financial stuff (more complete)

7/29/2019 Financial Stuff (More Complete)

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Mutual Funds

Summary

Amutual fundbrings together a group of people and invests their moneyin stocks, bonds, and other securities.

The advantages of mutuals are professional management,diversification,economies of scale, simplicity and liquidity.

The disadvantages of mutuals are high costs, over-diversification, possibletax consequences, and the inability of management to guarantee a

superior return.

There are many, many types of mutual funds. You can classify fundsbased on asset class, investing strategy, region, etc.

Mutual funds have lots of costs. Costs can be broken down into ongoing fees (represented by theexpense

ratio) and transaction fees (loads).

The biggest problems with mutual funds are their costs and fees. Mutual funds are easy to buy and sell. You can either buy them directly

from the fund company or through a third party.

What a Mutual Fund is

A mutual fund is a collection of stocks and/or bonds. You can think of a mutual

fund as a company that brings together a group of people and invests theirmoney in stocks, bonds, and other securities. Each investor owns shares, whichrepresent a portion of the holdings of the fund.

You can make money from a mutual fund in three ways:

1. Income is earned fromdividendson stocks andintereston bonds. A fundpays out nearly all of the income it receives over the year to fund ownersin the form of a distribution.

2. If the fund sells securities that have increased in price, the fund has acapital gain. Most funds also pass on these gains to investors in adistribution.

3. If fund holdings increase in price but are not sold by the fund manager,the fund's shares increase in price. You can then sell your mutual fundshares for a profit.

Funds will also usually give you a choice either to receive a check fordistributions or to reinvest the earnings and get more shares.
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Extra Reading (Dont have to read in depth)

Advantages of Mutual Funds

Professional Management- The primary advantage of funds is the professional

management of your money. Investors purchase funds because they do not have thetime or the expertise to manage their own portfolios. A mutual fund is a relativelyinexpensive way for a small investor to get a full-time manager to make and monitorinvestments. (For more reading seeActive Management: Is It Working For You?)

Diversification- By owning shares in a mutual fund instead of owning individual stocks

or bonds, your risk is spread out. The idea behind diversification is to invest in a largenumber of assets so that a loss in any particular investment is minimized by gains inothers. In other words, the more stocks and bonds you own, the less any one of themcan hurt you (think about Enron). Large mutual funds typically own hundreds of different

stocks in many different industries. It wouldn't be possible for an investor to build thiskind of a portfolio with a small amount of money.

Economies of Scale- Because a mutual fund buys and sells large amounts of securitiesat a time, its transaction costs are lower than what an individual would pay for securitiestransactions.

Liquidity- Just like an individual stock, a mutual fund allows you to request that yourshares be converted into cash at any time.

Simplicity- Buying a mutual fund is easy! Pretty well any bank has its own line of

mutual funds, and the minimum investment is small. Most companies also haveautomatic purchase plans whereby as little as $100 can be invested on a monthly basis.

Disadvantages of Mutual Funds Professional Management- Many investors debate whether or not the professionals areany better than you or I at picking stocks. Management is by no means infallible, and,even if the fund loses money, the manager still gets paid.

Costs - Creating, distributing, and running a mutual fund is an expensive proposition.Everything from the manager's salary to the investors' statements cost money. Those

expenses are passed on to the investors. Since fees vary widely from fund to fund,failing to pay attention to the fees can have negative long-term consequences.Remember, every dollar spend on fees is a dollar that has no opportunity to grow overtime. (Learn how to escape these costs inStop Paying High Mutual Fund Fees.)

Dilution - It's possible to have too much diversification. Because funds have smallholdings in so many different companies, high returns from a few investments oftendon't make much difference on the overall return.Dilutionis also the result of asuccessful fund getting too big. When money pours into funds that have had strongsuccess, the manager often has trouble finding a good investment for all the new money.

Taxes - When a fund manager sells a security, a capital-gains tax is triggered.Investors who are concerned about the impact of taxes need to keep those concerns inmind when investing in mutual funds. Taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax sensitive mutual fund in a tax-deferred account,such as a401(k)orIRA.
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At the fundamental level, there are three varieties of mutual funds:1)Equityfunds (stocks)

2)Fixed-incomefunds (bonds)3)Money marketfunds

All mutual funds are variations of these three asset classes.

Money Market FundsThe money market consists of short-term debt instruments, mostlyTreasury bills. This isa safe place to park your money. You won't get great returns, but you won't have toworry about losing yourprincipal. A typical return is twice the amount you would earn ina regular checking/savings account and a little less than the averagecertificate ofdeposit(CD).

Bond/Income FundsIncome funds are named appropriately: their purpose is to provide current income on asteady basis. When referring to mutual funds, the terms "fixed-income," "bond," and"income" are synonymous. The primary objective of these funds is to provide a steady

cashflow to investors.

Bond funds are likely to pay higher returns than certificates of deposit and moneymarket investments, but bond funds aren't without risk. Because there are manydifferent types of bonds, bond funds can vary dramatically depending on where theyinvest. For example, a fund specializing in high-yieldjunk bondsis much more risky thana fund that invests in government securities. Furthermore, nearly all bond funds aresubject to interest rate risk, which means that if rates go up the value of the fund goes

down.

Balanced FundsThe objective of these funds is to provide a balanced mixture of safety, income and

capital appreciation. The strategy of balanced funds is to invest in a combination of fixedincome and equities. A typical balanced fund might have a weighting of 60% equity and40% fixed income. The weighting might also be restricted to a specified maximum orminimum for each asset class.

Equity Funds

Funds that invest in stocks represent the largest category of mutual funds. Generally,the investment objective of this class of funds is long-term capital growth with someincome. There are, however, many different types of equity funds because there aremany different types of equities.

END
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Hedge Funds

Hedge funds pool investors money to make a positive return. Typically more flexible investment strategies than mutual funds. Uses leverage to profit in all markets. (Leverage = borrowing to increase

investment exposure thereby increasing risk as well.)

Also uses short selling and other speculative methods that arent oftenused by mutual funds.

Not subjected to some regulations designed to protect investors unlikemutual funds.

Investors do not receive law protections that commonly apply to mutualfunds. Eg. Level of disclosure of hedge funds is lower than mutual funds,

making it difficult to evaluate investment terms and verify representations.

Why Choose Hedge Funds?

The most cited reason to include them in any portfolio is their ability to reduce risk and

add diversification. Hedge funds claim absolute return mandates whereby returns are

minimally correlated with the equity market. In such a case, hedge funds provide a great

diversifier, particularly in times of increased market volatility and/or an outrightbear

market.

Risk Reduction

Provides consistent returns, thereby increasing portfolio stability even whentraditional investments are underperforming/ unpredictable.

Many hedge fund strategies generate attractive returns while having fixed-income-like volatility. (Fixed-income-volatility = predictable, low changes.)

The difference between a hedge fund and traditional fixed income, however, is that

during times of low interest rates, fixed income may provide stable returns, but those

are typically very low and may not even keep up with inflation.

Hedge funds, on the other hand, can use their more flexible mandates and creativity

to generate bond-like returns that outpace inflation on a more consistent basis. The

drawback, as previously mentioned, is that hedge funds have certain terms that limit

liquidity and are highly opaque.
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Return enhancement

Able to enhance overall returns of a portfolio by 2 ways:

1. Maintain low-risk portfolio by using low-volatility hedge fund to squeeze someadditional returns. Return on portfolio increases while maintaining low volatility.

2. Add a hedge fund with a high-return strategy to boost overall returns. Thesefunds generally take directional positions based on forecasts of future prices on

derivatives instruments such as stocks, bonds currencies etc. They often exhibit

high levels of volatility but when properly allocated, can give a nice boost in

returns without proportional increase in portfolio volatility.

Difference between a mutual fund and a hedge fund

Similarities

Bothmutual fundsandhedge fundsare managed portfolios. A manager will pick

securities that may perform well and group them into a portfolio. Portions of the fund are

then sold to investors who can participate in the gains/losses of the holdings. The main

advantage to investors is that they get instantdiversificationandprofessional

managementof their money.

Differences

1. Hedge funds are managed much more aggressive. They are able to take speculativepositions in derivative securities such asoptionsand have the ability toshort

sellstocks. This will typically increase theleverage- and thus the risk - of the fund.

This also means that it's possible for hedge funds to make money when the market is

falling. Mutual funds, on the other hand, are not permitted to take these highly

leveraged positions and are typically safer as a result.

2. Availability difference. Hedge funds are only available to a specific group ofsophisticated investors with highnet worth. The U.S. government deems them as

"accredited investors", and the criteria for becoming one are lengthy and restrictive.

On the other hand, mutual funds are very easy to purchase with minimal amounts of

money.


Unlike mutual funds, hedge funds are not subject to some of the regulations that aredesigned to protect investors. Depending on the amount of assets in the hedge fundsadvised by a manager, some hedge fund managers may not be required to register or tofile public reports with the SEC. Hedge funds, however, are subject to the same

prohibitions against fraud as are other market participants, and their managers owe afiduciary duty to the funds that they manage.
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Hedge fund investors do not receive all of the federal and state law protections that

commonly apply to most mutual funds. For example, hedge funds are not required to

provide the same level of disclosure as you would receive from mutual funds. Without

the disclosure that the securities laws require for most mutual funds, it can be more

difficult to fully evaluate the terms of an investment in a hedge fund. It may also be

difficult to verify representations you receive from a hedge fund.

Term Structure

Terms of each hedge fund is unique and can completely differ from another. They are

usually based on:

Subscriptions and RedemptionsHedge funds do not have dailyliquiditylike mutual funds do. Some hedge funds canhave subscriptions andredemptions monthly, while others accept them only quarterly.

The terms of each hedge fund should be consistent with the underlying strategy beingused by the manager. The more liquid the underlying investments, the more frequent

the subscription/redemption terms should be.

Lock-UpsSome funds require up to a two-year"lock-up"commitment, but the most common lock-up is limited to one year.

Equity Hedge

It is commonly referred to as long/ short equity and one of the easiest strategies to

understand. However, a variety of sub-strategies are present.

Long/Short Hedge fund managers can either purchase stocks that they feelare undervalued orsell shortstocks they deem to be overvalued. In most cases,

the fund will have positive exposure to the equity.

Market Neutral In this strategy, a hedge fund manager applies the same basicconcepts mentioned in the previous paragraph, but seeks to minimize the

exposure to the broad market. This can be done in two ways.

1. If there are equal amounts of investment in both long and short positions,the net exposure of the fund would be zero.

2. To have zero beta exposure. In this case, the fund manager would seek tomake investments in both long and short positions so that the beta

measure of the overall fund is as low as possible. In either of the market-

neutral strategies, the fund manager's intention is to remove any impact

of market movements and rely solely on his or her ability to pick stocks.

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STOCK OPTIONS

Summary

Anoptionis a contract giving the buyer the right but not the obligation to buy orsell anunderlyingasset at a specific price on or before a certain date.

Options arederivativesbecause they derive their value from an underlying asset. Acallgives the holder the right to buy an asset at a certain price within a specific

period of time.

Aputgives the holder the right to sell an asset at a certain price within a specificperiod of time.

There are four types of participants in options markets: buyers of calls, sellers ofcalls, buyers of puts, and sellers of puts.

Buyers are often referred to as holders and sellers are also referred to aswriters. The price at which an underlying stock can be purchased or sold is called

thestrike price.

The total cost of an option is called the premium, which is determined by factorsincluding the stock price, strike price and time remaining untilexpiration.

A stock option contract represents 100 shares of the underlying stock. Investors use options both tospeculateandhedgerisk. Employee stock optionsare different from listed options because they are a

contract between the company and the holder. (Employee stock options do not

involve any third parties.)

The two main classifications of options areAmericanandEuropean.Extra Reading (Dont have to read in depth)

The power ofoptionslies in their versatility. They enable you to adapt or adjust your

position according to any situation that arises. Options can be as speculative or as

conservative as you want. This means you can do everything from protecting a position

from a decline to outright betting on the movement of a market or index. Options are

complex securities and can be extremely risky.

WHAT ARE OPTIONS?

An option is a contract that gives the buyer the right, but not the obligation, to buy orsell anunderlyingasset at a specific price on or before a certain date. An option, just like

a stock or bond, is asecurity. It is also a binding contract with strictly defined terms and

properties.

Calls and Puts

The two types of options are calls and puts:

Acallgives the holder the right to buy an asset at a certain price within a specific period

of time. Calls are similar to having along positionon a stock. Buyers of calls hope that

the stock will increase substantially before the option expires.

Aputgives the holder the right to sell an asset at a certain price within a specific period
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of time. Puts are very similar to having ashort positionon a stock. Buyers of puts hope

that the price of the stock will fall before the option expires.

The Lingo

The price at which an underlying stock can be purchased or sold is called the strike price.

This is the price a stock price must go above (for calls) or go below (for puts) before aposition can beexercisedfor a profit. All of this must occur before theexpiration date.

For call options, the option is said to bein-the-moneyif the share price is above the

strike price. A put option is in-the-money when the share price is below the strike price.

The amount by which an option is in-the-money is referred to asintrinsic value.

The total cost (the price) of an option is called thepremium. This price is determined by

factors including the stock price, strike price, time remaining until expiration (time value)

andvolatility.

There are two main reasons why an investor would use options: to speculate and tohedge.

Speculation

The advantage of options is that you aren't limited to making a profit only when the

market goes up. Because of the versatility of options, you can also make money when

the market goes down or even sideways.

Hedging

The other function of options ishedging. Think of this as an insurance policy. Just as you

insure your house or car, options can be used to insure your investments against adownturn.

There are two main types of options:

American optionscan be exercised at any time between the date of purchase andthe expiration date.

European optionsare different from American options in that they can only beexercised at the end of their lives.

Long-Term Options

These options are calledlong-term equity anticipation securities(LEAPS). By

providing opportunities to control and manage risk or even to speculate, LEAPS are

virtually identical to regular options. LEAPS, however, provide these opportunities for

much longer periods of time. Although they are not available on all stocks, LEAPS are

available on most widely held issues.

Exotic Options (Non- standard)

The simple calls and puts we've discussed are sometimes referred to as plain vanilla

( Standard) options.

END
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Short Selling

Many investors make money on a decline in an individual stock or during a bear market,

thanks to an investing technique calledshort selling.

Short selling is not complex, but it's a concept that many investors have troubleunderstanding. In general, people think of investing as buying an asset, holding it while

it appreciates in value, and then eventually selling to make a profit. Shorting is the

opposite: an investor makes money only when a shorted security falls in value.

Summary

In ashort sale, an investor borrows shares, sells them and must eventuallyreturn the same shares (cover). Profit (or loss) is made on the difference between

the prices at which the shares are borrowed compared to when they are returned. An investor makes money only when a shorted security falls in value. Short selling is done onmargin, and so is subject to the rules of margin trading. The shorter must pay the lender any dividends or rights declared during the

course of the loan.

The two reasons for shorting are tospeculateand tohedge. There are restrictions as to what stocks can be shorted and when a short can be

carried out (uptick rule).

Short interesttells us the number of shares that have already been sold short ina security.

Short selling is very risky. You can lose more money than you invest but arelimited to 100% profit on the upside.

Ashort squeezeis when a large number of short sellers try to cover theirpositions at the same time, driving up the price of a stock.

Even though a company is overvalued, it may take a long time for it to come backdown. Fighting the trend almost always leads to trouble.

Critics of short selling see it as unethical and bad for the market. Short selling contributes to the market by providingliquidity,efficiencyand acting

as a voice of reason in bull markets.

Some unethical traders spread false information in an attempt to drive the priceof a stock down and make a profit by selling short.
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What is Short Selling?Short selling means when you purchase shares of stock. In purchasing stocks, you buy a

piece of ownership in the company. The buying and selling of stocks can occur with a

stock broker or directly from the company. Brokers are most commonly used. Theyserve as an intermediary between the investor and the seller and often charge a fee for

their services.

When using a broker, you will need to set up an account. The account that's set up is

either a cash account or amargin account. A cash account requires that you pay for your

stock when you make the purchase, but with a margin account the broker lends you a

portion of the funds at the time of purchase and the security acts as collateral.

When an investor goeslongon an investment, it means that he or she has bought a

stock believing its price will rise in the future. Conversely, when an investor goesshort,

he or she is anticipating a decrease in share price.
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Bond Basics

Bonds during ragingbull markets, seem to offer an insignificant return compared tostocks.

However, all it takes is abear marketto remind investors of the virtues of a bond'ssafety and stability. In fact, for many investors it makes sense to have at least part oftheir portfolio invested in bonds.

Definition of 'Bull Market'A financial market of a group of securities in which prices are rising or are expected torise. The term "bull market" is most often used to refer to the stock market, but can beapplied to anything that is traded, such as bonds, currencies and commodities.

Definition of 'Bear Market'A market condition in which the prices of securities are falling, and widespreadpessimism causes the negative sentiment to be self-sustaining. As investors anticipatelosses in a bear market and selling continues, pessimism only grows.

What Are Bonds?A company needs funds to expand into new markets, while governments need money for

everything from infrastructure to social programs. The problem large organizations run

into is that they typically need far more money than the average bank can provide. The

solution is to raise money by issuing bonds (or other debt instruments) to apublic

market. Thousands of investors then each lend a portion of the capital needed. The

organization that sells a bond is known as the issuer. You can think of a bond as an IOU

given by a borrower (the issuer) to a lender (the investor).The issuer of a bond must pay the investor something extra for the privilege of using his

or her money. This "extra" comes in the form ofinterestpayments, which are made at apredetermined rate and schedule. The interest rate is often referred to as thecoupon.The date on which the issuer has to repay the amount borrowed (known asface value) iscalled thematurity date. Bonds are known asfixed-incomesecurities because you knowthe exact amount of cash you'll get back if you hold the security until maturity.
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Summary

Bonds are just like IOUs. Buying a bond means you are lending out your money. Bonds are also called fixed-income securities because the cash flow from them is

fixed.

Stocks are equity; bonds are debt. The key reason to purchase bonds is to diversify your portfolio. The issuers of bonds are governments and corporations. A bond is characterized by its face value, coupon rate, maturity and issuer. Yield is the rate of return you get on a bond. When price goes up, yield goes down, and vice versa. When interest rates rise, the price of bonds in the market falls, and vice versa. Bills, notes and bonds are all fixed-income securities classified by maturity. Government bonds are the safest bonds, followed by municipal bonds, and then

corporate bonds.

Bonds are not risk free. It's always possible - especially in the case of corporatebonds - for the borrower to default on the debt payments.

High-risk/high-yield bonds are known as junk bonds. You can purchase most bonds through a brokerage or bank. If you are

a U.S. citizen, you can buy government bonds through Treasury Direct.

Often, brokers will not charge a commission to buy bonds but will mark up theprice instead.

Debt Versus Equity

Bonds aredebt, whereas stocks areequity. This is the important distinction between

the twosecurities. By purchasing equity (stock) an investor becomes an owner in a

corporation. Ownership comes withvoting rightsand the right to share in any future

profits. By purchasing debt (bonds) an investor becomes acreditorto the

corporation (or government). The primary advantage of being a creditor is that you

have a higher claim on assets than shareholders do: that is, in the case ofbankruptcy, a

bondholder will get paid before a shareholder. However, the bondholder does not share

in the profits if a company does well - he or she is entitled only to theprincipalplus

interest. To sum up, there is generally less risk in owning bonds than in owning stocks,

but this comes at the cost of a lower return.
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Why Bother With Bonds?

1) Retirement - The easiest example to think of is an individual living off a fixed income.

A retiree simply cannot afford to lose his/her principal as income for it is required to pay

the bills.

2) Shorter time horizons - Because money is needed for a specific purpose in the

relatively near future, fixed-income securities are likely the best investment.

Different Types Of BondsGovernment Bonds

In general, fixed-income securities are classified according to the length of time before

maturity. These are the three main categories:

Bills - debt securities maturing in less than one year.

Notes - debt securities maturing in one to 10 years.

Bonds - debt securities maturing in more than 10 years.

Municipal Bonds

Municipal bonds, known as "munis", are the next progression in terms of risk. The major

advantage to munis is that the returns are free from federal tax. Furthermore, local

governments will sometimes make their debt non-taxable for residents, thus making

some municipal bonds completely tax free. Because of these tax savings, the yield on a

muni is usually lower than that of a taxable bond. Depending on your personal situation,

a muni can be a great investment on an after-tax basis.

Corporate Bonds

A company can issue bonds just as it can issue stock. Large corporations have a lot of

flexibility as to how much debt they can issue: the limit is whatever the market will bear.

Generally, a short-term corporate bond is less than five years; intermediate is five to 12

years, and long term is over 12 years.

Corporate bonds are characterized by higher yields because there is a higher risk of a

company defaulting than a government. The upside is that they can also be the most

rewarding fixed-income investments because of the risk the investor must take on. The

company's credit quality is very important: the higher the quality, the lower the interest

rate the investor receives.

Other variations on corporate bonds includeconvertible bonds, which the holder can

convert into stock, andcallable bonds, which allow the company to redeem an issue

prior to maturity.
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Zero-Coupon Bonds

This is a type of bond that makes no coupon payments but instead is issued at a

considerable discount to par value.

END
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StocksThe Definition of a Stock

Plain and simple, stock is a share in the ownership of a company. Stock represents a

claim on the company'sassetsandearnings. As you acquire more stock, your ownershipstake in the company becomes greater. Whether you sayshares,equity, or stock, it all

means the same thing.

Different Types Of Stocks

There are two main types of stocks:common stockandpreferred stock.

Common stock

The majority of stock is issued is in this form. Common shares represent ownership in a

company and a claim (dividends) on a portion of profits. Investors get one vote pershare to elect theboardmembers, who oversee the major decisions made bymanagement.

Over the long term, common stock, by means of capital growth, yields higher returnsthan almost every other investment. This higher return comes at a cost since commonstocks entail the most risk. If a company goes bankrupt and liquidates, the commonshareholders will not receive money until the creditors, bondholders and preferredshareholders are paid.

Preferred stock

Represents some degree of ownership in a company but usually doesn't come with the

same voting rights. With preferred shares, investors are usually guaranteed a fixeddividend forever. This is different than common stock, which has variable dividends thatare never guaranteed.

Another advantage is that in the event of liquidation, preferred shareholders are paid offbefore the common shareholder (but still after debt holders). Preferred stock may alsobe callable, meaning that the company has the option to purchase the shares from

shareholders at anytime for any reason (usually for a premium).

What is a stock ticker?

A stocktickeris a report of the price for certain securities, updated continuouslythroughout the trading session by the various stock exchanges. A "tick" is any change in

price, whether that movement is up or down. A stock ticker automatically displays these

ticks, along with other relevant information, like volume, that investors use to stay

informed about current market conditions. The tickerprovides current information for

certain stocks, including: the ticker symbol (the one to four letter code that represents a

particular stock); quantity traded (volume for each transaction); price, a green "up"

arrow if price is higher than the previous day's closing value, a red "down" arrow if price

is lower than the previous day; and the net price change (either as a dollar amount or as

a percentage) from the previous day's close. If the price is unchanged, the arrow may be
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gray in color or simply absent. Often, the ticker symbol and the net price change appear

color-coded: green if the price is higher than the previous session, red if price is lower.

Risk

No guarantees when it comes to individual stocks. Companies often do not pay out dividends. No obligation to pay out dividends even for those firms that have traditionally

given them.

Without dividends, money can be profited only through appreciation of stockin open market

On the downside, any stock may go bankrupt, in which case your investmentis worth nothing.

Although risk might sound all negative, there is also a bright side. Greater riskdemands a greater return on your investment. This is the reason why stocks

have historically outperformed other investments such as bonds or savings

accounts.


What is the difference between the bond market and the stockmarket?

Thebondmarket is where investors go to trade (buy and sell) debt securities,

prominently bonds. The stock market is a place where investors go to trade (buy and sell)

equity securities like common stocks and derivatives (options, futures etc). Stocks are

traded on stock exchanges. In the United States, the prominent stock exchanges are:

Nasdaq, Dow, S&P 500 and AMEX. These markets are regulated by theSecurities

Exchange Commission (SEC).

The differences in the bond and stock market lie in the manner in which the different

products are sold and the risk involved in dealing with both markets. One major

difference between both markets is that the stock market has central places or

exchanges (stock exchanges) where stocks are bought and sold. However, the bond

market does not have a central trading place for bonds; rather bonds are sold mainly

over-the-counter(OTC). The other difference between the stock and bond market is the

risk involved in investing in both. Investing in bond market is usually less risky than

investing in a stock market because the bond market is not as volatile as the stock

market is.

END
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Credit Default SwapsCredit default swaps(CDS) are the most widely used type ofcredit derivativeand a

powerful force in the world markets.

How They Work

CDS contract involves the transfer of the credit risk ofmunicipal bonds, emerging

market bonds,mortgage-backed securities, orcorporate debtbetween two parties. It is

similar to insurance because it provides the buyer of the contract, who often owns the

underlying credit, with protection against default, a credit rating downgrade, or another

negative "credit event." The seller of the contract assumes the credit risk that the buyer

does not wish to shoulder in exchange for a periodic protection fee similar to an

insurance premium, and is obligated to pay only if a negative credit event occurs. It is

important to note that the CDS contract is not actually tied to a bond, but instead

references it. For this reason,the bond involved in the transaction is called the

"reference obligation."A contract can reference a single credit, or multiple credits.

Hedging and Speculation

CDS have the following two uses.

A CDS contract can be used as ahedgeor insurance policy against the default ofa bond or loan. An individual or company that isexposed to a lot of credit risk can

shift someof that risk by buying protection in a CDS contract. This may be

preferable to selling the security outright if the investor wants to reduce exposure

and not eliminate it, avoid taking a tax hit, or just eliminate exposure for a

certain period of time.

The second use is for speculators to "place their bets" about thecreditquality of aparticular reference entity. With the value of the CDS market, larger than the

bonds and loans that the contracts reference, it is obvious that speculation has

grown to be the most common function for a CDS contract. CDS provide a very

efficient way to take a view on the credit of a reference entity. An investor with a

positive view on the credit quality of a company can sell protection and collect the

payments that go along with it rather than spend a lot of money to load up on the

company's bonds. An investor with a negative view of the company's credit can

buy protection for a relatively small periodic fee and receive a big payoff if the

company defaults on its bonds or has some other credit event. A CDS can also

serve as a way to access maturity exposures that would otherwise be unavailable,

access credit risk when the supply of bonds is limited, orinvest in foreign credits

without currency risk.
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An investor can actually replicate the exposure of a bond or portfolio of bonds using CDS.

This can be very helpful in a situation where one or several bonds are difficult to obtain

in the open market. Using a portfolio of CDS contracts, an investor can create a

synthetic portfolio of bonds that has the same credit exposure and payoffs.

Trading

CDS contracts are regularly traded with the value of it fluctuating based on the

increasing/ decreasing probability that a reference entity will have a credit event.

Increased probability of such an event would make the contract worth more for the

buyer of protection, and worth less for the seller. The opposite occurs if the probability of

a credit event decreases.

A trader in the market might speculate that the credit quality of a reference entity will

deteriorate some time in the future and will buy protection for the very short term in thehope of profiting from the transaction. An investor can exit a contract by selling his or

her interest to another party, offsetting the contract by entering another contract on the

other side with another party, or offsetting the terms with the original counterparty.

Are better suited for institutional rather than retail investorsas CDS are traded over the

counter (OTC), involving intricate knowledge of the market and underlying assets and

valued using industry computer programs.

Market Risks

The market for CDSs is OTC and unregulated, and the contracts often get traded so

much that it is hard to know who stands at each end of a transaction.

There is the possibility that the risk buyer may not have the financial strength to abide

by the contract's provisions, making it difficult to value the contracts.

Theleverageinvolved in many CDS transactions and the possibility that a widespread

downturn in the market could cause massive defaults and challenges the ability of risk

buyers to pay their obligations, adds to the uncertainty.
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SwapsA swap is an agreement between two parties to exchange sequences of cash flows for a

set period of time. Usually, at the time the contract is initiated, at least one of these

series of cash flows is determined by a random or uncertain variable, such as an interest

rate, foreign exchange rate, equity price or commodity price. Conceptually, one may

view a swap as either a portfolio of forward contracts, or as a long position in one bond

coupled with a short position in another bond.

Plain Vanilla Interest Rate SwapIn this swap, Party A agrees to pay Party B a predetermined,fixed rate of intereston a

notional principalon specific dates for a specified period of time.

Concurrently, Party B agrees to make payments based on afloating interest rateto Party

A on that same notional principal on the same specified dates for the same specified

time period.

In a plain vanilla swap, the two cash flows are paid in the same currency. The specified

payment dates are called settlement dates, and the time between are called settlement

periods. Because swaps are customized contracts, interest payments may be made

annually, quarterly, monthly, or at any other interval determined by the parties.

The two parties do not exchange principal amount.

For example

On Dec. 31, 2006, Company A and Company B enter into a five-year swap with thefollowing terms:

Company A pays Company B an amount equal to 6% per annum on a notionalprincipal of $20 million.

Company B pays Company A an amount equal to one-year LIBOR + 1% perannum on a notional principal of $20 million.

LIBOR, orLondon Interbank Offer Rate, is the interest rate offered by London banks on

deposits made by other banks in theeurodollarmarkets. The market for interest rate

swaps frequently (but not always) uses LIBOR as the base for the floating rate. For

simplicity, let's assume the two parties exchange payments annually on December 31,beginning in 2007 and concluding in 2011.

At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000.

On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company

A $20,000,000 * (5.33% + 1%) = $1,266,000.

In a plain vanilla interest rate swap, the floating rate is usually determined at the

beginning of the settlement period. Normally, swap contracts allow for payments to be

netted against each other to avoid unnecessary payments. Here, Company B pays

$66,000, and Company A pays nothing. At no point does the principal change hands,

which is why it is referred to as a "notional" amount. Figure 1 shows the cash flowsbetween the parties, which occur annually (in this example).
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Figure 1: Cash flows for a plain vanilla interest rate swap

Plain Vanilla Foreign Currency SwapThe plain vanilla currency swap involves exchanging principal and fixed interest

payments on a loan in one currency for principal and fixed interest payments on a

similar loan in another currency.

Unlike an interest rate swap, the parties to a currency swap will exchange principal

amounts at the beginning and end of the swap. The two specified principal amounts are

set so as to be approximately equal to one another, given the exchange rate at the time

the swap is initiated.For example

Company C, a U.S. firm, and Company D, a European firm, enter into a five-year

currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per

euro (e.g. the dollar is worth 0.80 euro). First, the firms will exchange principals. So,

Company C pays $50 million, and Company D pays 40 million euros. This satisfies each

company's need for funds denominated in another currency (which is the reason for the

swap).

Figure 2: Cash flows for a plain vanilla currency swap, Step 1.

Then, at intervals specified in the swap agreement, the parties will exchange interest

payments on their respective principal amounts. To keep things simple, let's say theymake these payments annually, beginning one year from the exchange of principal.Because Company C has borrowed euros, it must pay interest in euros based on a eurointerest rate.

Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on adollar interest rate. For this example, let's say the agreed-upon dollar-denominatedinterest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year,Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D.

Company D will pay Company C $50,000,000 * 8.25% = $4,125,000.

As with interest rate swaps, the parties will actually net the payments against each otherat the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is$1.40 per euro, then Company C's payment equals $1,960,000, and Company D's

payment would be $4,125,000. In practice, Company D would pay the net difference of


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$2,165,000 ($4,125,000 - $1,960,000) to Company C.

Figure 3: Cash flows for a plain vanilla currency swap, Step 2

Finally, at the end of the swap (usually also the date of the final interest payment), theparties re-exchange the original principal amounts. These principal payments are

unaffected by exchange rates at the time.

Figure 4: Cash flows for a plain vanilla currency swap, Step 3

How do companies benefit from interestrate and currency swaps?

An interest rate swap involves the exchange of cash flows between two parties based on

interest payments for a particular principal amount. However, in an interest rate swap,

the principal amount is not actually exchanged. In an interest rate swap, the principal

amount is the same for both sides of the currency and a fixed payment is frequently

exchanged for a floating payment that is linked to an interest rate.

A currency swap involves the exchange of both the principal and the interest rate in one

currency for the same in another currency. The exchange of principal is done at market

rates and is usually the same for both the inception and maturity of the contract.

In general, both interest rate and currency swaps have the same benefits for acompany. These derivatives help to limit or manage exposure to fluctuations in

interest rates or to acquire a lower interest rate than a company would otherwise

be able to obtain.

Swaps are often used because a domestic firm can usually receive better ratesthan a foreign firm.

For example, suppose company A is located in the U.S. and company B is located

in England. Company A needs to take out a loan denominated in British pounds

and company B needs to take out a loan denominated in U.S. dollars. These twocompanies can engage in a swap in order to take advantage of the fact that each
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company has better rates in its respective country. These two companies could

receive interest rate savings by combining the privileged access they have in their

own markets.

Help companies hedge against interest rate exposure by reducing the uncertaintyof future cash flows.

Allows revision of debt conditions to take advantage of current or expected futuremarket conditions, allowing a lower amount needed to service a debt.

Allow companies to take advantage of the global markets more efficiently bybringing together two parties that have an advantage in different markets.

Although there is some risk associated with the possibility that the other party

will fail to meet its obligations, the benefits that a company receives from

participating in a swap far outweigh the costs.
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Currency Forward ContractsForeign currency forward contracts are used as a foreign currency hedge when an

investor has an obligation to either make or take a foreign currency payment at some

point in the future. If the date of the foreign currency payment and the last trading date

of the foreign currency forwards contract are matched up, the investor has in effect"locked in" the exchange rate payment amount.

By locking into a forward contract to sell a currency, the seller sets a future exchange

rate with no upfront cost.

For example, a U.S. exporter signs a contract today to sell hardware to a French

importer. The terms of the contract require the importer to pay euros in six months' time.

The exporter now has a known euro receivable.

Over the next six months, the dollar value of the euro receivable will rise or fall

depending on fluctuations in the exchange rate. To mitigate his uncertainty about the

direction of the exchange rate, the exporter may elect to lock in the rate at which he will

sell the euros and buy dollars in six months. To accomplish this, he hedges the euro

receivable by locking in a forward.

This arrangement leaves the exporter fully protected should the currency depreciate

below the contract level. However, he gives up all benefits if the currency appreciates. In

fact, the seller of a forward rate faces unlimited costs should the currency appreciate.

This is a major drawback for many companies that consider this to be the true cost of a

forward contract hedge. For companies that consider this to be only an opportunity cost,

this aspect of a forward is an acceptable "cost". For this reason, forwards are one of theleast forgiving hedging instruments because they require the buyer to accurately

estimate the future value of the exposure amount.

Like other future and forward contracts, foreign currency futures contracts have

standard contract sizes, time periods, settlement procedures and are traded on

regulated exchanges throughout the world. Foreign currency forwards contracts may

have different contract sizes, time periods and settlement procedures than futures

contracts.

Key Points:

Used mainly by banks and corporations to manage foreign exchange risk Allows the user to "lock in" or set a future exchange rate. Parties can deliver the currency or settle the difference in rates with cash.

Example: Currency Forward Contracts

Corporation A has a foreign sub in Italy that will be sending it 10 million euros in six

months. Corp. A will need to swap the euro for the euros it will be receiving from the sub.

In other words, Corp. A is long euros and short dollars. It is short dollars because it will

need to purchase them in the near future. Corp. A can wait six months and see what

happens in the currency markets or enter into a currency forward contract. Toaccomplish this, Corp. A can short the forward contract, or euro, and go long the dollar.


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Corp. A goes to Citigroup and receives a quote of .935 in six months. This allows Corp. A

to buy dollars and sell euros. Now Corp. A will be able to turn its 10 million euros into 10

million * .935 = 935,000 dollars in six months.

Six months from now if rates are at .91, Corp. A will be ecstatic because it will haverealized a higher exchange rate. If the rate has increased to .95, Corp. A would still

receive the .935 it originally contracts to receive from Citigroup, but in this case, Corp. A

will not have received the benefit of a more favorable exchange rate.

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