Appunti Economics of Financial Intermediation I, Appunti di Economia degli Intermediari Finanziari

Scarica Appunti Economics of Financial Intermediation I e più Appunti in PDF di Economia degli Intermediari Finanziari solo su Docsity! Economics of financial intermediation I Financial market: channels funds from person or business without investment opportunities (i.e., “Lenders-Savers”) to one who has them (i.e., “Borrowers-Spenders”) 1. Direct Finance Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets (bonds and stocks). 2. Indirect Finance Borrowers borrow indirectly from lenders via financial intermediaries Debt markets Debt markets allow governments and corporations to borrow. Borrowers issue a security, called a bond, offering interests (and in some cases the gradual repayment of the principal) over time until a specified date (maturity) when a final payment is made. The bond represents an obligation to repay interests and principal. The interest rate represents the cost of borrowing. According to the maturity of the bond, debt markets are classified as:  Short-term (maturity < 1 year)  Long-term (maturity > 10 year)  Intermediate-term (maturity in-between) Equity markets Equity markets allow corporations to raise capital by issuing equities such as (common) stock. Shareholders have claims to share the net income and the assets of the company. Equities often pay dividends, have no maturity date and represent an ownership claim in the firm, hence giving voting rights. Equity markets are less prominent in the Euro area and in Japan compared to the US. Primary markets New security are issued for the first time and sold to initial buyers. They typically involve an investment bank that underwrites the offering: it guarantees a price for the company’s securities and then sells them to the public. The corporation acquires thus new funds. Secondary markets Securities previously issued are now bought and resold by investors. For example, the NYSE in the U.S. and the Euronext in Europe are secondary markets. They involve both brokers and dealers: brokers execute orders on behalf of their clients, dealers buy and sell securities on their own account. However, the corporation that had issued them acquires no new funds. Secondary market are useful to provide liquidity, making it easy to buy and sell the securities of the company, and determine the price of the securities being placed in the primary market. Derivatives markets Derivatives provide payoffs that depend upon the value of an underlying asset (equity, interest rates, foreign exchange rates, commodities, etc.). they are used to hedge risk and also by speculator to make profits. The most important are: forward/futures contracts, swaps, options, credit derivatives. We can also classify markets by the maturity of the securities: 1. Money Market: Short-Term (maturity < 1 year) 2. Capital Market: Long-Term (maturity > 1 year) plus equities (no maturity) Internationalization of financial markets The standard is for borrowers to issue securities in their home country, denominated in their own currency => domestic market Foreign bonds are bonds sold in a foreign country and denominated in that country’s currency, subject to the foreign country’s regulation.  An Italian company issues bonds in the U.S. in USD (these are called Yankee bonds).  A U.S. company issues bonds in the Eurozone in euros (reverse Yankee bonds) Eurobonds are bonds denominated in a currency other than that of the country in which it is sold. They are underwritten by an international company using domestic currency and then traded outside of the country’s domestic market. The most popular are Eurodollar bonds, i.e. bonds denominated in U.S. dollars, issued by an international company and traded outside the U.S. they are subject to the regulation of the country where they are traded. Eurocurrency market: foreign currency deposited in banks outside of home country. The most popular are Eurodollars, i.e. U.S. dollars deposited outside the U.S. Main reasons for issuing on international markets:  Convenience: It may be cheaper to borrow money outside (e.g., U.S. companies borrowing in euros during the quantitative easing).  Possibility to reach more investors.  Less stringent regulation (for example, the regulation imposed by the SEC in the U.S. is particularly stringent) Functions of financial intermediaries 1. Transaction costs Transaction costs are the time and money spent in carrying out financial transactions. For example, if you lend 1,000 euros to the carpenter, there is the extra cost of hiring a lawyer to write a loan contract. Yield to maturity  When bond is at par (price=face value), yield equals coupon rate.  Price and yield are negatively related.  Yield greater than coupon rate when bond price is below par value Zero-coupon (or discount) bond: is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest payments; it just pays off the face value. Fixed-payment loan (or fully amortized loan): the lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month), consisting of part of the principal and interest for a set number of years. Coupon bond: pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid. Perpetual bonds and perpetuity Nominal vs real interest rate Real interest rate more accurately reflects true cost of borrowing. When the real rate is low, there are greater incentives to borrow and less to lend. Inflation-linked bonds can help protect bond investors from inflation. The face value and coupons are indexed to a defined price index. The investor obtains the (ex-post) real interest rate at the time of purchase. Rate of return Key facts about maturity and volatility  Prices and returns more volatile for long-term bonds because they have higher interest-rate risk.  No interest-rate risk for any bond whose maturity equals holding period.  For bonds with maturity > holding period, as rates increase, price falls, implying capital loss  Reinvestment risk occurs if investor holds a series of short bonds over long holding period.  Gain when i ↑, lose when i ↓ Duration Duration provides a better measure of a bond’s exposure to interest rate risk than maturity. Duration is a weighted average of the maturities of the future cash payments of the bonds (not required in this course). Duration is the time it takes to a bondholder to get her/his initial investment back. Duration is shorter than maturity (except for zero-coupon bonds), because of coupon payments (that can be reinvested).  The theory explains why yield curve has different slopes  When short rates are expected to rise in future, the average of future short rates is above today’s short rate => yield curve is upward sloping.  When short rates are expected to stay the same in the future, the average of future short rates is the same as today’s => yield curve is flat.  Only when short rates expected to fall will the yield curve be downward sloping Market segmentation theory Assumption: bonds of different maturities are not substitutes at all; therefore, markets are completely segmented. The interest rate at each maturity are determined separately by the demand and supply of bonds in that particular maturity segment. Liquidity premium theory Assumption: bonds of different maturities are substitutes, but are not perfect substitutes. Investors have a preference for liquidity, i.e., they prefer short-term rather than long-term bonds. This implies that investors must be paid a positive liquidity premium, 𝑙𝑛𝑡, to hold long term bonds. Forward rates Forward rates are the best possible forecast on future short term interest rates. Central banks Most central banks are publicly owned, with some exceptions: E.g., the Fed and the Bank of Italy are owned by their commercial bank members; the ECB is owned by the central banks of the Eurozone member states. Arguments for public ownership:  Central banks act in the ultimate public interest.  Private ownership bias central banks toward self-serving profit-making interests, hence increasing bank risk-taking and balance sheet troubles.  The global financial crisis highlighted concerns that the profit-making target of private shareholders could hamper them from saving the financial sector during financial crises Arguments for private ownership:  It guarantees central bank independence from the government whose main concern may be financing the fiscal budget.  To avoid control of capital, each shareholder is only allowed a small number of shares => no concentration.  Private owners would be required to recapitalize the central bank in the case of losses, which lifts this burden off the fiscal budget European Central Bank The European Central Bank (ECB) came into existence on June 1, 1998, to handle the transitional issues of the nations that became part of the Eurozone. All of the Eurozone countries retain their own National Central Banks (NCBs) and their own banking systems. Since not all of the EU member states have adopted the euro, the European System of Central Banks (ESCB) was established alongside the Eurosystem to comprise the ECB and the NCBs of all EU member states whether or not they are members of the Eurozone • The NCBs of the EU member states that have retained their national currencies are members of the ESCB which are allowed to conduct their own respective national monetary policies. Who owns the ECB  The capital stock of the ECB is owned by the central banks of the current EU member states.  The balance sheet of the ECB, i.e., its assets and its liabilities, is held by the NCBs.  More than 95% of the shares are held by Eurozone NCBs.  The ECB adjusts the shares every five years and whenever a new country joins the EU. The highest capital key percentages of the ECB’s capital are held by Deutsche Bundesbank and Banque de France. Decision-making bodies The four main decision-making bodies of the European Central Bank are:  Governing Council: main decision-making body of the ECB responsible for formulating monetary policy in the euro area. The main function of the Governing Council of the ECB is to conduct monetary policy with the primary objective to maintain price stability in the euro area. At the beginning of each month, the Governing Council decides on the monthly monetary policy decisions in accordance with the economic and monetary developments in the Eurozone.  Executive Board: responsible for the day-to-day operations and management of the ECB and the Eurosystem; the preparation of the Governing Council meetings; the implementation of monetary policy for the euro area in accordance with the guidelines specified and decisions taken by the Governing Council.  General Council: comprises the president and the vice-president of the ECB in addition to the governors of the NCBs of all the EU member states. It is a transitional body: encourages cooperation between NCBs and the EU, collects statistical ECB Monetary policy strategy  The primary objective of the ECB’s monetary policy is to maintain price stability  Traditional ECB monetary policy strategy has been: In the pursuit of price stability, the ECB aims at maintaining inflation rates below, but close to, 2% over the medium term. The central bank is the monopoly supplier of the monetary base:  It can set the conditions at which banks borrow from the central bank.  It can also influence the conditions at which banks exchange funds in the money market. In the short run, a change in money market interest rates triggers mechanisms and actions by economic agents. Ultimately the change will influence output or prices. In the long run, after all adjustments in the economy have worked through, a change in the quantity of money in the economy will be reflected in a change in the general level of prices. But it will not induce permanent changes in real variables such as real output or unemployment (technology, population growth or the preferences of economic agents are the determinants – and the Eurozone members are heterogeneous). Central banks in other large economies Most central banks in large economies (e.g. Bank of England, Bank of Canada, Bank of Japan, People’s Bank of China) share similar objectives in terms of monetary policy: - Price stability - Support to growth and employment They differ significantly in terms of independence: - The BoE is accountable to the United Kingdom Parliament (but not to the government) - The Canadian government has the ultimate responsibility for monetary policy. Hence, the ministry of finance can issue a directive that the BoC must follow Central banks of emerging markets  Emerging markets economies (EMEs) are economies of Asia, Latin America, and Eastern Europe that are growing rapidly and experiencing booming industrialization and increased exports.  Central banks of EMEs assume a more complex role in comparison to their counterparts in industrial nations.  Apart from central banking functions, banks of EMEs build and reform the financial infrastructure, develop the financial markets, and help with macroeconomic development.  They also actively manage foreign exchange reserves and implement policies that promote growth and exports The central banks in EMEs have less independence because many decisions are made jointly with the government. The conduct of monetary policy The primary objective of the monetary policy conducted by central banks is to maintain price stability. Official ECB interest rates The Governing Council of the ECB sets three key interest rates: - The interest rate on the main refinancing operations. In these operations banks can borrow liquidity from the Eurosystem against collateral on a weekly basis, at a pre- determined interest rate. - The rate on the deposit facility. Banks may make overnight deposits with the Eurosystem at a (pre-set) rate lower than the main refinancing operations rate. - The rate on the marginal lending facility. Banks obtain overnight credit from the Eurosystem at an interest rate (also pre-set) above the main refinancing operations rate Monetary policy instruments The ECB uses a number of monetary policy instruments to implement monetary policy. Standard: - Open market operations - Standing facilities - Minimum reserve requirements Non-standard: - Open market operations - Asset purchase programs ECB open market operations (standard) Main refinancing operations (MRO) are the main tool that the Eurosystem uses to inject liquidity in the banking system. MROs are arranged weekly with a maturity of one week. The transaction is a reverse transaction (repo or collateralized loan), i.e., the bank: 1. receives the funding and deposits collateral (eligible bonds) at the Central Bank at origination; 2. repays the loan and retrieves the collateral after one week Other refinancing operations include: - Longer-term refinancing operations (LTRO): reverse transactions with a longer maturity than the MROs. Regular longer-term refinancing operations with a maturity of three months. The bids are placed monthly, according to a calendar published on the ECB’s website. In recent years, LTROs have been complemented by operations with a 3-year maturity. - Ad-hoc operations bilaterally agreed with a selected group of counterparties (primary dealers) to manage the liquidity situation in the market in case of unexpected liquidity fluctuations ECB standing facilities The Eurosystem offers credit institutions two standing facilities: - Marginal lending facility in order to obtain overnight liquidity from the central bank, against the presentation of collateral – rarely used, banks borrow overnight on the interbank market (at a lower rate). - Deposit facility in order to make overnight deposits with the central bank (at present the deposit facility offers a negative interest rate) ECB minimum reserve requirements The ECB requires credit institutions established in the euro area to hold deposits on accounts with their national central bank. These are called "minimum" or "required" reserves. Required reserves are computed as a percentage of deposits and other debt securities with maturity up to 2 years (at present, 1%). The idea is: the higher (lower) the required reserves, the lower (higher) the bank lending to the economy. Example: Bank deposits: 1 mln EUR Minimum reserve: 1% of bank deposits = 10,000 EUR Only 990,000 EUR can be lent out to the economy ECB unconventional monetary policy Standard (conventional) monetary policy measures showed their limits in the financial crisis. - Targeted longer-term refinancing operations (TLTROs): they provide financing to credit institutions for periods of up to four years at attractive conditions. Purpose: to further ease private sector credit conditions and stimulate bank lending to the real economy. - Pandemic emergency longer-term refinancing operations (PELTROs): a series of 7 operations agreed in April 2020 to provide liquidity support to the euro area financial system and ensure smooth money market conditions during the pandemic period. - Asset-backed Securities Purchase Program (ABSPP): the Eurosystem conducts net purchases of asset-backed securities under the asset-backed securities purchase program. Collateral The Eurosystem provides credit only against adequate collateral. Typically, collateral refers to marketable financial securities, such as bonds, or other types of assets, such as non- marketable assets or cash. The term “eligible asset” is used for assets that are accepted as collateral by the Eurosystem. A “haircut” is applied to collateral, as a function of its riskiness. Short term government bonds - Government bonds with short maturities (up to 12 months). In Italy: Buoni Ordinari del Tesoro (BOT); typical expiries: 3, 6, 12 months. In the U.S.: Treasury bills (T-bills); maturities from 1 month to 1 year - Zero-coupon bonds. - The government pays the face (par) value at expiry. - The investor pays a price lower than the face value to buy a short-term government bond (in normal conditions i.e., positive interest rates). - The interest earned on the zero-coupon bond is the difference between the par value and the price paid Italian Treasury bills auctions - The auction is competitive on yield Interested dealers place their offers (max 5) in terms of both quantity and yield requested. The Treasury assigns the issue starting from the lowest yield until the entire issue has been allocated. The «accepted» offers are satisfied at the quantity and yield required (between a minimum and a maximum yield calculated by the Treasury). The Treasury computes the weighted average of the yields corresponding to the offers that have been accepted => yield of the Treasury bill. Treasury bills are then placed by the successful dealers to investors at a price in line with this average yield. Certificates of deposits They pay interest and principal at maturity; they cannot be withdrawn before maturity (the standard maturity is between 1 and 6 months). Two categories: Commercial paper - - Unsecured short-term debt instrument issued by a corporation. - Purpose: Financing of accounts payable and inventories and meeting short-term liabilities. - Maturity shorter than one year (shorter than 270 days in the U.S. to avoid registration requirements). - Usually issued at a discount from face value (like T-bills). - Only issued by corporations of top credit quality (they are unsecured). - Large denominations (> 100,000 USD or EUR). - Investors: Other corporations, financial institutions, wealthy individuals, and money market funds. - Usually traded on secondary markets in Europe, placed to investors and held to maturity in the U.S Commercial paper used as a cheaper alternative to bank loans. Foreign currency deposits - Foreign currency deposited in banks outside of home country. - The most popular are Eurodollars, i.e., U.S. dollars deposited outside the U.S. - As such, they are not subject to U.S. banking regulation. - Typically offered by large, multinational banks that can offer higher yields than domestic banks. - The depositors are businesses and banks. - Large denomination Interbank lending The interbank market is the market where banks lend money to each other. The interest rates at which these transactions take place represent some of the most important reference rates in the economy. The interbank market allows banks with a temporary liquidity deficit to borrow from banks with a temporary liquidity surplus. Maturity: overnight to few months Interbank rates - Federal funds rate: interest rate at which banks in the U.S. lend reserve balances to other banks overnight on an unsecured basis. - Eonia: European rate closest to Fed funds rate. It’s a weighted average of interest rates for unsecured overnight interbank lending in euros. It will be replaced by 2022 by €STR. - Repo and reverse repo: repo is an overnight sale of government securities with the agreement to buy them back; a 1-day loan backed by government securities. Reverse repo is an overnight purchase of government securities with the agreement to sell them back. The borrowing rate is called repo rate. The most common maturity is overnight, but can extend to 2 weeks. - Libor (London Interbank Offered rate): average of interest rates at which the leading global banks in London believe they would be able to borrow from one another. Each of the leading banks estimates its borrowing rate. It is prone to manipulation: Libor fixing scandal emerged in 2012. 5 currencies are exchanged (USD, JPY, EUR, GBP, CHF), and maturities are from one day to one year. it will be discontinued between 2021 and 2023. - Euribor (Euro Interbank Offered Rate): similar to Libor, but for interbank lending in euros by a panel of European banks. The only currency EUR, maturities from one week to one year. Libor and Euribor rates are key reference rates for: - Business loans (floating rate): typically granted at Libor or Euribor + fixed spread. Example: Company A obtains a bank loan at an interest equal to Libor + 2% - Mortgages (floating rate): typically granted at Libor or Euribor + fixed spread. Example: Your parents obtain a mortgage at an interest equal to Euribor + 1% - Interest rate derivatives: Most interest rate swaps are indexed at the Libor or Euribor (floating leg) The Libor Scandal How the Libro was determined: Each day shortly before 11 a.m. London time, the British Bankers Association (BBA) determined the matrix of Libor rates using a trimmed mean, excluding figures in the top and bottom quartiles. The official Libor rates as well as the rates contributed by the banks would be then published at about 11.30 a.m. daily. Libor rates should reflect the interest rates that banks pay to borrow money from each other but strictly speaking Libor rates are the rates at which banks could borrow (and need not be the actual borrowing rates). Thus, bankers reported false interest rates to manipulate the markets and boost their own profits. Doubts about the accuracy of Libor rates first emerged in 2007-08. Banks seemed to be reporting rates which were too low with respect to their actual borrowing rates. Investigations conducted by both the British and the U.S. regulatory authorities unveiled a full Libor fixing scheme in 2012. Evidence of Libor manipulation dating back to 2005. Banks would report artificially low or high interest rates to ensure profits, especially in the derivative segment. Replacing Libor - USD LIBOR => Secured Overnight Financing Rate (SOFR) – secured - GBP LIBOR => Sterling Overnight Index Average (SONIA) – unsecured - Euro LIBOR => €STR – unsecured - Euribor → continues alongside €STR The TED spread The TED spread is computed as the difference between the 3-month USD Libor rate the 3- month T-bill rate. The TED spread is a standard indicator of the risk in the banking system  Puttable Bonds: give the holder the right to demand early repayment of the face value of the bond. This option will be exercised if interest rates on the market have increased significantly compared to when the bond was issued. This option can normally be exercised only at certain dates. A variation is the extendable bond where the holder has the right to extend the bond’s life (when coupon rate exceeds current rates).  Convertible bonds: can be exchanged for shares of the firm’s common stock. The conversion can take place only at certain times during the bond’s life and is normally at the discretion of the bondholder. The conversion rate is prespecified in the bond indenture. Bondholders benefit from price appreciation of the company’s stock. Special class: Contingent convertible (CoCos) bonds that are automatically converted into equity if a pre-specified trigger event occurs. Used by banks (which are subject to minimum capital requirements) – when capital falls below a threshold, the CoCo is automatically converted into capital.  Covenants bonds: a set of agreements aimed at protecting bondholders from an increased riskiness of the issuer. They mitigate conflicts with shareholder interests. Negative covenants: forbid the issuer from taking certain actions (e.g., dividend limits, issuance of new debt, etc.), usually linked to threshold values of financial ratios. - Maximum debt-to-equity ratio - Minimum interest coverage ratio - Minimum level of earnings, etc. Positive covenants: force the issuer to undertake actions (e.g., insurance, auditing of financial statements, etc.). A covenant violation puts the company in technical default. Usually covenants include a cross-default clause (if one debt class defaults, all classes default). Covenants are also common in bank loans. Corporate bond Seniority  Secured bonds: collateralized by underlying assets that the bondholder can seize in case of default of the issue.  Senior unsecured bonds (debentures): backed only by the general creditworthiness of the issuer.  Subordinated (junior) debentures: lower priority claim, paid only after non- subordinated bondholders have been paid. Credit rating To facilitate the public placement of bonds, issuers usually request a rating. Alphanumeric symbols assigned by credit rating agencies (CRAs) to provide a concise evaluation of creditworthiness. It mitigates information asymmetries between issuer and investors. Credit risk Credit risk is the risk that the issuer will fail to repay its debt (principal and / or interests). The definition of default encompasses several events: - Liquidation - Missed interest payment after a grace period has expired (usually 30 days) The issuer applies for a rating to the credit rating agency and submits all the required information. The lead analyst in charge collects the information, processes it and makes a rating recommendation to the rating committee. The rating committee assigns the rating which is communicated to the issuer and publicly to investors. Determinants of credit rating Financial risk analysis → financial ratios Business risk analysis → market and sector, competitiveness, management skills, management strategies, corporate governance. Credit rating actions - Rating change (Upgrade/Downgrade): change in rating following a permanent change in creditworthiness - Credit watch (Positive/Negative): the CRA is collecting information about a new event that may impact the creditworthiness of the issuer. Normally resolved within six months with upgrade/downgrade/confirmation - Outlook (Positive/Negative/Stable): the CRA may decide to review its assessment in the next one or two years (no commitment to take future action) - Withdrawal: the CRA withdraws the rating if the bond issue has expired or if the company does not provide timely information to maintain the rating Risks in the bond market Corporate bonds are exposed to: - Interest rate risk - Liquidity risk: Corporate bonds are more illiquid than government bonds - Credit risk: Corporates are usually riskier than governments. No credit risk for companies rated AAA The derivative market: forward and futures contracts Derivatives contracts are financial assets whose value and payoff depend upon the value of an underlying asset. Derivatives can be traded: 1. On regulated exchanges (futures, options) - Standardized, less flexible 2. Over-the-counter (forward, swaps, credit derivatives) - Can be designed ad hoc, more flexible (although the most liquid contract are standardized) - Subject to counterparty risk (risk that the counterparty may not honor the contract) Use of derivatives Hedgers  Hedging involves engaging in a financial transaction that reduces or eliminates risk.  Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Speculators  Speculators try to make a profit from a security's price change.  Much easier to set up a speculative bet using derivatives than using the underlying assets. Arbitrageurs Arbitrageurs try to exploit arbitrage opportunities on the market, i.e., mispricing between the derivative and the underlying asset. Forward and futures contracts  Forward and futures contracts are agreements to buy or sell an asset at a certain time in the future for a certain price.  Forwards and futures represent a commitment to buy or sell.  The price (forward or futures price) is agreed now –at origination  The delivery of the asset will take place in the future –at delivery date/month  The payment will also take place in the future –at delivery date/month  Forwards and futures differ from a spot transaction, where payment and delivery are immediate Main differences between forward and futures contracts  Futures contracts are settled daily through margins, forward contracts are settled at delivery.  Futures contracts are guaranteed by the exchange, forward contracts are subject to counterparty risk.  The details of futures contracts are specified by the exchanged, forward contracts can be ad-hoc.  Futures contracts can only be closed by entering into an opposite position in the same contract, forward contracts can be closed upon agreement with the original counterparty (but most forward contracts lead to delivery in practice).  Typical assets traded under forward contracts are foreign currencies, while typical assets traded under futures contracts are commodities, stock indexes, foreign currencies, interest rates. Stock index futures Futures contracts on stock indices are very popular. They are settled in cash (no delivery of the index at maturity). The size of one futures contract is given by a monetary multiple (multiplier) of the index. Examples: One stock index futures contract on the S&P 500 is equal to $250 times the index, one contract on the FTSE 100 is £10 times the index, one contract on the FTSE MIB is €5 times the index, etc. Example: Consider an investor who takes a long position in five S&P 500 futures contracts with December expiry in March 2021.  The 9-month futures price of the S&P 500 in March 2021 is 2,080.  The futures (=spot) price of the S&P 500 in December is 2,250.  The investor, in December 2021, receives (2,250 – 2,080) × $250 × 5 = $212,500 Basic risk Hedging using futures contracts is hardly perfect. The hedger is exposed to basis risk. Components of basis risk:  The asset underlying the futures contract is not the same as the one the hedger needs to hedge – cross-hedging.  The hedging horizon may not coincide with any of the available futures expiries (for example the hedger wants to hedge a position between March and August but futures contracts are only available for March, June, September, December expiries).  The hedger may not be certain of the exact hedging horizon How to deal with basic risk  Cross-hedging: When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price.  When the hedging horizon is different from available futures expiries: choose a delivery month as close as possible, but later than, the expiration of the hedge. The Derivative market: Swap contract Interest rate swaps A swap, in general terms, is an agreement between two parties to exchange cash flows at specified future times according to certain specified rules. The most common type of swap is the plain vanilla interest rate swap (IRS). One party agrees to: 1. pay interest cash flows computed at a predetermined fixed rate on a notional principal for a predetermined number of years, and 2. receive interest cash flows computed at a floating rate on the same notional principal for the same period of time. The fixed interest rate is called swap rate. The floating interest rate is a standard reference rate (e.g., Libor or Euribor). Interest rate swaps are over-the-counter derivatives. Banks are the main swap dealers and trade IRS for themselves as well as for their customers. Banks are exposed to interest rate risk, as most of their assets and liabilities are interest-rate sensitive. IRS are used to hedge against interest rate risk. Elements of IRS  The swap (fixed) rate  The reference (floating) rate  The notional used to compute the interest cash flows (the notional is never exchanged in a plain vanilla IRS).  The periodicity of interest payments i.e., quarterly, semi-annual or annual.  The maturity of the IRS (it typically ranges between 1 year and 30 years).  The day count convention used to compute the interest cash flows Example: Consider an IRS where, in March 2021, Credit Suisse agrees to receive 6- month LIBOR from Goldman Sachs and pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million. Typical uses of an IRS Converting a liability from:  fixed rate to floating rate: Suppose that Goldman Sachs borrows mostly at a fixed (average) rate of 5.2% and then swaps fixed for floating with Credit Suisse. The net effect is borrowing at Libor + 0.2%  floating rate to fixed rate: Suppose that Credit Suisse borrows mostly at a floating (average) rate of Libor + 0.1% and then swaps fixed for floating with Goldman Sachs. The net effect is borrowing at a fixed rate of 5.1% Forward rate agreements  A forward rate agreement (FRA) is a contract between two counterparties to exchange a fixed interest payment for a floating interest payment on a single future date.  Over-the-counter instrument (like the IRS).  Most contracts are indexed at Libor (now SOFR or other replacement rates) or Euribor  The notional is never exchanged and only used to compute the interest payments.  An IRS is essentially a series of FRAs.  Every interest payment under the IRS is a FRA Currency swaps A currency swap is an agreement in which two parties exchange the principal amount of a loan (not always, but often) and the interest in one currency for the principal and interest in another currency. There are different types of currency swaps (fixed to fixed, fixed to floating, floating to floating). Unlike in an IRS, the notional is often exchanged both at inception and at maturity. The exchange rate at which the two notionals are exchanged at inception is typically the spot exchange rate between the two currencies. Example Suppose a U.S. MNC wants to finance a €40 million expansion of a German subsidiary. The current spot exchange rate is S0($/€) = $1.30/€. So, the equivalent dollar amount is $52million (€40m × $1.30/€). The project has an economic life of 5 years. What options does the company have?  Borrow US$ and convert to Euro – exposes company to exchange rate risk.  Borrow in Germany – rate available may not be as good as that in the U.S. if the subsidiary is relatively unknown.  Find a counterparty and set up a currency swap If they can find a German MNC with a mirror-image financing need for a subsidiary in the U.S., they may both benefit from a currency swap. With the spot exchange rate $1.30/€, the U.S. firm needs to find a German firm wanting to finance dollar borrowing in the amount of $52m. A swap bank familiar with the financing need for both MNC could arrange a currency swap that helps both companies find financing in the foreign currency without risk or extra costs.