Financial Systems Exam
Bond Market:
Contributions made by the bond market to the financial system:
- Contributes to the flow of funds  provides wholesale borrowers with access to long-term debt funds
+ by giving wholesale investors the opportunity to make long-term investments in a defensive asset
class
- Performs the price discovery function for long-term interest rates
- The yield at which other bonds trade reveal the risk premiums that apply to riskier bonds
Foreign Exchange Market
3 main functions of FX Market:
- Facilitate cross-currency payments that result from international trade, international financial flows +
the transfers between entities in different countries
- When a currency is floating, the FX market reveals the value of that currency  helps it adjust to
changing economic circumstances
- FX markets arrange the transfer of risks - through the use of forward contracts
AUD FX risk exposure of:
- Importers: need to purchase FX in the future – exposed to the risk of a lower AUD which will increase
cost of imports
- Exporters: will receive FX in the future which they will sell for AUD – risk lower export proceeds if AUD
appreciates
- Australians that lend/invest offshore: will want to sell foreign currency for AUD – risk if AUD
appreciates as they will receive less AUD from these investments
- Australians that borrow: will have to buy foreign currency in the future to repay loans – becomes
expensive is AUD depreciates.
Managing FX risk exposures: use of forward contracts – establish the exchange rate for a future settlement
date – removes uncertainty of unknown future spot rate
‘Spot’ and ‘Forward’ FX contracts:
- FX contract = specify the amounts of two currencies that will be exchanged on the settlement date
given the exchange rate at which the contracts were traded.
- Difference between spot + forward = date settlement occurs
o Spot = two business days after trade date
o Forward = settled the stated period after the spot settlement date (e.g. one-month forward =
settled one month and two days after trade date)
FX Dealers = organisation that is licensed by ASIC to trade foreign exchange in AUS
- Main dealers = major banks + international banks, which trade with each other and counterparties
Financial Systems Exam
FRA’s (Forward Rate Agreements)
Spot’ and ‘Forward’ rates:
- Spot = current interest rates that are observed in the wholesale financial markets (BBSW)
- Forward = apply to a period of financing that begins at a future date
- Implied forward = calculation from multi-period sport rates (e.g. if we are given 0r1 and 0r2, we can calc.
1r 2.
Unbiased-expectations hypothesis:
- Explains that forward rates are determined by the markets expectation of future spot rates
- Interprets yield curve shapes
Liquidity premium theory:
- Argues that longer-term securities expose investors to greater risk that shorter-term securities
- Interprets yield curve shape
Yield curves:
- Graphical representation of the term structure of interest rates
o Interest rates that apply to a particular class of assets according to their term
- Normal yield curve = indicates interest rates are higher as the securities term increases
- Inverse curve = short-term rates and higher than longer-term rates
- Flat = interest rates are the same regardless of securities term.
Futures Market
-
Established to manage the risk posed by volatile financial variables (i.e. interest-rates, exchange-rates
and share prices)
Performs price discovery (by establishing forward prices)
Futures contracts:
- Contract to buy a specific quantity of a commodity or financial instrument at a specified price with
delivery set at a specific time in the future
Long and short positions
- Buyer has the long position = contractual obligation to buy the contract item on the settlement date at
the agreed price
- Seller has the short position = contracted to sell on the settlement date at the agreed price
Role of clearinghouse in futures market:
- Clearinghouse in futures market = ASX Clear (Futures)
- Arranges the settlement of transactions and guarantees the performance of futures contracts.
- Clearinghouse manages traders’ default risk through novation and its system of margin payments
- Clearinghouse protects itself against default by ‘losing’ traders through a system of deposits called
margin payments.
Financial Systems Exam
BAB Futures as a Hedge instrument
- Issuers of BABs – exposed to the risk of higher than expected rates
- BAB futures can be used to create an offsetting position to hedge the exposure by:
o Selling BAB futures now
o Closing out the futures position (by buying the same BAB futures)
BAB vs FRAs
- Perform the same hedging purpose
- Differences:
o BAB futures are standardised contracts whereas FRAs meet the client’s specification
o BAB futures are traded whereas FRAS do not have a secondary market, hence BAB futures
hedge can be easily terminated
Interest Rate Swaps
A swap is an exchange of payments for an agreed period
- Performs risk-transfer function
- Arranged by swap dealers on an OTC basis and lack of secondary market
Fixed-for-Floating Swaps = ‘PLAIN VANILLA SWAP’
- Exchange of fixed-rate interest payments for floating-rate interest payments each swap period for the
term of the swap.
- Features of contract will include:
o Agreed principle upon which interest payments will be calculated
o Swap rate that determines fixed interest payments
o Reference rate used to determine floating rate (BBSW) at the start of each swap
o Calculation of net swap payments payable at the end of the swap period
These cancel out as we are now paying fixed as
well, thus, only floating interest payments are left
Financial Systems Exam
Plain Vanilla Swap as a Hedge:
- Value of swap is PV of swap payments (initially zero)
- BBSW will change unexpectedly during swap’s term
o BBSW rises = swap becomes valuable to fixed-rate payer
o BBSW falls = swap becomes valuable to floating-rate payer
Swap arranged by a dealer:
- Dealer’s income = form or a fee or more commonly through a spread between the swap rates they
quote
Swap Rate
- In order for both parties to agree to the swap:
-
The swap rate must equalise these payments
o Will be below average of the forward rates when the yield curve is normal and above whne
curve is inverse.
Exchange Traded Options
Option contracts
- Option = contract that provides its holder with the right (but not the obligation) to exercise the
contract
- Call = provides its holder the right to buy the contract item at the exercise price
- Put = provides its holder with the right to sell the contract item at the exercise price
*Buyer = long position (right to buy (call)/sell (put)), seller = short position (obligation to sell (call)/buy
(put))