Anna University Chennai  Regional Office, Coimbatore
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Spring 2011
BILL FRENCH CASE
Submitted By: Pratichi
Sharan Section B
Question 1: What are the assumptions implicit in Bill Frenchs
determination of his companys breakeven point?
The following assumptions are imp
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The deals of currency swaps are structured by a bank which also routes
the payments from one party to another. Currency swaps involve exchange of
assets and liabilities. The structure of a currency sw
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3
face value. E.g. bid price of 6 % of Dec. 06 Tnote is 100 and
8
4/32% of face value.
The US government has the option of calling the bonds away
from their owners before maturity and are called call
Anna University Chennai  Regional Office, Coimbatore
finance
FINANCE 1113007

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Suppose an FRA in which a financial institution agrees to earn an
interest rate of Rk for the period of time between T1 and T2 on a principal
amount of L.
Let RF is the forward LIBOR interest rate for
Anna University Chennai  Regional Office, Coimbatore
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FINANCE 1113007

Spring 2011
to floating swap, one party pays one floating rate and the other pays another
floating. Forward swaps include exchange of interest rate payments that do
not begin until a predetermined future date in
Anna University Chennai  Regional Office, Coimbatore
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4.
If m = 3 or 9 months, then the CBOT estimates allowed interest
to be c/4 (half a semiannual coupon). Under these assumptions,
the price of the bond if YTM is 3% will be:
CF =
C /2 + C /2(PVIFA3%,2
Anna University Chennai  Regional Office, Coimbatore
finance
FINANCE 1113007

Spring 2011
5.1
Introduction
In the recent past, there has been integration of financial markets
worldwide which have led to the emergence of some innovative financial
instruments. In a complex world of variety
Anna University Chennai  Regional Office, Coimbatore
finance
FINANCE 1113007

Spring 2011
B =
BD
.
1 + y/7
Dmod =
D
(1 + y)
B=BDmody
(4.7)
(4.8)
Hence the modified duration is the relative price change with respect to
change in yield.
In the above Table 4.1 the price of the bond is 94
Anna University Chennai  Regional Office, Coimbatore
finance
FINANCE 1113007

Spring 2011
Fabozzi et al., Foundations of Financial Markets and
Institutions, Pearson Education inc. Delhi, 2002.
Gupta, S.L., Financial Derivatives (Theory, Concepts and
Problems), Prentice Hall of India Ltd.,
Anna University Chennai  Regional Office, Coimbatore
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Spring 2011
the hedge ratio, which denotes the number of futures contracts made by
comparing relative price sensitivities of futures and cash instruments. With
the help of duration period and regression method, t
Anna University Chennai  Regional Office, Coimbatore
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FINANCE 1113007

Spring 2011
rs = a + brF.
(4.10)
where rs is historical changes in interest rate of the cash instrument
rF = Historical changes in the futures interest rates.
a, b = Regression coefficients
The hedger will be in
Anna University Chennai  Regional Office, Coimbatore
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FINANCE 1113007

Spring 2011
For infinitesimally change in yield curve ( y) the bonds price will be
changed as B shown by following equation.
B
= BD
y
or
B
B
= D y
(4.5)
(4.6)
Hence from relationship expressed by equation (4.6)
Anna University Chennai  Regional Office, Coimbatore
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Theories determining term structure: There are two types of risks
associated with interest bearing securities. Interest risk arises due to
changing nature of macroeconomic variables such as inflatio
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3.6.1 Monitoring of hedge
To monitor the hedge on a continuous basis the following information
should be looked for:
Cash/spot position: The hedger should have an idea of the current
position in cash/
Anna University Chennai  Regional Office, Coimbatore
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4.2.4 Zero rate
An nyear zero interest rate is the interest rate on an investment which
starts on todays date and last for nyears. In this time period no intermediate
payment is made. All the intere
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4.5
Hedging with Tbond futures
Fixed interest bearing securities have risks associated with the volatile
interest rate markets. Unfavourable interest rate change may lead to
potential capital loss to
Anna University Chennai  Regional Office, Coimbatore
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Spring 2011
fixed and pay floating. These rates are quoted for the number of maturities
and number of different currencies. The following table 5.1 shown an
illustration of the quotes where payments are exchanged
Anna University Chennai  Regional Office, Coimbatore
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FINANCE 1113007

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price sensitivity w.r.t. interest rate changes. In other words, a high duration
bonds price is more sensitive to interest rate changes than the low duration
bond. It is also defined as the weighted av
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3.9
Self assessment questions
1.
What do you understand by hedging? Explain the concept with
suitable illustrations.
2.
Discuss various concepts of hedging with suitable illustrations.
3.
Hedging prev
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4.3.5 Euro Dollar Futures
Dollars deposited in foreign banks are known as Eurodollars. This
practice was started in Europe to gain higher yield available on other
instruments in US money market. The f
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fixed rate at 68 basis points above (i.e. 5.95 + 0.68 = 6.63%) the Treasury
yield. Another example to understand the concept: Suppose a bank quotes a
US dollar floating to a fixed 6years swap rate as
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to initiate trading in longterm interest rate futures with the introduction of
Tbonds by CBOT in 1977. Other countries like Japan, France and UK have
longterm interest future market with almost sim
Anna University Chennai  Regional Office, Coimbatore
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5.5
Rationale behind swapping
To avoid risk of fluctuation in forex, interest rates, stock indices
investors attitude etc. the swap market has merged now to explain that why
firms and people want to e
Anna University Chennai  Regional Office, Coimbatore
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FINANCE 1113007

Spring 2011
brokerage, fees, translation and management costs etc. For this purpose expost measure of effectiveness should be calculated with the help of deviation
or significant difference between the anticipate
Anna University Chennai  Regional Office, Coimbatore
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portfolio of Rs. 1,00000 is vulnerable contracts.
Future
price
is
to increase in longterm interest rate.
reflecting 6% p.a. interest rate.
August 8
August 8
1000
Long term interest rate rises to 71%
Anna University Chennai  Regional Office, Coimbatore
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FINANCE 1113007

Spring 2011
interest rate bonds. The discount rate used reflect the riskiness of cash flows.
Generally the fixed rate interest cash flows have almost similar risk as the
floating rate flows. This is so because in
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4.
What are currency swaps? Discuss various features and types of
currency swaps with suitable examples.
5.
Explain various factors affecting the valuation of swaps. How
will you calculate the value o