MFP-4: CURRENCY AND DEBT MARKETS

ASSIGNMENT

Course Code : MFP-4

Course Title : CURRENCY AND DEBT MARKETS

Assignment Code : MFP-4/TMA/SEM-II/2017

Coverage : All blocks

Note : Attempt all the questions and submit this assignment on or before 31st October, 2017 to the
coordinator of your study center.
1. Briefly explain the structure of the currency markets in India. Discuss the various theories of
Exchange Rate Determination and elaborate on the major factors that influence currency volatility.
2. (a)What are Forward Rate Agreements (FRA)? Explain how FRA can be used to hedge currency
risk.
(b) Explain the following:
(i) Delta Hedging
(ii) Black Scholes Model
3. What is Money Market? Describe the different types of money market instruments and briefly
discuss the guidelines for the issuance of commercial paper.
4. What is meant by 'Duration of a bond? How is the duration and modified duration of a bond
calculated.
5. What are 'Interest Rate Futures'? Explain the process of pricing of interest rate futures.

ANSWERS

1. Briefly explain the structure of the currency markets in India. Discuss the various theories of
Exchange Rate Determination and elaborate on the major factors that influence currency volatility.

ANSWERS 1 :- There are two kinds of markets where borrowing and lending of money takes place
between fund scarce and fund surplus individuals and groups. The markets catering the need of
short term funds are called Money Markets while the markets that cater to the need of long term
funds are called Capital Markets.
Thus, money markets is that segment of financial markets where borrowing and lending of the short-
term funds takes place. The maturity of the money market instruments is one day to one year. In our
country, Money Markets are regulated by both RBI and SEBI.
Indian money market is divided into organized and unorganized segments. Unorganized market is
old Indigenous market mainly made of indigenous bankers, money lenders etc. Organized market is
that part which comes under the regulatory purview of RBI and SEBI. The nature of the money
market transactions is such that they are large in amount and high in volume. Thus, the entire
market is dominated by small number of large players. At the same time, the money market in India
is yet underdeveloped. The key players in the organized money market include Governments
(Central and State), Discount and Finance House of India (DFHI), Mutual Funds, Corporate,
Commercial / Cooperative Banks, Public Sector Undertakings (PSUs), Insurance Companies and
Financial Institutions and Non-Banking Financial Companies (NBFCs).

Structure of Organised Money Market in India

The organized money market in India is not a single market but is a conglomeration of markets of
various instruments. They have been discussed below:
Call Money / Notice Money / Term Money Market
Call Money, Notice Money and Term Money markets are sub-markets of the Indian Money Market.
These refer to the markets for very short term funds. Call Money refers to the borrowing or lending of
funds for 1 day. Notice Money refers to the borrowing and lending of funds for 2-14 days. Term
money refers to borrowing and lending of funds for a period of more than 14 days.
Treasury Bill (T Bills)
The bill market is a sub-market of the money market in India. There are two types of bills viz.
Treasury Bills and commercial bills. While Treasury Bills or T-Bills are issued by the Central
Government; Commercial Bills are issued by financial institutions
Commercial Bills
Commercial bills market is basically a market of instruments similar to Bill of Exchange. The
participants of commercial bill market in India are banks and financial institutions but this market is
not yet developed.
Certificate Of Deposits (CDs)
Certificate of Deposit (CD) refers to a money market instrument, which is negotiable and equivalent
to a promissory note. All scheduled commercial banks excluding Regional Rural Banks (RRBs) and
Local Area Banks (LABs) and Select All India Financial Institutions permitted by RBI are eligible to
issue certificates of deposits.
 Commercial Papers (CP)
Commercial Paper (CP) is yet another money market instrument in India, which was first introduced
in 1990 to enable the highly rated corporates to diversify their resources for short term fund
requirements.
Money Market Mutual Funds (MMMFs)
Money Market Mutual Funds (MMMFs) were introduced by RBI in 1992 but since 2000, they are
brought under the purview of the SEBI. They provide additional short-term avenue to individual
investors.
The Repo / Reverse Repo Market
Repo (repurchase agreement ) was introduced in December 1992. Repo means selling a security
under an agreement to repurchase it at a predetermined date and rate. Repo transactions are
affected between banks and financial institutions and among bank themselves, RBI also undertake
Repo. IN 1996, Reverse Repo was introduced. Reverse Repo means buying a security on a spot
basis with a commitment to resell on a forward basis. Reverse Repo transactions are affected with
scheduled commercial banks and primary dealers.
Discount And Finance House Of India (DFHI)
It was established in 1988 by RBI and is jointly owned by RBI, public sector banks and all India
financial institutions which have contributed to its paid up capital. DFHI plays important role in
developing an active secondary market in Money Market Instruments. From 1996, it has been
assigned status of a Primary Dealer (PD). It deals in treasury bills, commercial bills, CDs, CPs, short
term deposits, call money market and government securities.
Functions of Money Markets
Due to short maturity term, the instruments of money market are liquid and can be converted to cash
easily and thus are able to address the need of the short term surplus fund of the lenders and short
term borrowing requirements of the borrowers. Thus, the major function of the money markets is to
cater to the short term financial needs of the economy. The other functions are as follows:
1. Money Markets help in effective implementation of the RBIs monetary policy
2. Money markets help to maintain demand and supply equilibrium with regard to short term
funds
3. They cater to the short term fund requirement of the governments
4. They help in maintaining liquidity in the economy

Factors which influence the exchange

rate
Exchange rates are determined by factors, such as interest rates, confidence, current
account on balance of payments, economic growth and relative inflation rates. For
example:

If US business became relatively more competitive, there would be greater demand for
American goods; this increase in demand for US goods would cause an appreciation (increase
in value) of the dollar.
 However, if markets were worried about the future of the US economy, they would tend to sell
dollars, leading to a fall in the value of the dollar.

Determination of exchange rates using supply and demand diagram

In this example, a rise in demand for Pound Sterling has led to an increase in the value
of the to $ from 1 = $1.50 to 1 = $1.70

Note:

Appreciation = increase in value of exchange rate

Depreciation / devaluation = decrease in value of exchange rate.

Factors that influence exchange rates

1. Inflation

If inflation in the UK is relatively lower than elsewhere, then UK exports will become
more competitive, and there will be an increase in demand for Pound Sterling to buy UK
goods. Also, foreign goods will be less competitive and so UK citizens will buy fewer
imports.

Therefore countries with lower inflation rates tend to see an appreciation in the value of their
currency. For example, the long term appreciation in the German D-Mark in the post-war period
was related to the relatively lower inflation rate.

2. Interest rates

If UK interest rates rise relative to elsewhere, it will become more attractive to deposit
money in the UK. You will get a better rate of return from saving in UK banks. Therefore
demand for Sterling will rise. This is known as hot money flows and is an important
short run factor in determining the value of a currency.

Higher interest rates cause an appreciation.

Cutting interest rates tends to cause a depreciation

3. Speculation

If speculators believe the sterling will rise in the future, they will demand more now to be
able to make a profit. This increase in demand will cause the value to rise. Therefore
movements in the exchange rate do not always reflect economic fundamentals, but are
often driven by the sentiments of the financial markets. For example, if markets see
news which makes an interest rate increase more likely, the value of the pound will
probably rise in anticipation.
The fall in the value of the Pound post-Brexit was partly related to the concerns that the
UK would no longer attract as many capital flows outside the Single Currency.

4. Change in competitiveness

If British goods become more attractive and competitive this will also cause the value of
the exchange rate to rise. For example, if the UK has long-term improvements in labour
market relations and higher productivity, good will become more internationally
competitive and in long-run cause an appreciation in the Pound. This is a similar factor
to low inflation.

5. Relative strength of other currencies

In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because
markets were worried about all the other major economies US and EU. Therefore,
despite low interest rates and low growth in Japan, the Yen kept appreciating. In the
mid-1980s, the Pound fell to a low against the Dollar this was mostly due to strength
of Dollar, caused by rising interest rates in the US.

6. Balance of payments
A deficit on the current account means that the value of imports (of goods and services)
is greater than the value of exports. If this is financed by a surplus on the
financial/capital account, then this is OK. But a country which struggles to attract
enough capital inflows to finance a current account deficit will see a depreciation in the
currency. (For example, current account deficit in US of 7% of GDP was one reason for
depreciation of dollar in 2006-07). In the above diagram, the UK current account deficit
reached 7% of GDP at the end of 2015, contributing to the decline in the value of the
Pound.

7. Government debt

Under some circumstances, the value of government debt can influence the exchange
rate. If markets fear a government may default on its debt, then investors will sell their
bonds causing a fall in the value of the exchange rate. For example, Iceland debt
problems in 2008, caused a rapid fall in the value of the Icelandic currency.

For example, if markets feared the US would default on its debt, foreign investors would
sell their holdings of US bonds. This would cause a fall in the value of the dollar.

8. Government intervention

Some governments attempt to influence the value of their currency. For example, China
has sought to keep its currency undervalued to make Chinese exports more
competitive. They can do this by buying US dollar assets which increases the value of
the US dollar to Chinese Yuan.

9. Economic growth/recession
A recession may cause a depreciation in the exchange rate because during a recession
interest rates usually fall. However, there is no hard and fast rule. It depends on several
factors.
2. (a)What are Forward Rate Agreements (FRA)? Explain how FRA can be used to hedge currency
risk.
(b) Explain the following:
(i) Delta Hedging
(ii) Black Scholes Model

(A) What is a 'Forward Rate Agreement - FRA'

A forward rate agreement (FRA) is an over-the-counter contract between parties that
determines the rate of interest, or the currency exchange rate, to be paid or received on
an obligation beginning at a future start date. The FRA determines the rates to be used
along with the termination date and notional value. FRAs are cash settled with the
payment based on the net difference between the interest rate and the reference rate in
the contract.

BREAKING DOWN 'Forward Rate Agreement - FRA'

Typically, for agreements dealing with interest rates, the two parties exchange a fixed rate for a
variable one. The party paying the fixed rate is usually referred to as the borrower, while the
party receiving the variable rate is referred to as the lender.

As a basic example, assume Company A enters into an FRA with Company B in which
Company A will receive a fixed rate of 5% for one year on a principal of $1 million in one
year. In return, Company B will receive the one-year LIBOR rate, determined in three
years' time, on the principal amount. The agreement will be settled in cash in a payment
made at the beginning of the forward period, discounted by an amount calculated using
the contract rate and the contract period.

Forward Rate Agreement Payment Formula

The formula for the FRA payment takes into account five different variables. They are:

FRA = the FRA rate

R = the reference rate

NP = the notional principal

P = the period, which is the number of days in the contract period

Y = the number of days in the year based on the correct day-count convention for the
contract

The FRA payment amount is calculated by multiplying two terms together, the
settlement amount and the discount factor:
FRA payment = (((R - FRA) x NP x P) / Y) x (1 / (1 + R x (P / Y)))

Assume the following data:

FRA = 3.5%

R = 4%

NP = $5 million

P = 181 days

Y = 360 days

The FRA payment is calculated as:

FRA payment = (((4% - 3.5%) x $5,000,000 x 181) / 360) x (1 / (1 + 4% x (181 / 360))) =

$12,569.44 x 0.980285 = $12,321.64

If the payment amount is positive, the FRA seller pays this amount to the buyer.
Otherwise, the buyer pays the seller. As for the day-count convention, if the contract is
in British sterling, 365 days are used. In all other currencies the convention is to use 360
days.

b) Explain the following:

(i) Delta Hedging

(ii) Black Scholes Model

(i) Delta Hedging

(B) Delta hedging is an options strategy that aims to reduce, or hedge, the risk
associated with price movements in the underlying asset, by offsetting long
and short positions. For example, a long call position may be delta
hedged by shorting the underlying stock.
(C) Black Scholes Model

The Black Scholes model, also known as the Black-Scholes-Merton model, is a model
of price variation over time of Financial instruments such as stocks that can, among other
things, be used to determine the price of a European call option. The model assumes
the price of heavily traded assets follows a geometric Brownian motion with constant
drift and volatility. When applied to a stock option, the model incorporates the constant
price variation of the stock, the time value of money, the option's strike price and the
time to the option's expiry.

3. What is Money Market? Describe the different types of money market instruments and briefly
discuss the guidelines for the issuance of commercial paper.

The money market is where financial instruments with high liquidity and
very short maturities are traded. It is used by participants as a means for
borrowing and lending in the short term, with maturities that usually range
from overnight to just under a year. Among the most common money
market instruments are eurodollar deposits, negotiablecertificates of
deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial
paper, municipal notes, federal funds and repurchase agreements (repos).

TYPES OF MONEY MARKET INSTRUMENTS

Treasury Bills
Treasury bills (T-bills) are short-term notes issued by the U.S. government. They come
in three different lengths to maturity: 90, 180, and 360 days. The two shorter types are
auctioned on a weekly basis, while the annual types are auctioned monthly. T-bills can
be purchased directly through the auctions or indirectly through the secondary market.
Purchasers of T-bills at auction can enter a competitive bid (although this method
entails a risk that the bills may not be made available at the bid price) or a
noncompetitive bid. T-bills for noncompetitive bids are supplied at the average price of
all successful competitive bids.

Federal Agency Notes

Some agencies of the federal government issue both short-term and long-term
obligations, including the loan agencies Fannie Mae and Sallie Mae. These obligations
are not generally backed by the government, so they offer a slightly higher yield than T-
bills, but the risk of default is still very small. Agency securities are actively traded, but
are not quite as marketable as T-bills. Corporations are major purchasers of this type of
money market instrument.

Short-Term Tax Exempts

These instruments are short-term notes issued by state and municipal governments.
Although they carry somewhat more risk than T-bills and tend to be less negotiable,
they feature the added benefit that the interest is not subject to federal income tax. For
this reason, corporations find that the lower yield is worthwhile on this type of short-term
investment.

Certificates of Deposit
Certificates of deposit (CDs) are certificates issued by a federally chartered bank
against deposited funds that earn a specified return for a definite period of time. They
are one of several types of interest-bearing "time deposits" offered by banks. An
individual or company lends the bank a certain amount of money for a fixed period of
time, and in exchange the bank agrees to repay the money with specified interest at the
end of the time period. The certificate constitutes the bank's agreement to repay the
loan. The maturity rates on CDs range from 30 days to six months or longer, and the
amount of the face value can vary greatly as well. There is usually a penalty for early
withdrawal of funds, but some types of CDs can be sold to another investor if the
original purchaser needs access to the money before the maturity date.

Large denomination (jumbo) CDs of $100,000 or more are generally negotiable and pay
higher interest rates than smaller denominations. However, such certificates are only
insured by the FDIC up to $100,000. There are also eurodollar CDs; they are negotiable
certificates issued against U.S. dollar obligations in a foreign branch of a domestic bank.
Brokerage firms have a nationwide pool of bank CDs and receive a fee for selling them.
Since brokers deal in large sums, brokered CDs generally pay higher interest rates and
offer greater liquidity than CDs purchased directly from a bank.

Commercial Paper
Commercial paper refers to unsecured short-term promissory notes issued by financial
and nonfinancial corporations. Commercial paper has maturities of up to 270 days (the
maximum allowed without SEC registration requirement). Dollar volume for commercial
paper exceeds the amount of any money market instrument other than T-bills. It is
typically issued by large, credit-worthy corporations with unused lines of bank credit and
therefore carries low default risk.

Standard and Poor's and Moody's provide ratings of commercial paper. The highest
ratings are A1 and P1, respectively. A2 and P2 paper is considered high quality, but
usually indicates that the issuing corporation is smaller or more debt burdened than A1
and P1 companies. Issuers earning the lowest ratings find few willing investors.

Unlike some other types of money-market instruments, in which banks act as

intermediaries between buyers and sellers, commercial paper is issued directly by well-
established companies, as well as by financial institutions. Banks may act as agents in
the transaction, but they assume no principal position and are in no way obligated with
respect to repayment of the commercial paper. Companies may also sell commercial
paper through dealers who charge a fee and arrange for the transfer of the funds from
the lender to the borrower.

Bankers' Acceptances
A banker's acceptance is an instruments produced by a nonfinancial corporation but in
the name of a bank. It is document indicating that such-and-such bank shall pay the
face amount of the instrument at some future time. The bank accepts this instrument, in
effect acting as a guarantor. To be sure the bank does so because it considers the
writer to be credit-worthy. Bankers' acceptances are generally used to finance foreign
trade, although they also arise when companies purchase goods on credit or need to
finance inventory. The maturity of acceptances ranges from one to six months.

Repurchase Agreements
Repurchase agreementsalso known as repos or buybacksare Treasury securities
that are purchased from a dealer with the agreement that they will be sold back at a
future date for a higher price. These agreements are the most liquid of all money market
investments, ranging from 24 hours to several months. In fact, they are very similar to
bank deposit accounts, and many corporations arrange for their banks to transfer
excess cash to such funds automatically.
QUESTION 4 What is meant by 'Duration of a bond? How is the duration and modified duration of a
bond calculated.

ANSWER 4 : Our example shows that if the bond's yield changed from 5% to 6%, the
duration of the bond will decline to4.33 years. Because it calculates how duration will
change when interest increases by 100 basis points, the modified duration will always
be lower than the Macaulay duration.

Modified duration is a formula that expresses the measurable change in the value of a
security in response to a change in interest rates. Modified duration follows the concept
that interest rates and bond prices move in opposite directions. This formula is used to
determine the effect that a 100-basis-point (1%) change in interest rates will have on the
price of a bond. Calculated as:

BREAKING DOWN 'Modified Duration'

Duration measures the average cash-weighted term to maturity of a bond. It is a very
important number for portfolio managers, financial advisors and clients to consider when
selecting investments because, all other risk factors equal, bonds with higher durations
have greater price volatility than bonds with lower durations. There are many types of
duration, and all components of a bond, such as its price, coupon, maturity date and
interest rates, are used to calculate duration.

Modified Duration Calculation

Modified duration is an extension of something called Macauley duration, which allows
investors to measure the sensitivity of a bond to changes in interest rates. In order to
calculate modified duration, the Macauley duration must first be calculated. The formula
for the Macauley duration is:

Macauley duration = Sum of (PV)(CF) * T / market price of the bond.

Here, (PV)(CF) is the present value of a coupon at period t and T is equal to the time to
each cash flow in years. This calculation is performed and summed for the number of
periods to maturity. For example, assume a bond has a three-year maturity, pays a 10%
coupon, and that interest rates are 5%. This bond, following the basic bond pricing
formula would have a market price of:

$100 / (1.05) + $100 / (1.05)^2 + $1,100 / (1.05)^3 = $95.24 + $90.70 + $950.22 =

$1,136.16

Next, using the Macauley duration formula the duration is calculated as:

Macauley duration = ($95.24 * 1 / $1,136.16) + ($90.70 * 2 / $1,136.16) + ($950.22 * 3 /

$1,136.16) = 2.753

This result shows that it takes 2.753 years to recoup the true cost of the bond. With this
number, it is now possible to calculate the modified duration.

To find the modified duration, all an investor needs to do is take the Macauley duration
and divide it by 1 + (yield-to-maturity / number of coupon periods per year). In this
example that calculation would be:

Modified duration = 2.753 / (1.05 / 1) = 2.621

This shows that for every 1% movement in interest rates, the bond in this example
would inversely move in price by 2.621%.

QUESTION 5. What are 'Interest Rate Futures'? Explain the process of pricing of interest rate
futures.

An interest rate future is a financial derivative (a futures contract) with an interest-bearing

instrument as the underlying asset. It is a particular type of interest ratederivative. Examples
include Treasury-bill futures, Treasury-bond futures and Eurodollar futures.

uying an interest rate futures contract allows the buyer of the contract to lock in a future investment rate; not
a borrowing rate as many believe. Interest rate futures are based off an underlying security which is a debt
obligation and moves in value as interest rates change.
When interest rates move higher, the buyer of the futures contract will pay the seller in an amount equal to that
of the benefit received by investing at a higher rate versus that of the rate specified in the futures contract.
Conversely, when interest rates move lower, the seller of the futures contract will compensate the buyer for the
lower interest rate at the time of expiration.
To accurately determine the gain or loss of an interest rate futures contract, an interest rate futures price index
was created. When buying, the index can be calculated by subtracting the futures interest rate from 100, or
(100 - Futures Interest Rate). As rates fluctuate, so does this price index. You can see that as rates increase, the
index moves lower and vice versa.

How do you calculate the gain or loss on the futures contract?

Typically, the interest rate futures contract has a base price move (tick) of .01, or 1 basis point however, some
contracts have a tick value of .005 or half of 1 basis point. For example, for Eurodollar contracts, a tick is
worth $12.50 and a move from 94 to 94.50 would result in a $1250 gain per contract for someone who is long
the futures.
HEDGING WITH FUTURES
Many participants in the interest rate futures market hedge their positions that have an interest rate risk with an
offsetting futures contract. As the hedge becomes profitable and traders see less risk in the market, the hedge
will be peeled off.

Other participants will use interest rate futures to hedge forward borrowing rates. For example, it is currently
March and I need to borrow money in June for 1 month at Libor plus 2. The current LIBOR rate is 2.75% and
let's say the 3 month LIBOR futures are 3%. I will basically be locking in a 5% forward rate by shorting or
selling the LIBOR June1 month LIBOR futures contracts.

WHAT TYPES OF INTEREST RATE FUTURES ARE TRADED?

Interest rate futures in the US markets are traded on the CME (Chicago Mercantile Exchange). Below is the
list of short term interest rate futures contracts traded on US and foreign interest rates.
Three Month Eurodollars
Eurodollars refer to US dollars that are currently being held on deposit in foreign commercial banking
institutions. The ability for banks to be able to have access to fund US dollar loans to foreign purchasers of US
goods without the currency exchange rate risks makes the Eurodollar futures very attractive for hedging
purposes. For this reason, the Eurodollar futures market has exploded in the last 20 years and has become the
most highly traded futures contracts out there.
CME's Eurodollar contract reflects pricing at 3 month LIBOR on a $1 million offshore deposit.

One Month Libor

One month LIBOR contract is very similar to the Eurodollar contract; however, it represents a 1 month LIBOR
on a $3 million deposit.

EuroYen
Euroyen are similar to Eurodollars and represent Japanese Yen deposits outside of Japan.

13 Week Treasury Bills

Treasury backed instruments are considered risk free investments as they are backed in good faith by the
United States government. T-bill futures contracts are available in quarterly contracts.
One Month Fed Funds
Federal funds represent reserves Federal Reserve member banks in excess of the reserve requirement for
banks. These deposits are not interest bearing deposits and therefore banks lend these funds out to other
member banks for overnight term.
91-Day Cetes (Mexican Treasury Bills)
Cetes are government issued short term paper issued in Mexican Pesos. Similar to the US Treasury market,
Cetes is the basis for short term lending rates in Mexico.

28-Day TIIE (Mexican Interest Rate)

The TIIE is the benchmark interbank interest rate that Mexican banks use to borrow or lend from the Bank of
Mexico.