ACI DEALING
CERTIFICATE
WEBINAR TRAINING
Exam Code 002-101
Jointly facilitated by
Andre Kurten &
Craig Rod
2022
© Andre Kurten 2022
Examination Procedure
The examination lasts 2 hours and consists of 70 multiple-choice questions.
The overall pass level is 60% (42 correct answers), assuming that the
minimum score criteria for each topic basket is met. There is a minimum
score criteria of 50% for each topic basket. One mark is given for each
correctly answered question. No negative marking and questions are asked
in sequentially. Unlike the old syllabus, no distinction between theory and
calculation in each topic. Overall mark is considered.
Calculators: Some questions will require the use of a calculator. A basic one
will be provided on the computer screen. You may also use your own handheld calculator, provided it is neither text programmable nor capable of
displaying graphics with a size more than 2 lines.
Pass 60% - 69.99%, Merit 70% - 79.99%, Distinction 80% and above
NOTE: The exam questions assume that you are a dealer working in
London.
The exam topic basket structure
•Section 1 – Financial market Environment - 10 questions all theory
•Section 2 – Foreign Exchange - 18 questions -12 theory and 6 calculation
•Section 3 - Rates 18 questions -12 theory and 6 calculation
•Section 4 – FICC Derivatives - 14 questions -8 theory and 6 calculation
•Section 5 - Financial markets Applications - 10 questions all theory
© Andre Kurten 2022
Topic Basket 1
Financial Markets
Environment
Covered in Tutorial 1
© Andre Kurten 2022
Section Objectives
Overall Objectives: The overall objective of this topic
is for candidates to understand the functions
performed by financial markets in the economy and to
explain its different segments, their scope and
instruments. Candidates will be able to understand the
basic concepts of efficient markets and the impact of
regulation and codes in financial markets. Referring to
the life cycle of a typical financial market transaction,
candidates will be able to explain its main phases.
o 10 questions – 5 minimum correct answers
© Andre Kurten 2022
The Role of Financial Markets
Here are four important functions of financial markets:
1. Put's savings into more productive use - financial markets like banks
open it up to individuals and companies that need a home loan, student
loan, or business loan.
2. Determines the price of securities - prices of securities are determined
by financial markets which consider many economic factors as well as the
efficiency of the market.
3. Makes financial assets liquid - Buyers and sellers can decide to trade
their securities anytime.
4. Lowers the cost of transactions - In financial markets, various types of
information regarding securities can be acquired without the need to spend.
The efficient market hypothesis (EMH)
The efficient market hypothesis also known as the efficient market theory,
holds that market prices reflect all information.
The four major economic agents in the market are:
Government, financial institutions, corporations, and households.
© Andre Kurten 2022
The Financial Markets
. Where do financial markets exist?
Location - the market is anywhere that people either meet on a physical trading floor such
as the London Metal Exchange, or a virtual trading platform provided by vendors’ such as
Bloomberg or Reuters (Refinitiv) or global stock exchanges
The primary market – where instruments are issued for the first time.
The secondary market – where instruments already in issue are traded.
How do participants find each other in the market?
Intermediation – through a recognized and regulated financial intermediary like a bank or
pension fund or mutual fund. Equity markets and the market for CDs are good examples of
intermediation.
Disintermediation – where borrower and lender deal directly with each other. Commercial
paper market is a good example of disintermediation
Regulated markets – A regulated market usually operates under a license issued by the
relevant government body. Stock exchanges, Commodity exchanges and Futures exchanges are
good examples of regulated markets. Trading on a regulated market is done subject to the rules
of that market or exchange.
 Unregulated markets - An unregulated market is a market over which very little if any
government legislation, other than common law, exert a level of oversight and control to
protect investors. Money and foreign exchange are good examples of unregulated markets.
An unregulated market usually operates under the premise of ‘my word is my bond’, so
trades should be done under the covering of a legal contract between the parties subject to a
master agreement like ISDA.
© Andre Kurten 2022
The Financial System
GOVERNMENT
INTERMEDIATION
FUNDS
FIRMS
FUNDS
FINANCIAL
INTERMEDIARIES
INSTRUMENTS
HOUSEHOLDS
INSTRUMENTS
FIRMS
FUNDS
HOUSEHOLDS
SURPLUS
UNITS
INSTRUMENTS
DISINTERMEDIATION
GOVERNMENT
DEFICIT
UNITS
© Andre Kurten 2022
Typical Bank Treasury Structure
Dealing Room
Back office
Middle office
The dealing room is the engine room for creating deals.
Market risk therefore originates in the dealing room.
This risk is controlled in the dealing room by the imposition of limits.
The middle office is the area where risk emanating from the dealing room is
measured and reported.
Improper measurement or control can result in unexpected losses.
The back office is where deals are processed and settled. This is where
operational risk can be created through inefficient operations and processing
© Andre Kurten 2022
Dealing Room Functions
 Customer dealing
• Forex, Money, Bond, and Derivatives Markets
 Proprietary dealing
• using allocated risk capital to generate revenue from
speculation
 Managing the liquidity of the bank
• vital function of the treasury
 Executing Asset and Liability Management (ALM)
instructions
© Andre Kurten 2022
Dealers
They are responsible for making prices, market making and
facilitating the deal flow in the financial markets. Market
making involves showing two-way prices i.e., bids and offers.
In doing so they enjoy the following:
•Earn the spread between bid and offer
•Good relationships with clients and other banks
•Getting a good flow of information
They execute deals in the market through:
• Reuters dealing and other trading platforms
•Telephonically, or
•via the internet where the correct protocol exists for
internet dealing.
They input the deals so that the processing of deals can
begin but do not get to do confirmation or payment processing
© Andre Kurten 2022
Inter dealer Brokers- IDBs
 An example of an IDB is ICAP PLC
 They act as AGENT and facilitate deals between dealers in the banks and
charge a commission for this service
Details of commission structure are contained in a signed brokerage
agreement.
 IDBs DO NOT take positions but deal strictly back-to-back on client
instructions.
IDBs take the prices they have been quoted by the banks and quote the
highest bid and lowest offer back to the market anonymously
 Their vital role is providing liquidity, price discovery, and Information, to the
market .
Typical questions:
1. Clients of a voice broker quote EUR/USD at 1.1875/80, 1.1878/83,
1.1879/84, and 1.1877/82. What will be the brokers price?
2. Clients of a voice broker quote EUR/GBP at 0.6344/49, 0.6346/51,
0.6348/53, and 0.6349/53. What will be the brokers price?
© Andre Kurten 2022
Core Functions in Treasury Ops
BACK OFFICE
•Input and completion of deals
•Verification by confirmation
•Settlement
•Reconciliation
MIDDLE OFFICE
•Risk Management
•Accounting
•Documentation
•Financial Statements
•Analysis and Budgets
•Systems and telecommunications
The order in which a deal takes place is:
1.
2.
3.
4.
5.
Trade capture (deal entry) or registration – usually done by the dealer
Confirmation – must be done by the back office
Netting (if possible)
Payment (settlement)
Reconciliation - separate from the individuals responsible for payments
© Andre Kurten 2022
Treasury Operations
Today's Reality
• Front and back office must be independent but interdependent
• The Treasury Operations division within a financial institution has
grown into a key admin area due to two main reasons:
oLarge daily market turnover
oMulti centre operations
Payment Netting
•This has reduced high value payments and reduced credit and settlement risk
although errors can still be very costly
Straight through processing (STP)
•means no manual intervention post-trade
Segregation of duties
•clearly defined roles and responsibilities for front, middle and back office
Regulation and compliance
Risk management and separation of reporting lines
© Andre Kurten 2022
Global Market Codes and Regulation
The regulation and codes in financial markets are dealt with in
Tutorial 1 of the study guide. Please ensure that you familiarise
yourself with content in this section.
Market Codes
They are not legally binding, but promote open, fair, and effective markets.
1. UK Money Market code
2. The FX global Code
3. The Global Precious Metals Code
Regulations
Market participants and firms in breach of these regulations can be legally
sued and may be subject to fines and jail time if found guilty.
1. Market in Financial Instruments Directive II - MiFID II
2. Market Abuse Regulation – MAR
3. Benchmark Regulation – BMR
4. Dodd-Frank Wall Street Reform and Consumer Protection Act
5. European Market Infrastructure Regulation - EMIR
Although there is a brief overview of the Basel Accords I, II, and III, in
this section, they are dealt with in more detail in the Financial Market
Application tutorial 5 in the study guide
© Andre Kurten 2022
Topic Basket 2
Foreign Exchange
Covered in Tutorial 2
© Andre Kurten 2022
Section Objectives
Overall Objectives: The overall objective of this topic is for candidates to
understand and to be able to explain basic foreign exchange rate quotations,
their terminology, mechanics and the principal risks associated with FX spot
and forward instruments. At the end of this section, candidates will be able to
define the relationship between forward rates and interest rates, explain the
use of FX outright forwards for foreign currency risk management and the
use of FX swaps in rolling spot positions, hedging FX outright forwards, and
in creating synthetic foreign currency assets and liabilities. Candidates will
be required to perform basic calculations for FX market instruments. The
candidates will be able to describe NDFs and, explain their rationale.
Candidates will be able to understand and identify quotations for precious
metals, and demonstrate a basic understanding of the structure and
operation of precious metals’ financial market
• 18 questions comprising 12 theory and 6 calculation questions
– 9 minimum correct answers
© Andre Kurten 2022
Forex Jargon
Spot date - two good business days (in both currencies) after deal date
Value date - the date when delivery takes place on a deal
Bid- the rate at which the price maker is willing to buy the BASE Currency
Offer - the rate at which the price maker is willing to sell the BASE
Currency
Spot quotes- either to 4 decimals or in the case of JPY to 2 decimals
Spread – difference in points between the bid and offer price
Direct quote - 1 unit of USD in relation to quoted currency
Indirect quote - 1 unit of currency other than the USD in relation to USD
Bid/offer - A spot quote is always low/high. For example, 1.2535/40
indicates a bid at 1.2535 and offer at 1.2540. An example where a quote
appears as follows; 1.2595/05 it indicates a bid at 1.2595 and an offer of
1.2605. We describe this quote as one where the bid/offer crosses a big
figure.
NOTE: The currencies quoted indirectly against the USD are the
EUR,GBP, AUD, NZD; All others are quoted directly.
”My risk” – price taker acknowledging to the price maker that he knows that the quote
may change due to the delay in his response to the quote received
“Your risk” - price maker cautioning the price taker that due to the delay in his responding
to the price quoted, the quoted price may change.
© Andre Kurten 2022
Forex Jargon
Currency
dominance - The EUR is the dominant base currency in the
market. In any currency pair that includes the EUR, the EUR will be the
base. This is followed by the GBP, AUD, NZD, and then the USD. This can
be remember using the the acronym EGANU.
Reciprocal quote – This is done by inverting a conventional quote. For
example, given EUR/GBP calculate GBP/EUR. To do this, divide the given
exchange rate into 1. NOTE: When calculating a reciprocal given a bid and
offer, then the offer will become the bid and the bid the offer. For example,
EUR/GBP is 0.8530/0.8540 so GBP/EUR 1.1710/1.1723
Forward exchange rate - the rate agreed today for the exchange of one
currency for another at some date in the future other than spot
Outright – a forward contract for a future value date
Swap - a purchase for one value date with a simultaneous sale for a
different value date (Sale With A Purchase)
Overnight O/N - rolling out a position from today into tomorrow
tom/next T/N - rolling out a position from tomorrow into the spot date
Spot Next S/N - rolling out of spot into the next day
© Andre Kurten 2022
Dealing in Spot FX Markets
Consider
how you would deal in your own currency
against the USD or other major currencies
Always look at what you are doing in the base currency.
 You buy the base at the offer side from the market.
You sell the base at the bid side to the market.
If you have a QUOTED currency amount, you will
DIVIDE by the exchange rate to get the BASE currency
amount
If you have a BASE currency amount, you will MULTIPLY
by the exchange rate to get the QUOTED currency
amount
NOTE: As a market user receiving several quotes:
•You buy the base currency at the LOWEST offer
•You sell the base currency at the HIGHEST bid
© Andre Kurten 2022
Market-making and Pips
 Market-making is where a dealer is willing to quote
other market participants and brokers bids and offers in
a currency pair. The benefits are:
 Bid/offer spread
 Flow information
 Relationships
 One pip represents 0.0001 and one big figure
represents 0.0100
 In 1 million of the BASE currency 1 pip is equal to 100
of the quoted currency. For example, in the GBP/USD
 GBP 1,000,000 x 0.0001 = USD 100
 In 1 million of the BASE currency 1 big figure is equal
to 10,000 of the quoted currency. For example, in the
EUR/GBP
 EUR 1,000,000 x 0.0100 = GBP 10,000
© Andre Kurten 2022
Spot FX Questions
1. Spot cable is quoted at 1.6048-53 in the brokers, and you quote a customer 1.6050-55 in
USD 3 million, If they sell USD to you, how much GBP will you be short of?
A. 4,816,500.00
B. 1,868,809.57
C. 1.868,576.77
D. 4,815,900.00
2. Spot EUR/GBP is quoted at 0.8890 in 1,000,000 of the base currency, how much is one big
figure of worth?
A. EUR 10,000
B. EUR 100
C. GBP 8,890
D. GBP 10,000
3. When quoting the exchange rate between the AUD and the EUR, which currency should be
quoted as the base currency?
A. EUR
B. AUD
C. It depends whether you are in Europe or Australia
D. It really does not matter
4. What does the exchange rate USD/NOK 6.1050 indicate?
A. There are 6.1050 USD per 1 NOK
B. There are 6.1050 NOK to 1 USD
C. The inflation differential between the US and Norway
D. None of the above
© Andre Kurten 2022
Cross rates
An
exchange rate which is derived from two other quoted
exchange rates is called a cross rate.
•The stronger currency usually becomes the base currency in a
cross quote
Deriving a cross rates by using two dollar based or direct quote mid
rates. Given the following what is the CHF/HKD exchange rate:
USD/HKD is 7.2500 that is 1USD = HKD 7.2500
USD/CHF is 1.5000 that is 1USD = CHF 1.5000
We can deduce mathematically therefore that
CHF 1.5000 = HKD 7.2500
To find out how many HKD = 1CHF we need to divide both sides
by 1.5000 (to arrive at 1CHF on the left-hand side).
1.5000/1.5000 = 7.2500/1.5000
1CHF = HKD4.8333
or CHF/HKD= 4.8333
There are some simple rules which help when you are asked to
calculate a cross rate using bid/offer
© Andre Kurten 2022
Rules for cross rates
TWO DIRECT QUOTES (USD BASED QUOTES)
“Cross and divide” (divide high number by low number). For example,
to determine the CHF/HKD given
USD/HKD= 7.2515/7.2525
USD/CHF =1.1030/1.1035
BID = 7.2515/1.1035 = 6.5714
OFFER = 7.2525/1.1030 = 6.5752
CHF/HKD = 6.5714/ 6.5752 (spread is 38 points)
NOTE: When you are calculating a cross rate given two direct quotes, the
weaker currency is divided by the stronger currency and the stronger
currency becomes the base.
© Andre Kurten 2022
Rules for cross rates
TWO INDIRECT QUOTES (NON-USD BASED QUOTES)
As with two direct quotes you “Cross and divide” however, irrespective of
strength, here you divide the currency that will become the BASE by the
currency that will become the QUOTED following EGANU. Given EUR/USD
and GBP/USD, the dominant base currency is the EUR. So, the cross rate
will be EUR/GBP. So, you cross and divide the EUR/USD with the GBP/USD
EUR/USD= 1.2510/1.2520
GBP/USD = 1.4030/1.4040
BID = 1.2510/1.4040 = 0.8910
OFFER = 1.2520/1.4030 = 0.8924
EUR/GBP = 0.8910/0.8924
© Andre Kurten 2022
Rules for cross rates
A DIRECT AND INDIRECT QUOTE (different base currency)
“Straight down and Multiply” multiply the bid with the bid and the
offer with the offer. Once again ensure that you follow EGANU to
determine the base. Because AUD is the dominate base
currency, the cross rate will be AUD/CHF.
For example, to determine the AUD/CHF given
USD/CHF=
1.0520/1.0525
AUD/USD
= 0.7530/0.7540
BID = 1.0520x0.7530 = 0.7922
OFFER = 1.0525x0.7540 = 0.7936
AUD/CHF = 0.7922/0.7936
© Andre Kurten 2022
Cross Rate and Reciprocal Questions
1. You quote a client AUD/USD 0.9080/0.9085. What would you quote them if they wanted the
quote as USD/AUD?
A. 1.1013/1.1007
B. 1.1007/1.1013
C. 0.9085/0.9080
D. 0.9100/0.9110
2. What is the correct price for SGD/SEK given that:
USD/SGD 1.2760/1.2770
USD/SEK 6.4800/6.5200
A. 5.0784/5.1057
B. 8.2685/8.3260
C. 0.1957/0.1971
D. 5.0744/5.1097
3. Spot EUR/USD is quoted at 1.0055-60 and spot GBP/USD at 1.5575-80. What is the
EUR/GBP cross-rate?
A. 0.6456-57
B. 0.6454-59
C. 1.5482-95
D. 1.5661-73
4. What are the ISO codes for the currencies of India, Argentina and South Africa?
A. IDR, ARP, SAR
B. INR, ARP, ZAR
C. IDR, ARG, ZAR
D. INR, ARS, ZAR
© Andre Kurten 2022
Forward foreign exchange
Forward
foreign exchange is used to hedge against adverse
currency movements
Forward points (swap points) are determined by the deposit
rates of the TWO currencies applied to the current spot rate.
Where the actual forward points traded in the market deviate
too far away from the forward points implied by the interest
rates of the two currencies, then arbitrage is possible.
This form of arbitrage is referred to as covered interest rate
arbitrage.
Covered interest rate arbitrage involves borrowing (or
lending) one currency and using an FX swap transaction to
create the other currency at a more favourable interest rate
than is currently available in the money market.
© Andre Kurten 2022
Foreign Exchange and Money market
There
is a very close relationship between the foreign
exchange and the money market.
They share the same calendar roll mechanism for maturities.
For example, the maturity for a 1-month money market deposit
or FX Swap out of spot date of 4th May will be 4th June.
The sale of one currency automatically generates an
equivalent amount in the counter currency. For example, if you
are short of USD, you can sell GBP to raise USD in the FX
spot market.
Interest rate parity theorem states that there is no advantage
of going from a low interest rate currency into a high interest
rate currency if you hedge the exchange rate risk. The reason
being that the forward points are equal to the difference
between the interest rates of the two currencies for the period
of an investment.
© Andre Kurten 2022
Calculating a FX forward rate - 1
Positive Points
Assume that the exchange rate (SPOT) between USD and
CHF is 1.2500 (USD 1 = CHF 1.2500). Let us also assume
that the interest rate for one year in USD is 3%, and the interest
rate for CHF for one year is 5% (assuming 360/360 for both
currencies)
•Using the information given:
USD 1 CHF 1.2500
oThe USD/CHF one year
forward rate is:
1.3125 ÷1.03 = 1.2743
3%
5%
1 YR
oThe forward points are:
1.2743 - 1.25 = 0.0243
USD1.03 CHF 1.3125
OR
243 Points
© Andre Kurten 2022
Calculating a FX forward rate - 2
Negative Points
Let’s assume that the exchange rate (SPOT) between USD and
CHF is 1.2500 (USD 1 = CHF 1.25). Let us assume that the
interest rate for one year in USD is 5%, and the interest rate for
CHF for one year is 1%. (assuming 360/360 for both currencies)
USD 1 CHF 1.2500
1 YR
5%
1%
USD1.05 CHF 1.2625
•Using the information given:
oThe USD/CHF one year
forward rate is:
1.2625 ÷1.05 = 1.2024
oThe forward points are:
1.2024 - 1.2500 = - 0.0476
OR
negative 476 Points
© Andre Kurten 2022
Forward FX formula
The formula provided by the ACI calculates the forward outright rate.


 TCIR x days 
 1 


TCDB



Forward Points  Spot x 

 BCIR x days 

1





BCDB




Where:
TCIR = terms currency interest rate
BCIR = base currency interest rate
TCDB = terms currency day base
DCDB = base currency day base






 - Spot




Using the information from the previous example of positive points.
Here we use ACT/360 for one year so 365/360 for both currencies



 0.05 x 365  
1







360




Forward Points  1.2500 x
- 1.2500 


 0.03 x 365 


1







360
 
 




 1.050694 
 1.25 x 
 - 1.2500 
 1.030417 


 1.2746 - 1.2500
 0.0246 or 246 points
© Andre Kurten 2022
Discount and Premium
The points will be POSITIVE where the base currency interest rates
are lower than the quoted currency interest rates. The the base
currency is described as a premium and the quoted currency as a
discount in the forward market. Positive points are quoted
“Low/High”.
Positive points benefit the seller of the base currency on the forward
dates and points would be described as “in your favour”.
The points will be NEGATIVE where the quoted currency interest
rates are lower than the base currency interest rates. The base
currency is described as a discount and the quoted currency as a
premium in the forward market. Negative points are quoted
“High/Low”. Negative points benefit the buyer of the base currency
on the forward dates and points would be described as “in your
favour”.
NOTE: It is possible for swap points to be positive, par and negative
in a currency pair under certain yield curve conditions.
© Andre Kurten 2022
How do we know if points are
Negative or positive?
Points Negative
Quoted currency
Interest rates
Are higher than
Quoted currency
interest rates
The gap represents the
points i.e. the interest rate
differential
Are higher than
The gap represents the
points i.e. the interest rate
differential
Base currency
Interest rates
Points Positive
Base currency
Interest rates
The currency with the higher interest rate in the quoted pair is at a forward
discount to the other currency irrespective of whether it is the base currency
or not.
It is cheaper to buy the discount currency in the forward market.
© Andre Kurten 2022
Change in forward points
The
forward points (swap points) will change because of two
factors:
A change in the spot – but the move in the spot must be
significant.
A change in the interest rates of the two currencies – This
will have a much more significant effect on the forward points.
Some examples
1. In the EUR/USD, if USD interest rates are higher than EUR
interest rates, how would you describe the swap points and
which currency is at a premium? Then, if EUR rates fall, what
will happen to the swap points?
2. In the USD/JPY, if USD interest rates are higher than JPY
interest rates, how would you describe the swap points and
which currency is at a premium? Then, if USD rates fall, what
will happen to the swap points?
© Andre Kurten 2022
Forward FX quotation
Currency quotes in the spot market are generally 4 decimal places. For
Example, EUR/USD 1.1500/10. The exception is where a quote involves the
JPY. For example, CHF/JPY 109.85/90. Where The reciprocal is quoted as
JPY/CHF it can be to 6 decimal places. So, the example given as a
reciprocal would be JPY/CHF 0.009099/0.009103.
 Forward points (swap points) are quoted as whole numbers. However,
when adjusting the spot with the forward points you must convert the points
to a decimal before adding (or subtracting) the points to or from the spot. In
a 4 decimal place currency you divide the points by 10,000. For a 2 decimal
place currency you divide the points by 100. Where points are to 6 decimal
places (JPY/CHF) then divide by 1,000,000.
Unlike the spot market, forward points can be quoted to 6 decimal places.
Some examples
1. Spot USD/CHF 0.9875/80. 1-month points 10/9. (negative points)
1mth outright 0.9865/71 (0.0010 and 0.0009 subtracted from bid/offer respectively)
2. Spot EUR/JPY 120.20/25 1-month points 7.50/6.75. (negative points)
1mth outright 120.125/120.1825 ( 0.075 and 0.0675 subtracted from bid/offer
respectively)
3. Spot USD/SGD 1.1895/05. 1-month points 25/30. (positive points)
1mth outright 1.1920/1.1935 (0.0025 and 0.0030 added to bid/offer respectively)
© Andre Kurten 2022
Deriving swap points from O/R and spot
Calculating forward (swap) points given the spot and
outright:
Bid
Offer
3 month Outright = 179.07 179.42
minus
Spot GBP/JPY = 181.31 181.62
Forward points = -2.24
-2.2
Market quotation
224
220
To go from the decimal to the quoted points multiply by
100 for JPY. Remember for 4-decimal place currencies,
you multiply by 10,000.
The points are NEGATIVE (bid higher than offer). GBP
interest rates are therefore higher than JPY interest rates.
JPY Premium and GBP discount.
© Andre Kurten 2022
Cross forward FX - An Example
USD/NOK spot is 7.8350/60
USD/NOK 3 mth Fwd pts 340/380
GBP/USD spot is 1.5400/05
GBP/USD 3 mth Fwd pts 70/65
Step1- calculate 3 mth fwd for each
currency pair
3 month USD/NOK outright
7.8350
7.8360
+0.0340 +0.0380
7.8690
7.8740
3 month GBP/USD outright
1.5400
1.5405
-0.0070
-0.0065
1.5330
1.5340
Step 2 – calculate the cross
GBP/NOK 3 mth outright
(Direct and indirect quote use
straight down and multiply rule
stronger currency is the base)
USD/NOK
7.8690
7.8740
GBP/USD
1.5330
1.5340
GBP/NOK
12.0632
3mth outright
12.0787
© Andre Kurten 2022
Forward FX questions - 1
1. Overnight GBP/SGD is trading at Par. Overnight rates in the UK are trading at 3%.
What is the most likely rate for overnight rates in Singapore?
A. 2.96%
B. 3%
C. 3.04%
D. Too little information to determine
2. A 6-month SEK/NOK swap is quoted 140/150. Spot is 0.9445. Which of the following
statement is correct?
A. SEK interest rates are higher than NOK interest rates
B. NOK interest rates are higher than SEK interest rates
C. NOK interest rates are higher than USD interest rates
D. SEK interest rates and NOK interest rates are converging
3. The interest Rate Parity Theorem should work because, when one sells a low interest
rate currency to invest in high interest rate currency and hedges the currency risk
A. The cost of hedging is given by the forward points, which are equal to the
interest rate differential between the two currencies
B. The high interest rate currency will depreciate
C. The profit from the appreciation of the high interest rate currency has been
hedged away
D. Interest rates are mean reverting, which means the low interest rate will tend to
rise and the high interest rate will tend to fall
© Andre Kurten 2022
Forward FX questions - 2
4. Using the following rates:
Spot GBP/CHF 1.4235-55
Spot CHF/SEK 6.8815/45
3M GBP/SEK swap 140/150
What is the price for 3-month outright GBP/SEK?
A. 9.8141-9.8246
B. 9.8108-9.8279
C. 9.8098-9.8289
D. 9.8151-9.8236
5. If spot GBP/CHF is quoted 1.4275-80 and the 3-month forward outright is 1.4254-61,
what are the forward points?
A. 19/21
B. 2.1/1.9
C. 21/19
D. 0.21/0.19
6. Using the following rates, calculate the 6-month EUR/USD outright forward rate. Spot
EUR/USD 1.1155, 6-month (182-day) EUR deposits are 3.25%, and 6-month (182-day)
USD deposits are 2.05%
A. 1.1087
B. 1.1088
C. 1.1222
D. 1.1223
© Andre Kurten 2022
Outright Forward Exchange
This
is a transaction with one leg for a forward date other
than spot and the deals are done between banks and client.
•These
transactions are usually referred to as Forward
Exchange Contracts – FECs
For example, an exporter in the South Africa has USD
receivables in 3 months time. They wish to secure a rate
today for delivery in 3 months time.
The bank is quoting 3-month bid at 2000 pips and the spot
is 15.0000 so the customer will receive 15.2000 for his USD
in 3 months time irrespective of the prevailing spot. (quote
outright forward rate to clients and not the pips)
The bank in turn will use the FX swap market and the spot
market to hedge the customer deal.
In this example, the bank will buy and sell 3 – months and
sell USD/ZAR spot.

© Andre Kurten 2022
FX time Options
Banks
offer outright foreign exchange contracts to
their customers on the following basis:
1.Fixed
dated
•This
is the most common form of FX outright forward contract.
•This is a contact where the customer can only take up the
contract on the expiry date.
•The customer can however shorten or extend this contract using
a FX swap at their own cost.
2.Time
options
•this
is an FX outright contract where the customer has flexibility
on the drawdown date of the contract.
•Time options can be offered in two ways:
a.
b.
Partly optional – This is a contract which can be drawn down
only after a certain time has elapsed but must be taken up by the
expiry date.
Fully optional – this is a contract that can be taken up at anytime
from inception but must be taken up at expiry.
© Andre Kurten 2022
FX time Options - Pricing
Positive points
Partly Optional
The customer will sell the base currency to the bank at the bid side of the points for
the start of the forward period added to the bid of the spot. If they wish to buy the
base currency, they pay the offer side of the points for the full term of the contract
added to the offer of the spot.
Fully optional
The customer will sell the base currency to the bank at the bid side of the spot. If they
wish to buy the base currency, they pay the offer side of the points for the full term of
the contract added to the offer side of the spot.
Negative points
Partly Optional
If the contract is partly optional, the customer will sell the base currency to the bank
at the bid side of the points for the end of the forward period subtracted from the bid
of the spot. If they wish to buy the base currency, they pay the offer side of the points
for the near leg of the contract subtracted from the offer of the spot.
Fully optional
The customer will sell the base currency to the bank at the bid side of the points for
the full term subtracted from the bid of the spot. If they wish to buy the base currency,
they pay the offer side of the spot.
© Andre Kurten 2022
FX time Options - Pricing
Example- positive points
Spot USD/ZAR is 12.5075/85
1-mth points 200/210
2-mth points 425/435
3-mth points 550/570
a. A 3-month partly optional contract where the contract can be taken up after 1
month (1x3) would be quoted as USD/ZAR 12.5275/12.5655 ( bid: 12.5075+0.0200
offer: 12.5085+0.0570).
b.A 3-month fully optional contract where the contract can be taken up at anytime in
the 3 months would be quoted as USD/ZAR 12.5075/12.5655 ( bid: 12.5075 offer:
12.5085+0.0570).
Example- Negative points
Spot USD/CHF is 1.1075/85
1-mth points 30/25
2-mth points 45/35
3-mth points 50/45
c. A 3-month partly optional contract where the contract can be taken up after 1
month (1x3) would be quoted as USD/CHF 1.1025/1.1060 ( bid: 1.1075-0.0050 offer:
1.1085-0.0025).
d.A 3-month fully optional contract where the contract can be taken up at anytime in
the 3 months would be quoted as USD/CHF 1.1025/1.1085( bid: 1.1075-0.0050 offer:
1.1085).
© Andre Kurten 2022
Forward exchange swaps
This
•A
transaction involves TWO legs namely
spot leg AND a forward leg.
Assuming
a dealer wants to buy 3-month USD in an FX
swap against the CHF, he will then “sell and buy”.
This
means he will sell USD/CHF in the spot market and
buy the 3-month USD/CHF in the same amount with the
same counterparty simultaneously.
Deals are usually interbank.
The
spot price is agreed immediately between the buyer
and seller when the deal is done, and the points are added
to the spot.
•if
the points are negative, then the forward rate will be
LOWER than the spot.
•The spot agreed is usually the mid rate of the current
bid/offer.
© Andre Kurten 2022
Forward Forward swaps
This is a FX Swap starting at a future date other than spot
•For example, a dealer wants to do a FX Swap for 3
months starting in 3 months time.
•This is described as a 3x6 swap.
RULE: Take the far bid and subtract the near offer to get the
fwd–fwd bid and take the far offer and subtract the near bid to
get the fwd – fwd offer.
USD/CHF 3 mth Fwd pts 80/85
USD/CHF 6 mth Fwd pts 140/145
3x6 BID at 55 points. (140-85)
3x6 OFFER at 65 points ((145-80)
The 3 x 6 bid/offer is 55/65.
The ‘spot basis’ for a 3x6 forward forward swap is usually the
mid-rate of bid/offer of the outright forward for the START of
the forward period.
© Andre Kurten 2022
Forward foreign exchange
Value tomorrow price convention
“switch the T/N points to change the sign and add to or, subtract from the spot”.
Positive T/N Points
Negative T/N Points
The spot rate GBP/USD is 1.3500/1.3510
The T/N points are 2.5/2.6 (positive points L/H)
Switch the points to make them negative (H/L)
What is the bid/offer rate for tomorrow?
1.3500 1.3510
-0.00026 -0.00025
Tom price for GBP/USD = 1.34974/1.350750
The spot rate EUR/GBP is 0.8540/0.8545
The T/N points are 2/1 (negative points H/L)
Switch the points to make them positive (L/H)
What is the bid/offer rate for tomorrow?
0.8540 0.8545
+0.0001 +0.0002
Tom price for EUR/GBP = 0.8541/0.8547
Value today price convention
“add the overnight and tom/next points (bid with bid and offer with offer) and
switch to change the sign and add to or, subtract from the spot”.
Positive T/N and O/N Points
The spot rate GBP/USD is 1.3500/1.3510
O/N 2.8/3.0 and T/N 2.5/2.6
2.8 + 2.5 = 5.3 Bid 3.0 + 2.6 = 5.6
Switch the points to make them negative
What is the bid/offer rate for tomorrow?
1.3500 1.3510
-0.00056 -0.00053
Value today for GBP/USD = 1.34944/1.350470
Negative T/N and O/N Points
The spot rate EUR/GBP is 0.8540/0.8545
O/N 3/2 and T/N 2/1
3 + 2 = 5 Bid 2 + 1 = 3
Switch the points to make them positive
What is the bid/offer rate for tomorrow?
0.8540 0.8545
+0.0003 +0.0005
Value today price for EUR/GBP = 0.8543/0.8550
© Andre Kurten 2022
Forward FX questions - 3
7. If you are quoted the following rates at what rate can you buy cable for value tomorrow?
Spot cable
1.6540-43
O/N cable swap
1.20/1.15
T/N cable swap
1.80/1.72
A. 1.65444.15
B. 1.654480
C. 1.654185
D. 1.653880
8. How is an outright forward FX transaction quoted?
A. Forward points
B. Full forward exchange rate
C. Depends on whether is interbank or to a customer
D. Depends on the currency pair and sometimes the term
9. A “time option” is an outright forward FX transaction where the customer:
A. Has the right but not the obligation to exercise the outright forward at maturity
B. May freely choose the maturity of the option, given a 24-hout notice to the bank
C. Can choose any maturity date within a previously pre-arranged fixed period of time
D. May decide to deal at the regular maturity or on either the business day before or after the
regular maturity date
10. A customer calls for a 3 month forward outright quote in USD/CHF. Spot is 1.4915/20. The forward is
42/40. What price do you quote?
A. 1.4875/78
B. 1.4957/80
C. 1.4871/81
D. 1.4873/80
© Andre Kurten 2022
Forward FX questions - 4
11. The “spot basis” of a 3 against 6 months EUR/CHF forward/forward swap is:
A. always the forward EUR/CHF bid rate of the first swap leg
B. Generally, the prevailing 3-month forward EUR/CHF mid-rate
C. commonly the prevailing 6-month forward EUR/CHF mid-rate
D. normally the current spot EUR/CHF mid-market rate
12. If I say that I have “bought and sold” EUR/USD in an FX swap, what have I done?
A. Bought EUR and sold USD spot, and sold EUR and bought USD forward
B. Bought EUR/USD spot then sold EUR/USD forward
C. Taken a EUR loan in exchange for making a USD loan with the same counterparty
D. All of the above
13. You wish to sell a customer GBP/USD for value tomorrow. How can you hedge yourself?
a. Sell and buy GBP/USD T/N
b. Buy and sell GBP/USD T/N
c. Sell GBP/USD spot, and sell and buy GBP/USD T/N
d. Buy GBP/USD spot, and buy and sell GBP/USD T/N
14. 3-month EUR/USD FX swaps are quoted to you at 8/12. If the "points are in your favour",
what have you done?
A. Bought and sold 3-month EUR/USD through the swap
B. Sold and bought 3-month EUR/USD through the swap
C. Made the quote
D. Cannot say
© Andre Kurten 2022
NDFs - Non-Deliverable Forwards
 NDFs are currency contracts for difference (CFDs) and is like a
FRA for foreign exchange rates.
 They are traded in countries where there is no formal forward
exchange market or an illiquid forward market,
 NDF currencies: RUB, CNY, BRL, PHP,TWD,MYR, INR,
PKR,VND, EGP, KES, UAH, ARS, CLP, COP, PEN.
 Mainly used for speculation but can be used for hedging.
 They are like forward outright FX deals where a future rate of
exchange is agreed between the parties.
 At Expiry, only the DIFFERENCE between the fixing spot rate
and the NDF contract rate is settled in the convertible currency
(the base currency – usually USD).
 If at fixing the prevailing fixing spot rate is higher that the NDF
rate, the seller pays the buyer the difference.
 If the prevailing exchange rate is lower, the buyer pays the seller.
 There is never an obligation to take or make delivery of the
notional contract amount.
© Andre Kurten 2022
NDF Example
3-month NDF in USD/CNY at 6.2500.
Notional principal USD 10 million
2 scenarios in 3 months time:
USD/CNY fixes at 6.2600.
Difference of 100 pips on USD 10m is CNY100,000.
Settlement occurs in USD so 100,000/6.2600 = USD
15,974.44 seller pays the buyer.
2. USD/CNY fixes at 6.2300.
Difference of 200 pips on USD 10m is CNY200,000.
Settlement occurs in USD so 200,000/6.2300 = USD
32,102.73 Buyer pays the seller.
If this contract was used to hedge, the hedgers effective
exchange rate will be the NDF rate provided they can
procure the additional USD at the fixing rate in the spot
market



1.
© Andre Kurten 2022
The Precious Metals Market
ISO codes for precious metals
•Gold – XAU Fixing twice a day in London at 10.30am and 3.00pm
•Platinum – XPT
•Palladium – XPD
•Silver – XAG
The four major gold coins traded are: Kruger Rand, American Eagle,
British Sovereign
•all have a gold purity of 22 carats or 0.9167.
The Canadian Maple leaf with a purity of 24 carats or 0.9999
According to the LBMA (London Bullion Market Ass.) assay across the
range permitted for Good Delivery bars approximately 995.0 to 999.9 for
gold unless specifically agreed by the LBMA.
•They are to be within the weight range of 350 to 430 troy ounces for
gold.
•The bars are usually close to 400 troy ounces.
The gold forward offered rate is known as the ‘GOFO’ rate.
A LOCO account – is the equivalent of a Nostro account for gold.
There may be questions on the above points in the foreign exchange
section in the exam.
© Andre Kurten 2022
NDF and Precious Metal questions
1. The seller of a EUR/RUB NDF could be:
A. a potential buyer of EUR against RUB
B. speculating on an appreciation of the Russian Rouble
C. expecting rising EUR/RUB exchange rates
D. a seller of Russian Rouble
2. The daily gold fixing rate takes place at N.M Rothschild’s:
A. Once a day at 10:30am (London time)
B. Once a day at 3:00pm (London time)
C. Once a day at 12:00 noon (London time)
D. Twice a day 10:30am and 3:00pm (London time)
3. How many Yen would you pay to buy 1 ounce of gold if you were quoted the following?
XAU/USD 1575.25-75
USD/JPY 96.55-60
A. JPY 152,090
B. JPY 152,139
C. JPY 152,169
D. JPY 152,217
4. As far as fineness and weight are concerned, what are the London Bullion Market
Association (LBMA) requirements for a “good delivery bar”?
A. minimum 995/999.9 pure gold; weight of exactly 400 fine ounces
B. at least 995/999.9 pure gold; weight between 395 and 405 fine ounces
C. at least 995/1000 pure gold; weight of exactly 400 fine ounces
D. minimum 995/1000 pure gold; weight between 350 and 430 fine ounces
© Andre Kurten 2022
Topic Basket 3
Rates
Covered in Tutorial 3
© Andre Kurten 2022
Section Objectives
Overall Objectives: The overall objective of this topic is for candidates to
understand the principles of the time value of money, the function of the
interest rates markets, the characteristics of the main types of money market
instruments and interest rate capital markets instruments, as well as how
they satisfy the requirements of different types of borrowers and lenders.
Candidates will need to be able to calculate short-term interest rates and to
perform standard calculations using quoted prices. Candidates will
understand the basic characteristics and applications of a forward curve and
of a yield curve and will be required to calculate them. At the end of this topic
candidates need to be able to understand and outline the main features of
bonds, particularly how they can be structured, priced and used as a key
element in repo markets. Given the greater inherent complexity of repo
instruments, candidates are required to be able to explain and calculate repo
instruments issues and problems.
• 18 questions comprising 12 theory and 6 calculation questions
– 9 minimum correct answers
© Andre Kurten 2022
Day Count – Annual Basis Conventions
Always assume that you are a trader in London when doing
the exam. In all calculations, the day count/annual basis
convention used must be that which applies in London.
Not all currencies calculate interest using the same day countannual basis convention.
Domestic money markets use either ACT/365 or ACT/360
•ACT refers to the actual number of days in the investment period.
You will always be given the days, but NOT the day base in the
exam.
•The following currencies given in the exam use a 360 annual
basis convention. They are USD, EUR, CHF, CAD, SEK, NOK,
DKK, AUD, NZD, SAR, ARS, MXN, and JPY.
•Eurocurrency GBP, ZAR, PLN, HKD, SGD and INR use ACT/365.
Since 1999 USD Treasury bonds and notes, Euro Denominated
government bonds, GBP Gilts all use ACT/ACT convention for accrued
interest calculations.
© Andre Kurten 2022
Possible ACI Questions
1. Which of the following currencies use ACT/360 Day count/annual basis?
A. GBP B. ZAR C.NZD D. SGD
2. Which of the following currencies use ACT/365 Day count/annual basis?
A. AUD B. ZAR C. EUR D. JPY
3. What is the Day count/annual basis for accrued interest on GBP Gilts?
A. ACT/ACT B. ACT/360 C. 30/360 D. ACT/365
4. Which of the following are all ACT/365 currencies?
A. INR, SEK, USD, HKD
B. SAR, ZAR, INR, HKD
C. INR, ZAR, HKD, PLN
D. NZD, SEK, AUD, HKD
© Andre Kurten 2022
Benchmark Rates
 London Interbank Offered Rate - LIBOR (often referred to as ICE LIBOR)
calculated by the ICE Benchmark Administration (IBA) and is a mean (simple
average) of all the rates collected from several quoting banks. GBP, CHF,JPY, and
EUR LIBOR ceased to be published after the 31st December 2021. USD LIBOR for
one-week and two-month tenors ceased to be published after the 31st December
2021. The remaining USD LIBOR tenors will continue to be published until 30th June
2023.
 Euro Interbank Offered Rate - EURIBOR is calculated by the European Money
Markets Institute in Brussels and is a mean of all the rates collected from the panel
banks. The panel banks will quote the rates they believe are quoted by one prime
bank to another prime bank for interbank term deposits within the Euro Zone.
 JBA Tokyo Interbank Offered Rate – JBA TIBOR calculated by Japanese
Bankers Association as a prevailing market rate based on quotes for 5 different
maturities (1 week, 1, 3, 6, and 12 months) provided by reference banks as of 11:00
a.m. each business day.
 Tokyo Term Risk Free Rate - TOFR is a benchmark calculated by QUICK based
on the uncollateralized overnight call rate which involves almost no credit risk of
financial institutions. Like existing interest rate benchmarks such as LIBOR, the rate
is fixed as of the start of the interest rate calculation period, making the system and
administrative burden associated with the switch, relatively small. It is published for
1-, 3-, and 6-month tenors.
© Andre Kurten 2022
Overnight Index Benchmarks
These rates are referred to as risk-free rates (RFRs) and are VOLUMEWEIGHTED AVERAGE RATES
•
•
•
•
•
•
Sterling Overnight Index Average - SONIA calculated by Bank Of England (BOE)
and measures the cost of overnight, unsecured borrowing which includes
transaction amounts of GBP 25 million or more.
EUR short-term rate - €STR is calculated by the European Central Bank (ECB)
and reflects the wholesale euro unsecured overnight borrowing costs of euro area
banks which includes transaction amounts of EUR 1 million or more.
Effective Fed Funds Rate - EFFR for USD calculated by the NY Fed based on
unsecured deposits.
Secured Overnight Financing rate - SOFR is a a rate published by the NY Fed
and determined from GC repo transaction against US treasuries as collateral.
Swiss Average Rate Overnight - SARON calculated by the Swiss National Bank
and is based on repo transactions which are secured.
Tokyo overnight average rate - TONA calculated by the Bank of Japan is the cost
of borrowing in the Japanese yen unsecured overnight money market.
Typical exam questions:
1. Which of these risk-free rates represent secured transactions?
A. ESTR B. TONA C. SOFR D. All the above
2. Who calculates the SONIA? A. BOE B. BOJ C. SNB. D. FED
© Andre Kurten 2022
Rates format and basis points
Interest rates quoted as fractions and decimals
•The interest rates in the exam will be expressed as a decimal and quoted as a
percentage per annum. It is still fairly common practice in some markets to
express rates and prices as fractions.
Basis points
•1 basis point is 0.01% or 0.0001 as a decimal.
Payment of Interest
•Interest must be paid at least once every 12 months (annually) as interest rates
are quoted per annum.
Typical exam questions:
1. You quote a client a base rate of 3.15% and add a credit spread of 50 basis points.
What rate does the client pay?
A. 3.20% B. 3.55% C. 3.65% D. 8.15%
2. You invest in a 3-year Eurodollar deposit. How often will you receive interest?
A. Once B. 3 times C. 36 times D. 6 times
3. 20 basis points is equivalent to:
A. 0.20% B. 2% C. 0.02% D. 20%
© Andre Kurten 2022
Interest Rate Calculations
 For the exam you will need to be able to do simple interest
calculations in Section 1 as well as the sections covering
money markets, FRAs, futures, interest rate swaps.
 These calculations are the foundation for financial
mathematics.
 Always take care that you use the correct annual basis for
the currency when doing the calculations as answers the
examiners provide will all be ‘calculatable’ but only one will
use the correct day count/annual basis.
 Most of the calculations will be easily done using a simple
scientific calculator but are also done using the programed
formulae on the HP17BII calculator.
On the HP 17BII, all the simple interest calculations can be
solved using the PV formula. You can solve for any of the
variables in the formula. All interest rates should be input into
the formulae as a whole number and not a decimal.
© Andre Kurten 2022
Menu steps – Program the HP 17 BII
If you have been provided with or purchased a Hewlett Packard 17BII calculator then
it is a value asset in solving many of the calculations required in the exam. This is
achieved by using formulae which you can program into the calculator.
Push EXIT key until this menu appears
FIN
BUS
SUM
TIME
SOLVE
CURRX
choose SOLVE and the menu below will appear
CALC
EDIT
DELET
NEW
Choose NEW and the then start typing your equation using the alpha
characters and the numerals and brackets
The equation must have an equal number of these brackets “(“ as these
brackets”)” otherwise the equation will be rejected
Once you have completed typing the equation, push INPUT key and then
CALC.
If the formula is accepted, it will show you the formula menu. If it is
unsuccessful, it will beep you and return to the formula for editing.
To locate a formula in the calculator, use the scroll up
scroll down
buttons located on the left of the calculator below the input button.
© Andre Kurten 2022
Formula programming
HP17BII Programmable calculator
Go to the solve function and follow the prompts to type in these
formulae
Simple interest Present value formula
PV=FV÷(1+(IRxDAYS÷DB÷100))
Nominal interest rate converted to annual effective
ANN%=(((1+(SEMI%÷200))^2)-1)x100
Bond basis to Money Market basis
MM=BBx360÷365
Straight-Line Interpolation
SLINT=SR + (RQDYS-SHTDYS)÷(LNGDYS-SHTDYS)x(LR-SR)
Discount to yield
YLD=DR÷(1-(DR÷100xDAYS÷DB))
Repo Haircut
REPOCASH=BONDVAL÷(1+(HAIRCT÷100))
© Andre Kurten 2022
Formula and Abbreviations
Forward Exchange Outright Rate
FWDOR=SPTx(1+(QCIRxDYS÷100÷DBQ))÷(1+(BCIRxDYS÷100÷DBB))
Forward forward pricing for FRAs
FFR=((1+(LRxLD÷DB÷100))÷(1+(SRxSD÷DB÷100))-1)x(DB÷(LD-SD)x100)
Settlement amount of FRA
FRASET=(DAYSx(LIB-FRA)xAMT÷DB÷100) ÷(1+(LIB÷100xDAYS÷DB))
Effective rate
EFF=((1+(R1÷100xD1÷DB))x(1+(R2÷100xD2÷DB))x(1+(R3÷100xD3÷DB))
x(1+(R4÷100xD4÷DB))x(1+(R5÷100xD5÷DB))-1)x(DB÷(D1+D2+D3+D4+D5))
x100
Simple interest Present value formula
PV= present value FV= future value IR= interest rate DAYS = days in period DB=
day basis
Semi-annual to annual effective
ANN%= Annual effective percentage SEMI% = Nominal Annual percentage
Bond Basis to Money Market Basis
BB = Bond basis MM = Money Market basis
Discount to yield
YLD= true yield DR= pure discount rate DAYS= days DB= day basis © Andre Kurten 2022
Formula abbreviations
Straight-Line Interpolation
SLINT= Interpolated rate required RQDYS = required period SHTDYS = short days
LNGDYS = Long days LR= Long rate SR= short rate
Repo Haircut
REPOCASH= Repo Cash amount BONDVAL = Collateral value HC = Haircut
Forward Outright FX price
SPT = Spot QCIR= quoted currency interest rate DYS = days DBQ= day basis for
quoted currency BCIR= base currency interest rate DBB= Day basis for base currency
Forward forward pricing for FRAs
FRA = forward forward rate LR = long rate LD = long days SR= short rate SD= short
days DB = day basis
Settlement amount of FRA
FRASET= FRA settlement amount DAYS = days in the forward period LIB = LIBOR
(or equivalent) FRA= FRA rate AMT= notional amount DB = day basis
Effective rate
EFF= annual effective rate R1 = rate 1 D1 = days in period 1 DB= day basis R2, R3
etc same as for R1 and D1
Futures margin call calculation
MCALL=CONX(MTM-POS)XTICVALX100
MCALL = margin call, CON= number of contracts, POS= position price, MTM = mark© Andre Kurten 2022
to-market price and TIC=tick value for that contract
Simple Interest - interest due
Paid on a principal amount over a single period
I = PV x IR x D ÷ DB
WHERE:
I = Interest
PV = Initial Principal
IR = Rate as a decimal and NOT a percentage e.g. 1.25% is expressed as 0.0125
(1.25/100).
D = Time (days in Period)
DB = Annual Basis (360 or 365 days) Make sure you use the correct
EXAMPLE
You invest ZAR 1,000,000 for 180 days at 5.75%. How much interest will you earn
for the investment period?
Answer
Using the formula I = PV x IR x T ÷ DB
I = 1,000,000 x 0.0575 x 180 ÷ 365
= R28,356.16
Typical exam question:
You borrow EUR 10m for 6-months (182 days) at an interest rate of 0.75%p.a.
What interest amount do you pay at maturity? A.75,000 B.76,041.67 C.37,916.67
D. 37,397.26
© Andre Kurten 2022
Simple Interest - Future value
The future value is the original principal plus interest earned.
FV = PV + (PV x IR x D ÷ DB)
Also FV = PV x (1+(IR x D ÷ DB))
WHERE:
FV = Future Value or maturity value , PV = Principal, IR = Rate as a decimal and NOT a
percentage e.g. 1.25% is expressed as 0.0125 (1.25/100), D = day count (days in Period),
DB = Annual Basis (360 or 365 days)
EXAMPLE
You invest EUR 500,000 for 182 days at 3.75%.
How much will you receive back at the end of the investment period?
Answer
Using the formula FV = PV + (PV x IR x D ÷ DB)
FV = 500,000 + (500,000 x 0.0375 x 182 ÷ 360)
= 509,479.17
Typical exam questions:
1. You borrow USD 10m for 3-months (90 days) at an interest rate of 1.25%p.a.
What amount do you repay at maturity (capital plus interest)?
A.10,030,821.92 B.10,031,250 C.10,125,000 D. 10,123,287.67
2. What is the amount of principal plus interest due at maturity of a 1-month (32
day) deposit of EUR 50,000,000 placed at 0.37%p.a.?
A.50,015,416.67 B. 50,016,219.18 C.50,016,444.44 D. 50,016,958.33
© Andre Kurten 2022
Simple Interest – Present value
Present value formula:
PV = FV ÷ (1 + (IR x D ÷ DB))
EXAMPLE
How much must an investor invest today at 4.625% to achieve USD 500,000 at the
end of 273 days?
Answer
PV = FV ÷ (1 + (IR x D ÷ DB))
PV = 500,000 ÷ (1+ (0.04625 x 273 ÷ 360))
= 483,057.76
Typical exam questions:
1. After 6-months (180 days), you receive EUR 1,032,687.50 back on your
investment placed at a rate of 1.50%. What amount did you originally invest?
A.1,040,432.66 B.1,017,632.12 C.1,025,000 D. 1,017,426.11
2. How many GBP would you have to invest at 0.55% p.a. to be repaid 2,000,000
(Principal plus interest) in 90 days?
A.1,997,253.78 B.1,997,291.34 C.1,997,287.67 D. 1,997,250
© Andre Kurten 2022
Simple Interest – Per annum Interest rate
To calculate the per annum interest rate we manipulate the simple interest
formula to arrive at:
PA interest rate or IR = I ÷ PV x DB ÷ D x 100
Also IR = ((FV ÷PV) -1) x DB ÷ D
The per annum Interest rate is also known as a yield, holding period return
or true yield
EXAMPLE
A borrower pays USD 75,000 on USD 5,000,000 for a period of 90 days.
What interest rate did he borrow at?
PA interest rate = I ÷ PV x DB ÷ D x 100
PA interest rate = 75,000÷5,000,000x360 ÷90x100
= 6.00% p.a.
Typical exam questions:
1. You earn interest of 100,000 on a CHF deposit of 15,500,000 for 6 months (182
days). What interest rate was earned your deposit?
A.1.32% B.1.29% C.1.28% D. 0.65%
2. You borrow USD 5,000,000 and repay USD 5,075,000 after 180 days. What
interest rate was charged on your borrowing?
A.0.75% B. 3% C.5.75% D. 0.03%
© Andre Kurten 2022
Bond and Money market basis
To calculate the equivalent 365 day Money Market Basis (MM) rate given a
360 day rate Bond Basis (BB):
MM rate = BB Rate x 360 ÷365
To calculate the equivalent 360 day Bond Basis (BB) rate given the Money
Market Basis (MM)
BB rate = MM Rate x 365 ÷360
Explanation of the concept
A USD100,000 bond with an annual coupon of 5% will pay $5,000 in interest at the
end of the year. An annual coupon bond will pay a round amount of interest as its
coupon irrespective of the number of days in the year.
However, a USD100,000 money market deposit at 5% for 1-year, where the actual
days in the year are 365, will pay interest calculated as follows:
100,000 x 0.05 x 365 ÷ 360 = $5,069.44
The equivalent MM annual rate of 5% given the annual BB: 5 x 360/365 = 4.9315%
Therefore, if you are offered 5% Money Market or 5% Bond Basis, you would choose
Money Market as it will give you extra 5 days of interest.
So we can deduce that the Money Market equivalent rate will always LOWER than the
Bond Basis rate equivalent.
© Andre Kurten 2022
Nominal to annual effective
In the exam you may be required to convert a semi -annual rate to an
annual equivalent or vice versa. You can also be asked to compound a
number of given interest rates for consecutive periods to the effective
equivalent.
The ACI formula given for semi-annual to annual:
2
  semi - annual rate  
annual rate  1  
  - 1
2

 
As an example, convert a semi-annual rate of 4.65% to an annual equivalent:

 0.0465
 1  
2


2

  - 1  0.04704 or 4.704%

The ACI formula given for annual to semi-annual
Semi annual rate 
 (1  annual rate)  1 2
So taking an annual rate of 4.704% to its semi-annual equivalent:
 (1  0.04704) 1 2  0.046499or 4.65%
© Andre Kurten 2022
Compounding consecutive period rates
Using a scientific calculator, the formula to calculate the effective rate for
three consecutive periods is as follows :
(1+(IR1xD1/DB))x(1+(IR1xD1/DB)x(1+(IR2xD2/DB))x(1+(IR3xD3/DB))=-1=
xDB/(D1+D2+ D3)x100
I have indicated the formula given 3 consecutive rates, but you can use it
to solve for 2 or more consecutive rates.
An example: calculate the 9-month spot rate for USD given the following.
3-month spot rate 2.50% (91 days), 3x6 rate 2.65% (91 days) and 6x9 rate
2.75% (91 days)
(1+(0.0250x91/360)) x (1+(0.0265x91/360)) x (1+(0.0275x91/360))=-1=
x360/(91+91+91)x100 = 2.65% p.a.
Remember you can also use the EFF formula in the HP calculator.
Typical exam question:
What is the 6-month USD spot rate given the following:
3-month spot rate 2.25% (91 days), 3x6 (90) rate 2.35%
A. 2.30% B. 2.25% C. 2.31% D. 1.15%
© Andre Kurten 2022
BB to MM and Compounding Interest Questions
1. Which of the following rates represents the highest investment yield in the
Euromarket?
A. Semi-annual bond yield of 3.75%
B. Annual bond yield of 3.75%
C. Semi-annual money market yield of 3.75%
D. Annual money market rate of 3.75%
2. Convert 8.25% quoted on a semi-annually compounded money market basis
for USD to the equivalent annually-compounded bond basis.
A. 8.30%
B. 8.52%
C. 8.54%
D. 8.69%
3. If the 12-month US T-bill is quoted at 1.95% on a money market basis, what
is the equivalent yield on a bond basis?
A. 1.92%
B. 1.95%
C. 1.97%
D. 1.98%
© Andre Kurten 2022
BB to MM and Compounding Interest Questions
4. What equivalent rate would you pay annually if you were prepared to pay 6% semiannually?
A. 6%
B. 6.5%
C. 6.09%
D. 5.91%
5. An overnight deposit of GBP 10,000,000.00 is made on Monday at 0.40% and is then rolled
on Tuesday at 0.45%, on Wednesday at 0.50%, on Thursday at 0.48% and on Friday at
0.53%. How much is repaid (principal plus capitalised interest) on the following Monday?
A. GBP 10,000,936.99
B. GBP 10,000,950.03
C. GBP 10,000,937.02
D. GBP 10,000,646.59
6. What is the 9-month spot rate given:
3-month spot rate = 3.15%
3x6 FRA rate = 3.15%
6x9 FRA rate = 3.30% (Assuming 30/360 day count convention)
A. 4.86%
B. 3.26%
C. 3.23%
D. 3.19%
© Andre Kurten 2022
Yield Curves
Classic or Normal Yield Curve
Rate
•
•
•
•
This yield curve is gently upward sloping.
The Liquidity preference theory is used to
explain a classic yield curve. Simply stated the
longer I give up my money on deposit the less
liquid I am therefore I expect to earn a higher
interest rate.
A positive yield curve is steeply upward sloping.
A positive yield curve is explained using the
interest rate expectations theory
Maturity
Inverted or Negative Yield Curve
Rate
• The Interest rate expectations theory is used
to explain an inverted yield curve. Simply
stated, it says that although interest rates are
currently high, the yield curve indicates that
short-term interest rates are expected to be
lower in the future.
Maturity
• The Market segmentation theory is used to
describe a humped yield curve. Simply stated it
says that certain market participants operate in
clearly defined segments of the yield curve and
can only be persuaded to migrate to a different
segment if offered a significant premium to do
so.
Humped Yield Curve
Rate
Maturity
© Andre Kurten 2022
Yield Curves questions
1. Given the following interest rate scenario in June and November, how would you describe the yield curve
shape in June and what has happened to the yield curve between June and November?
June
November
1 month
2.27%
2.27%
2 months 2.35%
2.38%
3 months 2.40%
2.48%
6 months 2.65%
2.85%
12 months 2.75%
2.95%
A. Flat; Steepening
B. Normal; Flattening
C. Inverse; Flattening
D. Normal; Steepening
2. The Market Segmentation hypothesis suggests that the yield curve bends at some point along its length
because:
A. Investors have less appetite for longer-term investments
B. Borrowers prefer to borrow long-term but lenders prefer to lend short-term
C. Different types of institution tend to specialize in different maturity ranges
D. The risk premium becomes significant only at longer maturities
3. Short-term rates are higher than long-term rates. How would you describe the shape of the yield curve?
A. Flat
B. Normal
C. Inverted
D. Humped
© Andre Kurten 2022
Straight-line Interpolation
You may be required to do straight-line interpolation in the exam.
This is finding an interest rate (or forward points) between two points given the
quotes around that point. The assumption is that it falls on a straight line
between the two quotes given.
Examples
Given the 3-month (90 day) rate of 3.50% and the 6-month (180 day) rate of 4.10%
calculate the 4-month (120 day) rate. Calculate the difference between the far rate
and the near rate 4.10-3.50 = 0.60.
Divide this number by the months (or days) between the two dates
0.60 by 3 = 0.20. This is the rate increase (or decrease) per month. Add 0.20 to 3.50
= 3.70% which is the 4-month (120 day) rate.
Alternatively using days 0.60/90 = 0.0067 per day. 0.0067x30 = 0.20 + 3.50 = 3.70%
Typical exam questions
1. If the 90-day USD interest rate is 3.10% p.a. and the 180-day USD interest rate is
3.50% p.a., what is the 120-day interest rate using straight line interpolation?
2. The 92-day EUR/NOK rate is bid 302 and the 61-day EUR/NOK rate is bid 186.
What is the EUR/NOK bid rate for 81 days, assuming straight-line interpolation?
3. Calculate the 10-day mid-rate swap points Using SLI given the following mid-rates:
O/N 2, T/N 2.5, 1-Week 14, 2-Weeks 21, 1-month 65
© Andre Kurten 2022
Straight-line interpolation - Example
Given the 6-month points of 200 and 3-month points of 146, calculate the the 5-month
points. We assume that the points for the 5-months lies on a straight line between 3
and 6 months. The difference between the 6-month and 3-month points is 54 (200 –
146). So, the points increase by 54 between 3 months and 6 months. We can deduce
therefore that the points increase by 18 points per month. 54 divided by 3 = 18. Now
we can derive the 5-month points by deducting 1 months worth of points from the 6month points (or add two months worth of points to the 3-month points).
So, 18 subtracted from 200 to get 182 points for the 5 months.
You can also divide 54 by 90 days and multiply by 60 to get the change between the
3-months and 5-months
© Andre Kurten 2022
Forward forward rates
Forward forward interest rates are interest rates which
pertain today to deposit periods commencing in the future.
These rates are calculated from the two interest rates that
straddle than period.
If you know what the 3-month rate and the 6-month rate are,
as illustrated below, you are able to calculate the 3-month rate
starting in 3 months time. This rate would be referred to as a
3x6 or 3’s against 6’s.
NOTE: This is NOT the same as straight-line interpolation.
What is the rate for
this period?
0 Borrow funds for 3 months
3
Short funds for 3 months
6
Lend for six months
© Andre Kurten 2022
The Forward Forward Pricing Formula

FR  

 1  LD/DB  X LR   
DB

 - 1 X
 1  SD/DB  X SR    LD - SD
Where:
FR
LR
SR
SD
DB
LD
= forward rate
= long rate
= short rate
= short days
= day base
= long days
Using this formula, calculate the fair value for a USD 3-month SOFR
Interest rate starting in 3 months time (a 3x6) given the following
information:
6-month SOFR rate (LR) = 4% (0.04)
3-month SOFR rate (SR) = 3.50% (0.035)
SD =90 days
LD =180 days
DB = 360
© Andre Kurten 2022
3-Month SFOR forward interest rate
  0.04  180   
 
 1 
360     360 



FR 
1  
 100



  0.035  90 
 180  90 
 
 1 
360   
 
 1.02    360 
 
 100
  1  

 1.00875    90 
 4.461% p.a. for a 3 month rate in 3 months time
© Andre Kurten 2022
Checking the formula – An example
Lend 1m @ 4% for 180 days results in interest receivable of
$20,000 (1mx0.04x180/360)
Borrow 1m @ 3.5% for 90 days results in interest payable of
$8,750 (1mx0.035x90/360)
Difference in interest is $11,250 (20,000 – 8,750)
To calculate the fair value interest rate for the remaining 90
days, the rate calculated must utilize the capital plus interest
after the first 90 days to achieve the amount repayable at the
end of 180 days.
 Calculated as follows:
11,250
360

x
x 100
1,008,750 90
 4.461% p.a. for the 90 day 3x6 forward period
© Andre Kurten 2022
Forward/forward interest rate Questions
1. Using the following rates, what is the rate for a USD deposit which runs from 6 to 12
months?
6M (184-day) USD deposit
0.50%
12M (366-day) USD deposit 1.00%
A. 0.50%
B. 0.75%
C. 1.00%
D. 1.50%
2. If the 3-month rate is 4.5% and the 6-month rate is 4.95%, what is the 3x6 month forwardforward rate? (assume a 30/360 day count)
A. 4.125%
B. 4.725%
C. 5.225%
D. 5.340%
3. If the market is quoting the following rates, what is the 3x9 rate in SEK?
3-month (91-day) SEK 1.09%
6-month (182-day) SEK 1.22%
9-month (273-day) SEK 1.35%
A. 1.220%
B. 1.346%
C. 1.476%
D. 1.600%
© Andre Kurten 2022
Volume-weighted Average Rate
A dealer, who has concluded several transactions whether in the deposit or spot
foreign exchange market, needs to know what their net position is, and at what rate
they hold that position. This is a vital function in deciding what course of action needs
to be taken to either take profit or cut losses. This is easily determined using a
volume-weighted average rate calculation where each transaction is weighted by
multiplying the amount by the rate at which the transaction was done. The sum of the
weights is divided by the net sum of the transactions. This will give the dealer his net
position and the average rate of his position.
An example:
Calculate a dealers cost of funding after taking in the following EUR deposits for 90
days:
400m at 2.15%, 200m at 2.08%, 300m at 2.17%, and 600m at 2.05%
Because all the the transactions are for the same period and are all deposits, we can
simply multiply each amount by the rate to get the weighting.
+400 x 2.15 = 860
+200 x 2.08 = 416
+300 x 2.17 = 651
+600 x 2.05 = 1,230
+1,500
3,157 Average rate calculated as 3,157/1,500 = 2.105%
The dealer ends up long EUR 1,5Bn at an average of 2.105%
© Andre Kurten 2022
Volume-Weighted Average Calculations
An example with a borrowing and lending where you end up with a short position
If you have invested EUR 10 million for 182 days at 6% and borrowed EUR 7 million
for 182 days at 5.8125%, what is the average (breakeven) rate of the remaining
uncovered EUR 3 million position?
-10 x 6
= +60
+7 x 5.8125 = - 40.6875
-3
+19.3125
Divide the weighted amount remaining with the net position in EUR.
19.3125/3 = 6.4375% is the weighted-average rate at which you need to borrow the
remaining EUR 3million to breakeven on your money market book.
Typical Exam Question
You have taken in the following 3-month (90 day) deposits:
EUR 10,000,000 @ 0.60%
EUR 5,000,000 @ 0.40%
EUR 5,000,000 @ 0.50%
What is the average cost of funding?
A. 0.75%
B. 0.45%
C. 0.375%
D. 0.525%
© Andre Kurten 2022
Money Market Instruments
Interest-Bearing
or YIELD Instruments
•Deposits-call and term
•Certificates of Deposit (CDs)
Discount Instruments
•Treasury Bills
•Bankers Acceptances (BAs) – known as eligible bills in the UK. (GBP
denominated). BAs are often referred to a two-name paper.
•Commercial Paper
Not all these instruments are issued by banks, and all are unsecured. However,
Treasury Bills are seen as risk free as they are issued by Governments and therefore
should have the lowest yield.
 Eurocurrency deposits
A Eurocurrency deposit or borrowing is one which is undertaken in a currency that is
not the the domestic currency in the center where the trade is done. For example, a
USD deposit or USD CD done in London is referred to as Eurodollar Deposit or CD.
 Settlement
Irrespective of where a deal is undertaken or who does the deal, the currency will
always settle in the country where that is the domestic currency. For example, if two
German banks do a USD deposit in London, the deal will settle in New York.
© Andre Kurten 2022
Maturities in the Money Market
Value dates must be working days in the centre where the funds are
cleared and calendar rolls modified following (CRMF) will apply on deposits.
For example, a deposit will run from the 1st to 1st of maturing month and so on. If the
1st of the maturing month is a weekend or holiday, then the deal is rolled forward to to
the next good business day. IF however by rolling forward the maturity date would fall
into the next month, then you MUST roll backwards to the previous good day.
Periods for trading deposits (or foreign exchange) :
From overnight up to 4 weeks are classified as “short dates”
1 month to 1 year is classified as “fixed dates”
Longer than 1 year in medium term
Domestic deposits (GBP) value date is the same as the deal date, whereas
euro deposits (other than GBP) trade out of spot which is two good business
days after the deal date.
Month end deposits which start on the last business day of a month will mature on
the last dealing date of the future month. This is known as the “end-to-end”
convention.
For example, a GBP deposit done on the Wednesday 26th June for 2 months will
mature on the 26th August. A USD deal done on Wednesday 26th June will be for
value Friday 28th June (last working day in June) and would mature on 31st August
(last business day in August).
For example a 1-month deposit starting (value) Friday 27th February will mature on
the 31st March assuming no public holidays or weekend.
Turn of the month is a deal done starting on the last working day of the month and
maturing on the first working day of the next month.
© Andre Kurten 2022
Quotation and Dealing on Prices
Prices in the money market are ALWAYS quoted as percentages per
annum, either in decimals or fractions
Two sides to every price BID and OFFER
Difference between bid and offer is known as the SPREAD.
Most financial centers use Bid/Offer for cash
International Market quotation is used in the exam
Bid for Cash
Offer for Assets
5.15/5.25
Offer for Cash
Bid for Assets
London Market quotation is NOT used in the exam
Bid for assets
Offer for assets
5.25/5.15
Offer for cash
Bid for cash
Dealing as market maker or market user
Whenever you are quoted an interest rate or price by the market, you will ALWAYS borrow
(buy) at the higher price and lend (sell) at the lower price.
When YOU are quoting a price to a customer they will always borrow (buy) from you at the
higher price and lend (sell) to you at the lower price.
If the market quote for USD deposits is 5.15/25 (international) or 5.25/15 (London style) then
you would borrow at 5.25 and lend at 5.15 irrespective of the style of quote.
This principle is VERY IMPORTANT as many questions will test your ability to identify the side
on which you are dealing as part of the question.
© Andre Kurten 2022
Discount Instruments
Issued at a discount to Face value
Has no coupon rate
Face value repaid at maturity date
Fixed maturity date
To compare the return on straight discount instruments with interest
bearing instruments, you need to convert the discount to a yield
Banker’s acceptances (eligible Bills are often referred to as “two
name paper”)
To calculate the discount or purchase price of a discount instrument you
need:
The face value
The discount rate (or yield for yield to discount bills)
The days to maturity (tenor of the bill)
The day count convention i.e., 365 or 360
 The purchase price of straight discount bills is the face value minus
discount
 The purchase price of yield to discount bills is the present value of the
face value
NB: always check which interest rate is provided. It will be clear in the
question whether the interest rate is a discount rate or yield.
© Andre Kurten 2022
Discount Paper ACI Formulas
To calculate the discount amount for a straight discount bill
Discount Amount = Face value x discount rate x days/DB
To calculate secondary market proceeds (SMP) for a straight discount bill
SMP = Face Value X (1 - (Discount Rate x Days ÷ DB))
NB: To calculate the purchase price of the straight discount instrument you
can simply deduct the discount amount from the face value
To calculate SMP for a yield to discount bill
SMP = Face Value ÷ (1 + (yield Rate x Days ÷ DB))
This is the Present value formula for a known future cash flow.
To calculate the true yield of a straight discount rate
True yield = Discount rate÷ (1 - (Discount Rate x Days ÷ DB))
NOTE: Discount instruments are sold for a price below 100. This simply
means you will ALWAYS pay less than the face value for a discount
instrument.
NOTE: The true yield will always be HIGHER than the equivalent discount
rate
© Andre Kurten 2022
Straight Discount and Yield to Discount
USD Treasury bills are straight discount with tenors of 4,13,26
and longest 52 weeks.
US domestic commercial paper – USCP trades on a straight
discount and cannot be issued for more than 270 days.
Some discount instruments are quoted as a yield to maturity,
but are discount instruments.
Euro currency commercial paper ECP and GBP (Sterling)
Treasury Bills are quoted on a true yield rather than a straight
discount
Please note that GBP Treasury Bills are issued for 28, 91,182,
or a maximum of 364 days. (never issued for 364 to date)
ECP can be issued for periods of 7 to 365 days.
The purchase price is calculated in the same way as CD
consideration by using the present value calculation. The face
value is used as the future value.
© Andre Kurten 2022
Discount Instrument Examples
Straight Discount bill
A Treasury bill with a face value of USD 10m is issued at a
discount rate of 1.25% p.a. for 90 days. Calculate the discount
amount, secondary market proceeds (SMP), and true yield.
SMP = 10m x (1 - (0.0125 x 90 ÷ 360)) = 9,968,750
Or
Discount amount = 10,000,000 x 0.0125 x 90 ÷ 360 = 31,250
SMP = 10,000,000 – 31,250 = 9,968,750
True yield = 1.25 ÷ (1 – (0.0125 x 90 ÷ 360)) = 1.254%
Yield to Discount bill
Calculate the Secondary Market proceeds of a 91-day
Treasury Bill with a face value of GBP 10,000,000 trading at a
yield of 2.75% p.a.
SMP = 10,000,000÷ (1 + (0.0275 x 91 ÷ 365)) = 9,931,905.23
© Andre Kurten 2022
Discount instruments questions
1. Which of the following money market instruments typically pays return in the form of a discount to face
value?
A. USCP
B. Classic repo
C. CD
D. Euro CD
2. 145-day USCP is quoted at a discount rate 2.40%. What is the true yield?
A. 2.38%
B. 2.40%
C. 2.42%
D. 2.44%
3. A 91-day UK treasury bill with a face value of GBP 50,000,000 is quoted at a yield of 4.25%. How much is
the bill worth?
A. GBP 47,875,000.00
B. GBP 49,462,847.22
C. GBP 49,470,205.48
D. GBP 49,475,760.27
4. You are quoted a discount rate of 1.50%p.a. on a discount instrument with 30 days remaining to maturity.
What is the equivalent true yield to two decimal places?
A. 1.45%
B. 1.55%
C. 1.50%
D. 1.40%
© Andre Kurten 2022
Certificates Of Deposit - CDs
CDs are issued in bearer form mostly immobilized and held by custodians
and are actively traded in the secondary market.
The CDs have a fixed interest rate known as the coupon and interest is
paid at maturity for CDs shorter than 1 year and CDs longer than 1-year pay
interest periodically, usually semi-annually or annually.
CDs are issued with a fixed maturity of no longer than five years, but the
liquid market is generally for issues from one month to one year
 CDs can only be issued by banks and, like normal deposits, are
unsecured.
 Banks use CDs to raise term funding (raising liquidity).
CDs are usually issued at par and trade in the secondary market at the
current market yield relevant to the term to maturity
They usually trade at a price HIGHER than par (the face value).
To calculate the secondary market price, you need:
Par value (face value) of CD
Coupon or issue rate
Market Yield (Current rate at which CD is traded)
Days from issue to maturity
Days from settlement to maturity
day basis of 360 or 365
© Andre Kurten 2022
CD Calculations
Maturity Value of a CD
The maturity value of a CD is the par value plus interest for the full term applying the issue rate
or coupon. NB: The maturity value of the CD never changes and is paid by the issuer to the
holder at maturity.
MV = P + (P x C x D ÷ DB)
Also MV = P x (1+(C x D ÷ DB))
WHERE:
MV = Future Value or maturity value
P = Par value (also Face Value)
C = Coupon rate as a decimal and NOT a percentage e.g. 1.25% expressed as 0.0125 (1.25/100).
D = Time (days in Period)
DB = Annual Basis (360 or 365 days)
Secondary Market proceeds (SMP)
The SMP of a CD is the present value of the maturity value applying the current
market yield at sale
PV = FV ÷ (1 + (R x D ÷ DB))
Holding Period Return (HPR)
The HPR is the yield achieved by the investor for the period that they held the CD before
selling it. NB: When you hold a CD to maturity, whether bought as issue or in the secondary
market, the yield you achieve is equal to the yield at which you purchased the CD.
HPR = (SMP – PAR) ÷ P x DB ÷ D x 100
Also HPR = ((SMP ÷PAR) -1) x DB ÷ D x 100
© Andre Kurten 2022
CD Example
Calculate the maturity value, Secondary market proceeds, and holding period return
for a USD CD with a par value of USD 1,000,000 and a coupon of 6.50% issued for
180 days which is now sold at a market yield of 6% p.a. with 60 days remaining to
maturity.
Maturity Value
MV = 1,000,000 + (1,000,000 x 0.065 x 180 ÷ 360)
= 1,000,000 + 32,500
= 1,032,500
Secondary Market proceeds
SMP = 1,032,500 ÷ (1 +(0.06 x 60 ÷ 360))
= 1,032,500 ÷ 1.01
= 1,022,277.23
Holding period return
HPR = (1,022,277.23 – 1,000,000) ÷ 1,000,000 x 360 ÷ 120 x 100
= 22,277.23 ÷ 1,000,000 x 360 ÷ 120 x 100
= 6.683%
Issue
USD 1,000,000 par
6.50% coupon
Holding Period 120 days
Sale
Maturity
Remaining tenor 60 days
SMP 1,022,277.23
PV the Maturity value using
the market yield of 6% to
calculate the SMP
1,032,500
Maturity value is the Par
value plus interest for the
full period using the coupon
of 6.50%
© Andre Kurten 2022
Calculating the profit/loss on CD
When calculating the profit or loss on a CD, you need to
consider the difference between the book value of the CD which
is the original purchase price (the par value) plus accrued
interest to date against the consideration received at sale.
In our example accrued interest plus par value is:
1,000,000 +(1,000,000 x 0.065 x 120 ÷ 360) = 1,021,666.67
The “dirty price” at sale was equal to
1,022,277.23
To determine the profit (loss) subtract the book value from the
dirty price:
•1022,277.23 – 1,021,666.67 = 610.56 profit on sale of CD
An important way of determining whether a profit or loss has resulted:
 When selling a CD at a market yield HIGHER than the Coupon, you will
make a capital LOSS.
 When selling a CD at a market yield LOWER than the Coupon, you will
make a capital PROFIT.
 When selling a CD after issue date at a market yield EQUAL to the
Coupon, you will make a SMALL capital LOSS.
© Andre Kurten 2022
Islamic Money Market Instruments
As interest is forbidden under Sharia law, all financial instruments cannot offer a return in the
form of interest. The structures most used are Murabahah and Mudarabah
Murabahah
This contact is the most prevalent form of Islamic finance. The contract is effectively a sale on
profit or cost-plus contract. There are two contracts in Murabaha: first contract is between the
client (depositor or borrower) and the bank and the second is between the bank and the
supplier. The client orders a certain commodity through the bank and the bank then buys the
commodity from the supplier and sells it to the client with a specified profit whereby the client
makes a lump sum payment (in the case of a depositor) or a stream of deferred payments (in
the case of a borrower) to the bank.
Mudharabah
The term refers to a form of business contract in which one party brings capital and the other
personal effort. The proportionate share in profit is determined by mutual agreement. But the
loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets
nothing for his labour. The financier is known as ‘rabal-maal’ and the entrepreneur
as ‘mudarib’. As a financing technique adopted by Islamic banks, it is a contract in which all the
capital is provided by the Islamic bank while the business is managed by the other party. The
profit is shared in pre-agreed ratios, and loss, if any, unless caused by negligence or violation of
terms of the contract by the ‘mudarib’ is borne by the Islamic bank. The bank passes on this loss
to the depositors.
© Andre Kurten 2022
CD and Islamic money market questions
1. If the UK branch of a US bank issues a USD-denominated certificate of deposit in London, which of the
following types of CD has it issued?
A. euro B. foreign C. domestic D. Yankee
2. A 2.50% CD was recently issued at par which you now purchase at 2.35%. You would expect to pay:
A. The face value of the CD
B. More than the face value
C. Less than the face value
D. Too little information to decide
3. A CD with a face value of EUR 10 million and a coupon of 3% was issued at par for 182 days and is now
trading at 3.10% with 120 days remaining to maturity. What has been the capital gain or loss since issue?
A. Loss of EUR 52,161.00
B. Profit of EUR 47,839.00
C. Loss of EUR 3,827.67
D. Nil
4. You buy a 30-day 4% CD with a face value of GBP 20 million at par when it is issued. You sell it in the
secondary market after 10 days at 4.05%. What is your holding period return?
A. 4.05% B. 3.891% C. 3.838% D. 1.946%
5. How would you describe an Islamic money market instrument where there is a sharing of profit on a costplus basis?
A. Murabahah
B. rabal-maal
C. mudarib
D. Mudharabah
© Andre Kurten 2022
Introduction to the Bond Market
Bonds
are long-term financial instruments usually issued by
government
In the USA They are known as T-Notes (shorter then 10
years), or T-Bonds (longer than 10 years), and Gilts in London.
In France they are known as BTANs for short-dated bonds and
OATS for long-dated bonds. Germany are Bubl and Schatz for
short-dated bonds and Bunds for long-dated bonds.
MAJOR ISSUERS
•80% are government bonds, and the balance is made up by
bonds issued by public enterprises and banks
MAJOR BUYERS/TRADERS
•Insurance companies, pension funds, and other large
corporations and major financial institutions.
•Bonds are also used by swap traders to hedge open
positions.
© Andre Kurten 2022
Conditions of Bond Issue
When a bond is first issued, the issuer (borrower) will do so
under the covering of an Indenture. This indenture is often
referred to as a prospectus. This document provides the
conditions that the bond issuer agrees to fulfil on the bond
during its life and these typically relate to:
The coupon that will be paid and the frequency of the
payment
The redemption value of the bond at expiry.
Any options on the bond such as a call option which
gives the issuer the right but not the obligation to repay
the bond prior to expiry.
The issuer MAY NOT change the prospectus without the
express permission of the holder of the bond.
© Andre Kurten 2022
Zero Coupon Bonds
Non–coupon
bearing bonds usually issued by government.
They are the purest form of bond.
They ALWAYS trade below 100 that is, they are issued and
trade at a discount to their face value (less than their face
value) and the face value is repaid at maturity
They pay no interest so often NO TAX payable on interest,
They are MOST Sensitive to a change in interest rates.
Discounted using
market rate
Purchase date
Face value repaid at
Maturity
Maturity
© Andre Kurten 2022
Fixed Interest Bonds
Also
known as “Plain Vanilla” or straight bonds.
•This
is the usual form for issuing treasuries or gilts.
Pay fixed interest periodically usually semi-annually
Issued by government and other state organisations
as well as
corporates
They are usually issued at their face value also known as par.
•Bonds
same.
trade at par when the yield to maturity and coupon rate are the
Flip
Flop bonds and certain Brady bonds also pay a fixed
coupon.
All cash flows are discounted
using the yield to maturity to
arrive at the purchase price
Face value and last
coupon repaid at Maturity
Purchase date
Maturity
Coupons\
© Andre Kurten 2022
Floating rate notes (FRNs)
Issued
at par with floating coupon linked to a short-term
benchmark interest rate typically SOFR
The coupon is usually SOFR plus a fixed spread over the
SOFR rate e.g. 6-month SOFR + 50 basis points
They are usually issued by corporates
They are issued at face value and the near coupon is fixed in
advance and resets are done on each of the following coupon
dates
They are traded in a similar fashion to CDs and trade close to
their face value
6-month SOFR +
Margin
Purchase price close to Par
?
?
Face value and last
coupon repaid at
Maturity
Maturity
© Andre Kurten 2022
Index Linked Bonds
The
coupon payments are linked to an index
•typically
the inflation index
These bonds are issued at face value and usually by the
government against a fixed margin over CPI (Consumer Price
Inflation) Index
The coupon is fixed in advance and reset at predetermined
intervals
In the USA they are known as TIPS (Treasury InflationProtected Securities)
 Traded in a similar fashion to FRNs

CPI + Margin
Purchase price close to Par
?
?
Face value and last
coupon repaid at
Maturity
Maturity
© Andre Kurten 2022
Asset-Backed Securities
These
are bonds which have the backing of an income producing
asset, typically bank debt in the form of long-term debt instruments
such as mortgages or short-term debt instruments, such as credit
card receipts.
The assets are removed from the balance sheet of the bank and
placed in a separate entity referred to as a special purpose vehicle
(SPV)
There are usually different classes of bonds issued in a single issue
based on the credit of the underlying Assets.
This process is often referred to a securitisation
Issuing Bank
Removes assets
Frees up capital
Place assets in SPV against
which the bonds are issued
Trust or SPV
Issues bonds of differing
classes based on the
underlying credit
Balance sheet
Bond Market
© Andre Kurten 2022
Covered Bonds
 A covered bond is a package of loans that were issued by banks
and then sold to a financial institution for resale. The individual
loans that make up the package remain on the books of the banks
that issued them and serve as a collateral pool thus providing an
additional layer of security for holders of these bonds. Covered
bonds are a type of derivative instrument. Elements of the covered
bond may include public sector loans and mortgage loans.
 A covered bond is essentially a standard, corporate bond issued by
a financial institution with an extra layer of investor protection.
 One key difference between covered bonds and asset-backed
securities, is that the loans backing a covered bond remain on the
balance sheet of the issuing bank. Therefore, even if the institution
becomes insolvent, investors holding the bonds may still receive
their scheduled interest payments from the underlying assets of
the bonds, as well as the principal at the bond’s maturity. Because
of this extra layer of protection, covered bonds typically have AAA
ratings
© Andre Kurten 2022
Convertible Bonds
These
bond can pay a fixed or floating coupon usually issued
by corporates to raise capital as an alternative to issuing new
shares.
Imbedded in the bond is the right to convert the bond into
ordinary shares at a predetermined share price on specific
dates in the future (Bermudan option)
Traded in the market at a price reflective of:
•current interest rate conditions,
•the credit rating of the issuer,
•and the current value of the imbedded option
The right to exercise the option rests with the holder of the
bond
Once the bond is converted, the bond ceases to exist and the
holder now has ordinary shares in the company
© Andre Kurten 2022
Foreign Currency Bonds
These
bonds are issued by non-residents borrowers in a
domestic market.
•For
example, a Nigerian company wanting to borrow Pounds would
issue a GBP bond in the London market and this bond would be traded
in the UK domestic bond market.
The
Nigerian company issue would fall under the jurisdiction of
the UK bond market and would be subject to stringent credit
rating criteria.
These bonds have nick names such as:
•“Yankee”
for US bonds issues,
•“Samurai” for Yen, and
•“Bulldog” for Pounds.
Issuers
and investors can use the derivatives market to
manage the currency risk relating to the bond cash flows.
•The
most used structure is a cross-currency swap.
© Andre Kurten 2022
Eurobonds
These
bonds are issued outside of the jurisdiction of any
single currency and trade across international borders
They are issued in bearer form and therefore the holders
name DOES NOT appear on a register anywhere.
They are underwritten by international syndicates
They are usually issued in a currency other than the currency
of the country in which they are issued.
This market is the next biggest market after the government
bond market.
Issuers tend to be governments, parastatals, and large multinational corporations.
Euroclear and Clearstream are the main clearers for these
bonds in the global markets.
Once again derivatives are used to manage the currency risk
for issuers investors.
© Andre Kurten 2022
Islamic Bonds - Sukuk
Type of Sukuk
Sukuk al
murabahah
Sukuk al
mudarabah
Sukuk al-ijara
Sukuk al-salam
Sukuk al
musharaka
Sukuk al istisna
Characteristics
The SPV can use the investors capital to purchase an asset and sell it to the
obligator on a cost-plus-profit-margin basis. The obligator makes deferred
payments to the investors like a fixed income bond.
The investor and the SPV are silent parties and the party that utilises the funds
is the working partner. The profit from the investment activity is shared
between both parties based on the initial agreement, but any loss is absorbed
sole by the investors.
The ijara contract is essentially a rental or lease contract. The SPV receives
the proceeds from the investors and in return each investor gets part
ownership of the asset to be leased.
The investors funds are used to purchase assets from the obligator in the
future. This contract requires an agent (which could be the underwriter) to sell
the future assets because the investor wants cash back at maturity and not the
assets.
The investors holding this sukuk are the owners of the joint venture, asset, or
business activity and therefore have a right to share in the profits. The
investors have committee who participate in the decision-making process.
The investors are the buyers of a project and the obligator is the manufacturer.
The manufacturer delivers the finished project (usually a construction project)
to a buyer who, under a separate ijara contract, will lease the asset to another
party for regular payments.
© Andre Kurten 2022
Other forms of bonds
Junk
Bonds
•these
are corporate bonds which do not have investment grade status.
•In other words, they have been rated by the rating agencies as noninvestment grade.
•No Credit rating.
•The most recognised rating agencies are Standard and Poors (S&P)
and Moody’s.
•Junk bonds will usually trade at a price well below their face value.
Callable
bonds
•these
are bonds which can be recalled by the issuer prior to expiry
where they usually pay the holder the face value or a premium on the
face value for early redemption

Commercial paper
this
is paper issued by non-banking institutions
is usually of shorter duration than bonds and is typically a discount
instrument.
US Commercial paper is issued for periods not longer than 270 days.
© Andre Kurten 2022
Dirty price, Clean price and
Redemption value
Dirty price (also known as the all-in price)
•The clean price plus accrued interest and is the actual price
paid for the bond by the buyer.
Clean price
•is the price of the bond once an adjustment has been made for
the accrued interest. Bonds trade on clean price settle on dirty
price. The clean price will EQUAL the dirty price when the
settlement date is on a coupon payment date i.e., there is no
accrued interest adjustment.
 Redemption value of a bond
•is the amount paid back at maturity.
•A redemption premium is an amount paid over and above the par
value so, if a fixed income bond has an annual coupon of 5%, it will
usually pay back at least 105% at maturity.
•It should always pay at least PAR and never less than PAR.
© Andre Kurten 2022
Bond Quotation and Pricing
Bond quotation
Bonds are quoted in a market either as a clean price or as a
Yield-to-Maturity (YTM) i.e., in terms of interest rates.
NOTE: the price of a bond and is yield to maturity move
inversely to one another i.e., if the yield-to-maturity rises, the
price of the bond will fall and if the yield falls, the price of the
bond goes up.
Bond pricing
The actual price paid for the bond is known as the dirty price
the dirty price is the clean price plus accrued interest. It is given
as a percentage of the par value.
For a bond with a clean price of 104.000 and accrued interest
of 0.2500 the dirty price will be 104.250.
For a par value of USD10,000,000, the the actual price paid
would be 10,000,000 x 104.25% = USD10,425,000
© Andre Kurten 2022
Accrued Interest
Accrued Interest day count convention
•is calculated as ACT/ACT in most of the currencies. - Here the actual
number of days accrued, divided by the actual days in the year for annual
coupon bonds multiplied by the coupon. For a semi-annual bond it’s the
coupon multiplied by actual number of days accrued, divided by the actual
days in the coupon period multiplied by 2. For example, if there are 75 days
accrued and the coupon period has 183 days, then the calculation would be
based on 75/366 day-count. As an example, a 2% coupon has accrued
interest of 2x75/366 = 0.4098
•GBP, USD and Eurobonds apply this convention.
•It is unusual to find 30/360, ACT/360, or ACT/365
Accrued interest
•is the interest which has accrued between the last coupon date and the
settlement date of a bond transaction.
•To calculate accrued interest, multiply the coupon with the accrued days
and divide by the annual basis. For example, where the coupon is 5% and
the accrued days are 67 with the relevant annual basis is 365, then the
accrued interest will be 5 x 67/365 = 0.9718 per 100 of the par value of the
bond.
© Andre Kurten 2022
Accrued Interest 30/360 convention
Most bonds use ACT/ACT, but where the accrued interest
convention on a bond is 30/360, then it is assumed that each
whole month has 30 days and a year is therefore 360 days.
Example
You buy a bond on the 15th April 20XX which paid its last
coupon on the 15th January 20XX the deal settles on the 16th of
April 20XX (value T+1 from deal date). What are the number of
days used in the calculation of accrued interest where the
accrued interest is calculated using 30/360 convention?
Solution
15thJanuary to 15th February 30 days
15th February to 15thMarch 30 days
15th March to 15th April 30 days and 15th – 16th April 1 day
Total days = 91
© Andre Kurten 2022
Discount, premium and Par Bonds
A discount bond
•is a bond which trades at a price less than its face value.
•Therefore a bond priced at below 100 is trading at a discount.
•The yield to maturity is HIGHER than the Coupon when a bond is at a
discount
A premium bond
•is a bond which trades at a price more than its face value.
•Therefore a bond priced at above 100 is trading at a premium.
•The yield to maturity is LOWER than the Coupon when a bond is at a
Premium
A par bond
• is a bond which trades at a price which is equal to the face value i.e.
100%. Bonds very seldom trade at par in the secondary market. Bonds
are usually issued at par, but will trade at a premium or discount after
issue.
•When the yield to maturity is equal to the Coupon rate of the bond a
bond is at par.
© Andre Kurten 2022
Current yield on a bond
The current yield on a bond must NOT be confused with the Yield
to Maturity (YTM). The YTM is the interest rate at which a bond is
traded in some markets and which is applied to calculate the dirty
price of the bond.
The current yield is a CALCULATED yield which gives the investor
an idea of the return based on the coupon and the price paid for the
bond. (Current yield will be higher than the coupon when the bond
is trading at a discount and vice versa)
The calculation of the current yield is done as follows:
Bond coupon divided by the clean price of the bond multiplied by
100.
Example
A 7% bond with 10 years to maturity is trading at a clean price of 92.
What is the current yield?
Solution
7/92.00 x 100 = 7.608% or 7.61% rounded to two decimal places
© Andre Kurten 2022
Bond questions
1. You buy a straight bond at a yield-to-maturity of 3.50% with a coupon of 3%. It was originally
issued at par. The clean price you would expect to pay would be:
A. less than par B. Par C. more than par D. depends on the bonds credit rating
2. A 10-year zero-coupon bond was issued at a yield of 1.50% which you now buy at a yield-to-maturity of
1.25% with 7 years to maturity? You would expect to pay:
A.
B.
C.
D.
100% of par
More than 100% of par
Less than 100% of Par
Too little information to decide
3. A straight bond with a 5% coupon is bought at a dirty price of 103.725. The bond has a par value of
USD10,000,000. The amount due at settlement is:
A. 10,000,000
B. 10,050,000
C. 9,627,500
D. 10,372,500
4. A 2.50% bond is trading at a clean price of 105.735. What is the current yield?
A. 10.574% B. 2.364 C. 2.372% D. 5.735%
5. A bond is trading at a premium. Which of the following statements is correct?
A. The yield-to-maturity is higher than the coupon rate
B The yield-to-maturity is equal to the coupon rate
C. The yield-to-maturity is lower than the coupon rate
D. The bond has a AAA rating
© Andre Kurten 2022
The Repo Market
Repo is short for repurchase agreement it is a type of
securities financing transaction (SFT)
One party lends (sells) or offers securities (usually
Government bonds) in return for borrowing funds.
The lender of money has a SECURED deposit, which
usually attracts a lower interest rate than normal money
market deposits
The two main transaction types are:
•All in or Classic Repo
oone transaction two legs.
oThis can be a fixed dated or done on a call basis referred to
as open-ended.
•Sell/Buy Back
otwo separate deals one spot and one forward.
oThis CANNOT be open-ended.
© Andre Kurten 2022
The Repo structure
At inception - settlement date
Repo
seller
bond
Cash
Repo
buyer
At Maturity
Repo
seller
Cash plus repo interest
Bond
Repo
buyer
The party providing collateral at inception is known as the repo or the repo
seller
the party providing cash is known as the reverse repo or repo buyer.
© Andre Kurten 2022
The Repo Market
General collateral (GC) repo is one where any acceptable bond
can be given as collateral. A long-term GC repo is usually done as
a liquidity trade (to raise or lend cash).
NOTE: A short-dated GC repo is often done to fund a long bond
position.
Special repo is one where a specific bond is required. Special
repo is quoted as basis points BP below the GC repo rate.
NOTE: Special repo bonds are usually used to cover a short
position in that bond.
For example, if the special repo is trading at 50BP and the GC
repo rate is 3.75% then special repo rate is 3.25%
The lender of bonds (repo) bears the MARKET RISK on the bond
during the life of the repo and the lender of cash (reverse repo)
bears the CREDIT RISK during the repo.
Under a classic repo there can be
substitution (GC not special) of bonds,
Haircut and margining during the life of the transaction
© Andre Kurten 2022
Bullish Speculator
A bullish speculator expects the yield of a bonds to fall (prices to rise). She
buys a bond without having the cash purchase price. She does so as she is
able to access the repo market to fund her obligations on her position.
Purchase price
Speculator
Settlement T+3
bond
Spot Bond
Market
bond
Speculator
Settlement T+3
Repo
Market
Cash
Cash + Repo Interest
Speculator
Settlement T+10
Repo
Market
bond
bond
Speculator
Settlement T+10
Sale price
Spot Bond
Market
Goes “Long”
the bond today
Puts Bond out on
repo today
(general collateral)
Repays repo
cash + interest10
days from today
Unwinds Long
bond 7 days
from today
(hopefully at a
profit)
© Andre Kurten 2022
Bearish Speculator
A bearish speculator expects the yield of a bond to rise (prices to fall). She
sells a bond that she does not own. She does so as she can access the
repo market to borrow the bond to meet her obligation on her position.
Bond
Speculator
Settlement T+3
Spot Bond Goes “Short” the
bond today
Market
Sale Price
Cash
Speculator
Settlement T+3
Repo
Market
Puts cash out on
reverse repo
today (Special)
Repo
Market
Receives repo
cash + interest 10
days from today
Spot Bond
Market
Covers short
bond 7 days from
today (hopefully
at a profit)
Bond
Bond
Speculator
Settlement T+10
Cash + Repo Interest
Purchase price
Speculator
Settlement T+10
Bond
© Andre Kurten 2022
The All in or classic Repo
This is an over-the-counter repo (also known as an American
repo) where one party sell bonds (the repo) to another (the
reverse repo) while simultaneously agreeing to repurchase
them on a future date at a specified price.
If you do the repo (lend bonds), you BORROW cash on the
offer side of the market quote (the higher interest rate).
If you do the reverse (borrow bonds), you LEND cash at the
bid (the lower interest rate).
The sale and repurchase price are the same except for the
repo interest which is simply added to obtain the amount of
money due on expiry. Therefore, a classic repo is ONE
transaction with two legs.
Any coupons paid during the life of the repo, if paid to the
buyer by the issuer, must be paid back to the seller immediately.
© Andre Kurten 2022
The All in or classic Repo
The collateral is exchanged for cash at an agreed rate of
interest, for a fixed period or it can be open ended
An initial margin – know as a “haircut” – usually charged by
the LENDER of cash (the Repo Buyer or reverse repo). The
lender of cash in this instance takes collateral which exceeds
the value of the amount of cash loaned.
Margin calls during the life of the repo ensure the cash lender
that the value of the security never falls below the current value
of cash advanced. The current value of the cash is calculated
as the initial cash lent plus the accrued interest to date.
Margin calls can be provided either in the form of additional
security or the cash equivalent by the repo seller or buyer.
BOTH the REPO and the REVERSE REPO are subject to
margin calls during the life of the repo.
© Andre Kurten 2022
Haircut or margin on a Classic Repo
Factors influencing the size of the haircut or initial margin are:
•The longer the maturity the greater the chance of default
•The longer the collateral has to maturity, the more sensitive
it is to changes in interest rates.
•The creditworthiness of the seller (provider of collateral)
•The quality of the issuer of the collateral
•The illiquidity of the collateral (no or very little secondary
market activity)
•The Lack of a legal agreement like ICMA/GMRA covering
repo transactions.
“Flat basis” is a repo done with no margin.
NOTE: When doing a repo using treasury bills as collateral, the
repo rate should be HIGHER than the treasury bill yield.
© Andre Kurten 2022
Delivery under a classic repo
Delivery of the securities under a classic repo needs to be considered. It
can be done in one of three ways:
1. Collateral (bonds) could be delivered to the buyer for the term of the
repo. This is the safest form of repo transaction.
2. The collateral can be held in custody (HIC) by the repo seller. This is the
riskiest form of repo transaction. The danger under this arrangement is
that the seller could use the collateral twice to raise cash. This is known
as “double dipping”.
3. A custodian can be appointed to facilitate the transaction. This
arrangement is subject to a legally binding agreement signed by all three
parties. This is commonly referred to as a tri-party repo. Both
counterparts use the same custodian or repo agent. Segregated
accounts will be opened by the custodian for the express purpose of the
repo transaction. This kind of repo allows comfort to the buyer as no
double dipping can occur as the bonds are held as pledged in the buyers
account for the term of the repo. The custodian checks the eligibility of
the collateral, applies the haircut and manages margin calls and
substitution of bonds where required.
© Andre Kurten 2022
Sell/Buy Back
Two separate bond market transactions; a sale (purchase) in the
spot market and a purchase (sale) in the forward market
Repo rate is not explicit, but is implied in the forward price
The right to any coupon during the life of the repo accrues to the
BUYER of the securities. It will be refunded to the SELLER in the
buyback price.
Where a coupon is paid during the life of the repo, the buy back
price will be calculated as: original cash + repo interest – coupon –
interest earned on the coupon
The interest rate used to calculate the interest earned on the
coupon is the original repo rate.
Because full title passes in the spot leg from SELLER to BUYER,
ISMA documentation does not apply (although most counterparties
will have ICMA/GMRA agreements in place with each other)
Margining with these repos is done by canceling the buy back leg
and entering a trade with the new details. This is called repricing.
Sell/buy backs CANNOT be open ended
© Andre Kurten 2022
Repo Theory questions
1. Which of the following will tend to have the higher yield?
A. Treasury bill
B. Repo against Treasury bill collateral
C. They have the same yield
D. Cannot say
2. Which type of repo is the riskiest for the buyer?
A. Delivery repo
B. HIC repo
C. Tri-party repo
D. There is no real difference
3. Which party usually takes an initial margin in a classic repo?
A. The buyer
B. The seller
C. Neither
D. Both
4. What are the primary reasons for taking an initial margin in a classic repo?
A. Counterparty risk and operational risk
B. Counterparty risk and legal risk
C. Collateral illiquidity and counterparty risk
D. Collateral illiquidity and legal risk
© Andre Kurten 2022
Calculating the “haircut” and repo rate
HAIRCUT with fixed bond amount–calculate the start money
•Bonds market value (collateral value) divided by (100 plus the
haircut as a percentage)
Example
Collateral Value 995,000 offered and a haircut of 2%
995,000/102% or 995,000/1.02
= $975,490.20 cash against bond value at start of repo
HAIRCUT with fixed cash amount–calculate the bond value at start
•Cash amount x (100 plus the haircut as a percentage)
Example
-Cash $1m offered and a haircut 2%
1,000,000 x 102% or 1,000,000 x 1.02
= 1,020,000 bond value required at the start of repo
REPO RATE
NB: Repo rate in the exam is usually quoted in terms of cash
low/high e.g., 1.75/1.80. London quotes repo rate in terms of bond
high/low so 1.80/1.75
© Andre Kurten 2022
Dealing the repo rate




When doing the REPO (lending or selling bonds), you are borrowing
cash, so you would deal on the OFFER side of the repo rate
When doing the REVERSE REPO (borrowing or buying bonds), you
are lending cash, so you would deal on the BID side of the repo rate
The repo done Tom/Next or overnight is 1 day. One week and
spot/week are 7 days and two weeks is 14 days.
You need to answer 5 questions when facing a Repo calculation
question:
1. Am I doing the repo or reverse repo?
2. How long is the repo term?
3. What is the repo rate and am I borrowing or lending cash?
4. What is the collateral worth?
5. Is there a haircut?
Repo rate 1.75/80
When doing the reverse
Repo you deal at the bid
When doing the Repo
you deal at the offer
© Andre Kurten 2022
Classic Repo Example
FLAT BASIS REPO
A bank wishes to place out USD50 million Eurodollar bonds (doing the repo).
The bond has a coupon of 5,50% and matures on the 12/04/2025. The repo
rate is 6.50/6.60 for 7 days. The bond collateral value is $51,633,700.
By doing the repo, you are going to borrow funds at 6.60%
Determine repo interest and final consideration
$51,633,700 x 0.066 x 7/360 = 66,263.25 repo interest (MM convention)
51,633,700 + 66,263.25 = $51,699,963.25 final cash (Buy back price)
REPO WITH HAIRCUT (using the same details as above)
If there was a 2% haircut on the repo, then the start money would be
different.
51,633,700/102% = $50,621,274.50 is the start money
Determine the repo interest and final consideration
$50,621,274.50 x 0.066 x 7/360 = 64,963.97 repo interest
$50,621,274.50 + 64,963.97 = $50,686,238.47 final cash (buy back price)
© Andre Kurten 2022
Repo calculation questions
1. What market value of collateral does a dealer need against USD50 million in cash in a 3-day reverse repo
at a rate of 2.10% if he takes an initial margin of 2%.
A. USD 52,000,000
B. USD 51,000,000
C. USD 50,000,000
D. USD 49,000,000
2. The spot/week repo rate for the 4.25% DSL 2025 IS QUOTED TO YOU AT 2.35-38%. You buy bonds with
a market value of EUR 3,295,500 through a sell/buy-back. What is the buyback price?
A. EUR 3,297,004.19
B. EUR 3,297,005.86
C. EUR 3,297,025.09
D. EUR 3,296,985.23
3. Tom/next repo rates are quoted 1.75%/1.80%. You sell EUR10, 000,000 3.80% German Bunds with a
market value of 11,260,000. What is the repurchase price at maturity?
A. 11,261,189
B. 11,260,000
C. 11,260,563
D. 11,260,547.36
4. The tom/next GC repo rate for German government bonds is quoted to you at 1.75-80%. As collateral, you
sell EUR 10 million nominal of the 5.25% bund July 2025, which is worth EUR 11.260,000. If you have to give
an initial margin of 2%, the Repurchase Price:
A. EUR 11,035,336.41
B. EUR 11,035,351.74
C. EUR 11,039,752.32
D. EUR 11,039,767.65
© Andre Kurten 2022
Topic Basket 4
Fixed Income, Interest
Rate, Currency
and
Commodity Derivatives
Covered in Tutorial 4
© Andre Kurten 2022
Section Objectives
Overall Objectives: The overall objective of this topic is for candidates to
understand how derivatives work and their function in financial markets.
Candidates will be able to describe the mechanics of currency derivatives,
how to use them and the fundamentals of currency options. Candidates will
be able to identify basic currency option products and understand their
purpose. Candidates will be able to describe the mechanics of interest rate
derivatives, how to use them and the fundamentals of interest rate options.
Candidates will be able to identify basic interest rate option products and
understand their purpose. The candidates need to be able to perform basic
calculations referring to the derivatives products included in the Syllabus.
• 14 questions comprising 8 theory and 6 calculation questions
– 7 minimum correct answers
© Andre Kurten 2022

Definition
Derivatives
A derivative is a contract traded for a date other than the regular spot date
where the value of such a contract is derived from the value of the
underlying asset or instrument.

Hedging
Hedging is undertaking a trade to reduce the risk on an existing position.
For example, an import can enter into an FEC to reduce the risk of an
adverse move in the exchange rate.

Speculation
Gearing or leverage is entering a trade which has a larger nominal value
than the required cash to secure a trade. For example, you can enter a
trade on USD1m by putting down USD 10,000 which is a gearing or
leverage ratio of 100:1.

Simulation
Creating a synthetic portfolio

Arbitrage
To take advantage of mispricing between markets to make risk free profits.
For example, Trading FRAs against STIR futures to take advantage of
mispricing.
© Andre Kurten 2022
Forward Rate Agreement Defined
A FRA is an agreement between two parties, a buyer and a
seller that sets (fixes) the level of an interest rate for a specific
time in the future on a notional value.
For example, a 3-month period starting 3 months from now.
This period would be known as a 3x6 period.
•In 3 months time the FRA rate will be compared to the 3-month
market benchmark such as EURIBOR or SOFR, and
•the DIFFERENCE will be settled based on the notional principal.
•FRAs are therefore referred to as CFDs (contracts for
difference).
•FRAs are the ideal short-term derivative to hedge
mismatches in the money market funding book of a bank.
•FRA prices are derived using the forward forward rate
pricing model described in the Rates section.
•FRAs are not negotiable
© Andre Kurten 2022
FRA - Terminology
Contract amount: The Notional Principal Amount e.g. R50m used in the settlement
calculation
Contract currency: The currency in which the contract amount is denominated
Contract rate: The fixed interest rate agreed under the FRA agreement
Dealing (transaction) date: The date on which the FRA deal is done, and the FRA
rate is agreed
Fixing date: The date when the reference rate is determined (could be different to
the settlement date)
Settlement (value) date: The date on which the notional borrowing or lending
commences and the date on which settlement on the FRA is made
Maturity date: The date on which the notional borrowing or lending matures
Forward period: The number of days between the settlement and the maturity date
of the FRA
Reference rate: The market-based interest rate used on the fixing date to determine
the settlement amount payable/receivable e.g. 3-month SOFR
Settlement amount: The amount paid by one party to the other on the settlement
date of the agreement, based on the difference between the contract rate and the
reference rate, calculated on the notional amount of the FRA. Interest is usually paid in
arrears, but the settlement on the FRA is paid at the start of the interest period
(settlement date on the FRA). The settlement is therefore discounted, or net present
valued by using LIBOR fixing rate.
© Andre Kurten 2022
FRA - Diagram
Contract period prior to fixing
Deal Date –
when FRA rate
is agreed
Fixing Date –
when benchmark
is determined
Forward period
(notional borrowing or lending
period)
Settlement Date – Maturity Date –
when net payment nothing
is made
happens here!
NOTE: Fixing and settlement are on the SAME DAY in
domestic FRA markets e.g. GBP FRAs in London fix
and settle on the SAME DAY.
Foreign currency FRAs settle T+2 e.g. USD FRAs in
London fix TWO working days before settlement occurs.
© Andre Kurten 2022
Buying or Selling an FRA
The Buyer of the FRA
•The buyer of an FRA is a potential future borrower, or one with a floating rate
loan, and exposed to interest rates rising (short cash in the forward period)
•Buying the FRA is like borrowing money at a fixed rate for a future period.
When you buy an FRA you are synthetically long cash for the far date and
short the same amount of cash for the near date.
•If at fixing the Benchmark rate is ABOVE the FRA rate, the buyer receives the
difference and if the Benchmark rate is BELOW the FRA rate the buyer pays
the seller.
The Seller of the FRA
•The seller of an FRA is a potential future investor, or has an investment linked
to a floating rate, and is exposed to rates falling (long cash in the forward
period)
•Selling the FRA is like lending money at a fixed rate for a future period. When
you sell an FRA you are synthetically short cash for the far date and long the
same amount of cash for the near date.
•If at fixing the Benchmark rate is BELOW the FRA rate, the seller receives the
difference and if the Benchmark rate is ABOVE the FRA rate the seller pays
the buyer.
© Andre Kurten 2022
Buying an FRA to hedge
Borrower has a USD 50m floating rate loan priced at 3-month SOFR. She
thinks rates will rise in the next three months.
Market rates today
Borrows and
Fixes FRA and
Borrowing
3-mth SOFR 5.75%
buys FRA
borrows again
matures
3X6 FRA 6.00%
3x6 FRA period
Transactions today
Borrows at 5.75% FOR 90 days
t
3
Buys 3x6 FRA at 6.00%
3 months time
2 scenarios 3-month SOFR fixes at 6.25% or 5.75%
Scenario 1
Repays loan and borrows 50m at current SOFR 6.25%
SOFR is above FRA rate so receives difference 0.25%
Therefore, effective cost of funding 6.00% for 3 months
Scenario 2
Repays loan and borrows 50m at current SOFR 5.75%
SOFR is below FRA rate so pays difference
0.25%
Therefore, effective cost of funding 6.00% for 3 months
NOTE: IRRESPECTIVE of SOFR rate borrowing cost is 6.00%
6
© Andre Kurten 2022
Interest rate risk due to funding mismatch in the money market book
Borrow (go long) cash for 3
Repay cash plus interest
months and lend (go short) the and borrow that amount for
same amount for 6 months
the next three months
Receive 6-month cash plus
interest back on the lending
and repay the last 3-month
borrowing
Creates a short cash 3x6
position - you are over lent
3
t A 3-month Liability
6
A 6-month asset
In this scenario, because you have over lent (have a 3-month asset) in the
3x6, you need to borrow for 3 months in 3 months time. You are exposed
to interest rates RISING. To hedge, you would BUY a 3x6 FRA today.
Repay the cash plus interest
on the 6-month borrowing and
receive the last 3 month
lending
Creates a long cash 3x6
position - -you are over
borrowed
Lend (go short) cash for 3
Receive cash plus interest
months and borrow (go long) the and lend that amount for
same amount for 6 months
the next three months
t
A 3-month asset
A 6-month liability
3
6
In this scenario, because you have over borrowed (have a 3-month liability)
in the 3x6, you need to lend for 3 months in 3 months time. You are exposed
to interest rates FALLING. To hedge, you would SELL a 3x6 FRA today.
© Andre Kurten 2022
Selling an FRA to hedge
A large bank needs to lend USD 100m for 6 months in 6 months time linked
to SOFR. They think interest rates will fall in the next 6 months. They want to
lock in the investment rate for that period today.
Sells FRA
Fixes FRA and
Investment
FRA rate today
invests cash
matures
6X12 FRA 4.25%
Transactions today
Sells 6x12 FRA at 4.25%
6x12 FRA period
t
6
12
6 months time
2 scenarios 6-month SOFR fixes at 3.75% or 4.50%
Scenario 1
Invests 100m at current 6-month SOFR 3.75%
SOFR is below FRA rate, so they receive the difference 0.50%
Effective return on investment is 4.25% for 6 months (3.75 + 0.50)
Scenario 2
Invests 100m at current 6-month LIBOR 4.50%
SOFR is above FRA rate, so they pay the difference 0.25%
Effective return on investment is 4.25% for 6 months (4.50 – 0.25)
NOTE: IRRESPECTIVE of SOFR rate their return is 4.25%
© Andre Kurten 2022
FRA theory questions
1. In order to hedge a 6x12 forward-forward loan that you have made, you could;
A. Buy a 6x12 FRA
B. Buy a strip of money market futures if contracts were available for the period
C. Receive fixed on a 1-year annual/6s interest rate swap
D. Take a 12-month deposit
2. Today is Monday, 8th December. You sell a 9x12 FRA for value Thursday,10th
September next year. On what date is the settlement amount due to be paid or received
(assuming that there are no holidays)?
A. 8th September next year
B. 10th September next year
C. 8th December next year
D. 10th December next year
3. You have made a forward-forward loan for 3 months starting in 6 months time. Which of
the following would be the best hedge for this position?
A. Borrow money for 3 months and lend the equivalent amount for 6 months
B. Buy a 3X6 FRA in an amount equal to the loan notional value
C. Buy the near interest rate futures contracts in an equivalent notional of the loan
D. Buy a 6X9 FRA in an amount equal to the loan notional value
4. In the international market, a FRA in USD is usually settled with reference to:
A. SOFR
B. Fed funds
C. BBA LIBOR
D. EURIBOR
© Andre Kurten 2022
Calculation of Settlement Amount
Settlement Amount

 d 

 iL - iF   N  
DB  



  
d  
  
 1   iL 
DB   
  
Where:
iL
iF
N
d
DB
=
=
=
=
=
benchmark rate at fixiing
contract (FRA) rate
notional principal amount
actual number of days in the forward period
day count convention
(e.g. 360 for USD, 365 for GBP)
© Andre Kurten 2022
Calculation of Settlement Amount
Example
•FRA USD 50million (B or day base is 360)
•FRA rate 5.375%
•3-month USD SOFR Fixed at 6.25%
•FRA period 90 days


90
 50,000,000 
 (0.0625  0.05375) 
360


90 



1

0
.
0625





360




 109,375 1.015625
 107,692.31 paid by FRA seller to buyer
© Andre Kurten 2022
FRAs application and settlement questions
1. You have borrowed at 3-month SOFR+50BP. SOFR for the loan will be re-fixed in exactly
one month. The market is quoting:
1x3 USD FRA 0.42-45%
1x4 USD FRA 0.54-58%
1x5 USD FRA 0.57-62%
To hedge the next SOFR fixing, you should:
A. Sell a 1x3 FRA at 0.42%
B. Buy a 1x3 FRA at 0.45%
C. Buy a 1x4 FRA at 0.58%
D. Sell a 1x4 FRA at 0.54%
2. You have taken a position on future interest rates by buying a 1x4 (89-day) EUR 150
million FRA at 3.15%. If EURIBOR for the contract period turns out to be 3.27%, what is the
settlement amount, and do you pay or receive?
A. you pay EUR 44,143.14
B. you receive EUR 44,143.14
C. you pay EUR 44,500.00
D. you receive EUR 44,500.00
3. You have taken a position on future interest rates by buying a 6x12 (183-day) EUR
75,000,000.00 FRA at 0.57%. If EURIBOR for the contract period turns out to be 0.71%, what
is the settlement amount, and do you pay or receive?
A. You pay EUR 52,457.10
B. You receive EUR 52,457.10
C. You receive EUR 53,375.00
D. You receive EUR 53,183.05
© Andre Kurten 2022
Short-Term Interest Rate Futures
The Definition of a future contract
A futures contract is a standardised contract between two parties, to
exchange a standard quantity of a specified underlying asset on a
predetermined future date at a price agreed today, traded on an
organised Exchange guaranteed by the exchange
 Buying futures you are long and selling futures you are short
Futures prices should converge towards the spot price as the
contract moves towards the maturity. Any divergence between the
futures price and the spot is referred to as BASIS RISK.
Futures contracts are more secure than trading OTC products like
FRAs because of the reduced credit risk.
However, unlike FRAs, STIR futures are quoted as a PRICE rather
than an interest rate
The STIR price is arrived at by deducting the equivalent interest
rate from 100, so for example, an interest rate of 3,75% as a futures
price will be 100–3.75=96.25.
Futures prices can be quoted to 3 decimal places 96.255
100 – 96.255 = 3.745% is the equivalent implied forward forward
rate
© Andre Kurten 2022
New Short-Term Interest Rate Futures Specifications - 1
Specifications ICE 1-Month SONIA
ICE 3-Month SONIA
ICE 3-Month SARON
Contract size
£2,500*Rate Index
(3,000,000)
Delivery Months A maximum of 24
consecutive months will be
available for trading
£2,500*Rate Index
(1,000,000)
3rd Wednesday of March,
June September and
December such that 25
months are available for
trading
CHF 2,500*Rate Index
(1,000,000)
3rd Wednesday of March, June
September and December
such that 16 delivery months
are available for trading
1 tick 0.01 value £25 (3,000,000 x 0.01%
x1/12)
£25 (1,000,000 x 0.01%
x3/12)
CHF 25 (1,000,000 x 0.01%
x3/12)
Minimum Tick
0.0025 (£6.25) for front
delivery month
0.005 (£12.50) for all other
delivery Months
100 minus the numerical
value of the rate of interest
0.0025 (CHF 6.25) for front
delivery month
0.005 (CHF 12.50) for all other
delivery Months
100 minus the numerical value
of the rate of interest
One business day prior to the
third Wednesday at 18:00
London time
SONIA
One business day prior to the
third Wednesday at 18:00
London time
SARON
Quotation
0.0025 (£6.25) for front
delivery month
0.005 (£12.50) for all other
delivery Months
100 minus the numerical
value of the rate of interest
Last trading day The last business day of the
contract month at 18:00
London time
Market index at SONIA
expiry (EDSP)
© Andre Kurten 2022
New Short-Term Interest Rate Futures Specifications - 2
Specifications
Contract size
ICE 3-Month SOFR
$10,000*Rate Index
(4,000,000)
Delivery Months March, June, September ,
and December such that a
maximum of 24 delivery
months will be available for
trading
CME 3-Month SOFR
$2,500*Rate Index
(1,000,000)
3rd Wednesday of March,
June September and
December with the nearest
39 consecutive quarters
available for trading
CME 1-Month SOFR
$2,500*Rate Index (5,000,000)
1 tick 0.01 value $100(4mio x 0.01% x 3/12)
$25(1mio x 0.01% x 3/12)
$41.67(5mio x 0.01% x 1/12)
Minimum Tick
0.0025 ($25)
Contracts with 4 months or
less until termination
0.0025 ($6.25)
0.05 ($12.50)for all other
months
0.0025 ($10.4175) for the
nearest month
0.05 ($20.835) for all other
months
Quotation
100 minus the numerical
value of the rate of interest
100 minus the numerical
value of the rate of interest
100 minus the numerical value
of the rate of interest
Last trading day The last business day prior
to the 3rd Wednesday of the
next quarterly delivery
month. Trading will cease at
17.00 New York time
Market index at
expiry (EDSP)
SOFR
Nearest 13 consecutive months
will be available for trading
The last business day prior The last business day of the
to the 3rd Wednesday of the contract month at 17.00 New
York time
next quarterly delivery
month. Trading will cease
at 17.00 New York time
SOFR
SOFR
© Andre Kurten 2022
New Short-Term Interest Rate Futures Specifications - 3
Specifications
ICE 3-Month EURIBOR
Contract size
€2,500*Rate Index (3,000,000)
€2,500*Rate Index
(1,000,000)
3rd Wednesday of March,
A maximum of 24 consecutive
months will be available for trading
June September and
December and 4 serial
months, such that 28 delivery
months are available for
trading and the nearest 6
months being consecutive
calendar months
Delivery Months
ICE 1-Month Euro Overnight ICE 1-Month SOFR
Rate Index
1 tick 0.01 value
€25 (1mio x 0.01% x 3/12)
Minimum Tick
0.005 (€12.50) for all delivery 0.0025 (€6.25) for front delivery
Months
month
0.005 (€12.50) for all other delivery
Months
100 minus the numerical
100 minus the numerical value of
value of the rate of interest
the rate of interest
Two business days prior to
The last business of the calendar
month
the third Wednesday at
10.00am
EMMI EURIBOR
€STR
Quotation
Last trading day
Market index at
expiry (EDSP)
€25 (3mio x 0.01% x 1/12)
$10,000*Rate Index (12,000,000)
A maximum of 24 consecutive
months will be available for trading
$100 (12mio x 0.01% x 1/12)
0.0025 ($25) for the nearest month
100 minus the numerical value of the
rate of interest
The last business day of the contract
month at 17.00 New York time
SOFR
PLEASE NOTE Trading hours for ICE SOFR Futures
New York: 7.45 pm – 5pm or 19:45 – 17:00
London 12.45am – 10.00pm or 00:45 – 22:00
© Andre Kurten 2022
New Short-Term Interest Rate Futures Specifications - 4
Specifications
JBA EUROYEN TIBOR
Trading Unit
Y100,000,000
Delivery Months
20 quarterly months and 2 serial
months
Serial months are months other
than March, June, September and
December.
Y2,500 (100mio x 0.01% x 3/12)
1 tick 0.01 value
Minimum Tick
0.005 (Y1,250) for all delivery
Months
Quotation
100 minus the numerical value of
the rate of interest
Last trading day
Two business days prior to the
third Wednesday
Market index at
expiry (EDSP)
Three-month Euroyen TIBOR
PLEASE NOTE
Although USD LIBOR 3-month fixings will continue until the 30th June 2023, The ACI board of
education has decided to no longer include the 3-Month Eurodollar contracts in the exam.
As a result, the questions which were previously in the database, will be removed. All the questions
included in the exam from the 1st March 2022 will be based on the above futures contract
specifications.
© Andre Kurten 2022
Futures theory questions
1. A customer sells a 3-Month SARON futures contact. Which of the following risks
could he be trying to hedge?
A. An increase in forward USD/CHF
B. Falling CHF interest rates
C. A decrease in forward USD/CHF
D. Rising CHF interest rates
2. Which of the following is true?
A. The ICE 1-month SOFR futures contract has a tick value of USD 100 and a face
value of USD 12,000,000
B. The CME 1-month SOFR futures contract has a tick value of USD 41.67 and a
face value of USD 5,000,000
C. The CME 3-month SOFR futures contract has a tick value of USD 25 and a face
value of USD 1,000,000
D. All the above are true
3. What the minimum tick values for the 3-month SONIA and 3-month EURIBOR
futures respectively?
A. 0.0025 (£6.25) and 0.005 (€ 12.50)
B. 0.005 (£12.50) and 0.0025 (€ 6.25)
C. 0.01 (£25) and 0.0025 (€ 6.25)
D. 0.05 (£12.50) and 0.01 (€25)
© Andre Kurten 2022
Margining and settlement
 Initial Margin (determined by the exchange) is the amount




that is put up to open a futures position on an exchange.
This is held by the exchange and only refunded when the
contract expires or is closed out.
This initial margin is usually sufficient to cover a single day
loss. It is NOT used to pay variation margin.
Variation margin is payable (receivable) daily in cash based
on the contracts revaluation through a process called
marking-to-market (M-T-M).
The mark-to-market price or DSP (daily settlement price) is
usually determined by a volume-weighted average price
calculated using prices (usually the last 5 trades) traded
during a period prior to the close of the trading day.
Settlement and trading is guaranteed by the exchange and
margins are usually payable between 10h00 and 12h00 on
the day following the trade or mark-to-market.
© Andre Kurten 2022
Calculating variation Margin
As indicated in the previous slide, the variation margin is calculated daily
based on the current rate on your position against the daily settlement price.
Your margin account will either be debited (you pay) or credited (you receive)
with the variation margin amount in the currency of the contract that you
have traded. Lets look at an example
You go long 20 CME 3-Month SOFR contracts at 98.35.
The end of the day the M-T-M 98.455
Variation margin is calculated as 98.455-98.35 = 0.105 which is 10.5 ticks in
your favour because you are long and the M-T-M rate is higher.
Ticks x contracts x tick value = margin call due (or payable)
So 10.5 x 20 x 25 = USD 5,250 credit to your margin account (you receive).
You are now long 20 contracts at 98.455
The next day the M-T-M is 98.28 so 98.28-98.455 = -0.175 which is 17.5
ticks against you because you are long and the M-T-M is lower.
17.5 x 20 x 25 = USD 8,750 debit to your margin account (you pay).
After 2 days you will now be long 20 contracts at 98.28.
The effect on your margin account to date has been a net debit of USD3,500
The person who sold to you would have exact opposite effect. So futures
trading is often referred to as a ‘zero-sum game’
© Andre Kurten 2022
Margin Call Examples for new STIR futures contracts -1
One ICE 3-month SONIA futures contract is traded at 98.50 and at the end of
the day the mark-to-market is 98.55 (tick value on the 3-month SONIA future
is £25 unlike the old short sterling future which was £12.50)
98.55 – 98.50 = 5 ticks
1 x 5 x 25 =£125 paid by the seller to the buyer because the MTM rate is
higher than the traded price.
One CME 3-month SOFR futures contract is traded at 98.75 and at the end of
the day the mark-to-market is 98.85
98.85 – 98.75 = 0.10 which is 10 ticks
1 x 10 x 25 =$250 paid by the seller to the buyer because the MTM rate is
higher than the traded price.
One ICE 3-month SOFR futures contract is traded at 98.75 and at the end of
the day the mark-to-market is 98.85
98.85 – 98.75 = 0.10 which is 10 ticks
1 x 10 x 100 =$1,000 paid by the seller to the buyer because the MTM rate is
higher than the traded price.
NOTE: the full tick value of the CME 3-Month SOFR future is $25, because
each contract is USD 1,000,000 nominal The full tick value of the ICE 3-month
SOFR future is $100 because each contract is 4,000,000 nominal!
© Andre Kurten 2022
Margin Call Examples for new STIR futures contracts -2
Ten ICE 1-month SONIA futures contract is traded at 98.70 and at the end of
the day the mark-to-market is 98.65 (tick value on the 1-month ICE SONIA
future is £25 based on a nominal unlike the old short sterling future which was
£12.50) So, 98.65 – 98.70 = - 5 ticks
10 x 5 x 25 =£1250 paid by the buyer to the seller because the MTM rate is
lower than the traded price.
Ten CME 1-month SOFR futures contract is traded at 99.50 and at the end of
the day the mark-to-market is 99.455.
99.445 – 99.50 = -0.055 which is equal to 5.5 ticks
10 x 5.5 x 41.67 =$2,291.85 paid by the buyer to the seller because the MTM
rate is lower than the traded price.
Ten ICE 1-month SOFR futures contract is traded at 99.50 and at the end of
the day the mark-to-market is 99.455
99.445 – 99.50 = -0.055 which is equal to 5.5 ticks
10 x 5.5 x 100 =$5,500 paid by the buyer to the seller because the MTM rate
is lower than the traded price.
NOTE: the full tick value of the CME 1-Month SOFR future is $41.67, because
each contract is USD 5,000,000 nominal. The full tick value of the ICE 1month SOFR future is $100 because each contract is 12,000,000 nominal!
© Andre Kurten 2022
Futures calculation questions
1. What is the variation margin due on 10 ICE 3-Month SONIA futures contracts bought
at 97.255 if the closing rate on the same day is 97.45?
A. you must pay GBP 2,437.50
B. you will receive GBP 2,437.50
C. you must pay GBP 4,875
D. you will receive GBP 4,875
2. You are short of 6 June CME 3-Month SOFR futures contracts at 99.50. Yesterday, the
closing price was 99.35. Today's closing price is 99.105. What variation margin will be
due?
A. You will have to pay USD 5,925.00
B. You will receive USD 5,925.00
C. You will have to pay USD 3,675.00
D. You will receive USD 3,675.00
3. You are short of 6 June CME 3-Month SOFR futures contracts at 99.50. Yesterday, the
closing price was 99.35. Today’s closing price is 99.105. What has been the net effect on
your margin account to date?
A. USD 2,250.00 debit
B. USD 5,925.00 credit
C. USD 3,675.00 credit
D. USD 3,675.00 debit
© Andre Kurten 2022
STIR Futures vs FRAs
FUTURES
Buy futures if you
believe rates will FALL
Sell futures if you
believe rates will RISE
FRAs
Sell FRAs if you
believe rates will FALL
Buy FRAs if you
believe rates will RISE
Note: Buying FRAs is the same as selling futures
Selling FRAs is the same as buying futures
SO
To hedge a long FRA position BUY futures
To hedge a short FRA position SELL futures
THIS SLIDE IS IMPORTANT TO REMEMBER!!!!
© Andre Kurten 2022
FRAs vs Futures questions
1. You have a short position of 50 SOFR futures contracts. You can hedge your position by:
A. Selling a FRA for a similar notional amount
B. Buying a FRA for a similar notional amount
C. Selling a call option on the contract
D. Selling a put option on the contract
2. How would a corporate hedge the interest rate risk on floating-rate borrowing?
A. Sell interest rate caps
B. Sell futures
C. Sell FRAs
D. Buy futures
3. If a dealer needs to hedge an over-lent 3x6 position against IMM dates for which the FRA is
quoted 1.30-1.34% and futures at 98.64 - 98.69, which would be cheapest for him (ignoring
margin costs on futures positions) to cover his gap?
A. FRA
B. Futures
C. No difference
D. Too little information to decide
4. You sold a 4x7 FRA in November; you hedge this position using futures. What have you
done?
A. bought 3-month Dec futures
B. Sold 3-month Dec futures
C. Sold 3-month March futures
D. Bought 3-month March futures
© Andre Kurten 2022
Interest Rate Swaps - IRSs
An interest rate swap (IRS) can be defined as an exchange of
one set of cash flows for another based on:
•a notional principal amount, or
•an exchange for differences on a given set of cash flows.
The concept of a basic IRS is very similar to that of an FRA.
•The difference is that the FRA is applied to a single period cash
flow, and
•a swap is applied to cash flows over a longer period of time.
The important concept to remember is that the buyer of an
IRS (also known as the Fixed rate payer) is protected against
rising interest rates and the seller (the Fixed Rate receiver) is
protected against declining interest rates.
© Andre Kurten 2022
Interest Rate Swaps Structures
Plain vanilla swap
•This is a fixed for floating rate swap with a fixed notional value for the
life of the swap. This is by far the most common IRS done. Vanilla or
coupon swaps can be:
oA liability swap - this swap changes the way you pay interest on
a bond or loan
oAn Asset swap - this swap changes the way you receive interest
on a bond or investment
Accreting swap - A swap, which has a notional value that
increases over the life of the swap.
Amortizing swap - A swap, which has a notional value that
decreases over the life of the swap.
Rollercoaster swap - A swap, which has a notional value that
increases and decreases during the life of the swap.
Basis swap – A swap where one floating rate is swapped for
another floating rate. An example would be a 6-month SOFR
against 3-month SOFR swap.
© Andre Kurten 2022
The Swap Mechanism
“A” PAYS fixed to “B”
PARTY B
PARTY A
“A” RECEIVES floating from “B”
The rates exchanged can be a fixed rate for a floating rate or
floating for floating rate.
The counterparties will only exchange the difference between
the rates based on a Notional Principal amount
There will always be a start date, expiry date, fixing dates, and
settlement dates agreed on the swap
Day count convention is calendar rolls modified following CRMF
© Andre Kurten 2022
Liability Swap – an example
PAYS 6.50% fixed to
SB for 3 years
CASH
Bond Market
Borrower
PAYS
3-mth SOFR + 75 BP
Swap Bank
RECEIVES
3-mth SOFR
 The borrower has issued a FRN for 3 years at a rate of 3-month SOFR
plus 75 BP. They want to pay fixed on the loan rather than floating.
 The credit spread on the FRN cannot be hedged as it reflects the credit
worthiness of the issuer.
 Without changing its funding structure, the borrower has gone from
floating to fixed using the IRS market
 The borrower has effectively fixed their funding cost at 7.25% p.a. paid
quarterly for 3 years.
 The borrower has effectively created a synthetic fixed rate bond using the
IRS
 Because of the liquidity in the market, the borrower can restructure their
hedge at any time should their view on interest rates change.
© Andre Kurten 2022
Vanilla IRS – Application
Bank A PAYS fixed to
SB
CASH
Depositors
Bank A
Swap Bank
Bank A PAYS
daily call
Bank A RECEIVES
3-month LIBOR
Fixed Rate
CASH
Bond
Market
 Bank A is naturally a buyer of government bonds to meet its statutory
requirements.
 Bonds pay a fixed return. In a rising interest rate environment, this could
impact the banks returns.
 Bank A can switch the fixed return on the bonds to a floating return by
doing the vanilla IRS. They have created a synthetic floating rate bond.
 Effectively it is now running the basis risk between 3-month LIBOR and
the daily call on its funding book.
© Andre Kurten 2022
Coupon or Plain Vanilla Swaps







Over 75% of all swaps are plain vanilla
Fixed rate vs. floating rate cash flows
Notional Principal amount never exchanged
Principal is constant for the life of the swap
Reference index - EURIBOR, SOFR, etc.
3Month is the most common benchmark
Swaps subject to ISDA documentation.
 ISDA = International Swap and Derivatives Association
 Fixing in advance with Settlement in arrears
 Settlement is done on a netting basis which reduces the
counterparty risk
 Payer buys the swap and pays fixed and receives floating.
 Receiver sells the swap and receives fixed and pays floating.
 Coupon swaps are priced and quoted as a spread over the
government bond yield curve
© Andre Kurten 2022
Settlement calculation
2-year Plain vanilla IRS fixed against 6-month SOFR
0
6
Start date
First fixing
Second fixing
Settlement of
first fixing
12
Third fixing
Settlement of
second fixing
18
Fourth fixing
Settlement of
third fixing
24
Settlement of
fourth fixing
Swap matures
•The swap has a notional principal of USD 100 million
•The fixed rate is 2.75% on the swap
•The first 6–month SOFR fix is 2.50% done on the start date of the swap
•i.e. at 0 on the timeline above, the amount to be paid on second fixing is
calculated as follows:
o100,000,000 x (0.0275-0.0250) x 180/360 = $125,000 paid by the
buyer (fixed rate payer) to the seller (floating rate payer) on the second
fixing date.
•This process is repeated over the life of the IRS
© Andre Kurten 2022
Overnight Index Swap (OIS)










an OIS is a fixed/floating interest rate swap
The floating leg is a daily overnight or tom/next reference rate
The floating leg interest is compounded daily
the interest difference is exchanged as a single amount at
maturity of the swap
settlement is made net with no exchange of principal
Sterling Overnight Index Average (SONIA) is used for GBP
OISs
Euro Short-Term Rate (€STR) used for EUR OISs
Secured Overnight Financing Rate (SOFR) used for USD
OISs or the Effective Fed Funds Rate (EFFR)
Swiss Average Rate Overnight (SARON) used for CHF OISs.
Tokyo Overnight Rate (TONA) used for JPY OISs
© Andre Kurten 2022
Cross Currency Interest Rate Swap
 Differs from a normal IRS in that there is an exchange of
principal and the interest rates swapped are in TWO
DIFFERENT CURRENCIES.
 This exchange of principal can be done at the start of the
swap, but there MUST ALWAYS be an exchange of principal
at the end of the swap.
 The spot rate used for the principal exchange at expiry of the
CIRS is ALWAYS the same as the spot which was prevailing
at inception (and which may have been used at inception).
 These swaps can be floating for floating and are referred to
as a basis swap and are the most common currency swap.
 They can also be fixed for floating
 They are the ONLY swap which can offer fixed for fixed.
 These swaps are used primarily to hedge long term Foreign
Exchange exposure.
© Andre Kurten 2022
Interest Rate Swap questions -1
1. You are paying 5% per annum paid semi-annually and receiving 6-month SOFR on USD 10
million interest rate swap with exactly two years maturity. 6-month SOFR for the next payment
date is fixed today at 4.95%. You expect 6-month SOFR in 6 months to fix at 5.25%, and in 12
months a 5.35% and in 18 months at 5.40%. What do you expect the net settlement amounts
to be over the next 2 years? Assume 30-day months
A. Pay 250, receive 1,250, receive 1,750, receive 2,000
B. Receive 250,pay 1,250, pay 1,750 pay 2,000
C. Pay 2,500, receive 12,500 receive 17,500, receive 20,000
D. Receive 2,500, pay 12,500, pay 17,500, pay 20,000
2. You are paying 5% per annum paid semi-annually and receiving 6-month SOFR on a USD
10 million interest rate swap with exactly two years to maturity. 6-Month SOFR for the next
payment date is fixed today at 4.95%. How would you hedge the swap using FRA’s
A. Buy a strip of 0x6, 6x12, 12x18 and 18x24 FRA’s
B. Sell a strip of 0x6, 6x12, 12x18 and 18x24 FRA’s
C. Buy a strip of 6x12, 12x18 and 18x24 FRA’s
D. Sell a strip of 6x12, 12x18 and 18x24 FRA’s
3. If you funded your fixed-income investment portfolio with short-term deposits, how would
you hedge your interest rate exposure with interest rate swaps?
A. Pay fixed and receive floating through swaps for the term of the portfolio
B. Pay floating and receive fixed through swaps for the term of the portfolio
C. You cannot: the maturity of the swaps would be longer than that of the deposits
D. You should not: there would be too much basis risk
© Andre Kurten 2022
Definition of an Option
An option is a contract that gives the holder
(or buyer) of the option the right, but not the
obligation to buy (or sell) a specified quantity
and quality of a certain asset within a specified
period or on a specific date, at a price agreed
when the contract was entered into.
For this right, the buyer pays a premium and
the seller is obliged to honour the contract if
called on to do so by the holder.
© Andre Kurten 2022
Types of Option Contracts
A Call option
•gives the holder the right but not the obligation to
buy the underlying asset at some time in the future.
A Put option
•gives the holder the right but not the obligation to sell
the underlying asset at some time in the future.
NOTE: Options can either be:
•American - exercisable at any time up to expiry, or
•European -exercisable only at expiry.
•Options can also be styled Asian or Bermudan (see
workbook for definition)
© Andre Kurten 2022
Options Characteristics
The premium of an option is payable when the option is
traded.
•For currency options, the premium is payable value spot.
•For caps and floors, the premium can be paid at the start or
over the life of the option.
The exercise price of the option is known as the STRIKE
price.
When buying options, the most you can lose is the premium.
NOTE: The CREDIT RISK on a long option position can be
GREATER than the premium paid as the seller can default on
exercise date and any unrealised profit will be lost.
Selling options carries far greater risk than buying options.
Only options which are in-the-money will be exercised at
expiry
Out-the-money options expire worthless
© Andre Kurten 2022
Valuing Options
An
option will be more expensive the longer the time to expiry
and/or the higher volatility implied in the price, the more
expensive the option is
 When you sell options, you are described as being short the
option. The most you can earn when writing or selling
options is the premium you charge.
 When you buy options, you are described as being long the
option. The most you can lose when buying options is the
premium you pay.
Exchange traded options are exercised automatically by the
exchange at expiry if they are in-the-money.
Options are normally only exercised if they have intrinsic
value at expiry.
The HOLDER of an option and not the writer will exercise the
option at expiry.
© Andre Kurten 2022
Intrinsic Value and Time Value
The value of an option is the premium which someone is
prepared to pay for the option.
Intrinsic value
•represents the money you would make between the exercise
price and the market price if you were to exercise the option
immediately. Only in-the-money options have intrinsic value.
•Intrinsic value can only be POSITIVE.
Time value
•reflects the amount of premium in excess of the intrinsic value
that someone would be prepared to pay in the hope that the
option will be worth exercising before it expires
Option status
Call option
Put option
In-the-money
Spot price > strike price
Spot price < strike price
At-the-money
Spot price = strike price
Spot price = strike price
Out-the-money
Spot price < strike price
Spot price > strike price
Calls will only be exercised if the spot price is above the strike at expiry
Puts will only be exercised if the spot price is below the strike at expiry
© Andre Kurten 2022
Pricing Option Contracts
The
further out-of-the-money the exercise price,
the cheaper the option
The longer the time to expiry, the more expensive
the option is
The fair value price of an option is dependent on:
•the
strike price
•the term of the option
•the underlying asset price (spot)
•the prevailing risk-free interest rate
•the volatility of the underlying asset price (an option
premium is a positive function of implied volatility)
The
pricing model used to price currency options is usually
based on the Black and Scholes options pricing model.
Currency options we normally use Garman Kohlhagen Model
© Andre Kurten 2022
Option premium questions
1. Consider that you setup the following 6-month trading strategy with the following positions:
a.
b.
c.
d.
You buy a USD Call/CHF Put, strike 1.0500 premium of 45 CHF pips
You sell a USD Put/CHF Call, strike 0.9500 premium of 40 CHF pips
With USD/CHF Spot at expiry at 1.0000, what could be the maximum positive result, in
CHF pips, that can be achieved by this strategy?
You pay 5 CHF pips
You pay 85 CHF pips
You receive 5 CHF pips
You receive 40 CHF pips
2. Consider that you set up the following trading strategy for 2 years with the following
positions:
You sell a cap on 3-month GBP SONIA strike 1.00% with quarterly observations in advance
premium of 0.25% of the notional
You sell a floor on 3-month GBP SONIA strike 0.25% with quarterly observations in advance
premium of 0.35% of the notional
What could be the maximum positive result, in % of Notional, that can be achieved by this
strategy?
a. You receive 0.60% of the notional
b. You receive 0.25% of the notional
c. You pay 0.65% of the notional
d. You receive 0.35% of the notional
© Andre Kurten 2022
Valuing Options
Call values
Put values
when
Rise
Fall
Price of underlying rise
Fall
Rise
Price of underlying fall
Rise
Rise
Volatility rises
Fall
Fall
Volatility falls
Fall
Fall
Time to expiry reduces
Rise marginally
Fall marginally
Interest rates rise
Fall marginally
Rise marginally
Interest rates fall
© Andre Kurten 2022
Option Contract Expiry Profiles
Profit
LONG CALL
Profit
SHORT CALL
Premium
B
0
Asset price
Premium
LONG CALL
Limited risk of loss with unlimited
opportunity for gain
B
0
E
Loss
Asset price
E
Loss
E = exercise price
B = breakeven
SHORT CALL
Unlimited risk of loss with limited
opportunity for gain
© Andre Kurten 2022
Option Contract Expiry Profiles
LONG PUT
Profit
E
0
Premium
Asset price
0
B
LONG PUT
Limited risk of loss with
significant potential for gain
(between breakeven and zero)
B
E
Premium
Loss
SHORT PUT
Profit
Asset price
Loss
E = exercise price
B = breakeven
SHORT PUT
Limited potential for gain with
significant risk of loss (between
breakeven and zero)
© Andre Kurten 2022
Option Characteristics questions-1
1. An option contract that gives the buyer the right to exercise the option at several distinct
points during its life is called:
A. European-style option
B. American-style option
C. Bermudan option
D. Asian option
2. The seller of a call option has:
A. Substantial opportunity for gain and limited risk of loss
B. Substantial risk of loss and substantial opportunity for gain
C. Limited risk of loss and limited opportunity for gain
D. Substantial risk of loss and limited opportunity for gain
3. A put option is ‘out-of-the-money’ if:
A. Its strike price is higher than the current market price of the underlying commodity
B. If the spot price of the underlying commodity is higher than the strike price of the option
C. Its strike price is equal to the spot price of the underlying commodity
D. If the spot price of the underlying commodity is lower than the strike price of the option
4. An ‘at-the-money’ option has:
A. Intrinsic value but no time value
B. Time value but no intrinsic value
C. Both time value and intrinsic value
D. Neither time value nor intrinsic value
© Andre Kurten 2022
Option Characteristics questions-2
5. The exercise price in an option contract is:
A. The price of the underlying instrument at the time of the transaction
B. The price at which the transaction on the underlying instrument will be carried
out when the option is exercised
C. The price the buyer of the option pays to the seller when entering into the
options contract
D. The price at which the two counterparties can close-out their position
6. An option premium is normally a positive function of:
A. the traded volume
B. the historical volatility of the price of the underlying commodity
C. the style (European or American) of the option
D. the implied volatility of the price of the underlying
7. Which of the following does not directly determine an options fair value price?
A. the underlying assets current market price
B. volatility
C. market expectation as to future trends
D. time to maturity
© Andre Kurten 2022
Short Straddle Expiry Profile
Profit
0
E
Loss
Sell both a call and put option with the same strike price, notional
value, and expiry date
Expect very low volatility during the life of the strategy
Maximum profit = premium earned, with unlimited downside risk
ATM Straddles are delta neutral
© Andre Kurten 2022
Long Straddle Expiry Profile
Profit
0
E
Loss
Buy both a call and put option with the same strike price, notional
value, and expiry date
Expect volatility to be high during the life of the strategy
Maximum loss = premium paid, with unlimited upside potential
ATM Straddles are delta neutral
© Andre Kurten 2022
Option short Strangle
Profit
0
A
B
Asset Price
Loss
Sell a call and a put with a different strike (lower) price but
same expiry date and notional amount.
This is a strategy to benefit from low volatility
© Andre Kurten 2022
Option Long Strangle
Profit
0
A
B
Asset Price
Loss
Buy a call at and a put with with a different strike (lower)
price but same expiry date and notional amount.
This is a strategy to benefit from high volatility
© Andre Kurten 2022
A synthetic long asset position
Synthetic
Long asset
Profit
Short Put
0
Long Call
E
Spot Asset Price
Loss
Long call + Short put with same strike, notional, and expiry = SYNTHETIC LONG
ASSET POSITION
In theory the price of ATM puts and calls have the same premium and therefore the
cost of constructing a synthetic long asset should have little or no premium cost.
© Andre Kurten 2022
A synthetic short asset position
Synthetic
short asset
Profit
Short call
0
E
Spot Asset Price
Long put
Loss
Long put + Short call with same strike, notional, and expiry = SYNTHETIC SHORT
ASSET POSITION
In theory the price of ATM puts and calls have the same premium and therefore the
cost of constructing a synthetic short asset should have little or no premium cost.
© Andre Kurten 2022
Option strategy questions
1. An option trader tells you he is long a straddle. What has he done?
A. bought both a call and a put option with the same strike price, expiry, and maturity date
B. bought a call and sold a put option with the same strike price, expiry, and maturity date
C. sold a call and sold a put option with the same strike price, same expiry, and maturity date
D. bought a call and bought a put option with the different strike prices same expiry
2. What is the purpose of a short straddle option strategy?
A. To anticipate very low volatility in the price of the underlying commodity
B. To anticipate moderately high volatility in the price of the underlying commodity
C. To anticipate moderate volatility in the price of the underlying commodity
D. To anticipate very high volatility in the price of the underlying commodity
3. How can a short asset position be synthesised from options?
A. buy a call option and a put option at the same strike price
B. sell a call option and a put option at the same strike price
C. buy a call option and sell a put option at the same strike price
D. sell a call option and buy a put option at the same strike price
4. What is a short strangle option strategy?
A. A short call option + long put option with a higher strike price than the call option
B. A long call option + long put option with a lower strike price than the call option
C. A short call option + short put option with a lower strike price than the call option
D. A long call option + long put option with higher strike price than the call option
© Andre Kurten 2022
The Option “Greeks”
Delta
Delta measures the change in the option premium (price) resulting
from a change in the price of the underlying asset
•
•
•
•
Delta on a long call is positive and ranges between 0 and +1 and
you would SELL the underlying asset to delta hedge
Delta on a short call is negative and ranges between 0 and -1 and
you BUY the underlying asset to delta hedge
Delta on a long put is negative and ranges between 0 and -1 and you
BUY the underlying asset to delta hedge
Delta on a short put is positive and ranges between 0 and +1 and
you would SELL the underlying asset to delta hedge
Delta can also be seen as the likelihood of an option being exercised:
Out-the-money options have a delta BELOW 0.50 so less than 50%
chance of being exercised.
At-the-money options have a delta EQUAL to 0.50 so a 50% chance of
being exercised.
In-the-money options have a delta ABOVE 0.50 (50%) so greater than
50% chance of being exercised.
© Andre Kurten 2022
Delta Hedging
 Delta hedging is done to neutralize the change in the option
premium value.
• For options that are at the money (ATM), the delta is usually
0.50 (50%).
o This means for a 1c move in the market, the premium should
change by 0.5c.
• To delta hedge a short ATM USD/CHF call option in 10m
USD, the dealer would need to BUY 5m USD to be delta
neutral.
o The effect is that as the option goes in the money the option
value would increase and the option writer would be losing
money but because he has bought 5m USD, he will make
money on this position, thus neutralizing the loss on the option.
o If the option goes out of the money, the option writer will make
money on the option, but lose on the delta hedge.
• Dealers who trade an options curve will use delta hedging as
they are looking to make money from the volatility of price and
not the direction of price.
© Andre Kurten 2022
Delta Values for In-the-Money Options
 If a call option is in-the-money, the holder (buyer) would need to sell
the delta value of the underlying asset to remain delta neutral.
•
•
•
They are getting “long of the underlying” through the option.
The delta would range between +0.50 and +1.
The opposite is true for the person who has written the call as they
would be getting “short of the underlying” so their delta would range
between -0.50 and -1 and they would need to buy the underlying asset
to remain delta neutral.
 If a put option is in-the-money, the holder (buyer) would need to buy
the delta value of the underlying asset to remain delta neutral.
•
•
•
They are getting “short of the underlying” through the option.
The delta would range between -0.50 and -1.
The opposite is true for the person who has sold the put as they would
be getting “long of the underlying” so their delta would range between
+0.50 and +1 and they would need to sell the underlying asset to
remain delta neutral.
© Andre Kurten 2022
The Option “Greeks”
 Gamma
•
Gamma measures the change in the delta resulting
from a change in the price of the underlying asset.
• Gamma is often referred to as the 2nd derivative of
options pricing.
• Gamma ranges between 0 and 1.
• The gamma will be most sensitive to change when
the option strike is at-the-money close to expiry.
• Gamma exposure can only be offset by buying
(selling) options opposite to those already bought
(sold).
© Andre Kurten 2022
The Option “Greeks”
 Theta
•
Theta measures the change in the option premium
resulting from a change in the time to expiry of the
option
• The decay of time will result in the option loosing
value, all other factors remaining equal.
• Time value decays slowly at first and then increases
as the option approaches expiry.
• Theta is positive for options writers and negative for
option buyers.
© Andre Kurten 2022
The Option “Greeks”
 Vega
• Vega measures the change in the option
premium resulting from a change in the volatility
of the underlying asset price
• The more volatile the underlying asset price, the
more likely the option will expire in the money.
• If volatility increases, the value of the option will
also increase, all other factor remaining equal.
NOTE: Volatility measures change but not the
direction of prices quoted as a percentage per annum
© Andre Kurten 2022
The Option “Greeks”
Rho
 Rho measures the change in the option premium
resulting from a change in the risk-free interest rate
 Rho is the least important of the Greeks. If the
underlying asset is extremely sensitive to the
change in interest rates, then the option value will
change, all other factors remaining constant.
© Andre Kurten 2022
Interest Rate Options
CAPS
A Cap is an agreement whereby the buyer buys the right to
pay a predetermined fixed interest rate (strike rate) on given
dates over a period based on a notional amount. They will
receive the difference if the benchmark is above the strike
rate on those dates. For this right they pay a premium.
(used by borrowers)
NOTE: A cap can be described as a strip of European call
options
FLOORS
A floor is an agreement whereby the buyer buys the right to
receive a predetermined fixed interest rate (strike rate) on
given dates over a period based on a notional principal
amount. They will receive the difference if the benchmark is
below the strike rate on those dates.
For this right they pay a premium (used by lenders)
NOTE: A floor can be described as a strip of European put
options
© Andre Kurten 2022
Interest Rate Options
COLLARS
 This is a hedging strategy that can be used by long-term
borrowers or lenders where they reduce the cost of a hedge
by limiting the upside benefit.
 A borrower’s collar is the simultaneous purchase of a cap
and sale of a floor with a LOWER strike rate but the same
notional value and expiry date.
 A lender’s collar is the simultaneous purchase of a floor and
sale of a cap with a HIGHER strike rate but the same
notional value and expiry date.
 Borrowers are guaranteed a worse case rate - the strike on the cap and will limit the benefit of a favourable market move - the strike on the
floor.
 Lenders are guaranteed a worse case rate - the strike on the floor - and
will limit the benefit of a favourable market move - the strike on the cap.
© Andre Kurten 2022
Interest Rate Guarantee –IRG
An IRG is an agreement whereby the buyer buys the
right to pay (or receive) a predetermined fixed rate
(strike rate) for a SINGLE future period based on a
notional amount. For this right they pay a premium.
The buyer of an IRG call will receive the difference if
the benchmark is above the strike rate at fixing.
The buyer of an IRG put will receive the difference if
benchmark is below the strike rate at fixing.
An IRG can be considered a caplet or a floorlet.
An IRG Call (Put) can be considered as a call (put)
option on a FRA.
A cap can be seen as a strip of IRG calls (caplets)
and A floor can be considered to be a strip of IRG puts
(floorlets)
© Andre Kurten 2022
Swaptions
A swaption, as the name suggests, is an option on an interest rate
swap, and is European in style. An example would be a 6-month
swaption into a 5-year swap. The holder has the right but not the
obligation to exercise in 6 months time. There are two ways in which
a swaption can be exercised:
The holder can choose to enter into the swap for the term agreed under the
contract or,
• The holder can opt for a cash settlement on the difference between the
strike rate agreed on the swaption and the current fixed rate in the market.
A payer swaption - gives the holder (the buyer) the right but not the obligation
to pay a fixed rate and receive a floating rate if the swaption is exercised.
A payer swaption will only be exercised if the market fixed rate at expiry is
HIGHER than the swaption strike
A receiver swaption - gives the holder (the buyer) the right but not the
obligation to receive a fixed rate and pay a floating rate if the swaption is
exercised. A receiver swaption will only be exercised if the market fixed rate at
expiry is LOWER than the swaption strike
•
© Andre Kurten 2022
Currency Options
Characteristics of currency options
 A Call on one currency is a Put on the other currency.
For example, if you buy a USD/ JPY call option it is a Call on
USD and a Put on JPY. This would be the same as buying a
JPY/USD put option.
 Currency option premiums are payable value spot after the
deal date as a percentage of the base currency nominal
amount. For example, if the premium of a USD/CHF call
option in USD 10million is 0.50%, then the premium will be
USD 50,000 payable value spot from the deal date.
 A currency option is described as at the money when it has
a strike price EQUAL to the forward exchange rate.
© Andre Kurten 2022
Option Greeks and Caps and floors-1
1. The vega of an option is:
A. The sensitivity of the option value to changes in interest rates
B. The sensitivity of the option value to changes in implied volatility
C. The sensitivity of the option value to changes in the time to expiry
D. The sensitivity of the option value to changes in the price of the underlying
2. The delta of an ‘at-the-money’ long put option is:
A. Between -0.5 and -1
B. Between +0.5 and +1
C. +0.5
D. -0.5
3. The delta on a short “in-the-money” call is usually
A. +0.50
B. between -0.5 and -1.0
C. 1.0
D. zero
4. A 6 month into 5-year payer swaption against 6-month SOFR has a strike rate of 5%.
At expiry, the market fixes at 5.75%. Which of the following is true?
A. The seller will exercise the swaption on behalf of the buyer
B. The buyer will exercise the swaption
C. The swaption is out-the-money and will not be exercised.
D. None of the above
© Andre Kurten 2022
Option Greeks and Caps and floors-2
5. An interest rate cap can be described as:
A. A series or strip of European put options
B. A series or strip of European call options
C. A series or strip of American put options
D. A series or strip of American call options
6. Purchasing a USD/JPY call option is equivalent to:
A. Selling an JPY/USD put option
B. Selling a JPY/USD call option
C. Purchasing an JPY/USD put option
D. None of the above
7. How could you delta hedge a deeply “in-the-money” short put option?
A. Go short of the underlying asset equal to 50% of the size of the option contract
B. Go long of the underlying asset equal to 50% of the size of the option contract
C. Go long of the underlying asset equal to more than 50% of the full size of the option contract
D. Go short of the underlying asset equal to more than 50% of the full size of the option
contract
8. An interest rate guarantee (IRG) is effectively:
A. An FRA
B. An option on an FRA
C. A collar
D. An IRS
© Andre Kurten 2022
Topic Basket 5
Financial Market
Applications
Covered in Tutorial 5
© Andre Kurten 2022
Section Objectives
Overall Objectives: The overall objective of this topic if for candidates to
understand the importance that risk has in defining the financial institutions’
business models and to understand the relevance of effective risk
management framework as a key driver for sustainability of the business.
Candidates will understand and be able to explain and identify major risk
groups: market, credit, liquidity, operational, legal, regulatory and
reputational risk; and to understand the significance of risk groups for
different financial markets’ businesses and organizational units. Candidates
are expected to outline the methods and procedures needed to measure and
manage these risk types. Candidates will be required to outline the
framework for Asset and Liability Management as an integrated balance
sheet and risk management concept and to understand the importance of the
Basel Accords for risk management issues. .
• 10 questions comprising – 5 minimum correct answers
© Andre Kurten 2022
What is ALM?
ALM Incorporates the modern techniques used in
profitability and risk management of commercial banks.
These involve the following:
•Creating shareholder wealth
•Profit centre management
•Risk-adjusted performance management
•Pricing of credit risk and loan provision
•The management of interest rate and liquidity risks
As competition is reducing bank margins, the need for
more precise information and a complete asset and liability
management system is becoming an absolute necessity.
© Andre Kurten 2022
Principals of the BASEL Committee
1. Board and senior management oversight of interest rate
risk
2. Adequate risk management policies and procedures
3. Risk measurement and monitoring
4. Internal controls
5. Information for supervisory authorities
6. Capital adequacy
7. Disclosure of interest rate risk
8. Supervisory treatment of interest rate risk in the banking
book

These guidelines set by the Basel committee have prompted a
significant evolution in systems used by banks for managing interest
rate risk, which have gradually become more comprehensive and
accurate.
© Andre Kurten 2022
What is the function of the ALM team?
Banks have 3 main
sources of funds:
This is known as the available
stable funding - ASF. This must
be at least 100% of RSF
1. Deposits from clients
2. Interbank deposits
3. Shareholders equity
Banks invest in 5 main assets:
This is known as the required stable
funding - RSF
1. Reserves with the central bank
2. Loans
3. Interbank loans
4. Bonds
5. Fixed assets
 The ALCO comprises the CEO and heads of business
units in Credit, retail, corporate and Treasury.
 The ALM team or ALCO (asset and Liability Committee)
controls profit and risk.
•
They consider the banks solvency, liquidity management,
structural foreign exchange positions, Funds Transfer Pricing,
but most importantly Interest rate risk.
© Andre Kurten 2022
Available and Required Stable Funding
Available Stable Funding
This looks at the liability side of the balance sheet of a bank.
Equity is the most stable form of funding.
Next best is retail and demand deposits and savings.
The least stable form is short-term repo, deposits from other
banks and loans from the central bank.
Required Stable Funding.
This looks at the asset side of the balance sheet.
The most liquidity absorbing assets are consumer and
corporate loans
Next is mortgages
Then trading positions and financial assets
The least is cash and Central bank balances
© Andre Kurten 2022
Capital Adequacy
The Basel accord is the main capital adequacy structure that
bank supervisors use. The accord covers aspects of capital, risk
weighting of assets and the required capital ratio to meet the
banks product mix.
The basic Capital Adequacy Directive (CAD) sets the minimum
capital required at 8% of total risk-weighted assets (RWA).
•This is known as the Cooke Ratio
The three pillars of the BASEL Accord are:
1.Minimum Capital Requirements – measurement of capital adequacy for
credit, market, and operational risk.
2.The Supervisory Process – Risk management requirements (Internal
Capital Adequacy Assessment Process (ICAAP) and Supervisory Review and
Evaluation Process (SREP). The Liquidity Coverage Ratio –(LCR) and Net
Stable Funding Ratio (NSFR)
3.Market Discipline – Management must be transparent in reporting risk
© Andre Kurten 2022
Capital Adequacy under Basel II
Refers to the adequacy of a banks capital in relation to risk arising from:
•Assets (loans, negotiable paper)
•Dealing operations
•Off-balance sheet transactions
•Other business risk
Equity Capital enables a bank to bear risk and absorb unexpected
losses
Regulatory Capital
•Prescribed by the regulatory authorities in the country. This is split into two
main categories namely Tier 1 (core) and Tier 2.
 Economic capital
•this is the amount of capital needed to cover the risk being faced by a bank.
(usually in excess of Regulatory Capital).
•This is the capital specifically allocated to a branch of a bank.
•It can also be defined as capital at risk (CaR) and can be measured using a
VaR process.
© Andre Kurten 2022
Types of Capital
•Tier 1 (going concern capital)
oCommon equity Tier 1(CET1) capital comprises common shares, retained earnings; common
shares issued by consolidated subsidiaries.
oUnder BASEL III there are new targets for capital to be in place by 2019. these are:
oThe common equity in Tier 1 (CET1) must be a minimum of 4.50%.
oTotal Tier 1 capital (CET1 plus other Tier 1) must be a minimum of 6.0% (the additional 1.50%
balance is made up of non-cumulative prefs, hybrid instruments with a high trigger and terms at
issue of longer that 5 years )
oA conservation buffer of 2.50% CET1 will also be required making Tier 1 total 8.50%.
oTotal capital required remains 8% (6% tier 1 and 2% tier 2) with the 2.50% conservation buffer
totaling 10.50%
•Tier 2 (gone concern capital) (no longer distinction between upper and lower)
•Can be 2% to make up the total of 8%. It comprises, Subordinated term debt with original
minimum term of 5 years. Hybrid capital instruments with a low trigger, and undisclosed reserves.
•Tier 3 (no longer in use)
NOTE: Under BASEL III certain Tier 2 capital will go from being bonds to common equity if the
banks capital ratio falls below a certain level. These are referred to as CoCos (contingent
convertibles).
Gone concern capital is where the Tier 2 bonds lose their superior status and become common
stock if the bank regulatory capital falls below the required minimum (bankruptcy).
© Andre Kurten 2022
ALM and Basel III Questions
1. From 2019 the total capital requirement for banks under Basel III is defined as:
A. 8% of RWA plus conservation buffer
B. 10.5% of RWA plus conservation buffer
C. 8% of RWA plus countercyclical buffer
D. 10.5% of RWA plus countercyclical buffer
2. Under Basel III rules the meaning of RSF is:
A. Reviewed Supervisory Factor
B. Required Stable Funding
C. Riskless Stable Funding
D. Riskless Supervised Funding
3. Prudential regulation of banking book liquidity risk is dealt with by the Basel Committee
(Basel II/Basel III) in the context of:
A. capital adequacy regulations in Pillar 1
B. market risk and Tier 3 capital elements
C. internal management procedures subject to supervisory review in Pillar 2
D. market discipline, disclosure and transparency in Pillar 3
4. Which of the following is a function of asset and liability management (ALM)?
A. coordinated limit management of a financial institution’s credit portfolio
B. running a matched trading book
C. monitoring credit quality of assets and establishing a early warning system
D. managing the financial risk of the bank by protecting it from the adverse effects of
changing interest rates
© Andre Kurten 2022
Capital Adequacy
Credit Risk
Risk weighted assets
Trading Risk
Operational Risk
Credit Risk Weighting
•Two approaches:
•standardized approach which relies on external ratings; that is
ratings given by rating agencies such as Moody’s and Standard
and Poor or Fitch-IBCA
•The second approach which has received the most attention all
over the world is the Internal Rating –Based (IRB) approach
(available under two options: foundation or advanced)
We will examine each approach; the Standardised approach
and the foundational approach for IRB.
© Andre Kurten 2022
Credit Risk Weighting – Standardized
Approach
The Standardized approach is one where a weighting will be related to the
riskiness of the transaction, as identified by the rating of external rating
agencies such as Moody’s or S&P. The table below is the weighting given by
the Basel rules:
AAA-/AA- A+/AGovernments
0%
20%
Banks>3mths 20%
50%
Banks< 3mths 20%
20%
Corporates
20%
50%
BBB+/BBB50%
100%
20%
100%
BB+/B- Below B100%
150%
100%
150%
50%
150%
100%
150%
Unrated
100%
100%
20%
100%
A loan made to a A+ would be rated at 50% therefore a loan of $100 would
attract capital of ≥ 8% x ($100 x 50%) = $4
NOTE: The MAXIMUM risk weighting that can be applied to a loan is
1250%. This makes the capital held equal to the face value of the loan. (100
x 8% x 1250% = 100)
© Andre Kurten 2022
Credit Risk Weighting – Internal RatingsBased (IRB) Approach
In the IRB approach, the banks have to calculate the probability of default
of a corporate client over a 1-year time horizon.
•That is lending to a client today, what is the likelihood of default by the borrower
in one years time?
•This probability of default is referred to as the PD.
NOTE: to apply the IRB foundational approach you need two pieces of
information: the PD and the maturity of the loan.
With retail loans (small amounts), a similar PD can be calculated for a
portfolio of loans.
The three parameters prescribed under Basel Committee of Bank
Supervision (BCBS) to calculate the capital charge for credit risk under the
IRB Advanced approach are the following:
1. The probability of default (PD)
2. The exposure at default (EAD)
3. The loss given default (LGD) NOTE: LGD is the same as 1- recovery rate
Also;
Effective maturity (M)
M = maturity; b(PD) = maturity adjustment
R = correlation between defaults
© Andre Kurten 2022
Credit risk mitigation - Securitization
Securitization
is where bonds are issued which have the backing of an
income producing asset, typically bank debt in the form of long-term debit
instruments such as mortgages or short-term debt instruments, such as
credit card receipts. Securitization can only be done using a Special
Purpose Vehicle (SPV). These assets are known as CDO’s (collateralized
debt obligations) or CMO’s (collateralized mortgage obligations)
This is a popular way of banks freeing up capital and transferring credit risk.
There are usually different classes of bonds issued in a single securitisation
based on the credit of the underlying securitised asset.
Issuing Bank
Removes assets
Balance sheet
Frees up capital
Assets against which the
bonds are issued
Trust or SPV
Issues bonds of differing
classes based on the
underlying credit
Bond Market
© Andre Kurten 2022
Credit risk mitigation- credit derivatives
Credit derivatives are a relatively new phenomenon, and have
really only become prominent in the mid to late 90’s
A credit derivative is a privately negotiated contract whose value is
derived from the credit risk of a bond, bank loan, or some other
credit instrument. Credit derivatives allow the market participant to
separate default risk from the other forms of risk, such as interest
rate and currency risk
Three basic structures
•Credit Default Swap – CDS this bases the payoff on a specific credit
event, such as a bond down grading or default.
•A total return swap - Links a stream of payments to the total return on
a specific asset.
•Credit spread options - Ties the payoff to the credit spread on a
specific bank loan or bond.
© Andre Kurten 2022
Credit Derivative triggers
The standard ISDA documentation for credit swaps defines a set of credit
events which trigger the Credit Derivative. A credit event could be one of the
following:
•Payment default on an agreed-upon public or private debt issue (the reference
asset)
•Debt rescheduling
•A filing for bankruptcy
•Or some other specified event to which the two parties agree.
As a general rule, the credit event must be an objectively measurable event
involving real financial distress; technical defaults are usually excluded.
The reference credit is usually a corporation, a government, or some other
debt issuer or borrower to which the credit protection buyer has some credit
exposure.
The contract will contain a materiality clause which will:
•Call for a significant move of the reference credit’s underlying stock or bond
price
•Ensure that the market recognizes the credit event for what is
•Prevent an unnecessary trigger due to a default caused by legal questions
© Andre Kurten 2022
Operation Risk Weighting –
Basic Indicator Approach, Standardized Approach
and Advanced Measurement (AMA) approach
Basic Indicator Approach
•this is calculated as 15% of the average gross income of the bank over the last
three years.
•This is the simplest approach to Ops risk capital charge.
•Similar to SA
The standardized approach (SA)
•this is straight forward:
oThe capital charge is simply a multiple of the gross revenue of an activity,
averaged over the last three years.
oGross revenue is the sum of net interest margin and non-interest income (such a
fee charged).
oThe capital charge under this method is the same for all banks irrespective of
their operational control processes.
The Advanced Measurement Approach (AMA)
•under this approach, the banks themselves estimate statistically what could be
the worst operational losses, for a confidence level of 99.9%. This requires
estimation of two factors:
•The number (frequency) of operational losses over one year, and the potential
magnitude of these operational losses
© Andre Kurten 2022
Credit and Operation Risk Management Questions
1. Under Basel rules, what is the meaning of RWA?
A. Risk Weighted Assets
B. Risk Weighted Average
C. Recovery Weighted Assets
D. Risk Weighted Adjustments
2. When considering interest rate risk in the banking book, retail demand deposits without fixed
contractual maturity:
A. should be assumed to have zero duration
B. should be treated like other instantly variable rate liabilities, such as overnight money market
borrowing.
C. should be assumed to have a low correlation with money market reference rates
D. represent a minor contributor to interest rate risk and can safely be disregarded
3. Under Basel Securitization rules the highest potential risk weight is:
A. 350%
B. 750%
C. 1250%
D. 1500%
4. Which of the following statements about Credit Default Swaps (CDS) is correct?
A. CDS are used to recover funds from defaulted swap counterparties.
B. CDS provide protection against specified credit events to the party receiving the CDS premium
payments.
C. CDS provide protection against the default of the trade counterparty that buys the CDS.
D. CDS provide compensation to the protection buyer, should a specified credit event occur to a
third-party entity.
© Andre Kurten 2022
Interest rate risk management
Gap analysis (Maturity method)
•Interest rate risk is identified as the possible changes in net interest income.
The maturity method is generally used for the short to medium term.
•The gap is a concise measure of the interest rate risk that links changes in
market interest rates (either a parallel shift or titling of the yield curve) to
changes in the net interest income (NII) of the bank.
•The gap over a given period is defined as the difference between the amount
of rate sensitive assets and rate sensitive liabilities.
•A positive gap is one where rate sensitive assets exceed rate sensitive
liabilities. (lent floating and borrowed fixed in that gap)
•A negative gap is one where rate sensitive liabilities exceed rate
sensitive assets. (borrowed floating and lent fixed in that gap)
•A positive gap benefits from rising interest rates
•A negative gap benefits from falling interest rates
A 5-year loan that re-prices monthly would fall into the 1-month repricing
gap, but the 5-year liquidity gap.
A long 6x12 FRA would be considered as a 6-month asset and a 12-month
liability in gap analysis
© Andre Kurten 2022
Duration - 1
For longer term interest rate risk, banks tend to use the duration.
Duration (Macaulay) is the measure of the weighted average life
of an asset or liability on a banks book. (the time it takes to achieve
half of the benefits offered by the asset or cost of a liability)
Rules for duration
•The lower the coupon of a bond, the higher (longer) its duration
•The lower the yield to maturity, the higher its duration, so duration
will be highest for zero-coupon bonds. (NOTE: zero-coupon bonds
are also the most sensitive to yield changes)
•The longer a bond has to maturity, the longer its duration.
•As a bond maturity decreases, the duration of a bond decreases
Modified Duration, which is derived from duration, is a method
used to calculate the change in the basis point value – BPV caused
by a change in the yield curve.
This is important, because for a 1 basis point change in yield, not all
asset and liabilities change by the same value. Long-term assets
and liabilities are far more sensitive to yield changes than shortterm assets or liabilities.
© Andre Kurten 2022
Duration - 2
So importantly, a shift in yield curve may reflect a positive change to
a banks NII using simple gap or maturity method, but a negative
change to the profit of the bank using Modified Duration.
For example, the coupon interest on a fixed rate bond, which we
hold, is not affected by a change in the market yield, but the value of
the bond is certainly affected. Rising yields cause a unrealised loss
on the value of a bond and vice versa.
The Basel rules for a banks maximum interest rate
sensitivity
A revaluation loss as a result of an immediate parallel rise (or fall) of
the yield curve by 200bp may not exceed 20% of the banks own
funds (capital).
The maximum allowed duration of equity is 10 (20%/2%)
To lengthen the duration of your assets BUY long bond futures
To lengthen the duration of your liabilities SELL long bond futures
© Andre Kurten 2022
Basel III - Liquidity Risk
Liquidity Coverage Ratio - LCR
•The Basel III rules insist that a bank maintains a high liquidity coverage ratio.
This rule requires banks to have enough cash or near-cash to survive a 30-day
market crisis.
Net Stable Funding Ratio – NSFR (1 year time horizon)
•This ratio is applied to reduce the banks dependency on short-term funding and
is longer term in nature to limit over-reliance on short-term wholesale funding.
Leverage ratio
•This ratio refers to the amount of regulatory capital and the nominal amount of
on and off balance sheet exposures and derivatives. This is recommended to be
a minimum Tier 1 leverage ratio of 3%
Credit Value Adjustment (CVA) is PD x EAD x LGD or
PD x EAD x 1-recovery rate
Stress testing
•These are tools used to identify and manage situations which can cause extraordinary losses. They can be based on the following:
1. Replication of the strongest market shocks which occurred in the past
2. Statistical measures with extreme multiple of historical volatility
3. Subjective assumptions such as a 100BP move up or down in the Yield Curve
© Andre Kurten 2022
Funds Transfer Pricing
The main aims of internal funds transfer pricing system:
1.To transfer interest rate risk from the various units in the bank to one
central unit usually the Treasury. The Treasury can correctly evaluate
and manage this risk and where necessary apply the relevant hedging
policies
2.To evaluate the actual profitability of this activity by assigning
interest rate risk management to a single centralized unit
3.To remove the need for each division from dealing with the funding
of their loans or the investment of surplus deposits
4.To provide a more accurate assessment of the contribution of each
operating unit to the banks overall profitability.
The bank can either apply a single internal transfer rate
(ITR), (usually a floating benchmark like SOFR) or it can
apply multiple ITRs reflective of the maturity profile of
deposits and loans. This would often also include a liquidity
spread.
© Andre Kurten 2022
Hedge Accounting under IFRS 9
Hedge Accounting is applied when a transaction is undertaken to mitigate
the market risk on an existing position. The hedge must be shown to be
effective. Hedge accounting will no longer apply if it fails the effectiveness
test, or once the underlying position and/or the hedging instrument is
terminated or matures.
Fair Value Hedge
When a risk exposure is associated with the price of an asset, liability or firm commitment, and
when there are no uncertain cash flows involved with the risk, like a fixed income bond, the
hedging relationship is said to be a “fair value hedge”. The derivative (usually an IRS) must be
MTM, with the resulting gains / losses shown in earnings. In addition, the underlying exposure
due to the risk being hedged must also be MTM, and these results flow through current income
as well. To the extent that the two contributions to earnings are offsetting, the hedge will not
have an impact on current earnings. Imbalances between these two will, however, impact
earnings.
Cash Flow Hedges
A “Cash flow Hedge” is a hedging relationship where the risk exposure is that of an upcoming,
forecasted event, where the prospective cash payment (receipt) is an uncertain amount, like
that of a Floating Rate Note - FRN. For cash flow hedges, the derivative (usually an IRS) results
must be evaluated, with a determination made as to how much of the result is “effective” and
how much is “ineffective”. The ineffective component of the hedge results must be realized in
current income, while the effective portion is initially posted to “other income” and is later reclassified as income in the same time frame in which the forecasted cash flow affects earnings.
© Andre Kurten 2022
Gap analysis and Duration Questions
1. What is a ‘duration gap’?
A. the average maturity of liabilities on a balance sheet
B. the difference between the duration of assets and liabilities
C. the difference between the duration of the longest-held and shortest-held liabilities
D. the average maturity of the portfolio on the asset side of a balance sheet
2. Which of the following transactions would have the effect of lengthening the average duration
of assets in the banking book?
A. buying futures contracts on 30-year German Government bonds
B. selling futures contracts on 30-year German Government bonds
C. buying put options on 30-year German Government bonds
D. buying a 3x6 forward rate agreement
3. All other things being equal the interest rate risk of a fixed coupon bond is:
A. greater, the higher the coupon and the longer the term
B. greater, the lower the coupon and the longer the term
C. lower, the lower the coupon and the shorter the term
D. lower, the higher the coupon and the longer the term
4. A purchased 3X6 FRA should be reported in a gap report as
A. a given deposit with a term of six months
B. a taken deposit with a term of three months
C. a given deposit with a term of three months and a taken deposit with a term of six months
D. a taken deposit with a term of three months and a given deposit with a term of six months
© Andre Kurten 2022
FTP, Hedge Accounting Questions
1. The Liquidity Coverage Ratio imposed by Basel III requires a bank:
A. to keep enough highly liquid assets to cover its net liabilities for the next 10 days to guard
against severe liquidity stress
B. to keep enough highly liquid assets to cover its net liabilities for the next 30 days to guard
against severe liquidity stress
C. to keep enough highly liquid assets to cover its net liabilities for the next 60 days to guard
against severe liquidity stress
D. to retain enough liquidity to cover its assets against severe default risk
2. Which one of the following statements is incorrect? Hedge accounting of an existing position no
longer applies when:
A. The trader acquires additional exposure in the hedged item.
B. The hedging instrument is sold, terminated or exercised.
C. The hedged item is sold or settled
D. A hedge fails the effectiveness test.
3. Which of the following is NOT a requirement for applying hedge accounting?
A. Hedge documentation should be in place
B. The expected effectiveness of the hedge must be demonstrated at the start of the hedge
C. During the term of the hedge, the effectiveness of hedge must be measured and reported
D. The term of the derivative instrument and of the hedging item should be equal.
4. What is the function of liquidity transfer pricing?
A. It charges providers of funds for the cost of liquidity and allocates part of the net interest income
to users of funds as a benefit of liquidity
B. It measures the total amount of liquidity at risk
C. It allocates the net interest income as a result of interest rate mismatches between the
respective business units of the bank.
D. It attributes costs, benefits, and risks of liquidity to respective business units of the bank
© Andre Kurten 2022
Treasury Risk
Volatile exchange rates and interest rates together with a
market environment that has become increasingly complex,
makes risk management within the treasury a vital function.
Treasury risk management staff must have a trading
background or at least some technical skill to deal with the risk
control function within the treasury. Lack of expertise can result
in losses.
Segregation of duties and reporting is also vital within the
treasury environment
A professional standards review in addition to the
conventional audit is also recommended to review the conduct
of treasury officers
© Andre Kurten 2022
Credit Risks
Default Risk (counterparty risk)
•Exposure to the likelihood or possibility that a counterparty to an
outstanding transaction may not be able to settle due to bankruptcy or
liquidation.
•Such a loss leads to the product of the exposure at default (EAD) and the
loss given default (LGD).
Country Risk
•Caused mainly by a currency crisis where borrowers are unwilling or
unable to settle outstanding transactions.
•Political and economic factors play an important role in the assessment
of country risk.
•There are many reports generated by industry bodies detailing current
economic and political events within countries.
Settlement Risk
•Usually the risk that payment is effected on a currency transaction
without the receipt of payment in turn from the counterparty to the
transaction.
•In currency settlement this risk is referred to as HERSTATT RISK.
•CLS Bank is the safest way to mitigate settlement risk
© Andre Kurten 2022
Credit Risks
Replacement risk
•This is the cost of replacing a deal which is in default.
•Eg. if you enter a deal to purchase currency at a forward date
and the counterpart to the trade cannot deliver, you can cancel
the deal and enter a new deal to replace the exiting deal.
•Any price over and above the original price paid is the
replacement cost.
•You will only lose money if there was a positive unrealized P&L.
•The only time the full capital amount is at risk is when delivery
has already been made and cannot be revoked.
•The process of marking-to-market allows a bank to assess the
replacement risk on all outstanding deals on an ongoing basis.
•Close out netting is the commonly used netting where a
counterparty is in default.
© Andre Kurten 2022
Minimum Control Standards For Credit Risk
 Good credit assessment
 Credit limits imposed and monitored by management
• By counterparty
• By industry
• By country





Credit enhancement – Credit Derivatives
Default management – ISDA and ICMA documentation
Termination clauses – used in the IRS market
Payment netting – bilateral and multilateral
Covenants
• these are conditions that the borrower must adhere to in terms of the
loan agreement.
• Failure to adhere to the covenants can result in the bank demanding
immediate payment of the loan.
• There are usually financial and non-financial covenants attached to a
loan agreement.
© Andre Kurten 2022
Market Risks
Currency Risk (exchange rate risk)
•The cost of closing out open foreign exchange positions in
currencies to which the treasury is exposed.
•This can be as a result of FX or FX derivative positions.
•A common benchmark for controlling risk in this area is “the
maximum loss” permissible for one day on open positions.
•Real time feeds help to monitor the intra day risk on open
positions. Different currency exposure may result from
Transaction exposure
•spot or forward transaction losses money due to a change in the
exchange rate
Translation exposure
•value of foreign assets or profits of multinational company due to
a devaluation of currency
Economic exposure
•business profits affected by a change in the exchange rate for
exporters or importers
© Andre Kurten 2022
Market Risks
Interest Rate Risk
•Exposure to the changes in interest rates for interest rate products such as
bonds, FRAs, IRSs, caps, floors, and Interest rate futures.
•Banks also consider the risk of yield curve changing relative to the mismatch
between assets and liabilities (Gap Analysis).
•Liquidity ladders should be managed to gauge mismatches and monitor the
banks liquidity position.
NOTE: A loss as a result of an immediate upward (or downward) parallel
shift in the yield curve of 200bp may not exceed 20% of the banks regulatory
capital. (remember the equity ratio of 10) This a vital risk which needs to be
carefully managed!!
Equity Risk
•the risk that a market position is sensitive to equity market performance (stocks,
stock index futures, options)
Commodity risk
•the market value of a position is sensitive to commodity price changes
Volatility risk
•a market position is sensitive to the volatility of prices in FX, interest rate, equity
and commodity markets
© Andre Kurten 2022
Minimum Control Standards For
Market Risk
 Transaction approval
 Measurement
• Regular marking to market of open positions
• Gap analysis for interest rate exposure
• Risk identification using Value at Risk modeling
(VaR)
 Risk reporting
 Risk system development – good revaluation
 Limit approval
 Timeous inputting of deals
 Matching of hedges with the hedged instrument
© Andre Kurten 2022
Measuring Market Risk - VaR
 Value at Risk – VaR is a method of assessing market risk. VaR permits the
aggregation of market risks across asset classes. In other words it assesses
the exposure that the institution has on all open positions.
VaR is characterised by three key elements:
1.It indicates the MAXIMUM potential loss that a position or portfolio can
suffer
2.Within a certain confidence level (lower than 100%)
3.Limited to a certain time horizon that the position will remain constant.
•For example a USD 5m daily VaR at 95%confidence means the expected
loss should not exceed USD 5m 95 days out of 100 (or 19 days out of 20) It
also indicates that in 5 days out of 100 the expected loss could exceed USD
5m.
•Note: As the confidence level increases, so for example, if the 95%
confidence maximum expected loss is given as USD 5m, applying a 99%
confidence level could indicate a maximum expected USD 7m (99 day
out of 100).
Basel Accord recommends a 99% confidence level, a 10 day holding
period (the time the position is not altered or sold) using historical data of
© Andre Kurten 2022
Value at Risk Models
 The models most often used to measure VaR are:
1. Variance –covariance method
2. Monte Carlo simulation
3. Historical simulation
 Limitations of the VaR
1. It assumes log normal distribution of prices
2. It requires a constant volatility and correlation estimate
3. It assumes a linear payoff hypothesis that is the
assumption that price change is linear and not convex.
4. It provides no measure of the excess loss if the actual
loss is greater than the expected loss. One of the ways
to overcome this is to apply another risk measure
referred to as the Expected Shortfall.

Expected shortfall - is defined as the expected value of all losses in
excess of VaR and can be measured using stress testing
© Andre Kurten 2022
Credit Risk, Market risk, and VaR Questions
1. Taking collateral to hedge the credit risk on a counterparty means that you have:
A. Eliminated credit risk
B. Eliminated market risk
C. Taken a guarantee from the issuer of the collateral
D. Taken on market, legal and operational risks
2. Which of the following is described as Herstatt risk?
A. failure to meet settlement on an interest rate swap fixing
B. settlement failure on a foreign exchange spot transaction on value date
C. risk to counterparty on deal date for a forward exchange rate swap
D. the risk in trading EUR FRAs
3. What is the correct interpretation of a EUR 5,000,000.00 one-week VaR figure with a 99%
confidence level?
A. A loss of at least EUR 5,000,000.00 can be expected in 99 out of the next 100 weeks.
B. A loss of at most EUR 5,000,000.00 can be expected in 1 out of the next 100 weeks.
C. A loss of at most EUR 5,000,000.00 can be expected in 1 out of the next 100 days.
D. A loss of at least EUR 5,000,000.00 can be expected in 1 out of the next 100 weeks.
4. If the daily 90% confidence level VaR of a portfolio is correctly estimated to be USD
5,000,000, one would expect that:
A. in 1 out of 10 days, the portfolio value will decline by USD 5,000,000 or less.
B. in 1 out of 90 days, the portfolio value will decline by USD 5,000,000 or less.
C. in 1 out of 10 days, the portfolio value will decline by USD 5,000,000 or more.
D. in 1 out of 90 days, the portfolio value will decline by USD 5,000,000 or more.© Andre Kurten 2022
Dealing Room Limit Structures
Market risk and credit risk are only limited by the imposition of
LIMITS.
Credit limits
•these are used to control credit risk and are set OUTSIDE of treasury.
•A dealer must strictly keep within the limits set.
•Credit limits will be set by counterparty, market sector, and country.
Dealing limits
•these are limits used to control market risk. Limits will be set per
instrument, currency, dealer, desk, and dealing room.
•Most banks use VaR limits rather than a nominal positional limit. So for
example, a dealer has a VaR limit of $1,000 per basis on an open CD
position. This means that if the market moves adversely then the dealers
position cannot result in a loss of more than $1,000 per BP. So a VaR
limit attempts to indicate the level of market risk before it economic
consequences are realised.
LIMITS DO NOT CHANGE unless management adjust them.
© Andre Kurten 2022
Common Business Day conventions
 Calendar rolls Modified Following (CRMF)
• Convention applied when:
 concluding certain deals in particular deals which have a number of
events, e.g.
− an interest rate swap, or
− an interest rate option.
• This is a Business Day Convention whereby:
 payment days that fall on a holiday or weekend, roll forward to the next
Good Business Day,
− if that day falls in the next calendar month, the payment day rolls backward
to the immediately preceding Good Business Day.
 New bank holidays (public holidays)
•
Where a new bank holiday is declared, the new value date on
existing deals is the next business day
o
•
unless the counterparties have agreed otherwise.
In currency transactions, the affected parties should agree to adjust
the exchange rate according to the relevant forward mid-rate.
© Andre Kurten 2022
Other Identifiable Risks - 1
Legal Risk
•Caused by ineffective contracts which result in the inability to enforce
them. Before dealing with a client, banks should be clear that all the
necessary documentation is in place.
Reputational risk
•This is the risk arising from negative perception on the part of
customers, counterparties, shareholders, investors or regulators that can
adversely affect a bank’s ability to maintain existing, or establish new,
business relationships and continued access to sources of funding.
•Reputational risk may give rise to credit, liquidity, market and legal risk –
all of which can have a negative impact on a bank’s earnings, liquidity
and capital position.
Regulatory Risk
•Caused by the banks non-compliance with regulation, reporting and
compliance required by the financial authorities and or the Central Bank.
•The consequence can be the imposition of fines or in the worse case,
the withdrawal of the financial institution’s license to operate.
Model Risk
•the risk that computer model used by a dealer to price and value an
instrument is wrong. This is an operational risk, but clearly it can create
potential market risk.
© Andre Kurten 2022
Other Identifiable Risks -2
Specific risk
is a risk that affects a very small number of assets. This is sometimes
referred to as "unsystematic risk” or unique risk. Systematic risk is
where an entire asset class or sector is affected.
In a balanced portfolio of assets there is a spread between general
market risk and risks specific to individual components of that portfolio.
An example would be the risk of one bond in a portfolio of different
bonds losing value because of a downgrade of the issuer. Systematic
risk would be where the entire bond portfolio suffers loss as a result of
a market crisis.
Systemic risk
is the risk of collapse of an entire financial system or entire market, as
opposed to risk associated with any one individual entity, group or
component of a system.
•Often referred to as a ‘knock-on effect’.
Same way risk or wrong-way risk
is defined by ISDA as the risk that occurs when “exposure to a
counterparty is adversely correlated with the credit quality of that
counterparty”. It arises when default risk and credit exposure increase
together. An example would be buying a CDS on a defaulting reference
asset which was issued by the CDS writer.
© Andre Kurten 2022
Operational Risk
This is broadly defined as the likelihood of a loss, as
measured by the value of the loss, on the transaction
processed. This loss is usually caused by people,
processes, systems, or data. This is a risk which is
CONTROLLABLE by the bank.
Causes may be as a result of:
•Lack of proper procedures
•No segregation of duties
•Insider trading
•Market manipulation
•Lack of internal controls
•Insufficient systems
•Manual interventions
•Payment authorizations
•Unskilled or shortage of staff
•Capacity
•Disaster recovery policies
© Andre Kurten 2022
Minimum Control Standards
For Operational Risk
•
•
•
•
•
•
•
Timeous transaction processing
Constant Position reconciliation
Timeous input and confirmation
Good Cash management
Security for environment and systems
Proper customer service
Policy and procedure adherence – everyone must
understand the mechanics of the transactions
• Strictly controlled database management
• Good control and management on the introduction of new
products
• Good management information systems / exceptions
reports
© Andre Kurten 2022
Basic documentation
Basic documentation is necessary to
establish:
The business to be conducted
The limits on deal/transaction size
Who the authorised dealers are that
can bind the company
Who the authorised signatory/s are on
the confirmations
© Andre Kurten 2022
Documentation in current use
ISDA
•International Swap and Derivatives Association
•Documentation covers all treasury instruments except
Repos
 Credit support annex – CSA This is an annexure to the ISDA
which deals with collateral and margining of OTC derivatives
SIFMA/ICMA Global Master Repurchase Agreement (GMRA)
•encompassing the International Capital Market Association
– ICMA (previously ISMA), and
•Securities Industry and Financial Markets Association –
SIFMA (previously TBMA/PSA)
FEOMA
•Foreign Exchange and Options Master Agreement (IFXCO
– International FX and currency Options)
© Andre Kurten 2022
Other risks, Documentation and Limits Questions
1. You have just sold USD 5 million spot against JPY. What type of risk does NOT apply?
A. Market risk
B. Settlement risk
C. Basis risk
D. Credit risk
2. Which of the following scenarios offer an example of wrong way risk?
A. A bank purchases credit protection on highly-rated tranches of US mortgage-backed
securities from a US mortgage bank
B. A bank sells protection on the iTraxx main index at a level of 25 bps and shortly afterwards
the index crosses the 200 bps level
C. A bank sells EUR put/USD call ATM options with an expiry date of 6 months and
afterwards volatility moves up to substantially higher levels
D. A bank enters into a receiver’s swap while interest rates are increasing
3. The major risk to the effectiveness of netting is:
A. Credit risk
B. Settlement risk
C. Liquidity risk
D. Legal risk
4. If a counterparty refuses to pay the profit due to you on a derivatives transaction and argues
that you dealt with an unauthorized member of their treasury staff what type of risk are you
exposed to?
A. Legal risk
B. Market risk
C. Basis risk
D. Settlement risk
© Andre Kurten 2022
Netting
Payment netting
•This is applied to payments in the same currency
for the same value date. Where two banks have a
large volume of treasury transactions to settle on a
particular value date, the net pay and receive
amounts for each could be much reduced if these
were netted off against each other.
 Other forms of netting are usually applied when
there is default by a counterparty and open positions
exist.
•The main reason for this form of netting is to
prevent “cherry picking” by the liquidators
© Andre Kurten 2022
Types of Payment Netting
Bilateral netting of payments
Agreed between two parties and they enter into a contract. Very
easy to implement from a legal and systems point of view.
Bilateral netting of payments is described as ONE PAYMENT,
PER COUNTERPARTY, PER CURRENCY, PER DAY
Multilateral netting of Payments
This is much more complex and is easiest to understand when
examining the structure of a CLEARING HOUSE. Multilateral
netting of payments is described as ONE PAYMENT, PER
CURRENCY, PER DAY
There are several participants in the netting process and there
is normally a redistributing of default risk.
Continuous linked settlement (CLS) is a Multilateral netting system for FX
settlement. It is the most effective in preventing loss due to default.
Payment netting is consider best market practice by the ACI FMA
© Andre Kurten 2022
Other Forms of Netting
Netting by novation
This is a netting arrangement where the existing contracts are
netted out and cancelled and replaced by a single new (nova)
contract
Close out netting
This is applied by an area outside of treasury in the instance of
a bankruptcy. All open positions are marked to market and a
single payment is made to settle all outstanding commitments.
This is usually the type of netting applied in ISDA and ICMA
documentation in the case of a bankruptcy.
Standardised documentation has been set up for OTC derivatives contracts
by industry bodies such as the International Swap and Derivatives
Association (ISDA) and ICMA (International Capital Market Association)
which contain netting clauses for confirmation and payment netting.
© Andre Kurten 2022
Reconciliation's
Internal recon's – position keeping is used to determine
market exposure, unrealised P&L, and current net position
An example
A dealer makes the following spot EUR/USD transactions:
Buys EUR10mio at 1.1001, buys EUR 25,5mio at 1.0993, and sells EUR 20mio at
1.1011
1. What is his position after these trade and what is the average rate?
EUR
RATE
USD
+10,000,000 x 1,1001 = - 11,001,000
+25,500,000 x 1.0993 = -28,032,150
-20,000,000 x 1.1011 = +22,022,000
+15,500,000
-17,011,150
17,011,150/15,500,000 = 1.0975 average rate on a long position of EUR15,5mio
2. If the end-of-day revaluation rate is 1.0990, what is his unrealised profit or loss?
EUR
RATE
USD
+15,500,000
-17,011,150
-15,500,000 x 1.0990 +17,034,500
Square
+23,350
So the dealers unrealised profit at the end of the day is USD23,350
© Andre Kurten 2022
Nostro and Vostro accounts
Nostro account is “our” foreign exchange account held with
an overseas correspondent bank
•e.g. from London Bank perspective, their USD account held with
Citibank NY
Vostro account is a local currency account held on behalf of
an overseas client bank
•e.g. from Citibank NY perspective, the London Bank USD
account held with themselves. Sometimes also referred to as a
Loro account.
Note: A Nostro and Vostro account are the same account.
A Loco account is an account for gold in London.
•It can be described as a “nostro account” for gold.
© Andre Kurten 2022
Netting, Recons and Nostro Questions
1. At the end of the day, you are short CHF 3,500,000.00 against SEK at 6.9275.You are
asked to revalue your position at 6.9190.What is the resulting profit or loss?
A. Profit of CHF 29,750.00
B. Profit of SEK 29,750.00
C. Loss of SEK 29,750.00
D. Loss of CHF 29,750.00
2. What type of risk would you face if a payments system failed?
A. Credit risk
B. Market risk
C. Liquidity risk
D. Legal risk
3. What is a ‘vostro’ account?
A. your account in a foreign currency with another bank
B. your account in domestic currency with another bank
C. an account held with your bank by another in a foreign currency
D. an account held with your bank by another in your currency
4. You are the fixed-rate payer in a plain vanilla interest rate swap. If your counterparty
defaults, your exposure at default is:
A. greater, the higher the market swap rate and the shorter the term
B. lower, the lower the market swap rate and the shorter the term
C. lower, the lower the market swap rate and the longer the term
D. greater, the higher the market swap rate and the longer the term
© Andre Kurten 2022
Straight Through Processing
Four main factors that help streamline STP:
1. Front-end (dealing) data capture
2. Standard Settlement Instructions - SSIs
3. Immediate matching of confirmations
SWIFTNet Accord, TRAM, or BART
4. Automated payment systems – A Real Time
Gross Settlement System (RTGS)
These have become the building blocks that have
taken the concept of STP from theory to practice.
Deals can now go from initiation to settlement
without ANY manual intervention.
© Andre Kurten 2022
Continuous linked Settlement
 CLS eliminates the settlement risk in cross currency payment
instruction settlement through CLS Bank in NY.
• This is achieved by linking the local central bank Real Time Gross
Settlement (RTGS) systems in the participating countries.
• This occurs during a five-hour window of their overlapping business
hours: in this window, settlement instructions for a particular date are
settled and funds are requested to be paid in and are paid out by CLS
Bank.
 CLS Bank is based in New York and is a multi-lateral netting
system for currency settlement and achieves STP.
 Only currencies which are part of CLS can settle through the
system.
 Only counterparties in countries which are part of CLS can
use the system.
 Currency pair, counterparty, and time determine whether a
deal can settle through CLS.
© Andre Kurten 2022
Some Essential Abbreviations - 1
PLEASE NOTE: You may face questions regarding a number of
abbreviations in the exam in both ALM and Risk Management
sections in the exam.
 CREDIT RISK
• IRB – Internal Rating Based. An approach to measure the capital required
for credit risk applied using the banks own models.
• CVA– Credit Value Adjustment is equal to PDxEADxLGD. This is used as
an add-on for capital charges on OTC derivative contracts (similar to a
credit spread on a loan)
• ICAAP – Internal Capital Adequacy Assessment Process
• PFE– Potential Future Exposure. This is used to determine the amount of
credit that needs to be taken on an OTC derivative transaction (usually and
IRS). Two methods used. Add-on and statistical calculation
• PD– is the average probability that a counterparty will default at a specific
time or during the term of a contract.
• EAD- Exposure At Default. This is the value of a financial contract or claim
at the time of default.
• LGD- Loss Given Default. This is the exposure that a bank will lose if a
counterparty defaults. (remember LGD = 1 – recovery rate)
© Andre Kurten 2022
Some Essential Abbreviations - 2
 CREDIT RISK (CNTD)
• CCF- Credit Conversion Factor. Used for standby facilities and letters of
credit
• CCP – Central Counterparty. A clearing institution that acts as an
intermediary between market participants.
• EEPE – Effective Expected Positive Exposure. This is the mean
(average) of Effective Expected Exposure during the life of OTC
derivative contracts.
• CDS- Credit Default Swap. A credit protection instrument to protect
against the default of a reference asset or borrower.
• RWA – Risk weighted assets.
 LIQUIDITY RISK
• LCR– Liquidity Coverage Ratio. Requires banks to hold high quality liquid
assets to meet at least 100% of net cash outflows over a 30-day period
during a stress scenario.
• NSFR – Net Stable Funding Ratio. A longer term structural liquidity ratio.
It distinguishes between;
•
•
•
ASF - Available Stable Funding (liability side of the banks balance sheet)
RSF - Required Stable Funding (asset side of the banks balance sheet)
ASF must always be greater than 100% of RSF.
© Andre Kurten 2022
Some Essential Abbreviations - 3
 LIQUIDITY RISK (CNTD)
• BPV- Basis Point Value also know as DV01 or the dollar value of a basis
point. This is the change in the value of a security or portfolio for a 1 BP
change in interest rates.
• HQLA – high quality liquid assets. These are the class of assets a bank
must hold under the LCR requirements
 OPERATIONAL RISK
• ORM– Operational Risk Management. A department (required under
BASEL) set up to formulate and implement policy for the control of
operational risk.
• BCP– Business Continuity Plan. This is a logistical plan which allows a
bank to return swiftly to normal operations following a disaster or crime.
• RSA- Risk Self Assessments. Also sometimes referred to as risk and
control self assessments (RCSA). A process where an organisation
identifies and assesses their own risks.
• KCI– Key Control Indicators. Also sometimes referred to as key risk
indicators – KRI. These are early warning signals used to establish the
degree to which risks are still occurring and/or how effective controls are.
© Andre Kurten 2022
Some Essential Abbreviations - 4
 OPERATIONAL RISK (CNTD)
• BIA– Basic Indicator Approach. This is one of three capital
requirement measurements for operational risk. It is set at 15% of
the banks gross profit.
• SA- Standardized Approach is the second available method of
capital requirement measurements for operational risk. Similar to
BIA as a percentage of individual business units profit, but only
used if it is lower than BIA.
• AMA – Advanced Measurement Approach. The third available
method of capital requirement measurements for operational risk.
Here the bank uses its own model to determine the capital
requirement drawing on a database of at least 3 years history of
operational losses.
• IFRS- International Financial Reporting Standards
© Andre Kurten 2022
Abbreviations Questions
1. What is the primary purpose of trading limits?
A. To manage market risk
B. To manage operational risk
C. To manage legal risk
D. All of the above
2. A bilateral netting agreement in the foreign exchange market is:
A. A formal agreement between 2 parties to net off all payment due in a single currency for
each settlement date.
B. A formal agreement between a number of parties to net off all payments due in a single
currency for each settlement date
C. An informal legal agreement between 2 parties to net off all payments due in a single
currency for each settlement date.
D. An informal agreement between a number of parties to net off all payments dues in a
single currency for each settlement date.
3. Under Basel rules the meaning of CCF is:
A. Currency Conversion Factor
B. Credit Conversion Factor
C. Credit Contribution Factor
D. Credit Collateralization Factor
4. Under Basel III rules the meaning of RSF is:
A. Reviewed Supervisory Factor
B. Required Stable Funding
C. Riskless Stable Funding
D. Riskless Supervised Funding
© Andre Kurten 2022
EXAMINATION PREPARATION BLOCK
1.
2.
3.
4.
5.
Use the self-study practice exams
Post questions on the WhatsApp group
Enroll for the exam
Take and pass the exam!
Study well and study smart!
© Andre Kurten 2022