (European Interbank Offered Rate): It is based on the interest rates at which a
panel of European banks (~24) borrow funds from one another for a specific set of
maturities. In the calculation, the highest and lowest 15% of all the quotes collected are
eliminated. The average of the remaining rates is then published at about 11:00 am each
day, Central European Time.
FED FUND: the rate at which banks trade funds in USD overnight.
EONIA (Euro Overnight Index Average): is the average rate of overnight loan & deposit
between ~35 banks in EUR (the average is volume weighted).
INTRO TO 49
CONVENTIONAL FINANCE
IR products: IR Swaps
IR Swaps (IRS):
A swap is an OTC derivative instrument involving the exchange of a series of future
cash flows between two parties over a period of time. This contract has offsetting
obligations – each party pays a series of cash flows at various future dates, while
receiving another series of cash flows in exchange. Note that the cash flows do not
need to be paid on the same dates. The cash flow amounts are either set in advance
or calculated before each payment with reference to some observed underlying
market variables.
The usual exchange of cash flows in a swap is fixed for floating, though other
structures (floating for floating or fixed for fixed) are also possible. Single currency
swaps are the most common type of swap and are often given the generic term
"interest rate swaps" (IRS). There is also a thriving market for cross-currency swaps,
where values are also dependent on interest rates. However, the biggest market (by
far) is that for interest rate swaps.
INTRO TO 50
CONVENTIONAL FINANCE
IR products: IR Swaps (2)
INTRO TO 51
CONVENTIONAL FINANCE
IR products: IR Swaps (3)
IR Swaps (IRS):
Swap payments are based on a notional principal (USD 100 million), but this amount
is never transferred between the two parties. Any payments to be made are
calculated as a percentage of this fixed underlying amount.
One way of viewing an IRS is to consider it as a pair of offsetting fixed rate and floating
rate loans. Each counterparty is simultaneously borrowing and lending the principal
amount. The net capital amount is zero, but the interest payments differ.
Although, IRSs are OTC derivatives but there are quite standardised:
INTRO TO 52
CONVENTIONAL FINANCE
IR products: IR Swaps (4)
Today T1 T2 Tn
Time
The present value of a swap is the sum of the present value of the two legs
A swap is said to be at-par if its present value is zero
The swaps are quoted as the fixed rate that makes the swap at-par i.e. that makes the
present value of the swap equal to zero
Numerical example:
INTRO TO
SwapValuation
53
CONVENTIONAL FINANCE
IR products: Cross-currency Swaps
US Corporate Bank
USD Asset
USD Floating rate USD Debt
USD Floating rate
USD Notional at effective date
- A European company has assets in USD but raises his money in EUR
- For example an aeronautical company who sell planes in USD but has a debt in EUR
- Its balance sheet is not equilibrated
- Cross currency swap can be used to transform EUR debt into USD one
CCY swap
transforming the
EUR debit into USD
one
Notional
Notional
in USD
in EUR
Libor Libor Libor
T1 T2 T(n-1)
Euribor+ Euribor+
Euribor Euribor+
Notional +spread spread spread Notional
in USD spread in EUR
- This EUR-SUD basis was very close to 0% before the crisis, and was almost
constant. At that time, traders were usually not hedging their basis risk.
- - However, after the crisis this spread was very volatile causing a lot of trouble
and losses to traders who were not hedged
Basis Swaps:
Basis Swaps:
- Similarly to the x-ccy basis, the basis spread was close to zero prior to the
crisis but became very volatile afterwards
The continuous compounding corresponds to the “limit” case where the interest paid
and re-invested continuously compounding for x years is exp (R%*x)
Today
1% R%? 3 years
1 year
3%
INTRO TO 62
CONVENTIONAL FINANCE
IR products: Forward Contract (2/2)
From Party B perspective, if I have 100$ to invest for a time horizon of 3 years, I can
either:
(1)- invest it today for 3 years
(2)- invest it today for 1 year and re-invest the proceeds for 2 years
INTRO TO 63
CONVENTIONAL FINANCE
IR products: Forward Rate Agreement (FRA)
Short Term Future: It is very similar to a forward contract. The main differences with
a forward contract are:
-The futures are exchange-traded unlike the forward that are more Over-The-Counter
(OTC) agreements. The major exchanges on which short term futures are traded are:
Chicago Mercantile Exchange (CME), Liffe (NYSE Euronext Group) and Eurex
-The underlying forward rate is a 3M rate: USD Libor 3M or EURIBOR3M.
-The quotation mode: the contract is quoted as 100*(1-rate) e.g. a quotation of 99.5
means an underlying rate of 0.5%
-The contract is subject to daily margin calls
-The future contract is standardised in terms of expiry, underlying rate and the
nominal amount per contract.
INTRO TO 65
CONVENTIONAL FINANCE
IR products: Short Term Futures (2)
INTRO TO 66
CONVENTIONAL FINANCE
FX non-optional products (3)
FX FORWARD (contd):
How to derive the fair FX forward rate?
Let’s look at the following example: EUR/USD spot is at 1.10 today. We would like to
derive the 1M par/fair forward rate. The 1M EUR interest rate is at 0.1% and the 1M
USD interest rate is at 0.5%.
If I have 110 USD today that I would like to exchange into EUR in 1M, I can either:
1- invest it in 1M USD deposit for 1M and convert the proceeds to EUR after 1M or
2- convert the money today into EUR and invest it in a 1M EUR deposit
In case (1), after 1M, I will get 110$*(1+0.5%/12) to be converted in EUR at the FX rate
in 1M. At the end, the amount in EUR I would get is 110*(1+0.5%/12)/FX1M
In case (2), I will get 100EUR today that will get me 100EUR*(1+0.1%/12) after 1M.
Because there should be no arbitrage, the expected value of FX1M should be:
FX FORWARD (contd):
Or more generally:
We can see that depending on the level of the rates in the two currencies, the FX
Forward can be either higher or lower than the FX Spot, and thus the swap points can
be either positive or negative.
FX SWAP:
In an FX swap, there are two legs – the near leg and the far leg. The exchange rate at
the near leg is the spot price and the rate applicable at the far leg is the forward rate.
INTRO TO 68
CONVENTIONAL FINANCE
Vanilla options definition
An option is a contract that give its holder the right but not the obligation to buy or
sell an underlying asset in the future at a price that is fixed today (called strike).
A call option gives the right to buy the asset in the future at the strike price if it is
lower than the market price.
A put option gives the right to sell the asset in the future at the strike price if it is
greater than the market price
The buyer of an option pays a premium to purchase the contract. This is the only
payment that is made by the option buyer. The option seller maximum profit is
limited to the premium.
The buyer of the option can loose the premium and also the payoff at maturity if the
option seller defaults
INTRO TO 69
CONVENTIONAL FINANCE
Vanilla options definition
INTRO TO 70
CONVENTIONAL FINANCE
FX Vanilla options
Vanilla FX Call/Put:
A Vanilla FX option is a contract that allows its holder to exchange two currencies in
the future using a pre-defined exchange rate called the strike of the option.
A call (resp. put) FX option on a currency pair FOR/DOM is an option that allows you
to buy (resp. sell) FOR currency in the future at an exchange rate=strike.
INTRO TO 71
CONVENTIONAL FINANCE
FX Vanilla options (2)
FX Call/Put relationship:
As seen in the previous example, a call option on EUR/USD allows you to buy EUR at a
pre-defined strike (1.05 for instance).
The mechanics of the call option can also be seen as selling the USD for a specific rate
because in order to get EUR, we paid the equivalent USD.
For this reason, when defining a call option on EUR/USD, we usually say “Call
EUR/Put USD”
INTRO TO 72
CONVENTIONAL FINANCE
IR Vanilla options
Caplet:
A caplet is a call option on the Libor. It allows its holder to borrow money in the future
at a strike K instead of the prevailing Libor.
Let’s take the example of a caplet where the underlying Libor is 3M and the maturity
of the caplet is 1Y with a strike of 1%.
The mechanics of such caplet are as follows:
- At the expiry = 1Y, the caplet holder will check the value of the spot Libor3M (the
Libor that starts at that time for 3M)
- If this Libor rate is lower than the strike, then nothing happens
- If this Libor rate is greater than the strike, then the caplet holder can borrow
money for a period of 3M at a rate equal to the strike (instead of Libor). So at
1Y3M, the caplet holder will get:
- Please note the payout happens at 1Y3M and not 1Y i.e. in a Vanilla caplet the
payout happens at (expiry of the option + tenor of the underlying Libor) and not at
the expiry of the option
INTRO TO 73
CONVENTIONAL FINANCE
IR Vanilla options
Floorlet:
A floorlet is a Put option on the Libor. It allows its holder to lend money in the future
at a strike K instead of the prevailing Libor.
Let’s take the example of a Floorlet where the underlying Libor is 3M and the maturity
of the caplet is 1Y with a strike of 1%.
The payout of such Floorlet at 1Y3M
- Please note the payout happens at 1Y3M and not 1Y i.e. in a Vanilla caplet the
payout happens at (expiry of the option + tenor of the underlying Libor) and not at
the expiry of the option
INTRO TO 74
CONVENTIONAL FINANCE
IR Vanilla options
Cap/Floor:
Caps = a strip of caplets on the same underlying Libor, that pays over regular periods
the payout of the underlying caplets.
Floor = a strip of floorlets on the same underlying Libor that pays over regular periods
the payout of the underlying floorlets.
INTRO TO 75
CONVENTIONAL FINANCE
IR Vanilla options
Swaption:
A swaption is the option to enter in a swap in the future at a specific strike. The strike
will be the fixed rate of the swap transaction.
For a swaptions, we don’t talk about Call and Put option but rather on Payer or
Receiver swaptions:
- A payer swaption is an option to enter a swap in which we will pay the fixed rate
and receive the floating rate
- A receiver swaption is an option to enter a swap in which we will receive the fixed
rate and pay the floating rate
INTRO TO 76
CONVENTIONAL FINANCE
IR Vanilla options
Swaption:
Finally, like other options, a swaption can have a different types of exercise: European,
American or Bermudan BUT the vanilla swaption are European.
Let’s consider a EUR Payer Phyiscal swaption with maturity 1Y and underlying swap
the 5Y swap. Let’s fix the strike at 2%.
INTRO TO 77
CONVENTIONAL FINANCE