Re: Greenspan' and Derivatives

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Arbitrage is not the same as hedging:

Arbitrage: Simultaneous purchase and sale of two different contracts (or
a combination of cash and futures) to take advantage of perceived
mispricing. In a pure arbitrage, mispricing is locked in and a risk-free
profit made through trades.

Hedge: A sale of futures contracts to offset the ownership or purchase
of the underlying cash commodity in order to protect it against adverse
price moves; or, conversely, a purchase of futures contracts to offset
the sale of the underlying cash commodity, again for protection against
adverse price moves.

In-the-money: In call options, when the strike price is below the price
of the underlying futures. In put options, when the strike price is
above the price of the underlying futures. In-the-money options are the
most expensive options because the premium includes in- trinsic value.

Out-of-the-money: Option calls with strike prices above the price of the
underlying futures, and puts with strike prices below the price of the
underlying futures.

Mark-to-market: The practice of crediting or debiting a trader's account
based on the daily closing prices of the futures contracts he is long or
short.

Net position: The difference between the open contracts long and the
open contracts short held in any one commodity by any individual or group.

Open contracts: Contracts which have been bought or sold without the
transaction having been completed by subsequent sale, repurchase, or
actual delivery or receipt of commodity

Open interest: The number of "open contracts." It refers to unliquidated
purchases or sales and never to their combined total.

Cross hedge: When a cash commodity is hedged by using futures contracts
based on another commodity.

German Government Bonds and Notes
Source: Federal Reserve System
(The complete Activities Manual (pdf format) can be downloaded from the
Federal Reserve's web site)

GENERAL DESCRIPTION

The federal government of Germany issues several types of securities:
bonds (Bunds), notes (Bobls and Scha¨tze) and Treasury discount paper
(U-Scha¨tze). Government agencies such as the Federal Post Office and
the Federal Railway have also issued bonds (Posts and Bahns) and notes
(Scha¨tze). In addition, with the unification of West and East Germany
in October 1990, the German Unity Fund began to issue Unity Fund bonds
(Unities) and notes (Scha¨tze). The outstanding debt issues of the Post
Office, Railway, and Unity Fund have since been folded into the
so-called Debt Inheritance Fund, which has led to an explicit debt
service of these issues through the federal government. Hence, these
issues are guaranteed by the full faith and credit of the federal
government. All government-guaranteed securities are available in
book-entry form only.

The government also issues U-Scha¨tze, zero-coupon Treasury notes with
maturities of one to two years which may not be purchased by foreigners,
and short-term Treasury bills, with one-half- to one-year maturities,
which may be purchased by foreigners. However, the secondary market for
these instruments is small and does not attract substantial foreign
investment. Therefore, the following discussion will focus on bonds and
notes.

CHARACTERISTICS AND FEATURES

Bunds are issued regularly, usually in deutschemarks (DM) 20 billion to
DM 30 billion blocks, with maturities ranging from 8 to 30 years. Bunds
are issued in a minimum denomination of DM 1,000, and a typical issue
carries a maturity of 10 years. Bunds are redeemable in a lump sum at
maturity at face value (bullet structure) with interest paid annually.
Until 1990, all bonds issued by the federal government and other public
authorities were non-callable and bore a fixed coupon. However, since
February 1990, some callable floating-rate bonds have been issued.

Special five-year federal notes (Bobls) have been issued by the federal
government since 1979, but foreign investment in these securities has
been permitted only since 1988. In the past, medium-term notes with
four- to six-year maturities (Scha¨tze) were issued irregularly by the
federal government, the Unity Fund, and the Federal Post Office and
Railway. However, in 1995, the Ministry of Finance decided to
discontinue the issuance of these securities to create more transparency
in the market. All Bobls and existing Scha¨tze issues are fixed-coupon
securities with bullet maturities.

Stock-exchange settlement takes place two market days after trade date
(T+2). International settlement takes place three business days after
trade date (T+3). As of January 1, 1994, German federal government notes
and bonds no longer trade ex-coupon. They trade on a cum-coupon basis;
the purchaser of the bond pays the seller accrued interest from the last
coupon date to settlement. Interest is accrued on a 30/360-daycount
basis in which each month is assumed to have 30 days and a year is
assumed to have 360 days.

USES

German government bonds and notes are used for investment, hedging, and
speculative purposes. Foreign investors, including U.S. banks, often
purchase German government securities as a means of diversifying their
securities portfolios. In particular, the low credit risk and deep
liquidity of German government bonds and notes encourages the use of
these instruments as non-U.S. investment vehicles. German government
securities may also be used to hedge German interest-rate risk or
foreign-currency risk related to positions in deutschemarks. Speculators
may use German government bonds to take positions on changes in the
level and term structure of German interest rates or on changes in the
foreign-exchange rates between Germany and the United States. Because it
is a deep and efficient market, some German futures contracts and
options are priced relative to Bund issues.

DESCRIPTION OF MARKETPLACE

Issuing Practices

Bunds are issued using a combination of syndication and bidding
procedures. Part of the issue is offered at fixed terms to the members
of the Federal Bond Consortium, which consists of German banks, foreign
banks in Germany, and the Deutsche Bundesbank (German Central Bank). The
Bundesbank is the lead bank in the syndicate and determines the
allocation of the offerings among the syndicate members. These
allocations are changed infrequently. During the syndicate meeting, the
coupon rate, maturity, and issue price are determined by the government
and syndicate, although the total size of the issue is unknown.
Syndicate members receive a fee from the government for selling bonds
received through syndicate negotiations.

A further tranche is issued to the syndicate by means of an
American-style auction. The terms—coupon rate, maturity, and settlement
date—are the same as those determined in the syndicate meeting, although
the overall size of the issue is not specified. The German Central Bank
accepts bids starting with the highest price and accepts lower bids
until the supply of securities it wishes to sell is depleted.
Non-competitive bids may also be submitted, which are filled at the
average accepted price of the auction. The size of the issue is
announced after the auction. The difference between the issue size and
the amount that has been issued through the underwriting syndicate plus
the auction is retained by the Bundesbank for its bond market operations.

Bobls are issued on a standing-issue basis (similar to a tap form in
which a fixed amount of securities at a fixed price is issued when
market conditions are considered favorable) with stated coupon and
price. During the initial selling period, which may last a few months,
the price is periodically adjusted by the Ministry of Finance to reflect
changes in market conditions. The sales of a given series are terminated
when either the issuing volume has been exhausted or the nominal
interest rate has moved too far away from the going market rate. The new
series is launched within a short period of time. Only domestic private
individuals and domestic non-profit institutions are permitted to
purchase the issues in the primary market. German banks (which cannot
purchase these securities for their own account) receive a commission
for selling the bonds to qualified investors. After the selling period
is over and an issue is officially listed on the German stock exchange,
the securities may be purchased by any investor.

Secondary Market

German bonds are listed and traded on all eight German stock exchanges
seven days after they are issued. Bobl issues are officially listed on
the stock exchanges after the initial selling period of one to three
months. In addition to the stock exchange transactions, substantial
(OTC) over--the-counter trading occurs. In Germany, the secondary market
for both stocks and bonds is primarily an interbank market.

For some issues, prices are fixed once during stock-exchange hours
(stock-exchange fixing takes place from 11:00 a.m. to 1:30 p.m.
Greenwich mean time +1). However as of October 3, 1988, variable trading
was introduced at the German stock exchanges for Bunds, Bobls, Bahns,
and Posts issued after January 2, 1987, with a minimum size of DM 2
billion. The Unity Fund issues also participate. After the fixing of the
prices on the stock exchanges, the securities are traded on the OTC
market (OTC hours are from 8:30 a.m. to 5:30 p.m.). Bunds are typically
quoted in the OTC market on the basis of a difference from the fixing
price, for example, a price quote of -10 means a price of 10 pfennigs
(1/100 of a DM) less than the fixing price.

Seventy to 80 percent of the secondary-market trading of Bunds, Bahns,
and Posts takes place in the OTC market. About 75 percent of Bobl
trading takes place in the OTC market, as does most Scha¨tze trading.
However, the stock markets are important because the prices determined
there provide standard, publicly available benchmarks.

Market Participants

Sell Side

The underwriting of public authority bonds is done by the Federal Bond
Syndicate, which consists of German banks, foreign banks in Germany, and
the Deutsche Bundesbank (German Central Bank). German banks are
responsible for placing Bobls with qualified investors.

Buy Side

Domestic banks are the largest holders of German bonds, and private
German individuals are the second largest investment group due in part
to the propensity of German households to save and invest their savings.
German insurance companies are also major holders of German bonds, as
are German investment funds. Foreign investors, such as U.S. commercial
and investment banks, insurance companies, and money managers also hold
German government securities.

Market Transparency

The market for German government bonds and notes is active and liquid,
and price transparency is considered to be relatively high for these
securities. Several vendors, including Reuters and Telerate, disseminate
price information to the investing public.

PRICING

Bonds and notes are quoted as a percentage of par to two decimal places.
For example, a price of 98.25 means that the price of the bond or note
is 98.25 percent of par. Bonds are traded on a price basis, net of
accrued interest (clean). Prices generally move in increments of five
pfennigs. The bid/offer spread is usually eight pfennigs for liquid
issues and 15 pfennigs for less liquid issues. For notes, bid/offer
spreads are five to 10 pfennigs for liquid issues.

HEDGING

Interest-rate risk can be hedged using swaps, forwards, futures, or
options, or by taking a contra position in another German government
security. The effectiveness of a particular hedge is dependent on
yield-curve and basis risk. For example, hedging a position in a
five-year note with an over-hedged position in a three-year note may
expose the dealer to yield-curve risk. Hedging a 30-year bond with a
bond future exposes the dealer to basis risk if the historical price
relationships between futures and cash markets are not stable. Also, if
a position in notes and bonds is hedged using an OTC option, the
relative illiquidity of the option may diminish the effectiveness of the
hedge. Foreign-exchange risk may be hedged with currency swaps,
forwards, futures, and options.

RISKS

Liquidity Risk

The German government bond market is the third largest bond market in
the world, and is considered the most liquid government bond market
after the U.S. government bond market. Bunds are the most liquid and
actively traded bond issues in Germany. Unities issued by the German
Unity Fund are generally as liquid as Bunds, but Bahn and Post issues of
government agencies are fairly limited compared with the federal
government’s bonds. Therefore, these agency securities tend to be less
liquid and generally trade at a higher yield than Bunds.

The on-the-run (most recent) Bund issue is the most liquid of its
category and serves as the benchmark. The most liquid area of the Bund
yield curve is in the eight- to-10-year maturity range, as most Bund
issues carry a 10-year maturity. Similar to Bunds, on-the-run Bobls are
the most liquid type of note. Off-the-run prices are not as transparent
as current coupon securities, which makes these issues less liquid and
trading more uncertain. Of course, larger issues of bonds and notes are
generally more liquid than smaller ones.

At the stock exchange, the German Central Bank makes a market in Bunds,
Bobls, Unities, and Post issues. The German Central Bank is responsible
for maintaining an orderly secondary market in these securities and
regularly intervenes to support or regulate their prices. This tends to
increase the liquidity in the market for these issues. However, the
Bundesbank is not responsible for stabilizing Scha¨tze prices. For this
reason, these securities tend to be much less liquid than Bunds or
Bobls; their issue sizes are also normally much smaller. The Railway
Bank makes a market in Bahn issues, which enhances the liquidity of
these issues.

Interest-Rate Risk

German bonds and notes are subject to price fluctuations due to changes
in German interest rates. The variation in the term structure of
interest rates accounts for the greatest amount of local market risk
related to foreign bonds. Longer-term issues have more price volatility
due to interest-rate fluctuations than do shorter-term instruments.
Therefore, a large concentration of long-term maturities may subject a
bank’s investment portfolio to unwarranted interest-rate risk.

Foreign-Exchange Risk

Currency fluctuations can account for up to two-thirds of the return and
risk of an un-hedged international fixed-income portfolio. There are two
types of currency risk related to foreign bonds: (1) the coupons and
face value are paid in the foreign currency, which means that any change
in the exchange rate affects the bond’s value to the U.S. investor, and
(2) the bond’s yield may be affected by currency movements.

A number of factors exert a direct influence on foreign-exchange rates,
including the balance of payments and prospective changes in that
balance; inflation and interest-rate differentials between Germany and
the United States; the social and political environment in Germany,
particularly with regard to the impact on foreign investment; and
central bank intervention in the currency markets. Historically, German
exchange rates have been very stable.

Political Risk

A change in the political environment, withholding tax laws, or market
regulation can have an adverse impact on the value and liquidity of an
investment in foreign bonds. Investors should be familiar with the local
laws and regulations governing foreign bond issuance, trading,
transactions, and authorized counterparties.

ACCOUNTING TREATMENT

The accounting treatment for investments in foreign debt is determined
by the Financial Accounting Standards Board’s Statement of Financial
Accounting Standards (SFAS) No. 115, ‘‘Accounting for Certain
Investments in Debt and Equity Securities,’’ as amended by SFAS 125,
‘‘Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities.’’ SFAS 125 has been replaced by SFAS
140, which has the same title. Accounting treatment for derivatives used
as investments or for hedging purposes is determined by SFAS 133,
‘‘Accounting for Derivatives and Hedging Activities.’’ (See section
2120.1, ‘‘Accounting,’’ for further discussion.)

RISK-BASED CAPITAL WEIGHTING

German government bonds and notes are assigned to the 0 percent
risk-weight category.

LEGAL LIMITATIONS FOR BANK INVESTMENT

German government bonds and notes are type III securities. As such, a
bank’s investment in them is limited to 10 percent of its equity capital
and reserves.

REFERENCES

 Fabozzi, Frank J., and Franco Modigliani. Capital Markets:
Institutions and Instruments. Englewood Cliffs, N.J.: Prentice-Hall, 1992.
 Fabozzi, Frank J. Bond Markets, Analysis, and Strategies. 3d ed. Upper
Saddle River, N.J.: Prentice-Hall, 1996.
 Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The Handbook of Fixed
Income Securities. 4th ed. New York: Irwin, 1995.
 Urich, Thomas J. U.K., German and Japanese Government Bond Markets.
Monograph Series in Finance and Economics. New York: New York University
Salomon Center at the Leonard N. Stern School of Business, 1990.
 J.P. Morgan Securities. Government Bond Outlines. 9th ed. April 1996.


Henry C.K. Liu




Warren Mosler wrote:
> --- Michael Perelman <michael@xxxxxxxxxxxxxxxxx>
> wrote:
>
> > Can you elaborate?  Thanks.
> >
> > On Wed, Mar 12, 2003 at 08:22:40AM -0800, Warren
> > Mosler wrote:
> >
> > > FYI,
> > >
> > > US dealers are laying off German default insurance
> > > on German banks...
> > >
> > > warren
>
> Best to use an example.  Assume a US dealer/bank,
> such as Citibank, offers one year 'credit default
> swaps' on German govt debt for .15 to its customers
> and you
> decide to buy $100 million notional from them.
> You pay them $150,000 and they agree to let you
> deliver up to $100 million face amount of any german
> govt debt to them at 100 in the event that germany
> defaults on any of its debt.  In the case of actual
> german default the bonds may be trading at, say,
> 80, for example, which means you could then buy
> 100 million face value for 80 million in the market
> place and deliver them to Citibank for 100 million.
> If there is no german default in the next 12 months
> you lose your 150,000 premium you originally paid.
>
> Citbank, of course, is not likely to keep that
> kind of risk on its books, and the reason it offered
> to accept your 150,000 might be because it has a
> source to 'lay off' that risk, for example, by paying
> only 140,000 to another counterparty who is then
> responsible to Citibank in the case of default.
>
> However, I have reason to believe that dealers
> are 'laying off' this risk on german banks, which
> is in fact a 'waste of money' as they won't be able
> to pay if germany defaults, etc. and so the original
> dealer who 'thinks' he's not at risk is in fact at
> risk, and, worse, is at risk with only 10,000 of
> premium in his pocket.
>
> Hope this helps!
>
> warren
>
>
>
>
>
>
>
>
>
> =====
> http://www.mosler.org
>       http://www.moslerauto.com
>
> Primary email contact:  wmosler@xxxxxxxxxx
>
> __________________________________________________
> Do you Yahoo!?
> Yahoo! Web Hosting - establish your business online
> http://webhosting.yahoo.com