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Report On

Speculation, Arbitrage and Hedging

Submitted To:
Tofayel Ahmed
Lecturer,
Bangladesh Institute of Bank Management
Submitted By:
Name
Abdullah al Masud
Hasan Mahmud
Mostafizur Rahman
Sayem Rahman Chowdhury
Md. Rayhan Morshed
Rakibul Hasan Khan Rocky
Mohammad Fahad

ID No.
181424
181425
181431
181438
181452
181459
181460

Date of submission: November 12,


2015

Dhaka School of Bank


Management

Bangladesh Institute of Bank


Management
1

TABLE OF CONTENT
Serial No.
01
02
03

Content Title
Speculation
Arbitrage
Hedging

Page No.
03-06
06-11
12-22

Speculation
Speculation is the practice of engaging in risky financial transactions in an attempt to profit
from fluctuations in the market value of a tradable good such as a financial instrument, rather
2

than attempting to profit from the underlying financial attributes embodied in the instrument
such as capital gains, interest, or dividends. Speculators play one of four primary roles in
financial markets, along with hedgers who engage in transactions to offset some other preexisting risk, arbitrageurs who seek to profit from situations where fungible instruments trade
at different prices in different market segments, and investors who seek profit through longterm ownership of an instrument's underlying attributes

Speculation and investment


The view of what distinguishes investment from speculation and speculation from excessive
speculation varies widely among pundits, legislators and academics. Some sources note that
speculation is simply a higher risk form of investment. Others define speculation more
narrowly as positions not characterized as hedging. The U.S. Commodity Futures Trading
Commission defines a speculator as "a trader who does not hedge, but who trades with the
objective of achieving profits through the successful anticipation of price movements. The
agency emphasizes that speculators serve important market functions, but defines excessive
speculation as harmful to the proper functioning of futures markets.

The benefits of speculation


Sustainable consumption level
When a harvest is too small to satisfy consumption at its normal rate, speculators come in,
hoping to profit from the scarcity by buying. Their purchases raise the price, thereby
checking consumption so that the smaller supply will last longer. Producers encouraged by
the high price further lessen the shortage by growing or importing to reduce the shortage. On
the other side, when the price is higher than the speculators think the facts warrant, they sell.
This reduces prices, encouraging consumption and exports and helping to reduce the surplus.

Market liquidity and efficiency


If any particular market had no speculators, then only producers and consumers would
participate in that market. With fewer players in the market, there would be a larger
spread between the current bid and ask price of for the products. Any new entrant in the
market who wanted to trade the products would be forced to accept an illiquid market, may
3

trade at market prices with large bid-ask spreads, or even face difficulty finding a co-party to
buy or sell to. A commodity speculator may profit the difference in the spread and, in
competition with other speculators, reduce the spread. Some schools of thought argue that
speculators increase the liquidity in a market, and therefore promote an efficient. As more
and more speculators participate in a market, underlying real demand and supply can become
diminishingly small compared to trading volume, and prices may become distorted. Without
speculators, it is difficult to create an efficient market. Speculators are there to take
information, and speculate on how it affects prices, producers and consumers, who may want
to hedge their risks, need counter-parties
Bearing risks
Speculators also perform a very important risk bearing role that is beneficial to society. For
example, a farmer might be considering planting corn on some unused farmland. Alas, he
might not want to do so because he is concerned that the price might fall too far by harvest
time. By selling his crop in advance at a fixed price to a speculator, the farmer can hedge the
price risk and is now willing to plant the corn. Thus, speculators can actually increase
production through their willingness to take on risk.
Finding environmental and other risks
Speculative hedge funds that fundamental analysis "are far more likely than other investors to
try to identify a firms off-balance-sheet exposures", including "environmental or social
liabilities present in a market or company but not explicitly accounted for in traditional
numeric valuation or mainstream investor analysis", and hence make the prices better reflect
the true quality of operation of the firms.
Shorting
Shorting may act as a "canary in a coal mine" to stop unsustainable practices earlier and thus
reduce damages and forming market bubbles.

The disadvantages of speculation

Winner's curse

Auctions are a method of squeezing out speculators from a transaction, but they may have
their own perverse effects; see winner's curse. The winner's curse is however not very
significant to markets with high liquidity for both buyers and sellers, as the auction for selling
the product and the auction for buying the product occur simultaneously, and the two prices
are separated only by a relatively small spread. This mechanism prevents the winner's curse
phenomenon from causing mispricing to any degree greater than the spread.
Economic bubbles
Speculation is often associated with economic bubbles. A bubble occurs when the price for an
asset exceeds its intrinsic value by a significant margin, although not all bubbles occur
because of speculation. Speculative bubbles are characterized by rapid market expansion
driven by word-of-mouth feedback loops as initial rises in asset price attract new buyers and
generate further inflation. The creation of the bubble is followed by a precipitous collapse
fueled by the same phenomenon. Speculative bubbles are essentially social epidemics whose
contagion is mediated by the structure of the market. [12] Some economists link asset price
movements within a bubble to fundamental economic factors such as cash flows and discount
rates.
In 1936 John Maynard Keynes wrote: "Speculators may do no harm as bubbles on a steady
stream of enterprise. But the situation is serious when enterprise becomes the bubble on a
whirlpool of speculation. (1936:159) Mr. Keynes himself enjoyed speculation to the fullest,
running an early precursor of a hedge fund. As the Bursar of the Cambridge University King's
College, he managed two investment funds, one of which, called Chest Fund, invested not
only in the then 'emerging' market US stocks, but also periodically included commodity
futures and foreign currencies, albeit to a smaller extent (see Chua and Woodward, 1983) .
His fund achieved positive returns in almost every year, averaging 13% p.a., even during the
Great Depression, thanks to very modern investment strategies, which included inter-market
diversification (i.e., invested not only in stocks but also commodities and currencies) as well
as shorting, i.e., selling borrowed stocks or futures to make money on falling prices, which
Keynes advocated among the principles of successful investment in his 1933 report ("a
balanced investment position [...] and if possible, opposed risks."
Volatility

According to Ziemba and Ziemba (2007), Keynes risk-taking reached 'cowboy' proportions,
i.e. 80% of the maximum rationally justifiable levels (of the so-called Kelly criterion), with
overall return volatility approximately three times higher than the stock market index
benchmark. Such levels of volatility, responsible for his spectacular investment performance,
would be achievable today only through the most aggressive instruments (such as 3:1
leveraged exchange-traded funds). He chose modern speculation techniques practiced today
by hedge funds, which are quite different from the simple buy-and-hold long-term investing.
It is a controversial point whether the presence of speculators increases or decreases the
short-term volatility in a market. Their provision of capital and information may help
stabilize prices closer to their true values. On the other hand, crowd behavior and positive
feedback loops in market participants may also increase volatility at times.

Speculation Techniques for Stocks


Speculators make money by purchasing stock and hoping for a price increase. Their strategy
differs from that of investors who buy stocks and hold them for a long period to earn
dividend income. All stock investing brings some risk, but the level varies based on your
strategy. Higher returns often require a riskier strategy. The best strategy for you depends on
your age, risk tolerance, tax situation, family size, income and the amount you can invest.
You can consult a broker for help developing a trading strategy, or you can save money on
commissions by doing your own research with an online trading account.
Effects of Speculation
Increased activity by speculators can have a significant effect on a stock's price. The
collective response to earnings, price patterns and breaking news creates momentum. If
speculators believe the stock will increase in value, their purchases might drive the price up.
On the other hand, speculators' loss of confidence can send the price into a freefall.
Conflicting opinions lead to sideways movement in which volume might be high but the net
effect on the price is minimal.
Margin Trading
If your broker allows margin trading, you can borrow against the securities in your account to
purchase more stock than you could otherwise afford. This is helpful when you think a stock
is about to skyrocket and you would like to purchase as many shares as possible. Depending
on your broker's terms, you might be able to borrow as much as twice the value of the
6

account. However, you're charged interest on the loan until you pay it back. And you can get
into trouble if the stock price drops instead of rising. The broker may issue a margin call that
would require you to cover the amount of the loan within a specified period.
Options
You also can purchase an option that gives you the right to trade a stock at a certain price
before the expiration date. "Put options" allow you to sell a stock, and "call options" allow
you to purchase a stock at the specified strike price. There's no obligation to exercise the
option before it expires, but you lose the money you paid for it if you don't. Ideally, you want
to exercise your option when the difference between the market price and option price gives
you the greatest profit.
Hedges
Another speculation strategy is to make trades in opposite directions to hedge your
investment and reduce the overall risk present in your portfolio. You can purchase shares of
stock you think will rise, plus a put option to sell at a slightly lower price. This will limit your
potential loss if the stock tanks, but it lowers your overall profit because you will lose the
option price even if you realize your best-case scenario. You also could hedge a risky
investment by diversifying your portfolio with bonds, mutual funds and lower-risk stocks.

Arbitrage
Arbitrage is strategy in finance with the help of which an individual can make risk-less profit
by taking advantage of price difference between the two markets of same security.
Arbitrage Advantages and Disadvantages
Given below are some of the advantages and disadvantages of arbitrage

Arbitrage Advantages
1.

The biggest benefit of doing arbitrage is that the risk element is next to nil, it can better
understood with the help of an example, if a multinational company is listed in stock markets
of New York and London and in New York market it trade at $100 and in London market it
trades at 160 and exchange rate is $1 = 2 than ideally it should trade in London markets at
7

200. Now a person thinking of doing arbitrage would sell stock in New York market and buy
the same stock in London market and thus he or she would be able to make risk-less profit.
2.

Arbitrage helps in keeping the price of securities across the markets more or less same
and therefore it help in better price discovery of an asset and also put an end to price variances
in securities across various markets.

3.

It helps in making the financial markets more efficient because imagine if there were no
arbitrageurs than stocks would have kept trading at different prices in different markets leading
to speculation by few individuals which would have damaged the real investors confidence in
stock market.
Arbitrage Disadvantages
1.

Many individuals only take into account the price aspect and they ignore the
transactions costs and taxes associated with buying and selling of asset which in turn
results in wrong estimation of profits and may even lead to loss if price difference is not
much.

2.

In real life there are not many arbitrage opportunities and even if there are then in
order to make profit put of such situations you need to have latest technology in order to
take positions quickly and also expertise to make such transactions which only few
people possess.

3.

One requires lot of money in order to do arbitrage, it is not as if you have $2000 then
you can do it rather one need to have much more money in order to do a profitable
arbitrage.
4. Multiple dimensions. The trader must thoroughly understand the arbitrage mechanism
before determining which currency pairs to buy and which to sell. Each arbitrage
package consists of two buys and one sell or one buy and two sells. Miscalculating
any one of the three trades can cause disaster.
5. Advanced monitoring techniques are usually required. This means calculating the
preceding analysis on several pairs simultaneously in real time and will involve a

software program that continually analyzes streaming quotes. It is possible to perform


these tasks manually, but the trader must have a high tolerance for tedium.
6. Technically, arbitrage is supposed to be a risk free scenario. However there is a risk of
not being able to establish the arbitrage situation
Types of Arbitrage
There are different types of arbitrage that are prevalent in the financial market. With the help
of arbitrage strategies, an arbitrageur (an individual who is involved in arbitrage transactions)
can avail the benefit of price differences existing in various markets. An arbitrage is
commonly referred to as a risk-free gain or risk-free profit.

The term arbitrage is principally utilized in various types of financial sectors and they
are the following:
Stock market
Bond market
Commodity market
Derivatives market
Currency market or forex market
The different types of arbitrage are the following:
Municipal bond arbitrage:

Municipal bond arbitrage is also known as municipal arbitrage or municipal bond relative
value arbitrage or simply muni arb. This is basically a hedge fund strategy. In case of
municipal bond arbitrage, the hedge fund managers apply two approaches. The first approach
is seeking relative value benefits both in case of short-term municipal bonds and long-term
municipal bonds. The second approach refers to interest rate swaps between municipal bonds.

Merger arbitrage:

Merger arbitrage is also known as risk arbitrage. In this type of arbitrage, the stock of a
particular company, which is going to be taken over is purchased and at the same time, the
stock of the company, which is going to take over the former company are short sold.
Depository receipts:

A depository receipt is that form of a security, which is provided in the form of a tracking
stock on a financial market located in another country. Here the profit arises from the spread
between the real value and the perceived value.
Convertible bond arbitrage: A convertible bond is that type of a bond, which can be
converted into a specified number of shares of a company. Convertible bond prices are
dependent on three principal elements; the credit spread, the stock price, and the interest rate.
The profit of convertible bond arbitrage arises from the functions of these elements.
Statistical arbitrage: In this kind of arbitrage, the arbitrageurs take the advantage of the
differences in anticipated values.
Covered interest arbitrage: In this kind of arbitrage, a financial instrument or security is
bought by an investor in the denomination of a foreign exchange or foreign currency, and the
foreign exchange risk is hedged through the sale of a forward contract in the sales proceeds of
the financial instrument again in the home currency.
Uncovered interest arbitrage: In case of uncovered interest arbitrage, funds or monies are
sent to another country for availing the benefit of increased interest rates in forex agencies.
Regulatory arbitrage: In this type of arbitrage, a regulated organization avails the benefit of
the deviation between the regulatory positioning and the economic or real risk.
Triangle arbitrage: It is also known as triangular arbitrage and in this approach, the benefit
is taken out from a condition of disequilibrium lying between three forex markets.
Telecom arbitrage: This type of arbitrage strategy is utilized by Telecom arbitrage
organizations, such as Action Telecom UK.
Political arbitrage: In this approach, political knowledge or calculations about the future are
implemented for discounting and forecasting values of securities.
Fixed income arbitrage: This kind of arbitrage is primarily related to hedge funds.
10

Volatility arbitrage: It is also known as vol arb and is a form of statistical arbitrage. It is
used with the help of buying or selling of a delta neutral option portfolio and the underlier of
the portfolio.
Arbitrage Disadvantages
Procedure of Arbitrage
Arbitrage takes three common forms in forex and international money
market:
1. Locational arbitrage
2. Triangular arbitrage
3. Covered interest arbitrag
Locational Arbitrage
Commercial banks providing foreign exchange services normally quote
about the same rates on currencies, so shopping around may not
necessarily lead to a more favorable rate. If the demand and supply
conditions for a particular currency vary among banks, the banks may
price that currency at different rates, and market forces will force
realignment. When quoted exchange rates vary among locations,
participants in the foreign exchange market can capitalize on the
discrepancy. Specifically, they can use locational arbitrage, which is the
process of buying a currency at the location where it is priced cheap and
immediately selling it at another location where it is priced higher.
Example: Akron Bank and Zyn Bank serve the foreign exchange market
by buying and selling currencies. Assume that there is no bid/ask spread.
The exchange rate quoted at Akron Bank for a British pound is $1.60,
while the exchange rate quoted at Zyn Bank is $1.61. You could conduct
locational arbitrage by purchasing pounds at Akron Bank for $1.60 per
pound and then selling them at Zyn Bank for $1.61 per pound. Under the
condition that there is no bid/ask spread and there are no other costs to
conducting this arbitrage strategy, your gain would be $.01 per pound.
11

free in that you knew when you purchased the pounds how much you
could sell them did not have to tie your funds up for any length of time.
Locational arbitrage is normally conducted by banks or other foreign
exchange whose computers can continuously monitor the quotes provided
by other banks noticed a discrepancy between Akron Bank and Zyn Bank,
they would quickly engage in locational arbitrage to earn an immediate
risk-free profit. Since bid/ ask spread on currencies, this next example
accounts for the spread.
Gains from Locational Arbitrage Your gain from locational arbitrage is
based on the amount of money that you use to capitalize on the exchange
rate discrepancy, along with the size of the discrepancy
Triangular Arbitrage
Cross exchange rates represent the relationship between two currencies
that are different from ones base currency. In the United States, the term
cross exchange rate refers to the relationship between two non-dollar
currencies.
EXAMPLE : If the British pound () is worth $1.60, while the Canadian
dollar (C$) is worth $.80, the value of the British pound with respect to the
Canadian dollar is calculated as follows:
Value of in units of C$= $1.60/$.80= 2.0
The value of the Canadian dollar in units of pounds can also be
determined from the cross exchange rate formula: Value of C$ in units of
=$.80/$1.60 =.50 Notice that the value of a Canadian dollar in units of
pounds is simply the reciprocal of the value of a pound pound in units of
Canadian dollars.
Gains from Triangular Arbitrage
Gains from Triangular Arbitrage If a quoted cross exchange rate differs
from the appropriate cross exchange rate (as determined by the
preceding formula), you can attempt to capitalize on the discrepancy.
12

Specifically,

you

can

use

triangular

arbitrage

in

which

currency

transactions are conducted in the spot market to capitalize on a


discrepancy in the cross exchange rate between two currencies.
Covered Interest Arbitrage
The forward rate of a currency for a specified future date is determined by
the interaction of demand for the contract (forward purchases) versus the
supply (forward sales). Forward rates are quoted for some widely traded
currencies (just below the respective spot rate quotation) in the Wall
Street Journal. Financial institutions that offer foreign exchange services
set the forward rates, but these rates are driven by the market forces
(demand and supply conditions). In some cases, the forward rate may be
priced at a level that allows investors to engage in arbitrage. Their actions
will affect the volume of orders for forward purchases or forward sales of a
particular currency, which in turn will affect the equilibrium forward rate.
Arbitrage will continue until the forward rate is aligned where it should be,
and at that point arbitrage will no longer be feasible.
Steps Involved in Covered Interest Arbitrage
Covered interest arbitrage is the process of capitalizing on the interest
rate differential between two countries while covering your exchange rate
risk with a forward contract. The logic of the term covered interest
arbitrage becomes clear when it is broken into two parts: interest
arbitrage refers to the process of capitalizing on the difference between
interest rates between two countries; covered refers to hedging your
position against exchange rate risk. Covered interest arbitrage is
sometimes interpreted to mean that the funds to be invested are
borrowed locally. In this case, the investors are not tying up any of their
own funds. In another interpretation, however, the investors use their own
funds. In this case, the term arbitrage is loosely defined since there is a
positive dollar amount invested over a period of time. The following
discussion is based on this latter meaning of covered interest arbitrage;

13

under either interpretation, however, arbitrage should have a similar


impact on currency values.

Hedging:
Hedging is a risk management strategy used in limiting or offsetting
probability of loss from fluctuations in the prices of commodities,
currencies, or securities. In effect, hedging is a transfer of risk without
buying insurance policies.
Hedging employs various techniques but, basically, involves taking equal
and opposite positions in two different markets (such as cash and futures
markets). Hedging is used also in protecting one's capital against effects
of inflation through investing in high-yield financial instruments (bonds,
notes, shares), real estate, or precious metals.
We use financial derivatives for hedging purpose. The mostly used
hedging techniques are,
1.
2.
3.
4.

Forward
Future
Option
Swap

Forward:
A forward is an agreement between two counterparties - a buyer and
seller. The buyer agrees to buy an underlying asset from the other party
(the seller). The delivery of the asset occurs at a later time, but the price
is determined at the time of purchase. Any commitment between two
parties to trade an asset in the future is a forward contract.
The advantages of forward contracts are as follows:

Highly customized - Counterparties can determine and define the


terms and features to fit their specific needs, including when
delivery will take place and the exact identity of the underlying
asset.
14

Transactions take place in large, private and largely unregulated


markets consisting of banks, investment banks, government and

corporations.
Contains Non-standardized terms.
Underlying assets can be a stocks, bonds, foreign currencies,
commodities or some combination thereof. The underlying asset

could even be interest rates.


Margin Requirements do not exists.
Forwards are tailor made and can be written for any amount and

term.
It offers a complete hedge.
Forwards are over-the-counter products.
The use of forwards provide price protection.

The disadvantages of forward contracts are:

It requires tying up capital. There are no intermediate cash flows

before settlement.
All parties are exposed to counterparty default risk - This is the risk
that the other party may not make the required delivery or

payment.
It has no third party guarantee.
They tend to be held to maturity and have little or no market

liquidity.
Contracts may be difficult to cancel.
There may be difficult to find a counter-party.

Future:
Future contracts are also agreements between two parties in which the
buyer agrees to buy an underlying asset or a financial instrument from the
other party (the seller). The delivery of the asset occurs at a later time,
but the price is determined at the time of purchase.
The advantages of trading futures contracts:

Terms and conditions are standardized in terms of quantity of goods

and delivery date.


It is guaranteed by third party, the clearinghouse.
No counter party risk exists.
15

Its traders must post a good-faith margin deposit.


Trading takes place on a formal exchange regulated by a specific
government agency wherein the exchange provides a place to
engage in these transactions and sets a mechanism for the parties

to trade these contracts.


Commission charged for futures trading are relatively low.
Future contracts are highly leveraged financial instruments which
permit achieving greater gains using a limited amount of invested

funds.
It is possible to open short as well as long positions & positions can

be reversed easily.
Lead to high liquidity.
There is no default risk because the exchange acts as a
counterparty, guaranteeing delivery and payment by use of a

clearing house.
The clearing house protects itself from default by requiring its
counterparties to settle gains and losses or mark to market their

positions on a daily basis.


Futures are highly standardized, have deep liquidity in their markets

and trade on an exchange.


An investor can offset his or her future position by engaging in an
opposite transaction before the stated maturity of the contract.

The disadvantages of trading futures contracts:

Leverage can make trading in futures contracts highly risky for a

particular strategy.
Futures contract is standardized product and written for fixed

amounts and terms.


Lower commission costs can encourage a trader to take additional

trades and lead to over-trading.


It offers only a partial hedge.
It is subject to basis risk which is associated with imperfect hedging
using futures.

Option: A financial derivative that represents a contract sold by one party


(option writer) to another party (option holder). The contract offers the
buyer the right, but not the obligation, to buy (call) or sell (put) a security
16

or other financial asset at an agreed-upon price (the strike price) during a


certain period of time or on a specific date (exercise date).
Types of Options
There are many different types of options that can be traded and these
can be categorized in a number of ways. In a very broad sense, there are
two main types: calls and puts. Calls give the buyer the right to buy the
underlying asset, while puts give the buyer the right to sell the underlying
asset. Along with this clear distinction, options are also usually classified
based on whether they are American style or European style. This has
nothing to do with geographical location, but rather when the contracts
can be exercised. So the main four types of option contracts are

Calls

Puts

American Style

European Style

Calls
Call options are contracts that give the owner the right to buy the
underlying asset in the future at an agreed price. You would buy a call if
you believed that the underlying asset was likely to increase in price over
a given period of time. Calls have an expiration date and, depending on
the terms of the contract, the underlying asset can be bought any time
prior to the expiration date or on the expiration date..
Puts
Put options are essentially the opposite of calls. The owner of a put has
the right to sell the underlying asset in the future at a pre-determined
price. Therefore, you would buy a put if you were expecting the underlying
17

asset to fall in value. As with calls, there is an expiration date in the


contact.
American Style
The term American style in relation to options has nothing to do with
where contracts are bought or sold, but rather to the terms of the
contracts. Options contracts come with an expiration date, at which point
the owner has the right to buy the underlying security (if a call) or sell it (if
a put). With American style options, the owner of the contract also has the
right to exercise at any time prior to the expiration date. This additional
flexibility is an obvious advantage to the owner of an American style
contract.
European Style
The owners of European style options contracts are not afforded the same
flexibility as with American style contracts. If you own a European style
contract then you have the right to buy or sell the underlying asset on
which the contract is based only on the expiration date and not before.
The advantages and disadvantages of options
Options are a very unique investment vehicle so it is important to learn
the unique characteristics of options.
Advantages

Leverage. Options allow you to employ considerable leverage. This


is an advantage to disciplined traders who know how to use
leverage.

Risk/reward ratio. Some strategies, like buying options, allows you


to have unlimited upside with limited downside.

Unique Strategies. Options allow you to create unique strategies


to take advantage of different characteristics of the market - like
volatility and time decay.
18

Low capital requirements. Options allow you to take a position


with very low capital requirements. Someone can do a lot in the
options market with $1,000 but not so much with $1,000 in the
stock market.

Disadvantages

Lower liquidity. Many individual stock options don't have much


volume at all. The fact that each optionable stock will have options
trading at different strike prices and expirations means that the
particular option you are trading will be very low volume unless it is
one of the most popular stocks or stock indexes. This lower liquidity
won't matter much to a small trader that is trading just 10 contracts
though.

Higher spreads. Options tend to have higher spreads because of


the lack of liquidity. This means it will cost you more in indirect costs
when doing an option trade because you will be giving up the
spread when you trade.

Higher commissions. Options trades will cost you more in


commission per dollar invested. These commissions may be even
higher for spreads where you have to pay commissions for both
sides of the spread.

Complicated. Options are very complicated to beginners. Most


beginners,

and

even

some

advanced

investors,

think

they

understand them when they don't.

Time Decay. When buying options you lose the time value of the
options as you hold them. There are no exceptions to this rule.

Less information. Options can be a pain when it is harder to get


quotes or other standard analytical information like the implied
volatility.

19

Options not available for all stocks. Although options are


available on a good number of stocks, this still limits the number of
possibilities available to you.

SWAPS: Swaps are derivative instruments that involve an agreement


between two parties to exchange a series of cash flows over a specific
period of time.
Types of SWAP

Interest rate swap


Currency swap
Commodity swap
Credit default swap
Zero coupon swap
Total return swap

Interest Rate Swaps


The most popular types of swaps are plain vanilla interest rate swaps.
They allow two parties to exchange fixed and floating cash flows on an
interest-bearing investment or loan.
Assume Paul prefers fixed rate loans and has loans available at either
floating rate (LIBOR+0.5%) or at fixed rate (10.75%). Mary prefers floating
rate loan and has loans available at either floating rate (LIBOR+0.25%) or
at fixed rate (10%). Due to her better credit rating with the lender, Mary
has the advantage over Paul in both the floating rate market (by 0.25%)
and in fixed rate (by 0.75%). Her advantage is greater in the fixed rate
market, so she goes for fixed rate loan. However, since she prefers the
floating rate, she gets into a swap contract with a bank to pay LIBOR and
receive a 10% fixed rate.

20

Paul borrows at floating (LIBOR+0.5%), but since he prefers fixed, he


enters into swap contract with the bank to pay fixed 10.10% and receive
the floating rate.

Benefits: Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank,
and receives LIBOR from the bank. His net payment is 10.6% (fixed). The
swap effectively converted his original floating payment to a fixed rate,
getting him the most economical rate. Similarly, Mary pays 10% to the
lender and LIBOR to the bank, and receives 10% from the bank. Her net
payment is LIBOR (floating). The swap effectively converted her original
fixed payment to the desired floating, getting her the most economical
rate. The bank takes a cut of 0.10% from what it receives from Paul and
pays to Mary.
Currency Swaps
A swap that involves the exchange of principal and interest in one
currency for the same in another currency.
Assume an Australian company is setting up business in the UK and
needs GBP 10 million. Assuming AUD/GBP exchange rate at 0.5, the total
comes to AUD 20 million. Similarly, a UK-based company wants to setup a
plant in Australia and needs AUD 20 million. The cost of a loan in the UK is
10% for foreigners and 6% for locals, while that in Australia is 9% for
foreigners and 5% for locals. Apart from high cost of a loan for foreign
companies, it might be difficult to easily get the loan due to procedural
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difficulties. Both companies have the competitive advantage in their


domestic loan markets. The Australian firm can take a low-cost loan of
AUD 20 million in Australia, while the English firm can take a loan of GBP
10 million in the UK. Assume both loans need six monthly repayments.
Both companies can get into a currency swap agreement.
At the start, the Australian firm gives AUD 20 million to the English firm,
and receives GBP 10 million, enabling both firms to start business in their
respective foreign lands. Every six months, the Australian firm pays the
English firm the interest payment for the English loan = (notional GBP
amount * interest rate * period) = (10 million * 6% * 0.5) = GBP 300,000.
While the English firm pays the Australian firm the interest payment for
the Australian loan = (notional AUD amount * interest rate * period) = (20
million * 5% * 0.5) = AUD 500,000. Such interest payments continue until
the end of the swap agreement, at which time, the original notional forex
amounts will be exchanged back to each other.
By getting into a swap, both firms were not only able to secure low-cost
loans, but they also managed to hedge against interest rate fluctuations.
Variations also exist in the currency swaps, including fixed v/s floating and
floating v/s floating. Parties are able to hedge against volatility in forex
rates, secure improved lending rates, and receive foreign capital.
Commodity Swaps
Commodity swaps are common among people or companies that use raw
material to produce goods or finished products. Profit from a finished
product may take a hit if the commodity prices vary, as output prices may
not necessarily change in sync with the commodity prices. A commodity
swap allows receipt of payment linked to the commodity price against a
fixed rate.
Assume two parties get into a commodity swap over one million barrels of
crude oil. One party agrees to make six-monthly payments at a fixed price
of $60 per barrel and receive the existing (floating) price. The other party
will receive the fixed and pay the floating.
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Assume that price of oil shoots up to $62 at the end of six months, then
the first party will be liable to pay the fixed ($60 *1 million) = $60 million,
and receive the variable ($62 * 1 million) = $62 million from second. Net
inflow will be $2 million from the second party to the first.
In case the price dips to $57 over next six months, the first party will pay
net $3 million to the second party.
The first party has locked in the price of commodity using a currency
swap, achieving a price hedge. Commodity swaps are effective hedging
tools against variations in commodity prices or against variation in
spreads between the final product and the raw material prices.
Credit Default Swaps (CDS)
Another popular type of swap, the credit default swap, offers insurance in
case of default on part of a third-party borrower. Assume Peter bought a
15-year long bond issued by ABC, Inc. The bond is worth $1,000 and pays
annual interest of $50 (i.e., 5% coupon rate). Peter worries that ABC, Inc.
may default, so he gets into a credit default swap contract with Paul.
Under the swap agreement, Peter (CDS buyer) agrees to pay $15 per year
to Paul (CDS seller). Paul trusts ABC, Inc. and is ready to take the default
risk on its behalf. For the $15 receipt per year, Paul will offer insurance to
Peter for his investment and returns. In case ABC, Inc. defaults, Paul will
pay Peter $1,000 plus any remaining interest payments. In case ABC, Inc.
does not default throughout the 15-year long bond duration, Paul benefits
by keeping the $15 per year without any payables to Peter.
CDS work as insurance to protect the lenders and bondholders from
borrowers default risk. (Related: Credit Default Swaps: An Introduction)
Zero Coupon Swaps (ZCS)
Similar to the interest rate swap, the zero coupon swap offers flexibility to
one of the parties in the swap transaction. In a fixed-to-floating zero
coupon swap, the fixed rate cash flows are not paid periodically, but only
once at the end of the maturity of the swap contract. The other party
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paying floating rate keeps paying regular periodic payments following the
standard swap payment schedule.
A fixed-fixed zero coupon swap is also available, wherein one party does
not make any interim payments, but the other party keeps paying fixed
payments as per the schedule.
Such zero coupon swaps are primarily used for hedging. ZCS are often
entered into by businesses to hedge a loan in which the interest is to be
paid at maturity, or by banks that issue bonds with end-of-maturity
interest payments.
Total Return Swaps (TRS)
A total return swap allows an investor all the benefits of owning a security,
without actually owning it. A TRS is a contract between a total return
payer and total return receiver. The payer usually pays the total return of
an agreed security to the receiver, and receives a fixed/floating rate
payment in exchange. The agreed (or referenced) security can be a bond,
index, equity, loan, or commodity. The total return will include all
generated income and capital appreciation.
Assume Paul (the payer) and Mary (the receiver) enter into a TRS
agreement on a bond issued by ABC Inc. If ABC Inc.s share price shoots
up (capital appreciation) and it also pays a dividend (income generation)
during the swap contract duration, then Paul will pay Mary all those
benefits. In return, Mary will have to pay Paul a pre-determined
fixed/floating rate during the duration of swap.
Effectively, Mary receives total rate of return (in absolute terms) without
actually owning the security. She has the advantage of leverage. Mary
represents a hedge fund or a bank that benefits from the leverage and the
additional income without owning the security.
Paul transfers both the credit risk and market risk to Mary, in exchange for
a fixed/floating stream of payments. He represents a trader, whose long
positions can be effectively converted to a short-hedged position, using a
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TRS. He can also defer the loss or gain to the end of swap maturity using a
TRS.
The advantages and disadvantages of SWAP
Advantages
1. Borrowing at Lower Cost:
Swap facilitates borrowings at lower cost. It works on the principle of the
theory of comparative cost as propounded by Ricardo. One borrower
exchanges the comparative advantage possessed by him with the
comparative advantage possessed by the other borrower. The net result is
that both the parties are able to get funds at cheaper rates.
2. Access to New Financial Markets:
Swap is used to have access to new financial markets for funds by
exploring the comparative advantage possessed by the other party in that
market. Thus, the comparative advantage possessed by parties is fully
exploited through swap. Hence, funds can be obtained from the best
possible source at cheaper rates.
3. Hedging of Risk:
Swap can also be used to hedge risk. For instance, a company has issued
fixed rate bonds. It strongly feels that the interest rate will decline in
future due to some changes in the economic scene. So, to get the benefit
in future from the fall in interest rate, it has to exchange the fixed rate
obligation with floating rate obligation. That is to say, the company has to
enter into swap agreement with a counterparty, whereby, it has to receive
fixed rate interest and pay floating rate interest. The net result is that the
company will have to pay only floating rate of interest. The fixed rate it
has to pay is compensated by the fixed rate it receives from the
counterparty. Thus, risks due to fluctuations in interest rate can be
overcome through swap agreements. Similar, agreements can be entered
into for currencies also.
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4. Tool to correct Asset-Liability Mismatch:


Swap can be profitably used to manage asset-liability mismatch. For
example, a bank has acquired a fixed rate bearing asset on the one hand
and a floating rate of interest bearing liability on the other hand. In case
the interest rate goes up, the bank would be much affected because with
the increase in interest rate, the bank has to pay more interest. This is so
because, the interest payment is based on the floating rate. But, the
interest receipt will not go up, since, the receipt is based on the fixed rate.
Now, the asset- liability mismatch emerges. This can be conveniently
managed by swap. If the bank feels that the interest rate would go up, it
has to simply swap the fixed rate with the floating rate of interest. It
means that the bank should find a counterparty who is willing to receive a
fixed rate interest in exchange for a floating rate. Now, the receipt of fixed
rate of interest by the bank is exactly matched with the payment of fixed
rate interest to swap counterparty. Similarly, the receipt of floating rate of
interest from the swap counterparty is exactly matched with the payment
of floating interest rate on liabilities. Thus, swap is used as a tool to
correct any asset- liability mismatch in interest rates in future.
Disadvantages
1) Early termination of swap before maturity may incur a breakage cost.
2) Lack of liquidity.
3) It is subject to default risk.

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