The Trade Lifecycle - Baker Robert P.

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financial instrument and will need to manage it in order to draw dividends or coupons in the future from the issuer (Ford Motor Company or IBM respectively). An analogy is to purchasing home insurance from an insurance broker. Once the broker has sold the insurance he is finished with the deal; in the event of a claim you would have to go straight to the insurer.

      3.2 Future (forward)

      The definition of a forward or future is very similar and the resulting cashflows are identical. There are some technical differences explained in section 5.1 but for now we shall consider them as one.

      As the name implies, a future is a product that will result in an exchange of assets sometime in the future, although the price and amount is agreed now. Also, the trade is legally binding as from now. It is very similar to a spot trade with a very long settlement period. Since the agreed price now and the prevailing market price at time of exchange may be different, both parties will have to come to an agreement for the fair price of the product, taking into account expected future prices.

Futures can be physical or cash settled as shown in Figures 3.2 and 3.3 respectively. Physical settlement means an actual exchange of cash for asset at the future time. Cash settlement means that at settlement, we take the difference between the prevailing market price and the price at which the trade was agreed and one party pays that cash difference to the other.

Figure 3.2 Cashflows on physical future trade

      Figure 3.2 shows a physical futures exchange. We agree now that at a future time (known as the future settlement date), we will pay cash and receive a fixed amount of a commodity. All the exchanges are therefore known from now.

Figure 3.3 Cashflows on cash future trade

      However a cash settlement future works differently. Suppose we agree now to buy 1m troy ounces of gold from Commerzbank at USD 1000 per troy ounce for cash settlement in six months from today. If, in six months' time, gold was trading at USD 1010 per troy ounce, Commerzbank would owe us:

      They would pay USD 10m in cash and no gold would change hands.

      If, on the other hand, the price in six months fell to USD 994, we would have to pay:

      3.3 Loan

      Loans are common in everyday life. If we are the borrower (the purchaser of the loan) then we receive money now and pay back that money plus interest at a fixed time in the future. If the agreed interest rate is fixed, say 5 % per year, then the size of the two cashflows is defined from the beginning.

Figure 3.4 depicts our cashflows if we borrow money for future repayment at a fixed interest rate.

Figure 3.4 Cashflows on fixed loan

Some loans can be based on floating rate interest, as in Figure 3.5. This means the parties agree that the interest rate will be based on some reference index plus an agreed margin on top as shown in Figure 3.5. For example, LIBOR plus 200 basis points (one basis point is 0.01 % so 200 basis points is 2 %). The size of the repayment cashflow will not be determined until just before it is due. At a pre-agreed time known as the fixing date (say 11am two business days before repayment is due), the parties will look at the prevailing LIBOR rate (this is a published figure) and determine the size of the repayment. For example:

      ■ Size of loan: GBP 10,000,000

      ■ LIBOR rate at fixing: 3.45%

      ■ Size of repayment will be: 10,000,000 × 5.45 % = GBP 545,000.

Figure 3.5 Cashflows on floating loan

      3.4 Deposit

      A deposit is, in effect, the opposite of a loan. We give money to the counterparty today and expect the money returned plus interest at some future time. Some deposits attract interim interest at regular periods (annually or semi-annually). Others receive one interest payment at the end. In both cases, the original deposited amount is repaid at the end of the deposit period.

Figure 3.6 shows a deposit with repayment interest at regular intervals and the final receipt for the principal plus the last instalment of interest.

Figure 3.6 Cashflows on deposit with regular repayments

      3.5 Swap

      The term swap is very general, giving rise to many meanings (e.g. commodity swap, FX swap, credit default swap etc). However, when otherwise unqualified, it is taken as being an interest rate (IR) swap.

The simplest form of interest rate swap is a trade with several pre-defined settlement dates and a nominal notional amount of money that is never exchanged. One side (by convention the buyer) pays a fixed amount on each settlement and the other side pays a floating amount determined by some reference index (such as LIBOR). This is known as a fixed for floating swap (see Figure 3.7). The size and direction of each settlement is unknown at time of transaction. Shortly before each settlement date, the two sides determine the amount to be paid or received by looking at the reference index (a process known as fixing; the date is known as the fixing date).

Figure 3.7 Cashflows on swap trade

      For example, the IR swap is defined by:

      ■ Notional USD 1m.

      ■ We pay fixed rate of 3 %.

      ■ We receive float of LIBOR USD 6m rate.

      ■ Settlement every six months for 2.5 years.

      Suppose that just before the first settlement, after the trade has been running six months, a fixing of the reference index (LIBOR USD 6m) is taken and found to be 2.5 %.

      So we pay 3 % of 1 million and receive 2.5 % of 1 million. This results in us making a net payment of USD 5000.

      Now, at the second settlement after 12 months, suppose the reference index is 3.2 %. Therefore we pay 3 % of 1 million and receive 3.2 % of 1 million. So we receive net USD 2000.

      This process continues for each settlement period of the swap.

      Common variations are floating-floating and currency swaps. A floating-floating swap is where both sides have a floating amount determined by two different reference indexes. For example, we pay LIBOR USD 3m and received LIBOR USD 6m (the 3m being a different index to the 6m).

      A currency swap (not to be confused with an FX or foreign exchange swap) is where the two sides are in different currencies. For example, we pay fixed 3 % of a dollar notional and receive a floating rate in euros based on LIBOR EUR, which is then converted to dollars at the prevailing foreign exchange rate on fixing day to determine the direction and size of settlement.

      Although there is always a notional amount in any interest rate swap, this is never actually exchanged. It is only used for determination of amount to be paid or received.

      3.6 Foreign exchange swap

Not to be confused with currency swaps, a foreign exchange swap is

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