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Business Anaylst Ultimate Guide to Financial Products

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					  Process Accounting
Cost-Benefit Analysis
      PdT
                                                                              '   ,
                                                                                  .


Cost-benefit analysis: what is it?



   A financial analysis process for determining the trade-off between the
   cost of a specific action and the benefit (savings or increased revenue)
   that results from it

   Stated simply, "If I undertake this action:

         What will change?
         By how much?
         Is it worth it?"
Whv do a cost-benefit analysis?



 Cost-benefit analysis provides a structured approach to:
      Demonstrate the economic impact of a solution

      Compare alternative solutions
 A
4QP   Choose a solution that enhances shareholder value
 V

      Identify the key leverage points in a decision

      Articulate major points of uncertainty and the likely impact on a project

      Demonstratelsell your recommendations to clients
Cost-benefit analysis serves as a project management tool for planning
and control
There are three major building blocks in a cost-benefit analysis
To be complete, you must consider at least eight components of cost,
benefit and risk
The objective is to identify the key line items of each component by
considering a broad set of areas in conjunction with an organizational
units' financials

      COSTS                                                         BENEFITS
   Initial one-time costs                                  Revenue Enhancements
     - Project Management G W ~ & ~ W * ~ L )                   - Interest revenues
     - Research and Development                                 - Fee revenues
             Research and Developer effort                      - Transactions revenues
             Client involvement                                 - Market Making revenues
             Development environment                        Cost savings
     - Retirement of existing assets and liabilities            - Direct costs
             Labor I  vendor contracts                          - Support costs
             Hardware disposal                                  - Risk-related losses
             Software contracts                             Intangibles
             Leases                                             - External compliance
     - lmplementationlRollout                                   - Strategic alignment with future
             Implementation labor                                 business objectives
             Capital equipment purchase                         - Strategic fit with technology
             Software purchase                                    architecture
              Severance                                         - Control
   Ongoing costs                                                - Superior information
     - System support
             AD support                                         RISK FACTORS
             P&S support
             Vendor support
     - Software license                                    -    Technology risk
     - Labor and benefits                                  -    Project Scope
   Terminal costs                                          Benefit-related
     - Retirement of old assets (        s
                                         c,
                                                ~      ~   -)   Business Volatility
     - Benefit of selling old assets                       -    Impact uncertainty
Each component requires its own data gathering excercise
                                                                                                      bN+      +
                                                                                                              dn .-t-
                                                                                                          )bus&-
                                                                                                   ) 4 y ~ f p * u 5 ,F   ~   W   C   ~
       COSTS                                                           BENEFITS
    Initial one-time costs                                   Revenue Enhancements (uuy ~ o w b ~ ~ c t h v e )
      - Project Management                                             OU income statements, business
                detailed workplans                                     managers
      - Research and Development                             Cost savings
                systems                                       -   - Direct costs
      - Retirement of existing assets and liabilities                         proposed workflowslactivity
                                                                              based costing
                OU expense statements and asset lists
      - lmplementationlRollout                                    - Support costs
                                                                              finance, systems
                detailed workplans, systems, proposed
                workflows, finance
                                                                  -    Risk-related losses
                                                                              credit, finance, business
                                                                              managers
    Ongoing costs                                            Intangibles
      - System support                                                 business managers
                systems, proposed workflows/activity based
                costing, finance

    Terminal costs                                                    RISK FACTORS
      -   Retirement of old assets
                systems
      - Benefit of selling old assets                              systems, finance, operations managers
                OU asset lists                               Benefit-related
                                                                      business managers
"Time Value of Money" is a key concept in costlbenefit analysis      (i&&
                                                                     ,. 1
                                                                          C
                                                                                   '.'




   Costs typically occur well before benefits accrue. Because "a dollar
   today is worth more than a dollar tomorrow," you need to
   which takes Time Value of Money into account
                                                                              A.
   Present Value (PV) and Net Present Value (NPV) allow us to take into
   account the variation in timing

   Terminology refresher:
    - Cash flows - the actual receipts and expenditures, instead of
      accounting measures since accounting leads to concepts that do
      not translate into when funds leave the bank or return (e.g.,
      depreciation, reserves, etc.). Usually calculated versus "doing
      nothing"
    - Reauired Rate of Return - the extra amount you require above and
      beyond your original investment one year forward (akin to 'interest'
      you wish to receive) tc)
                                                                  e   ,
                                                                      .
The following is an illustration of the logic behind PV and NPV
Present Value: an example



Problem:

   A company expects a cash inflow of $100,000 two years from now.
   What is the present value of this cash flow? Assume a required rate of
   return of 15% and a risk free rate of 4%
                        (ao;. &
                         d.n(     -d
                                  y)


Solution:

   The time period "n" is 2 since the cash flow is two years from now. "r" is
   . I 5 since the required rate of return is 15%. C, is $100,000, the inflow
   of cash. Therefore:
                                                                                       ir'


IRR is related to NPV and similarly recognizes the time value of money



                                                                NPV

   As we've said, NPV is the sum of the PVs of all the cashflows
   NPV = C + C,/(l+r) + C,/(l +r)* + ... + C,/(l+r)n
          ,




                                                               wq
        Decision Rule: Accept project, if NPV > 0
                                                                            ;Pv>dClaws.
   IRR is the discount rate that makes the NPV zero.
    C + C,/(I+IRR) + Cd(l+lRR)2 + ... + CnI(l+IRR)n= 0
     ,                                                                             .
          Decision Rule: Accept project, if IRR > Required rate of return

   Use NPV and not IRR. Often the decisions made are the same using
   NPV and IRR. However, under certain circumstances, they are not.
   For example, sometimes there can be multiple IRRs.
                                                                                  ,*,   .
Net Present Value and Internal Rate of Return: an example




Problem:

   A project requires an initial investment of $2000. It has a useful life of 3
   years and the net cash flows at the end of years 1 , 2 and 3 are $1000,
   $1 000 and $5000 respectively. The required rate of return is 10
   percent.



Solution:

   NPV = -2000+ 1000/1.1+ 1000/1. + 5000/1.1 = $3492
                                l2
   IRR = 68%
                                                                               n


"Payback" is another commonly used method but does not take into               +,
account the Time Value of Money                                                3




   Payback Period
    - Number of years it takes before the cumulative net cashflows equal the
      initial investment
    - Decision Rule: Accept project, if Payback Period < Cutoff Period


   This method is simple to use, but fundamentally ignores cash flows
   subsequent to the payback date and does not distinguish between when cash
   flows occur



   Often used by pragmatic managers whose belief is that nothing stays
   constant for more than 2-3 years, so why make a decision on something 4-5
   years out?
          Payback Period: an e x a m ~ l e
                     .       -                        --


             I
                         ~                      ~




                 -                  Scenario 1

                                                                 Payback              NPV
                                                                                     (r=15%)

                                        - -.4
                                         -
                                                                 2 years


                                          Time




                                    Scenario 2
                                 $900




                                                                  2 years




  $ Note: This example assumes TO occurs immediately. Using Excel, the first value is assumed
   ,Lamua time period later.
    0
2l28196                                                                                       15
Comparison of Payback Period, IRR and NPV




              risk due to increasing              Ignores the time value of

              flows as the time horizon           Emphasizes short-run
                                                  profitability to the exclusion o
                                                  long-run profitability



                                                  required rate of return

              Recognizes the time value of        payback and N Y V
              money                               Can yield multiple and thus
              Used for return on investment       ambiguous results
              calculations at the project level

   NPV        Conceptually superior to            Requires an estimate of the        Accept project if NPV > 0
              payback                             required rate of return
              Does not ignore any cash flow       More difficult to apply than
              Recognizes the time value of        payback
              money
              Easier to apply than IRR
              Does not yield multiple results
         Cost-benefit analysis: practice case
                                                                                  5yr5    OO*
                                                                                         \I.~
               Application Development has estimated an FX system to require 70 work months (at
               $10,000 per work month). The new system would replace the software package you
     ;~r&      bought last year for $100,000. While the old system needs 2 work months of AD
    c'bl. ou
    .          maintenance per year, the new system will need 5 work months per year. The net
               cost of retiring the existing system is not significant.
               You have to purchase 4 additional workstations at $10,000 each and the P&S support
               charges are $2000 per year for each workstation.
               In addition, you have to reengineer the process flows requiring 2 work months of effort
               from GTO consulting at $10,000 per work month.
               Automation would allow your FX operation to save 6 FTE's with salaries and benefits
               of $70,000 each per year, plus associated occupancy savings of $60,000 per year. In
               addition, this would allow you to process an additional volume that could generate
               $50,000 in additional revenues per year for the firm.
               Assume all one-time cash flows are at the end of year 1 and ongoing costs and
               benefits begin in year 2.
            Deliverables:
            1) Using a 20% required rate of return and a 5-year period, calculate NPV, payback
               period and IRR.
            2) Should you undertake this proposal? Why or why not?
ZRB19j
Solution to practice case

                       -- -...- .---
        -...    -                 -.                                                                .- --        .
                                                                                                                 .

        Incremental Costs

        % T o - c o ~ s ~ a ii--$700
         A G l F i s d Development
                             i-- - . $20                                                     ---. ... ...
                                                                                                        .   -              --
        ~--itii-Fmeni-o-f-E~IsiingSy-stem----
         ---  -                                                                                              -
                                                                                                            -.
        Implementation                                                  I                                        I
                                                    ~.        ~
                                                                                                                                    ~- . . ..
                                                                                                                                     ~.     .      .
                                                                                                                                                ~. . .
         .. . .       .. . .
                         .                     .
                                                    Capital Equipment                 $40
                                                                                                                 I




                                               ".


             .. ... ... ..     . .. . .... -
        Revenues




                                                                                                                 I..
        Present Value
                                                                                    ----
                                                                                                                       .
                                                                                                                       $ 2 4- $237
                                                                                                                             -
                                                                                                                                         I
                                                                                                                                                $198
                                                                                                                                                         1
                                                      --
        Payback Period
                                          --                            I                                                       ~




        --         --                                             .-    !   1!3~@           /_---
                                                                        I
                                           o Refurn
                                            f                                 53%

                                                                                             -       L
         NPV: Accept project, since NPV > 0
         IRR: Accept project, since IRR > 20%
         Payback: Accept project, if Cutoff period desired > 1.3 years
Practical considerations



   During the costlbenefit analysis, you should focus on using
   estimates/"back of the envelopes" before expending energy on
   precision. Most managers will understand the value of this approach
   and 'detailing' often occurs many months after beginning work

   Typically, basing your cash flows on 'do nothing' is the easiest

   Determining "r" requires an examination of the riskiness of the project
   and understanding the cost of capital of the bank

   You should typically not attempt to derive "r". While not impossible, the
   effort generally leaves you exposed to errors. Typically, finance will
   provide a figure for rate of return. Unless exceptionally risky, "r" takes
   the form of "somewhere between 15-20%"

   The Technology Chief Operating Office is developing a Technology
   Investment Analysis tool. It will shortly be available and will allow you to
   quickly conduct a costlbenefit analysis
Advanced Techniaues



  An alternate approach increasingly used in the bank is
  "certainty equivalent". In this approach PV=(C,-
  RP)/(l+r,)" where RP is the risk premium and r, is the
                                                             pJf& Sr*r-=
  risk free rate. This approach allows the user to derive
  their own risk factors. The appendix provides more      .L       SWQ .

  detail
        &.
       ( -A r     i   5   ea. ~~a a ~ \ t \ o w
                           ~                .)

$.An options approach is used to take into account the
  ability to cancel a project at any point in time. The
   appendix provides more detail                                           +"
    c*l. L C 1
Sensitivity analysis should be performed to assess the robustness of the   .   ,

decision and to identify the key leverage points

Using the previous example:



 NPV   t
                                                              Discount




                        I, 1        NPV range = $428 - $727
                                                                 0.3




                 0.1          0.2     0.3           0.4
                                             Discount Rate
         Use sensitivity analysis to identify the key leverage points


                 Management should always be driven by prioritization of effort.
                 Sensitivity analysis allows you to identify the key leverage points

            Example:

             I        Sensitivity to Revenue Assumption
                                                                       Sensitivity to Cost Savings Assumptions
                                                                                                                 I

                                    Percent Change
                                                               I I                    Percent Change




                 Having identified the key leverage points, you can now manaae them:
                  - Get precision estimates on the ones that really matter
                  - Manage them by making sure your estimates are right
                 Your analysis should typically be a range. Derive the range by looking
                 at each individual component (project management, systems
                 development, etc.) and using judgement about the likely variation
2128/%
                  b   Ma7ab\~b                       w    b   \W
                                                                   ~   r        d
You'll find yourself in philosophical discussions about your assumptions:                                      ...
should certain items be in or out?


     "Sunk costs"     "We just spent $300,000 on a new system last year". True, but irrelevant. If your
                      baseline calculations take into account the capabilities of the $300K system and
                      your improvements end up in a positive NPV, then the sunk costs are irrelevant.
                      (potentially, sunk costs have some terminal value)
                     ;$Cch    & &aolV5 ; w v o l u d : iw&&. C ~ ~ ~ O W S
                                      d
                     iOStwe &&&0lDILI: d0 4 I - ~ .
                                              .      I
                                                       are.


     Severance       "The displaced employees can find other jobs in the bank" If true, then don't
                     include them. If not, displacement costs must be included. Typically an issue for
                     large projects. Check with finance on their position.



     Occupancy       "If we kee up the space, the bank won't do anything with it" Nevertheless, you
                     should typically include this as a benefit. because 1) typically your OU's budget
                     will get credit for freeing it, 2) if you don't highlight this to the corporate office,

                                    e
                     how do you ex ect them to take action? This depends on the area and floor you are
                     dealing with. s p e hW/ F,~&+\

     Support costs   Support costs typically track with the number of people supported. If you're
     (HR, finance,   reducing the number of operations staff, should you be looking to take any credit
     etc.)           for reducing support costs? While conceptually true, you'd have a hard time
                     justifying this on a small project. Also look at charging out versus allocated costs.
Recommendations, practical tips, and summary
                                                                                           ."


    Cost-benefit analysis is an important decision-making tool used as part
                                                        -

    of the assessment phase and to identify key barriers -7 L ~ U W    z
                                                                 grrocl*
                                                                        &   -   *me-
*   Confirm assumptions with the relevant groups (e.g., project managers,
    finance, systems, clients)

    Supplement quantitative analysis by an analysis of intangibles
                                                                 ,SW;UJ          --Lh-s-
                                                                           CYd? )
    Incorporate other relevant factors such as taxation in the model using
    input from the financial group

    Assess project interdependencies and joint benefits ( s y y ' ~ )

    The power of the tool is in its ability to confirm the validity of a project,
    not in the precision. "Accurate, but not precise"

    Early on, don't go for detail; instead, make reasonable assumptions.
    Use sensitivity analysis to pinpoint where you need to go for precision
                                                                          0

Recommendations, practical tips, and summary (continued)



   You want your project to be virtually impervious to errors in the
   assumptions. Otherwise, you probably shouldn't be recommending it!

   In addition to NPVIyou need to be able to explain to the manager the
   impact to his bottom line

   Cost-benefit analysis should be an on-going process. Return to your
   analysis as your learn more and results become apparent.

   Payback is conceptually bad, but you're often asked for it.

   Beware of doing your analysis in a vacuum. Get finance involved.
,
a    JPMorgan                                                            K ~ s k DRAFT




                                             FxUSION
                                    Risk Management Service


                                   Technical Specification



                  This document is a work in progress.. .




                                                              Abstract
                                                         This document describes the technical
                                                         requirements for FxUSION Risk Management and
                                                         P&L Service.




    Copyright Q 1997, by JP Morgan and Co.                    Page 1 of 28
    Author: Eun Ju Park
    Dale Created: Nov. 20, 1999
    Last Modified: February 11, 1999
  JPMorgan                                                                                                                               Risk DRAFT




PHASE I OVERVIEW  ...........................................................................................................................3
RISK EVENT FLOW .............................................................................................................................4

POSTING AN EVENT ON TO RTSENS ............................................................................................                   6
   RTSENS EVENTTABLE................................................................
   STORED                                             .  .
                   NEEDED: ............... . ............................
          PROCEDURES
   ERROR MESSAGETABLE  .......................................................................................................................           7
   RISK OUTPU                                                                                                                                            7


   BATCH                      NEEDED:...........................................................................................................
                         LEVELS                                                                                                                   9
   AD-HOC DE@R CALCULATION                                                                                                                        9
        VOLATILITY AND CORR                                                                                                                       9
   DE@ROUTPUT      ................... ........    ..................................................................................................
                                                                                                                                                 10
       L M I T S ......................................................................................................................................
                                                                                                                                                 10
TRADE DATA FROM FXGDB..........................................................................................................11
CURVES AND BENCHMARK PRICES ...........................................................................................        12
       DEFINITIO
   CURVE                                                                                                                                               12
   BENCHMARK
           PRICES                                                                                                                                      13
                         ..............................................................................................................
   BUILDING THE ZERO CURVE                                                                                                                             13
SCREEN REPORTS        ............................................................................................................................
                                                                                                                                               15

4:15 REPORTS ..................................................................................................................................19

CRMG REQUIREMENTS..............................................................................................................                20
   CRMG FEED EXAMPLE .........................................................................................................
            .                                                                                                                          21
                                    .
   CRMG FEED LAYOUT .................... ..............................................................................................22
RISK VIEWS (TRADER'S PROFILE)              ............................................................................................24
REFERENCE DATA.........................................................................................................................25
   GET STIRT AND FX BOOK LIST ................... ......
                                               A
                                  ..
   GET PRODUCT .................... ..................
               LIST
   GET CURRENC
   CCY-MAP
         TAB

                ......................................................................................................................... 26
ISSUESIQUESTIONS:

DEMO .TOPICS DISCUSSED ........................................................................................................           28
   JAN   25. 1999 .DEMO TO DEAN L L I A M S AND CHRIS
                               W                         ............................
                                                    MILLER                                                                     .
                                                                                                                               . ....................... 28
                                                                                                                                .




Copyright O 1997. by I P Morgan and Co                                                                                 Page 2 of 28
Author: Eun l u Park
Date Created: Nov . 20. 1999
Last Modified: February 11. 1999
 JPMorgan                                                                             Risk DRAFT


Phase I Overview

Phase I of the FxUsion risk proposes to use the FXOptions risk engine (RTSens) in combination with direct
data extraction from FXGDB and the SBS display mechanism. The scope of the phase I deliverable is as
follows:

        Trade data extraction from FXGDB
        Trader Profile Setup (risk view definitions)
        Risk reporting
                 PVBP
                 EQC - Equivalent Contracts
                 3ME - 3 Months Equivalents
        4: 15 Reporting
        Dear Calculation and reporting
        CRMG reporting
        Curve Definitions

The product types covered for phase I is as follows:

         FX Forwards
         O/N Fixing Instruments ( OIS, Avg. Fed Fund)
         FRAs
         IRS
         Futures
         Other - (bullion, deposits, and T-Bills)

The current production RTSens engine will be modified to handle STIRT products as specified above. The
new RTSens will replace the existing version in production upon the completion of Phase I installation.
There will be a single RTSens engine running globally. SBS will be the basis of the GUI. The current
SBS code base will be taken and modified to fit the STIRT display requirements.




Copyright O 1997, by JP Morgan and Co.                                     Page 3 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
                                                                                        Risk DRAFT


Risk Event Flow



                                             FXGDB




                                          A 1  RTSens
                                                  4
                                                               F X Library




      kvent Table

                                                                             Risk Output Table
                                              6




                                                SBSGUI




1.  Calculation request is triggered from the SBS GUI (by a user)- SBS writes the request on to the
    RTSens Event manager table. (The event data needs to be specified)
2. RTSens reads the calculation request.
3. RTSens gets the relevant trade data from FXGDB. (data extractions method and layout needs to be
    specified further)
4. RTSens calculates the requested sensitivity
5 . RTSens writes the calculated sensitivity to the output table (data layout needs to be specified)
6. RTSens posts the 'calculation complete' event to the event manager table
7. SBS GUI reads the 'calculation complete' event
8. SBS GUI get the sensitivity data from the output table and display to user.

The FXO database servers will be used in the production environment. Currently there are 2 databases
defined in the FXO server (fxprod andrtsens-db). A third database (risk-db) will be created for STIRT risk
processing.

All trade data is stored in FXGDB, there will be no internal storage of trades data. Reference data such as
book, desk, currency, product and legal entity will he refresh nightly from FXGDB and stored in the risk-db
database. The risk-db database will hold the following information:

         Yield Curve definition
         Trader's Profiles (risk views)
         Books
         Desk

Copyright O 1997, by JP Morgan and Co.                                       Page 4 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
 JPMorgan                                           Risk DRAFT


        Legal Entity
        Product
        Currency
        RTSens Parameters




Copyright O 1997, by JP Morgan and Co.   Page 5 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: Febmary 11,1999
.>


      JPMorgan                                                                                 Risk DRAFT


     Posting an event on to RTSens

     RTSens Event Table

     Written to by SBS to post a calculation event, to be read by RTSens to run calculations, to be read by SBS
     to refresh screen upon completion of a RTSens calculation.

     The request will contain 2 types of calculation for phase I:

              Sensitivity calculation request -      22
              De@r calculation request
                       By CCY                        42
                       ALL                           43
                       By Region                     44

              P&L for Phase I1


     The current events table in the FXO database will be used to post the events from the GUI. In addition
     to the eventposting - 2 additional event description table will b e f l e d . They are as follows

     EventBook table: (rtsens-db)

     Column Name                          Type             Description
     Id-event                             Int              Event id returned as a result of position an event
                                                           on to the FXO event table
     Id-book                              Char(l5)         Book name
     Id-disp-ccy                          Char(3)          I S 0 Ccy code
     Id-prd                               Char(l0)         Product name for d e e r calculation event only
     Id-ccy                               Char(3)          I S 0 Ccy code for de@r calculation event only

     EventReference table: (rtsens-db)

     Column Name                          Type             Description
     Id-event                             Int              Event id returned as a result of position an event
                                                           on to the FXO event table
     Id-prd                               Char(l0)         Product name
     Id-yld-curv                          Char (30)        Curve name
     Id-ccy                               Char (3)         currency

     Each calculation event posted will have associated book list and a producVcurve pair list. RTSens will
     read the event and pick up trades which match the booklproduct list. RTSens than will calculate all
     sensitivity using the product-yield curve pair defined for that event.

     Stored Procedures needed:

     Ins-event - posts an calculation event on to the FXO event table for RTSens (rtsens-db)
     Parameter                              I VO I Datatype I Remarks
     Id-action                              II       I 1nt       I Action id which indication type of RTSens
     Copyright O 1997, by IP Morgan and Co.                                         Page 6 of 28
     Author: Eun lu Park
     Date Created: Nov. 20, 1999
     Last Modified: February l I, 1999
   JPMorgan                                                                                           Risk DRAFT


I Id-event                                 10        I Int          I Event id                                     I
 Get-event-status   -checks the status of an event on to the FXO event table for RTSens (rtsens-db)
 Parameter                                U0      Datatype     Remarks
 Id-event                                 1       Int          Event id
 Id-status                                0       Char(l)      C - Complete
                                                               P - Pending
                                                               F - Failed
                                                               A - Aborted


 Ins-evt-book - inserts book list for a given event (rfsens-db)
 Parameter                              I VO ( Datatype I Remarks
 Id-event                               II      I Int         I Event id
 Id-book                                II      I Char (15) 1 Book name to insen
 I n s - e v t g r o d y c -inserts product, yield curve and currency for a given event (rrsens-db)
 Parameter                                        U0      Datatype     Remarks
 Id-event                                         I       Int          Event id
 Id-prod                                          1       Char (10)    Product name
 Id-yld-curve                                     I       Char (30)    Yield Curve Name
 Id-ccy                                           I       Char (3)     Currency code


 E r r o r Message Table

 If the get-event-status returns a F (fail) or A (abort) in the id-status field, an error message for the specific
 event id will be stored here. This table will be cleared daily.

 Column Name                            Type                 Description
 Id-event                               Int                  Event id
 Tx-err-msg                             Char(256)            Error Message




 Risk O u t p u t

 Written to by RTSens, stores calculated data (PVBP, EQC, 3ME, market value, notional ...)

 SensData table: (risk-db)
 Column Name                            Type                 Description
 Id-event                               Int                  Event id
 Id-book (remove)                       Char (40)            Book name
 Id-prd                                 Char (40)            Product name
 Id-ccy                                 Char (3)             I S 0 currency code
 Id-bucket                              Char(l5)             Yield curve bucket description (i.e. SIN, IW, 2W,
                                                             IM, 3M, lY, etc ...)
 Dt-bucket                              Datetime             Actual date of the bucket
 Id-disp-cry (remove)                   Char(3)              Equivalence display ccy
 Id-sod                                 Char (1)             Start of day indicator ( Y N )

 Copyright 0 1997, by JP Morgan and Co.                                               Page 7 of 28
 Author: Eun Ju Park
 Date Created: Nov. 20, 1999
 Last Modified: February 11, 1999
 JPMorgan                                                                  Risk DRAFT




                                         Notion amount in Future value terms




                                         Market value in Local c c




Copyright 0 1997, by IP Morgan and Co.                           Page 8 of 28
Author: Eun lu Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
 JPMorgan                                                                                   Risk DRAFT




For the phase I implementation, m r will be calculated upon user request via the GUI. This ability to
request a full m r calculation will be limited to few individuals. It is expected that for the Phase I
implementation, the full de@r calculation will be utilized only few times a day (e.g. Start of day, for 4:15
reporting).

As with sensitivity calculations, the & calculation event will be posted on to the RTSens event table by
the GUI. At this time all de@r levels will be calculated using the current market data (trades, rates, etc ...).
T h e m output will be static until the next calculation event is requested.

When displaying && numbers, either from the GUI or any paper report, the respective processes will
simply read the data from the  rn
                               output table and display accordingly.


Batch De@r Levels Needed:

    0    Total I)cer - 1 dear number for all ccy's and all regions and products (Global STIRT D e a r )
    0    Consolidated by currency across all products.
         Consolidated by Region across all products and ccy's (NY, London, Asia)
         m r by trader (this has been request by Dean Williams, may not be feasible forphase I )


Ad-Hoc De@r calculation request

 In addition to the batch & calculation, a user may request an ad-hoc dear. Users may select a
combination of CCY/Product/Book/Desk and request an ad-hoc calculation. The GUI will post an event to
RTSens for the calculation

Please refer to 'Posting an event to RTSens' section forfurther information.

FxLib will provide the appropriate m r calculation functions - to be discussed further          ...
De@r Volatility and Correlation Mapping Table

This table is required to map Risk benchmarks with CRMG benchmarks, the information will be used for
initialization of De@r calculation in the FX Library. The volatility and correlation field will be updated bi-
weekly from the CRMG vol and cor files.

A bi-weekly process will be in place to ftp the vols & cor file from CRMG and to upload the data into the
tables identified below:

Dear-vol-mappings table: (risk-db)
Column Name                     Type                   Description
Id-ccy                          Char(3)                I S 0 currency Code
Id-bnch-crmg                    Int                    CRMG benchmark code
Nm-bnch-crmg                    Char(30)               CRMG benchmark name
Nm-bnch                         Char(l0)               FX Risk benchmark name (e.g. CASH-ON,
                                                       CASH-TN, CASH-SN, CASH-lW, CASH-IM,
                                                       CASH-lY ... ; for point > lYear IRS-IRM,
Copyright O 1997, by JP Morgan and Co.                                           Page 9 of 28
Author: Eun l u Park
Date Created: Nov. 20, 1999
Last Modified: Febmruy 11, 1999
 JPMorgan                                                                              R~sk DRAFT


                                                    IRS-2Y. ..; for futures FRA-11, FRA-12,
                                                    FRA-13.. .)
Rt-vol                             Double           VolatilityllOO

Dear-correlation table: (risk-db)
Column Name                       Type              Description
Id-bnch-crmg                      Int               CRMG benchmark code
Id-bndh-crmgcor                   Int               Correlated CRMG benchmark code
Rt-cor                            Double            Correlation


D e a r Output

Written to by RTSens, stores calculated De@r

Dear-output table: (risk-db)
Column Name                        Type           Description
Event Id                           Int            RTSens event id
Id-lvl-dear                        Char(20)       Values are: ALL, CCY, TRADER, ADHOC,
                                                  REGION
CCY                                Char(3)        If        request is by CCY, this field will contain
                                                  the I S 0 Ccy code
nm-trader                          Char(25)       If de@r request is by Trader, this field will contain
                                                  the Trader name.
Region                             Char(25)       If the de@r request is by Region, this request will
                                                I contail the Region Name
Amt-dear                          I Float       I Calculated dc@r number
         Limits

Risk will be responsible for maintaining the   limits. For Phase I, the limits table will be maintained via
isql by the development team.

Dear-limits table: (risk-db)
Column Name                        Type             Description
Id-office                          Char (10)        LocationIOffice name (NY , London, Asia)
Am-limit-dear                      Float            Dear limit




Copyright O 1997, by JP Morgan and Co.                                     Page 10 of 28
Author: Eun lu Park
Date Created: Nov. 20. 1999
Last Modified: February 11,1999
 JPMorgan                                           Risk DRAFT



Trade Data from FXGDB

        Xiabo tofinalize with Tony


Stored procedures -




Copyright Q 1997, by JP Morgan and Co.   Page I I of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Mod~fied: Febmary l I, 1999
 JPMorgan                                                                               Risk DRAFT


Curves and Benchmark Prices
(extractedfrom Julian Webb's StritRisk.doc)
Eventually the risk management/valuation engine will directly use the curves and benchmark prices entered
in the Fusion pricer. However for phase I a simpler solution is proposed.


Curve Definition
There will be a default swaps curve and cash/futures curves defined (probably with the same benchmarks as
RMM)

????
For any currency it will be possible to override the default curves - so it will be possible to specifL how
many serial contracts to include in the USD 3M Futures curve for example and to add 'yexi-futures"
around FOMCmeeting dates $required. There will be no user interface provided to define these curves, it
will be niaintained via isql.
.....
77777


yield-curveTable: (risk-db) - yield curve name
Column Name                       Type                 Description
Id-curv-yld                       Int                  Yield Curve Id
Nm-curv-yld                       Char (40)            Yield curve name
Id-ccy-alph                       Char (3)             I S 0 ccy code
Id-typ-ct-dy                      Int                  Day count basis
Dtupd-1st                         Datetime             Date updated last

Yield-curve-values Table: (risk-db) - yield curve benchmarks
Column Name                    I Type              I
                                                   Description
Id-curv-yld                    I Int             I Yield Curve Id
It-typ-int
     ..                        I Int             I Interest type identifer - maps to values in interest
                                                                      .~
                                                   type t a b ~ e ( e CASH, SWAP, MONEY
                                                   MARKET, etc.. .)
                               I Int             I Period amount 1-2-3 etc. .. for 1 Week. 2 Week or
Am-prd                                             I
                                                   3-Year
Id-typ-rtprd
      ..                       I Int             I Period type indentifier - maps to
                                                   period-~etes-types table (e.;. D(ay), W(eek),
                                                   M(onth), Y(ear)).
Dtupd-1st                        Datetime          Date updated last

Interest-types: (risk-db) - benchmark mapping table
Column Name                       Type            Description
Idtyp-in1                         Int             Interest type identifier
Id-order                          In1             Order for display only
Nm-typ-int                        Char (35)       Interest type name (e.g. CASH, SWAP, MONEY
                                                  MARKET)

Period-rate-types:    (risk-db) - period mapping table
Column Name                          Type            Description
Id-typ-rt-prd                        Int             Period type identificr
Nm-typ-rt-prd                        Char (35)       Period type name (e.g. D(ay), W(eek), M(onth),
                                                     Y(ear)).
Copyright O 1997, by JP Morgan and Co.                                      Page 12 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
 JPMorgan                                                                               Risk DRAFT




Benchmark Prices
The FX Options system already has available USD OIS rates and FX forward points for each currency -
these rates are updated once a day with the latest STIRT published rates.

We are proposing to derive the benchmark prices required for the STIRT tweaking curves from an implied
interest rate curve calculated from the USD OIS rates and FX points that are already available in the FX
Options system.

So for example the GBP futures prices required as input to the GBP cashtfutures curve will be derived from
the GBP interest rate curve derived from USD OIS and GBP FX points.

This approach means that the basis effects between these different instruments will be missed and the
resulting curves could not be used for revaluation. However STIRT instruments do not have significant
second order sensitivities so using slightly off-market benchmark prices has very little impact on the
PVBPs. A quick test showed that the PVBP of a 3M FRA changed by less than 1% when the benchmark
futures prices were moved by 50bp from a level of approximately 5%.

This approach will significantly simplify the task of adding STIRT risk management to RTSens.



Building the Zero Curve
(FXLib description from Lowrence Mason)

Building of tweakable zero curves for risk calculations can be broken down into three stages:

    I. building of currency fx implied zero curves
    2. pricing of benchmarks off these zero curves. Benchmarks are used to define zero curves for risk
       management calculations.
    3. building tweakable zero curves from these benchmarks


                                                  -
1. Building of currency fx implied zero curved a zero curve for all currencies is required here

    for usd, an OIS zero curve is built using OIS benchmark rates from the existing F X 0 benchmark
    database. The set of USD OIS benchmarks that define this zero curve are those in the FXO benchmark
    database. The FXL will provide the analytics for this.

    for non-usd, an fx implied zero curve is built. Fx forward points used are those from the FXO
    benchmark database. Again, the set of forward points that define this zero curve are those in the FXO
    benchmark database. The USD reference curve will be the USD OIS curve built previously. The FXL
    will provide the analytics for this.

With these two steps complete, there is a single zero curve per currency.

2. Pricing of benchmarks off these zero curves - definitions of tweaking zero curve are now required.

Copyright 0 1997, by JP Morgan and Co.                                       Page 13 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11. 1999
 JPMorgan                                                                                  Risk DRAFT


This is best illustrated by example:

For GBP we require two zero curves for tweaking purposes;

    0    Cash, Swap. Instruments required are; Cash SN, IW, IM, 3M, 6M. IY. Swaps 2Y, 3Y
    0    Cash, Futures, Swap. Instruments required are; Cash,. SN, IW, IM, 3M. Futures, Mar99, Jun99,
         Sep99, Dec99. Swaps 2Y, 3Y

This definition is not currently maintained and work is required in FXO/RTSens to maintain these
definitions. These definitions are required to be flexible but the rate of change will be low (say 1 per
month).

Using the FXL, each of these instruments needs to be priced from the appropriate zero curve built in step
one. Calls are required to the FXL to say 'price this cash 3M instrument from this zero curve'where the
zero curve is the fx implied curve from earlier.

                                                                -
3. Building tweakable zero curves from these benchmarks with the benchmarks and associated prices
generated in step 2. 'tweakable'zero curves can be built using the FXL. This is the final step for building
of zero curves.

Using the (new) zero curve definitions, cash-swap, or cash-future-swap zero curves are now built using the
FXL. The FXL is called with vectors of instruments and their associated prices. These are used to build
'tweakable'zero curves.

For example, a GBP Cash-Swap (C-S) zero curve is built using the following inputs;

         Cash
         SN       5
         IW       5.1
         IM       5.2
         3M       5.3
         6M       5.7
         IY       5.9
         Swap
         2Y       6.2
         3Y       6.8

The resulting zero curves are then used in risk calculations. The reason for generating the C-S, C-F-S zero
curves from the USD OIS and FX benchmark points is so that tweaking is shown against Cash-Swap (or
Cash-Future-Swap) buckets.




Copyright 0 1997. by JP Morgan and Co.                                          Page 14 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11. 1999
 JPMorgan                                                                                                       Risk DRAFT


Screen Reports

Realtime sensitivity reports will be requested via the following screen:


A single curreny tab


                         ,yield curve selection   I.                                              loutput C C Y Selection              vI
                                                                 IDEM
                                                          Total I SubTotal 1 FX Fwd. I    FRAr I      Futures   I   IRS
                                                            25.W     (10.00       1.00      (1.00
                                                           115.00     12.00      (2.50       2.50




                                                                     GBP   I    JPV   I   USD     I   etc...    I   ...     I     Total   I
                                                                 4


                                                             /
                                                       Selectable tabs by CCY
                                                                                                                                Figure A - l

Input

Profile Selection:
         Users will be able to select a pre-defined profiles (see Risk view setup section) which will default
         the following info

                       Yield Curve Selection
                       Product Selection
                       Currency Selection
                       Desk Selection
                       Book Selection

Yield Curve Selection:

           Users will be able to select a specific Yield Curve definition defined in the system. A list of yield
           curve names will make up the yield curve list.




Copyright O 1997, by JP Morgan and Co.                                                          Page 15 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
                                                                                         Risk DRAFT


ProdlCCYIDesWBook Selection




         For all selections one or more items may b e selected.

Products List:
                  Avg. Fed Fund
                  Bullion
                  Deposits
                  IRS
                  FRAs
                  Futures
                  FX Forwards
                  01s
                  T-Bills

CCY List, Desk List, Book List:

                  List of CCYs, Desks, Books defined in FXGDB (for Phase I1 - ref data will provide this
                  list to risk)

Basic Usage

Example I: Product, ccy and book selected, the sensitivity will be calculated for all positions within the
selected Product, CCY and Book combination

Example 2: Product, ccy and Desk select, the sensitivity will be calculated for all positions within the
selected Product, CCY and Desk combination, where all books under the selected desks are automatically
picked up for the calculation. Since Desk and Book are hierarchical, if a book is selected, than the Desk
selection is ignored.

Output Sensitivity Selection:

         The following calculated data will be available:

                           Notional
                           Market Value (NPV)
                           PVBP
                           3 Months Equivalent
                           Equivalent Contracts
                           2 US Treasury Equivalent

Copyright @ 1997, by JP Morgan and Co.                                        Page 16 of 28
Author: Eun lu Park
Date Created: Nov. 20, 1999
Last Modified: February 1 1 , 1999
 JPMorgan                                                                                                                               R I S ~ DRAFT


Output CCY Selection

              Users may request all sensitivities to by displayed in a specific currency equivalents. The list will
              contain valid currencies as defined in the Risk system. Add "Local CCY" as part of the selection
              list - to display each tabs in local ccys.


Output Results

Sensitivity Output will be displayed as specified in figure A-I. Each curreny will be presented in a separate
tab (pages) where the last tab (page) will display the totals for each currency. See figure A-2 below.



                           [yield ~ u r v Selection
                                          e                                                                             [output CCY Seleclion              n
                                                                              .
                                                                             In...,                                                                               I
                               Buckets      Dale      Rate%        Tafd      DEM Told   GBP Tofd           JPY Tole1         SKKTolal      USDTotd   ZARTotd
                                 SN      IODBC-94      55W           25.00      (1O.W)       l.W                (1.00)                        (5.W)     (5.W)
                                 1W      lb-DBC-94     6.OW         (15.W)       12.25      (2.501               2.50             0.25         2.W      1O.W
                                 2W      23-Dec-94     6125         (52201                                                       (1.25)        1.25
                                 1M      10Jan-95      65W           1000       (18.65)    (10W1                                 (5.W)        (3.651
                                                                      0.25        8.65       0.20                5.W              1.20         2.25
  Bullion                       3M       V-Mar-95                     0.13        4.00                           4.W
                                4M       ll-Apr-95     10.200         5.26 '      3.25       2.50                0.25            (2.00)        2.50
                                5M       9-MOy-95      11.250        40.W         0.25                          (I.W)                          1.25
                                bM       V-JuwV5       13.W          25.80        (3.~)                         15Wl             13.501        4.25        1.25




1 1 ,
  Clsar All    Sdrst All
                           1     3V
                                 2v      V-DBC-V7
                                         110~ec-w    1 ;;:;:1        ""I
                                                                     32.50 1
                                                                     14.99 1
                                                                                      "4
                                                                                       12.5011
                                                                                      (13.SO)I
                                                                                                 15.001
                                                                                                  2.50 I
                                                                                                 (4.05)l         7.25
                                                                                                                        I
                                                                                                                         1
                                                                                                                                 (5.W)l
                                                                                                                                 15.Wll
                                                                                                                                (20.50)1       1.91        1.25




                                                                select&      tabs by CCY
                                                                                                                                                      Figure A-2




Copyright 0 1997, by JP Morgan and Co.                                                                            Page 17 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
 JPMorgan                                          Risk DRAY7


Current RMM Screen




Copyright O 1997, by JP Morgan and Co.   Page 18 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified. February 1 I . 1999
 JPMorgan                                                                    Risk DRAFT


4:15 Reports




                                               FXCom
                                         Position & DEaR: Rater



            -
WA            I
             a
Core EUR.   -i
            -
            OW
             FF
            -
            SF,
            -
            NLO
             BFr
            -
            L,,
            m!
            -
            -
            ECU
            -
            ESP
            -
            OKI
            -
            #OK
            -
            ItP
             SEX
            -
            FIM
            -
            AT*
            -
            PLN
            -
            HUF
            -
            OR0
            -
            -I(

            -
            SII
              v
             A$
             NZO
            -"KO
            -,OR
            -
            KRW
            WIR
            -
            -
            KiD
             THB
            -
            CHI
             NZO
            -
            TWO
            -
            AR5
            -
            BRL
            -
            CLP
            -
            m P
            -
            Em
             WXN
            -
            PEN
             EGP
            -
            ILS
            -
            NR
            -
            PHP
            -
            WE
            -
            RUB
            5/1R
            -
            -
            TRL
            -
            YEB
              ZI-R
             GOLD
            SILVER
            - OIL
            - GA3

            DEsR




Copyright O 1997, by JP Morgan and Co.                            Page 19 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February I I . 1999
 JPMorgan                                                                         Risk UKAFT


CRMG requirements
An excel spreadsheet file which contain the following data:

Header:
          PDS Version
          StreamId
          SDNDFlag
          AsOfDate
          CreationDate
          CreationTime
          Incremental

FX Data:                                              IR Data:
       FactCategory                                           FactCategory
       Exposure                                               Exposure
       Sensitivity                                            Sensitivity
       Fact                                                   Fact
       OrgTag                                                 OrgTag
       BaseImnt                                               BaseImnt
       DervImnt                                               DervImnt
       Currency                                               LegalEntity
       LegalEntity                                            WhereManaged
       WhereManaged                                           Maturity
       Ignore                                                 EquivPeriod
                                                              Ignore

Deer Data:                                            Revenue Data:
          FactCategory                                       FactCategory
          Sensitivity                                        RevenueType
          Usage                                              Revenueperiod
          Fact                                               Fact
          OrgTag                                             OrgTag
          LegalEntity                                        LegalEntity
          WhereManaged                                       WhereManaged
                                                              <




Copyright 0 1997, by JP Morgan and Co.                                  Page 20 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11,1999
 JPMorgan                                                DRAFT
                                                   R I S ~




              -
CRMG Feed Example




Copyright O 1997, by JP Morgan and Co   Page 21 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
 JPMorgan                                                                                               Risk DRAFT                                                                .
                                                                                                                                                                                  ,




CRMG FEED Layout




                                                                                                                                      -
                                                                                                                                      &-
                                                                                                                                       -
                                                                                                                                            STREAM HEADER

                                                                                                                                            COLUMN LIST
                                                                                                                                      C-- DATA ROW




1   ~actcategory
    Revenue
    Revenue
                   Ihadine
                   lother
                                          IDLY
                                          1 DLY
                                                     IX
                                                     (x
                                                                        IX <by Desk>
                                                                        IX <by k r k ,
                                                                                              IX (ie. 991
                                                                                              [ X ( i e 99)
                                                                                                                IX
                                                                                                                IX
                                                                                                                                                           COLUMN LIST

                                                                                                                                                           DATA ROW

    Revenue
    ~evenue
    nu"-
    Fancategory
    Risk
                   Tnding
                   other


                   Senritivily
                   ~DE~R
                                          MTO
                                          IMTD

                                          I~r?ige
                                          Business
                                                     X
                                                     Ix
                                                     ,,
                                                     .
                                                     Fact
                                                     X
                                                            ",.,"",,X



                                                     END OF DATA BLOCK
                                                                        X <by Desk,
                                                                        IX <by Desk,

                                                                        lorg~ag
                                                                        IX <by k r k s
                                                                                              X (i.c. 99)
                                                                                              IX (ie. 99)

                                                                                              l ~ e ~ a l ~ n t i t y Iwherc~anrgcd
                                                                                              IX (ie. 99)
                                                                                                                 X
                                                                                                                Ix


                                                                                                                IX                I
                                                                                                                                      -
                                                                                                                                      7
                                                                                                                                            TOTAL RISK CALC BY BUS1
                                                                                                                                                           COLUMN LIST
                                                                                                                                                           DATA ROW

                                                                                                                                            * Global FX Total preferred but ri:
                                                                        END OF FILE




Copyright @ 1997, by J P Morgan and Co.                                                  Page 22 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February l I, 1999
 JPMorgan                                          R ~ s k DMFT


RTSens Infrastructure requirement



To be determined   ....




Copyright O 1997, by JP Morgan and Co.   Page 23 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
                                                                                                Risk U M F T


 Risk Views (trader's profile)

 Users will have the ability to set up profiles (or risk views). A profile can contain the following criteria:
         Desk
         Book
         Product
         Currency

 Users may select one or many items from each of the criteria above

 Profile table
 c.
  ,n          XT---                     'P......           Description
 Idgrofile                              Int                Profile id
 Nm-profile                             Char (25)          Profile name
 Am-st-dt                               Int                ????
 Unt-st-dt                              Int                ????
 7   .   ..           .".               7

                                                           Default curve definition
                                                            .
                                                           . -
 Id-yld-crv-usd                     I Int              8
                                                       I USL: default curve
                                                              7
 -
 nt           kt                    I          ....-
                                        nateTime       , 1a ~ t
                                                       I --..update date
 Id-seq-upd                         I Int              I ????
 Id-ofc                             I Int              (   Office id (???)

 Profile-value table
I Column Name                       I Type             I Description
 Id-profile                         I Int              I Profile id
 Id-~YP
     ..                             I Char ( I )       I Profile type indicator (B-Book, D-Desk, O-Office,
                                                                            tit~,
                                                           ~ - ~ e g a ~ E nP-Product, C-currency)
 Id-value                               Int                Id of the id-typ
 Id-prd                                 Int                Product id
 Id-yc                                  Int                Yield curve id
 Id-ccy-alph                            Char (3)           I S 0 ccy code




 Copyright 0 1997, by JP Morgan and Co.                                               Page 24 of 28
 Author: Eun Ju Park
 Date Created: Nov. 20, 1999
 Last Modified: Febmary 1 1, 1999
 JPMorgan                                                                                 Risk DRAFT


Reference Data

All reference data will be loaded nightly (via batch process) from FXGDB.

Get STIRT and FX Book list
       Stored Procedure name:




        [QWGT~~L-
Get Product list
       Stored Procedure name:
       Output fields (also table layout)
               Field Name                Type                               Description
        Nm-prod                  I Char(25)         I Product name
                                 I                  I




Get Currency list
       Stored Procedure name:
       Output fields (also table layout)
              Field Name                 Type                               Description
        Id-ccy-is0                I Char (3)        I I S 0 currency code
                                 I                  I




Internal currency mapping table - this tables is needed to reference I S 0 ccy values (provided by
FXGDB) with the FXO curreny codes

Ccy-map table

               Field Name                 Type                            Description
          Id-ccy                     Char (3)           I S 0 ccy code
          Id-ccy-alias               Char (3)           FXO internal ccy code


Copyright Q 1997, by JP Morgan and Co                                          Page 25 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
                                                                                        Risk DRAFT




1. (4Dec98) Date roll - global database for NY, London and Singapore. When can we roll the date
    forward?
         conversation wlDean (7Dec98): We can assume to have one systems clock globally. It will
         most likely roll around 5pm EST. Pricing also has one business date, with the exception of
         NZD and TRL which rolls earlier. Dean did not see a problem of Am waiting if NY couldn't
         roll the date forward in case of a delay as long as it doesn't happen too often.
2. (4Dec98) Book sharing - how are books shared? Book-ccy per trader or another breakdown?
         Dean (7Dec98): We can assume only one trader owns a booWccy combination. He would like
         to he able to see DeaR, P/L and Position (to the less extent) information by trader.
3. (4Dec98) Risk Views - should 2 traders have the need to view the same calculated data at the same
    time even if the calculated data is old - meaning that there are new trades in the system from the time
    trader1 opened the view and trade2 opens the view.
         Dean (7Dec98): No need. They will just refresh it to get the latest information.
4. (4Dec98) Yield curve values - how often should the points on the yield curve be updated. At SOD,
    4:15. intradav
         Dean (7Dec98): For Phase I, once a day update is fine. We will need to follow up with the
         London folks to know when the rates get updated in FXO. For Phase 11, P/L, we will need to
         get the EOD rateslcuwes.
5 . (4Dec98) Drilldown facility in the risk view - to what level should risk display drilldown information
    (if any)?
         Dean (7Dec98): Nice to have. It will be useful hut not required for Phase I.
                                                     -
         Raquel(14Jan99): not needed for phase I London
6. (4Dec98) Multiple CCY in a single view - will trader need to see multiple ccy/products on a single
    view?
7. (4Dec98)           levels - what de@r levels are required?
8. (4Dec98) Global risk management. What does it mean?
         Dean (7Dec98): We can look at this in two ways. We can force the issue by having the
         traders hook all "like" trades into a single hook. We can't do this until TCM is fully
         deployed. The other is by being able to give a trader an option to pick a currency and set of
         books to search. For instance, she might he interested in seeing all HKD position in
         SingBook and NY-Book. The system should search all HKD positions in these books and
         report the numbers.
9. (4Dec98) Regarding EMU, how should the risk numbers be reported for in-currencies?
         Dean (7Dec98): If the trades were booked in a legacy currency, he would like to see the
         numbers as such. For Euro positions, however, he would like all legacy numbers to be
         included. For example, let's say we have three trades in the system:
         - FRF $100
         -    FRF $30
         -    EUR$50
         He would like to see $130 under FRF and $180 under EUR.

        Raquel(14Jan99)- will check with London Traders.
10. (17Dec98)The status of the following analytics is unknown. Need to coordinate with Julian Webb
                 Calculate price
                 Calculate sensitivity
                 Calculate M r
        (17Dec98) Sunil spoke with Neil - he is currently developing the calc price and calc
        sensitivity. No completion date communicated.


Copyright O 1997, by IP Morgan and Co.                                       Page 26 of 28
Author: Eun Ju Park
Date Created: Nov. 20, 1999
Last Modified: February 11, 1999
 11. (07Jan99)Mark Hayden - I think that it would also be useful to be ahle to store the copy of the Var file
 (3ME), dated, within FxUSION as this would allow NY to gain access to the London EOD report, should
 they need it.

 12. (07Jan99) Mark Hayden - FxUSION will be ahle to store an end-of-day rates scenario for London
          (Eun Ju's comments) Yes, FxUsion price and rate services will be storing official EOD
                                   -
          curves. In the interim for the initial RMM replacement, we will be sharing the rates from
          FXO, which I believe hold EOD rates but I will check on this.

 13. (07Jan99) We will need to display risk info in any output ccy.

 FxLib Questions to Neill(14, 15,16)

 14. (08Jan99) It is said that we will build an OIS curve for USD and cashswap and cash-future-swap
 curves for JPY.
          a) Which curve should we use as the 'discounter'/ 'irModel'as defined in the FXALib API doc for
          pricingltweaking this irsSwap?
          b) Will users ever request using a curve other than the cashswap and cashFutureSwap curves for
          tweaking?
          C) Under what circumstance will we have to define iborEsimator and onEstimator curves for
          computing pricelpresent value?

          If we need them, what types of curves are they, how should they be generated?

          d) As in c), same types of questions, hut w.r.t. FixingsDatabase;
          e) What curve should we use in order to tweak a USD IRS swap?

 15. (08Jan99) As there are about a dozen optional parameters for defining an FXALib IRSwap object, is
-.
 there a minimal set of parameters out of them for defining an FXALib IRSwap object in order for it to be
 tweakable?

 16. (081an99) Is there any dependency between the optional parameters for defining an FXALib
 instrument object, and the optional parameters for tweaking that object? Say for example, if that JPY
 irswap was defined with 'payFltMonts', 'payFixMonths', noatstub', etc, then in order to price it /compute
 its resent value, must one define iborEsimator and onEstimator curves while using the PV method?

 17. (20Jan99) Eun Ju - for the Totamotal (by ccy) tab in the risk screen - how should be display the
 benchmark rows, if different ccy have different benchmarks?

 For example if USD has benchmarks:

          SN, 7D, 1M, 3M, 6M, 1Y

 and JPY has benchmarks:

          SN, 14D, 1M, 3M, 6M. 9M, IY, 2Y, 3Y

 (25Jan99) Dean & Chris response - display the union of all YC points, show sensitivities in the
 buckets as they appear in the ccy screens. No need to re-tweak using the TOTAL YC points.


 Copyright 0 1997, by 1P Morgan and Co.                                         Page 27 of 28
 Author: Eun lu Park
 Date Created: Nov. 20, 1999
 Last Modified: February 11, 1999
     4.


PO             JPMorgan                                                                                 Risk DRAFT


          DEMO - Topics Discussed

          Jan 25,1999 -Demo to Dean Williams and Chris Miller

          1.   SOD position - would like to see positions broken down by SOD and intra-day. Issues with what is
               really SOD in the Global hook world.

               Chris Miller clarified -
                   I was referring to change in sensitivities due to new trades, not change in rates.
                   In other words, I would like SOD sens, new trades sens, and the total.

          2.   Discussed issue #17

               The Tota!fTotal (by ccy) tab in the risk screen - how should be display the benchmark rows, ifdifferent
               ccy have different benchmarks?

               For example i f U S 0 has benchmarks:

                        SN, 7 0 , IM, 3M, 6M, IY

               and JPY has benchmarks:

                   SN, 1 4 0 , IM, 3M, 6M. 9M, IY, 2Y, 3Y

               (25Jan99) Dean & Chris response - display the union of all YCpoints, show sensitivities in the
               buckets as they appear in the ccy screens. No need to re-tweak using the TOTAL YCpoints.

          3. De@r by trader, Dean would still like to see         by trader - not within the phase I scope, hut will
             start analysis. Nice to have ad-hoc deQr via the risk screen - will provide since it is fairly simple to
             calculate and display 1 & number in realtime.

          4.   Add rates to the risk screen

          5.   The need for drilldown was brought up - discussed the merits of drilldown to trade level - could not
               determine whether it was needed at this time. Position and Market value screen may he sufficient for
               Phase I.




          Copyright O 1997, by JP Morgan and Co.                                          Page 28 of 28
          Author: Eun Ju Park
          Date Created: Nov. 20, 1999
          Last Moditied: February 1I , 1999
                                         nk Corporation
                                   winni-
                rwlr        I-mawma

        OYI
                        I Defn: The Knock Out Option is a starhjud o p t i i that automablly
                                terminates if spot trades at or beyond a pmbtermined bvel
                                (the "outstrike") before maturity. Unlike the Kick Out Option,
                                spot travels in the wt-of-th-mony direction in order to
                                reach the wtstrike.


6"                      I Defn: The Kick Out Optii is a standard option h t automatiilly
                                   terminates if spot trades at or beyond a predetermined level
                                   (the 'outstrike') before maturity. Unlike the Knock Out Option,
                                                       m-
                                   spot travels in the l ty           direction in order to
                                   reach the wtstrike.


                            Defn: The Knock Out Forward is a standard forward that automatically
                                  terminates if spot trades at or beyond a predetermined level
                                  (the 'knockout price") before the cutoff &te (2 &ys prior to
                                  settlement).




                            Defn: The Double Knock Out Option is a standard option that
                                                                                       ihr
                                  automatiilly terminates if spot trades at or beyond .l . of
                                  two predetermined levels (the "outstrikes') before maturity.




                            Defn: The Lock Out pays out a fixed amount at maturity u k .
                                                                                      n.
                                  spot ever t n h s at or beyond a predetermined level (the
                                  "wtstrike') M o r e maturity.




                            Defn: The Doubk Lock Out pays out a fixed amount at maturity
                                  unk88 spot trades at o bqbyond oMmf of two pr&&.d
                                                          r
                                  levels (the 'wtstrikes') M o m maturity.
                        I                                                                            I
(c) Swiss Bank Corporation 1995
                                          nk Corporation
                                    vemmntrr
                            IC WI#YIY
                            m numum
          nl
                            Ddn: T h . K n o d r l n O p t i o n i s a r t m d . r d o p ( i o n t h . 1 ~
                                 ~intoe~ifrpottmdosatorkyonda
                                 pnd.1.nnilwdkvd(th.'me')bofofemrturlty.unlik.Nw,
    .a..---..                    KickInOption,tpottmvrkinth.out~dimctbn




    1
    11
                                 inw6rtoruchUmbWo.


                            Ddn: T h e K i c k I n O p ( i o n i r a r t m d . r d o @ i o n t h a t ~
                                 -ned-lpt-at~-a

    ....-
    *-         -                 pnd.t.nninsd kv.l (me 'inrtrik.') before malurny. Unllke me
                                 KnodcInOp(ion,rpottravdsinth.h4wmomydhctbn
                                 in w 6 r to reach the ininrtrik..

         Y
    ..........--------
                            Dofn: The Lock In pays out a fixd amount at maturity if and only
                                  ifspotmrtradesatorbeyonda~W(~
                                  'instrike') before maturity.




                            Dofn: T h e ~ O p t i o n g i v n t h . h . t h . ~
                                  ~buk.td~mnd.Clorur0th.rk.k.t
                            Lhfn: ThCompomdOptionisanop(iononart.nd.rdo@ion.
'-Oph                       Lhfn: TheClmrOplm~askndardop(ionN.wOmIh.
                                  hold.rto~onorbdontho'chooaod.lo'whother
                                  the option will k a call or a put.
I                                                                                                            I
(c) S    h Bank Corporation 1995

                                                     2
m i n a t e s if spot
          ] Swiss Bank Corporation
              24 Hour Exotic Options
         m,   Le4ea    m TmklnnlEW
                       Smac k.r
              )(lr(~on m
                        .,,,
                               ~ k i oa
                                m um a o
                                                   >




I                     I Defn: The Knock In Option is a standard option that automaticallv
                                 omes into existence if soot trades at or bevond
                                                                            a"
                                 redetermined level (the"instrikemlbefore ; t!
                                 k k In Option, spot travels
                               ..I order to reach-theinstrikb.

IGK IN

                                                                                   -
                       Defn: The Kick In Option is a standard option that automatically
                             comes into existence if spot trades at or beyond
                              redetermined level (the 'instrike') M o r e matul
                              nock In Option, spot trave'- :- "- '- "- ---
                              I order to reach the instrikc

    N
DCK I
                                     Statistics

               The Science of Summarizing and
                        Analyzing Data




                    Different Statistics Courses
          + How to be a statistics consumer
          + How to be a statistics producer
           + How to invent new statistics




f'roferrar Anron Bronn(Z1?\87%07?7      7/17/95
                                      This Statistics Course
          4 Statistics needed to understand
            subsequent courses
          4 Basic descriptive statistics

          + Distributions
          4 Association




Professor Aoron Brown(212)877-0727       7/17/95




                   Morgan Earnings Per Share




Proferror Anron Brown (?I?)877-0727      7/17/95
      Mean Earnings Per Share , .
+ $6.02+$7.80+ $7.95+ $5.80+ $5.21
 = $32.78
+ $32.78/5 = $6.556
 We write $6.56




    Median Earnings Per Share
+ Data: $6.02, $7.80, $7.95, $5.80, $5.21
+ Sorted: $5.21, $5.80, $6.02, $7.80, $7.95
+ Median: $5.21, $5.80, $6.02, $7.80, $7.95
+ Median is $6.02
                           Mean, Median, or Mode?
               Mean 1994 taxable income of class that entered Harvard in 1973:
               $2,075,000
           +   2,000 People in class
               Bill Gates: $2,500,000,000
           +   Steve Balmer: $500,000,000
               Eightothers:$1,000,000,000
               Rest of class: $150,000,000
               Total Income $4,150,000,000

               Median Income: $85,000
               Mode: S0,OOO to $75,000          &%&'       fl&mi*4db.)
Prolerror Aaron Brown (212)877-0727   7/17/95




                                 Can We Rely on Data?
           + Accounting Numbers (NO+%                                 %
                                                                      c)




           .
             Asset Prices Idf: ~ ~ q ~ d . &
           + Government Statistics [@c           + . d
                                                  +A )  M
             Polls op\uis*$8 b&'"g $5.
             Analytic Numbers (IlkVo\.&\>b& lxnn &,
           + Expert Estimates
             Unidentified or unknown source
        Anron Brown(?12)877-0727
Profcr~or                             7/17/95
                                      Standard Deviation
          + Mean is $6.56
          + ($6.02-$6.56)2+ ($7.80 -$6.56)'  + $$7.95 -$6.56)'
            + ($5.80 -$6.5612 + ( $5.21 -$6.56)
          + = ($0.54)~ $1.24 + $1.39~+ ($0.76)~ ($1.35)~
                       +                            +
          + = 0.29 + 1.54 + 1.93 + 0.58 + 1.82
          + = 6.16
          + 6.1615 = 1.23
                                     41.23 = $1.11
l'rolcwor Aaron Brown(212) 87%6727     7/17/95




           + Clear Financial Registers
           + Enter Data
           + Ask for statistics
                                              HP12C: Mean



          + Clear Registers f, SST
           + Enter Data: 1,         C+, 2, C+, 3, .Z+
           + Press g 0

Professor Aaron Bro*m(212)87%0727   7/17/95




                   HPl2C: Standard Deviation



           + Clear Registers f, SST
           + Enter Data: 1, C+, 2,Z+,            3, C+
           + Press g . (gives n-1 form)
                                       Excel (one variable)
           + Enter Data, say cells A1:A5
             Mean: =Average(Al:A5)
           + Standard Deviation: =StDevP(Al:A5)
             for n form and =StDev(Al:A5)for n-1
           + Many other useful functions


                        &
Ptoferror Aaron Brown (212) 877-0727    7/17/95




                                  Quarterly Returns from
                                           Morgan Stock

             -0.92%,-6.38%,17.15%, 21.15%        -%= 3,2l@   %
           + Compute Mean, Median, Standard           b     \      9"
             Deviation, and 68%and 95%confidence -
             intervals assuming Normal distribution    = \1    %
                                                              @9




Professor Aaron B1own(212)871-0727      7/17/95
                                               Histogram




Professor Aaron Brown(212)877-0727   7/17/95




                              Numbers per Employee
          Year                 Net Earnings Compensation
          1994                 $71,240      $129,991
          1993                 $104,390     $146,186




           Compute Means and Standard Deviations
Professor Aaron Brown(212l877-0727   7/17/95

                                               1241 333,
                                  Association Measures
          Year                 Net Earnings      Compensation
          1994                 $71,240           $129,991
          1993                 $104,390          $146,186
          1992                 $110,106          $120,963
          1991                 $86,017           $113,638
          1990                 $77,498           $110,888
          Mean                 $89,850           $124,333
          St.Dev.              $%+%8-lbl%'$7     $l%57% 14)2%3
           Compute Correlation and Betas
Profearor Aaron Brown (212)87/-0727    7/17/95




                                      HP7 2C: Correlation
                                                   Coefficient



           + Clear Registers f, SST
           + Enter Data: 1,1, C+,2,2, C+,3,3, E+
           + Press g 2
           + press x>cy 0.i 3b!3 = f l y r ~
                                                   HP7 2C: Beta



           + Clear Registers f, SST
           + Enter Data: 1,1, E+, 2,2, E+, 3,3, .E+
           +Press1,g2,x><y,Rl,O,g2,x~y,Rl ,-


Proferror Aaron Brown (212)877-0727      7/17/95




                                       Excel (two variables)
             Enter data, say in Al:A5 and Bl:B5
           + Correlation: =Correl(Al:A5,Bl:B5)
           + Beta: = LinEst(Al:A5,Bl:B5) (A has
             dependent variable)
             LinEst Function can take more
             arguments to do a complete regression
             Excel can handle more variables

Profesror Aaron Brow," (212)877-0727     7/37/95
                                                        Case
          1.Italoil asks the bank for a statistical
              analysis of its monthly profit margin.
              Compute relevant statistics, draw a
              histogram, and set up confidence
              intervals for next month's profit.




Profesror Aaron Brown (212)877-0727    7/17/95




                                                 One Answer
           J Italoil's monthly profit margin is highly
                  variable, ranging from a high of $45,400 to a
                  low of ($22,170).The mean profit is $10,638
                  but the standard deviation is $14,533. The fact
                  that the standard deviation is greater than the
                  mean implies that there is a substantial
                  chance of a negative return in any month.
                  There appears to be approximately a 23% &I        VL
                  chance that Italoil will lose money in any
                  month.
                                                              <
                                                              c a    4
Professor Aaron   Brown(212)877-0727   7/17/95
                                                             +)-
                                                       One Answer
                  J   The correlation coefficient of Expenses with
                      the Lira exchange rate is -0.998, the
                      correlation coefficient of Revenue with next
                      month's exchange rate is 0.744 and with last
                      month's exchange rate is 0.936. This means
                      that Expenses decline and Revenue increases
                      as the Lira weakens and that the relation,

-,&.
4&&3
  2
   0~                 especially the Expense relation, is almost
                      perfectly predictable. This provides Italoil
                      with something of a natural hedge.
        Profc%ror Aaron B1orn(Z12)87%47?7    7/17/95




                                                             Case
                  3. How would you use the results of (2) to
                      set up a hedging strategy for Italoil?




        Proferror Anron Rronm(212)87%-0727   7/17/95
                                                  Case
         2. Italoil then asks how the profit depends
           on the exchange rate. Does it depend on
           concurrent exchange rates or rates of
           past or future months? Compute
           relevant statistics.




Frofeuor Arron Brown(21?)8776727   7/17/95




                                             One Answer
                                                   .
          J   Italoil's profits are dependent on the
              Lira/US$ exchange rate in two ways.
              Their expenses are in Lira so these are
              completely dependent on the current
              exchange rate. The US$ revenues are
              statistically related to both the previous
              month's and the next month's exchange
              rate.
                                               One Answer
         4 To put    together a good hedge we use
             the p's of the currency with the
             revenue. If Italoil buys 709,957,625 Lira
             the month before delivery and
             310,140,939 Lira the month after
             delivery (paying 1,000,000,000 in the
             delivery month) they will be almost
             perfectly hedged.




                                                     Case
          4. Analyze the variability of monthly
            profitability after your hedging strategy
            from (3) is put into place.




Proferror Anron Brown(2121877-0727   7/17/95
                                                One Answer
          J   Their mean profit will increase over
              18%,to $12,590 while the standard
              deviation will fall to $558. With this
              hedge in place, Italoil can be confident
              of steady profits.




Professor Aaron Brown (212)877-0727   7/17/95
n
\   '
        COMPUTER WORKSHOP
        Projecting a spreadsheet
                                                                                                 l
                                                                                                 m
        Spreadsheets at Morgan
        Spreadsheet skills are an important part of your toolkit as a Morgan employee. Morgan uses spreadsheets
        for many purposes, such as analyzing a client company's credit needs and debt capacity, tracking costs,
        and projecting budgets. No matter what your job is at Morgan, the chances are good that at some point,
        you will need to either use or create a spreadsheet.


        Morgan spreadsheet standards
        An important aspect of spreadsheet use at Morgan is that spreadslieets are usual& designed to be used
        by more [Itan oneperson. You may "inherit" another employee's spreadsheet, or you may need to pass a
        spreadsheet to someone in another department. Because spreadsheets are usually common property, it's
        important that your spreadsheet makes sense to other people and is well documented. This workshop will
        explain the most helpful and important standards that Morgan wants to see in a spreadsheet.


        No accounting needed!
        The examples you will work with are based on simplified financial statements (Income Statement and
        Balance Sheet). They provide a good exercise for you to practice spreadsheet skills, including the
        documentation and layout styles Morgan prefers. You do not need to understand accounting to do the
        sprearlsheefs.




        JPM Core Program                                Page 1                                 @ 1995 JPMorgan
          WORKSHOP 1                                                              Projecting a spreadsheet


'         Projection
          Using the spreadsheet to see the future
           One of the most important ways spreadsheets are used at Morgan is in making predictions @rejections or
          forecasts) about future expenses or financing needs. Whether you use Excel to estimate a client
           company's financing needs or your own project's budget requirements, projections follow the same
           pattern of construction.


          The two key formulas for projections
          All projections are based on two key formulas. If you can use these formulas, you can construct a
          projection.




                                   decreases by some growth factor:
                                   "Sales will rise 5% per year."
                                   "We will reduce advertising costs

                                                                          Last year's sales: 5000
                                                                          Growth factor:     5%




                                   fraction of another line item:
                                   "COGS will be 80% of sales."           Income before taxes:      1200




           What about the assumptions?
           Notice that the projection formulas refer to growth factors or percentages of other items. These are
           called assumptions and are your best guess about future conditions ("I thinksalary expenses will rise by
           5% over last year's salary expenses"; "I assume that taxes w l remain at the samepercentage of income
                                                                         il
           as last year.'>


           Count on it: your assumptions will change!
    n
    ,>.
           At Morgan, your assumptions go in a special area called the assumption block. The material on the next
           page explains more about assumption blocks. You will construct an assumption block in this workshop.


           JPM Core Program                                  Page 2                                 o 1995 JPMorgan
WORKSHOP I                                                              Projecting a spreadsheet


                          REFERENCE: Assumption Blocks
   All forecasts or projections into the future are based on assumptions. To understand a spreadsheet,
   you must see and understand the assumptions on which it was built.

   An assumption block is a separate section of the spreadsheet that contains the assumptions you have
   made in building the spreadsheet. It should includeall your assumptions, even those that seem
   obvious.

   Theformulas in the spreadsheet must be linked to the data in the assumption block.)
   Example: Suppose that you are calculating your department's budget needs for the next year. You
             expect your equipment expenses to grow by 5%. You should place the 5% growth rate
             in the assumption block and label it clearly. Your formula to calculate equipment
             expense must refer to the cell in the assumption block that contains the 5% growth rate.




                           Figure 1. Use of a s s u m p t i o n s in formulas


                    Why assumption b l o c k s are important at M o r g a n
   Assumptions should be documented and placed in their own section for three important reasons:

    'Documentatioti You and others can easily see the assumptions that were used in building the
                    projection. Good documentation is crucial in a company like Morgan, where
                    your spreadsheet may be passed to another person, or where you may receive a
                    spreadslieet from someone else.

     Flexibility1       One rule of spreadsheets at Morgan: tlrey will clrange. Your initial assumptions
                        may change many times. If the spreadsheet is well constructed, you can change
                        data in the assumption block and see the new results immediately.

    ?Accuracy *         If you have buried your assumptions in formulas instead of placing them in an
                        assumption block, you may forget to change an assumption in an obscure
                        formula. Then your spreadsheet will no longer be accurate.




JPM Core Program                                 Page 3                                 O 1995 JPMorgan
WORKSHOP 1                                                                 Projecting a spreadsheet




                         REFERENCE: How to Create a Projection

 1. Type the labels in Column A.


12. Widen Column A to fit the labels.
                                                                                                             I
3. Type the numerical data for the base period in Column B.


4. Create an assumption block. Include your assumptions about the growth of any item. If the cost of
   one item depends on the cost of some other item, calculate the fraction and use it as your assumption
   for future costs.


 5. Set number formats as needed (currency, percent, date).


6 . Create formulas for the projection for Period 1 (first period after your base period data). Base
    formulas on assumptions in assumption block.



I7. Make your formulas copyable. Use Absolute Reference as necessary.
                                                                                                             I
    8. Copy Year 1 formulas across all years of the projection.


19. Add cosmetics. Set a time limit for this activity, which can waste hours of your time.
               Insert rows (only ifnecessary; use sparingly)
                                                                                                             I
               Range name sections
               Add documentation




    JPM Core Program                                 Page 4                                o 1995 JPMorgan
WORKSHOP 1                                                                 Projecting a spreadsheet



        REFERENCE: Spreadsheet layout and formatting conventions

            Observe these conventions when you design a spreadsheet at Morgan:

      Do not leave blank columns between columns of data or between labels and number data.

      Keep blank rows to a minimum.

 **Donot create subtotals in separate columns. All the data belonging to one year should stay in the
   same column to save room on printouts and make copying more accurate.

      Remember that most people will be looking at printouts. Keep your columns of data narrow to fit
      more on each page.

 0.   If your spreadsheet is large, place each major section of your spreadsheet on a separate worksheet.
      Document the sections and their locations on the first worksheet in your workbook.

 0-   For large spreadsheets, design an opening screen that includes the following:
            The name of the spreadsheet and its purpose or scope
            Your name and phone number
            Date of last revision
            List of the major sections in the spreadsheet and a "map" of how to get to them

 0,   Locate your cursor at the opening screen before you make your final save.

      Use the following techniques to draw attention to important data or information, but use flrem
      sparingly:
            Italics
            Bold
            Shading
            Boxes

:.Do not surround most of your data with boxes or grid lines.;Keep       it simple and clear.

 *'Limit the number of fonts to no more than 2. Always in style at Morgan:
         Helvetica, Arial, or MS Sans Serif
         Times Roman

      Avoid flashy colors, ornate type styles, too many lines, boxes andpanerns. Simple, clear design is
      best.




JPM Core Program                                    Page 5                                    O 1995 JPMorgan
WORKSHOP I                                                                    Projecting a spreadsheet




     DATA FOR KEYES MANUFACTURING CORPORATION
              Keyes Manufacturing Corporation commences operations on January 1. The accounting
              records of Keyes Manufacturing Corporation as of December 31 (same year) reveal the
              following:




              Income Statement Items
              Income
              Sales Revenue .........................              $2,000
              Cost of Goods Sold .................                 (1.200)
              Gross Margin ........................                   800

              Erpenses
              Selling Expenses .....................
              Administrative Expenses .........
              Operating Expenses ................
              Interest Expense ......................
              Total Expenses ........................
              Net Income before Taxes ........
              Income Tax Expense ...............
              Net Income ..............................




                                                NOTES
              This is a simplified Income Statement. It does not contain all the line items or subtotals
              you would find in a real Income Statement.

              All amounts are abbreviated into thousands (actual Sales are 2,000,000).
                            -.                            -   <
              Notice that negative numbers are shown in pa~enthea (a standard accounting practice).
              Make sure the negative numbers on your spreadsheet are formatted with parentheses.




JPM Core Program                                          Page 6                                 Q 1995 JPMorgan
      WORKSHOP 1                                                              Projecting a spreadsheet


"r\   PROBLEM 1                               Create a projection
      In this workshop, you will create a projection for Keyes Manufacturing Corporation, using the data on
      Page 6. Your job is to use the data and the reference information on Pages 2 - 5 to create an income
      statement for Keyes and to project its performance 5 years into the future. Follow the steps below,
      referring to the reference guides on Page 4 as necessary:

      Step 1. Open the file KEYES on your diskette. Skip down about 10 - 12 rows. Input the data and label it
              "Year 0." Create an Income Statement based on this data. (Projection Reference, Steps I - 3)


      Step 2. Using the percentage of sales method, derive the following percentages for Year 0 and put them
              in an assumption block. Start the assumption block in Row 3. (Projection Reference, Steps 4 - 5)

                      Cost of Goods Sold              ?% of Sales
                      Selling Expenses                ?% of Sales
                      Administrative Expenses         ?% of Sales


      Step 3. Assume that Interest Expense will remain at the same dollar amount (not the same percentage)
              for each of the following five years. (Projection Reference, Steps 4 - 5)


n
.-
 ..
      Step 4. Assume that the ratio of tax payments to net income before taxes will remain the same as in
              Year 0 throughout the projection. (Projection Reference, Steps 4 - 5)


      Step 5. Assume that sales will go up 10% per year for each of the following 5 years. Project Keyes
              Corporation's income statement for 5 years. (Projection Reference, Steps 6 - 8)


      Step 6. Add simple documentation at the top of the spreadsheet. It should include the name of the
              company, the financial statements included, and your name. Check the spreadsheet for
              readability and clarity. Made adjustments if necessary. Spendonly a few moments on tlzk task
              (Projection Reference, Siep 9)


      Step 7. Save the spreadsheet on your diskette as KEYESI.


      Step 8. Print the spreadsheet. Include a header and footer that contain the following:
              Header:      Your name                   Name oftlie sprearlsheet                Today's date
              Footer:      WORKSHOP 1                                                          The time



                   HINT    Go to the File Page Setup command and click on the HeaderIFooter tab.
r\
1-


      JPM Core Program                                 Page 7                                  @ 1995 JPMorgan
    WORKSHOP I                                                                Projecting a spreadsheet


P   PROBLEM 2                              Refine your projection

    Now that you've created a basic projection, the next step is to refine it. After doing some research on
    Keyes, you make several discoveries that change some of your assumptions:


       A.   After discovering a schedule of planned new product releases, you revise your estimates of sales
            growth. You now assume that sales will rise according to the following table:

                                                Year 1

                                                Year 2          10%

                                                Year 3          11%

                                                Year 4          12%

                                                Year 5



       B. New tax laws mean that in Year 2 tax expense will rise to 34% ofNet Income Before Taxes and
          will remain at this level throughout the rest of the projection.
0
       C.   Financing needs will rise due to capital demands brought about by the new product releases.
            You assume that interest expense will rise by a factor of 50%peryear, starting in Year 2 and
            continuing through the rest of the projection's life.




    Step 1. Revise your KEYESI projection to reflect the new information. Be sure to revise the assumption
            block.



    Step 2. Save the revised spreadsheet on your diskette as KEYES2.



    Step 3. Print the spreadsheet. Revise the header's title to reflect the changes you've made.




    JPM Core Program                                   Page 8                                 O 1995 JPMorgan
     WORKSHOP 1                                                                Projecting a spreadsheet

                                          COST REDUCTIONS

     In your research, you discover that a "leaner, meaner" new CEO promises to enforce drastic cost-control
     measures. Further reading convinces you that the CEO will be able to make the following reductions in
     costs:




                                                                          r 5 will remain at
                                                                       ear4 percentage)




     In fact, a very attractive bonus will reward the new CEO for achieving these cost reductions.


     Step 1. Refine KEYESZ to reflect the changes listed above. Document all assumptions in the assumption
r\
..
             block.


     Step 2. Save the revised spreadsheet on your floppy disk as KEYES3.


     Step 3. Print the spreadsheet. Revise the header appropriately.




     JPM Core Program                                  Page 9                                  @ 1995 JPMorgan
         WORKSHOP 1                                                               Projecting a spreadsheet


                                   OPTIONAL: The KEYES Bonus Plan

         If the new CEO actually achieves these ambitious cost reductions, the board of directors certainly
         believes that such an accomplishment warrants a bonus. They have negotiated a bonus criterion that is a
         function of both reduced costs and increased sales, the exact areas where the new CEO is expected to
         focus attention. Your previous analyses have projected both the sales revenues and reductions in
         administrative overhead. Now it's time to project the bonus.

              I
         Pl~ase :        If the ratio of Total Sales Expenses and Administration (GS&A) to Total Sales is less
                         than 20% of sales, hen the bonus will be 1%of the company's net income.

         Step 1: Use KEYES3 for this analysis.

         Step 2. Add the bonus assumptions to your assumption block:

                         Manaaement Bonus Analvsis
                         Criterion: GSAlSales less than:
                         Bonus.factor:

         Step 3: In the next row of your assumption block, use an IF function to show whether the CEO qualifies
                 for a bonus. The IF function should answer YES or NO. Copy your function across to all years.
PI
,.
 :   -   Step 4. In the next row, calculate the bonus amount that the CEO will receive. It should appear in only
                 those years when the CEO qualifies for it.

         Step 5. Save the spreadsheet as KEYBONUS and print a copy of your analyses.




                 See nextpage for information about the IF function.




         JPM Core Program                                  Page 10                                O 1995 JPMorgan
WORKSHOP 1                                                       Projecting a spreadsheet


                    REFERENCE:              The IF Function
The IF Function         The IF function is valuable for automating certain types of varying
                        calculations. You can use IF to analyze changing variables and make
                        decisions based on preset criteria.
                        Example: Ifsales meet or exceed tlte target, calculate a 10% bonus.

                        An IF statement will allow the spreadsheet to check the sales figure
                        against the target and make a decision about the bonus.

                        The Excel IF function has the following form:
                                =IF(condition,true,false)

Arguments               The IF function contains three arguments:
                        Condition       The statement you are analyzing.
                                        Example: Sales meet or exceed the target

                        True            What the spreadsheet should do if the condition is met.
                                        Example: Place (10% times salary) in the cell

                        False           What the spreadsheet should do if the condition is not
                                        met.
                                        Example: Put 0 in the cell

                        Example: IF(Sales>5000O,Salaly'.l,O)
                        The example will calculate 10% of the current salary value and place it
                        in the cell containing the IF function.

Words in IF Functions   You can use either values or words in the True and False arguments. If
                        you want the IF statement to use words, you must enclose the words in
                        quotes.
                           Example: IF(SALES>=5000OO,"YES'~"NO'~
                        Notice that the commas separating the arguments go outside the quotes.




JPM Core Program                         Page 11                                 O 1995 JPMorgan
     WORKSHOP 1                                                                        Projecting a spreadsheet


c
'                          OPTIONAL: The KEYES Bonus Challenge
     Suppose the CEO negotiates a more favorable bonus that provides additional compensation if better
     reductions are achieved.

     Phase 2 Bonus Plan:     Ifthe ratio of Total Sales Expenses andAdministration (GS&A) to Total Sales
                                is less than 19% then the bonus will increase to 1.5% of the company's net
                                income.

     You now have three possible outcomes instead of two:

                                 CONDITION                                       OUTCOME
                    Ratio of GS&A to Sales >= 20%                       No bonus
                    Ratio of GS&A to Sales < 20% and > 19%              Bonus of 1% of Net Income
                    Ratio of GS&A to Sales < 19%                        Bonus of 1.5% of Net Income


     However, the IF function allows for only two outcomes. What can you do? Try to figure the logic out on
     your own or look at the hint below.'


     Step 1. Add new entries to your assumption block to show the Phase 2 criterion and bonus factor.

r\
.-   Step 2. Modify the IF functions to incorporate this new aspect of the bonus calculations.

     Step 3. Save the spreadsheet again as KEYCHALL and print a copy of your analysis.




                            REFERENCE: Table of Logical Operators
                      I     =       I Eaual             I     <>      I Not eaual to               I
                            >.      I Greater than      I     >=      I Greater than or equal to
                            <       I Less than         I     <=      I Less than or equal to




r\     HINT: Nest one IF statement inside another. =IF(condition, true,lF(condition, true, false)


     JPM Core Program                                       Page 12                                Q 1995 JPMorgan
-       COMPUTER ASSIGNMENT
    C   Creating a Morgan spreadsheet


        On your own
        In this assignment, you will use your projection skills to build a forecast of expenses and income for a
        new company called Chemalite. You will create an assumption block and build the spreadsheet with it.
        Read the CHEMALITE case, below. In this case, you will project first-year performance for a new
        company. The assumptions are based on best-guess estimates and hope, since the company has no
        historical data.



                                             The CHEMALITE Case
        Bennett Alexander, a consulting chemical engineer, founded a corporation in January 1985 to produce
        and market one of his inventions. The company's only product was a small plastic cylinder filled with
        chemicals. When activated, the chemicals gave off a bright yellow-green light, hence the product (and
        company) name: Chemalite.

        Using the 1985 Income Statement and Balance Sheet information in Exhibits I and 11, Bennett created a
        complete balance sheet and income statement on his computer. He based his statements on the following
0   >
        assumptions:


                      USEFUL LIVES:
                               Patent and startup costs                    5 years
                               Machinery                                   10 years

                      CORPORATE INCOME TAX RATE                     40% of earnings before taxes




        NOTE: This case uses base data and background informationfrom David A. Wilson's case, Chemalite, Inc., which
              Harvard Business School published in 1976 (Case #I 77-078). The Computer Projection Case was written
              by Scott A. Williams, copyright 1987 by J.P.Morgan. The case is designed to demonstratefeatures of
              computer modeling, not accounting. Its accounting assumptiom have been simplified and should not be
              taken as a realistic model of current accounting practices.




        J P M Core Program                                 Page 1                                  Q 1995 JPMorgan
     COMPUTER ASSIGNMENT 1                                             Projecting a spreadsheet

-P   Exhibit I

                                          lncome Statement
                                For the year ended December 3 ' 1985
                                                             1,


     Income
     Sales                                                  754,500
     Cost of Goods Sold                                   (625,000)
       Gross Margin                                        calculate      (Subtract COGS from Sales)

     Expenses
     Selling. General, and Administrative Expenses
      Advertising Expense                                  (22,500)
      R&D Expense (prototype)                               (23,750)
      Depreciation & Amortization
        Patent and startup costs depreciation    from Balance Sheet       (Use a cell reference to this item
                                                                          on Balance Sheet)
       Machinery amortization                   from Balance Sheet        (Use a cell reference to this item
                                                                          on Balance Sheet)
          Total Depreciation & Amortization               calculate       (Add)
         Operating Expense                                calculate       (Add all expenses to this point)

r\   Interest Expense

     lncome before Taxes                                   calculate      (Gross Margin minus interest
                                                                          exp. and operating exp)
     lncome Tax Expense                                    calculate      (Income tax rate times Income
                                                                          before Taxes

        Net Income                                         calculate




                           NOTE: Net income for 1985should equal $20,850.




     JPM Core Program                                Page 2                               o 1995 JPMorgan
     COMPUTER ASSIGNMENT I                                            Projecting a spreadsheet

r'   Exhibit II

                                             Balance Sheet
                                           December 31,1985


     ASSETS
     Cash                                                 113,000
     Accounts Receivable                                   69.500
     Inventory                                             55,000
     Patent and startup costs                             132,500
      Amortization (this year)                           calculate        (Divide costs by no. of years)
      Accumulated. Amortization                          calculate                  N
                                                                          (Total of a years' amortization)
       Net Patent                                        calculate        (Subtract Accum. Amort from
                                                                          Patent & S.U. costs)
     Machinery                                            212.500
      Depreciation                                       calculate        (Divide machinery cost by no. of
                                                                          years)
      Accumulated. Depreciation                          calculate        (Total of all years' depreciation)
      Net Machinery                                      calculate        (Subtract Accum. Depr. from
                                                                          Machinery cost)

                                                         calculate



     LIABILITIES AND EQUITY
     Total Liabilities                                            0
     Common Stock                                           500,000
     Retained Earnings                                            0       (Net income from last year)

     Total Liabilities 8 Equity                          calculate        (Add)




                                  NOTES:   Total Assets should equal $534,750.

                                           Total Liabilities 8 Equity should equal Total Assets.




     JPM Core Program                              Page 3                                 O 1995 JPMorgan
     COMPUTER ASSIGNMENT I                                             Projecting a spreadsheet

r'   PART I:Complete the historical data

     Step 1. Open the file CHEM and examine it. The file is on your computer files diskette. The labels and
             the numbers in Exhibits I and I1 have already been input for you.

             NOTE: Please do not insert or delete rows and columns! Workfrom yourfloppy disk!


     Step 2. Fill out the 1985 data in the assumption block. Then complete the income statement and the
             balance sheet, using the information found on Pages 3 - 4.

             Note: Be sure to link formulas to the information in the assumption block.


     Step 3. Save the file on your diskette as CHEMHlST,




     JPM Core Program                                 Page 4                                 O 1995 JPMorgan
     COMPUTER ASSIGNMENT I                                               Projecting a spreadsheet

C\   PART 2: Project the Income Statement

     After reviewing product sales forecasts, Bennett made the following assumptions about 1986 and 1987:




                                                            $5,000    each year




     Step 1. Fill in the rest of the assumption block in the CHEMHIST file.


     Step 2. Project Chemalite's income statement for 1986 and 1987, using the assumptions.

                                                   Helpful hints
     I    Format negative numbers (expenses) so that they appear in parentheses. Be careful! Numbers may
                    -                                       - -

          not appear as negatives in the assumptions table above.
       0. Accumulated depreciation: Create a formula to calculate accumulated depreciation (this year's
          depreciation plus last year's accumulated depreciation). Use the same method to calculate
          accumulated amortization.
       *. Retained earnings: This year's net income plus last year's retained earnings.
          Make all your formulas copyable.


     Step 3. Save the completed projection on your floppy disk as CHEMPROJ.


      Step 4. Print the completed projection. Include a header that contains your name and today's date.


      Step 5. Click the Click here when finished button and follow the instructions on the screen. You will
              receive a printout. Be sure to turn it in with the rest of the assignment even if it looks odd.


                                                 Turn in:

                                  The diskette with your name on it

                                  The Chem printout produced by the SAVE and
                                  PRINT button

                                  The CHEMPROJ printout




      JPM Core Program                                 Page 5                                  o 1995 JPMorgan
     COMPUTER ASSIGNMENT
r\   Creating a Morgan spreadsheet


     On your own
     In this assignment, you will use your projection skills to build a forecast of expenses and income for a
     new company called Chemalite. You will create an assumption block and build the spreadsheet with it.
     Read the CHEMALITE case, below. In this case, you will project first-year performance for a new
     company. The assumptions are based on best-guess estimates and hope, since the company has no
     historical data.



                                          The CHEMALlTE Case
     Bennett Alexander, a consulting chemical engineer, founded a corporation in January 1985 to produce
     and market one of his inventions. The company's only product was a small plastic cylinder filled with
     chemicals. When activated, the chemicals gave off a bright yellow-green light, hence the product (and
     company) name: Chemalite.

     Using the 1985 Income Statement and Balance Sheet information in Exhibits I and 11, Bennett created a
     complete balance sheet and income statement on his computer. He based his statements on the following
r\
.    assumptions:


                   USEFUL LIVES:
                            Patent and startup costs                     5 years
                            Machinery                                   10 years

                   CORPORATE INCOME TAX RATE                     40% of earnings before taxes




     NOTE: This case uses base data and background informationfrom David A. Wilson's case, Chemalite, Inc., which
           Harvard Business School published in I976 (Case #177-078). The Computer Projection Case was written
           by Scott A. Williams, copyright 1987 by J.P.Morgan. The case is designed to demonstratefeatures of
           computer modeling, not accounting. Its accounting assumptions have been simplified and should not be
           taken as a realistic model of current accountingpracfices.




     JPM Core Program                                   Page 1                                  O 1995 JPMorgan
     COMPUTER ASSIGNMENT 1                                            Projecting a spreadsheet

0
1
     Exhibit I

                                           lncome Statement
                                 For the year ended December 31,1985


     Income
     Sales                                                 754,500
     Cost of Goods Sold                                  (625,000)
       Gross Margin                                       calculate      (Subtract COGS from Sales)

     Expenses
     Selling, General, and Administrative Expenses
      Advertising Expense                                  (22,500)
      R&D Expense (prototype)                              (23,750)
      Depreciation & Amortization
        Patent and startup costs depreciation    from Balance Sheet      (Use a cell reference to this item
                                                                         on Balance Sheet)
        Machinery amortization                 from Balance Sheet        (Use a cell reference to this item
                                                                         on Balance Sheet)
          Total Depreciation & Amortization               calculate      (Add)
         Operating Expense                                calculate      (Add a// expenses to this point)

.
r\   Interest Expense

     Income before Taxes                                  calculate      (Gross Margin minus interest
                                                                         exp. and operating exp)
     Income Tax Expense                                   calculate      (Income tax rate times lncome
                                                                         before Taxes

        Net Income                                        calculate




                           NOTE: Net income for 1985 s h o u l d equal 520,850.




     JPM Core Program                               Page 2                               0 1995 JPMorgan
     COMPUTER ASSIGNMENT I                                            Projecting a spreadsheet

p    Exhibit II

                                             Balance Sheet
                                           December 31,1985


     ASSETS
     Cash                                                 113,000
     Accounts Receivable                                   69,500
     Inventory                                             55,000
     Patent and startup costs                             132,500
      Amortization (this year)                           calculate       (Divide costs by no. of years)
      Accumulated. Amortization                          calculate       (Total of all years' amo~tization)
       Net Patent                                        calculate       (Subtract Accum. Amort. from
                                                                         Patent & S. U. costs)
     Machinery                                            212.500
      Depreciation                                       calculate       (Divide machinery cost by no. of
                                                                         years)
      Accumulated. Depreciation                          calculate       (Total of all years' depreciation)
      Net Machinery                                      calculate       (Subtract Accum. Depr. from
                                                                         Machinery cost)

     Total Assets                                        calculate        (Add)
r\
     LIABILITIES AND EQUITY
     Total Liabilities                                            0
     Common Stock                                           500,000
     Retained Earnings                                            0       (Net income from last year)

     Total Liabilities 81Equity                          calculate        (Add)




                                  NOTES:   Total Assets should equal $534,750.

                                           Total Liabilities & Equity should equal Total Assets.




     JPM Core Program                              Page 3                                 O 1995 JPMorgan
     COMPUTER ASSIGNMENT 1                                              Projecting a spreadsheet

e\   P A N I:Complete the historical data

     Step 1. Open the file CHEM and examine it. The file is on your computer files diskette. The labels and
             the numbers in Exhibits I and I1 have already been input for you.

             NOTE: Please do not insert or delete rows and columns! Workfrom yourfloppy disk!


     Step 2. Fill out the 1985 data in the assumption block. Then complete the income statement and the
             balance sheet, using the information found on Pages 3 - 4.

             Note: Be sure lo linkformulas to the information in the assumption block.


     Step 3. Save the file on your diskette as CHEMHIST




     JPM Core Program                                 Page 4                                 o 1995 JPMorgan
         COMPUTER ASSIGNMENT I                                                 Projecting a spreadsheet


'\ ,     PART 2: Project the Income Statement

         After reviewing product sales forecasts, Bennett made the following assumptions about 1986 and 1987:




         Step 1. Fill in the rest of the assumption block in the CHEMHIST file.


         Step 2. Project Chemalite's income statement for 1986 and 1987, using the assumptions.

                                                       Helpful hints
         I*- negative numbers (expenses) so that they appear in parentheses. Be careful! Numbers may
           Format                                                ~   ~




              not appear as negatives in tlie assumptions table above.
              Accumulated depreciation: Create a formula to calculate accumulated depreciation (this year's
              depreciation plus last year's accumulated depreciation). Use the same method to calculate
p;            accumulated amortization.
y   .P        Retained earnings: This year's net income plus last year's retained earnings.
         0.   Make all your formulas copyable.


         Step 3. Save the completed projection on your floppy disk as CHEMPROJ.


         Step 4. Print the completed projection. Include a header that contains your name and today's date


          Step 5. Click the Click here when finished button and follow the instructions on the screen. You will
                  receive a printout. Be sure to turn it in with tlie rest of tlie assignment even if it looks odd.



                                                      Turn in:

                                       The diskette wit11your name on it

                                       The Chem printout produced by the SAVEand
                                       PRINT button

                                       The CHEMPROJ printout




          JPM Core Program                                  Page 5                                  0 1995 JPMorgan
1. Think: w * m k r i l w k r o n o n 8 , n o t y o u n
      Wbdopuwrtm*?                   Whnrcrimdoywwmt~?




3. Dznnh.rtndrrst.bywhiehtod.(huthrprobi.nrmldto~ttu.dutian
    Tmn ufh isuc of coacanto the deckion n d e z into a a h i o n for judgk your
    popouL ( e l . , my inwrted funds must esm at lewthe cumnt time deposit rate).
    N a t d d i h d b g m criteria (e.g., a client must have at luEt SSMM of
    invettawc l+i&y).

4. ~ t h o ~ r t r u e h r r r r o u n d a " t o g l c r o e ~
      WbrPonertammtQyouwsnttkewdicncttoremcmber? W h i o c t e o       recnhI~f
      dre a#.
      W h u k e y ~ n l u e t o t h a t n u i n p o i n t ?Jhsethemonyoclrcrublirhed
      aiaPi.rd ~ x p athem u complae droughts relating to the nuin point in the
                           r
      slmc way.
      What suppxtiag evidence or further d     d CMI you provide for each key meaye
      to ssiafy the PYdience?


5. W the pnssntrtren based on your "logk tree"'
    Start with a beginning that includes a statement of significance (why the audience
      should h a to you), the main point (what) and key ma~agea
                                                              (how) in o h r of
      impoaance.
      RutrtetbefiRtkeym~s~anddirc~~eechru~g~cntintumuMil
      y w have answued all the questions tbe dccisim maker k likely to raise. Do the
      snme for al the key mersqa.
                 l
      Tocmclude,summuizebynpeatingthemrinpointPndkeymess~.                   Statethe
      next step.
      At each stage, before p d g , check with tbe audience to mesh expectaions
      c~ccming
      -   m*
      - main point and key messages,
      - next steps.
                                                Includes appropriate
                                            /information




                   1
                     Content that meets
                   / audience's needs       t   Is structured logically

                                             \ Addresses audience's


                1
                                                concerns




               1                             , easy to understand
                                              Are

indude three
components
            -
            (
Most effective
presentations          Visuals that
                       support the
                       spoken message
                                            f   *dd

                                             'Focus on key messages
                                                                              communication
                                              Effective platform
                                            / skills                      Vocel Merest
                   \ Deliverv stvle that /
                       builds &ecjibility
                                                md
                                                audience
                                                        wi+,   <    1
                                                                     '    ~onftd.nt

                                                                          lm*e
                                                                                   movement

                                                                                 UM w d h ~
                                                                          Respond to non-verbal cues
                                                                          Handle discussion comfortably
        JPM Core
        Accounting Module
        Instructor: Fred Choi

0
L   J
            Understand the basic definitions of assets, liabilities and owner's equity                     I
            Recognize and be able to indicate the effects of transactions on the elements of the balance
            sheet accounting equation


        r                                         The income Statement                                     1
            Understand the basic definitions of revenues, expenses, gains,and losses
            Recognize and be able to indicate the effects of transactions on the elements of the income
            statement equation
            Understand the relationship between the income statement and the balance sheet


                       Mamrfaauw's vs. Merchandiser's Balance Sheet and h a m e Statwent                   1
            Understand the differences and similarities between a manufacturer's and merchandiser's
            financial statements
            Review actual financial statements



f'>                                                  ORBalanee Sheet                                           I
3
            Understand the basic definition of an off-balance sheet instrument and review examples
            Examine the uses and the impact on the financial statements


                                                  Acwunting Overview                                           1
            Understand the key approaches to accounting cash instruments and derivatives
            Understand criteria for hedge accounting



        I                           Exposure and Oppomtnity Management @OM)                                    I
            Examine the Exposure Management Cube and be able to identify various exposures from the
            linancial statements
            Understand the methods and financial instruments used to hedge the exposures
            Discuss the different types of accounting for financial instruments
            Understand how the financial instruments are accounted for in JPM's and the client's books




n
        I                                                Case study                                            1
.. .        Read an annual report and be able to identify financial exposures
            Discuss the financial instruments that can be used to hedge the financial exposures
         JPM Core
     Accounting Module
     Instructor: Fred Choi


            Understand the basic definitions of assets, liabilities and owner's equity
            Recognize and be able to indicate the effects of transactions on the elements of the balance
            sheet accounting equation



     r                                            TheIncome Statement                                      I
            Understand the basic definitions of revenues, expenses, gains, and losses
            Recognize and be able to indicate the effects of transactions on the elements of the inwme
            statement equation
            Understand the relationship between the income statement and the balance sheet



     I                 Manufacturer's w. Merchandiser's Balance S e t and lncome Statement
                                                                 he                                        1
            Understand the differences and similarities between a manufacturer's and merchandiser's
            financial statements
            Review actual financial statements



?'
 -   I                                              Off-Balance Sheet                                      I
..
            Understand the basic definition of an off-balance sheet instrument and renew examples
            Examine the uses and the impact on the financial statements


                                                  Accounting Overview                                      1
            Understand the key approaches to accounting cash instruments and derivatives
            Understand criteria for hedge accounting


                                    Expomre and Opportunity Management (EOM)                               I
            Examine the Exposure Management Cube and be able to identify various exposures from the
            financial statements
            Understand the methods and financial instruments used to hedge the exposures
            Discuss the different types of accounting for financial instruments
            Understand how the financial instruments are accounted for in JPM's and the client's books


     I                                                  Case study                                         1
I-       * Read an annual report and be able to identify financial exposures
                                instruments that can be used to hedge the financial exposures
            Discuss the financ~al
                                                                                               Account~ngModule

I
                                                                                                                   1


                                                          .
                                                          i
                                                           Balance Sheet
                                                           Income Statement

                                                          .Cash Flow
                                                           Changes i n
                                                           Owner's Equity
                                                           Off-Balance Sheet




           I   ,Assets   = Liabilities + Owner's Equity                                                           I

f'l Z




           I
           1
           I
           I
                                                          Total Assets = Total Liabilities + Ownel's Equity
                                                                         (Borrowed Funds)   (Owner's Funds)




                                                                                                              :.:<..

                                                           Cash and cash equivalents
                                                          r Marketable securities
                past transactions or events
                                                           Accounts receivable
                                                           Inventories
                                                           Prepaid expenses(.&,     w




      ~.
                                                                                          -
                                                                                          !
P
"M           Core                                                                                        Accounting Module




                               w &\
              Fixed Assets - bw,, t                y,,
                                                     ,
         1                                                   1
                                                                 !
             Machinery                                                Probable future sacrifices of economic
               Computers                                              benefits to other entities as a result of
             Building                                                 transactions or events
             Land
             r Land improvements




     (        +Accounts payable
                                                                     + Long-term notes payable

     /
     1
              +Short-term notes payable
              +Unearned revenues (G&cW~
              + A c c ~ e expenses
                          d
                                                                     +Discount on lease financing
                                                                     +Bonds payable
                                                                     + Deferred income tax liability
              + Dividends payable                                         -l=y INS*J;,&.
                                                                             UI


     iI




             + Residualinterest in the assets of an entity           + Capital stock -
              that remains after deducting its liabilities                            -
                                                                     + Paid-in capital w
                                                                     +Retained earnings
                                                                     +Treasury stock
!   JPM Core                                                                                             Accounting Module




                                                                  Account Mechanics
                                                              I
          Enables a firm to record increases or
          decreases to a financial statement
          component and compute an ending
     I    balance



                                                                            Ownet's Eauitv Acct.




         w (2)   Cash sales

r\
*.
            Beginning Bal           100

                                                                           Ownet's Equity Acct.
            Ending Balance 250                                              Debit (Dl)   /credit (Cr)




         Balance Sheet
         +How much was spent on Inventory7
          What is the total amount in Assets7                                        Balance Sheet
                                                                                     As of lU31104




                 I
                 I                   x co
                                      n                   I

                                                                                           1
                                                                           ASSETS               UABlllTlES


                 I
                                  Balance Sheet
                                  AS 01 12131r34
                                                                                  &
                     ash
                         ASSETS


                          :,;
                           ,



                     Inventory -
                                        NP
                                            UABlUTlES

                                        Owner's
                                                   $ SO
                                                                      Inventory
                                                                                  -
                                                                                  $2,000
                                                                                  -
                                                                                               Owner's
                                                                                               Equity     .0
                                                                                                         150
                                                                                                     $2.000     1.1
                               -                .0
                                        Equity 1 5 0
                                                   -200
                                                   $,0        /   Assets = Liabilities + Owner's Equity
!        JPM core                                                                                           Accounting Module




              Let's build a balance sheet ...                         Balance Sheet
                                                                          111 lnvest $2,000 in business
                                                                      b   1115 Purchase $400 inventory on account


                                                                 /        Assets    =   Liabilities    +   Owner's Equity   1


                                                                 I   BAL.
                                                                            -
                                                                                          Ccoo




          ,   -111 lnvest $2,000 in business                              111 lnvest $2,000 in business
                                                                          1/15 Purchase $400 inventory on account
              .1115 Purchase $400 inventory on account                r



                Assets    =   Liabilities   +   Owner's Equity             Assets   =    Liabilities   +   Owner's Equity




               1115 Purchase $400 inventory on account                                    Balance Sheet


                Assets    =   Liabilities   +   Owner's Equity


                                -
                                -
    '>
i
         JPM Core                                                                                     Accounting Module




                                                                 +Inflows or other enhancement of assets or
                                                                  settlement of liabilities in exchange for goods




                                            -            -
              Net Income = Revenue + Gains Expenses Losses




                                                                 S a l e of an asset for more than its cost
                 Interest revenue                                +Settlement of a liability at less than its cost
r\
    >




          I     Examples                                     I   Expenses          - b ~ p-ed.4 ,-olc8.
                                                                                         i&

               + Gain on sale of property or equipment           +Outflows or the using up of assets as a
                 Extinguishment of debt at less than its          result of the e n t i i s ongoing major or
                 carrying value                                   central operations




.-
17  --
?
        JPM Core                                                                                            Accounting Module




                                                                      +Sale of an asset for less than its cost
             +Selling, general and administrative expenses            +Settlement of a liability at more than its
              Depreciation expenses                                    carrying value
                 &dm DC d c e a ) ;
                 ~ w ~ I ~ O                     C




             Examples                                                 Accounting Mechanics
         I
         /
             . Loss on the sale of investment
             c Extinguishment of debt at more than its
                                                                 I

                                                                      RevenueslGains Acct.           ExpensesRossesAcct.
               carrying value
    0




                                                             1   1


                                                                                          -
                    Assets                 Exvenses                    1125 Cost of sales = $400 (Inventory)

                                                                        Assets     =   Liabilities    +   Owner's Equity
                                                                     Beg. -               $ 400              $2,000
                                                                     Bal. $2,400          -                  -
                                                                     112s   a             -                           Rev.

                                          %&.
                                                                     1/25   a                                0
                                                                                                             -       Exp.
    r
    2
     \                                    '
                                          -
                                                                     BAL.
                                                                            -             -!fcxl             LZ!&?&
i
    JPM Core                                                                                                       Accounting Module




                                                                         Income Statement
                                                                        r 1125 Cashsales = $800 (Cash)

     1    + 1/25


            Assets
                   Cost of sales = $400 (Inventory)

                         =   Liabilities      +   Owner's Equity
                                                                   1    .I125 Cost o f sales = $400 (Inventory)

                                                                              Assets     =   Liabilities    +   Owner's Equity


     i   Beg' $2,400
         Bal. -
     ' 1125 2
         1125
                                  $ 400
                                  -
                                  -
                                                     $2,000
                                                     -
                                                      0
                                                     8 0 Rev.
                                                     -Exp.
                                                                       Bal.
                                                                       1125
                                                                               $2.400
                                                                               -
                                                                               2
                                                                       1125 (400)
                                                                                                $ 400
                                                                                                -
                                                                                                -
                                                                                                -
                                                                                                                    -
                                                                                                                     92,000

                                                                                                                    800
                                                                                                                    (400) Exp.
                                                                                                                              Rev.
             -                    -
         BAL -                    -                  -
                                                     -                 BAL                      -
                                                                                                -                   -
             -                    -                                            -




     /     Income Statement
          + 1125 Cash sales      = $800 (Cash)
                                                                       Relationship of Income Statement
                                                                       to the Balance Sheet

          + 1125 Cost of sales     = $400 (Inventory)
                Assets   =      Liabilities   +   Owner's Equity   1             Cash
                                                                                        ASSETS
                                                                                            $2,800   1      LIABILITIES
                                                                                                           AIP      $ 400     I I
         Beg. -
         Bal. $2,400               $ 400
                                   -                  $2,000
                                                      -
         1125   2                  -                   0
                                                      8 0 Rev.
         1125 (400)                -                  (400) Exp.
         BAL. $2,800               -
                                   $ 400              52,400
                -                  -                  -




           lncome Statement                                              Financial Statements

                           lncome Statement
                         For Year Ended 12131194
                                                                   I .        Let's take a look at a Merchandiser's
                                                                              Balance Sheet and Income Statement


                   Cash Sales



                   NET INCOME
;
    JPM Core                                                                                    Accounting Module




     1    Current Assets Section




                                                                                  t lnventoriable Costs




         Merchandising Company             -            I                                                     I
         Income Statement                                   Financial Statements
                                                             Let's tak:e a look at a Manufacturer's
                                                             Balance




               Non-lnventoriable
               Costs

                                       t
                                   Operat~nq
                                           Income   I

                                                            Manufacturing Company -
                                                            Income Statement
     I    Current Assets Section
                                                                           when




                                                               Non-lnventoriable
                                                               Costs

                                                                                       Operatinq Income
1.
"    JPM Core                                                                                     Accounting Module




                                                                The Balance Sheet
                       S.. ?          1                         -Moment in time
                        .
                       ..
                       %
                       *> :
                         :.
                       -. .. :<..:*
                       x<e.. :.
                         ..,Y..X<
                        .~. :
                                      1    et's take
                                          a lookat
                                            GM's
                                                                -Assets = Liabilities + Owner's Equity
                                                                The Income Statement
                                                                -Period of time
                                                                -Net lncome =
                                                                                    -
                                                                 Revenues + Gains Expenses -Losses




          Off-Balance Sheet                                    Off-Balance Sheet
      I   Instruments                                  1   I   Instruments                                      I
                                                               +Not all of an entity5 rights and obligations
                                                                are shown on the face of the balance sheet      1




          Off-Balance Sheet
          Instruments
          + Represent contractual rights and
           obligations, however...
           -The contract amount (notional
             amount) is not recorded
           -The contract amount will not be
             exchanged until the future or not be
             exchanged at all
,r
         JPM Core                                                                                     Accounting Module




 0
 .~
 -   ~




                flows in the future based on a notional
                amount or reference amount that will never


          1                 Fixed Interest Payments          1

                          Floating Interest Payments


          1    Notional: $1 0,000,0000                       I



                                                                 c Where can we find     information about these
                                                                     instruments in the financial statements?




              +Accounting Policy                                 b   Let's now take look at the accounting for
              b Notional Principal Amounts
                                                                     on- and off-balance sheet financial
                Fair Values (unrealized gains o                      products
                losses on the derivative
                instruments)
c
         JPM Core                                                                               Accounting Module




               Not based on the instrument
               It is based on how the instrument is used


                                                                             Accounted
                                                                             foras..  .




                                                            lBalance Sheet
                                                             -Certain instruments are recorded and
                                                              carried at original cost




              -Interest income and expenses are             securities that are available for sale)
                accrued as earnedlincurred                  Fixed assets
                                                           C u r r e n t and Long-term liabilities
                                                                                                      BL
                                                            revenue sand expenses
                                                           e Derivatives used as   hedges of these    @dP@
                                                            instruments

    f'
    e
'             JPM Core                                                                                              Accounting Module




                   Available for Sale

                  +Securities that are available for sale are carried
                    at fair value                                                   sale
                  b Changes in fair value are recorded in a                     '   -Government bonds
                    separate component of stockholders' eauitv                      -Corporate bonds
                                                                                    -Marketable equity securities
                                                                                    -Derivatives used as
                                                                                     for sale securities



                                                                                                                             *Z
                                                                                                                              /




                    Changes in value are recorded in trading
                    revenue




                  • Derivatives are accounted for as trading
                    instruments unless.. .
                                                                        1   1   .Why do you need to know?

                  r Hedge accounting criteria are met...



                                                                                                   CLIENT
                                                                                                   FOCUS!!
r\  \:
     ,   .'
JPM Core                                                                                             Accounting Module




                                                          I                                                        i
      Derivatives will be accounted for differently           c Item being hedged exposes the enterprise
      depending on how they are used                           to pricelinterest rate risk
 ,    The accounting treatment is the kev in
      designing an effective hedging strategy for
      our clients                                              If interest a t e
                                                               increases to 10%


                                                                The price of the bond will decrease and an
                                                                unrealized loss will be incurred on the bond.
                                                                Bond exposes the enterprise to price risk.




      exposure t o risk

 iI                       -
      Sell T-bond future 3 months


 I
 I                                         Offset
                                           each
                                           other
                                                                                    t   Designated
                                                                                          hedge




                                                                                     Hedge lnstmment




  I                                                   I   I                         TIME
                                                                                                                    I
JPM Core                                                              Accounting Module




                                     What is Exposure?                              I
                               r

                                     A. A heavy metal rock gmup

                                     6. A form of frostbite

                                     C. Item subject to financial risk

                                     D. A flasher's preoccupation




                                   @ What is Exposure &
 I
                           I
     Financial Exposures
                                    + EOM is JPM's approach for assisting
                                     corporate clients in managing financial
                                     exposures




                                            Manaaement Cube
                                     Ex~osure
'   JPM Core                                                                                                                             Accounting Module




r
           Exposure Management Cube
                                  Market Risk Factors                                                       Market Risk Factors
                                                                                              interest        ~oreign       ~omm~dity
                                                         Price                                  Rate
                                                                                                                                                 Equnies
                                                                                                             Exchange         Price
        Revenue




         Exposure Management Cube                                          I
                                  Market Risk Factors
                   lntemt           Foreign          Comdii      Equnles
                     ate           Exchange           Price



                                                                                                            .
                   Tm
                  - i lag         r international                                                                           r Commdiier
                   betwee"         sales                                                       between       =la             sales
                   sales date      Competitive                                                 sales date    ~ o   ~    ~    t a     i   ~   ~
                   and cash        cumncy                                                      and cash      E U ~ ~ E Y
                   exchange        exposure                                                    exchange     exposure
                   Seasonal                                                                  r Seasonal
                   or cycll~ill
                   sales




                                                                               I    Exposure Management Cube
                                                                                                            Market Risk Factors
                                                                                              Interest       Foreign        Cornmdny
                                                                                    Ddvsrs      Rate        Exchange                             Equnies
                                                                                                                              Price

       .Revenus .Tim lag
                    between
                               rlnternational
                                 sales
                                                                 .
                                                                 bvestmm
                                                                 revenue
                                                                                   rW

                                                                                   a
                                                                                   '
                                                                                   '
                                                                                        GS   r Funding
                                                                                              R W
                    sales date . ~ o r n p e t n i ~ ~                                        materis~s
                    and cash     cumncy                                            OF         ~~VE~~OIY

                  . exchange
                    SeilSONI
                    ~rcycli~al
                                 exp-ure
                                                                                   9 d
                                                                                   Sd&,
                    sales
                  .Sales on
                    credk
'   JPM Core                                                                                                                                                                    Accounting Module




    'I         Exposure Management Cube                                                           j   1         Exposure Management Cube                                                            I
                                                                                                                                                Market Risk Factors
                                                                                                                               interest          ~oreign              ~omnadii
                                                                                                                mvem                            Exchange                             Equitie.
                                                                                                                                                                        PnCe
         1 r COGS 1 r Fundin.               1                 I                                                           1                 /                     1
         1                       1
                          1 zeriaiS 1
                               inventolv
                                                r Pmductlon
                                                 process
                                                 done
                                                 oveneas
                                                                                                          /.COOS              .Funding
                                                                                                                               raw
                                                                                                                                                -Pmduc(ion
                                                                                                                                                    D~OCBSS
                                                                                                                                                                      -Rnw
                                                                                                                                                                        materials




                                                                                                                Exposure Management Cube
                                                                                                      I


                Value
               omem

             r selling,
              general
                               interest


                          r Rcalarch
                              and
                                 t e
                                                Market Risk Factors
                                                  Foreign
                                                 Exchange
                                                                  Commodtl~
                                                                    Price
                                                                                  Equitis
                                                                                                                value
                                                                                                                Drivers

                                                                                                              .Selling,
                                                                                                                general
                                                                                                                               intest
                                                                                                                                 bb

                                                                                                                          r Rcrcanh
                                                                                                                              and
                                                                                                                                                Market Risk Factors


                                                                                                                                                r
                                                                                                                                                 Foreign
                                                                                                                                                Exchange

                                                                                                                                                    Expemes
                                                                                                                                                    incurred In
                                                                                                                                                                       CoMltV
                                                                                                                                                                        Price
                                                                                                                                                                                     Equnia
                                                                                                                                                                                                    I
                              derclopmant                                                                       and           dsvcloprnent          foreign           rnaport
                                                                                                                admin.        '""d'"B               cumncie~           cAd$,




     1         Exposure Management Cube
                                                                                                  I
                                                                                                  I
                                                                                                      1   ,     Exposure Management Cube
                                                                                                                                                                                                    I
                                                Market Risk Factors                                                                             Market Risk Factors
               Value           lnterest           Foreign         Commdii         ~ ~ u i t i s                 Value          Interest           Foreign             Comdii         ~     ~    ~   i   t   i
               Driven            R~~~                                                                           Driven           R~~~
                          ,                      Excnange           Price                                                                        Exchange              Price


         1 .^ Current         r Long-term
                               g:":;.       I
                                            I

                                                              I
                                                              I               I
                                                                                                                              -Long-term .Manetable
                                                                                                                               and Wtt-
                                                                                                                               term den .Accounts
                                                                                                                              .Maketable
                                                                                                                                                 securities

                                                                                                                                                 ECei~ble   in
                                                                                                                               s ~ u r i t i o r fonign
                                                                                                                                                 curre"q
"   JPM Core                                                                                                                                           Accounting Module




                                                                          I
            Exposure Management Cube                                                   Exposure Management Cube
                                          Market Risk Factors             /   /                  1                      Market Risk Factors
                                                                                                                    I                    /
                                                                                                                             ~~~~~~~~~




                          lntwest
                            Fate
                                           Foreign
                                          Exchange
                                                          Ccmmodii
                                                            Price         I1           Value
                                                                                                I      interest
                                                                                                        am+.
                                                                                                                            ~~reign
                                                                                                                         =v-#,=m--
                                                                                                                                             mmmdity
                                                                                                                                              Price
                                                                                                                                                                 E ~ ~ N I ~
                     1
                                                                                                                                             .
                                                                                                                                         1                  1
           r Cumnt       -Longterm -MaICctabk        .Inventory                                        Longterm -Manetable                   Invmmry        .Manetable
            Assek         and short-   recuriUes
                          t e n d e m rAccountr
                         -Marketable   receivable in
                                                        -bw
                                                        -Won in
                                                               material

                                                          pmsesr
                                                                                                       m d short-
                                                                                                      termdem
                                                                                                     .Ma1*.bk
                                                                                                                        .
                                                                                                                  recurlbe*
                                                                                                                  A E C O U ~
                                                                                                                  mcewablein
                                                                                                                                              -mwm h r l a l r e c u n h r I
                                                                                                                                             -won
                                                                                                                                                 n m c s
                          SRUriM       fmlgn            -Finished
                                       cunency            goods




                                                                                      Exposure Management Cube
                                                                                                                        Market Risk Factors
                                                                                      VdYe            IntEMt             FOreign             "mmodnv
                                                                                      Drivers          Fate             Exchange               Price             EquiUa

                                                                                  -   Rxed
                                                                                      Assek
                                                                                                     Dsbl      LoaBo" of
                                                                                                               fixed a-b
                                                                                                     financing of
                                                                                                                        .
                                                                                                  faed ane*   .~urchans
                                                                                                r Asset        fmmforelgn
                                                                                                  replacemm    suppliers
                                                                                                  and funding
                                                                                                  amngemnts




                                                                                      Exposure Management Cube
                                                                          I


                                                                          1 1 1"                      interest
                                                                                                        F a         1
                                                                                                                        Market Risk Factors
                                                                                                                         Fonign
                                                                                                                        Erchanoe         I "EwI                  Equnles




                                      1               1
                                                                                  r   Fixed
                                                                                      Assets
                                                                                                rkbl
                                                                                                  financing of
                                                                                                  fixed assets          .
                                                                                                                        rh   6 o n of
                                                                                                                         fixed a n e h
                                                                                                                         pumhaas
                                                                                                                                             Conrtructjon
                                                                                                                                             of rued
                                                                                                                                             assets
                                                                                                                                                                r Funding
                                                                                                                                                                 fixed
                                                                                                                                                                 assek
                                                                                                                                                                            of


     I I             r~sset
                         reDlascmnt
                                          hmrorelgn
                                          sumllem
                                                                                                .Asset
                                                                                                  repkcemm
                                                                                                  and fundha
                                                                                                                         fmm foreign
                                                                                                                         rupplirs
                                                                                                                                                                 Ihmugh
                                                                                                                                                                 equm
JPM Core                                                                                                                                 Accounting Module


 I
                                                                          ,     Exposure Management Cube
                                                                                                                                                       I




     Llabilhies   r Fixed rate
                                                                          I/
                                                                          I
                                                                               Value
                                                                               Drlvws    /   Interest
                                                                                               Rate     I
                                                                                                          i.ono-tirm
                                                                              i-Liabi~itlai .Fixed rate / .
                                                                                                            nvmrnrL
                                                                                                             Fonign
                                                                                                             khrnoe

                                                                                                             i
                                                                                                                o :
                                                                                                                  I
                                                                                                                      Risk Factors
                                                                                                                         /
                                                                                                               C EIiEquitles     ~
                                                                                                                                                       !
                    floating
                    rate debt
                  r ConvsMbl
                    bonds




     Exposure Management Cube                                         I
                                 Market Risk Factors                                                        Market Risk Factors
     Valve         Interest        Foreign                                     Value         Interest
     Drivers         Fate         Exchange      "FEpnv       Equlba
                                                                               Driverr         Fate
                                                                                                             Foreign
                                                                                                            Exchange         CoFEpwEqunies
     Uabilities   r Fixed rate   .Long-term   r Liabilhies
                                               linked to                                                                     linked to       wanants
                    f b t         :i2nated     com-ny
                                               indices                                                                       indices
                  -Converubl      cumncies




I    Examples of EOM
                                                                      I   Ii- Exposure Management Cube
                                                                              ,-
                                                                               -T--
                                                                                                               -
                                                                                                                                                       I



     +Let's take some
      exposure examples
      for each of these
      value driven.. ..
i
        JPM Core                                                                                               Accounting Module




                                                                    /                                                             I
5

              Revenues - Foreign Exchange                                                 -
                                                                            Example Foreign Exchange

              Example: Sales in a foreign curmncy
              - Finnlvcommitted sales of Coke denominated
          I     in a foreign currency are subject to currency
                fluciations until the sales are recorded
              -Rate at which sales will be recorded (in U.S.
                dollars) is unknown
              Where can you find this in Coke's financial
                                                                    1            Exposure: 30DM
                                                                                                                   j-        'I
              statements?                                                        Day I: 30DM @ 1.4DM/$         =    $21
                                                                                 Day 30: 30DM @ I.6DM/$        =
                                                                                 Potential Loss:                    ($2)




              .Enter into a foreign exchange forward                        c Firm commitment to lock in amount of
                contract to hedge the potential currency                        dollars
                fluctuations
                                                                        I                      $21 on Dav 30
                                                                                                        ,




                                                                                              30DM on Day 30




                                                                                                           -
                                                                                              ccounting Forward
                                                                3


              Sales   = 30DM               Forward Contract
                                                                            b   Contract open  -
                                                                                -Record notional as off-balance sheet item
                                                                                -Defer unrealized gains/losses until
                                                                                                                                  I
                            2 Loss    $2 Gain                                     contract matures


                               v.
                            Offsets each other

    r-'
    >
                             (perfect hedge)
                                                                                 Accounting Module




                                                    JPM's Accounting - Forward
/                   -
    Accounting Forward Contract
                                                I



    Contract matures
    -Include realized gain in the measurement
      of the sales dollars
    -Sales recognized in income when earned

        Sales Account

                19 (sale)
                 2 (hedge)




        rent for Coke and JPM?




                                                                 instrument is




    Why is this important?
                         ,'-
<   JPM Core                                                                                                            Accounting Module




        1    Exposure Management Cube                                     I   1             -
                                                                                  COGS Commodity Exposure
                                                                                  * Example: General Motors purchases large
            I\/   1 1                       I   Market Risk Factors   I            quantities of metals for use in car production
                                                                                   -Costs of these metals fluctuate
                        con 01 goods sold
                                            I   I    I I
                                                     1x1
                                                                I                  -Gmss margins fall as costs increase
                                                                                  +Where can you find this in GM's financial
                                                                                   statements?




        1   Example - Commodity Exposure
                                                                          I

                                                                              1
                                                                                   Example - Commodity Exposure
            w GM enters into a c o n t a c t t o purchase
                                                                                                -
    '
    r
              25,000 lbs of metalat t
            m r i c g f o r delivery i n 3 months
                                                               w                  Exposure price of the metal increases
                                                                                  before GM pays:

                                                                                  Today:     25,000 lbsl$1.50 per lb.        $37,500
                                                                                                                                        I
                                                                                  Day 90: 25,000 lbs/$1.70 per lb.           $42.500
                                                                                  Potential Loss:                           ($ 5,000)




                                                                              I
             JPM Response                                                          Commodity Price Swap
              Enter into a commodity swap to fix the
              price paid for metals
                                                                                            Future price X 25,0001bs
'   JPM Core                                                                                                       Accounting Module


     I                                                              I                                                                    I



                                                                        1       No entries recorded until legal title to inventory
                                                                                is passed to GM




                                    Offseis
                                (perfect hedge)




                                                                /       I   .Trading -mark to market
                                                                                                                                     I




              Exposure Management Cube
           -mp.,l,~,              B
                                          -              ,
                                                                        I Current Assets - Equity Exposure
                                                                            tExample: Coke invests 5% in the stock of a

         l,$.l         wmdwn:
                                          Market Risk Factors                bottling company
                                                                             -Plan to sell investment in the next month
                                                                             -Don't know what price will be at the time of
                                                                               sale
                                                                            *Where can you find this in Coke's financial
L            JPM Core                                                                                                   Accounting Module




         '    1                  -
                   Example Equity Exposures
                                                                          1
                                                                               I

                                                                               /
                                                                                                 -
                                                                                   Example Equity Exposure                            I
              I     Coke o w n s 500 shares o f ABC
              I     Bottling Co. worth $10 p e r share                              Exposure:          $5,000 (500 shares X $10)

                                                                                    Day 1:             $10 per share
                                                                                    Day 30:            $ 8 per share
                                                                                    Potential loss:    $1000 (500 shares X $2)




              I
                   JPM Response
                   Pumhase a put option to lock in the price of the
                                                                          I/   /
                                                                                   JPM Response
                                                                                   .Put O d i o n =                                   1
                   stock.                                                             strike Price ($10) X 500 shares = $5,000
                  P A put option will give the buyer the right, not the               Value shares ($8) X 500 shares =
    0
    ~~
                   obligation, to sell the underlying instrument at
                   the agreed-upon or strike price.
                                                                                      Gain on option                     -
                                                                                                                      = $1,000




                                                                                                         Offsets
                                                                                                      (perfect hedge)
    JPM Core                                                                                         Accounting Module




                  I                                   I
                             Income Statement

                   Loss on sale          $(1,000)
                   Gain from option
                                          -0-




                                                                 +Example: OM'S Notes and Loans Payable
                                                                  include obligations with not only fixed but
                                                                  also variable rates
                                                                  -Interest rates fluctuate with changes in
                                                                    the market
                                                                  -Adverse changes in the market rates
                                                                    increase cost of borrowing on variable
                                                                    rate obligations
                                                                 +Where can you find this in GM's financial
                                                                  statements?




     /                   -
         Example Interest Rate Exposure                          JPM Response                                         II
                                                                 + Enter into an interest rate "plain vanilla" swap
         Day 1        $10,000,000 3 year note,
                                                                  to achieve a desired balance between fixed
                      LIBOR = 8%                                  and floating rate debt
                      Interest payment            = $66,667

         Day 90       LlBOR increases,
                      LlBOR now = 9%
                      Interest payment            =   75.ooo
0
L        Potential increase in interest expense   =   ($8,333)
V   P   M Core
                                                                                            Accounting Module



n


           General Mot01
                       'S                     JP Morgan
                            Fixed Rate (8%)
                                $66.667
                                                                           \       /
                                                                             Offset
                            Floating Rate                               (pelfect hedge)
                               (LIBOR)
                               $75,000




                                                          -Link swap for life of the loan                 I
                                                                                 Accounting Module




                                              2 .Identify the exposures Exxon is cumently
                                               .
                                                hedging
                                              3. Develop a strategy for hedging Exxon's
                                                 potential exposure to foreign exchange
                                                 rates from sales in foreign currencies




+Let's go over the exposures Exxon is
 hedging ...                            I I    +Let's review how Exxon might use a swap
                                                to hedge interest rate risk on debt
8   JPM Core                                                                                                         Accounting Module




           Exxon Energy Limited                                          w   Exxon's hedging strategy:
           Exposure:                                                         -Assume rates will rise, therefore, swap
                                                                               $228 million floating rate term loans to
           -$228 million floating a t e term loans
                                                                               fixed rate
         w If rates rise, Exxon's interest expense
           increases                                                                           Fixed
                                                                                                               "----....--....
                                                                                                          -I     Swap
                                                                                                               I wuntwparfy.-
                                                                                                                        .....
     1                                                         1   (   ~loatingl             Floating                               1




     /   *What hedging strategy hould JPM
          recommend to orotect sales revenue from                  1     Q.

                                                                         A.
                                                                                What is the specific exposure?

                                                                                Exchange rates might change before
                                                                                sales are recorded in U.S. dollars thereby
                                                                                reducing sales revenue
                                                                                                                        1




         Q.    How can E u o n hedge this exposure?

         A.    Enter into a foreign exchange contract at
               the time of the sale to lock in the amount of
                                                                   I                            Dollars                             I
               U.S. dollar to be received


                                                                   I                     Foreign Currency
i   JPM Core
                                                     Accounting Module




        T h e financial statements are the basic
         tools for identifying client exposures
        +Numerous strategies can be designed to
         hedge against financial exposures
         Understanding the accounting for cash and
         derivative instruments is essential in
         determining the appmpriate he
f\                   PLAYERS I N THE FINANCIAL MARKET
                          JP MORGAN TRAINING PROGRAM
                                 PRESENTATION BY
                                 FRANK J . FABOZZI




     Mpyright Frank J. Fabozzi


P
                                                     JPM Core
                                                      Players


     Performance Objectives
     At the end of this module, participants will be able to:

         Classify institutions and individuals as: financial intermediaries, users and suppliers of funds
         Explain the goals and constraints that apply to assorted institutional borrowers and investors and bow
         that affects their behavior
         Understand the markets and instruments through which funds are transferred from investors to
         borrowers
         Discuss the significance of intermediation, securitization and risk transformation in the financial system
         Understand the changing role of financial intermediaries


     Pre-Reading
         "The Big Banks Are Back" from Euromoney, May 1995
         "Who Needs Syndicates?' from Euromoney, March 1995



     Instructor
r\
-.   Frank Fabozzi, consultant
     (G137W, 19137W)


     TIME: 3 hrs
ISSUERS AND INVESTORS
0 THERE ARE E N T I T I E S THAT I S S U E F I N A N C I A L ASSETS,   BOTH
DEBT INSTRUMENTS AND EQUITY INSTRUMENTS

0 THERE ARE INVESTORS WHO PURCHASE THESE                       FINANCIAL
ASSETS

0 NOT UNCOMMON FOR AN E N T I T Y TO BOTH I S S U E A F I N A N C I A L
ASSET AND AT THE SAME T I M E I N V E S T I N A DIFFERENT
F I N A N C I A L ASSET

0 L I T T L E SENSE      TO   DISCUSS      ISSUERS      AND    INVESTORS
SEPARATELY

0 SIMPLY REFER TO BOTH ISSUERS AND INVESTORS                             AS
E N T I T I E S THAT PARTICIPATE I N THE F I N A N C I A L MARKET

O ' A SIMPLE C L A S S I F I C A T I O N OF THESE E N T I T I E S CAN BE
C L A S S I F I E D AS FOLLOWS:
       (1) CENTRAL GOVERNMENTS
       (2) AGENCIES OF CENTRAL GOVERNMENTS
       (3) MUNICIPAL GOVERNMENTS
       (4) SUPRANATIONALS .w~r\b.%&
       (5) NONFINANCIAL BUSINESSES G Y ~ M ~
       (6) FINANCIAL       ENTERPRISES
       (7) HOUSEHOLDS
fi
.
1       (1) CENTRAL      GOVERNMENT

        0 BORROW FUNDS FOR A WIDE-VARIETY OF REASONS

        0 DEBT OBLIGATIONS ISSUED BY CENTRAL GOVERNMENTS CARRY
        THE FULL F A I T H AND CREDIT OF THE BORROWING GOVERNMENT.

        0   IN US ROLE OF         RAISING    FUNDS RESTS      WITH THE
        DEPARTMENT OF THE             TREASURY: OBLIGATIONS      CALLED
        TREASURY SECURITIES
        0 I N JAPAN,    O
                       N+
                          THE MINISTRY  OF FINANCE I S RESPONSIBLE FOR
        R A I S I N G FUNDS V I A THE SALE OF SECURITIES.



        0 MANY CENTRAL GOVERNMENTS ESTABLISH AGENCIES TO R A I S E
        FUNDS TO PERFORM S P E C I F I C FUNCTIONS

A       o N US FEDERALLY AGENCIES
          I                               WERE CREATED BY CONGRESS TO
    b   REDUCE THE COST O F R A I S I N G FUNDS FOR CERTAIN BORROWING
        SECTORS OF THE ECONOMY DEEMED TO BE IMPORTANT ENOUGH
        TO WARRANT ASSISTANCE.

        0 IN     US   THERE ARE TWO TYPES OF GOVERNMENT AGENCIES:

                FEDERALLY-RELATED I N S T I T U T I O N S = ARMS OF THE
        FEDERAL   GOVERNMENT.    EXAMPLE GOVERNMENT             NATIONAL
        MORTGAGE ASSOCIATION
            GOVERNMENT-SPONSORED   ENTERPRISES         =    PRIVATELY
        OWNED, PUBLICLY  CHARTERED ENTITIES.          EXAMPLE FEDERAL
        HOME LOANMORTGAGE CORPORATION          (FANNIE MAE)
n
.   0 AGENCY OBLIGATIONS MAY OR MAY NOT BE GUARANTEED BY
    THE FULL F A I T H AND CREDIT OF THE CENTRAL GOVERNMENT
    THAT CREATED THE AGENCY.



    0 MOST COUNTRIES HAVE M U N I C I P A L I T I E S THAT R A I S E FUNDS
    I N THE CAPITAL MARKET

    0 I N US,    M U N I C I P A L GOVERNMENTS INCLUDE STATES,
    COUNTIES,  AND C I SIE.
                        T           THESE ENTITIES       ALSO CREATE
    1      1    ~ AND SPECIAL ~ DI TRI TS
                            ~         S C~        TO RAISE ~ FUNDS FOR
                                                   ~             ~           ~   ~

    A SPECIFIC



    0 ORGANIZATION THAT I S FORMED BY TWO OR MORE CENTRAL
    GOVERNMENTS THROUGH INTERNATIONAL TREATIES

A   0 PURPOSE FOR CREATING I S TO PROMOTE                      ECONOMIC
<
    DEVELOPMENT FOR THE MEMBER COUNTRIES
    0 BUSINESSES ARE   CLASSIFIED                   INTO    NONFINANCIAL          AND
    FINANCIAL BUSINESSES

    0 THESE E N T I T I E S BORROW FUNDS I N THE DEBT MARKET AND
    RAISE FUNDS I N THE EQUITY MARKET

    0  NONFINANCXAL BUSINESSES ARE D I V I D E D INTO                         THREE
    CATEGORIES :
         I
         )
         (      CORPORATIONS
          1 ) FARMS
         ( 1
         ( 1 ) NONFARM/NONCORPORATE BUSINESSES.
          1 1

    (6)  FINANCIAL BUSINESSES, MORE POPULARLY REFERRED TO
    AS FINANCIAL INSTITUTIONS, PROVIDE SERVICES RELATED TO
    ONE OR MORE OF THE FOLLOWING:

    1. TRANSFORMING AL
                  FINANCI       ASSETS ACOUIRED           THROUGH THE MARKET AND
A   CONSTITUTING THEM I N T O A DIFFERENT, AND MORE WIDELY PREFERABLE,
    TYPE OF ASSET-- WHICH BECOMES T H E I R L I A B I L I T Y .

    2.    BROKERING OF F I N A N C I A L ASSETS ON BEHALF OF CUSTOMERS

    3.    EXCHANGING OF F I N A N C I A L ASSETS FOR THEIR OWN ACCOUNT

    4. A S S I S T I N G I N THE CREATION OF F I N A N C I A L ASSETS FOR THEIR
    CUSTOMERS AND THEN S E L L I N G THOSE F I N A N C I A L ASSETS TO OTHER MARKET
    PARTICIPANTS

    5.    PROVIDING   INVESTMENT ADVICE TO OTHER MARKET P A R T I C I P A N T S



    7.    PROVIDING FUNDS
           FINANCIAL    I N S T I T U T I O N S INCLUDE:
f-l
           DEPOSITORY INSTITUTIONS                   (COMMERCIAL  BANKS,
      SAVINGS AND LOAN ASSOC1AT.IONS                  SAVINGS BANKS, AND
      CREDIT UNIONS)

           ~NSURANCE COMPANIES               (LIFE     AND     PROPERTY   AND
      CASUALTY COMPANIES)

           PENSION FUNDS
           ENDOWMENT
           I N V E S ~ E N T COMPANIES      (OPEN-END        AND   CLOSED END
      FUNDS)

           SOME NONFXNANCIAL    BUSINESSES HAVE SUBSIDIARIES
      THAT PROVIDE FINANCIAL SERVICES:       CAPTIVE FINANCE
      COMPANIES (E. G. , GE CREDIT,  GMAC)
               ,
n   SUMMARY
    OF 1 9 9 4
                 OF   CREDIT   MARKET DEBT OUTSTANDING    AS OF THE      THIRD    ~UARTER




    DOMESTIC      NONFINANCIAL      SECTOR                         $     2,765.5
        U. S . GOVERNMENT                                  202.6
        HOUSEHOLD                                        1,826.8
        NONFINANCIAL         BUSINESS
             NONFARM NONCORPORATE                           37.9
             CORPORATE                                     249.6
        STATE AND LOCAL GOVERNMENT                         448.6




    FOREIGN SECTOR                                                     S 1,250.4
                                                                        - - - - ---
    TOTAL   CREDIT       MARKET ASSETS                                 $16,691.0
    .............................................................
                  RESERVE 'BULLETIN
    SOURCE: FEDERAL
    ............................................................
0 S P E C I A L TYPES O F F I N A N C I A L I N S T I T U T I O N S THAT PLAY
THE B A S I C ~ R O L E ~ O F ~ T R A N S F . O R M I N G ~ ~ I N A N C I A L W A S S E T S f T H A T
ARE-LESS-DESIRABLE,FOR-A-LARGE-PART-OF-THE,PUBLIC,INTO
OTHER F I N A N C I A L ASSETS--;THEIR=OWN,LIABILI-TIES--WHICH
RE MORE WIDELY PREFERRED THE PUBLICBY

0 T H I S TRANSFORMATION I N V O L V E S A T L E A S T ONE O F F I V E
ECONOMIC FUNCTIONS:




     (3)      REDUCING           THE      C O S T S ~ O F ~ C O N T R A C T I N G AND
~~INFORMAT.ION~PROCESSING

      (4)   P R O V I D I N G A rPAYMENTSlMECHANISM
     BORROWER:
     Ms. SMITH NEEDS     $ 1 0 , 0 0 0 TO PURCHASE A CAR
         NEEDS A FIVE     YEAR LOAN

      N
     I A WORLD  WITHOUT F I N A N C I A L INTERMEDIARIES SUCH AS A
     BANK, THERE WOULD BE A MISMATCH          OF THE NEEDS OF MR.
     JONES MS. SMITH
           AND



       .
     1 ENGAGE      A CREDIT ANALYST TO ASSESS THE CREDIT OF   MS.
     SMITH
r\   2.      ENGAGE AN ATTORNEY TO WRITE UP THE LOAN AGREEMENT
i?
'.




     GIVES     MR. JONES I A
                       V       A   6-MONTH C D '
     1 .THE MATURITY SOUGHT
     2. NO CREDIT RK
                   I
                   S   (BECAUSE OF DEPOSIT   INSURANCE)
     3. NO NEED TO CONTRACT W HI
                               T   MS. SMITH     NOR NEED TO
     ANALYZE CREDIT



     1 .ACCEPTS THE LOAN MATURITY                  T
                                   SOUGHT BY MS. SMI H
     2. ACCEPTS THE CREDIT R I S K
     3.  PERFORMS THE CONTRACTING AND CREDIT ANALYSIS
     FUNCTION
     INTERMEDIARIES TO
          WILL EXPOSE THEMSELVES                      DIFFERENT
     DEGREES OF EACH TYPE OF RISK

     HOW MUCH IRISK~THEY#ARE~WILL'ING~T,OIAC~CEP;T
                          -   -                ,DEF!ENDSION

     1. ~NATURE~~OF~THE~LLIABIL'ITIESJ
                                     (DISCUSSED   FURTHER LATER)

n    2. IREGU~TORY#CONSIDERAT-IONS~
.-
     3 . ~MANAGEMENT~PO~~ICY
                             ASS ETmSECUR I$I.ZAT$ONI
    THE PROCESS OF I C R E A T ~ _ I ~ N G ~ E C U R I ~ E S ~ E A C K E D I B Y ~ L ! O A N S ~ I S
                              S T
    REFERRED TO AS ~ T E C U B U I Z A ~

    THE RESULTING  SECURITIES                 ARE COMMONLY REFERRED TO AS
            -
    ASSET B M E B SECURITI E S




    THE 4TRAOI$IONAL~SYSTE$
                          FOR I!INANCING,THE,ACQUISITION
    OF ASSEIS,CALLED FINANCIAL
                    FOR ONE            INTERMEDIARY,     SUCH
    AS A COMMERCIAL BANK, THRIFT, OR INSURANCE COMPANY,
    TO:



            (2)                 ITS PORTFOLIO OF ASSETS,
                                                I I
                  ~ E T A I N ~ T H E U I i O A NN
n
.   THEREBY AccER~ING,THE,cREDI~~RIsK-AssocrAtED~wITH-THE
    eLOAN




            (4)~TAIN~F.UNDS&ROM~THEfiP,UBL-ICj WITH WHICH TO
    F_INANCE  ITS   A S S E ~ (EXCEPT FOR THE SMALL AMOUNT
    REPRESENTING   THE INSTITUTION'S   EQUITY)
?7     ASSET   E U I I A I NI
              S C RTZ TO ,S   RADICALLY DIFFERENT      FROM THE
.      TRADITIONAL SYSTEM FOR FINANCING THE A C Q U I S I T I O N OF
       ASSETS

        WITH ASSET S E C U R I T I Z A T I O N [MORE THAN ONE- I N S T I T U T I O N ,
       _                  I
      *MAY BE INVOLVED N LENDIN'G
      L        -                                CAPITAL

       A LENDING SCENARIO CAN LOOK L I K E T H I S :

             (1)                                -.. ,
                    A- BANK CAN- ORIGINATE A LOAN

             (2) THE BANK CAN S E L L THE LOANS I T ORIGINATES !TO:
      -AN- INVESTMENT   BANKING   R
                                  I
                                 FM     THAT CREATES A SECURITY
       BACKED BY THE POOL OF LOANS,

             (3)THE dNVESTMENT BANKER CAN .OBTAIN'                          CREDIT
        -
       ENHANCEMENT FROM A THIRD-PARTY GUARANTOR,

             (4)                                               O
                 THE ,INVESTMENT BANKER CAN S E L L THE RIGHT T ;
r"\                                                             ,
       SERVICE THE LOANS TO A COMPANY S P E C I A L I Z I N G I N
.
.      SERVICING
       .           LOANS

             (5)     THE INVESTMENT         BANKING F I R M      CAN     S E L L THE
       SECURITIES      TO INDIVIDUALS       AND INSTITUTIONAL          INVESTORS;
       b


                                                                                     '
       SIDES          THE ORIGINAL   BANK, AN INVESTMENT    BANK, AN 4
                                                                                         '
                                                                                         ,


       :INSURANCE        COMPANY,   A   THIRD-PARTY    GUARANTOR,   A :
      ? SERVICING        COMPANY,    AN    INDIVIDUAL,   AND    OTHER
      :,INSTITUTIONAL      INVESTORS PARTICIPATE                   r ;
      t..
       THE'ORIGINATING         B A N K 3 1 N OUR EXAMPLE DOES NOT HAVE TO
      iABSORB THE CREDIT          RISK,    SERVICE     THE LOAN,;PR        PROVIDE
       ;THE FUNDING
       \
THE MOST   COMMONLY C I T E D L B E N E ~ I : T S A O F ~ S E C U R I ~ I Z A T I O N ~ A R E
    SECURITIZATION   CONVERTS I L L I Q U I D LOANS I N T O SECURITIES
                                                                     I
    WH
     T
     I     GREATER LIQUIDITY AND REDUCED CREDIT       - RK -S
                                                            I -



           (1)   I T I S BACKED BY A D I V E R S I F I E D POOL OF LOANS

           (2)             -
                 THERE I S -CREDIT ENHANCEMENT)
                                         -


    THIS  PERMITS #INVESTORS  TO BROADEN T ER
                                          HI     UNIVERSE OF
    .
    ZNVESTMENT OPPORTUNITIES.   *IT TENDS TO .IMPROVE
                                    ALSO
    RETURNS THROUGH THE .REDUCTION       OF    - . COST OF
                                              THE
    INTERMEDIATION,




A     BECAUSE A FINANCIAL             OR NON-FINANCIAL         ENTITY  CAN
w
      S E C U R I T I Z E A LOAN I T ORIGINATES, OR S E L L I T TO SOME
      E N T I T Y THAT WILL S E C U R I T I Z E I T , THE LENDER NOW HAS;A
    L MORE-LIQUID           ASSET THAT I T CAN SELL I F CAPITAL I S
      NEEDED
    w- -

    T H I S SHOULD .REDUCE THE SPREAD BETWEEN LENDING RATES
    ~ N D  DEFAULT-FREE ASSETS,SUCH AS TREASURY SECURITIES

    AS THE MARKET FOR ASSET-BACKED SECURITIES MATURES,
    COMPETITION AMONG ORIGINATORS SHOULD PRODUCE LOWER
    LENDING RATE SPREADS I N LOAN MARKETS,
      SECURITIZATION            HAS MAJOR IMPLICATIONS    FOR   FINANCIAL
      MARKETS AS WELL AS THE STRUCTURE                    OF    FINANCIAL
      I N S T I T U T I O N S SUCH AS BANKS AND THRIFTS

      S E C U R I T I Z A T I O N EVENTUALLY MAY REPLACE THE TRADITIONAL
      SYSTEM OF INDIRECT              FINANCING;
      .-
      ,-
                                                  '


      SECURITIZATION      PROVIDES cDIRECT FINANCING BETWEEN
      BORROWERS     AND     INVESTORS,  SHORT-CIRCUITING       THE
      TRADITIONAL     INTERMEDIARIES.     POOLING        OF ASSETS.
      REINFORCED BY PRIVATE .CREDIT        ENHANCEMENT REDUCES1
      --
      CREDIT    RKI
                  S TO MORE ACCEPTABLE LEVELS FOR INVESTORS

      RECASTING CASH FLOWS SO AS TO CREATE DIFFERENT BOND
      'CLASSES OR TRANCHES   PROVIDES' VARYING  MATURITIES
                       IE
      ACCEPTABLE TO A WD  RANGE OF INVESTORS:

f-7   THUS, SECURITIZATION SERVES A ROLE S I M I L A R TO M A T U R I N
                                .
      INTERMEDIATION WHILE S' H I F T I N G I T S R I S K TO THE ULTIMATE
      LENDERS?
                                                                        -
      L-




      THE SUCCESS OF SECURITIZATION.INDICATES THAT I T I S A
      MORE' EFFICIENT                 ' I KN
                        METHOD FOR LN I G       BORROWERS AND
      INVESTORS-THAN TRADITIONAL FINANCING   THROUGH FINANCIAL
      INTERMEDIARIES

      CONSEQUENTLY, THE ROLE OF BANKS AND THRIFTS MAY HAVE
      TO BE REASSESSED
A
.
    THE TRUE~INNOVAT~IONS~IN~THIS~MARKE~
    SECURITIES THEMSELVES BUT
                                       ARE NOT REALLY THE


         (1)  REDUCTION~OF~ISK~THRO~UGH,p,OOOLING~ASSETS
    AND VRIVATEfiCREDI-ENHANCEMENT AND
n
.     OVERVIEW OF ASSET/LIABILITY MANAGEMENT FOR
      FINANCIAL INSTITUTIONS




     [~TDEPOSITORY
               INSTITUTIONS           SEEK TO GENERATE INCOME BY
      ,THE DIFFERENCE BETWEEN THE RETURN THAT THEY EARN ON
      'ASSETS AND THE COST OF T H E I R FUNDS

      DIFFERENCE I S REFERRED TO AS A-SPREAD;
                                     .,
      OBJECTIVE OF A DEPOSITORY I N S T I T U T I O N I S TO EARN A
        OIIE
      P STV    SPREAD BETWEEN THE ASSETS I   T INVESTS N (WHAT
                                                            I
      I
      T HAS SOLD THE MONEY FOR) AND THE COSTS OF I S FUNDS T
             I
      (WHAT S HAS PURCHASED THE MONEY FOR)

A
Zr    .
      (21L I F.E
           I'   .
                    INSURANCE COMPANIES ARE I N THE SPREAD BUSINESS



                                                      -
                       FUNDS ARE NOT I N THE SPREAD BUSINESS ;
                                           ./
       SEEK :TO COVER THE COST OF PENSION OBLIGATIONS AT: A
      [MINIMUM COST; THAT I S ,BORNE BY THE SPONSOR;
                              L
                                                     OF THE
       PENSION PLAN

     f4.   ,INVESTMENT COMPANIES FACE NO E X P L I C I T COSTS FOR THE
      FUN~STHEY ACQUIRE; AND MUST .SATISFY
      I
                                                          NO SPECIFIC
                                             N THE CASE OF ONE TYPE
      L I A B I L I T Y OBLIGATIONS, (EXCEPT I
      OF INVESTMENT
      A T ANY TIME2
                          COMPANY THAT.AGREES-TO-REPURCHASE. SHARES
                                                                 .  .
     J
n
.L
     NATURE       OF    A LE
                        I IT
                       L BI I S
     0 BY THE L I A B I L I T I E S MEAN THE AMOUNT AND T I M I N G OF THE
     CASH OUTLAYS THAT MUST BE MADE TO S A T I S F Y THE
     CONTRACTUAL TERMS OF THE OBLIGATIONS ISSUED

     0 THE L I A B I L I T I E S OF ANY F I N A N C I A L I N S T I T U T I O N CAN BE
     CATEGORIZED ACCORDING TO FOUR TYPES AS FOLLOWS:




     TYPE   I                     KNOWN                       KNOWN
     TYPE   I1                    KNOWN                       UNCERTAIN
     TYPE   I11                   UNCERTAIN                   KNOWN
     TYPE   IV                    UNCERTAIN                   UNCERTAIN


     TABLE ASSUMES THAT THE E N T I T Y THAT MUST BE P A I D THE
     OBLIGATION  I L NOT CANCEL THE FINANCIAL
                WL                              INSTITUTION'S
n
u
     O B L I G A T I O N PRIOR T o ANY ACTUAL OR PROJECTED PAYOUT
     DATE
n
.-   DEPOSITORY
     L-_-                   -I-NSTITUTIONS-,
       0 SEEKS TO [EARN A P O S I T I V E SPREAD: BETWEEN T H E r . S E T S '
     T
     :
     I             I
           INVESTS N  CLOANS AND SECURITIES)         AND THE COST OF
     ... FONDS' (DEPOSITS
       ITS
         -         -        AND OTHER SOURCES)

       0 DIFFERENCE BETWEEN INCOME AND COST I S REFERRED TO AS
       SPREAD INCOME OR MARGIN INCOME
      i-
                                      - i-         I          \
       0 SPREAD INCOME SHOULD ALLOW THE I N S T I T U T I O N TO MEET
       OPERATING EXPENSES AND "EARN-- A--FAIR     PROFIT ON I T S
          -
      'CAPITAL-.
              L




      0           I N     GENERATING   SPREAD  INCOME
      I N S T I T U T I O N FACES FOLLOWING RISKS:.
                                                           -
                                                           A    DEPOSITORY
                                                                       -    -
      I
             CREDIT R I S K
               -  L
                                 . REGULATORY R I S K
             INTEREST RATE! (OR FUNDING)          IK
                                               RS )
                  L


       0 -REGULATORY R I S K I S THE R I S K THAT #REGULATORS-WILL
n
.     -
       CHANGE THE RULES' SO AS TO ,ADVERSELY
      ,EARNINGS  OF THE INSTITUTION, '
                                     ,
                                            L
                                                       IMPACT  THE:


      0 ,INTEREST RATE - R I S K - I S THE R I S K THAT A )DEPOSITORY t
      INSTITUTION'S   SPREAD INCOME        WL
                                            IL     SUFFER BECAUSE OF:'
      CHANGES I N INTEREST RATES
       --

       0 THE PROBLEM OF PURSUING A STRATEGY OF POSITIONING,A
       DEPOSITORY   I N S T I T U T I O N .BASED ON INTEREST RATE!
      .EXPECTATIONS' I S THAT CONSIDERABLE ADVERSE FINANCIAL
      L

       CONSEQUENCES WILL RESULT I F THOSE EXPECTATIONS ARE NOT
      REALIZED
      i-
                      : .
      0 SOME INTEREST RATE R I S K I S INHERENT I N ANY BALANCE
      SHEET OF A DEPOSITORY I N S T I T U T I O N
n     o MANAGERS MUST BE WILLING TO A C C E P ~ S O M E I R I S K , BUT
\.
      THEY CAN TAKE VARIOUS MEASURES TO ADDRESSbTHEeINTERgT
     wRATE*SENSITIVI~ly#OF THE INSTITUTION 'S ILIABILLI-TXESIAND
      IqTSnASSETS

      0   A        DEPOSITORY    INSTITUTION   SHOULDmHAVE.A_N
      ASSET/IEIABI    LLI.TM~COMMIT,TEEITHAT I S RESPONSIBLE FOR




     -
      0   REGULATORS-HAVE-PROPOSED,POLICIES,~OR,DE~OSITORY
      INSTITUTIONS gR-MEASURING.AND,REPORTING,INTEREST-RATE
      RISK.
     COMMERCIAL                BANKS-,
.    L - _ / - - --                -


     0 PROVIDE NUMEROUS SERVICES                               THAT   CAN   BE    BROADLY
     C L A S S I F I E D AS FOLLOWS:

                (1)     I N D I V I D U A L BANKING
                (2)   'INSTITUTIONAL           BANKING!
                (3)   ;GLOBAL BANKING

        --
     0 (BANK FUNDING              -- THREE SOURCES
                (I):DEPOSIT~
                (2)   NON-DEPOSIT BORROWING;
                (3)   COMMON STOCK AND RETAINED EARNINGS /
                                                      .                     -
      0 BANKS AREVHIGHLY LEVERAGED F I N A N C I A L I N S T I T U T I O N S ,
      WHICH MEANS THAT MOST OF THEIR FUNDS COME FROM
                         t

     t BORROWING

r\
..   0 PESERVE REQUIREMENTS
       I
                                               ,
     0 BORROWING I N THE "FEDERAL FUNDS MARKET;

            *I F ACTUAL-RESERVES-EXCEED-REQUIRED - *- RESERVES,
     .DIEEERENCE-IS-  REFERRED-TO~AS~EXCESSRESERVES                              ---
            *     RESERVES
                  --               ARE
                                    -    .
                                             PLACED       I N . NON-INTEREST      BEARING
     ACCOUNTS
       -

            *
           THERE I S AN ,OPPORTUNITY                           COST ASSOCIATED         WITH
     <EXCESS RESERVES;

            *         - --       .
           THERE ARE PENALTIES IMPOSED ON BANKS THAT DO -NOT
     SATISFY-THE-RESERVE   REQUIREMENTS
     t- -            --*

            *                                             --
           BANKS HAVE AN,INCENTIVE TO MANAGE T H E I R RESERVES
     SO AS TO-SATISFY
                                        -
                      RESERVE REQUIREMENTS-AS,SRECIS~~~      AS                        -
n
     -
     POSSIBLE'
r\              *  BANKS TEMPORARILY     __SHORT OF
                                           I--          THEIR    REQUIRED

             --
5            RESERVES CAN,BORROW,RESERVES,EROM,BANKS           ,
                                                            ,HT AE
                                                            T AHV
                      +."
             EXCESS-RESERVES

                * MARKET WHERE BANKS CAN ,BORROW-OR       --
                                                        LEND -RESERVES I S
             --
             THE FEDERAL FUNDS MARKET.

                * INTEREST RATE CHARGED TO BORROW FUNDS I N T H I S
             MARKET I S THE FEDERAL FUNDS R A T E .

             0 BORROWING AT THE FED DISCOUNT WINDOW

         *
     4FUNDS INTEREST             RATE THAT THE FED CHARGES TO       BORROW^
     i
     k
      1 RATE
             AT THE            DISCOUNT WINDOW I S CALLED THE DISCOUNT,


             0 REGULATION

                *    .BANKS   ARE-REGULATED- AND SUPERVISED
                                                          b
                                                              BY SEVERAL
A
.                -                         NIIS
             FEDERAL 4ND STATE GOVERNMENT E TTE
-
                * * A T FEDERAL LEVEC,   SUPERVISION I S UNDERTAKEN BY
                      :FEDERAL RESERVE BOARD
                       OFFICE OF THE COMPTROLLER OF THE ?CURRENCY,
                       FEDERAL DEPOSIT INSURANCE CORPORATION
                                                                           t       1
              : @,
                REGULATORS HAVE PLACED RESTRICTIONS OF T H E I R OWN'
     \ON THE TYPES OF SECURITIES THAT A BANK CAN TAKE A
     P
       P O S I T I O N I N FOR I T S OWN INVESTMENT PORTFOLIO          .       I


     .-  -
                                                                 * ,


                .
                '*   RISKrBASED CAPITAL REQUIREMENTS*
                                                    ,
                      #
                      REQUIREMENTS BASED ON A FRAMEWORK ADOPTED I N
             JULY     1988)BY  THE ~BASLE COMMITTEE:   ON  BANKING
             REGULATIONS AND SUPERVISORY PRACTICES
                      #
                      REQUIREMENTS BASED ON CREDIT O F ASSETS AND ON
             INTEREST RATE RISK>
              L - - -
                                   I-
                                                                -
n
                                   2
n
>
    SAVINGS AND LOAN ASSOCIATIONSj
    I     - . _ _ _ -
                                                         -       ,


    0    B A S I C MOTIVATION BEHIND CREATION OF S&LS WAS
    PROVISION-OF- FUNDS FOR FINANCING THE PURCHASE OF A
    i,   - .                                  -  --
          -
                                                   "2
                                                        f
                          -   -    A




    HOME
    .
    --
    0                                                         .
        L I K E BANKS, S&LS MAY BE CHARTERED UNDER E I T H E R1
    STATE OR FEDERAL STATUTES.
    <
        0 AT THE FEDERAL LEVEL, T H E P R I M A R Y REGULATOR OFCS&LS
        S THE !DIRECTOR
        I                OF THE OFFICE       OF THRIFT. SUPERVISION
        (DOTS)    '


        0 ASSETS

              *
           TRADITIONALLY, THE ,ONLY ASSETS I N WHICH S&LS WERE
    ALLOWED TO INVEST HAVE BEEN ,MORTGAGES, MORTGAGE-BACKED
                                                    -
    SECURITIES,    AND GOVERNMENT 'SECURITIES                                         \


n
?
              *
              ACCEPTABLE L I S T OF INVESTMENTS NOW INCLUDES
      CONSUMER     LOANS     (LOANS   FOR     HOME   .IMPROVEMENT,
     AUTOMOBILES,      EDUCATION,   MOBILE   'HOMES,    AND CREDIT
     ~ARDS)       ,
                 NON-CONSUMER LOANS : (COMMERCIAL,       CORPORATE',
      BUSIN'ESS,   OR AGRICULTURAL       LOANS),   AND                   MUNICIPAL^
    ,SECURITIES.

        0 C A P I T A L REQUIREMENTS


    FOR BANKS
              *
         !RISK~BASED
                      -
                                  CAPITAL   GUIDELINES       1
                                                                  I IA
                                                                 SML R   TO       -
                                                                              THOSE

    L- -
n    INSURANCE COMPANIES,
         --
     i-- - -          "   .   -




     0 INSURANCE COMPANIES ARE .FINANCIAL INTERMEDIARIES
     THAT, [FOR A PRICE, WILL MAKE A-PAYMENT ' I F A CERTAIN,
      .
     EVENT OCCURS,.

     0 TWO TYPES OF INSURANCE COMPANIES:
                INSURANCE COMPANIES
               LL E
                 I
                 F                  ("LIFE COMPANIES")
           PROPERTY AND CASUALTY INSURANCE  COMPANIES                   (!!P&C)
     C M A I S)
      O PN "
         ' E                  .
     0 KEY D I S T I N C T I O N BETWEEN L I F E AND   P&C   COMPANIES:

               *    D I F F I C U L T Y OF PROJECTING WHETHER A POLICYHOLDER
     WL
      IL           BE P IA D      OF^   AND,

               * I F SO,          HOW MUCH THE PAYMENT WILL BE

               * AMOUNT   AND T I M I N G OF CLAIMS ON P&C COMPANIES ARE
n
.:   .MORE D I F F I C U L T TO PREDICT BECAUSE OF THE ,RANDOMNESS OF
      NATURAL CATASTROPHES AND THE UNPREDICTABILITY             OF COURT,
               I
      AWARDS N L BI Y I IT
                      AL             CASES;   '
     C     .

      0 INSURANCE POLICY AND PREMIUMS

               *AN INSURANCE POLICY I S A          LEGALLY BINDING
      <CONTRACT FOR WHICH   THE POLICYHOLDER      ,-(OR OWNER) PAYS
     (PREMIUMS    N
                  I   EXCHANGE FOR THE INSURANCE                  ;
                                                          COMPANY 's
       PROMISE TO PAY S P E C I F I E D SUMS CONTINGENT ON FUTURE
       EVENTS j

               *   WHEN THE POLICY I S ACCEPTED'BY   AN INSURANCE
      COMPANY;          I T BECOMES AN ASSET FOR THE OWNER AND A
                                                         .          +

     < L I A B I L I T Y FOR THE INSURANCE COMPANY,

               *I F THE ,OWNER F A I L S TO PAY PREMIUMS,        THE P O L I C Y
      I S S A I D TO'LAPSE, OR TERMINATE

n
r\   0 SURPLUS AND RESERVES
2-




        * S I N C E THE ACCOUNTING       TREATMENT OF BOTH ASSETS AND
     L I A B I L I T I E S I S ESTABLISHED BY STATE STATUTES COVERING
     AN INSURANCE COMPANY, SURPLUS I S COMMONLY REFERRED TO
     AS STATUF*ORYmSURRLUS

         * ISSUES     OF   DETERMINING      VALUES   OF   ASSETS   AND
     LIABILITIES

         *   STAV,TPRY&URP.LUS I S IMPORTANT BECAUSE,REGULAT.ORS
      VW
      1I
       E      H
              TIS     AS THE L       u       ~         ~             ~
     lUP,ON~T,OIFAY,P,OL-ICYHOLDERS~

         *   ~GROWTHkOFATHISaSURP,LUS      FOR AN INSURANCE COMPANY
      WL
       IL   -H-BUSINESS~N
n
-    (UNDERWRI-TE-
                                     .*:
0   0 REGULATIONS AFFECTING INVESTMENT DECISIONS




        *    EACH STATE ESTABLISHES I T S OWN REGULATIONS

        *     -~ O ~ ~ I N S U R A N C E ~ C O M M I S S I O N E R S
             MODEL,LAWS,AND,REGULATIONS
    N A T ~ I O N
                                                        ARE DEVELOPED BY THE

    (NAZI,   A VOLUNTARY              ASSOCIATION         OF   STATE      INSURANCE
    COMMISSIONERS

         * THREEaRRINCIpALTAREAS           THAT THE N A I C HAS ADDRESSED
    THAT A ~ F E C T ~ M E N T ~ D E C I S I O N S B I A N D S T R A T E G I E S OF
                                --
    INSURANCEmCOMPANIES:
         (1) H O W . A S S E T S ~ ~ U E D ~ F-, O R B R E G U L ' A T O R Y ~ R E P , O R
                                            + -


    E O S E A
         (2) GUIDEL-INE&F,ORIINvES,TMENTS
         (3) ~1SK;BASEDfiCAP.I~TAL~REQUIREMENTS               --
0
.   LIFE INSURANCE COMPANIE5
                    -   -
    ---
    i

    0 MANY-OF THE-PRODUCTS SOLDIBY                           L I F E COMPANIES HAVE AN
    INVESTMENT-FEATURE
                --
                                                 C'




    0 BECAUSE OF T H I S                   FEATURE,        THEY   COMPETE WITH OTHER
       N A
    r FI ANCI L                  INSTITUTIONS.      THAT  SROVIDE INVESTMENT
    'INSTRUMENTS
                                  .
                                   AND WITH                       -
                                                 DIRECT MARKET INVESTMENTS - IN1-
    4
     SECURITIES
                         -
    0 NATURE OF THE L I A B I L I T I E S

          *   L I A B I L I T I E S ARE THE INSURANCE P O L I C I E S THAT THEY
     HAVE     UNDER WRIT TEN^4
                                                      i




          *      THERE ARE ,RISKS I N THE L I A B I L I T I E S OF                  AN
                                                                -
     I N S T I T U T I O N AS WELL AS I N THE PORTFOLIO OF ASSETS

              *
            FOR A L I F E COMPANY,                        MANY OF THE PRODUCTS ARE
n
\
     INTEREST-RATE SENSITIVE  ,
              *
           :INTEREST RATE OFFERED ON AN INVESTMENT-TYPE
    LINSURANCE POLICY I S CALLED THE CREDITING RATE?

              *
              I F THE CREDITING RATE OF A POLICY I S NOT
      COMPETITIVE WITH MARKET INTEREST RATES OR RATES
      OFFERED BY OTHER LF IE    COMPANIES,  AN OWNER 'MAY ALLOW.
    IITHE POLICY                  I
                   TO LAPSE OR, F PERMISSIBLE,         B I
                                                        E
                                                  MAY +GN    TO'
      BORROW AGAINST THE 'POLICY
     \   -        -



              *       THUS MAJOR R I S K I S LAPSE R I S K )

     0 TYPES OF P O L I C I E S

              *
            T E R M ' L I F E INSURANCE I S A CONTRACT THAT PROVIDES
    (A D E A ~ H BENEFIT        BUT -NO CASH BUILD-UP;,   IT- HAS [NO 1
     INVESTMENT      COMPONENT 7
n
-
                *---
              (WHOLE              LIFE:   INSURANCE .1 I S
                                                  -.         A   POLICY   WITH   qcO,
        FEATURES :
\




                        (1)     ,PAYS OFF A STATED AMOUNT.'UPON:THE       _DEATH) OF
        THE INSURED'-
                        (2)
                   -ACCUMULATES  A     CASH                         - -
                                                                 VALUE 7THAT     THE
    (_POLICYHOLDER' CAN BORROW AGAINST. .,

                    *
                  ~NIVERSAL    IE
                              LF  POLICY  I
                                          S A WHOLE-LIFE PRODUCT
         I N WHICH THE POLICYHOLDER PAYS A PREMIUM FOR INSURANCE
         PROTECTION'AND FOR A ,SEPARATE FEE CAN INVEST I N :A
         VEHICLE7 THAT PAYS A COMPETITIVE   INTEREST RATE RATHER
        :THAN THE BELOW-MARKET CREDITING     RATES OFFEREDON A$
        (WHOLE L E
                 I
                 F     POLICY                                    u
        I
        I
                    *
                    VARIABLE L I F E POLICY I S A WHOLE L I F E POLICY
            THAT PROVIDES A DEATH BENEFIT THAT DEPENDS ON THE
            MARKET VALUE OF THE INSURED'S   PORTFOLIO AT THE TM IE  OF
            THE DEATH
n
                            #
                      TYPICALLY COMPANY INVESTS PREMIUMS I N COMMON
            STOCKS, AND HENCE JV~RIABLE L E   F
                                              I POLICIES- ARE REFERRED
            T'
            10 AS EQUITY-LINKED P O L I C I E S

                *     ANNUITY I S A REGULAR PERIODIC PAYMENT MADE BY
            THE      INSURANCE COMPANY TO A     POLICYHOLDER  FOR A
            SPECIFIED     PERIOD OF T E
                                     M
                                     I

                *   GUARANTEED INVESTMENT                CONTRACT     I S [A     PURE,
                        PRODUCT^




    r
            INVESTMENT

                        #
                  FOR A SINGLE PREMIUM L I F E COMPANY AGREES TO
     . P A Y THE P R I N C I P A L AMOUNT AND A PREDETERMINED ANNUALAI
                                                                                        fi
    I CREDITING RATE OVER THE L I F E OF THE INVESTMENT, A L L , O ~
       WHICH I S P A I D AT THE MATURITY DATE
.?
(    PENSION
     I ---'    -FUNDS
     0 PENSION PLAN I S A FUND THAT I S ESTABLISHED FOR THE
     PAYMENT OF ,RETIREMENT BENEFITS t

     0 THE E N T I T I E S THAT ESTABLISH PENSION PLANS--CALLED
     THE TPLAN SPONSORS--ARE        PRIVATE BUSINESS E N T I T I E S
     :ACTING FOR:

            *EMPLOYEES
           (STATE AND LOCAL E N T I T I E S ON BEHALF OF THEIR
     EMPLOYEES
           ,UNIONS ON BEHALF OF T H E I R MEMBERS
               -
             N VD
           ' I DI I UALS FOR THEMSELVES

     o TYPES       OF PENSION    PLANS

          *   TWO       BASIC   AND      WIDELY   USED   TYPES   OF   PENSION
     PLANS:
n
-
.         DEFINED
     PLANS)
                          CONTRIBUTION         PLANS AND DEFINED      BENEFIT-


          *  I
            N A(DEFINED    CONTRIBUTION    PLAN THE P L A N SPONSOR,
      JS RESPONSIBLE   ONLY FOR MAKING  SPECIFIED  CONTRIBUTIONS
     [INTO THE PLAN .ON BEHALF OF QUALIFYING PARTICIPANTS
     L             - -
                    #
                 PAYMENTS THAT WILL BE MADE T O QUALIFYING
     TPARTICIPANTS UPON RETIREMENT: WILL DEPEND ON THE
     .-
      INVESTMENT PERFORMANCE OF THE ASSETS; I N WHICH THE
      PENSION FUND ARE INVESTED

                    #
                 THEREFORE               THE    EMPLOYEE   BEARS      ALL   THE
     -
     XNVESTMENT R I S K >
      -
                    #PLAN SPONSOR GIVES THE PARTICIPANTS VARIOUS
     OPTIONS ' A S - T O THE INVESTMENT VEHICLES I N WHICH THEY
     MAY I N V E S T
.
r\                 #   [END
                         I
                       DFE       CONTRIBUTION                      I
                                              PENSI%N 'PLANSI COME N
     SEVERAL LEGAL FORMS: MONEY PURCHASE PENSION PLANS,
     ~ ~ O I ( K )> P m N S , AND EMPLOYEE STOCK OWNERSHIP PLANS
      (ESOP).
                                               -
                       A f
                                                   -4

            *     I N    ,DEFINED  B E N E F I T PLAN:  THE PLAN SPONSOR?
      AGREES TO MAKE S P E C I F I E D DOLLAR PAYMENTS       ?bQUALIFYING
     ,EMPLOYEES       AT ' RETIREMENT           (AND,SOMEPAYMENTSTO,
      BENEFICIARIES      I
                         N CASE OF' DEATH-BE~RE-RETIREMENT)

            * THE 'PENSION OBLIGATIONS ARE EFFECTIVELY THE
      DEBT OBLIGATION OF THE PLAN SPONSOR, WHO ASSUMES THE
     (RISK! OF 'HAVING I N S U F F I C I E N T FUNDS * I N T H E -PLAN-.TO
      SATISFY THE CONTRACTUAL PAYMENTS THAT MUST BE MADE TO
      RETIRED EMPLOYEES


                         UNDER.
                             ..   -
                                      ERISA.
                                      ..   ,
                                           .

n
>
     o   MANAGERS OF PENSION FUNDS

            *A PLAN SPONSOR.CAN DO ONE OF THE FOLLOWING WITH
     THE PENSION   ASSETS UNDER ITS CONTROL:
            (1) :MANAGE A L L THE PENSION ASSETS I T S E L F E.,  (I.
     USE (IN-HOUSE MANAGEMENT)

                (2) ,DISTRIBUTE
                             THE PENSION ASSETS TO ONE OR MORE
      MONEY MANAGEMENT FIRMS    TO MANAGE          (I.   ,    -
                                             E. 'USE :EXTERNAL 7
     -
     ,MONEY MANAGERS);
            (3) :COMBINE ALTERNATIVES ;(I) AND (2)
     0 PENSION ADVISORS

           # ,MONEY MANAGERS ARE RESPONSIBLE FOR HANDLING THE
                      -
     (FUNDS ALLOCATED TO THEM BY THE PLAN SPONSOR
7
c
:   ' RC L
       T
    C II A
             #   THE (PLAN
                      VE
                    CI T
                   A T II S
                              SPONSOR , I S
                                  N
                                  I   THE
                                              lRESPONSIBLE FOR OTHER
                                              'INVESTMENT  MANAGEMENT
                    -          2

    PROCESS

             #
            TO A S S I S T PLAN SPONSORS I N MAKING VARIOUS
    DECISION  I N    THE    INVESTMENT  MANAGEMENT PROCESS,
    EXTERNAL PENSION FUND ADVISORS OR CONSULTANTS ARE
    ENGAGED

             #
             ADVISORS MAY A S S I S T A PLAN SPONSOR I N THE
                                                         -   -
     FOLLOWING WAYS:
         0     DEVELOPING PLAN JNVESTMENT POLICY ANDL-ASSET
             !ALLOCATION AMONG THE MAJOR ASSET CLASSES
         o ,ACTUARIAL      A VSN
                            DIIG               AL
                                              L IT
                                             (I B I Y    MODELING AND
            C FORECASTING)
            ,
         0     DESIGNING  OFLBENCHMARKS THAT THE FUND'S MONEY
               MANAGERS WILL' BE MEASURED AGAINST
         0    'MEASURING AND MONITORING THE PERFORMANCE- OF
               THE FUND'S MONEY MANAGERS
         0     MEASURING TRADING COSTS AND ANALYSIS'OF THOSE
               COSTS
         0     fINDEX FUND CONSTRUCTION WHEN A PENSION PLAN-
               ELECTS TO MANAGE INDEXED FUNDS INTERNALLY
         0     SEARCHING FOR AND RECOMMENDING MONEY MANAGERS
               TO PENSION PLANS
         0     PROVIDING S P E C I A L I Z E D RESEARCH'
     0     INCLUDE   COLLEGES
                            I       PRIVATEmSCHOOLS,
                                   <.r                                        MUSEUMS,
                                                                                 _ c
                                                                                  1 .
    'H~SPITALS;--  AND ,F,OUNDATIONS,
                              -


    0 INV.ES.mENTJINCOME,GENERATED
    ARE USED,F,OR,THE-OPERATION

    o I
                                                     FROM THE FUNDS INVESTED
                                                  FITHEIINS~I~TION

      N THE CASE OF A COLLEGE, THE INVESTMENT INCOME S      I
                                                                       -
    USED TO MEET CURRENT OPERATING EXPENSES AND CAPITAL
    EXPENDITURES 1       . , THE CONSTRUCTION OF NEW BUILDINGS
    AND SPORTS F CLTE )
                A II I S

    0 MOST OF THE LARGE ENDOWMENTS I N THE U.S.                                        ARE
    INDEPENDENT OF ANY F I R M OR GOVERNMENTAL GROUP.

    0 @OMEmEND-OWMENTS ARE COMPANYISPONSORED? OR LINKEDkTO
    CERTAINrCOMMUNITIES

n
Z
    o OTHERS ARE TERMED                'LOPERAT-ING~F;OUNDATIONS''   L---      BECAUSE
    THEY r A W A R D r M O S T ~ O F ~ T H E I R ~ G I F T S ~ T O m T H E ~ I R . [ O W N r U ~ ~ ~ S
    RATHER     THAN       TO     ORGANIZATIONS                OUTSIDE         OF       THE
    FOUNDATIONS
         ZNVESTMENT COMPANIES,
         -,
        I-.    -              +




         0 SELL'SHARES TO THE PUBLICrAND INVEST THE'PROCEEDS I N
           DV R I I D
         A { I E SFE
           i          - ~ORTFOLIO OF SECURITIES

        0 EACH-SHARE THAT THEY S E L L REPRESENTS A PROPORTIONATE
         .
        TINYEREST -N A PORTFOLIO OF SECURITIES~
                   I
                                                    -                                                             >"




         0 TYPES OF INVESTMENT COMPANIES

                    1 OPEN-END
                     .                     FUNDS
                                 4MANAGED FUND
                                  SELLS AT NAV'DEFINED   LATER PLUS LOAD
                    2.       [CLOSED-END - FUNDS:
                                MANAGED FUND
                                SELLS L I K E ANY SHARE OF STOCK?
                    3.       { U N I T TRUSTS


n        0 NET ASSET VALUE                       (NAV)         PER SHARE
.>
I'
                                                 G a r k e t value of portfolio                 - Liabilities'_
         r&
          j
              * .   .~
              a s s e t val'ue per
                             - .
                               .           -t
                                     s h a r G - = * ( - - - - - r - - : - - - - - - - - - - - - - - - - - - - - - - - - -'- - - - - -
                                                  'Number of -shares outstanding
                                                      -- .- fund -.-                                    -     -




         0 FUND OBJECTIVES AND P O L I C I E S

                         *
                 WHEN A FUND I S OFFERED, A PROSPECTUS MUST BE
        /PROVIDED- TO THE POTENTIAL INVESTOR

                         *
                  EVERY PROSPECTUS) FOR A FUND MUST INCLUDE A
        (STATEMENT ABOUT THE ,INVESTMENT   OBJECTIVES~ THAT THE
         MANAGER OF THE FUND- SEEKS TO ACCOMPLISH       AND THE
        (POLIC1ES;THAT    THE MANAGER WILL FOLLOW TO MEET THE
         INVESTMENT  OBJECTIVES

         0 REGULATION

                    *
                 A L L INVESTMENT COMPANIES ARE REGULATED AT THE
              -
        .TEEDERAL LEVEL;
n   w
                                                                    34
p   INVESTMENT BANKERS

                                WHO   NEED          A
                                             T O I R- I S E B F ; U N D S ,   ,ASSIST   THEM   INW



          (2) F;OR~INVESTORS'  WHO WISH &OJINVEST~~UND~,   FACILITATE THIS
     PROCESS BY,ACTINGIASflBROKERS-IN                                     -
                                                    THEIBU-YINGIANDaSELLINGp
    (0 FASEC uRI TIES?
FOLLOWING   FOUR D E F I N I T I O N S OF INVESTMENT B A N K I N G SUGGESTED RANGING
FROM BROADLY I N C L U S I V E OF WIDE-RANGING F I N A N C I A L SERVICES TO THE
NARROW T R A D I T I O N A L I S T D E F I N I T I O N :

"1. THE BROADEST      DEFINITION     INCLUDES VIRTUALLY  ALL ACTIVITIES     OF
MAJOR WALL STREET     FIRMS,     FROM INTERNATIONAL  CORPORATE UNDERWRITING
TO R E T A I L BRANCH MARKETING TO A HOST OF OTHER F I N A N C I A L SERVICES
(E.G.,    REAL ESTATE AND INSURANCE).

2. THE    NEXT BROADEST D E F I N I T I O N E N V I S I O N S INVESTMENT BANKING A S
COVERING A L L C A P I T A L MARKET A C T I V I T I E S ,     FROM UNDERWRITING AND
CORPORATE FINANCE, TO MERGERS AND A C O U I S I T I O N S (M&A) AND F A I R N E S S
OPINIONS,    TO FUND MANAGEMENT AND VENTURE CAPITAL.                   EXCLUDED, FOR
EXAMPLE,    ARE THE S E L L I N G OF S E C U R I T I E S TO R E T A I L CUSTOMERS,
CONSUMER R E A L ESTATE BROKERS, MORTGAGE BANKING, INSURANCE PRODUCTS,
AND THE LIKE.           INCLUDED INVESTMENT
                                  IS     MERCHANT BANKING,           WHEN
BANKERS WORK AND INVEST        FOR THEIR      OWN ACCOUNT.          ALSO INCLUDED IS
THE N O N R E T A I L TRADING OF BLOCKS OF S E C U R I T I E S FOR F I N A N C I A L
INSTITUTIONS.

3. HERE INVESTMENT BANKING I S D E F I N E D TO I N C L U D E ONLY       CAPITAL
MARKET          ACTIVITIES,    STRESSING       UNDERWRITING  AND   MERGERS   AND
ACOUISITIONS.          EXCLUDED, FOR EXAMPLE, ARE FUND MANAGEMENT, VENTURE
C A P I T A L , COMMODITIESI ASPECTS OF R I S K MANAGEMENT, AND THE L I K E .
DEPENDING ON F I R M ORIENTATION, RESEARCH MAY ALSO B E EXCLUDED I F I T
I S USED P R I M A R I L Y TO SUPPORT R E T A I L SALES. (NOTE THAT THE CHANGING
P R O F I L E OF INVESTMENT BANKING WOULD NOW I N C L U D E MERCHANT BANKING I N
THIS      DEFINITION.)

4. THE        NARROWEST D E F I N I T I O N TAKES INVESTMENT BANKING BACK TO I T S
H I S T O R I C A L FOUNDATIONS, L I M I T I N G THE F I E L D S T R I C T L Y TO UNDERWRITING
AND R A I S I N G OF C A P I T A L I N THE PRIMARY MARKETS, AND THE TRADING OF
S E C U R I T I E S (BROKER/DEALER) I N THE SECONDARY MARKET.                      I S HARD TO
                                                                                 ( IT
CONCEIVE OF A CONTEMPORARY D E F I N I T I O N OF INVESTMENT BANKING THAT
WOULD EXCLUDE M&A, SO T H I S ONE I S FOR H I S T O R I A N S AND P U R I S T S . ) "
                                                                           P


     ~NKTURE F -BUSINESS?
            O
.
..
                                              f


     0 'HIGHLY LEVERAGED FIRMS

     0 BECAUSE OF CERTAIN A C T I V I T I E S THAT THEY ARE ENGAGED
     I N , =NCREASED APPETITE FOR *CAPITAL-

     o  GENERATE !REVENUE FROM COMMISSIONS~,                    :FEE           INCOME,
     %SPREADAND P R I N C I P A L A C T I V I T I E S . '

      0 A C T I V I T I E S CAN BE D I V I D E D I N T O THE           FOLLOWING
     'REVENUE-GENERATING A C T I V I T I E S :
           PUBLIC OFFERING OF SECURITIES'
         r2.;iPu~~~c        TRADING    OF SECURITIES
         (3: .PRIVATE PLACEMENT OF SECURITIES
         (4: :SECURITIZATION           OF ASSETS
                               ~ CU
         (5: l M ~ AND ATS ~ ~ s    ~
                                    Q
                                    II
                                    S
                                    N
                                    O
          16: MERCHANT BANKING:
          7       :TRADING;       AND    ICREATION       'S
                                                        .I
                                                     OF R K                    CONTRO~
0
.    *INSTRUMENTS,
     C
           8.' MONEY    MANAGEMENT

           *   FIRM  I
                THAT S           INVOLVED   I
                                            N         MOST OF THE ABOVE S
                                                                        I
     REFERRED TO A 1   1           ~  ~  FIRM
                                          ~       ~    -    ~   ~      ~        ~    "
                          THE  TYPICAL         UNDERWRITING       PROCESS       INVOLVES     THREE
                          FUNCTIONS:
          -4
        !-I
              I
                      !(I) K D V I S I N G THE ISSUER ON THE TERMS AND ?HE T I M I N G OF
                      .THE OFFERING,
        L-            -
                           N
                          I THE   ROLE AS ADVISOR TO AN ISSUER,       INVESTMENT
                          BANKERS MAY BE CALLED UPON' TO DESIGN A SECURITY
                          STRUCTURE THAT I S MORE PALATABLE TO INVESTORS.
         >
         ,'       \
        ,                 (2)    BUYING THE SECURITIES FROM THE ISSUER,
        6 >THE
           ,                   UNDERWRITING          PROCESS      NEED    NOT     INVOLVE     HS
                                                                                              TI
                          FUNCTION

r\                        FIRM  COMMITMENT: WHEN AGREES TO BUY THE                    SECURITIES   -
<

                          FROM THE ISSUER AT A SET P R I C E

                                 0 RK
                                    S
                                    I     IB
                                     FIRM ACCEPTS I S THAT THEcPRICE I T P A I D
                      <TO PURCHASE THE SECURITIES FROM THE ISSUER :WILL BE
                       LESS THAN THE PRICE I
                                           T RECEIVES'       I
                                                        WHEN T (REOFFERS THE
                      -
                      ,SECURITIES TO THE PUBLIC.

                                 0 TOlSHARE UNDERWRITING R I S K AN INVESTMENT BANKING
                       F I R M WILL FORM A SYNDICATE OF FIRMS TO UNDERWRITE THE
                      :ISSUE'

                      'BEST-EFFORTS: I
                                    FM
                                     R         IB
                                          AGREES ONLY TO USE ITS EXPERTISE
                  TO S E L L THE SECURITIES /AND DOES NOT BUY THE E N T I R E 7
        r-    -,
                 IISSUE) FROM THE ISSUER.



.   *    -
                  .
                  '
                  /
                                 0 T O l R E A L I Z E GROSS SPREAD,   A L L OF THE SECURITIES,
                                                                                           -.

A
r\
..   'YUST.?BE SOLD TO THE PUBLIC AT THE PLANNED REOFFERING
                   --
      P R I C E .)

           0 REQUIRES A GREAT DEAL OF MARKETING MUSCLE.




     NOT ALL DEALS ARE UNDERWRITTEN     USING   THE TRADITIONAL
     SYNDICATE PROCESS.

     SEVERAL VARIATIONS:   "BOUGHT DEAL:" FOR THE UNDERWRITING
     OF BONDS AND                AUCTION PROCESS
    (A)     ISUCCE-SS~UL~UNDERWRI$INGplltISSUE                      REQUIRES          A




      * ~REVENUE~GENERATEDFROM
          (1) ,THEqBID=ASKIISPREAD
          (2)   A P P R E C I A T - I O N ~ O F ~ T H E ~ P R I C E THEISECURIT-IES
                                                                OF
HELDrINmINVENTORY*
-


        (3) &CARRY&
    (B)  VARIOUS STRATEGIES                    EMPLOYED BY TRADERS TO
GENERATE REVENUE FROM P O S I T I O N S I N ONE OR MORE
                                                  -
SECURITIES: A R B I m T R A G E F l A N D I A S P E C U L A W
    A  RESTRICTION IMPOSED ON BUYERS *OF PRIVATE PLACED
    SECURITIES I S THAT THEYiMAY NOT BE SOLD FOR TWO YEARS
    AFTER ACQUISITION

    THUS,    THERE S I              -
                         (NO.+LIQUIDITY   I
                                          N   THE MARKET    FOR THAT/
    T I M E PERIOD-,
    i
    r;,   -
                  ,
                  '

    [BUYERS OF PRIVATE     PLACED SECURITIES         MUST           BE
     COMPENSATED FOR THE LACK OF L I Q U I D I T Y ,
      .
      '
     IN R I L1990 SEC RULE 144A" BECAME EFFECTIVE:
        ~ ~

              * RULE :ELIMINATES TWO YEAR HOLDING-PERIOD +BY
     PERMITTING       LARGE INSTITUTIONS       TO TRADE SECURITIES
     A Q RD
      C UE
         I         I
                   N    A PRIVATE     PLACEMENT AMONGST THEMSELVES
    :WITHOUT     HAVING   TO REGISTER     THESE SECURITIES WT
                                                           , IH    THE
    SEC:
n
-             *
          UNDER (RULE 144A: A LARGE INSTITUTION          I S 'DEFINED~
    AS ONE HOLDING A T LEAST $ 1 0 0 M I L L I O N OF THE SECURITY.,
     0 REFERS TO I S S U A N C E ~ O F I S E C U R I . T ~ E S ~ T H A T ~ H A V E ~ A ~ F ? O O L ~ ~ F
     ~SSETSWASBCOWATERAL~.



     o INCLUDED
          UNDER M&A ACTIVITY                               IS:
         LEVERAGEDIBUYOUT XkBOS)
         RESTRUCTURINGi AND .RECAP.I;TAL-IZATIONS OF COMPANIES
           L_


       REORGANIZAT~ION~OF~BANKRU~T~COMF~ANIES~AND   TROUBLED
       *-
     0 PARTICIPATE I N ONE OF SEVERAL WAYS:
          (A) ,FINDING@M&AMCANDIDATES
          (B)    A D V I S I N G W A C Q U I R I N G ~ C O M P A N I E S OR TARGET
     COMPANIESW
     +
          (c) ASSIST~ING#ACQUIRINGnCOMP&NIES I N O B T A I N I N S H E
     NECESSA~F,UND
                                                                      -
                         --  L




fi   0 MAY &ROVIDEIITS.OWN~CAPIITAL     FOR ~BRIDGEUFINANCING:
     THIS IS ONE ~WREIOFIMERCHANT~BANK.ING;
                                                       -
     0 A C T I V I T Y I N WHICH AN ~~BICOMMITS,IT~S~OWN~EUNDS BY
     E I T H E R TAK~ING~AN~EQUI~~INTEREST~OR~CREDI~TORUPOSITION
     I N COMPANIES




+.   0 CREATED SUBSIDIARIESWHATnPMANAGEwFUNDS

     0 ~EEIIINCOME   GENERATED FROM MONEY MANAGEMENT
                               RISK AND RETURN MODULE

                         JP MORGAN TRAINING. PROGRAM
                                  PRESENTATION BY
                                 FRANK J. FABOZZI




0   copyright Frmk J. Faboni
0
-.               LEARNING OBJECTIVES
     AFTER   THIS   PRESENTATION    YOU   SHOULD
     UNDERSTAND:
     0 HOW TO VALUE ANY FINANCIAL ASSET
     0 EXPLAIN WHAT I S MEANT BY THE CASH FLOW OF
     A FINANCIAL ASSET
     0 WHY A SECURITY SHOULD BE VIEWED AS A
     PACKAGE OF ZERO-COUPON SECURITIES
     0 WHAT THE TRADITIONAL YIELD MEASURES ARE
     AND THEIR LIMITATIONS
     0 WHAT THE VARIOUS SOURCES OF RETURN ARE
C?   FROM HOLDING A SECURITY OR A PORTFOLIO
     0 HOW TO CALCULATE THE ALL-IN-COST OF FUNDS
     FOR A BORROWER
     0 WHY THE TOTAL RETURN APPROACH I S SUPERIOR
     TO YIELD FOR ASSESSING THE POTENTIAL RETURN
     FROM HOLDING A SECURITY
     0 RISK MEASURES ASSOCIATED WITH INVESTING
     0 HOW RISK CAN BE QUANTIFIED
     0 WHAT ASSET PRICING MODELS SAY ABOUT RISK
     0 THE EMPIRICAL EVIDENCE ON RISK AND RETURN
,p   I N MAJOR CAPITAL MARKETS
 -
A'
                          2
L **
       0 WHAT I S MEANT BY MARKET EFFICIENCY AND I T S
       IMPLICATIONS FOR FUND RAISING AND INVESTING
       0 HOW THE DEGREE OF INTEGRATION OF GLOBAL
       FINANCIAL MARKETS AFFECTS FUNDING AND
       INVESTING DECISIONS
       0 THE FACTORS LEADING TO GLOBALIZATION OF
       FINANCIAL MARKETS
       0 THE REASONS FOR FINANCIAL INNOVATION
       0 THE DEVELOPMENT OF VARIOUS FINANCIAL
       INSTRUMENTS I N TERMS OF THE RISKS FROM THE
       PERSPECTIVE OF ISSUERS AND INVESTORS
?         :
    PART I RISK AND RETURN
    DEFINITION: VALUATION I S THE PROCESS OF
    DETERMINING THE FAIR VALUE OF A FINANCIAL
    ASSET
    FUNDAMENTAL PRINCIPLE OF VALUATION: THE
    VALUE OF ANY FINANCIAL ASSET I S THE PRESENT
    VALUE OF THE EXPECTED CASH FLOW
    ESTIMATING CASH FLOW
    SIMPLY, THE CASH THAT I S EXPECTED TO BE
    RECEIVED EACH PERIOD FROM AN INVESTMENT
    I N THE CASE OF COMMON STOCK, I T DEPENDS ON
    FUTURE DIVIDENDS AND THE SELLING PRICE (OR
    TERMINAL PRICE)
    I N THE CASE OF A FIXED INCOME SECURITY, I T
    DOES NOT MAKE ANY DIFFERENCE WHETHER THE
    CASH FLOW I S INTEREST INCOME OR REPAYMENT OF
    PRINCIPAL
    CASH FLOW FOR ONLY A FEW TYPES OF SECURITIES
    ARE SIMPLE TO PROJECT
    NONCALLABLE TREASURY SECURITIES HAVE A KNOWN
    CASH FLOW
'   FOR A TREASURY COUPON SECURITY, THE CASH
    FLOW I S THE COUPON INTEREST PAYMENTS EVERY
    S I X MONTHS UP TO THE MATURITY DATE AND THE
    PRINCIPAL PAYMENT AT THE MATURITY DATE
    EXAMPLE: THE CASH FLOW PER $100 OF PAR VALUE
    FOR A 7% 10-YEAR TREASURY SECURITY I S THE
    FOLLOW IN^:
       $3.5 (7%/2 X $100) EVERY S I X MONTHS FOR
    THE NEXT 20 SIX-MONTH PERIODS AND
       $100 20 SIX-MONTH PERIODS FROM NOW
    FOR ANY FIXED INCOME SECURITY I N WHICH
    NEITHER THE ISSUER NOR THE INVESTOR CAN
    ALTER THE REPAYMENT OF THE PRINCIPAL BEFORE
    I T S CONTRACTUAL DUE DATE, THE CASH FLOW CAN
    EASILY BE DETERMINED
    ASSUMING THAT THE ISSUER DOES NOT DEFAULT
    :-
--...    THE DIFFICULTY I N DETERMINING THE CASH FLOW
         I S FOR SECURITIES UNDER THE FOLLOWING
         CIRCUMSTANCES:
             .
            1 EITHER THE,ISSUER OR THE INVESTOR
            HAS THE OPTION TO CHANGE THE
            CONTRACTUAL DUE DATE OF THE REPAYMENT
            OF THE PRINCIPAL
                     o CALL PROVISIONS
                     o PUT PROVISIONS
            2    THE COUPON PAYMENT I S RESET
            PERIODICALLY  BASED ON SOME REFERENCE
            RATE AND THERE ARE RESTRICTIONS ON
            THE NEW COUPON RATE (THAT I S , THERE
rf          I S A CAP OR A FLOOR)
C
 -
            3. THE INVESTOR HAS AN OPTION TO
            CONVERT THE FIXED INCOME SECURITY TO
            AN EQUITY ISSUE
            4. THE CASH FLOW I S NOT DENOMINATED
            I N THE CURRENCY OF THE INVESTOR
            5. THE CASH FLOW DEPENDS ON THE
            EARNINGS OF THE COMPANY -- DIVIDENDS
----
r \    DISCOUNTING THE CASH FLOW
       ONCE THE CASH FLOW FOR A SECURITY I S
       ESTIMATED, THE NEXT STEP I S TO DETERMINE THE
       APPROPRIATE INTEREST RATE
       THREE QUESTIONS:
           .
          1 WHAT I S THE MINIMUM INTEREST RATE
          THE INVESTOR SHOULD REQUIRE?
          2. HOW MUCH MORE THAN THE MINIMUM
          INTEREST RATE SHOULD THE INVESTOR
          REOUIRE?
          3. SHOULD THE INVESTOR USE THE SAME
n         INTEREST RATE FOR EACH ESTIMATED CASH
-         FLOW OR A UNIQUE INTEREST RATE FOR
          EACH ESTIMATED CASH FLOW?
       THE MINIMUM INTEREST RATE THAT AN INVESTOR
       SHOULD REOUIRE I S THE YIELD AVAILABLE I N THE
       MARKETPLACE ON A DEFAULT-FREE CASH FLOW
                  r H I S I S THE YIELD ON A U.S.



                             ESTION
r .
    --   TRADITIONAL VALUATION APPROACH
         DISCOUNT EVERY CASH FLOW OF A SECURITY BY
         THE SAME INTEREST RATE (OR DISCOUNT RATE)
         EXAMPLE: THREE HYPOTHETICALlO-YEAR TREASURY
         SECURITIES SHOWN I N E X H I B I T 1: A 12% COUPON
         BOND, A 8% COUPON BOND, AND A ZERO-COUPON
         BOND




r\
+
         .............................................................
         E X H I B I T 1: CASH FLOW FOR THREE 10-YEAR HYPOTHETICAL TREASURY
         SECURITIES PER $100 OF PAR VALUE (EACH PERIOD I S S I X MONTHS)
                                       TREASURY SECURITY
         PERIOD           12% COUPON           8% COUPON          0 COUPON
         ..................................................................
r
-    CONTEMPORARY APPROACH
     FUNDAMENTAL FLAW OF TRADITIONAL APPROACH:
     VIEWS EACH SECURITY AS THE SAME PACKAGE OF CASH FLOWS
     EXAMPLE: A 10-YEAR U.S. TREASURY BOND WITH AN 8%
     COUPON RATE. THE CASH FLOW PER $100 OF PAR VALUE WOULD
     BE 19 PAYMENTS OF $5 EVERY S I X MONTHS AND $105 20 SIX-
     MONTH PERIOD FROM NOW
     THE TRADITIONAL PRACTICE WOULD DISCOUNT EVERY CASH
     FLOW USING THE SAME INTEREST RATE
     THE PROPER WAY TO VIEW THE 10-YEAR 8% COUPON BOND I S
     A PACKAGE OF ZERO-COUPON INSTRUMENTS
     EACH CASH FLOW SHOULD BE CONSIDERED A ZERO-COUPON
     INSTRUMENT WHOSE MATURITY VALUE I S THE AMOUNT OF THE
.-
     CASH FLOW AND WHOSE MATURITY DATE I S THE DATE OF THE
     CASH FLOW
     THUS, A 10-YEAR 8% COUPON BOND SHOULD BE VIEWED AS 20
     ZERO-COUPON INSTRUMENTS
     REASON THAT THIS I S THE PROPER WAY I S BECAUSE I T DOES
     NOT ALLOW A MARKET PARTICIPANT TO REALIZE AN ARBITRAGE
     PROFIT
     BY VIEWING ANY FINANCIAL ASSET I N THIS WAY,          A
     CONSISTENT VALUATION FRAMEWORK CAN BE DEVELOPED
     EXAMPLE: UNDER THE TRADITIONAL APPROACH TO THE
     VALUATION OF FIXED INCOME SECURITIES, A 10-YEAR ZERO-
     COUPON BOND WOULD BE VIEWED AS THE SAME FINANCIAL
     ASSET AS A 10-YEAR 8% COUPON BOND
     VIEWING A FINANCIAL ASSET AS A PACKAGE OF ZERO-COUPON
fl
%.
 "
 *
      INSTRUMENTS MEANS THAT THESE TWO BONDS WOULD BE VIEWED
      AS DIFFERENT PACKAGES OF ZERO-COUPON INSTRUMENTS AND
      VALUED ACCORDINGLY
      THE DIFFERENCE BETWEEN THE TRADITIONAL VALUATION
      APPROACH AND THE CONTEMPORARY APPROACH I S DEPICTED I N
      EXHIBIT 2 WHICH SHOWS HOW THE THREE BONDS WHOSE CASH
      FLOW I S DEPICTED I N EXHIBIT 1 SHOULD BE VALUED
      WITH THE TRADITIONAL APPROACH. THE MINIMUM INTEREST
                                                       0
      RATE FOR ALL THREE SECURITIES'IS THE YIELD ON A 1 -
               ..
      YEAR U S TREASURY SECURITY
      WITH THE CONTEMPORARY APPROACH THE MINIMUM YIELD FOR
      A CASH FLOW I S THE .THEORETICAL RATE THAT THE U.S.
      TREASURY WOULD HAVE TO PAY I F I T ISSUED A ZERO-COUPON
      BOND WITH A MATURITY DATE EQUAL TO THE MATURITY DATE
      OF THE ESTIMATED CASH FLOW.

 -.   THEREFORE, TO IMPLEMENT THE CONTEMPORARY APPROACH I T
      I S NECESSARY TO DETERMINE THE THEORETICAL RATE THAT
      THE U.S. TREASURY WOULD HAVE TO PAY TO ISSUE A ZERO-
      COUPON INSTRUMENT FOR EACH MATURITY
      ANOTHER NAME USED FOR THE ZERO-COUPON RATE I S T H E : m >
      CRATE?
      AS WILL BE EXPLAINED, THE SPOT RATE CAN BE ESTIMATED
      FROM8THE TREASURY YIELD CURVE
EXHIBIT 2: COMPARISON       OF   TRADITIONAL   APPROACH AND CONTEMPORARY APPROACH   IN   VALUING   FINANCIAL
ASSETS
EACH     PERIOD I S S I X MONTHS

               DISCOUNT   (INTEREST)RATE                            TREASURYSECURITY
PERIOO     TRADITIONAL    APPROACH CONTEMPORARY APPROACH 12% COUPON   8% COUPON    0                 COUPON
.........................................................................................
           10-YEARTREASURY RATE   1-PERIOD RATE
                                           SPOT
           10-YEARTREASURY RATE   2-PERIOD SPOT RATE
           10-YEARTREASURY R A T E3-PERIOD SPOT RATE
           10-YEARTREASURY RATE   4-PERIOD SPOT RATE
           10-YEARTREASURY RATE   5-PERIOD SPOT RATE
           10-YEARTREASURY RATE   6-PERIOD SPOT RATE
           10-YEARTREASURY RATE   7-PERIOD SPOT RATE
           10-YEARTREASURY RATE   8-PERIOD SPOT RATE
           If?-YEARTREASURY RATE  9-PERIOD SPOT RATE
          .YEAR TREASURY RATE 10-PERIOD SPOT RATE
           10-YEARTREASURY RATE 11-PERIOD RATE
                                           SPOT
           10-YEARTREASURY RATE 12-PERIOD SP.OT RATE
           10-YEARTREASURY RATE 13-PERIOD SPOT RATE
           10-YEAR TREASURY RATE 14-PERIOD SPOT RATE
           10-YEARTREASURY RATE 15-PERIOD SPOT RATE
           10-YEARTREASURY RATE 16-PERIOD SPOT RATE
           10-YEARTREASURY RATE 17-PERIOD SPOT RATE
           10-YEAR TREASURY RATE 18-PERIOD SPOT RATE
           10-YEAR TREASURY RATE 19-PERIOD SPOT RATE
           10-YEARTREASURY RATE 20-PERIOD SPOT RATE            :
?
w
    DISCOUNT RATE AND SECURITY PRICES
    THE HIGHER THE INTEREST RATE AT WHICH THE EXPECTED
    CASH FLOW OF A SECURITY I S DISCOUNTED, THE LOWER THE
    PRICE OR VALUE OF A SECURITY
    THEREFORE, SECURITY PRICES AND INTEREST RATES CHANGE
    I N THE OPPOSITE DIRECTION
    AS INTEREST RATES RISE, DISCOUNT RATES RISE, AND PRICE
    DECLINES
                         RETURN MEASURES
     SOURCES OF RETURN
     HERE ARE FOUR SOURCES OF RETURN FROM HOLDING A
     SECURITY
      1
     ( ) CONTRACTUAL COUPON INTEREST FOR A DEBT OBLIGATION
     (2) DIVIDEND INCOME FOR EARNINGS
     (3) CAPITAL GAIN (OR LOSS)
     (4) REINVESTMENT INCOME


     YIELD.MEASURES THAT RELATE CURRENT INCOME TO SECURITY
     PRICE ONLY
.~
,
.

                                       ANNUAL COUPON INCOME
     CURRENT YIELD FOR A BOND =       ......................
                                      MARKET PRICE OF BOND

                                      ANNUAL DIVIDEND INCOME
     DIVIDEND YIELD FOR STOCK     =    ........................
                                      MARKET PRICE OF STOCK
-- .-,   YIEU) FOR ANY TYPE OF IWESTMENT
         THE .YIELD ON AN INVESTMENT I S THE INTEREST RATE\ THAT
         WILL MAKE THE PRESENT VALUE OF THE CASH FLOW EQUAL TO;
                                           .
         THE I N I T I A L INVESTMENT :
         THE COMPUTATION OF THE YIELD FOR ANY INVESTMENT I S
         COMPUTED I N THE SAME WAY
          THE WIELD: ON AN INVESTMENT, WHICH I S ALSO CALLED THE
         :INTERNAL RATE OF RETURN; I S FOUND BY TRIAL AND ERROR

         ILLUSTRATION
         INVESTMENT  WH
                      I
                      T A COST OF $7,704 W H
                                          T
                                          I  FOLLOWING
         PROJECTED CASH FLOW




         YEARS FROM PROJECTED     PRESENT VALUE AT
            NOW:    CASH FLOW:    14%       12%
               1    $2,000       $1,754   $1,786
               2     2,000        1,538    1,594
               3     2,500        1,688    1,780
               4     4,000        2,368    2,544
                                 ------    ------
                        TOTAL $7,348      $7,704
         IRR I S 12% SINCE I T I S THIS INTEREST RATE THAT MAKES
         THE PRESENT VALUE O F .,THE CASH FLOW EQUAL THE COST
?
..-.
  ,    TRADITIONAL YIELD MEASURES FOR FIXED INCOME SECURITIES
       TRADITIONAL YIELD MEASURES INCLUDE:
         YIELD TO MATURITY    YIELD TO CALL    YIELD TO WORST

       YIELD TO MATURITY
       YIELD TO MATURITY I S THAT INTEREST RATE THAT EQUATES
       THE PRESENT VALUE OF THE CASH FLOW (COUPON INTEREST
       AND REDEMPTION VALUE AT MATURITY) TO THE MARKET PRICE.

       COMPUTATIONALLY, THE YTM I S FOUND USING AN ITERATIVE
       PROCEDURE.
       ILLUSTRATION : HYPOTHETICAL BOND
         YEARS TO MATURITY = 7
 .,
  -      COUPON RATE     8%
         MARKET PRICE      = $814.10
         MATURITY VALUE = $1,000
         SEMIANNUAL PAYMENTS
       FOR HYPOTHETICAL BOND, THE YTM I S THAT INTEREST RATE
       THAT WILL MAKE THE PRESENT VALUE OF THE CASH FLOW OF
       14 PAYMENTS OF $40 EACH SIX-MONTHS AND $1,000 14
       SIX-MONTH PERIODS FROM NOW EQUAL TO $814.10
       6% I S THE INTEREST RATE THAT MAKES THE CASH FLOW EQUAL
       TO THE PRICE ($814.10).      HENCE, 6 PERCENT I S THE
       SEMI-ANNUAL YIELD-TO- MATURITY
(?
 --   BOND EQUIVALENT YIELD: MARKET CONVENTION
      THE CONVENTION FOR CONVERTING A SEMI-ANNUAL TO AN
      ANNUAL YIELD I S TO DOUBLE THE SIX-MONTH YIELD. HENCE,
      THE YIELD TO MATURITY FOR OUR HYPOTHETICAL BOND I S

      THIS I S IMPORTANT TO REMEMBER BECAUSE THE YIELD
      COMPUTED I N THIS MANNER (DOUBLING THE SEMIANNUAL
      YIELD) I S CALLED THE BOND EQUIVALENT YIELD
 -&
      THE YIELD TO MATURITY DOES TAKE INTO ACCOUNT ANY
      CAPITAL GAIN OR LOSS COMPONENT OF TOTAL RETURN.
      DOES I T TAKE INTO ACCOUNT THE THIRD SOURCE -- INTEREST
      ON INTEREST?
      YES, I T DOES. HOWEVER, I T IMPLICITLY ASSUMES THAT THE
      PERIODIC CONTRACTUAL COUPON PAYMENTS ARE REINVESTED AT
      THE YIELD TO MATURITY.
      FOR EXAMPLE, I F THE YIELD TO MATURITY I S 12%, I T I S
      ASSUMED THAT THE COUPON PAYMENTS ARE ENTIRELY
      REINVESTED AT A RATE OF 12%.
      ILLUSTRATION OF DEPENDENCE OF RETURN ON INTEREST ON
      INTEREST
      INVESTMENT I SUPPOSE INVEST $1,000 FOR 30 YEARS AT AN
                  :
      INTEREST RATE OF 10% COMPOUNDED SEMIANNUALLY.
P
-.-
 1        AT END OF 30 YEARS WILL HAVE $18,679
      INVESTMENT 11: SUPPOSE INVEST $1,000 I N 3 0 YEAR
      TREASURY WITH A 10%COUPON AND SELLING AT PAR. YIELD
      TO MATURITY I S 10%
          TOTAL PROCEEDS AFTER 30 YEARS:
       TOTAL COUPON PAYMENTS = $3,000    PRINCIPAL = $1,000
           AT END OF 3 0 YEARS WILL HAVE $4,000
      DIFFERENCE OF $14,679 MADE UP BY REINVESTING COUPON
      PAYMENTS AT CALCULATED YIELD
      <REINVESTMENT RISK: FOR A BOND I T I S THE RISK THAT THE
      ACTUAL REINVESTMENT RATE WILL BE LESS TIIAN THE
       CALCULATED YIELD..
    .
    -%'.*
            -   YIELD TO CALL:
                RULE OF THUMB: A CONSERVATIVE INVESTOR WOULD USE THE
                LOWER OF THE TWO MEASURES I N EVALUATING INVESTMENT
\               MERITS OF A CALLABLE BOND
\
    -..          YIELD TO CALL CALCULATED USING SAME PROCEDURE AS TO
                 COMPUTE YIELD TO MATURITY: I.E. Y~IELD~TOICALL I S THE
                 INTERESTmRATE THAT W I LL MA~(EBTHE~IRRESENT~~L:UE~OF~CASH
                rF:kOWI-ASSUMINGrTHEaBOND~IS@CAL!l!ED EQUAL~TOITHE~~ARKET,
                 RRICE~OF~THE~BONDg
                THERE ARE   TWO   DRAWBACKS WITH    THE   YIELD-TO-CALL
                MEASURE:
                    1
                   ( ) REINVESTMENT RATE FOR COUPON PAYMENTS ARE
                ASSUMED TO BE EQUAL TO THE Y.IELD TO CALL (SAME PROBLEM
                AS THE YIELD TO MATURITY) AND



                YIELD TO WORST
                SMALLEST OF ALL POSSIBLE YIELD TO CALLS (CALCULATED
                FOR EACH CALL DAY) AND YIELD TO MATURITY
r
Y-
 &                        TOTAL   RETURN
     THE  PROPER MEASURE OF RETURN I S THE TOTAL-     RETURN,
     WHICH CONSIDERS A L L SOURCES OF RETURN




     WHEN AN INVESTOR S N I A)
                             ?
                             G
                             K
                             I       INVESTMENT DECISIONS, THE
     INVESTOR T R I E S TO ESTIMATE THE TOTAL RETURN THAT WILL
     BE REALIZED OVER SOME PLANNED INVESTMENT HORIZON

     WHEN AN INVESTOR S B I G
                      I   EN   EVALUATING  WHI
                                             T     RESPECT TO
     INVESTMENT PERFORMANCE, THE TOTAL RETURN I S THE RATE
     THAT WAS ACTUALLY REALIZED OVER SOME T I M E PERIOD

P
%
r-
 ;    ILLUSTRATION OF TOTAL RETURN CALCULATION FOR A BOND
     BY ASSUMING A SE IID
                    P CFE    INTEREST RATE AT W I H
                                               HC   COUPON
     PAYMENTS WILL BE REINVESTED, A TOTAL RETURN CAN BE
     COMPUTED




     STEPS I
           N COMPUTING               THE TOTAL RETURN FOR AN ISSUE                      SOLD
     PRIOR TO MATURITY




     (A)  THE DOLLARS THAT WILL BE RECEIVED FROM THE COUPON
     PAYMENTS,

     (B) INTEREST-ON-INTEREST BASED ON THE COUPON PAYMENTS
     AND THE ASSUMED REINVESTMENT RATE, AND
 -
     (c)     THE EXPECTED SALE PRICE AT THE HORIZON DATE

     THE  EXPECTED PRICE    DEPENDS   ON THE                                 INVESTOR'S
     EXPECTATIONS ABOUT FUTURE INTEREST RATES

     GIVEN     THE EXPECTED FUTURE INTEREST RATE FOR THE BOND
     AND      REMAINING YEARS TO MATURITY OF THE BOND, PRICE
     CAN      BE

     STEP 2:         CALCULATEWTHE~IN                            E THAT WL       I L MAKE
     THE ~ A M O U N T ~ I N V E S T E D ~ G ~ T O ~ T H E ~ T O T A L ~ F , U T U R E ~ D O L : L A R S .




     STEP 3:          TO ANNUALIZE           THE ABOVE TOTAL RETURN CAN DO
r\
; r
 a
      ONE OF      THE    FOLLOWING     ASSUMING   R   I S   A   SEMIANNUAL
      NUMBER:

             :2 X R'      = 'ANNUALIZED ON A BEY B A S I S
        -      '2'
        (1 + R)    -    l7 =   ANNUALIZED ON AN EFFECTIVE       COMPOUNDED
      'BASIS 1
        - -
 ..c-     ILSRT
              O
          LUTAI N      o F COMPUTATION OF THE TOTAL RETURN FOR AN
          ISSUE SOLD PRIOR TO MATURITY

          CONSIDER     A 20-YEAR BOND WITH A COUPON RATE OF           8%,
          SELLING     FOR $828.40
          Y I E L D TO MATURITY = 10%
          ASSUME: HORIZON THREE YEARS
          HORIZON YIELD       (YIELD     BOND WL
                                               IL   BE SELLING  FOR      AT
          HORIZON)     = 7%       REINVESTMENT  RATE   6% PER YEAR       (3%
          EVERY S   X
                    I   MONTHS)

          TOTAL RETURN BASED ON THESE ASSUMPTIONS          S
                                                           I     17.2%   AS
          SHOWN BELOW:

                :
          STEP 1 THE TOTAL   FUTURE DOLLARS THREE YEARS FROM NOW
          I S EQUAL TO THE SUM OF



 -   _,

          (2) THE INTEREST-ON-INTEREST ON THE COUPON INTEREST
          PAYMENTS ASSUMING A REINVESTMENT RATE OF 3% EVERY S I X
          MONTHS: $ 18.72

          (3) THE PRICE OF THE BOND AT THE END OF THE THREE
                                                  I L HAVE 17
          YEARS: AT THE END OF THREE YEARS, BOND WL
          YEARS TO MATURITY

          BY  ASSUMPTION,  INVESTOR EXPECTS THAT T I
                                                  HS        I L BE
                                                      BOND WL
          SELLING   TO OFFER A YIELD TO MATURITY OF 7%. THE P I E
                                                               RC
          OF A 17-YEAR BOND WITH AN 8% COUPON RATE SELLING TO
                   IL
          OFFER A YE D    TO MATURITY   OF   7% S
                                                I   $1,098.50.



          STEP 2: CALCULATE THE INTEREST RATE THAT WIL
                                                    L  MAKE THE
          AMOUNT INVESTED GROW TO THE TOTAL FUTURE DOLLARS.
f'
STEP 3:     TO ANNUALIZE THE ABOVE TOTAL RETURN CAN DO
ONE OF    THE FOLLOWING ASSUMING R I S A SEMIANNUAL
NUMBER:
r
#
.
-
:\     SCENARIO ANALYSIS
       ILLUSTRATION:
       PURCHASE CANDIDATE :
       PO-YEAR, 9% NONCALLABLE       BOND SELLING    AT    $109.896

       INVESTMENT HORIZON: 3 YEARS
       ASSUMPTION :
       REINVESTMENT  RATE CAN VARY FROM 3% TO             6.5%
       THE HORIZON Y I E L D FROM 5% TO 12%

       THE TOP PANEL ON NEXT PAGE SHOWS THE TOTAL FUTURE
       DOLLARS AT THE END OF THREE YEARS UNDER VARIOUS
       SCENARIOS.




 ...
k...
       THE PORTFOLIO MANAGER KNOWS MAXIMUM      NU
                                                II
                                           AND MM M    TOTAL
       RETURN SCENARIOS UNDER WHICH EACH WILL BE REALIZED.

        F
       I THE   PORTFOLIO MANAGER HAS THREE-YEAR L I A B I L I T I E S I N
       WIH
        HC   T HAS GUARANTEED, SAY, 6%, THEN THE PORTFOLIO
             I
       MANAGER WILL BE CONCERNED WITH SCENARIOS THAT WILL
       PRODUCE A THREE-YEAR TOTAL RETURN OF 6%.
     Nnnd A: 9 3 mupon, 20-year noncallahle hnnd
--           1.9
     Pltcc: $ W A 6         Yield lo maturity: 8.00%
     lnvestmcnl horiton: 3 ytnrs


                                         Weld at end 01 hntirnn
                5.00%    6.0117b   7          R.OOlh     9.00%      1O.m    11.m     f2.flO?h

                                         lforirnn price
                145.448 13j.698 119.701 109.206 1 0 0 . W 91.9035           R4.76.l 78.4478

      Reinv.                                Total future dnnllnrx
        rote     5.00%    b.W%      7 . m     8.m         9.00%     lb.W%   ll.lM%   I2.rmTh




       Reinv.
        rate
o INDEXES
    ARE USED TO GAUGE THE RELATIVE                PERFORMANCE
OF A MANAGER

o INDEX
    CONSTRUCTORS CALCULATE     THE TOTAL RETURN OF A
COMPOSITE OF SECURITIES OVER SOME T I M E PERIOD

o THERE ARE      INDEXES    CONSTRUCTED FOR ALL   MAJOR ASSET
CLASSES

      *   FOR STOCKS:      S&P 500
                           NYSE COMPOSITE
                           Dow JONES
                           RUSSELL STOCK INDEXE
                           WILSHIRE  STOCK INDEXE
      *   FOR BONDS:    :LEHMANBOND.INDEXES
                        ,SALOMON BROTHERS INDEXES
                         MERRILL LYNCH'INDEXES

o LIMITATIONS      OF INDEXES FOR ASSESSING   PERFORMANCE:
     DO NOT     CONSIDER R I S K
                             RISK
      RISKS ASSOCIATED WITH INVESTING I N FINANCIAL ASSETS


      TO ACCOMPLISH A CERTAIN INVESTMENT OBJECTIVE,               A
      PORTFOLIO MANAGERiMAY HAVE TO SELL A SECURITY.

      FOR                       I A CA
           EXAMPLE, SUPPOSE A FN N I L            N TT TO
                                                  I SIUI N    HAS A
      PORTFOLIO OF SECURITIES WITH A MARKET VALUE OF $10
      MILLION AND MUST SATISFY A L I A B I L I T Y OBLIGATION OF $10
      MILLION TWO YEARS FROM NOW.

      HS
      TI     I A CA
            FN N I L I SIUI N
                     N TT TO     FACES THE R K
                                            S
                                            I        THAT TWO
      YEARS FROM NOW, WHEN $10 MILLION MUST BE WITHDRAWN
      FROM THE PORTFOLIO TO SATISFY THIS L I A B I L I T Y , THE
      MARKET VALUE OF THE PORTFOLIO MAY BE LESS THAN $10
'
r
>.'
      MILLION.

       N
      I GENERAL,  INVESTORS ARE EXPOSED TO THE RISK THAT THE
      VALUE OF A SECURITY .(OR A PORTFOLIO) WLIL    DECLINE IN?
                    S RISK S REFERRED TO AS~PRICE- RISK.]
      THE FUTURE. THI        I                   -..     .

      THE GENERAL MOVEMENT OF THE STOCK MARKET AS A WHOLE S
                                                          I
      THE PRIMARY FACTOR CONTRIBUTING TO THE PRICE RISK OF
      COMMON STOCK.

      FOR BONDS,           I
                   CHANGES N INTEREST RATES ARE THE PRIMARY
      FACTOR CONTRIBUTING   TO PRICE RISK, SINCE WHEN INTEREST
      RATES RISE, THE PRICE OF A BOND DECLINES.

      THE MATURITY                     T
                   OF A BOND AFFECTS I S   PRICE  IK
                                                 RS :           THE
      LONGER THE MATURITY, THE GREATER THE PRICE RISK
    DEFAUL-RISK,     ALSO REFERRED TO ASL~REDIT~RISK, -3S THE
                                                         I
    R I S K THAT THE .ISSUER~OF A BOND MAY BE tUNABl!E&TOmMAKE
    TIMELY PRINCIPAL AND ,INTEREST PAYMENTSON THE ISSUE.


    TYPICALLY,            S
                          I
                DEFAULT R K   I
                              S GAUGED BY RATINGS                 ASSIGNED
    BY    COMMERCIAL RATING COMPANIES:
         MOODY'S INVESTOR SERVICE
         STANDARD & POOR'S CORPORATION
         DUFF & PHELPS
         FITCH INVESTORS  SERVICE
    DEFAULT         I
                    S
                   RK     S A RESULT OF TWO TYPES OF RS :
                          I                                  IK
                        BUSINESS R I S K AND FINANCIAL R I S K

    1. IBUSINESS~RISK
         -          -   I S THE R I S K THAT THE ICASH~FEOWUOFBAN
    -
                    -


    'ISSUER WILL BE IIMPAIREDABECAUSE.LOFIADVERSE~ECONOMIC
P    CONDI;T.IONS MAKING I T ~DIF;~ICULTmTOHMEET1)I-TS~OPERAT~ING


    FOR EXAMPLE, A HOTEL CHAIN    I
                                  T
                                 WH    A LARGE NUMBER OF
    RESORT PROPERTIES WILL SEE A REDUCTION OF I T S CASH
    FLOW DURING SEVERE ECONOMIC TIMES.

    2. C    ~             ~            ~
                                 ~ THE R I S K THAT THE CCASHIFLOW OF AN
                                                ~     ~     ~     ~     ~    ~
    ISSUER WILL~NOT~BE
                THESE OBLIGATIONS
    OBL'IGATXONS'.                INCLUDE THE REPAYMENT
    OF DEBT AND INTEREST PAYMENTS.
       1
       . U DT
       I .
      CQ T I Y  OR MARKETABILI-TY       I A CA
                                  OF A FN N I L     ASSET REFERS

       -
      TO THE EASEmWITHmWHICH~I;TmCAN~BE~SOl!D
     (VALUE?

      TI
      HS
                                                (AT-ORmNEARWI-TS


             I S AN IMPORTANT AND WIDELY USED NOTION, ALTHOUGH
      THERE I S AT PRESENT NO UNIFORMLY ACCEPTED D E F I N I T I O N
      OF L I Q U I D I T Y .




     I~ITUS,
      D I
     ~I~YRK                      ARISES FROM THE dDIEFICUklXmOFI
                                THEN,
                               IT
     ~SELQINGVAN~ASSET. CAN BE THOUGHT OF AS THE
     DIFFERENCE      BETWEEN THE "TRUE VALUE" OF THE ASSET, AND
(7   THE L I K E L Y PRICE, LESS COMMISSIONS.

      FOR MANY OTHER     I A CA
                        FN N I L   ASSETS, YQ
                                           TUII
                                             DIL                                          I
                                                                                          S
     DETERMINED BY CONTRACTUAL ARRANGEMENTS.

     ORDINARY      BANK DEPOSITS,  FOR EXAMPLE, ARE PERFECTLY
     L I Q U I D BECAUSE THE BANK HAS A CONTRACTUAL OBLIGATION
     TO CONVERT THEM AT PAR ON DEMAND.

       N
      I THE CASE       OF FINANCIAL ASSETS THAT ARE TRADED I N THE
     MARKET, THE I P R I M A R ~ M E A S U R E ~ O F ~ D I W S THE SZ       I            IE
     OF T H E I S P R E A D ~ B E T W E E N ~ T H E ~ B I D I P R I C E * A N D ~ T H E ~ A S K ~ P R I C E ~
     QUOTED BY AN ENTITY, ,I?LIUSICOMMISSIONS;                -
     THE GREATE~~~LTHI~~SPREAD~ANDJICOMMISSIONS:
                                     THE (GREATER*
      THE CLIQUIDI:~mRISK+
INFLATIONS
    I
    S
   RK OR PURCHASING-POWER RK
                           I                               S THE R K
                                                           I       I
                                                                   S
                                                    -
THAT $ H A N G E S ~ I N ~ T H E ~ R E A L ~ R E T UTHE INVESTOR
REALIZE AETER~ADJUSTING~FOR-INFI!ATION
                                                     R~
                                                              WILL
                                                                   WLI
                                                                     L
                                                                       BE
NEGATIVE.



REINVESTMENT    I
                S
               RK     S THE R K
                      I      S
                             I   THAT PROCEEDS~RECEIVED
L
 IN-FUTURE        WILL HAVE TO BE REINVESTED@ATflA.LOWER
,P,OTENTIALINTEREST*RATE




FOR   A FIXED
rBORROWERmCAN

HOLDS
                   INCOME



AND ASSET-BACKED SECURITIES
                              SECURITY,      THE
                                      ITY D T .
                                       . I B A EO
                                               d
                                                    -
                                                    RISK-HAT~THE


      FOR CALLABLE BONDS, MORTGAGE-BACKED SECURITIES,
                                                       F ~ T EWOAN
                                                             H




THE   RISK THAT AN INVESTOR HAS NO CLUE OF WHAT THE RISK
IS.
                       DISCUSSION QUESTIONS
     IDENTIFY
        THE RS S
             IK  ASSOCIATED              WH
                                          T
                                          I    THE   FOLLOWING
     ALTERNATIVE INVESTMENTS:

     1 FORAN
      .                    T
                           I
                INVESTOR W H A ONE-YEAR INVESTMENT HORIZON,
     PURCHASING   A ONE-YEAR TREASURYB L
                                      I
                                      L   VERSUS PURCHASING
     A 30-YEAR TREASURYBOND




     4.   FOR AN INVESTOR   WH
                             I
                             T    A   FIVE-YEAR    INVESTMENT
     HORIZON,  PURCHASING A SOVEREIGN     BOND (WITH    DOLLAR
-
-,
 .   DENOMINATED CASH FLOW PAYMENTS) VERSUS PURCHASING A
     U.S. CORPORATE BOND WITH A B RATING
     5.   FOR  AN INVESTOR   WH
                              I
                              T    A FOUR-YEAR   INVESTMENT
     HORIZON,  PURCHASING A LESS ACTIVELY TRADED 10-YEAR  AA
     RATED BOND VERSUS PURCHASING   A 10-YEARAA RATED BOND
     THAT I S ACTIVELY TRADED

     6. FOR AN INVESTOR WH
                         T
                         I    A TWO-YEAR INVESTMENT HORIZON,
     PURCHASING THE COMMON STOCK OF IBM VERSUS PURCHASING
     A TWO-YEAR TREASURY   NOTE

     7. FOR AN INVESTOR WITH A TWO-YEAR INVESTMENT HORIZON,
     PURCHASING THE COMMON STOCK OF I B M VERSUS PURCHASING
     A 30-YEARTREASURYBOND
                             QUANTIFYING RISK
     RK
      S
      I      CAN  BE MEASURED AS THE VARIABIL-1.w-OF-THE
     COTENTIAL~RETURN~AROUND  THE MEAN OR EXPECTED VALUE

      N
     I STATISTICS,  A POPULAR MEASURE OF V A R I A B I L I T Y I S THE
     VAR1ANCE)ORhTHE SQUARE ROOT OF THE VARIANCE WHICH I S
     CALLED THE STANDARDmDEVIATION




     MORE    SPECIFICALLY,   THE         ~STANDAR&DEVIATION&
                                               - -.-
     HISTORICA~RETURNS#ISIUSED.



     FOLLOWING FORMULA:
                                    T
                                  ----     (X       - XI*
                   VARIANCE     = \       -----------
                                                T

                                  I-   T - 1
                                      ~=l
     AND THEN



     WHERE    XT   =    OBSERVATION T ON VARIABLE        X
                   =    THE AVERAGE SAMPLE VALUE FOR VARIABLE      XT
              T     =   THE NUMBER OF OBSERVATIONS I N THE SAMPLE

             N
            I THE STOCK
                      MARKET, THE H I S T O R I C A L DATA USED I S
     THE RETURN ON SOME STOCK MARKET INDEX           -


             N
            I THEBOND MARKET, THE H I S T O R I C A L DATA USED I S
r'   THE PARTICULAR INTEREST RATE OF INTEREST
C   ~NTERPRETING   THE   ANNUALIZED   STANDARD DEVIATION
     N
    I ORDER   TO INTERPRET THE STANDARD DEVIATION,         MUST
    REVIEW SOME BASIC PROBABILITY THEORY.

    INMANY        APPLICATIONS    INVOLVING    PROBABILITY
    DISTRIBUTIONS,  I T I S ASSUMED THAT THE UNDERLYING
    PROBABILITY DISTRIBUTION I S A NORMAL DISTRIBUTION.




    THUS, THE PROBABILITY     B ANN
                          OF O T I I G A VALUE LESS THAN
    THE EXPECTED VALUE, S I   50%. THE PROBABILITY    OF
    OBTAINING A VALUE GREATER THAN THE EXPECTED VALUE I S
    ALSO 50%.

    2   THE PROBABILITY  THAT THE ACTUAL OUTCOME WL
                                                  IL BE
    WITHIN A RANGE OF ONE STANDARD DEVIATION ABOVE THE
    EXPECTED VALUE AND ONE STANDARD DEVIATION BELOW THE
    EXPECTED VALUE S 68.26% ROUNDED OFF TO 68.3%.
                       I

    3   THE PROBABILITY  THAT THE ACTUAL OUTCOME WZLL BE
    WITHIN A RANGE OF TWO STANDARD DEVIATIONS ABOVE THE
    EXPECTED VALUE AND TWO STANDARD DEVIATIONS BELOW THE
    EXPECTED VALUE S 95.46% ROUNDED OFF TO 95.5%.
                       I

    4   THE PROBABILITY  THAT THE ACTUAL OUTCOME WL  IL BE
    WITHIN A RANGE OF THREE STANDARD DEVIATIONS ABOVE THE
    EXPECTED VALUE AND THREE STANDARD DEVIATIONS BELOW THE
    EXPECTED VALUE I S 99.74% ROUNDED OFF T O 99.7%.
..
-
     o WHAT           DOES T  I MEAN FI   THE ANNUALIZED          STANDARD
                                                                        I.
     D E V I A T I O N OR ANNUALIZED INTEREST RATE V O L A T I L I T Y (E,
     STANDARD D VA I N E I TO    OF INTEREST RATES) FOR LONG-TERM
     BONDS I S , SAY, 15%?

             T
     0 I MEANS THAT I F THE P R E V A I L I N G INTEREST RATE
     (YIELD)          ON LONG-TERM BONDS S        I   7%, THE STANDARD
     D E V I A T I O N OF LONG-TERM Y I E L D S I N ONE YEAR I S 105 B A S I S
     POINTS (7% TIMES 15%).



          1.THERE S A 68.3% PROBABILITY
                      I                          THAT THE YE D
                                                           IL  ON
     LONG-TERM BONDS ONE YEAR FROM NOW WILL BE W I T H I N ONE
     STANDARD D E V I A T I O N BELOW AND ABOVE 7%.

     THUS, THERE S A 68.3% PROBABILITY
                  I                    THAT THE'YIELD ON
     LONG-TERM BONDS ONE YEAR FROM NOW WILL BE BETWEEN
     5.95% AND 8.05%.
0
          2. SIMILARLY,             FROM THE PROPERTIES    OF A NORMAL
     D I S T R I B U T I O N WE KNOW THAT THERE I S A 95.5% PROBABILITY
     THAT THE Y I E L D LEVEL ON LONG-TERM BONDS ONE YEAR FROM
     NOW WILL BE W I T H I N A RANGE OF TWO STANDARD DEVIATIONS
     (BETWEEN 4.9% AND 9.10%)

          3. THERE I S A 99.7% P R O B A B I L I T Y I T WILL BE W I T H I N
     A   RANGE OF THREE STANDARD DEVIATIONS                 (3.85% AND
     10.15%)   .
          NOTICETHAT THE LARGER THE YE D IL    VOLATILITY,   THE
     LARGER THE RANGE OF THE Y I E L D LEVEL I N THE FUTURE.

          HS
          TI  MEANS THAT THERE S I         GREATER UNCERTAINTY        ABOUT
     THE FUTURE Y I E L D LEVEL.
--.*   0 WHAT DOES I T MEAN I F THE ANNUALIZED                STANDARD
        E I TO
       D VA I N  FOR THE RETURN ON THE S&P 500 S  I           20% MEAN
       ASSUMING THAT THE HISTORICAL MEAN I S lo%?

           T
       0 I MEANS THAT. THE STANDARD DEVIATION OF THE RETURN
       ON THE S&P 500 S 200 BASIS
                      I           POINTS (10% TIMES 20%).




             2. THERE I S A 95.5% PROBABILITY THAT THE RETURN
       WL
        IL    BE BETWEEN 6% AND 16%.

             3.   THERE I S A   99.7% PROBABILITY   I T WILL BE BETWEEN
       4% AND
r)
 -
-*
     HISTORICAL LOOK AT RISK AND RETURN I N CAPITAL MARKETS
     EMPIRICAL EVIDENCE ON    I
                             RK
                              S   AND RETURN FOR   U.S.,   JAPAN
     AND CANADA FOLLOWS

     EACH TABLE SHOWS THE MEAN RETURN AND THE STANDARD
     DEVIATION FOR EACH ASSET CLASS

     WHILE   HAVE NOT DISCUSSED       ASSET CLASSES,  AI
                                                     B SC
     CONCLUSION THAT THE AVERAGE RETURN FOR AN ASSET CLASS
     I S POSITIVELY RELATED TO I T S RISK

     POWERFUL  NN
              FDG
               I I :    IMPLICATION SI  THAT, ON AVERAGE,
     INVESTORS HAVE BEEN REWARDED FOR TAKING ON ADDITIONAL
     RISK.
r).
li..
       .........................................................
                                                  TTTS
                                                    II
       U.S. FINANCIAL MARKETS: 1926-1992 SUMMARY SASC                              OF   ANNUAL
       RETURNS (REWARD) AND STANDARD DVIN
                                       AO
                                      EIT    RKI
                                             ( S)
                                                      RMT
                                                       T C
                                                      AIHEI        E MT I
                                                                  G O E RC          STANDARD
                                                        MEAN        MEAN           DEVIATION

       COMMON STOCKS-
       SMALL COMPANY STOCKS
       LONG-TERM  CORPORATE BONDS
       LONG-TERM  TREASURY BONDS
       INTERMEDIATE-TER   TREASURY BONDS
       TREASURY BILLS
       INFLATION




       .........................................................
       JAPANESEFINANCIAL            MARKETS: 1973-1987
 -
 '
 ,     SUMMARY SASC
       DVO
         AI
        EITN
                TTTS
                  II
                 RKI
                 ( S)
                                      OF ANNUAL RETURNS        (REWARD)      AND    STANDARD
                                                      RMT
                                                       T C
                                                      AIHEI        E MT I
                                                                  G O E RC          STANDARD
       SECTOR N
              I       JAPAN                             MEAN        MEAN           DEVIATION
       ...............................................................
                                                  1
       LARGE A P I T A L I Z A T I O N
             C                           STOCKS       13.29%       12.07%            16.31%
                                                2
       SMALL CAPITALIZATION              STOCKS       16.74        14.07             26.72
                                            3
       LONG-TERM CORPORATE BONDS  8.90  8.76 5.56
       LONG-TERM GOVERNMENT BPNDS 8.88  8.70 6.15
       SHORT-TERM INSTRUMENTS     7.26  7.24 2.74
       INFLATION                   6.08 5.92 5.94
       ................................................................
       1 .   AS   MEASURED    BY   THE TOKYO STOCK EXCHANGE IINDEX.
       2.    As   MEASURED    BY   THE TOKYO STOCK EXCHANGE I1 INDEX.
       3.    AS   MEASURED    BY   THE LONG-TERM BONDS OF N I N E ELECTRIC COMPANIES.
       4.    AS   MEASURED    BY   THE RATE ON BOND REPURCHASE AGREEMENTS
       ................................
                           AUH
       SOURCE: TABLE 1 OF YS S I              HAMAO, "JAPANESE                  LS
                                                                                I
                                                                STOCKS, BONDS, BL ,
       AND INFLATION: 1973-87,"              JOURNALF PORTFOLIO
                                                     O             MANAGEMENT (WINTER
       19891, P. 24.
._/
                                       ARITHMETIC     GEOMETRIC        STANDARD
SECTOR   IN   CANADIAN                   MEAN           MEAN          DEVIATION
...............................................................
ALL STOCKS                               11.49%         12.92%          17.87%
LONG-TERMINDUSTRIAL BONDS                 6.22           6.63            9.82
LONG-TERMCANADA BONDS                     5.35           5.78           10.27
TREASURY BILLS                            5.84           5,92            4.20
INFLATION                                 4.71           4.77            3.81
................................
SOURCE: JAMESE. HATCH AND ROBERT W. WHITE, CANADIAN STOCKS. BONDS,
BILLS. AND INFLATION VA: INSTITUTE
                     (CHARLOTTESVILLE,                OF CHARTERED
FINANCIAL ANALYSTS, 1988).
...................................................................
-    WHAT MODERN PORTFOLIO THEORY AND &AI~I.TALIMARKET.THEORY
     SAY ABOUT RISK
     THEORY SAYS       THAT       THE   RELEVANT~MEASURE~OF~RISK
                                                              I S
     ~YSTEMATIC~RISK
      w
     THAT    S
             I,    S
                   I
                  RK      N
                          I       GENERAL     CAN BE D D D
                                                      VE
                                                      II                  INTO      TWO
     RISKS :



     ~ T ~ R I S K ~ I S ~ M E A S U R E DBY THE VARIANCE             OR .STANDARD
     DEVIATION

     UNSYSTE-SK*aRISKS
     L
       -
                                                                  -
                                          THAT ~ A N ~ B E ( D I V E R S I ~ I ~ A W A Y ~

           ALSO CALLED D I V E R S I F I A B L E OR RESIDUAL RISKS

     ISYSTEMAECIIRISKS        =   RISKS THAT CANmNO_T,BE D I V E R S I F I E D
                                                              -
     AWAY                                                    1   P"
..
                                                            #
           ALSO CALLED NONDIVERSIFIABLE R I S K

     ECONOMIC   LOGIC:      INVESTORS  CAN   DIVERSIFY   ANY
     UNSYSTEMATIC R I S K SO THEY SHOULD ONLY BE COMPENSATED
     FOR THE RISKS THAT THEY CANNOT ELIMINATE
r\
 -
     '   TWOTHEORIES       OF ASSET PRICING:

         1. C PAA S T
               I ,
               ,
             AT L S E             PRCN , O E
                                   , I I GM D L      (CAPMISAYS THAT THE
         ONLY IRELEVA                             SaaKKET,RISK

               THE    RELATIVE MEASURE OF \RISKIISIITHE~BETA~_OF                   A
         STOCK OR     ATORTFOLIO
               BETAWINDICATES~~LTHE~MOVE                         STOCK       OR    A
         PORTFOLIO TO THE MARKET OVERALL

               BETAS
                   I  ESTIMATED              SN
                                            UIG   HISTORICAL       DATA      UIG
                                                                              SN
         REGRESSION ANALYSIS

               EXAMPLE,
                      F THE BETA OF A STOCK S ESTIMATED
                      I                       I            AT .8
         USING REGRESSION ANALYSIS AND THE S&P 500 I S THE
         MARKET INDEX USED, T H I S MEANS THAT I F THE RETURN ON
         THE S&P 500 I S        lo%,
                              THEN THE RETURN ON THE STOCK I S
         EXPECTED TO BE 8%
ni

               THE CAPM   POSITS    THAT MARKET R K
                                                  I
                                                  S            S
                                                               I       THE   ONLY
         SYSTEMATIC R I S K     --
                                 THERE ARE NO OTHERS

               THE CAPM
                      SHOWS THE RISK/RETURN             RELATIONSHIP         FOR A
         STOCK OR A STOCK PORTFOLIO

               THE CAPM    S
                           I:




         A  STOCK WITti A BETA. EQUAL TO ZERO SHOULD HAVE THE
         RISK-FREE RETURN

         A    STOCK WITH A       BETA     EQUAL TO ONE HAS AN          EXPECTED
(?
(?
-*-   RETURN EQUAL TO THAT OF THE MARKET

      ~BETA,IS
         ---       THE   ~UANTIFICATIGN   OF RISK   ACCORDING   TO   CAPM




            ALSOSHOWS THE RELATIONSHIP      BETWEEN RISK              AND
      RETURN AND POSITS THE RELEVANT R I S K MEANS




          AS WITH THE CAPM, THEORY SAYS THAT AN INVESTOR
      SHOULD REALIZE THE RISK-FREE RATE AND REWARD FOR
      SYSTEMATIC RISKS
r\
&-
 .   QUANTIFYING THE SENSITIVITY OF BOND PRICES TO INTEREST
     RATE CHANGES
     FOR  BONDS, AN APPROXIMATION OF THE PRICE R I S K      TO
     CHANGES I N INTEREST RATES I S A BOND'S (DURATION:

     MORE SPECIFICALLY,      DURATION MEASURES THE APPROXIMATE
     PERCENTAGE CHANGE I N THE PRICE OF AN ASSET OR THE
     MARKET VALUE OF A PORTFOLIO I F INTEREST RATES CHANGE
     BY 100 B A S I S POINTS

     SO, FOR EXAMPLE, THE.PRICE OF A BOND WITH A DURATION
     OF 4 WILL CHANGE BY APPROXIMATELY 4% I F INTEREST RATES
     CHANGE BY 100 BASIS POINTS




     FOR A 50 B SS
                AI   POINT        I
                           CHANGE N  INTEREST RATES, THE
-1
     PRICE OF A BOND WITH A DURATION OF 4 WILL CHANGE BY
     APPROXIMATELY 2%

     ALL FINANCIAL ASSETS HAVE A DURATION     SINCE   THEY ALL
     RESPOND TO CHANGES I N INTEREST RATES

     FOR EXAMPLE, F THE DURATION
                  I                OF A STOCK SI  .5, THIS
     MEANS THAT THE PERCENTAGE CHANGE I N THE PRICE OF THE
     STOCK WILL BE APPROXIMATELY .5% I F INTEREST RATES
     CHANGE BY 100 BASIS POINTS.
(?
 .. -
        RISK/REWARD MEASURE
        SHARPE  INDEX  I
                       S   A MEASURE OF         REWARD/RISK    AI
                                                              R TO
        CALCULATED ON AN HISTORICAL B A S I S

        THE           I
            NUMERATOR S THE DIFFERENCE     BETWEEN THE PORTFOLIO
        RETURN AND THE RISK-FREE RATE

        THE  S
            RK
             I   OF THE PORTFOLIO I
                                  S     MEASURED BY THE STANDARD
        DEVIATION OF THE PORTFOLIO




        THUS THE SHARPE INDEX I
                              S A MEASURE OF THE EXCESS
        RETURN RELATIVE TO THE TOTAL V A R I A B I L I T Y O F THE
f7
 .,     PORTFOLIO.
p..
.    ..                 .
                       J P. MORGAN'S RISKMETRICS~~
-
..



          HAS TWO MEASURES OF MARKET RISK
           .
          1 DAILY EARNINGS AT RISK "DEAR": MEASURES MAXIMUM
          ESTIMATED LOSSES ON. A GIVEN POSITION THAT CAN BE
          EXPECTED TO BE INCURRED OVER A DAY WITH 95%
          PROBABILITY
          DEAR I S MEASURED AS FOLLOWING FOR A SINGLE ASSET:
          MARKET VALUE OF A POSITION
          TIMES SENSITIVITY OF VALUE TO CHANGE I N PRICE
          TIMES ADVERSE PRICE MOVE PER DAY
          2. VALUE AT RISK "VAR": MEASURES MAXIMUM ESTIMATED
          LOSSES I N MARKET VALUE OF A GIVEN POSITION THAT BE
r\
~,
          EXPECTED TO BE INCURRED UNTIL THE POSITION CAN BE
          NEUTRALIZED OR I S REASSESSED
          FOR AN INDIVIDUAL ASSET FOUND AS FOLLOWS:
          VAR = DEAR TIMES
              SQUARE ROOT OF TIME TO DECISION HORIZON
C         1
    PART 1 : FINANCIAL INSTRUMENTS
    WHAT YOU NOW KNOW:
      .
    1 RISKS OF ISSUERS (FROM OUR DISCUSSION OF PLAYERS)
    2. RISKS ASSOCIATED WITH INVESTING
    3. THE RISK/REWARD RELATIONSHIP
    NOW LET'S LOOK AT THE DEVELOPMENT OF FINANCIAL
    INSTRUMENTS I N TERMS OF 1 AND 2
    BEFORE DOING SO LOOK .AT:
     .
    1 NOTION OF MARKET EFFICIENCY AND I T S IMPLICATIONS
    FOR FUND RAISING AND INVESTING
    2. THE DEGREE OF INTEGRATION OF GLOBAL FINANCIAL
    MARKETS AND I T S IMPLICATIONS FOR FUNDING AND INVESTING

L
    3. THE FACTORS LEADING TO GLOBALIZATION OF FINANCIAL
    MARKETS
    4. CLASSIFICATION OF GLOBAL FINANCIAL MARKETS
    5. REASONS FOR FINANCIAL INNOVATION
(2          MARKET EFFICIENCY AND I T S IMPLICATIONS
     MARKET EFFICIENCY MEANS THAT ALL INFORMATION I S
     EMBODIED I N PRICE OF SECURITIES (OR SECURITIES TO BE
     ISSUED) SO THAT:
      .
     1 INVESTORS CANNOT REALIZE ABNORMAL RETURNS AFTER
     ADJUSTING FOR THE SECURITY'S RISK
     2. ISSUERS CANNOT REALIZE A LOWER COST OF FUNDS FOR
     THE SECURITY'S THAT THEY ISSUE THAN I S APPROPRIATE FOR
     THE RISK
     THAT I S , PRICES FAIRLY REFLECT INFORMATION AVAILABLE
     TO MARKET PARTICIPANTS
r\    INTEGRATED VERSUS SEGMENTED WORLD CAPITAL MARKETS
      ISSUER
        MAY SEEK TO R I E
                     AS              FUNDS OUTSIDE  IS
                                                    T    LOCAL
      CAPITAL MARKET WITH THE EXPECTATION OF DOING SO AT A
      COST LOWER THAN THAT I N I T S LOCAL CAPITAL MARKET

      WHETHER  H
              TSI   S
                    I  POSSIBLE  DEPENDS ON THE DEGREE OF
      INTEGRATION OF CAPITAL MARKETS

      TWO EXTREMES: WORLD   CAPITAL        MARKETS CAN BE CLASSIFIED
      AS EITHER
            COMPLETELY SEGMENTED OR
            COMPLETELY INTEGRATED

      COMPLETELY  SEGMENTED MEANS THAT INVESTORS     I
                                                     N   ONE
      COUNTRY ARE NOT PERMITTED TO INVEST I N THE SECURITIES
      ISSUED BY AN ENTITY I N ANOTHER COUNTRY

       N
      I A COMPLETELY  SEGMENTED MARKET, THE REQUIRED RETURN
---
  1   OF SECURITIES OF COMPARABLE RISK THAT ARE TRADED I N
      DIFFERENT CAPITAL MARKETS THROUGHOUT THE WORLD I S
      DIFFERENT EVEN AFTER'ADJUSTING FOR TAXES AND FOREIGN
      EXCHANGE RATES

      AN M LC TO
         I PI A I N  I        I
                     S THAT F A BORROWER RAISES           I
                                                    FUNDS N
      THE CAPITAL MARKET OF ANOTHER COUNTRY, I T MAY BE ABLE
      TO DO AT A COST THAT I S LOWER THAN DOING SO I N I T S
      LOCAL CAPITAL MARKET

      COMPLETELY  INTEGRATED CAPITAL  MARKET MEANS THAT THERE
      ARE   NO  RESTRICTIONS     PREVENTING  INVESTORS   FROM
      INVESTING I N SECURITIES ISSUED I N ANY CAPITAL MARKET
      THROUGHOUT THE WORLD

       N
      I SUCH   AN IDEAL WORLD CAPITAL MARKET, THE REQUIRED
      RETURN ON SECURITIES OF COMPARABLE RISK WILL BE THE
      SAME I N ALL CAPITAL MARKETS AFTER ADJUSTING FOR TAXES
      AND FOREIGN EXCHANGE RATES
P
-z
                                      48
 - --   AN I PI A I N
           M LC TO     I
                       S THAT THE COST OF FUNDS WL
                                                 I L BE THE
        SAME REGARDLESS OF WHERE I N THE CAPITAL MARKETS
        THROUGHOUT THE WORLD A CORPORATION ELECTS TO RAISE
        THOSE FUNDS

        REAL-WORLD  CAPITAL MARKETS ARE NEITHER        COMPLETELY
        SEGMENTED NOR COMPLETELY INTEGRATED

        RATHER   THEY FALL SOMEWHERE I N BETWEEN

        SUCH MARKETS CAN BE REFERRED TO AS MILDLY   SEGMENTED OR
        MILDLY INTEGRATED

        AN  M LC TO
           I PI A I N   FOR FUND-RAISING E TTE
                                          NII S    I
                                                   S THAT N A
                                                           I
        WORLD CAPITAL MARKET THAT CAN BE CHARACTERIZED I N T H I S
        WAY, THERE ARE OPPORTUNITIES TO RAISE FUNDS AT A LOWER
        COST I N SOME CAPITAL MARKETS OUTSIDE THE LOCAL CAPITAL
        MARKET

f'
 .~
 ..
,.-   FACTORS LEADING TO THE BETTER INTEGRATION OF CAPITAL
      MARKETS


      (1) DEREGULATION OR L I B E R A L I Z A T I O N OF CAPITAL MARKETS
      AND A C T I V I T I E S OF MARKET PARTICIPANTS I N KEY F I N A N C I A L
      CENTERS OF THE WORLD

      (2)  TECHNOLOGICAL ADVANCES   FOR MONITORING WORLD
      MARKETS, EXECUTING ORDERS, AND ANALYZING  FINANCIAL
      OPPORTUNITIES; AND,

      (3)   INCREASED I N S T I T U T I O N A L I Z A T I O N OF CAPITAL MARKETS.
%
.   -i
         CLASSIFICATION OF CAPITAL MARKETS
         THERE I S NO UNIFORM SYSTEM FOR C L A S S I F Y I N G THE GLOBAL C A P I T A L
         MARKETS




                                                             EXTERNAL MARKET
                                                      (ALSO CALLED INTERNATIONAL
                                                       MARKET, OFFSHORE MARKET,
                                                       AND EUROMARKET




         DOMESTIC MARKET: WHERE ISSUERS DOMICILED I N THE COUNTRY I S S U E
         SECURITIES AND WHERE THOSE S E C U R I T I E S ARE SUBSEQUENTLY TRADED

         FOREIGN MARKET OF A COUNTRY:       WHERE ISSUERS NOT DOMICILED I N THE
    4    COUNTRY ARE ISSUED AND TRADED

              RULES GOVERNING THE ISSUANCE OF FOREIGN S E C U R I T I E S ARE
              THOSE IMPOSED BY REGULATORY AUTHORITIES WHERE THE
              SECURITY I S ISSUED

         EXTERNAL     MARKET:   INCLUDES    SECURITIES   WITH        THE  FOLLOWING
         DS I G I HN
          I TN US I G     FEATURES:    .
              (1) THEY ARE UNDERWRITTEN BY AN INTERNATIONAL SYNDICATE
              (2) THEY ARE OFFERED A T ISSUANCE SIMULTANEOUSLY TO INVESTORS I N
         A NUMBER OF COUNTRIES, AND
              (3) THEY ARE ISSUED OUTSIDE THE J U R I S D I C T I O N OF ANY SINGLE
         COUNTRY
         FINANCIAL INNOVATION
-/*

         COMPETITION AMONG FINANCIAL   INSTITUTIONS HAS BROUGHT FORTH AND
         FOSTERED THE DEVELOPMENT OF NEW PRODUCTS AND MARKETS

         REGULATIONS     THAT IMPEDE THE FREE FLOW OF C A P I T A L AND COMPETITION
         AMONG FINANCIAL     INSTITUTIONS (PARTICULARLY   INTEREST RATE CEILINGS)
         HAVE FOSTERED THE DEVELOPMENT OF F I N A N C I A L PRODUCTS AND TRADING
         STRATEGIES TO GET AROUND THESE RESTRICTIONS




         SINCE THE 1              ~
                          9 6 0 ~THERE   HAS BEEN A SURGE N
                                                          I     SIGNIFICANT    FINANCIAL
         INNOVATIONS

         OBSERVERS  OF FINANCIAL         MARKETS HAVE CATEGORIZED     THESE INNOVATIONS
         I N DIFFERENT WAYS

         HERE ARE      J U S T TWO WAYS SUGGESTED TO C L A S S I F Y THESE INNOVATIONS




G   ..
         CATEGORIES:

              0 MARKET-BROADENING INSTRUMENTS, WHICH INCREASE THE L I Q U I D I T Y
         OF MARKETS AND THE A V A I L A B I L I T Y OF FUNDS BY ATTRACTING NEW
         INVESTORS AND OFFERING NEW OPPORTUNITIES FOR BORROWERS;

                 0   RISK-MANAGEMENT INSTRUMENTS, WHICH REALLOCATE F I N A N C I A L
         R I S K S TO THOSE WHO ARE LESS AVERSE TO THEM OR WHO HAVE OFFSETTING
         EXPOSURE, AND WHO ARE PRESUMABLY BETTER ABLE TO SHOULDER THEM; AND

              0 ARBITRAGING   INSTRUMENTS AND PROCESSES,     WHICH ENABLE
         INVESTORS AND BORROWERS TO TAKE ADVANTAGE OF DIFFERENCES I N COSTS
         AND RETURNS BETWEEN MARKETS, AND WHICH REFLECT DIFFERENCES I N THE
         PERCEPTION OF RISKS, AS WELL AS I N INFORMATION, TAXATION, AND
         REGULATIONS
P   +.   2. BANI    FOR      SETTLEMENTS
                          INTERNATIONAL
         ANOTHER   CLASSIFICATION        SYSTEM OF FINANCIAL           INNOVATIONS   BASED ON
         MORE S P E C I F I C FUNCTIONS:    .
         A.     PRICE-RISK-TRANSFERRING        INNOVATIONS ARE THOSE THAT PROVIDE
         MARKET P A R T I C I P A N T S WITH MORE E F F I C I E N T MEANS FOR DEALING WITH
         P R I C E OR EXCHANGE RATE R I S K .

         B. CREDIT-RISK-TRANSFERRING            INSTRUMENTS ARE THOSE THAT REALLOCATE
         THE R I S K OF DEFAULT

         C.   k I Q U I D I T Y - G E N E R A T I N G INNOVATIONS DO THREE THINGS:

              I
             ()   INCREASE THE L I Q U I D I T Y OF THE MARKET
             (11) ALLOW BORROWERS TO DRAW UPON NEW SOURCES OF FUNDS
             ( 1 ) ALLOW
              1 1           MARKET       PARTICIPANTS     TO   CIRCUMVENT CAPITAL
         CONSTRAINTS IMPOSED BY 'REGULATIONS

         D. CREDIT-GENERATING AND EQUITY-GENERATING INNOVATIONS: INSTR
         TO INCREASE THE AMOUNT OF DEBT FUNDS A V A I L A B L E TO BORROWERS AND TO
         INCREASE   THE  CAPITAL   BASE   OF  FINANCIAL         AND   NON-FINANCIAL
.. ...   INSTITUTIONS
THERE ARE    SOME WHO BELIEVE  THAT THE MAJOR IMPETUS FOR INNOVATION
HAS BEEN THE ENDEAVOR TO CIRCUMVENT (OR "ARBITRAGE")     REGULATIONS
AND F I N D LOOPHOLES I N TAX RULES

AT THE OTHER EXTREME. SOME HOLD THAT THE ESSENCE OF INNOVATION                 I
                                                                               S
THE INTRODUCTION OF F I N A N G I A L INSTRUMENTS THAT ARE MORE E F F I C I E N T
FOR R E D I S T R I B U T I N G R I S K S AMONG MARKET P A R T I C I P A N T S

  T
I WOULD APPEAR THAT MANY OF THE INNOVATIONS THAT HAVE PASSED THE
TEST OF T I M E AND HAVE NOT DISAPPEARED HAVE BEEN INNOVATIONS THAT
PROVIDED MORE E F F I C I E N T MECHANISMS FOR R E D I S T R I B U T I N G R I S K

OTHER    INNOVATIONS   MAY JUST REPRESENT A MORE EFFICIENT           WAY OF DOING
THINGS

FOLLOWING          APPEAR TO BE   THE   MOST   IMPORTANT    ULTIMATE    CAUSES   OF
F I N A N C I A L INNOVATION:

1.  INCREASED V O L A T I L I T Y OF    INTEREST   RATES.    INFLATION.     EOUITY
PRICES. AND EXCHANGE RATES

2.   ADVANCES I N COMPUTER AND TELECOMMUNICATION TECHNOLOGIES

3.  GREATER   SOPHISTICATION  AND              EDUCATIONAL      TRAINING     AMONG
PROFESSIONAL MARKET PARTICIPANTS

4.   F I N A N C I A L INTERMEDIARY COMPETITION

5.   I N C E N T I V E S TO GET AROUND E X I S T I N G REGULATION AND TAX LAWS

6.   CHANGING GLOBAL PATTERNS OF F I N A N C I A L WEALTH
    NOW LET'S LOOK AT THE FINANCIAL INSTRUMENTS FROM PERSPECTIVE OF
,
    ISSUERS AND INVESTORS
     .
    1 SHORT-TERM FUNDING INSTRUMENTS
    A.    FEDERAL FUNDS:
         DEPOSITORY NEED TO BORROW SHORT TERM TO COVER RESERVE DEFICIENCY
         INVESTMENT ALTERNATIVE FOR SHORT-TERM LENDING

    B.   REPO MARKET:
         NEED FOR DEALERS TO FUND P O S I T I O N S OR COVER SHORT P O S I T I O N S
         USED BY CUSTOMERS FOR LEVERAGED TRANSACTIONS           .
         OUTSIDE U.S. SOME MARKETS HAVE NOT DEVELOPED S I N C E I N U.S.
            TREATED AS COLLATERALIZED BORROWING WHILE I N COUNTRIES
            SUCH AS JAPAN  TREATED AS A BUY AND SELL RESULTING          I
                                                                        N
            TRANSFER TAXES

    c. EURODOLLAR CD       MARKET:
            MAJOR REASON FOR DEVELOPMENT WAS TO CIRCUMVENT INTEREST RATE
    C E I L I N G IMPOSED ON DEPOSITS I N THE U.S.

    D.   BANKERS OF
                  ACCEPTANCES MARKET:
c       A VEHICLE FOR FINANCING TRADE,
    INTERNATIONALLY
                                                  DOMESTIC BUT MORE IMPORTANTLY



    E.   COMMERCIAL     PAPER MARKET
          CORPORATE BORROWERS NEED TO BORROW SHORT TERM
          LIMITATIONS:
             1. NEED BACKUP F A C I L I T I E S , R A I S I N G COST OF FUNDING
             2. L I M I T E D TO INVESTMENT GRADE ISSUERS
          WITH CREDIT ENHANCEMENT, MARKET HAS OPENED TO A L I M I T E D NUMBER
             OF NONINVESTMENT GRADE ISSUERS

    G.   MEDIUM
              TERM NOTE MARKET
         MISNOMER: ACTUALLY A . MARKET THAT COVERS SHORT-TERM                 TO VERY
    LONG-TERM FUNDING NEEDS

         ALLOWS CERTAIN ISSUERS TO R A I S E SHORT TERM DEBT WITH BACK UP
    FACILITIES

          STRUCTURED NOTES        ALLOWS THE CREATION OF          A WIDE RANGE OF
    INSTRUMENTS   CUSTOMIZED        TO THE "BETS" SOUGHT          BY INSTITUTIONAL
    INVESTORS
      2. LONGER TERM DEBT FUNDING INSTRUMENTS
      A.   CREATION         OF ZERO COUPON INSTRUMENTS
           ISSUED BY CORPORATES, AGENCIES, AND SOVEREIGNS
           E L I M I N A T E S REINVESTMENT R I S K
           TAX AND ACCOUNTING ADVANTAGES I N U.S. I N I T I A L L Y ,   BUT S T I L L
                   P R E V A I L I N SOME COUNTRIES

      B.   FLOATING   RATE INSTRUMENTS
           ISSUED BY CORPORATES (PARTICULARLY FINANCIAL),      AGENCIES,           AND
               SOVEREIGNS
           PROVIDES A BETTER MATCHING OF ASSETS AND L I A B I L I T I E S

         I S S U E SHOULD TRADE CLOSE TO PAR VALUE AS LONG AS REQUIRED SPREAD
      DOES NOT CHANGE




      C.   PUTABLE BONDS
           ISSUE TO PAR SINCE BOND COULD BE
                  SHOULD TRADE CLOSE                                        PUT AT PAR
           HOLDING A S I D E CREDIT ISSUE, L I T T L E P R I C E R I S K
           IMPORTANT  FEATURE FOR MONEY MARKET FUNDS TO MAINTAIN             $1 NAV
f'
 -.
            PUT FEATURES HAVE BEEN INCLUDED I N FLOATING RATE NOTES TO
      OVERCOME THE PROBLEM OF AN INCREASE I N REQUIRED SPREAD FORCING THE
      I S S U E TO SELL BELOW PAR


      D.   DEFERRED  COUPON SECURITIES
         TWO PURPOSES:
         FOR LOWER RATED ISSUERS RESULTING FROM A LEVERAGED BUYOUT,
      PROVIDES T I M E TO GENERATE CASH FLOW TO MET INTEREST OBLIGATION ON
      DEBT

           FOR CERTAIN INVESTORS, CAN SELL I S S U E PRIOR TO F I R S T COUPON
      PAYMENT, R E A L I Z I N G A G A I N BUT GET PREFERENTIAL TAX TREATMENT FROM
      THEIR   GOVERNMENT'S TAXING          AUTHORITY
p,
<-
     E.   COLLATERALIZED   DEBT SUCH AS ABS AND MBS
           ISC CUSSED I N LECTURE ON "PLAYERS"
           ADVANTAGES FOR INVESTORS:
            CREDIT ENHANCEMENT REDUCES CREDIT RISK
            BETTER PREDICTABILITY   OF CASH FLOW
            ALLOWS THE TRANCHING OF CREDIT RISK AND          CASH FLOW UNCERTAINTY
                  RISK
           ADVANTAGES TO ISSUERS:    DISCUSSED     EARLIER

     F.   HIGH YIELD    (JUNK) BOND MARKET
            BASICALLY   SECURITIZATION       OF A DEBT
            PRIOR TO MARKET, LOWER CREDIT           ISSUERS WERE FORCED TO FUND VAI
     BANK LOANS WHICH REQUIRED COMPENSATION FOR I L L I O U I D I T Y
         MARKET CREATED A SECURITY WITH GREATER MARKETABILITY              THAN LOAN
     AND MADE P U B L I C MARKET A V A I L A B L E TO LOWER CREDIT ISSUERS

     6.   DEBT    IH
                 WTQT
                    IY
                   EU    KICKERS
         ALLOWED ISSUERS TO RAISE       FUNDS AND EFFECTIVELY        SELL EMBEDDED
     CALL OPTIONS ON EOUITY




     A. DUAL CURRENCY BONDS: PAY COUPON INTEREST N ONE CURRENCY AND PAY
                                                    I
     THE P R I N C I P A L I N A DIFFERENT CURRENCY
         CAN BE STRUCTURED SO THAT THE CURRENCIES ARE PREDETERMINED OR
     THAT EITHER ISSUER OR INVESTOR HAS A CHOICE OF CURRENCY

               I H NONEOUITY
     B. BONDS WT                 WARRANTS:       WARRANTS    ARE ISSUED   AS PART OF
     A BOND OFFERING

           WARRANT GRANTS THE WARRANT OWNER THE RIGHT TO ENTER I N T O ANOTHER
     F I N A N C I A L TRANSACTION WITH THE ISSUER


     I SYNDICATED BANK LOANS
      .
        SPREAD THE CREDIT R I S K AMONG BANKS I N THE LOAN SYNDICATE
Cf-
--
 :....   EQUITY


         EUROEQUITY  ISSUES ARE THOSE ISSUED   SIMULTANEOUSLY                            I
                                                                                         N     SEVERAL
         NATIONAL MARKETS BY AN INTERNATIONAL SYNDICATE




         THE   OFFERING,      $43   MILLION,     WAS    MANAGED BY        THE      UNITED     BANK     OF
         SWITZERLAND


             .
          I R I S I N G STOCK PRICES THROUGHOUT THE WORLD
            1
          1 .            DESIRE OF    INVESTORS        TO DIVERSIFY THEIR PORTFOLIOS
         INTERNATIONALLY
            1.
          1 1 DESIRE OF CORPORATIONS TO EXPAND T H E I R SOURCES OF EQUITY
         FUNDING
            IV.       GOVERNMENTS WHO SOUGHT INTERNATIONAL INVESTORS FOR THE
         E N T I T I E S THAT THEY P R I V A T I Z E D




         AN  INCREASING     NUMBER OF U.S.            FIRMS    HAD    EQUITY       OFFERINGS      THAT
                        U OQ I
         INCLUDED A E R E U YT     TRANCHE

         THE INNOVATION I
                        N THE          EUROEQUITIES       MARKETS S
                                                                  I        NOT N
                                                                               I        TERMS OF NEW
         EQUITY STRUCTURES

         RATHER, T
                 I   S N THE DEVELOPMENT OF
                     I     I                                   AN    EFFICIENT         INTERNATIONAL
         CHANNEL FOR D I S T R I B U T I N G E Q U I T I E S




         THE DEPTH AND BREATH OF THE MARKET CAN BE ILLUSTRATED BY NESTLE,
         WHICH WAS ABLE TO USE THE INTERNATIONAL MARKET TO R A I S E MORE THAN
         $400 MILLION N EU
                      I   QT
                           IY   FUNDS THREE SEPARATE TIMES N 1985
                                                           I

         THE SZ
              IE  OF THE EUROEQUITIES                  S
                                      MARKET, HOWEVER, I                       STILL    CONSIDERABLY
         SMALLER THAN THAT OF THE EUROBOND MARKET



                                                    58
      WHEN   A CORPORATION I S S U E S EQUITY OUTSIDE OF I T S DOMESTIC MARKET AND
      THE EQUITY I S S U E I S SUBSEQUENTLY TRADED I N THE FOREIGN MARKET, I T
      I S T Y P I C A L L Y I N THE FORM OF AN INTERNATIONAL DEPOSITARY RECEIPT
      (IDR)
      BANKS ISSUE IDRs AS EVIDENCE OF OWNERSHIP OF THE UNDERLYING                    STOCK
      OF A FOREIGN CORPORATION THAT THE BANK HOLDS I N TRUST

      EACH IDR MAY REPRESENT OWNERSHIP OF ONE OR MORE SHARES OF COMMON
      STOCK OF A CORPORATION

      THE ADVANTAGE OF THE I D R STRUCTURE S THAT THE CORPORATION
                                           I                            DOES NOT
      HAVE TO COMPLY WITH A L L THE REGULATORY I S S U I N G REQUIREMENTS OF THE
      FOREIGN COUNTRY WHERE THE STOCK I S TO BE TRADED

      I D R S ARE T Y P I C A L L Y SPONSORED BY THE I S S U I N G CORPORATION

      UNITED   STATES   VERSION   OF THE   IDR   S
                                                 I   THE   AMERICAN   DEPOSITARY   RECEIPT
      (ADR)
r?)
 2    SUCCESS    OF THE ADR STRUCTURE THAT N
                                           I           FACT RESULTED N
                                                                     I       THE RISE    OF
      I D R S THROUGHOUT THE WORLD
--   PREFERRED STOCK
     PREFERRED STOCK I S A CLASS OF STOCK, NOT A DEBT INSTRUMENT,             BUT I T
     SHARES CHARACTERISTICS OF BOTH COMMON STOCK AND DEBT

     LIKE  THE HOLDER OF COMMON STOCK,           THE   PREFERRED STOCKHOLDER S
                                                                             I
     ENTITLED TO D I V I D E N D S

     UNLIKE THOSE ON COMMON STOCK, HOWEVER, DIVIDENDS              ARE A SPECIFIED
     PERCENTAGE OF PAR OR FACE VALUE




     DISADVANTAGE   TO ISSUER:    D I V I D E N D S NOT TAX DEDUCTIBLE

     ADVANTAGE  TO INVESTOR:          SPECIAL   TAX    TREATMENT    FOR   CORPORATE
     TREASURERS: D I V I D E N D EXCLUSION
                                              J.P. MORGAN




                                               SWAPS




                                                 Patricia V. Linton
.
r---------------------------------Corporate     Finance and Capital Markets----.............................
                                                3 2 0 West 19th Street
                                              New York, New York 1001 1
                                                 Tel: (212) 242-8509
                                                Fax: (212) 727-9045
                     INTEREST RATE SWAPS




Copyrisht 1995: Patricia V. Linton
                                            JPM CORE: SWAPS
                                                  l-day Agenda

                                       Introduction to Interest Rate Swaps
                                       - Growth and evolution of the swap market
                                       - Structure of basic swap: trading on comparative advantage
                                       - The nature and motivations of swap-market participants
                                       - End-users: creating a target client profile
                                       - Intermediaries: assessing the strengths of JPM

                                       Use of Interest Rate Swaps
                                       - Plain vanilla fixed-to-floating and reverse
                                       - Use of Treasuries, Eurobonds, Futures behind the scenes
                                       - Links to JPM swap book: market-making, warehousing
                                       - Flexibility in pricing: how much is there?
                                       - Benefits of swaps: what does the customer get? how does the
                                       trader make a profit?
                                       - Uses of swaps: what are the customer's needs? how does the
                                       bank benefit?

                                       Strategic Applications of Interest Rate Swaps
                                       - Client views of locking/unlocking interest rates
                                       - Creative permutations based on client position:
                                              - Deferrals
                                              - Amortization
                                              - Step-ups, step-downs
                                       - The trading book: Mark-to-market NPVs, Yield curve plays
                                       Risks of Interest Rate Swaps
                                       - Interest rate risk
                                       - Liquidity risk
                                       - The valuation of risk
                                       - Bank guidelines for credit risk assessment

Afternoon                                                          Currency Swaps
                                       Introduction to ~ o r e i g n
                                       - Recent trends in FX volatility
                                       - Technical relationship between interest rates and FX rates
                                       - Basic structure of foreign currency swap
                                       - Source of comparative advantage: global cross-currency f l e d
                                       income markets
                                       - Distribution of benefits




Copyright 1995: P a t r i c i a V. Linton
                                Structure and Operations of FX Swaps
                                - Fixed-to-floating and fixed-to-fuced
                                - Comparison to strips of long-dated forwards/futures
                                - Comparison to cross currency swap market pricing
                                - Swap pricing parameters:
                                        - Product nuances and their impact on price
                                        - T i e , size, customization requirements
                                - Pricing flexibility
                                - Yield curve synthetics underlying fx swaps quotations
                                - Size, liquidity, competitive position, organizational structure,
                                role of marketers

                                Strategic Applications and Risks of Foreign Currency Swaps
                                - Types of swaps: fixed-to-fixed, fixed-to-floating, arbitrage play
                                - The customer's view: designing a risk profile, financial
                                engineering
                                - The trader's view: cross currency interest rate volatility
                                - Risks: how to value exposure?
                                - Locking in a foreign exchange gain using a swap
                                - Customer outlook
                                - Bank Trader outlook




Copyright 1995: Patricia V. Linton
                                                    Table of Contents




     Summary and Objectives             ......................................                                        1

     I.      Interest Rate Swap Fundamentals . . . . . . . . . . . . . . . . . . . . . .                              2

     I1 .    Advantages of Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                  5

     Exercise I ..................................................                                                    10
     I11 .   Participants in Interest Rate Swaps . . . . . . . . . . . . . . . . . .                                  11

     Exercise I1 ..................................................                                                   13
     IV .    Role of the Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . .                         14
     V.      Swap Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           15

r\   Exercise I11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     24
     VI .    Types of Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             26
     Exercise IV .................................................                                                    28

     Exercise V . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   35

     VII . Uses of Interest Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . .                          36
     Exercise VI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      40
     VIII . Risks in Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            41
     Exercise VII ................................................                                                    46




     Copyright 1995: P a t r i c i a V   . Linton
                                           SUMMARY

This module enables participants to identify the structure of an interest rate
                                                                                          3
swap and how it achieves goals of interest rate exposure management. Interest
rate swaps as arbitrage tools in financial management are reviewed.

                                           OBJECTIVES

Upon completion of this module, participants will be able to:

1.       Describe an interest rate swap.

2.       Identify the basic structure of an interest rate swap.

3.       Identify the players in the interest rate swap market.

4.       Discuss the benefits of interest rate swaps.

5.       Describe different types of swaps including coupon swaps, basis swaps
         and asset swaps.

6.       Identify swaps linked with options.
                                                                                          C,
7.       Identify the price quoting conventions of interest rate swaps.

8.       Calculate the basis spreads and their allocation to the parties in an interest
         rate swap.

9.       Discuss how interest rate swaps pennit users to arbitrage the yield curve.

10.      Calculate the cost of matched and mismatched swaps.

11.      Identify the benefits and risks of matched and mismatched swaps.




Cowright 1995: P a t r i c i a V. Linton
r
-
L
 '                        I. INTEREST RATE SWAP FUNDAMENTALS


     Definition of an interest rate swap:


             The exchange of interest rate payments between two counterparties over a
             pre-arranged period of time. Principal is never exchanged.



     Types of swaps:
                        interest rate

                        currency

                        cross-currency interest rate

                        commodity
(1
.-
 -


     Evolution of the swap market:


              Swaps have evolved from back-to-back loans which were popular during
              the early 1970's. The first swap was done in 1981 between The World
              Bank and IBM. From the early swaps of 1981 the market now has an
              estimated notional principal outstanding over $5 trillion (1993 figures) in
              of which 30% is in the US$ market.




     Copyright 1995: P a t r i c i a V. Linton
Reasons for interest rate swaps:


       Access to types of funding not available

H      Management of interest rate exposure

        Lock-in profits of a project

H       Hedge exposure of assets with an income stream

        Speculate on rate movements

       Hedge exposure on floating-rate liabilities




Copyright 1995: Patricia V. Linton
      Coupon Swap (Plain Vanilla):
f-'
      -      Player (Company A) wishes to obtain floating-rate financing, yet has
             access only to the fixed-rate market. A floating-rate player (Company B)
             would rather pay fixed rates. Both companies issue their own debt and
             agree to pay each other's interest payments. An example of this would
             look like the following:




                                            Fixed-Rate
                            Company A      Floating-Rate     Company B




                                   I
                                   '                              I
                                                                  '
                            Fixed-rate                        Floating-rate
                                Debt                               Debt




             Both companies issue debt in the same principal amount.


             They agree upon the maturity of the swap payments. At maturity they
             repay their own debt and the swap expires.




      Copyright 1995: Patricia V. Linton
                                    1.
                                     1      ADVANTAGES OF SWAPS


          Interest rate swaps reduce the cost of corporate borrowing as the parties
          share the benefits of comparative advantage.

          Swaps allow corporate borrowers to receive rates in markets otherwise
          unavailable to them.

          Swaps allow corporate borrowers to:

                    Act on interest rate expectations

                    Manage cash flows

                    Manage maturity of debt



Comparative vs. Absolute Advantage:




Copyright 1W5: P a t r i c i a V . Linton
         Company A has an absolute advantage in the fixed market of 150 basis
         points (10.0 - 8.5) and an absolute advantage in the floating market of 50
         basis points (518 - 118).

         The comparative advantage is the better company's overall funding
         advantage. The difference in the absolute advantages is the comparative
         advantage. In the example above, Company A has a comparative
         advantage of 100 basis points (150 - 50) in the fixed-rate market.




Copyright 1995: P a t r i c i a V. Linton
Setting Up a Swap:




         Each company would issue debt where they have the best advantage. In
         other words, A would issue fixed-rate debt because they have a
                                                                                       0
         comparative advantage of 65 basis points (from the absolute advantage of
         9.75 - 8.85 = 90 BP compared to 25 in the floating market from L + 50
         - L 25).+

         Let's take a look at what a swap would look lik:

         0         Each company issued $25 million in 5-year debt. Company A is
                   paying 8.85% fixed while B is paying LIBOR    + 112 with the rate
                   reset every 6 months.




Copyright 1995: P a t r i c i a V. Linton
              The swap quote calls for Company B to pay Company A a fixed-
              rate while Company A pays Company B LIBOR. The fixed rate
              depends on how the 65 BP of comparative advantage are shared.



              P
                                              ?       %
                                   -   4
                  Company A                LIBOR           Company B
                                       ,
                                       -                  P




                     v                                         v
               $25 million                                 $25 million
                a t 8.85%                                 at   LIBOR + 50




Copyright 1 5 Patricia V. Linton
           W:                                     8                         (intsuap)
Calculating the Advantages of an Equal Split (65 + 2) Swap:




         The swap splits the comparative advantage of 65 basis points between the
         two companies. In other words, each party would pay 32.5 basis points
         less than they would pay without a swap for their desired liability
         structure.




Copyright 1995: P a t r i c i a V. Linton
                                               EXERCISE I


    Given the following information, complete the comparison chart by filling in
    the spaces.

    1.      Company A has an absolute advantage in the fixed market of 80 basis
            points and a comparative advantage of 50 basis points.


                                               Company A      Company B

            Rating:                               AAA              BBB

            Fixed funding:                        -                10.75%

            Floating funding:                     L   + 20         -


.
    2.       Explain why the absolute advantage is much larger in the fixed market
             compared with the floating market.




    Cowright 1995: P a t r i c i a V. Linton
       There are several participants in the interest rate swap market:


                   The fured-rate payer pays the fixed-rate side of the swap and
           .   .   receives the floating-rate payments.

                   The fured-rate receiver pays the floating-rate side of the swap and
                   receives the fixed-rate payments. This participant "provides"
                   access to fixed rates to counterparties.

                   The market maker quotes a Zway price for swaps. The market
                   maker functions as the counterparty to each side of a swap and
                   carries the default risk of each side of the swap.

                   The broker or agent functions as arranger of the swap but carries
                   no risk.



       There are several groups of borrowers whose cash flows put them into
       natural positions in an interest rate swap transaction:

                   Natural fured-rate payers have a predictable cashflows and
                   typically borrow under floating-rate programs. They would prefer
                   fixed-rate debt to match their cashflows.

                   Natural fured-rate receivers are companies that are very highly
                   rated and who would benefit from trading their advantageous fixed-
                   rates for sub-LIBOR floating rates.




                          .
Copyright 1995: Patricia V Linton
                                            BANK SWAP DEALERS




                                             Biggest Bank Dealers

         Bank                                 1994 (billions)   Change from 1993
         J.P. Morgan
         Banker's Trust
         Chase Manhattan
         Chemical
         Citibank
         FUS~  Chicago
         BankAmerica
         First Interstate




Copyright 1995: P a t r i c i a V. Linton
                                            EXERCISE I1


Name two types of companies or institutions in each category:



         (a)       natural-fixed rate payer:




         (b)       natural fixed-rate receiver:



                                                                LJ




Copyright 1995: P a t r i c i a V. Linton
                          IV. ROLE OF THE INTERMEDIARIES


         Originally swaps were structured by the two counterparties without the
         use of an intermediary or market maker. This led to concern among
         senior management of the corporations regarding:
                   credit risk

                   access to the entire market
                   documentation


         These concerns led to the use of intermediaries to facilitate swaps. The
         role of the market maker today is:

                   find a counterparty or take the position themselves (warehouse the
                   deal = hold inventory of open positions)

                   accept the risk that a party may default on the deal

                   complete acceptable documentation

                   complete secondary swaps


         The market makers received fees originally in the area of 75 basis points.
         Due to the competitive nature of the swap market, fees have been
         virtually eliminated today. Market makers earn income on swaps from
         the trading profits generated by the bidlask spread.


         Market makers now may not have a counter-party to each transaction.
         Instead, they may opt to warehouse a swap or use their own position to
         offset the deal.




Copyright 1995: P a t r i c i a V. Linton
                                           V.   SWAP PRICING


Terminology:


                  Bid: swap rate quoted to fixed-rate receiver


                  Offer: rate quoted to fixed-rate payer


                  Trade date: date the parties commit to swap




Factors influencing swap pricing:


                  Fixed rate funding supply and demand


                   The slope of the yield curve


                   Risk being assumed by the market maker


                   Competition between market makers


                   Complexity of the swap.




Copyright 1WS: P a t r i c i a V. Linton
-
,

        Generic fixed payment conventions:
0   I




                       Semiannual payment

                       Act1360 accounting basis for accruing fixed interest on T-bill or
                       prime-based swaps

                       Act1365 accounting basis for accruing fixed interest on Treasury
                       bond based swaps



        Generic floating payment conventions:


                       No spread over or under floating index

                       Payment frequency is the same as floating index's term

                       ACT1360 accounting basis for 6-month LIBOR, the standard quote
                       used on the floating-rate side.

                       Reset frequency may vary:
                        -       It may be the same as the index: 3-month LIBOR reset every
                                90 days
                        -       It may vary from the index: 3-month LIBOR reset monthly

                        Quotation basis for floating-rate side of a swap is typically on a
                        money-market equivalent yield.




        Copyright 1995: Patricia V. Linton
Secondary market:


                   Swap sales: the sale or assignment of swap position to take
                   advantage of capital gains.


                   Reverse swaps: a new swap which is used to offset existing swap.


                   Swap terminations: involves a cash payment to market maker to
                   terminate swap. Most agreements have formulas for necessary cash
                   payments.


NOTE:              Deviations from these conventions will increase the cost of the
                   swap due to custornization




Copyright 1995: P a t r i c i a V. Linton
      Pricing a swap with an intermediary:
P
.-
-
               The following example illustrates a swap with a market maker and the
               following comparative advantage situation:




               Company A has a 105 basis point absolute advantage in the fixed market
               and a 50 basis point absolute advantage in the floating market. Overall,
f-'
 .             Company A has a comparative advantage of 55 basis points in the
               fixed-rate market.

                If we assume that Company A wants to borrow under a floating program,
                then their 2 choices are as follows:




              Company A                             py                    Market Maker




                                                         7
                Floating                            Fixed
                 LIBOR                              7.25%




Pi




      Copyright 1995: P a t r i c i a V.   Linton   18
        Market makers use a swap quoting ladder that looks like this:


        Example:        NOT FOR DISTRIBUTION TO CLIENTS

                          INDICATIVE PRICES AS OF 9:30 AM




Notes:          Swaps based on Notional Principal Amount up to $200MM

                Treasury Yield x 3601365 before adding BP




Copyright 1995: Patricia V. Linton
                         Assumptions:
                         -         swap will be for 7 years
                         -         7-year Treasuries are currently yielding 7.28%
                         -         bid is Treasuries + 45 BP (quote to fixed-rate receiver)
                         -                             +
                                   offer is Treasuries 49 BP (quote to fixed-rate payer)
                         -         the notional principal amount is $25 million


                         The swap is drawn below:




           Company
                                     T+45 BP
                                     (7.63%).

                                                  Market Maker
                                                                 .   T+49 BP
                                                                     (7.67%)
                                                                                  Company

                                   LIBOR                             LIBOR

                 T                                                                       T
               7.25%                                                              LIBOR + 50
              Fixed                                                               Floating
              USS25MM                                                              USS25MM



                             COMPANY A MARKET MAKER                          COMPANY B

Fixed funding        (7.25%)
Floating funding                                                                  +
                                                                                (L '50)
Market Maker floating (L)                              L- L                     L
Market Maker fixed   7.63 %                            7.67% - 7.63%            (7.67%)

Net cost                           L - .38
Direct cost                        LIBOR
Gain                               38 BP




      Copyright 1995: P a t r i c i a V. Linton
The example can be illustrated using cash flows:

                                                   A's Cash Flow
                                                    (in $000'~)

  6-Mos.         Payments to                    Swap w/Mkt.Maker          Net          Savings p.a.
  Period         Third Party                  Receipts Payments        Cashf lows      over Direct

      0                 25,000                       -                  25,000
      1                 -906.25                    953.75   -LIBOR    -LIBOR+ 47.50
      2                 -906.25                    953.75   -LIBOR    -LIBOR+ 47.50        38
      3
                              I,                                 I,
      4                                              I
                                                     ,                   I,                 I
                                                                                            ,

      5
     14               -25,906.25                   953.75   -LIBOR    -LIBOR+ 47.50P       38

                In period 0, Company A receives the fixed-rate principal of $25 million
                from its third party lender.

                In period 1 -- after the first 6 months -- Company A pays semiannual,
               fixed-rate interest of $906,250 to the third-party lender (25,000,000 x
               7.25% x 112)

               Under the Swap, in period 1 Company A receives semiannual, fixed-rate
               payments of $953,750 from the Market Maker (25,000,000 x 7.63 % x
               112).

               Also, under the Swap, in period 1 Company A pays LIBOR to the
               Market Maker.

               Company A's net cash flow, therefore, in period 1 is -LIBOR             +
               $47,500.

               The cash flows are all the same until the final period.

               In period 14 (end of the 7th year), Company A repays the original
               $25,000,000 plus the semiannual interest to the third party. Company A
               receives from and pays to the Market Maker the same amounts as in
               previous periods. The net cash flow in the final period, therefore, is -----
               -$25,000,000 - LIBOR + $47,500.

                Company A's direct floating quote was LIBOR. But through the swap,
                Company A pays LIBOR - .38% annually.                                                  L)

      Copyright 15'95: P a t r i c i a V. Linton            21                             (intswap)
0                                                        B's Cash Flow
                                                          (in $ 0 0 0 ' ~ )

    6-Mos.        Payments to                      Swap w/Mkt.Maker                 Net        Savings
    Period        Third Party                      Receipts Payments              Cashflows    over Direct
       0              25,000                                                         25,000
       1          - (LIBOR+62.5)                    +LIBOR        -958.75          -1021.25
       2          -(LIBOR+62.5)                     +LIBOR        -958.75          -1021.25        13
       3
       4                    ,I                      I,              ,I                1,            ,I

       5
      14          -LIB.- 62,500                     +LIBOR        -958.75         -26,021.25       13


                In period 0, Company B borrows $25 million from its third-party,
                floating-rate lender.

                In period 1, after the first 6 months, Company B pays its third-party,
                floating-rate lender its direct market rate of LIBOR  .50%                 +
                ($25,000,000 x .50% x 112 = $62,500 semiannually over the LIBOR
                rate).

                Under the Swap, in period 1 Company B receives LIBOR from the
                Market Maker and must pay the Market Maker the semiannual, fixed-rate
                payment based on the Market Maker's quote = $958,750 ($25,000,000 x
                7.67% x 112).

                Company B's net cash flow in period 1 is:

                          The $958,750 payment under the Swap PLUS the 50 bp differential
                          paid semiannually between the payment to the third party
                          (LIBOR+ .SO%)and the Swap receipt from Market Maker
                          (LIBOR) -- $62,500 ($25,000,000 x .50% x 112). So, its net
                          cashflow is $1,021,250 (958,750 62,500).            +
                The remaining flows duplicate those described in period 1 .

                In Period 14 Company B must now repay the third party the original $25
                million.

                Company B is now paying a fixed rate of 8.17% rather than its direct
                fmed market rate of 8.30% for a savings of 13 basis points annually.

       Copyright 1995: P a t r i c i a V. Linton                   22                                    (intsuap)
CONFIRMATION OF SAVINGS USING INTERNAL RATE OF
RETURN:


Step 1:            Make sure the HP's registers are clear for the calculation.

Step 2:            Enter the amount that will be received at the time the money is
                   borrowed as a negative number into [g] [CFo].

Step 3:             Enter the cashflow associated with the semiannual payments into
                    [gl [CFjl.

Step 4:             Enter the number of periods into [g] Nj].

Step 5:             Enter the final interest and principal payment in into [g] [CFj].

Step 6 :            Calculate the IRR for semiannual periods.

Step 7:            To annualize this IRR, multiply it by 2, the number of semiannual
                   periods in a year.                                                                0
    6 Mos.              B's
    Period          Cash Flow                      Keystrokes                 Display
                                                [ f-1 CLEAR [REG]                 0.00
       0            (25,000)                    25000 [CHSI [gI [CFOI       -25,000.00
       1              1,021.25                  1.021.25 [g] [CFj]            1,021.25
       2              1,021.25                  13 [gl [Njl                      13.00
       3              1,021.25
       4              1,021.25
       5              1,021.25
      14             26,021.25                  26021.25    [gl [CFjl       26,021.25

                                                [fl [IRRI                     4.085


   Effective All-In
   Borrowing Cost                           -      4.085 x 2            -    8.17 p.a.




         The same analysis could be used to analyze Company A's all-in cost if
         LIBOR could be known for each period.                                                       u
Copyright 1995: P a t r i c i a V. Linton                23                              (intswap)
                                            EXERCISE 11
                                                      1


Given the following information, diagram the swap and determine the
advantages for each company.

                  Assumptions:
                  -         Company A can borrow money in the floating market at
                            LIBOR and in the fixed market at 7.15%. It believes interest
                            rates will fall.
                  -         Company B can borrow money in the floating market at
                            LIBOR+ 718 and in the fixed market at 8.40%. It has fixed
                            revenues.
                  -          The swap is for 5 years.

                   -         Using the quote sheet on p. 19, determine the bidloffer swap
                             rates for the 5 year swap.




Copyright 1995: P a t r i c i a V. Linton
2.       Using the quote sheet on p. 19, show the results of each swap by filling
         in the net funding column in the chart below. In the net cost of funds     L,
         column, please indicate the company's net after-swap position: fixed or
         floating and at what rate?




                                           note on LIBOR




Copyright 1W5: P a t r i c i a V. Linton
                                           VI. TYPES OF SWAPS


             A coupon swap where parties exchange fixed- and floating-rates is the
             most common interest rate swap.

             Other interest rate swaps include:

                     Basis swaps

                     Asset swaps

                     Zero coupon swaps

                      Swaps with options

      BASIS SWAPS (also called money market swaps) refer to the exchange of 2
      floating-rate indexes.

             Participants agree to swap different floating-rate indexes. As an example,
--
i '
-
             one participant may agree to swap his commercial paper rate to pay T-bill
             based payments.



                                                T-bill   +   spread
                                                                      b
                            Company A               30 day CP             Bank
                                            -   4
                                           -

                                   v                                         v
                         30-day CP Debt                                   Treasury
                                                                          funding




      Copyright 1995: Patricia V. Linton
          A participant wanting to swap commercial paper into a fixed-rate would
          first enter a LIBORIfixed-rate swap and then enter a into second
          CPILIBOR swap.
                                                                                         c)

          Basis risk between funding source and income from initial swap is thus
          eliminated.




            Swap #1                                      Swap #2
 Fixed to Floatina rate S w a ~                        Index S w a ~

                                                                    t
Counterparty Fixed rate                      Company      CP + 40       Counterparty
                                                                            2

                                                v




          Advantages of basis swaps include:

                    Interest rate management: match basis of debt to take advantage of
                    interest rate expectations.

                     Match funding: match liability structure to assets.

                     Maturity management: shorten or lengthen maturities.




 Copyright 1995: P a t r i c i a V. Linton
                                     EXERCISE IV


1.     Calculate the gain to a financial subsidiary from each of the following
       swaps:

       Corporate funding             Bank Receives:           Bank Pays:




Copyright 1995: Patricia V. Linton          28
2.   ,   List the risks in these swaps.




3.       How should the Treasurer choose between these 2 swaps. In what
         environment should these swaps be considered?




Copyright 1995: Patricia V. Linton
        An ASSET SWAP refers to a swap that alters the basis of an investment from
        fixed- to floating-rates (or floating to fixed rate).

                 An asset swap is beneficial for an investor holding a fixed-rate asset who
                 wants to convert it to a higher yielding floating-rate asset.


                                 Diagram of Fixed to Floating Rate Asset Swap



                          fixed-rate                                      fixed-rate
    Investor                                             Market   ""
    l
    -
    l
    r
    y                   floating-rate                                    floating-rate
                                                                                              fixed-
              fixed-rate
    Fixed-rate
    Investment




                  An asset swap is beneficial for an investor holding a floating-rate asset
                  who wants to convert it to a higher yielding fixed-rate asset.


                                 Diagram of Floating- to Fixed-Rate Asset Swap



                            fixed-rate                                  fixed-rate



    4
        Company A                                    r     Market
                                                           Maker    4
                          floating-rate                                 floating-rate
                                                                                             floating-
                    floating-rate                                                        Floating-


         Borrowing                                                                       Investment



'
r
>




         Copyright 1995: P a t r i c i a V. Linton
A ZERO COUPON BOND SWAP allows a borrower to transform floating-
rate debt into a synthetic zero coupon bond.                                            d
         The borrower who becomes the ultimate fixed-rate payer does not make
         periodic payments.

         The market maker paying the floating-rate pays semiannually.

         The market maker is taking greater risk than it does in other form of
         swaps.


                         , Interim Payments on Zero Coupon Swap



                                               LIBOR
                               Market
                               Maker

                                               Principal
                                               fee

                                                                  7
                                                             Floating-
                                                             rate debt




                                            Payment at Maturity




                            1 F
                             LE I
                             Market Maker       4




Copyright 1995: P a t r i c i a V. Linton           31                      (intsuap)
I


         SWAPS WITH OPTIONS represent the following:
r\
         Plain Vanilla Swap (no options):

                 The example shown is a $25 million four year swap.


              Amount   25
            (millions)
                       20                --
                                    15   --
                                    10 --
                                      5 --

                                                         I       I       I                Time
                                                                 t
                                                         1       2       3       4       (years)




    .'
    I
    .-   Extendible Swap:
                  A swap where one counter-party has the option of extending the original
                  life of the swap. The example reflects a $25 million coupon swap for an
                  original term of 4 years and extendible to 6 years.


           Amount   25                                                       ---         1
         (millions)
                    20              --                                                     I
                              15    --                                                     I
                              10    --                                                     I
                                5   --                                                     I
                                                     I       I       I
                                                                     I
                                                                                     I
                                                                                     I     I    Time
                                                     1       2       3       4       5         (years)




         Copyright 1995: P a t r i c i a V. Linton
Puttable Swap:

         When a counter-party would like an option to cancel the swap prior to
         maturity, it is called a puttable swap. The example reflects a $25 million
         swap for a maturity of 6 years with an option to cancel after the first 3
         years.

   Amount            25

                      20    --
                            --                              I
                      15
                            --                              I
                      10

                        5   --                              I
                                                            I
                                            I       I       I       I        I
                                                    I                        I
                                            1       2       3       4        5     6
                                                                        Time (Years)



Amortizing Swap:

         An amortizing swap is entered into for an original amount which
         decreases each term until maturity when it reaches a zero balance. The
         example reflects an original $40 million swap which amortizes by $10
         million each of the 4 years of the swap.

       Amount    40
      (Millions)
                            30   --

                            20   --

                            10   --
                                                I       I       I                 Time
                                                        I
                                                1       2       3        4       (years)



Copyright 1995: P a t r i c i a V. Linton
r



r
'   .-
    -
         Drawdown Swap:

                  A drawdown swap begins with a notional amount and increases over the
                  term of the deal. The example reflects a 5-year swap with yearly
                  increases of $10 million from the original amount up until the 4th year.



              Amount
           (Millions)               40    --

                                    30 --



                                    20    --

                                    10

                                             I       I    I
                                                          I
                                                              I
                                                              I                Time
                                                     1    2   3         4      (Years)




         Copyright 1995: P a t r i c i a V. Linton       34                          (intsuap)
                                       EXERCISE V


Match the swap on the left with the definition on the right.


                 SWAP                             DEFINITION


- puttable                             A.   notional amount increases over time

- amortizing                           B.   swap may be for a longer maturity than
                                            the original date

- drawdown                             C.   one party may terminate the swap before
                                            the maturity


-       extendible                     D.   the notional amount decreases over the life
                                            of the swap
                                                                                          i,
- basis                                E.   exchanging floating-rate index




Copyright    W:
            1 5 Patricia   V. Linton
                           W. USES OF INTEREST RATE SWAPS

Alter AssetILiability Structure:,


         A U.S. company (company A) issues a $30 million Eurobond at a fixed
         interest rate but as his business is priced at a floating-rate he looks to
         enter a swap. A mortgage company (company B) receives the majority of
         their income from fixed rate-mortgages. They, however, are funded by
         borrowing floating-rate money at LIBOR + 112. A market maker
         arranges a swap between these two counter-parties which looks like the
         following:




                                                             Fixed
  Company
                                             Market Maker

                        Floating                            Floating

     v   '                                                                      7

$30 million                                                    Mortgages   Funding
Eurobond                                                       at Fixed    at LIBOR
                                                                           +   1/2




 Copyright 1995: P a t r i c i a V. Linton
Lock or Unlock Funding Rates:


         Company A issues a 7-year Eurobond to fund operations at 9 %. As they
         feel that rates will drop, they enter into a coupon swap based upon
         LIBOR with a bank. The swap can be graphically represented as:




                       Company A             LIBOR




                               v
                       Eurobond
                       at 9%




         Rates did fall. Company A now enters into another coupon swap
         agreeing to pay 8 % fixed and receive LIBOR. Company A has locked in
         a rate of 8 % on their original 9% Eurobond.




pZy-.qqy=.pq
                              8%                       9%
                                               v
                                            Eurobond
                                             at 9%




Copyright 1995: P a t r i c i a V. Linton
r


    r'   Manage Interest Rates and Maturities:


                  A shipbuilder receives an offer for a $50 million cargo ship to be
                  delivered in 3 years. Past experience has been that these ships can take
                  up to 5 years to complete. As for the payments, the customer will pay are
                  pegged to a fixed-rate and the shipbuilder can only issue floating- rate
                  money, he enters into the following swap:




                                                         Floating-rate
                              Shipbuilder                                  Market Maker




                                        v
                              Floating-rate




                  The swap is structured as follows:

                                                         Shipbuilder has the option to extend
                                                          swap for 2 more years.
          Amount
         (millions)
                                                                                   II
                              50                                           ----
                              40    --                                                  1
                                    --                                                  I
                               30
                                    --                                                  I
                               20
                                    --                                                  I
                               10
                                                                                        I
                                                     I        I                I
                                                                               I
                                                                                        I    Time
                                                              I
                                                     1        2        3       4        5   (years)


         Copyright 1995: P a t r i c i a V. Linton                38                         (intsuap)
Fixing the Rate on a Revolver:


         The manufacturer of a power plant will be drawing funds from a
         revolving credit on a yearly basis. The revolver is priced at LIBOR +
         314. If LIBOR increases by more than 60 basis points over the life of the
         7- year project, they will lose money. To compensate for this he enters
         into the following swap:


                                                    Fixed
                     Manufacturer                                        Market Maker
                                                4




                               v
                   LIBOR + 3/4




         The swap is constructed as follows:

                       Amount (millions)




                                                                             -     Time
                                            1       2   3        4   5   6   I    (years)

Copyright 1995: P a t r i c i a V. Linton                   39
                                                EXERCISE VI


    1.       A company is contracting to build an office building that will be
             completed in 3-5 years. The construction company (company A) has
             access to floating-rate funds at prime. To prevent a loss due to high
             interest rates construct a swap for this company.




>   2.       A bank (bank A) receives the majority of their revenue from short-term
             loans priced at prime. This bank must fund itself at a rate tied to LIBOR.
             What type of swap would you recommend if bank A asked for help in
             managing their interest rate gap?




    Copyright 1995: P a t r i c i a V. Linton
                                            W I . RISKS IN SWAPS


Risk to the Market Maker:


         In today's swap market, the market maker takes the largest risks. These
         include:

                   potential loss due to counter-party failure

                   remarketing costs for replacement of counter-party

                   warehousing risks

                   complexity risk

                   Beginning in 1992, the BIS has imposed a 3 % risk-adjusted capital
                   requirement on banks who act as market makers in the swap
                   market.




Copyright 1995: P a t r i c i a V. Linton
           If the market makers suffers a counterparty default due to adverse interest
P
C
           rate movement, the loss can be calculated.


    EXAMPLE:

                                         SWAP AT INCEPTION




                       Fixed at 8%                   Fixed 8.1%

                                                                          Floating
                                                                          @ 6+%

                                                                       Floating




    Copyright    W:
                l 5 Patricia V. Linton
         If market rates begin to rise, increasing the floating-rate to 9 % and the
         new fixed rates on swaps to 11% Bid and 11.1 % Offer, the new cash
         flows just before default would be:
                                                                                         C)

                                     SWAP JUST BEFORE DEFAULT




                   Floating 9%

I
Company
                       Fixed         @ 8%
                                            Maker
                                            Market    4Fixed @   8.1%




Companv A defaults:

                                                 Inception
                                               fixed/floating
                                                                          At Default
                                                                        fixedtfloating
                                                                                         0
Market maker does not remarket:

Market maker receives                          8.1%    6%
Market maker pays
Net

Market maker remarkets:

Market maker receives                          8.1% 6 %
Market maker pays                              8%   6%
Net                                           0.1%


         If Company A were to default in a rising interest rate environment, the
         market maker would suffer a loss.




Copyright 1995: P a t r i c i a V. Linton
     Companv B defaults:
r\
                                            Inception         At Default
                                          fixedlfloating    fixedlfloatin~

               t
     ~ a r k e maker does not remarket:

     Market maker receives
     Market maker pays
     Net

     Market maker remarkets:

     Market maker receives
     Market maker pays
     Net



.-
..           If Company B were to default in a rising rateenvironment, the market
             maker would not suffer a loss.




     Copyright 1995: Patricia V. Linton
Risk to the Counterparty:


         The counter-parties are not without risks in a swap. These risks include:


                   price risk ( the cost of unwinding a swap where the costs exceed
                   today's market).

                   the costs of having a swap in place after the debt has been repaid
                   or the asset sold.




Copyright 1995: P a t r i c i a V. Linton
                                           EXERCISE VJI


1.      In the following cases assume a swap and a subsequent default have taken
        place. The rates indicated show swap rates at the outset of a transaction
        and at the time of default. (For simplicity, there is no spread to the
        market maker.) Assume the market maker does remarket each deal.
        Calculate the gaintloss to the market maker.



              Inception                         At Default   EEQ
         Case -
         - fixed floating                   fixed floating   Defaulting

         1        9%       '          7%     11%      9%     fixed-rate payer
         2        9%                  7%     11%      9%.    fixed-rate receiver




Copyright 1W5: P a t r i c i a V. Linton
                 FOREIGN CURRENCY SWAPS




Cowright 1995: P a t r i c i a V. Linton
                                               Table of Contents




Summary and Objectives            ......................................                                        1
I.     Description of a Foreign Currency Swap . . . . . . . . . . . . . . .                                     2
I1 .   Market Overview ......................................                                                   3
I11 .  Development of Foreign Currency Swaps ................                                                   6
Exercise I ...................................................                                                  8
IV .   Basic Structure of a Currency Swap . . . . . . . . . . . . . . . . . . . .                               9

Exercise I1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    14
V.     Quoting Conventions ..................................                                                  16

Exercise I11 ................................................                                                  20
VI .   Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 22
Exercise I V . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   26   3
VII .  Foreign Currency Swap Applications . . . . . . . . . . . . . . . . . . .                                28

Exercise V ..................................................                                                  30
VIII . Advanced Applications .................................                                                 33
Exercise VI .................................................                                                  36
IX .   Risks of Foreign Currency Swaps . . . . . . . . . . . . . . . . . . . . . .                             38
Exercise VII ................................................                                                  44




Copyright 1995: P a t r i c i a V   . Linton
                                                  SUMMARY


      This module enables participants to describe the structure of a foreign currency
      swap. The development of the foreign currency swaps market and how it
      relates to foreign exchange exposure management is reviewed.


                                                  OBJECTIVES

      Upon completion of this module, participants will be able to:

      1.      Describe the structure of a foreign currency swap.

      2.       Link foreign currency swaps to the global long-term debt market.

      3.       Identify players in the foreign currency swap market.

      4.       Explain the role of credit differentiation in comparative advantage
               funding.
f'
      5.       Identify how a foreign currency swap manages exchange rate risk.

      6.       Structure fixed-to-floating, fixed-to-fixed and asset foreign currency
               swaps.

      7.       Link a foreign currency swap to option arbitrage.

      8.       Identify the sources of price quoting conventions in foreign currency
               swaps.

      9.       Describe the uses and benefits of foreign currency swaps.

      10.      Discuss the role of arbitrage in foreign currency swaps.

      11.      Describe how foreign currency swaps can be used to lock in foreign
               exchange gains.

      12.      Identify the risks of foreign currency swaps.
n
...
 -




      Copyright 1995: P a t r i c i a V. Linton        1
              I.     DESCRIPTION OF A FOREIGN CURRENCY SWAP



         A foreign currency swap entails the exchange of periodic interest
         payments and principal across currencies at known rates between 2
         counterparties. -It is also called Currency Exchange Agreement).



         Currency swaps can be thought of as the salelrepurchase of currencies
         with payments made to reflect differentials in interest rates.



         Currency swaps are for a fixed term with payments made at specified
         intervals (points in time).



         Currency swap quotes are the basis for determining differentials agreed
         upon at outset.
                                                                                   3

         They are most often done in conjunction with a specific financing or
         investment to lock in a favorable rate in the home currency.




Copyright 1995: P a t r i c i a V. Linton
                                       11. MARICET OVERVIEW


         Approximately $1 trillion in notional principal outstanding (versus $5
         trillion for interest rate swaps), with a very high growth rate.

         Currency swaps entered into in 1994 totaled about $100 to $150 billion, a
         significant increase since the market first began with $1.5 billion in 1981.

         A large percentage of currency swaps are the result of Eurobond
         financings. In 1994 $80-$120 billion of currency swaps were the direct
         result of Eurobond financings, roughly three quarters of the total.

         In fact, the Eurobond market is becoming increasingly swap driven, with
         the breakdown by currencies as follows:

                                Currency Distribution of Fixed-Rate
                                International Bonds Swapped in 1994
                                       (US$ billions equivalent)

                                                         Percent        Share of
                                  Total        Total     of issues      all swaps
                                  swapped     issues     swauped        bv value

         US dollar
         Yen
         Swiss Franc
         Aust. dollar
         ECU
         Can. dollar
         Deutschemark
         French franc
         NZ dollar
         Sterling
         Danish Krone
         Neth. guilder
         Others




Copyright 1995: P a t r i c i a V. Linton        3
                   GROWTH OF FOREIGN CURRENCY SWAPS




                      SWAPS RELATED TO EUROBONDS
                                      ANNUAL GROWTH
            140

            120-

            100-
       V)
       Z
       o     80-
       3
       m
       V)
             60-
       3

             40-

             20-

              0
                   1981        1983   1985     1987    1989     1991   1994
                                              YEARS

                           -m- Eurobond with Swap +N w Cwreny Swaps
  -




Copyright 1995: Patricia V. Linton
        As with interest rate swaps, the keys to currency swap market growth are
        continuing innovation (eg. options) and extending the secondary market
        (sometimes called unwind swaps), as well as interbank trading.

        Large commercial/investrnent banks are increasingly quoting two-way
        market prices for some currencies. They are willing to take a position
        (warehousing) to find counterparties later, though this is done to a lesser
        extent than with interest rate swaps (and with wider spreads than interest
        rate swaps).

        Participants include:

                  Financial institutions including banks, thrifts, and insurance
                  companies
                  Corporations
                  Sovereigns
                  State and local governments

        Foreign currency swap market makers are typically investment and
        commercial banks. Insurance companies such as AETNA are now
        guaranteeing swap performance and functioning as brokers.

         Brokers must be skillful in:

                   Finding counterparties
                   Finding new applicants

         Market makers must be skillful in:

                   Structuring transactions
                   Assessing credit implications
                   Flexibility in assessing market risk

         Reasons for using foreign currency swaps include:

                   Achieving an optimal borrowing rate on specific financing or
                   investment
                   Hedging
                   Taking advantage of an outlook on currency or interest rate
                   movements.


Copyright 1995: P a t r i c i a V. Linton      5                                   (fcsbig)
Comparative Advantage

         Following the abolition of the Bretton Woods Agreement on fixed
         exchange rates in 1971, foreign currency exchange rates fluctuated
         rapidly. Techniques were developed to exploit differences in borrowing
         rates across currencies.

         Borrowers' comparative advantage in different currencies led to the
         development of the swap market.

         The first guiding principle of comparative advantage is that one or both
         companies has cheaper access to one currency relative to a desired
         currency.

         In a foreign currency swap, each company "sells" its comparative
         advantage to the other.

         The cost savings on an aggregated basis is shared between the two
         companies.

         Reasons for comparative advantage include:

                   Name recognition in local markets

                   Regulatory constraints

                   Variations in credit assessment


Straight Currency Swaps

         The mechanics, accounting and tax implications of straight currency
         swaps differ considerably from parallel and back-to-back loans.

         Swaps are not direct lending, rather they are the sale of currencies with a
         concomitant agreement to buy them back at a fixed exchange rate and at
         fixed date in the future.                                                        d
Copyright 1995: P a t r i c i a V. Linton     6                                (fcsbig)
         Foreign currency swaps are carried off-balance sheet, as opposed to
         parallel and back-to-back loans. This produces a favorable debt ratio.

         Periodic payments to reflect interest rate differentials are made from the
         buyer of the high interest currency to the buyer of the low interest
         currency.

         Foreign currency swaps can have either fixed or floating rates.

         Maturities for foreign currency swaps are generally within 5 to 10 years,
         with a few in the 12 to 18-year range.

         The right of set-off is implied in the ability to terminate the obligation
         should one party default on any payments.




Copyright 1995: P a t r i c i a V. Linton
                                     EXERCISE. I


1.     Name two users of currency swaps and what their purpose might be.


                        User               Puroose




2.      Define comparative advantage.




3.     What characteristics of the global capital marketplace contribute to the
       use of foreign currency swaps?




Copyright 1995: Patricia V. Linton
                 IV. BASIC STRUCTURE OF A CURRENCY SWAP


         A foreign currency swap entails 3 distinct sets of cash flows:

                   The initial exchange of principal between the participants which
                   may or may not occur within the swap.

                   The interim exchange of interest payments over the term of the
                   swap.

                   The re-exchange of principal upon maturity or termination of the
                   swap.




                   A U.S. company needs to borrow Y10 billion for 5 years. Its
                   direct rate for borrowing Yen is 7.5%. This U.S. company
                   borrows US dollars at 10%.

                   A Japanese company needs to borrow $100 million for 5 years. Its
                   direct rate for borrowing US dollars is 11% . This Japanese
                   company borrows Yen at a rate of 6.5 %.

                   The current exchange rate is Y 100/$1.00.

                   The U.S. company will swap its ability to borrow $100 million at
                   10% for the Japanese company's ability to borrow Y10 billion at
                   6.5%.




Copyright 1995: P a t r i c i a V. Linton
                   The initial exchange of principal would appear as:




                                                   --     -   .. .
                                                "sells $ 1 0 0 ~
                                                                .    .
                                                               at 10%"
                                                                         - - ..
                                                                         .

                         U.S.
                       company                                                    Company
                                            4
                             A                   "Sells




                   $100M Debt                                                     YlOB Debt
                   at 10%                                                          at 6.5%




Copyright 1995: P a t r i c i a V. Linton
                  For simplicity (actual calculations are described in the next
                  section), let's say the interim payments of interest are calculated
                  by:



                      Notional Principal             x   Swap Rate




                  U.S. Corp will pay Yen at: Y 1 billion x 6 5%
                                                0           .

                                                         =    Y650,000,000


                   Japanese Corp will pay $ at:              $100 million x 10%

                                                             = $10,000,000




                                            Pays Y650,000,000           I
                 U.S.                                                  c    Japanese
               Company                                                      company
                                   4
                                    I         Pays $10,000,000




                     7                                                            v
           $100M Debt                                                        YlOB Debt
           at 10%                                                              at 6.5%




Copyright 1995: P a t r i c i a V. Linton
         After 5 years, the swap expires and principals are re-exchanged.
                                                                                      L,

                                            I   "Returns $100M"
                       U.S.                 4                         Japanese
                     Company                                          Company
                                                                  b
                                                "Returns Y10"     I



                      v                                                  v
                 $100M Debt                                           YlOB Debt
                 at 10%                                                 at 6 . 5 %



                   The U.S. company saves lOOBP annually since it is able to obtain
                   Yen at 6.5 % instead of 7.5 %.

                   The Japanese company saves lOOBP annually since it is able to
                   obtain US dollars at 10% instead of 11% .                          3
H        A foreign currency swap with a market maker will alter the cash flows
         and the savings of the participants.

                   Example:

                   A U.S. company needs to borrow Y10 billion for 5 years. Its
                   direct rate for borrowing Yen is 7.5%. This U.S. company
                   borrows US dollars at 10%.

                   A Japanese company needs to borrow $100 million for 5 years. Its
                   direct rate for borrowing US dollars is 11% . This Japanese
                   company borrows Yen at a rate of 6.5 %.

                   The current exchange rate is Y100/$1.00.




Copyright 1995: P a t r i c i a V. Linton
 -
c'          A market maker proposes the following swap to the participants:

                                             Market             Market
                                             Maker              Maker
                                                                Offer

                    US$ swap quote           US$ 10%          US$ 10.10%
                    Y swap quote             Y 6.5%           Y 6.62%
                                             Quoted against USD LIBOR

                    The exchange of principal at the outset and at maturity are still the
                    same as above. The interim cash flows of principal and interest
                    payments are altered as follows:




                      v                                                       v
                 $100M Debt                                              YlOB Debt
                 at 10%                                                   at 6.5%




                     The swap savings to the U.S. company are reduced by the presence
                     of the market maker. The yen rate to the U.S. company is 6.62 %
                     rather than its own 7.5% for a savings of Y 88BP. Note you
                     cannot net yen basis points with dollar basis points.

                     The swap savings of the Japanese company are also reduced by the
                     presence of the market maker. The dollar rate for the Japanese
                     company is 10.10% rather than its own 11% for a savings of US$
                     90BP. Again, savings across currencies cannot be netted directly.




     Copyright 1995: Patricia V. Linton
                                            EXERCISE 11


1.        Diagram a 7-year currency swap for the following participants showing
          the interim annual cash flows between them. The U.S. Company is
          looking for the cheapest Sterling liability to fund an expansion of its
          operations in London while the U.K. Company is looking for the
          cheapest US$ liability to offset its large US$ asset position.

                                                   Bank Swap Quotes
          Participant Direct Mkt Rate              -
                                                   Bid          Offer




                                                   Against USD LIBOR


          The notional principal amount is US$100 million and the currency
          exchange rate is US$1.60/£.




Copyright 1995: P a t r i c i a V. Linton
J



    r'   2.      What is the total income to the market maker?




         3.       What are the savings to the US and to the UK company?




         Cowright 1995: P a t r i c i a V. Linton
                            V.      QUOTING CONVENTIONS

Methods of Calculating lnterest

       The method of calculating interest depends on the currency being quoted.
       Usually the fixed-rate interest payment convention follows the local
       market convention for government issues.

       For fured-rate payment streams, there are two basic methods: semiannual
       and annual.

               A semiannual yield:

               -       is the same as bond equivalent yield (BEY)
               -       is two times the semiannual coupon payment months, etc.
               -       is effective for half a year but quoted on a nominal annual
                       basis
               -       uses a 365day year
               -       is used in the U.S. domestic bond market and the U.K.,
                       Canadian and commonwealth countries.

               An annual yield:
                                                                                            L,'
               -       is the same as Association of International Bond Dealers
                       (AIBD) yield
               -       is used with bonds that pay interest once a year
               -       is effective for one year
                -      uses a 365day year
                -      is used in the Eurobond market as well as for most European
                       government issues and domestic Japanese bonds.

       The floating-rate side of a currency swap, usually six-month U.S. dollar
       LIBOR, is quoted as a money market yield.

                A money-market yield:
                -       does not include interest on interest (i.e., is effective for one
                        interest period-three months, six months, etc.)
                -       uses a 360-day year
                -       is used for all U.S. money market instruments.


Copyright 1995: Patricia V Linton
                          .                  16
              All counterparties and intermediaries must understand the bases of quotes
f-'           in order to accurately assess the cost of swaps. Rates quoted on different
              basis cannot be compared directly. Also, rates quoted in different
              currencies also cannot be compared directly.

      Quoting Fixed-to-Floating Currency Swaps

              These swaps are quoted in the form of a fmed-rate currency against
              six-month U.S. dollar LIBOR. This standardization makes swaps more
              liquid and easier to trade.

              Example: A three-year fixed French franc to dollar LIBOR swap would
              be quoted as 7.22130 vs. dollar LIBOR. That is, the bank pays 7.22 % in
              French francs and receives dollars at LIBOR. The bank receives 7.30%
              in French francs and pays dollars at LIBOR.

      Quoting Conventions of Leading Currencies

              In most cases, the convention for calculating interest payments on swaps
              follows the convention for government debt issues in the local currency.
              The conventions for government securities in the major currencies are
              listed below.




      Copyright 1995: P a t r i c i a V Linton
                                       .
         Quoting conventions are often a source of confusion in the swap market.
         The offer rate on a French franc swap may be quoted as:                          L)
                             Basis
         4.79%               Semiannual actua11365: BEY,' U.S. standard
         4.85%               Annual actuall365: AIBD
         4.72%               Semiannual actua11360: MMY, U.S. standard
         4.78%               Annual actua11360: AIBD


         All these rates are correct and equivalent:

                   Converting from actual1365 semiannual (BEY) to actual1365 annual
                   (AIBD):


                              AIBD          =   [(I +             -      x    1m




                   Converting from actual1365 annual (AIBD) to actual1365
                   semiannual (BEY):

                              BEY           = 2(Jl    +   AIBD - 1 ) x 100



                      BEY        =    2(J1      +    .0485   -   1) x   100   =    4.79




Copyright 1995: P a t r i c i a V. Linton
                        Converting from actual1360 semiannual (MMY) to actual1365
f'                      semiannual (BEY):

                                                                             365
                                                                 BEY = MMY x -
                                                                             360


                                                             365
                                                BEY = 4.72 x - = 4.79%
                                                             360


                        Converting from actual1360 annual to actual1365 annual (AIBD):

                                                                                                     365
                                                  AIBD                      =           Annual MMY x -
                                                                                                     360


                                             AIBD



     Floating-Rate lndex

              The floating-rate index is usually six-month U.S.dollar LIBOR,
              calculated on an actuall360day basis without compounding (MMY).

              Non-dollar denominated interest rate swaps are available in many
              currencies. The most common currencies and the typical floating rates
              are:
                                 .. . . .. .. .                                                                                            . . . . . . . (./../.// : . .
                                ........................ ..: ..,: : . : :, . . . . ....................:. . .:. . .:. . . . . . . .:. .:. ................ . . : . .: .................
                                .......... .. . . . . . . . ...............
                                ..::.........:                                             . . . .......        :

                                i::::.. ,,:,ClNCy ::ij,,
                                ........
                                ....... . . . . . . . .. .. . .. .. . . . .
                                . .                                               i:;                     ;i;:i;i.q.
                                                                                              ;:;;;jii~oA~~G,';~~~
                                                                                                ...... : . . . . . . . . . . . . . . . . . . . . . . . .

                                  Sterling                                                       Sterling LIBOR
                                   Canadian Dollars                                              90-day Banker's Acceptances
                                   Australian Dollars                                            Australian Dollar Bank Bills
                                   Deutschemarks                                                 DM LIBOR
                                   Yen                                                           Yen LIBOR



     Copyright 1995: P a t r i c i a V. Linton                                                         19                                                                                 (fcsbig)
                                            EXERCISE 111

1.       Using the rates below,

                             Currencv          5-Year Swap
                             USD               7.35139
                             French francs     8.12117

                             Against USD LIBOR currently 6.00%

         diagram the transaction between LVMH, Disney and the Market Maker.
         Make sure the diagram shows:
         -         the FF rate the bank pays and receives
         -         the USD fixed rate the bank pays and receives
         -         the USD LIBOR flows

         LVMH (Louis Vuitton Moet Hemessey) wants to borrow fixed rate US
         dollars for five years. Its best opportunity is to borrow fixed-rate French
         francs and enter into a swap receiving fixed-rate FF and paying US$
         LIBOR and then enter a US dollar interest rate swap as a payer
         (receiving US$ LIBOR and paying fixed-rate dollars).

         Disney will borrow fixed-rate dollars for five years and enter into a full-
         term interest rate swap receiving fixed-rate dollars and paying US$
         LIBOR. Disney will then enter a five year currency swap contract to
         receive US$ LIBOR and pay fixed-rate French francs.




Copyright 1995: P a t r i c i a V. Linton
.
     2.       Identify the quotation basis of each of the three payment streams.
(I




     3.      Make the necessary rate conversions to calculate the cash flows for the .
             period May 15, 1995 - November 15, 1995 if the notional principal of
             the swap is USDlOO million, the exchange rate is FFSJUSD and the swap
             settles semiannually BEY. Show the cash flows on a diagram.




     Copyright 1995: P a t r i c i a V. Linton
                                            M. PRICING


         The pricing of foreign currency swaps depends on several factors
         primarily related to prevailing interest rates and foreign exchange rates.

         A foreign currency swap can be thought of as the internal rate of return
         of a series of futures or forward contracts.

         A short-dated foreign currency swap (1 year maturity) can be generated
         from the currency futures market.

          JAPANESE YEN (IMM)
                                            As the exchange             CANADIAN DOLLAR (IMM)
          12.5 million yen.
          s per 100 yen
                                            rates indicated are         1oo.000 dollars.
                                                                        S per Can s
                                            forward exchange
                                            rates, they can be
                    .m                      used to create a
          Dec       .7949                                               Dec       .7598
          Spot = .no0
                                            one-year swap.              Spot   = .7798


         Example: if a company borrowed 100 million Canadian dollars for one                    L,
         year at 8 % payable quarterly, it could transform this into a US dollar
         liability by entering the following position:

                   Selling the C$100 million and buying USD at the spot rate.

                   Buy C$2 million (long position, 20 contracts) for each of the first 3
                   quarters and C$102 (120 contracts) for the final quarter.

         0         This will produce a known USD cost of funds as follows:

                   Kevstrokes                                Displav

                   100,000,000 [CHS] [ENTER]                 -100,000,000
                   .7798 x [g] [CFO]                         -77,980,000
                   2,000,000 x .7759 [g] [CFj]               1,551,800
                   2,000,000 x .7697 [g] [CFj]               1,539,400
                   2,000,000 x .7645 [g] [CFj]               1,529,000
                   102,000,000 x .7598 [g] [CFj]             77,499,600
                   [fl [IRRl X 4                             5.36%


Copyright 1995: P a t r i c i a V. Linton         22
f-'              In the longer-dated market, foreign currency forward contracts can be
                 used to achieve the same result as the futures contracts.

                 The rate information that generates the forward exchange rates, and
                 therefore the IRR, comes from the prevailing market. We can calculate
                 the implied forward exchange rates using the formula:



             I   1
                  1   +
                      +
                           FX interest rate
                          USD interest rate
                                                       -
                                                            I
                                                            1   x 100 = p.a. Premiwn/Discount


                 and then use the HP-12C to solve for the forward exchange rate as
                 follows:

                 Step 1.           Input the spot FX exchange rate into [PV].
                 Step 2.           Input the p.a. premium or discount into [i].
                 Step 3.           Input the number of years into [n].
                 Step 4.           Solve for the forward exchange rate by pressing [FVI.

                 Example: The 5-year DM Bund carries a rate of 8.50% and the 5-year
                 US Treasury carries a rate of 6.50%. The current spot exchange rate is
                 DM1.6300IUSD. What is the 5-year forward exchange rate?

                  1 + .085
                                                  x   100   =   1.8779 p.a. premium of the USD
                  1 + .065

                          Kevstrokes                        Displav

                          1.63 [ P v                        1.6300

                          1.8779 [i]                        1.8779




                 The five-year forward exchange rate is DM1.7889lUSD.


      Copyright 1995: P a t r i c i a V. Linton                 23
         Examule: A company wishes to convert a 2-year 100 million Swiss franc
         8 % fixed-rate funding (annual payments) into US$.                              L)
                    The company can use either a currency swap or a "strip" of foreign
                    exchange forward contracts. If the cash interest rates are known,
                    the forward exchange rates can be calculated.
                    Assume:            spot rate           = 1.46 Sf?/$
                                       1-year forward    . = 1.48 Sfr/$
                                       2-year forward      = 1.51 Sfr/$

                    The covered cost in dollars can be calculated as follows using the
                    HP-12C:

                    Keystrokes                                 Displav

                    100 [CHS] [ENTER]                          -100.00

                    1.46 + [g] [CFO]                            -68.49

                    8 [ENTER] 1.48 + [g] [CFj]                    5.41

                    108 ENTER] 1.51 + [g] [CFj]                  71.52




                    Thus a currency swap would have to result in a rate for US$ of no
                    more than 6.21 % when swapped for Sf? 8 % in order to be
                    competitive with a strip of forwards.




Copyright 1995: P a t r i c i a V. Linton           24
            The following other considerations influence foreign currency swap
P           pricing:

            Structure

                      Foreign currency swaps can be tailored to meet specific
                      requirements.

                       The greater the mismatch with underlying cashflows and degree of
                       complexity, the greater will be the spread demanded by the market
                       maker (and thus the cost to the swap counterparties).

             Credit Standing

                       Ratings and credit quality perceptions of each counterparty will
                       affect the costs of the underlying transaction (for borrowers) and
                       the swap payments each must make.


             Availability of Counterparties

                       Is there a scarcitylabundance of either payers or receivers for one
                       or both currencies?

             Maturity

                       Generally, the longer the maturity, the higher the interest payments
                       in each currency, and the higher the swap payments for both
                       counterparties.

             Regulatory factors

                       Exchange controls

                       Withholding taxes

                       Other tax considerations (eg. timing of when interest
                       incornelexpense are realized)




    Copyright 1995: P a t r i c i a V. Linton
                                                EXERCISE IV


1.       The five-year Australian dollar yield curve shows an interest rate of 12%.
         The U.S. Treasury five-year yield is 8%. The spot exchange rate is
         A$1.2700/USD.

         a.        What is the per annum premium of the U.S. dollar?




         b.        What is the 5-year forward exchange rate?




2.       Use the Yen futures quote below and transfer a Y12.5 billion one-year
         liability at 5 % payable quarterly into USD. (Assume the payment dates
         are the same as the futures contract dates.)
                                                 JAPANESE   YEN (IMM)
                                                 12.5 million yen.
                                                 t per 100 yen
                                                 Mar        .7925
                                                 Jun        .7930
                                                 Sep        .7933
                                                 Dec        .7949

                                            I    Spot = .7915           I




Copyright 1995: P a t r i c i a V. Linton
      3.       The Treasurer of a U.S. company wishes to finance US$ 75 million at a
f'
- ,            fixed-rate for three years. Assume he has three alternatives:

               (1) a straight domestic issue at 8.50%,

               (2) issuing an equivalent amount of DM at 9 % (annual payments) for 3
               years and entering into a currency swap where the 3-year rates are
               DM9.00/9.10% and USD8.05/8.15% or

               (3) converting the German bond's DM payments to US$ via a strip of
               forwards. The forward DM/US$ rates are:

                                              Date      DM/US$
                                              Spot      1.690
                                              1 year    1.700
                                              2 years   1.710
                                              3 years   1.720

                Which is the superior alternative in terms of rate?




       Copyright 1995: P a t r i c i a V . Linton
                 VII. FOREIGN CURRENCY SWAP APPLICATIONS


        Foreign currency swaps are used for several reasons:

        Company is unable to finance directly in desired currency
                   Unknown name

                   Prohibitively high cost
                    Desired maturities not available


        Company is blocked by currencylexchange control regulations

                   Excess liquidity because of inability to repatriate foreign currency
                   profits

                   Example: A French subsidiary of a U.S. company has FF liquidity
                   that can be taken out of France only at a prohibitively high cost.
                   The subsidiary can enter into a currency swap with a French
                                                                                          0.
                   company which has dollar liquidity in which it pays FF and
                   receives US$.


        Company is hedging long-term currency exposures

                   Long-term supply or purchase contracts frequently span periods of
                   5 to 15 years.

                   Currency swaps and long-term forward exchange agreements are
                   basically the only hedges available (off-balance sheet) for reducing
                   the foreign exchange risks of such long maturities.

                   A supplier receiving a foreign currency would enter into a swap in
                   which it pays the foreign currency and receives its home currency
                   (the opposite would be true for a purchaser).




Copyright    W:
            1 5 P a t r i c i a V. Linton
         Accounting Considerations

                   A direct borrowing in a foreign currency has translation exposure
                   impact in many countries.

                   Currency swaps have no translation exposure: gains and losses are
                   included in current income.

                   Companies wishing to decrease or eliminate reported foreign
                   exchange impacts when financing in a foreign currency may do so
                   by funding in their home currency in conjunction with either a
                   currency swap or long-term forward agreement.

         Minimize costs/maximize returns

                   Currency swaps are in many ways the "link" that is driving the
                   globalization of financial markets.

                   An issuer or investor with a financial objective (eg. floating-rate in
                   home currency) will look at the costslreturns from achieving it
                   directly or indirectly, choosing the method which results in the
                   most favorable rates.

                   The underlying financial instrument chosen may be in a currency,
                   or have payment characteristics, completely different from the
                   desired liability structure.

                   As stated earlier, approximately three quarters of Eurobond
                   financings are swapped into a different currency.

                   In fact, new financings are the dominant reason for entering into
                   currency swaps, and are the driving force on the pricing side.




Copyright 1995: P a t r i c i a V. Linton      29                                   (fcsbig)
                                                  EXERCISE V
                                                                                          L)
    Using the foreign currency swap quotes below, structure the best swap that
    meets the needs of the counterparties in the situation below:



                                                CURRENCY SWAPS
                       3 YEAR              4 YEAR     5 YEAR     7 YEAR     10 YEAR
             STG       10.10113            10.11114   10.17120   10.18122   10.20124
             SF        7.71177             7.60167    7.50157    7.36141    7.30136
             DM        9.01105             8.87191    8.77182    8.53158    8.43148
             JY        6.00104             6.03108-   6.04108    6.14117    6.15119




,
I
    Situation
                             ALL QUOTES VERSUS 6 MONTH DOLLAR LIBOR




             A multinational company wants to borrow Sterling at a fixed-rate for 7
                                                                                          t,
             years. The multinational wants the cheapest possible rate, either directly
             or indirectly. It would pay STG 10.5 % on a bulldog bond but has
             excellent name recognition throughout the world. It can also borrow at
             DM 8.5% and SFr 7.5%.


             An institutional investor owns a portfolio of 7 year Eurobonds including
             SFr bonds paying 7.45 % and DM bonds paying 8.5 % . However, it
             would like to convert one of the assets to Sterling to take advantage of
             higher interest rates, convinced the pound won't depreciate enough to
             make it worse off (or may even appreciate).




    Copyright 1995: P a t r i c i a V. Linton
                                     EXERCISE V (cont'd)


1.     Diagram the swap showing all the parties, currency swap rates and direct
       product rates.




2.     Show the net results of the swap to all parties.




Copyright 1995: Patricia V. Linton
3.      Using the attached quote sheet, fill in the net funding column indicating
        the after swap position of the borrowers. Please identify their final                  L)
        position as fixed or floating, currency and rate.

                                            CURRENCY SWAPS

                   3 YEAR              4 YEAR        5 YEAR        7 YEAR        10 YEAR
        US$ 6.4416.50                  6.8016.90     6.9116.99     7.5917.70     7.9117.99
        STG 10.02110.1                 10.08110.15   10.16110.22   10.17110.25   10.28110.35
        SF 7.7217.92                   7.6217.82     7.5217.71     7.3417.55     7.3017.52
        DM         8.9119.03           8.9019.01     8.8919.01 .   8.8418.96     8.7718.88
        TY         6.6616.75           6.5516.67     6.5316.64     6.3516.46     6.3016.42
        C$         8.5018.73           8.5818.72     8.6018.76     8.6018.75     8.5818.74

        (Assume: Floating side is US$ LIBOR.)




Copyright    W:
            1 5 P a t r i c i a V. Linton
                             W I . ADVANCED APPLICATIONS


Locking In an Unrealized FX Gain

       The currency swap can be a particularly effective way of locking in
       unrealized gains on seasoned foreign currency denomination debt issues.

       When using swaps for this purpose, companies pay' particular attention to
       the accounting and tax treatment. Using a swap can help a company:

                 Lock in a favorable movement in FX rates AND

                 Defer the taxation of the gain.


       Example: Consider the following opportunity for Volkswagen: Five
       years ago, it borrowed USDlOO million for 10 years at a rate of 9.5%
       (annual payments) when the exchange rate was DM2.00lUSD. The
       current market offers the following:


                                   DM Securitv        USD Securitv
       Maturity                    5 years            5 years
       Coupon                      9.25 % (annual)    7.50% (annual)
       Price                       Par                Par
       FX rate                     DM1.50             USDl


       Since the DM has appreciated against the dollar, Volkswagen has an
       unrealized gain equal to the reduced value of its USD debt in DM terms
       (from DM200,000,000 to DM150,000,000 = DM50,000,000).
       Volkswagen has the choice of

                 Buying up its outstanding USD bond issue by issuing a new DM
                 bond and incurring an immediate taxable event, or

                 Entering a foreign currency swap to lock in the appreciation of the
                 DM while deferring the tax on the DM gain.



Copyright   1W5: Patricia   V. Linton            33
         Assume a market maker will structure the transaction using prevailing
         market rates.                                                                 id)


         Step 1: Identify the principal amount required to buy back the
         outstanding bonds or serve as the initial principal in the swap by
         calculating the present value:

         1.        Insert the current payment stream into [PMT].
         2.        Insert the redemption amount into [FV].
         3.        Insert the number of years remaining into [n].
         4.        Insert the prevailing market rate into [i].
         5.        Solve for [PV].

         Kevstrokes                            Dis~lav
         9,500,000[PMT]                        9,500,000
         100,000,000[FVI                       100,000,000
         5 [nl                                 5
         7.50 [i]                              7.50
         [pvl                                  -108,091,770

         Step 2: Using the current exchange rate, identify the DM amount that          0
         would need to be issued and the coupon payment stream on that amount.




         Step 3: Identify the swap cash flows and solve for the rate to identify the
         benefits.
                                            DM162,137,655 at,maturity
                            - - - - - - - - - - - - - - - - - - -
                                 - - - - - - - - -                I
                        i
                        I         /         USD100.000.000 at mat.
                                                                     i
                                                                     I   i
                     Volkswagen                                  Market Maker

                                                DM14,997,733
                                               (9.25% x DM162,137,655)
                          v
                     USD100,000,000 Debt
                     9.5%; 9,500,000


Copyright 1995: P a t r i c i a V. Linton             34
 -
r'            Solve for the rates of the cash flows to Volkswagen and the Market
              Maker:

               1.         Enter the original value of the initial exchange into [PV] .
              2.          Enter the payment obligations as a negative into [PMT].
              3.          Enter the exchange at maturity as a negative into [FV].
              4.          Enter the remaining term of the obligation into [n].
              5.          Solve for [i].

              Market Maker:                     USD108,091,770 [PV]
                                                -9,500,000 [PMT]
                                                -1oo,ooo,000 [FV]
                                                5 [nl
                                                [i] = 7.50%

               Volkswagen:                      DM200,000,000 [PV]
                                                -14,997,733 [PMT]
                                                -162,137,655
                                                5 [nl
                                                [i] = 4.00%

               The market maker pays the current market rate of USD7.50% while
               Volkswagen has created a borrowing rate of DM4.00% while reducing
               AND deferring its taxable gain to DM37,862,345 five years from now.




     copyright 1995: P a t r i c i a V. L i n t o n
                                          EXERCISE VI


Five years ago, a Canadian company borrowed US$lOMM at 9.50% payable
annually maturing in ten years. The exchange rate in effect at that time was
C$1.42/$1.00. Today, the following market rates are in effect and the Canadian
company wants to lock in its unrealized foreign exchange gain without incurring
a taxable event.

                Currency           Term       Rate
                US$                 5 years   7.0%
                C$                  5 years   8.0%

                Spot FX rate: C$1.16/$1.00.



1.     Identify the principal amount required to buy back the outstanding bonds
       or serve as the initial principal in the swap.




2.     Identify the C$ amount that would need to be issued and the coupon
       payment stream on that amount.




Cowright    W:
           1 5 Patricia   V.   Linton
r'   3.     Structure a swap which enables the Canadian company to lock in its
            exchange gain. Diagram the swap with arrows showing the payments of
            principal and interest.




     4.     Show the rate result of the cash flows to the Canadian company and the
            Market Maker.




     5.     List the benefits to the Canadian Company.




     Copyright 1995: Patricia V. Linton
                          IX. RISKS OF FOREIGN CURRENCY SWAPS

Credit risk

                      Risk of default by counterparty: the market maker's potential loss
                      depends on the movement of foreign exchange rates.
                      -          a counterparty may default
                      -          the value of the swap is subject to market rate changes
                      -          realization of risk requires both an adverse rate movement
                                 and a counterparty default

                      It is a contingent risk - i.e., interest rates and foreign currency
                      exchange rates at the time of default.

                      The level of risk is usually greater in currency swaps than for
                      interest rate swaps for the following reasons:
                      -          principal is exchanged, rather than just interest
                      -          there is no net settlement, as there is in interest rate swaps
                      -          both FX and, interest rates movements impact the market
                                 value, rather than just interest rates

                      Default by one party does not necessarily cause loss to the
                      intermediary. For loss to occur, there must be both a default and
                      adverse movement of interestlexchange rates. If one party defaults,
                      the intermediary has to make the payments it guaranteed to the
                      remaining counterparty, if there is one.


Sovereignlexchange control risk

                      A counterparty possessing the currency it is required to pay under
                      the swap agreement may be unable to deliver because of
                      unanticipated foreign exchange controls. This problem is usually
                      covered in the documentation.

                      Changes in tax treatment of interest incornelexpense from currency
                      swap transactions can have adverse effects on the income statement
                      of the counterparty.                                                             d
C w r i g h t 1995: P a t r i c i a V . Linton        38                                    (fcsbig)
i


     Mismatch risk
r\
                        One or both counterparties may have mismatch risk due to
                        differences in amounts or timing.

                        Differences in amounts can result in a partial or excess hedge (eg.
                        currency receipts are more or less than interest to be paid or
                        received)

                        Differences in timing can result in having to make an interest
                        payment in a foreign currency before the actual swap receipt,
                        resulting in some foreign exchange exposure. In this case the swap
                        receipt would be sold on the spot market. (The risk is that the
                        foreign currency will depreciate in the interim. This risk is
                        typically borne by the market maker.)

     Basis risk

                        Basis risk for currency swaps is relevant when payments or receipts
                        are based on a floating-rate index and the associated borrowing or
                        investment is based upon a different index.

                        The risk is that-the differential will narrow or widen, causing the
                        cash flows not to be offset.

                        For example, a currency swap in which the receiver of 6-month
                        US$ LIBOR is using the proceeds to pay interest on a loan priced
                        off the 6-month CD rate entails basis risk to the extent that the
                        relationship between these two indices changes.

     Market risk
              0         As with any financing, investment or hedging decision there is the
                        risk that another alternative or a no-hedge decision would have
                        worked to the company's advantage (in retrospect).

                        The following table summarizes the foreign exchange riskslbenefits
                        of converting a home currency financing or investment to a foreign
                        currency (the opposite effects are true when converting financing
                        cash flows from foreign currency to home currency).


     Copyright 1995: P a t r i c i a V. Linton     39                                   (fcsbig)
                   Effects of Changes in Foreign Exchange Rates
                   When Converting From Home to Foreign Currency




                    Interest rate risk is also inherent in the decision whether to convert
                    payments to either a fixed or floating basis as summarized in the
                    following table for floating rates (the opposite effects are true for
                    fixed rates).

                                                     Effects of Changes in Interest Rates
                                                       When Choosing Floating Rates
                   ............... .;: .
                   :.:..                              :    ............................. :               .......: : ................................   ...i.....   ........... :. . . . . . . . .
                      . . . . . . . . . . . M. O . . . .
                   ~. :. ~. ~. ~. T.......... . .. -. M>:.!.E. .N. .T. . :. .;. .~. .:.~ .I.N. V E. .S T M. ~ ~ ~ : : ; ~ :
                   :::                      .. .             $FINANCING. . . . . . . . . . .
                                                                .. . .. .. .                             .
                                         .
                   . .. .. .. .. .. .. .:. . :. .: . . : : I .:......... :.:..........: : .:.. .:..: ,:....:.:,,.
                   ......
                                                S;..~         .~;
                   , ~ : ~ ~ ~ T : ; : R A T E ~~~~~i~~ . ~ ~ Positive
                   ... . . . . . .:... . . . . . :
                    ..                                                 . .. . . . .. . . : . : ..
                    ..: ..: . ... . ... ... ... ... . .. ... . .... . . . . . . . . . . . ... . ... . ... . . . . ::.
                      . . . ,:,               :
                                               . . .                                                  ........
                   : : ~ .~. S. T. :.R .A. .T. E. S., .; .F..&. Lpositive
                  -.:. .     . . . .           . . . .       ..                                          ,
                                                                                                                   ;,                                                Negative


Flexibility risk

                    Although the secondary market for currency swaps is growing,
                    there is still limited liquidity, or ability to unwind contacts before
                    maturity.

                    If the associated issue contains an option-like feature which results
                    in the early retirement (further extension) of the debt, (eg. callable,
                    puttable, extendible, convertible) then failure to unwind the swap
                    (or have its maturity be too short) can result in a currency
                    exposure.




Copyright 1995: P a t r i c i a V. Linton                                                                               40
*
         Calculating the GaidLoss on Default
    r\
                  The gain or loss on default is a function of the interest rate differential of
                  the two currencies involved, the length of time to scheduled maturity and
                  the current spot FX rate.

                  The interest rate differential affects the forward rates. The forward
                  discount/premium implied in the swap may be very different from market




                                                                               '
                  forward rates at the time of default.

                  The length of time until maturity influences the number of interest flows
                  that must occur and the magnitude of the prernium/discount resulting
                  from the interest differentials.

                  The spot FX rate determines the amount that the intermediary has to pay
                  a new counterparty to assume the offsetting position on the date of
                  default.

                  Example: Assume the following swap has taken place:
    P
    %.
                  -
                            Term: 5 years
                  -         FX Spot: FF5lUSD
                  -                      l
                            ~ o t i o - kprincipal: USD 10,000,000
                  -         USD BidIOffer = 8.0018.10
                  -         FF BidlOffer = 9.0019.10




                            Company           .rsll~ll/m*jj
                                                       Market    4
                                                                     US$8.10
                                                                     FF/P %
                                                                        0         Company




                                   v                                                  v
                         $lO,OOO,OOO                                           FF50,000,000
                         at 8.0%                                                   at 9.0%




         Copyright 1995: P a t r i c i a V. Linton
                                                                                           .   C



         Assume, one year has passed and Company B defaults. The new market                \
         conditions are as follows:
                                                      -   ~




                                                                                      u
                                                                                      ,/




         -         FX Spot: FF6JUSD         -        4-year USD rates: 7.25%
                                            -        4-year FF rates: 8.25 %

         The Market Maker is receiving FF4,550,000 and paying USD800,OOO
         with an obligation to return USD10,000,000 in exchange for
         FF50,000,000 at the end of year 4.

         The Market Maker can cover his position by borrowing FF, converting
         them into USD and then investing the USD. This will, in effect, replace
         Company B .

                   Step 1: Calculate the USD investment required to generate a flow
                   of USD800,000 at today's rates:

                   Kevstrokes               Dis~lay
                   800,000 [PMT]            800,000
                   10,000,000 [FVI          10,000,000
                   4 [nl                    4
                   7.25 [i]                 7.25
                   [PV                      -10,252,614

                   Step 2: Convert the USD amount into FF at the prevailing rate:



                   This amount will be borrowed at the prevailing rate of 8.25 %
                   causing an interest expense of FF5,075,044.

                   Step 3: Calculate the present value of the FF flow the Market
                   Maker receives in the swap at the current market rate of 8.25 %:

                   Kevstrokes               Dis~lay
                   4,550,000 [PMT]          4,550,000
                   50,~,000   Fl'J          50,000,000
                   4 [nl                    4
                   8.25 [i]                 8.25
                   [PV                      -51,399,856


Copyright 1995: P a t r i c i a V. Linton       42
                   Step 4: Calculate the gain or loss to the Market Maker:

                   PV of FF received in swap           FF51,399,856
                   PV of FF loan amount               -FF61.5 15,684
                   LOSS                               -FF10,115,828

                   If the Market Maker is a US Bank, the loss should be converted to
                   USD at FF6lUSD:



                   Step 5: Proof of loss position:

                   FF Rec'd bv Bank         FF paid bv Bank Net
                   4,550,000                5,075,044       -525,044
                   "                        8,              "




                   Kevstrokes               Dis~lay
                   525,044 [PMT]            525,044
                   11,515,684 [FV]          11,515,684
                   4 [nl                    4
                   8.25 [i]                 8.25
                   [PVI                     -10,115,828




Copyright 1995: P a t r i c i a V. Linton        43                            (fcsbig)
                                            EXERCISE VII


1.       The Market Maker booked the following swap one year ago.
         -         Term: 7 years
         -         FX Spot: Y125lUSD
         -         Notional principal: USD10,000,000
         -         USD BidIOffer = 7.5017.60
         -         Y BidJOffer = 6.0016.10

         Today, the USD payer has defaulted and the following market conditions
         are in effect:
         -         Spot FX: Y130
         -         6-Year USD rate: 7.0%
         -         6-Year Yen rate: 5.75%

         Calculate the gain or loss to the Market Maker in this case.




Copyright 1995: P a t r i c i a V. Linton
      2.      Describe the difference between mismatch and basis risk.
f-'




      3.       Give 2 advantages of a no-hedge decision.




      Copyright 1595: P a t r i c i a V. Linton
Global Swaps at J.P. Morgan




John Corrie, Managing Director
Swaps Risk Management
Table of Contents


          a Derivatives Business Overview
            - The Derivatives Market
            -The Global Swaps Business at J.P. Morgan
            - Competitor Data
          a Risk Management
            - Overview
            - Risk Management in Day to Day Dealing
          a Pricing a Transaction and the Risks
           l nvolved
Derivatives Business Overview
Derivatives Market Growth
Outstanding notional principal of swaps
$ equivalent in billions

                Option related
                Currency swaps
                Interest Rate Swaps




Source: ISDA Data 1987-1994
Competitor and Market Data
JPM vs. Competitor- size of total derivatives books
Notional amounts in $ billions
                                                P
                                                 1993
         Chemical                               2,479
         Citibank                    2,664      1,975
         J.P. Morgan                 2,471      1,654
         BT                          1,981      1,907
         BankAmerica                 1,376         nla
         UBS                            nla     1,581
         SBC                            nla     1,498
         Goldman Sachs                  nla     1,030
         Salomon                        nla       999
         Merrill Lynch                  nla       891
         Morgan Stanley                 nla       629
         CSFP                           nla       512
Source: Risk Magazine
Competitor and Market Data
Market standing - Risk Magazine rankings

Interest Rate Swaps:            1994   1993   Currency Swaps:            1994    1993

  US$
  Yen
  Spanish Peseta
  DM
  Lira
  British Pounds                  *     1     Int Rate OptionslSwaptions: 1994   1993

                                               US$                         1      3
                                               ECU                         1      1
                                               Yen                         2      2
                                               SFR                         *      3
* J.P. Morgan not rated in top three
Derivatives Business at JPM
  JPM has achieved a position as one of the world's leading derivatives dealers
    Risk Maqazine, September 1994: "A quick glance at the 1994 Risk rankings reveals a
    similar picture to last year, with J.P. Morgan and Swiss Bank Corporation (SBC)
    consolidating their dominant positions in swaps and options, respectively, despite
    increased competition."
    Treasurv & Risk Management, July-August 1995: "Morgan is easliy the leader in four
    of the five product segement covered in our questionaire (plain vanilla, interest rate
    option products, exchange traded futures, sophisticated or unusual structures)."
  Market Share
    In 1994, JPM has achieved 10% market share in interest rate swaps and a 13%
    market share in currency swaps over the 8.75% and 11.5% shares earned in 1993.
The Derivatives Business at JPM by Asset Classes


       Interest Rate      Insurance
       Currency           Credit
       Prepayment         FX
       Equity             Benefit Responsive
       Commodity          Emerging Markets
Global Swaps Products and Hedges

   lnterest Rate Derivatives    Hedges
          Interest Rate Swaps        Government Bonds
          Currency Swaps             Futures
          CapsIFloorslCollars    a   Exchange Options
      a   Swap Options               OTC Options
      a             Out
          Knock 11-11 options    a   Deposits
      a   Index Amortizing           CorporatesIAgencies
          Binaries                   FX
                   Swaps
          'CMTIB~S~S
          Yield Curve Swaps
          Yield Curve Spread
          Options
Global Swaps Statistics

       1994 revenue amounted to $577.9 vs a plan of
       $539.4
       Revenues in 1993 and 1992 amounted to $532.4
       and $410.4, respectively
       Contribution amounted to $416.4 in 1994
Market Volatility and Revenue


        Market volatility obviously has an impact on swaps
        revenues
      a Average daily revenues dropped from $3.2 MM in Q l to
        $1.6 MM in Q2, but bounced back to $1.9 MM in Q3
        Looking at the daily revenue trends, the most significant
        factor is that for all 5 quarters displayed, the standard
        deviation for our daily earnings is centered on a positive
        number, not zero
Distribution of Daily Global Swap Group Revenue



     Days   1;

             6
 1993 Q3     4
             2
             0
            12
             9




                 0      2             4     6
                     Daily Revenues ($mm)
J. P. Morgan's Approach to Risk Management


      The following pages highlight the flow of
       a customer deal......
    Risk Management Guidelines *


                  -* A-
                      *
                       Risk Catego%
                 --,,-,,                      Recomm!?!!&E!~LeE

                       Market Risk            Valuation and portfolio testing

                       Credit Risk            Measurement and monitoring of
                                              exposure and credit
                                              enhancement.
                       Operational Risk       Appropriate personnel, systems
                                              and controls
                       Legal Risk             Work within industry to improve
                                              enforceability

8   As recommended by the Group of 30 Study
Functions Involved in a Transaction....
What is performed and who does it.
                                                --.       Tr.-A-.-.I........
                                                           "-".-
                                                               -
                                                              --                            -.-..
                                                                                                "--
       r r      , ,", , -,-
                . ", ,-- ,, -           "-"
                                        ,--      -.
                                                 .
                                                 ,.                            .. ,, - *
                                                                                   ,- -

                  / Market ~
                    .............
                    ,               i   s   ~         ~   g oRerat!o.!.x!~ C~%!a.ekk
                                                              ~ ~           s k1
                                                                                       ^-
                                                                                       I
                                                                                       -w



                                                                                                  1   :
..the Interaction Between these Groups that may be
                              ...
Involved in Getting a Deal Done
....And their Roles in the Process.
           ..........................................................................
           ..........................................................................
           Trading                                                                      Pricing, Market and Model Risk Control
            Marketer                                                                    Trade, Execution, Documentation
            Financial                                                                   Market Risk Control, Independent Price Testing
            Derivatives Research                                                        Risk and Model Control
            Global Credit                                                               Exposure Management
            CRMG                                                                        Market,and Credit Risk Reviews
            Legal                                                                       Documentation
            GTO                                                                         Timely Booking, Confirmation and Settlement of
                                                                                        Transactions
            CrediULegal Monitoring                                                      Ensures Compliance with Policies
      ji
      1 Audit
            ..                           ,.
                                         .            --                    _1
      ..............................................................................-
      iL.                                  -..                                  .=
                                                                                -.
                                                                                ,. :=
                                                                                   -
                                                                                        Reivew All Practices
                                                                                                .........................? ....=.m..-e=,mfi=z*..
                                                                                                                         .-.                       ......7.sm=.7.p..     ...............-.7.7.-,.m...7.....s
                                                                                                                                                                       ==a
  The Control Steps
The following are the control steps used in this process......

              Marketing - Client Suitability
              Model Risk
              Credit Risk
              Legal Risk
              Operations Risk
              Independent Verification
              Market Risk
Step One: Discussion With the Client




             The client and JPM marketer work closely on
     A       developing an appropriate transaction depending on
     t       the client's needs
           a A formal written document is sent to the client
             confirming the terms of the deal to be transacted
Step One: Discussion with the Client (cont'd)
The marketer is aware of several factors to be discussed with management
especially on complex deals to assess suitability risk

                                    Level?
                 Client ~o~histication
                 Complexity of Deal?
                 Relative Size of Transaction?
                Offsetting Existing Position?
                Who was Aware of the Deal?
                Competitively Bid?
                Who Initiated the Deal?
                 Term Sheets Sent?
                 Research Materials Supplied?
                 Confirmation of JPM Role?
                 Suitability Risk Acceptable?
Step Two: Model Risk Control (Pre-Trade)

             The marketer speaks with the Trading Desk about
             pricing the deal
             The Trading Desk evaluates the transaction and
             determines what types of risks are involved, and what
             inputs are needed to price the deal (eg, volatility
             information, FX rates, interest rates). This varies
             depending on the complexity of the deal
             If a new model or a variation on an existing model is
             required, Derivatives Research may play a role
    1        DR reviews the model, and ensures that all risks are
    1        properly identified, if this is a new type of transaction
             Both Trading and DR perform independent testing on
             the model and compare their results for
             reasonableness
Step Three: Credit Risk Control (Pre-Trade)


              The marketer discusses the potential transaction
              with the appropriate account officer in Global Credit
              The account officer reviews the deal's exposure on
              a loan equivalent basis with senior credit managers
              Global Credit makes a decision on the amount of risk
              that can be taken, and if there is any credit
              enhancement required
Step Four: Legal Risk Control (Pre-Trade)

             a   Confirm client's ability to transact the deal
Step Five: Operational Risk




  Cash Movements between GTO and Client   / I\   N          ~ from GTO to 'Iient ~
                                                                     ~               ~   ~   ~   ~




                                                     GIL Input
Step Six: Independent Price Verification
Step Seven: Market Risk Control



       The Trading Desk will hedge the risks associated
       with this transaction within its overall portfolio. This
       includes hedging currency, interest rate, correlation,
       and volatility risk
       Position and PIL information is available on an
       intraday basis to assist in the management of these
       risks
       The entire portfolio will also be evaluated against
       the desk's DEaR limit
Pricing a Transaction and the Risks Involved
Daily Gamma P& L
 Daily P & L Chart

               J. P. Morgan - USD Swap Derivatives Live PIL & Position Analysis (All Books)
                                              (Close Rates as of 5:37 PM)
   300   '                                                                                                30




                                                                                                           --
              SN      1M       2M       3M      6M       1 Yr     2 Yr      3 Yr   5Yr      lOYr   30Yr
                                              0
                             Total lOYr Position       fntraday             0    Gamma
Curve PAL- 9 9 4 @readP&L- >24 GmnmaP&L- >I184 I n t r d q P&L- >0 CarNFutBasis P&L->-I95
Total P&L- >I207 Total lOYr- A 4 0 Delta DE@R- >2.75 Vega DE@R- >1.96 Told DE@R- >3.02
Concluding Remarks


     a Managing risk on complex derivatives transactions
       requires input from many different business groups
       In order for the process to be successful, each link in
       the communication chain needs to understand their
       role in the risk management process and needs to
       aggressively play their part
     a Independent checks and balances are useful, but
       they often take place after the trade
       Ideally the risk management process should take
       place as an integral part of executing a transaction
Financial Instruments
                                                TABLE OF CONTENTS



r?
.
     Fed Funds .......................................................................................... 1
     Repurchase Agreements (RPs; Repos) .........................................................3
     Commercial Paper (CP) .......................................................................... 5
     Bankers Acceptances (BAS)...................................................................... 6
     Certificate of Deposit (CD) ....................................................................... 7
     Bank Loan Sales . Short-term Participations................................................... 8
     U.S. Treasury Bills (T-bills) .....................................................................  9
     U.S. Treasury NoteslSonds ..................................................................... 11
     The Agency Market . Overview .............................................................12
                            An
     U.S. Corporate Bonds .Investment Grade .................................................... 13
     Private Placement .................................................................................. 15
     Eurobonds (Fixed Rate) ..........................................................................17
     Yankee bonds ...................................................................................... 19
     Floating Rate Notes (FRNs) ..................................................................... 21
     Municipals: General Obligation Bonds .........................................................23
     Municipals: Revenue Bonds ..................................................................... 25
     Asset-Backed Securities.......................................................................... 27

n    Mortgage-Backed Securities (MBS) ............................................................ 29
     Foreign Exchange ................................................................................. 33
     Loan Product: Line of Credit..................................................................... 35
     Loan Product: Commitment ...................................................................... 37


     These market summaries are used in the Financial Instruments module of the Core. Morgan Finance
     Program . They are designed to give participants an overview of the markets. They are not meant to
     be comprehensive. but rather introductory.
                                               FED FUNDS

     Description
n
'
.-   Short term non-collateralized loans between member banks of the Federal Reserve System. Banks
     borrow funds to meet federally imposed reserve requirements and lend out excess funds to e m
     interest income. The name Fed Funds comes from the fact that all member banks of the Federal
     Reserve System must maintain deposits at a Federal Reserve Bank. On a daily basis, banks adjust
     their account balance by borrowing and lending these deposits in the interbank market.
     Maturity
     90% of the market consists of overnight loans. Loans for longer periods of time are called Term
     Fed Funds but are less common.
     Pricing
     Interest on Federal Funds is paidlmeived at maturity and is calculated on an actuaY360 day basis.
     Market Characteristics
     Loans of Federal Funds are traded like securities with interest rates determined by supply and
     demand. It is a highly liquid market with daily trading volume frequently exceeding $100 billion.
     The Federal Funds rate is considered the benchmark U.S.short term interest rate. The Federal
     Reserve carefully monitors and influences it as it is a key tool of monetary policy.
     Issuers
     Any member bank of the Federal Reserve System, for example,commerical banks, savings banks,
     savings and loan associations, and credit unions.
     Investors
     Same as issuers.
     Additional Information
     Money center banks tend to be net borrowers of Fed Funds because often their loans and
     investments exceed their deposits. Conversely, smaller regional banks are usually net lenders
     because they receive more deposits than they need to fund loans and investments.
     Credit Risk
     Federal Funds, like many loans, are non-collateralized and thus expose the lender (seller) to
     counterparty credit risk
     settlement Risk
     Since 90% are overnight, settlement risk is small. Term funds are more exposed to settlement risk.
     Market Risk
     Term trades have more interest rate r s than overnight loans. For example, a bank might lock in
                                          ik
     one month borrowing at lo%, only to see rates decline to 9%.
 -
i '
                                 REPURCHASE AGREEMENTS (RPs REPOs)

           Description
-'/
  I
      .-   A repo can be best described as acquisition of immediately available funds by simultaneously
           selling securities and agreeing to repurchase the same securities at a specified price and date,
           including interest. A reverse rep0 is the mirror image of a repo. The entire transaction can be
           viewed as a collateralized loan. The most common instruments used as collateral are U.S.
           Treasury and federal agencies securities.
           Pricing
           The Repo rate is lower than Fed Funds rate due to the underlying collateral (either U.S. Treasury
           instruments or agencies) and the supply of investable funds from entities which are not permitted to
           panicipate in the Fed Funds market. Interest calculation is based on an actuaY360-day year basis.
           Market Characteristics
           1. Repos are extensively used for fmancing long and short securities positions of major dealers
              and money center banks. Investors in this market look for converting their excess cash
              balances into short term collateralized loans.
           2. The market also allows government entities to meet regulatory requirements of having to invest
              any unused funds in high credit liquid instruments.
           3. The overnight repo market is very liquid. Overnight transactions account for 80% of the total
              transaction volume. Term repos and continuous repos, which are less liquid, make up the rest.

P          Issuers
           Major dealers and money center banks use repos to fmance-theirpositions.
           Investors
           Statdocal government, pension funds, money market mutual funds, corporations, financial
           institutions.
           Additional Information
           1. The Fed uses RPs to affect the supply of money in the system which impact the Fed Funds
              rate.
           2. Securities are valued at the current price plus accmed interest less a "haircut". The haircut
              represents the margin demanded by the "lender" which is a function of 1) term of RP, 2) type
              of securities, and 3) coupon rate of the underlying securities.
           3. For term repos it is common to have the underlying securities to be marked to marhet so as to
              reflect the changes in the value of the underlying securities and to maintain the agreed upon
              margin.
           Credit Risk
           Failure by the repo counterparty to honor the contract Investors must take either direct or clearing
           bank-custodian delivery of securities in order to reduce their exposure to the loss of title to the
 C\        underlying collated.
Settlement Risk
Since repo market is a cash market, all repo trades "settle" on the same day with "repurchase"
settling on the next day,. The underlying secmities are transferred against payments over the
Federal Reserves's security w r (fed wire). If one "fails" to deliver a security, the failing party
                             ie
does not "receive" cash. However, he still owes the interest to the counterparty.
Market Risk
Standard overnight r e p s and term repos with the "mark-to-marktet" provision may reduce the
price risk from the fluctuation in the interest rate movement. However, special repo agreement
may incur market risk andlor settlement risk.
                                      COMMERCIAL PAPER (CP)

      Description
n'
.
f
      Short-term debt issued as unsecured promissory notes in bearer form. Depending on individual
      credit ratings, commercial paper allows issuers to raise funds more cheaply than bank borrowing.
      Maturity
      Usually for 30 days or less, but can be up to 270 days until maturity. CP is never issued for
      maturities over 270 days so as to avoid SEC registration requirement
      Pricing
      CP is most frequently priced on a discount basis, although some are interest-bearing. Interest is
      calculated on an actuaV360 day basis.
      Market Characteristics
      There is a very illiquid secondary market because most paper sold to investors is held until
      maturity. Dealers and issuers will bid back CP but at wide spreads and this is uncommon.
      Issuers
      Issued by large finance, leasing, bank holding companies, manufacturers, retailers, corporates,
      foreign governments, and securities fums as an alternative to bank loans. CP is usually issued by
      top-rated concerns and is often backed by a bank line of credit or committed facility. Some issuers
      bypass the intermediation senices of banks and place paper directly with investors.
r\
      Investors
      Investors put a large emphasis on credit quality. They include; money market funds, pension
      funds, insurance companies, banks and corporates.
      Additional Information
       There also exists a small amount of unrated "Junk CP. Eurocommercial Paper is paper issued in
       the eurornarket Maturities for Euro CP tend to be longer than US CP and prices are quoted as a
     . spread to LIBOR.
      Credit Risk
      CP is generally a market for high credit quality issuers. Most issues are rated by at least two major
      rating agencies. Over 90% of CP is rated A I + M which is the highest rating given by S&P and
      Moody's respectively. The credit risk of CP is bankruptcy of the issuer and if relevant, the failure
      of the bank issuing a letter of credit or other backstop facility.
     Settlement Risk
     Intra-day settlement risk occurs as payment is received at 4 p.m. for securities delivered earlier.
     Market Risk

r'   Like al money market instruments, CP is affected by changes in short term interest rates.
           l
                                  BANKERS ACCEPTANCES (BAS)

    Description
n
I
    Bankers Acceptances (BAS) are short term ( e sthan 180 days to maturity), negotiable drafts
                                                 ls
    whose repayments are guaranteed by the banks that "endorsed" the drafts. They are issued at a
    discount and are repaid in full. BAS are the most common financing vehicle for international and
    domestic trade as well as for the warehousing of readily marketable staples.
    Pricing
    BAS are traded on a diiunt basis with yield calculated on an actud360 basis. The pricing of BAS
                                                           "
    depends on the creditworthiness of the " a c c e p ~ g bank.
    Market Characteristics
    Maturities of the most commonly traded BAS do not exceed 180 days. Due to the "two-name"
    characteristic of BAS and their to liquidity in the secondary market, BAS are less risky than CP and
    usually carry lower yields. Investors consider BAS an investment alternative to CDs and CP.
    Issuers
    Both domestic and international entities engaged in trade, and warehousing of goods.
    Investors
    Commercial banks, foreign banks, money market mutual funds, and municipalities.
    Additional Information
    Top tier BAS with maturities of less than 180 days are deemed "eligible" by the Federal Reserve
    System (that is "eligible" to be bought and sold by the Fed for their own account). Even though
    the Fed today rarely transacts in the BA market, banks still place value on "eligible" BAS because
    only "eligible" BAS may be bought or sold by member banks without incurring a reserve
    requirement Banks differentiate "eligible" papers from "non-eligible" ones by charging higher
    commissions. BAS are generally issued in bearer form.
    Credit Risk
    The credit risk to an investor is minimal because BAS are "two-name guaranteed" instruments
    (primary obligation of the accepting bank and secondary obligation of the issuer).
    Settlement Risk
    Most BAS are backed by documentation such as trade invoices, bills of lading or warehouse
    receipts.
    Market Risk
    L i e most money market i n s m e n t s , dealers could take a capital loss if they sold BAS prior to
    maturity and interest rates had moved against them.
                                  CERTIFICATE O F DEPOSIT (CD)

     Description
f"
     A CD is a negotiable instrument signifying a time deposit made with a bank that pays a futed or
     variable rate of interest for a specified perios. Domestic CDs are issued in bearer form.
     Maturity
     Maturities range from 7 days to 12 months. The most popular maturities are 1,2,3, and 6
     months.
     Pricing
     CDs are sold on an interest bearing basis. Interest is usually paid at maturity and yield is calculated
     on an actuaU360 day basis.
     Market Characteristics
     An active secondary CD market exists. Each bank's CD trades at a level according to its perceived
     creditworthiness. Dealers take positions in the market, but most CDs are ultimately sold to money
     market funds and institutional ihvestors.
     Issuers
     Domestic CDs are issued by US banks. Yankee CDs are originated by US branches of foreign
     banks and denominated in dollars. Thrifts issue Thrift CDs. Euro CDs are CDs issued by banks
     outside the US, with interest and principal paid in US dollars. The interest rate on Euro CDs is
     usually pegged to LIBOR.
     Investors
     Banks, foreign governments, central banks, municipalities, corporates, individuals, money market
     funds, and pension funds.
     Additional Information
     The CD market has declined in size by more than 50% since 1981, yet the secondary market still
     remains highly liquid. The Euro CD market is more active than the domestic CD market. Euro
     CDs are US dollar-denominated time deposits abroad issued by foreign branches of US banks and
     foreign banks.
     Credit Risk
     CDs have explicit deposit insurance up to $100,000. The creditworthiness of the issuing bank
     determines the credit risk of the CD.
     Settlement Risk
     Settlement is usually cash (same day) or regular (next business day).
     Market Risk
     Like all money market instruments, CD prices move with changes in short term interest rates as
     well as the perceived soundness of the banking industry.
I     r\
      1
          .
              Description
              A bank sells a portion of a loan it made to an investor who purchases these short tern money
              market loans. The bank does so for many reasons such as obtaining fee income, satisfying short
              term financing needs of its clients, and providing liquidity for its balance sheet. In short, a bank
              originates and then sells loans.

fL            Maturity
              Maturity usually ranges from 1 week to 3 months and typically is less than 6 months.
\             Pricing
              Yields are priced off the Eurodollar market and generally are 5-10 basis points above A l p 1 CP
              due to relative illiquidity of the loan sale market. Loan Sales are interest bearing instruments with
              yield calculated on an actual1360 day basis.

I             Market Characteristics
              There is no secondary market for Loan Participations sold by Morgan. Under the terms of a Loan
              Participation Agreement, the bank reserves the right to enforce the obligations of the borrower.

 I            Issuers



 Ii   i'
      ~-
              As stated above, participated loans involve relatively high credit quality borrowers. Commercial
              banks (mostly money center banks) issue the participation under a Master Participation Agreement.
              The bank serves as an intermediary between borrower and investor.
              Investors


 I            Domestic commercial banks, corporations, insurance companies, pensions funds, and foreign
              banks.
              Additional Information
              Bank Loan Sales offer attractive yields to investors over alternative investments such as CP or
              CDs. The typical transaction size is $10MM to $20MM.
              Credit Risk
              Morgan generally offers participations to non-banks on loans made to borrowers whose senior
              debt ratings are or would be Baa or better and have CP ratings of A21P2. To other banks, Morgan
              offers some sub-investment grade loans. Risks of default are commensurate with the public rating.
                                U.S. TREASURY BILLS (T-BILLS)


n
.
     Description
     U.S. Treasury Bills (T-Bills) are short term (one year or less) obligations of the U.S. government,
     with maturities of 13 weeks, 26 weeks, and 52 weeks, commonly referred to as 3 month, 6
     month, and one year bills, respectively. These instruments represent the default-free market
     interest rate. They are regularly issued on a discount basis. The "on-the-run" issues (the latest T-
     Bill issued in each maturity) are considered to be the bench market interest rates for the respective
     period.
     Pricing
     The original sale of T-Bills is done through submining competitive bids and non-competitive
     tenders. For the competitive bids, both yield and desired amount of securities are submitted. Non-
     competitive tenders indicate only the desired amount of securities (less than $1 million). All of the
     non-competitive tender bids will be fded at the average price of the successful bids from the
     competitive auction. Competitive bids are fded starting at the highest price (lowest discount yield)
     until the "stop-out" price (highest discount yield) is reached. T-Bills are quoted on discount yield
     basis with the yield calculated on an actuaV360 day year basis.
     Market Characteristics
     1. T-Bill market is dominated by institutional investors. The market is the most liquid of the
        money market instruments. Market making is done by more than 40 primary dealers (JP
        Morgan Securities is one of the primary dealers) as well as by a large number of the
        "secondary" dealers.
     2. The bid-offer spread is the smallest of the money market instruments. Bills are traded globally
(1      (major markets in New York, London, and Tokyo). Most trading is in New York.
     Issuers
     Treasury Department issues T-Bills to fund the Federal deficit
     Investors
     Investors are attracted by the safety and liquidity. Major participants are money market fund
     managers, commercial banks, federal reserve system, foreign central banks and financial
     institutions, corporations, and individuals.
     Additional Information
     1. Since all T-Bills settle through the Federal Reserve Bank wire transfer system, investors need
        pre-arranged custodian services from the member organization.
     2. The announcement for the weekly 3 month and 6 month T-Bill auction is made on Tuesday and
        held on the next Monday, with settlement occuring on the following Thursday. For one year
        T-Bills, the auction announcement takes place every four weeks on Friday, the auction is held
        on Thursday for settlement the following Thursday. The trading of T-Bills begins with the
        announcement for the settlement on Thursday. This period is called "when issued " (WI)
        trading period.
     3. There is an active market for T-Bill futures.
        Credit Risk
                         ul
        None. It canies fl faith and credit of the U.S. Government and is considered a default-free
        instrument
fi
1
    .   Market Risk

        Same as other money market instruments, i.e., exposure to adverse changes in interest rates.
                                    US TREASURY NOTESBONDS

     Description
r\
1
 .   Interest bearing debt instruments issued and secured by the full faith and credit of the US
     government
     Maturity
     Notes are issued with maturities of 2,3,5,7, and 10 years. Bonds have 30 year maturities.
     Pricing
     Interest is paid semi-annually and yield is calculated on an actuaYactual day basis. Prices are
     quoted as a percent of par in points and 32nds of a point (i.e. 99-16/32 equals ninety-nine dollars
     and f f ycents per hundred dollars of bonds).
          it
     Market Characteristics
     The Treasury market is dominated by 40 primary dealers who provide liquidity in the secondary
     market and serve as a conduit through which the Fed conducts monetary policy. The market is the
     second largest and most liquid in the world. The bidloffer spreads on Treasuries are very narrow.
     Short selling is also possible because of a highly developed rep0 market.
     Issuer
     The US Government
     Investor
     Insurance companies, pension funds, banks, foreign governments, central banks, corporates, etc.
     Additional Information
     Since August 1986, notes and bonds have been issued in book-entry form only. T-bond futures as
     well as options on futures are bought and sold at the Chicago Board of Trade (CBT) and the
     London International Financial Futures Exchange (LIFFE). The income from Treasury securities
     is exempt from state and local, but not federal taxes.
     Credit Risk
     Treasuries are perceived to be free of credit risk as they are backed by the full faith and credit of the
     US government.
     Settlement Risk
     Treasuries generally settle on the next business day, however cash (same day), skip-day (two
     days), and corporate (five days) settlements do exist Viually no settlement risk is involved as
     delivery versus payment occurs through the Federal Wire System.
     Market Risk
     Securities with long maturities change much more dramatically in price than shorter ones do for the
     same change in interest rates.
r\
                            THE AGENCY MARKET: AN OVERVIEW

     Description
0
.-   Federally sponsored agencies such as the Federal National Mortgage Association (FNMA), Federal
     Home Loan Banks (FHLB), and Student Loan Marketing Association (SLMA) act as financial
     intermediaries which borrow funds and make direct loans. These agencies issue debt to finance
     their operations. They perform a public service by assisting in sectors of the US economy such as
     agricultural, housing, and student loan financing. In 1989, Congress established the Resolution
     Funding Corporation (REFCORP) and authorized its borrowing up to $30 billion in order to
     finance the savings and loan bailout
     Maturity
     Securities range in maturity from 3 months to 30 years.
     Pricing
     Agencies trade on a spread over Treasury securities of similar maturity. Spreads depend on supply
     conditions, issue specific characteristics (i.e. call provisions) as well as the credit status of the
     specific sponsoring agency. Interest is calculated on a 301360 day basis.
     Market Characteristics
     The Agency market is the thud largest domestic fured income market behind Mortgages and
     Treasuries. Agency securities are not explicitly guaranteed by the US govenunent. They are less
     liquid than US Treasuries but more so than Eurobonds and Corporates. Agency issues are not
     sold directly to investors. Rather, Agencies are syndicated to a group of dealers who distribute
     them and provide a secondary market for the securities. Most Agency securities are in book-entry
     form and are cleared through the Federal Reserve's wire system.
     Investors
     Investors in this market desire a relatively safe, liquid investment with yield pick up over
                                                                           .
     Government securities. Investors include: insurance comoanies. comorations. mutual funds.
     central banks, commercial banks, and broker-dealers.
                                                                         .

     Credit Risk
     To date, no agency has ever defaulted on an issue. Spreads widen when investors perceive credit
     problems in the economy. For instance, FNMA and Federal Farm Credit System experienced
     credit crises in 1982 and 1985, respectively, causing investors and traders to sell Agency
     securities. This led to a widening of their spread over Tresuries out to 200 basis points.
                                  U.S. CORPORATE BOND:                INVESTMENT GRADE

                Description
    n
    1
        -   '
                A corporate bond is a private-sector borrowing in the public market with maturities ranging from
                one to forty years, with the majority of the bonds maturing m two to thirty years. Public offerings
                must be registered with SEC under the Securities Act and the issuer must comply with the periodic
.               disclosure requirements under the Securities Exchange Act Interest rate is either fixed or floating
                (adjustable rate or variable rate). The terms and conditions of the borrowing are specified in the
                bond indenture.
                Pricing
                Pricing reflects both the credit quality of the issuer and terms and conditions of the issue. The rate
                of intemt paid can be either fixed or floating:
                Fixed          Coupon rate and coupon payment date are fixed at the launch date. A spread over
                               the comparable treasury is agreed upon when the issuer accepts the lead manager's
                               offer.
                Floating:      The coupon on a floating rate note is l i e d to an index (e.g. CD, Prime, T-Bill,
                               Libor, etc.)
                Market Characteristics
                Utilities:     Generally the bonds are long-term, futed-rate and secured with sinking fund
                               provisions.

    r\
     .
                Indurm'als:    Lately maturities have shortened. Timing of issues is sensitive to interest rates and
                               swap rates. LBO activities have caused a deterioration in the overall credit quality
                               and a widening of the spread for this sector.
                Flnnncial:     Funding activities are often tailored to match the interest rate exposure of the
                               underlying assets.
                Issuers
                Institutions with rating of BBB/Baa or above.
                Investors
                Market dominated by institutional investors, including insurance companies, fund managers
                (pension, mutual, trust), and state funds.
                Settlement Risk
                Not a major issue due to DTC settlement procedures.
                Market Risk
                There are threecomponents: events risk-the deterioration of credit quality due to LBOs and the
                excess leverage taken on to fend off a hostile takeover attempt; reinvestment risk - arising from an
                issuer exercising the call option; yield curve risk - changes in the Treasury yield curve.
    f'
     Credit Risk
     Overall credit quality has deteriorated in the industrial sector largely due to increased leverage from
     mergers and acquisition and from leveraged buyout (LBO) activities. Credit analysis is now a key
r\   factor in marketing, pricing, and selling corporate bonds.
     Additional Information
     Bond classification is based on 1) issuing entity, 2) interest payment method, 3) security
     arrangement, and 4) repayment provision:
     1) Issuing Entities          Public Utilities
                                  Industrials
                                  Banks & Finance Compahies
     2) Method of Interest        Registered Bond: ownership and title to the bond are registered
        Payment                   with the issuing entity and transfer of ownership is accomplished only
                                  through the endorsement by the owner. Securities are settled through
                                  the Depository Trust Company (DTC).

     3) Security Arrangement      Mortgage Bond: gives bond holders a fust mortgage lien on the
                                  properties of the issuer.
                                  Collateral Trust Bond: pledges personal property such as stocks,
                                  notes or bonds as security (not real property) to the bond holders.
                                  Equipment T m t Cerrijicate: pledges specifically identified equipment
                                  which is sufficiently standardized (e.g. rolling stocks, airplanes,
                                  tankers) to secure necessary fmancing.
                                  Debenture Bonk is an unsecured bond with general claim on all
                                  unpledged assets of the issuers. Generally have more shingent terms
                                  and conditions than secured debts.
     4) Repayment                 Call Protection Provision: protects investors from having the bonds
        Provkion                  called away from them for a specified period (usually 3-10 years
                                  depending on the tenure of the bond).
                                  Refwtding Provision: prevents the issuer from redeeming the
                                  outstanding amount of the bond, for a specific period of time, if the
                                  redemption proceeds are coming from lower-cost funds obtained with
                                  issues ranking equally with or superior to the debt to be redeemed.
                                  However, if the proceeds are from sources other than lower cost
                                  refmancing, such as retained earnings, sales of stocks, or disposition
                                  of properties, refunding is allowed. At this point, the bond will
                                  become immediately callable in whole or in part Therefore, a
                                  refunding provision does not offer the investor as much protection as
                                  call provisions do.
                                  Sinking Fund Provision: requires periodic redemption of a specified
                                  portion of the bond in advance of final maturity.
                                        PRIVATE PLACEMENT


n
.-
     Description
     The term private placement refers to direct and private sales of securities to a limited number of
     "sophisticated" investors. Because securities are not offered to the public, "privately placed"
     securities are exempt from the Securities Exchange Commission's registration requirements
     (Section 4(2) of the Securities Act of 1933). Types of financing instruments that can be arranged
     in this market range from straight debt to equity and derivative products.
     Pricing
     Typically, interest is paid semi-annually, calculated on a 30-day monthl360-day year basis. The
     pricing is a spread over the comparable Treasury (bid side). The maturity of the comparable
     Treasury is equated with the average life of the private placement Given liquidity constraints and
     the lack of required financial disclosure, the spread is higher than that of a public issue.
     Market Characteristics
     1. Growth of the Murket: over the past decade, the size of the private placement market has
        grown tenfold (from approximately $18 billion to $202 billion). Increased activity in the
        private placement of high yield securities was partly responsible for the growth. The
        introduction of SEC Rule 144A, which allows secondary trading of privately placed securities
        between "sophisticated" investors, should encourage further growth and expansion in this
        market
     2. Event Risk (U.S. Investors): investor concern over "event risk" is not only reflected in the
        spread but also in the covenants. Investors require an "event" language clause which gives
        investors an opportunity to seek remedy in the event of the change in control, failure to meet
r\      the investment grade criteria, or failure to meet the fmancial covenants. Generally, private
        placements have more negative covenants in the bond indentures than public issues.
     3. Lack of Underwriting Commimnt: notes are placed on a "best efforts" basis.
     Issuers
     Suitable for "A" to "BB" rated borrowers as well as unrated entities (both domestic and foreign
     corporations) which would receive similar or better credit ratings if they were rated.
     Investors
     Institutional investors that are deemed "sophisticated" by the SEC. Examples are insurance
     companies, corporate, state, and municipal pension funds, bank trust departments, and more
     increasingly foreign institutional investors.
     Additional Information
     There is flexibiity in formulating complex structures with unusual terms and conditions. Other
     benefits include simplicity and cost saving from neither having to register with the SEC nor having
     to obtain a credit rating. Globalization of the market as well as the increased liquidity (SEC rule
     144A) should attract issuers that have shunned away from the registration requirements and
     incremental costs.
     Market Risk
     Although "tailored" covenants may diminish event risk, they cannot completely eliminate it.
                                        EUROBONDS (FIXED RATE)

        Description
n
T
    .   Eurobonds are negotiable debt instruments, mostly in bearer form, that are issued and sold to
        investors outside of the country whose currency is used. They can be issued in almost any
        currency and have no withholding tax deducted from coupon payments. Unlike "Foreign Bonds",
        such as Yankees, Euros are not issued into a domestic market, so they are largely outside the
        restrictions and legal regulations of any single country. The bond covenants are usually less strict
        than domestic corporate issues.
        Maturity
        Maturities range from 1 to 10 years with 3,4,5,7, and 10 year maturities the most popular.
        Pricing
        Fixed rate Eurobonds are priced at a spread over Treasury securities of the same maturity. Interest
        is paid annually and yield is calculated on a 301360 day basis.
        Market Characteristics
        In 1990, the total amount of Eurobonds outstanding was approximately $750 billion which i 1963n
        was only $2 billion outstanding. However, a large portion of the market is illiquid, since many
        issues are "locked away" in retail accounts in Switzerland, Germany and the Benelux countries. A
        wide variety of structures (FRN's, Equity-linked, dual currency, etc.) exist. Interest rate and
        currency swap markets have enabled many Eurobond issuers to tailor their liabilities.

fi      Issuers
        Mainly sovereigns, supranationals, corporations, fmance companies and commercial banks with
        high credit ratings.
        Investors
        Individuals (often through bank-run mutual funds), cenual banks, pension funds, insurance
        companies, and corporations who are looking for a market with a large range of issues,
        instruments, and currencies.
        Additional Information
        There exist different types of Eurobonds: straight (or plain vanilla), equity-related (consisting of
        convertibles or with equity warrant features), and exotic (which are tailored for the investor). Put
        or call features may be available within a Eurobond. The market is largely self-regulated by the
        Association of International Bond Dealers (AIBD), though it is becoming more closely regulated
        by various Governments departments.
        Credit Risk
        The market is very "name conscious"; name recognition and reputation of issuer are extremely
        important. The majority of the issuers are of high credit quality but there is a market for lower
        quality issuers.
Settlement Risk
Market clearing systems such as Euroclear and Cede1 provide a sophisticated clearing, delivery and
transfer system. Settlement occurs seven days after the trade date on a delivery versus payment
basis. This minimizes settlement risk.
Market Risk
 ie
Lk all debt instruments, the price of a Eurobond changes with general level of interest rates.
There is also risk that the country in which the bonds were issued could change its taxing and
regulatory treatment Eurobonds are subject to spread risk if the underlying issuer's credit
deteriorates.
                                             YANKEE BONDS

       Description
n
\- I   A Yankee Bond is a publicly offered debt issued by a foreign entity in the U.S. market. Offerings
       of Yankee Bonds are required to registered and fde periodic disclosures with the Securities
       Exchange Commission ("SEC").
       Pricing
       Yank bonds generally follow the conventions of the U.S. corporate debt market (i.e., a spread
       over the comparable Treasury with interest payable semi-annually and yield calculated on an actual
       1360 day year basis).
       Indicative pricing for 7,10,30 year maturity (for AAA to A credit for 7 and 10 year maturity
       debts. For 30 year maturity applies to AAA to AA.)

                          Maturity     I    7 Years     I    10 Years         I    30 Years
                          Spread            55 - 77          55 - 75               70 - 80

       Market Characteristics
       Although the public offering of debt instruments in the U.S. capital market is highly regulated and
       more complex than Euromarket, the Yankee Bond market provides quahhl foreign entities access
       to the world's largest capital market. In addition the Yankee market provides longer maturities than
       the Euromarket The market segments securities into clearly defined credit rating and sector
       categories. This market benefits from being part of a large, liqujd and well defined fxed income
       securities market Growth in the Yankee market is attributable to a) the U.S. investors concern
.      over the "event r s "of the U.S. corporate debt, b) increasing sophistication of investors in
                         ik
       evaluating the risk associated with investing in these instruments and c) the issuers' desire to
       expand the array of available funding sources.
       Issuers
       The majority of the issuers are rated AA or above. High grade sovereigns and supranational
       organizations, Canadian provinces, foreign financial institutions, foreign corporations, and foreign
       utilities.
       Investors
       Major investors are sophisticated portfolio managers, money managers, insurance companies,
       pension funds, and mutual funds.
       Additional Information
       As is the case of the domestic bond offerings, Yankee offerings require the issuer to meet the terms
       and conditions of the Trust Indenture Act of 1939 specifying certain provisions as well as the
       appointment of a trustee within the bond indenture.
     Credit Risk
     Traditionally identified as high quality credit, due to the process that a prospective issuer has to go
     through to offer securities in the U.S.market.
f'
     Market Risk
     Event risk is not as prevalent as in the domestic issues.
                                  FLOATING RATE NOTES (FRNs)

     Description
n
1
     Long-term debt insuument with a variable rate of interest The rate is stated as a spread relative to
     an interest rate benchmark (commonly LIBOR) and adjusted periodically, on a money market
     basis, when each coupon is due (usually every 3 or 6 months). While the benchmark rate may
     move from period to period, the spread remains constant.
     Maturity
     From 2 years to undated petpetuals. The majority 5 year range.
     Pricing
     Interest is set in relation to LIBOR, paid and reset periodically, and calculated on an actuaU360 day
     basis. Prices tend to be less volatile than straight fixed rate debt issues due to the regular
     adjustment of the coupon based on prevailing market rates.
     Market Characteristics
     Very liquid instruments characteristics by depth in the secondary market Lead managers invite a
     group of co-managers to underwrite the entire issue to insure wide distribution. Floating rate notes
     are popular with issuers at times of very high interest rates, as was the case in the early 1980's.
     Issuers
     Mainly banks and sovereigns, but also agencies and sometimes corporates.
r\
1
     Investors
     Cenval banks, banks, pension funds, insurance companies, etc.
     Additional Information
     Many variations on FRNs exist such as Capped FRNs, Mismatch FRNs, Convertible FRNs, and
     Perpetual FRNs. "Petpetuals" are floating rate notes with no final maturity. They offer a higher
     return than typical short maturity FRNs. The majority of FRNs are callable before maturity.
     Credit Risk
     Issuers of many different credit backgrounds exist in the market Bank and sovereign risk are the
     primary credit risks that FRN investors face since they form the largest group of issuers. AAA
     rated issues are not predominant in this market The perpetual market suffered through a series of
     collapses. In 1986, for instance, as interest rates fell in the US, investors began to perceive
     perpetual issues to be more like equity. The collapse of perpetuals still casts a shadow on the entire
     FRN market.
                       MUNICIPAL BONDS:              GENERAL OBLIGATION BONDS

         Description
n
.
1
         General Obligation Bonds are debt instruments issued by states, counties, cities, or special tax-
         exempt entities and secured by the unlimited taxing power of these entities. Investor interest in
         these instruments stem from the income tax exempt status (exempt from federal tax and generally
         from state and local taxes if the bond holder is resident of the state and locality) of the interest
         income. Notes are issued for maturities from 90 days to 3 years, while bonds are from 3 years to
         20 to 30 years.
         Pricing
         Most municipal debt is issued at par with semi-annual coupons. Municipalities are no longer
         allowed to issue bearer form securities. Only book-entry or fully registered form is allowed.
         Market Characteristics
         Although the market is large in size (over 80,000 different issuers each with a dozen or more
         issues), it is relatively illiquid. Issues can be either term or serially issued; many are callable.
         Most states mandate that G.O. Bonds be marketed via competitive bidding from underwriters.
         Trading is done over-the-counter on the "net basis". Generally, settlement is done on "regular
         basis" (i.e., T + 5, the fifth business day following the trade date). Other settlement methods are
         1) cash settlement, 2) mutually agreed date, or 3) "when, as, and if issued" basis.
         Issuers
         States, Counties, Cities, and Special Districts which have taxing powers.
A
t-   '   Investors
         Individual investors (directly or through mutual funds and taxempt unit investment trusts),
         property and casualty insurance companies, and commercial banks (their interest has declined
         recently with recent tax code changes).
         Additional Information
         1 . Legal Opinion
            A qualified legal opinion is crucial in a) determining legal status of the issuer to issue tax-
            exempt bonds; b) verifying that the issuing entities enacted necessary laws to assure the tax
            exempt status of the bond., and c) certifying that the bond indenture provides security
            safeguards to the bondholders.
         2. Credit Ratings
            In assigning credit ratings, both Moody's and S&P consider the following factors: a) overall
            debt burden; b) sound fwal policies; c) local tax base and availability of intergovernmental
            revenue sharing; and d) overall socioeconomic conditions. Both institutions assign similar
            l e e r ratings: Moody's (Aaa to C); S&P (AAA to D) with qualitative adjustment signs on Aa to
            B and AA to BB, for Moody's and S&P respectively.
    3. Equivalent Taxable Yield
       Equivalent Taxable Yield = Tax Exempt Yield * (1 - Marginal Tax Rate).
P   4. Tares
       The Tax Reform Act of 1986 eliminated t x advantages that commercial banks had to expense
                                                 a
       and deduct interest paid to fmance municipal bond portfolios. Furthermore, the law eliminated
       "private uses" of the tax exemption status for "private uses" by the municipalities (e.g.,
       stadiums, middle income housing, resources recovery and public power). Consequently, the
       municipal market decreased substantially in size.

    Credit Risk
    Unlike corporate bonds, event risk is not a concern. The risk is from default due to fiscal
    mismanagement by municipal administrators. The ability to assess risk has improved with
    increased disclosure of fmancial matters. Rating changes can affect the prices of these securities.
                              MUNICIPAL BONDS: REVENUE BONDS

      Description
n
.
I '
      Debt insouments issued in registered form by state or local governments, agencies, or authorities.
      The interest paid on these securities is generally exempt from federal taxation, and often exempt
      from state and local taxes in the state of issuance. Revenue bonds are issued to finance specific
      "public purpose" projects. Funds required to service the debt are paid from the project's revenue.
      Maturity
      Municipal notes have maturities of 90 days to 3 years, while bonds mature in 3 to 30 years.
      Pricing
      Munis pay interest semi-annually and yield is calculated on a 301360 day basis. Yields on
      Municipal securities are compared to after tax returns on taxable debt
      Market Characteristics
      The secondary market is not as active as the government bond market Bid-asked spreads are
      relatively wide. Munis are less responsive to changes in the economy than Treasuries, but are
      more sensitive to changes in regulation concerning their tax exempt status. The market is driven by
      credit considerations as well as segmented by category of issuing entity. Many of the long-term
      securities are illiquid and are inefficient trading vehicles. Additionally, it is difficult for dealers to
      short an outstanding issue. Recently, some commercial banks have begun underwriting and
      distributing revenue bonds.
(?    Issuers
      State and local governments, agencies, authorities, counties, school districts, towns, and other
      public bodies.
      Investors
      Individuals, commercial banks (see Additional Information below), insurance companies, mutual
      funds, and corporations.
      Additional Information
      Tax law changes in 1986 eliminated the tax advantage for commercial banks to invest in Municipal
      securities. Subsequently, commercial banks have had little interest in holding these bonds.
      Credit Risk.
      A broad credit range of issuers exists in the Municipal revenue bond market The credit rating
      agencies review the sources of repayment and any other credit enhancements in determining the
      bond's credit rating. Revenue bonds are generally considered a greater credit risk than GOs.
      Therefore, they are often backed by either a bank letter of credit or municipal insurance. A rating
      scale exists which rates debt issues from "very strong capacity to repay principal and interest" to
      "speculative capacity to repay".
      Market Risk

r\
 -    Munis are effected by changes in interest rates. sudden changes in tax treatment and call risk.
                                    ASSET-BACKED SECURITIES

     Description
r\
     Debt instruments collateralized by a pool of loans or receivables. When assets are securitized, the
     issuer pools the underlying assets and then packages them into securities. These securities are then
     sold to investors. Generally, the securities are "passthroughs" in which interest and principal
     payments on the underlying assets are passed on to investors by a servicing institution. Servicing
     of assets is typically retained by the seller.
     Maturity
     Average maturities of Asset-Backed instruments are 4-6 years, but credit card receivables'
     maturities range from 1 to 5 years.
     Pricing
     Interest is paid monthly, quarterly, or semi-annually. Issues are priced on a spread over Treasuries
     basis. Due to call risk, "Asset-Backs" are priced at a wider spread to Treasuries than non-callable
     corporates. Originally, they are.issued at a discount
     Market Characteristics
     The market has seen considerable growth in the last few years. Issuance has grown from $10.2
     billion in 1987, $25.7 billion in 1989 to over $40 billion in 1990. Prepayments do exist, but since
     the stated maturities are short, prepayments do not significantly impact Asset-Backed securities'
     average lives.
     Issuers
     Banks, finance companies, banks, and central banks.
     Investors
     Pension funds, insurance companies, banks, and central banks.
     Addition Information

     The most commonly used collateral is as follows: automobile receivables; credit card receivables;
     lease receivables; and manufactured housing contract receivables, with Certif~cates Automobile
                                                                                       for
     Receivables (CARS) Certificates for Amortizing Revolving Debt (CARDS) accounting for
                           and
     over 90%of the Asset-Backed Securities market CARDS provide a AAA credit risk with a
     premium yield of 25 to 30 basis points versus comparable AAA industrial debt
     Credit Risk
     The rating agencies analyze the quality of the underlying assets as well as review the issuer's credit
     and the underwriting practices. Credit enhancement is used to insulate investors from "normal"
                                                                                                 -   ~   ~   ~   -   ~   -

                               credit enhancement is either a third-party letter of credit or a subordinated
     credit defaults. U S ~ % ~ ,
     interest. There are. several layers of credit risk such as failure to receive payments on the
     underlying receivables, defaults on the letter of credit, and banlauptcy of the issuerlservicer of the
      ass-throu~hs.
    As protection against possible default, the percentage of receivables used as collateral can be
    increased or decreased. Even though in theory the insolvency of an issuerlservicer should not
    result in a loss to the investor, in reality anyttung that disrupts the collection process could be a
n   credit risk.
    Settlement Risk
    Similar to credit risk
    Market Risk
    Besides general interest rate risk, some Asset-Backed structures are subject to prepayment risk
    (similar to mortgage backed securities-when interest rates fall, consumers tend to pay down debt at
    a faster pace). This subjects the holder of an Asset-Backed Security to reinvestment risk.
                              MORTGAGE-BACKED SECURITIES (MBS)

        Description
n
.
1   1
        Mortgage-Backed Securities Pass-Throughs (MBSPT) are securitized instruments supported by a
        pool of mortgage loans. The mortgage loans that comprise each pool have similar characteristics.
        The majority of MBS are guaranteed by quasi-governmental agencies: GNMA, FHLMC, and
        FNMA. Private-label MBSPT (those securities that are neither guaranteed nor issued by an
        agency) are sold to institutional investors with varying degrees of private credit enhancement
        MBSFT typically represent pro-rata ownership in the underlying pool of mortgages. The pool of
        mortgages supply the cash flows for the MBSPT. MBSPT investors receive scheduled monthly
        payments of interest and principal as well as unscheduled prepayments of principal from the
        underlying pool of mortgage loans. The monthly cash payments from the mortgagors are "passed-
        through" intermediary servicers to the MBSPT investors. Fees are deducted by the senricers for
        services rendered.
        Pricing
        Pricing is a function of the expected speed of prepayment on the underlying mortgage pool which
        thereby influences the cash flow pattern for the MBSPT investor. One method of measuring the
        relative value of MBS is "option adjusted spread" (0.4s). The OAS is calculated using the treasury
        yield curve, interest rate volatilities, and prepayment speed assumptions.
        Market Characteristics
        The MBS market has produced products that are tailored to meet the demands of both borrowers
        and investors. An example is the collateralized mortgage obligation (CMO) which satisfies the
0       shorter maturity criteria of certain investors (see attachment for brief descriptions on major
        products).
        Issuers
        Private financial institutions issue siwcant amounts of securities through the agencies as well as
        through private label issuers. FNMS and FHLMC also issue directly.
        Investors
        Institutional investors (pension funds, insurance companies, mutual funds), thrifts, commercial
        banks.
        Additional Information
        Factors which affect prepayment decision and predict prepayment speeds have to be considered
        (see attachment).
        Prepayment Decision
        The decision to prepay is a function of economic and non-economic factors which affect the mortgage
        borrower. Major factors are:
n
1'
        1 . Refinancing:                 The decision is a function of existing mortgage rates compared to
                                         the available market interest rate as well as the difference between
                                         these rates.

        2. Housing Requirement:          If the primary residence fails to meet the housing requirement due
                                         to change in the family size, divorce, job transfer, or other non-
                                         economic factors, the chances of prepayment will increase.
        3. Assumability/Due-on-sale: If the existing mortgage can be assumed, the probability of
                                     prepayment will decrease. For some non-FHANA supported
                                     mortgages, the mortgage cannot be assumed by a third party and
                                     mandatory prepayment (due-on-sale) is the norm.
        4 . DefoltltlForeclosure:        Primarily a function of fmancial condition of the mortgage
                                         borrower and the cost of default
        5 . others:                      Factors beyond control of mortgage borrowers, such as natural
                                         disaster and regional economic conditions, may accelerate
                                         prepayment
        Measuring Prepayment
        Understanding the market convention used to measure prepayment risk is necessary in order to
        compare MBS related instruments. Two commonly used methods are:
A
f   '   1. PSA Model:                    The PSA model is defined by a monthly series of annual
                                         prepayment rates. For up to 30 months, the monthly prepayment
                                         rate is assumed to be increasing at a 0.2%constant percentage rate
                                         (CPR) per month and after 30th month, the mortgage prepayment
                                         rate is assumed to remain constant at 6% CPR per year for the
                                         balance of mortgage's life.
        2. CPWSingle Monthly             Assumes that prepayment will occur at a constant rate. It
           Mortality (SMMJ:              measures the average prepayment per year (monthly for
                                         SMM) as a percentage of the current principal balance.
        While FHA Experience and 12-year Prepaid Life methods are not currently used, some existing MBS
        are analyzed based on these two methods.
        1 . FHA Eperience:               Is based on the termination rate of FHA mortgage insurance (FHA
                                         Survivorship Table). Market convention uses prepayment behavior
                                         corresponding to the FHA Survivorship Table as the base. A
                                         200% FHA Experience represents twice as fast as the base case and
                                         a 50% FHA Experience represents one half as fast as the base case.
        2. 12-year Prepaid Life:         Assumes that there is no prepayment in the first 12 years and the
                                         principal will be paid-off in a single balloon payment on year 12.
    Credit Risk
    G N M A paper canies the full faith and credit of the U.S. Government Although FNMA and
    FHLMC are not government entities, they both enjoy "agency" status. Other mortgage related
    structures generally have credit ratings of AA or better.
.
    Market Risk
    MBS generally have durations of 2 to 6 years. Often, M B S have greater reinvestment risk than
    comparable non-callable duration instruments due to the uncertainty of their cash flow patterns.



                      GNMA (Ginnie Mae)                FNMA (Fannie Mae)               FHLMC (Freddie Mac)


    Organization    seated in 1968 when             Resent form of the           Created in 1970 under Federal
                    FNMA was divided into two       organization was created in  Home Loan Mortgage
                    entities. GNMA is an            1968. Although it became a Corporation Act. FHLMC's
                    instrumentality of the U.S.     private corporation whase    pass-through securities are
                    government under HUD and        shares are traded in the New termed participation certificaw
                    can only service VA/FHA         York Stock Exchange, ill     (PCs)which are ownership
                    supported mortgages.            activities are under the     interests in FHLMC purchased
                    GNMA is not an issuer of        supervision of HUD and can qualifiedmortgages. Non-
                    mostgage-backed securities.     depend w fmancial support    voting preferred stock is traded
                    It only guarantees MBS put      by the T e s r Dept.
                                                             rauy                in New York and F'aciic stock
                    together by approved issuers.                                exchanges.
                    The issuers have the
                    responsibility of managing
                    and servicing the cash flows.


    Mortgage        FHA-insured or VA-              Conventional (non-FHA           Major emphasis on the
    Pool            guaranteed mortgage pool.       insured or non-VA guaranteed    enhancement of smndary
                    The securities represent        single family residential       m r e liquidity for
                                                                                     akt
                    undivided interest in a pool    mortgage) and a small           conventional residential
                    of mortgage.                    percentage of W       A         mortgages. More than 40
                                                    supponed mortgages.             product lines, reflecting the
                                                    FNMA MBS represent              variab'tlities of conventional
                                                    undivided interest in a         mortgages. Minor role for
                                                    mortgage pool.                  VA/FHA supported mortgages.

                                                                                    Timely payment of interest and
    Support        Full faith and credit of the     Timely payment of principal     ultimate payment of principal
                   U.S. government for timely       and interest is guaranteed by   is gumteed by FHLMC.
                   payment of principal and         FNMA. FNMA is                   Recently. FHLMC has added
                   interest.                        m i d & to be an "agency"       the Gold pmglam which offers
                                                    by the investment               timely payment of P&I.
                                                    community.
                                                                                                                     -
    Agency          Program          Description

    GNMA            GNMAI            A mortgage pool consisting of single issuer mortgage
    (Ginnie Mae)                     loans with less than 24 month since issuance and same interest
0                                    Iate.

                    GNMAII           Unlike GNMA I, the mortgage pool can either be a Custom
                                     pool or a multiple pool. A custom pool represents single
                                     issuer mortgage pool whereas a multiple pool represents a
                                     collection of similar mortgage loans submitted by lenders.
                                     Each panicipant in a multiple ("jumbo") pool only administers
                                     mortgages it has submiaed. The mortgage interest rates in
                                     GNMA I1 pool can only vary withm one percent.

                                     The benefit to the investors of putting together a jumbo pool
                                     is having more consistent cash flows than GNMA I based on
                                     larger pool size and its geographical diversity. Disbursement
                                     of monthly cash flows is handled through a cenualiid paying
                                     agent.

    FNMA            STANDARDMBS      The MBS represents undivided interest in a pool of
    (Fannie Mae)                     either fixed or adjustable-fate and 15 or 30-year conventional
                                     mortgages.

                    STRIPPED MBS     By varying the portion of interest and principal cash flows.
                                     FNMA was able to create two new pass-through securities.
                                     The main use of strips (either principal only (PO), interest
                                     only go), or strip with uneven cash flows) is for hedging
                                     interest rate volatility.
    FHLMC           GUARANTOR        In this program, originators swap a pool of
    (Freddie Mac)   (SWAP PROGRAM)   mortgages consisting of confmed conventional or VAIFHA
0                                    supported mortgages for FHL.MC PCs with or without
                                     collateral for borrowing, or sold in the market. n i s program
                                     was enacted by FHLMC in order to alleviate the financial
                                     burdens of originators who carried below market rate
                                     mortgages on their books.

                    CASH PROGRAM     Unda this program, originators sell their mortgages to
                                     FHLMC fm newly originated and seasoned fixed-x adjustable-
                                     rate mortgages having maturities of up to 30 years. The price
                                     at which FHLMC wiU buy these mortgages will be determined
                                     by FHLMCs required net yield.
    CMOS                             Created by FHLMC in 1983. CMOs attempted to minimize
                                     (he uncertainty emanating from mortgage holders' right to
                                     exercise prepayment. This was done through combining a
                                     number of mortgage pools and creating a serially matwing
                                     debt instrument (fxed rate with a stated maturity) with
                                     mortgage pools serving as the collateral. Since 1983, different
                                     derivative types of CMOs have come to the market w meet
                                     investor demand.
                    PAC CLASS        Provides average life and yield protection within a specit%d
                                     PSA.

                    TAC CLASS        Rovides protection from shortening of average l i e
                    REVERSE TAC      Provides protection born extension of the average
                    CLASS            life.

                    FLOATER CLASS    Has its interest rate tied to a floating rate (commonly LIBOR).
                    Z - BOND CLASS   Does not payput interest over the bond's life. Interest acmes
                                     until the maturity date (similar to a zero coupon bond).
                                         FOREIGN EXCHANGE


      Description
/?
I .
.-    Foreign exchange trading involves the exchange of one country's currency for another country's
      currency. A foreign exchange contract is an agreement between two parties specifying two
      currencies to be exchanged at an established price and settlement date. In a "spot" transaction,
      senlement occurs two business days after the transaction date. Trades that settle more than two
      days after the transaction date are called "forward" transactions.
      Maturity
      Spot trades settle within two days, while the maturity of forward trades range from three days to
      many years.
      Pricing
      In the interbank market, traders simultaneously quote both the buy (bid) and sell (offer) sides of
      the transaction. Theoretically, when a dealer quotes a price the counterparty's intentions (if they
      want to buy or sell) are not known.
      Market Characteristics
      FX is essentially an interbank market even though corporate and institutional investors do play a
      role. The "major" currencies (US Dollar, Yen, Deutschemark, Sterling, French, Belgian, and
      Swiss Franc. and the Canadian Dollar) are traded in large volume and have very liquid forward
      markets. The "minor" currencies such as the Australian Dollar, the Dutch Guilder, and the Italian
      markets. Finally, the "exotic" currencies l i e the Argentine Peso and the Gxrek Drachma are
f?    sparsely traded with no liquidity in the forward markets.
      Additional Information
      The FX market is used for both hedging and speculating. Central banks intervene in order to
      smooth out fluctuations in their respective currencies. Cross rates, rates of exchange between two
      currencies where one of them is not the US Dollar (i.e., the exchange rate between Deutschemarks
      and Yen or rates that do not involve the US$), are also important.
      Credit Risk
      The exposure a trader is willing to take from a specific counterparty is the credit risk. At Morgan,
      internal guidance credit lines are used to control the amount of risk.
      Settlement Risk
      Primarily, there is the risk that the counterparty will go bankrupt between trade date and settlement
      date. There is also a settlement risk occuring from time differences that cause one currency to be
      delivered hours before the other. In order to manage this risk the Morgan Bank restricts the
      amount of settlement that may occur with a given counterparty on any day. The monitoring system
      is called the Daily Settlement Limit (DSL).
Market Risk
Participants make and lose money when exchange rates move in their favor or against them.
Major Players
Commercial banks, investment banks, central banks, pension funds, and corporations.
                             LOAN PRODUCT: LINE O F CREDIT

        Description
i 7
.
t
        A borrowing facility ma& available to a client for a fixed period of time. Usually,
        there are no specific terns or conditions that are attached to this type of loan product.
        The facility is reviewed once a year at JP Morgan. There are two major types -
        advised and intemal guidance lines.
        1 . Advised Line
            Client is advised in writing of the bank's willingness to extend credit. There are
            no covenants included in the letter. An advised line is not a commitment and the
            bank may legally withdraw the line upon notification. In the U.S. banks charge a
            fee for extending a line of credit. (In Europe, an advised line is referred to as an
            overdraft, no fee is charged until the line is drawn down).
        2. Guidance Line
            A credit line established at the bank for intemal control purposes only (monitoring
            the bank's overall exposure to a client or counterparty). The client is not notified
            of the size and the bank receives no compensation. While theoretically the bank
            can cancel the line, if past usage of the line establishes an "impliedn obligation, the
            bank may have difficulty cancelling the line.
            Guidance lines are set up to cover a variety of activities involving
            clients/counterparties. There are line facilities for 1) foreign exchange trading and
            settlement, 2) securities trading, 3) Eurocurrency deposits, and 4) federal funds.
2-3
I   '       Daily Settlement Guidance Lies:
            Establishes the maximum daily counterparty settlement exposure. The daily
            settlement limits eliminate neither the risk of loss on settlement nor the risk of
            losses from market movement.
        ADVISED LINES
        Pricing
        Pricing depends upon market competition and credit quality of the borrower. There is
        a pre-arranged fee for establishment of the line and a spread over a specified market
        rate is charged upon usage.
        Market Characteristics
        Corporates usually prefer to maintain a line of credit in order to assure the availability
        to funds in case of an emergency (i.e., as a backstop to a corporation's commercial
        paper program). A line of credit may be used instead of a committed facility to
        backstop a corporation CP program.
        Issuers
        Commercial banks and other non-bank financial institutions.
     Investors
     The bank may participate out sections of loans to other banks, mutual funds and
     insurance companies. Loan participations generally appeal to short term investors.
 '
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f
     Credit Risk
     Risk of default due to fmancial difficulties of borrower.
     Settlement Risk
     The counterparty's failure to honor/conclude the business transactions andlor
     contracts.
     Market Risk
     There is event risk (deterioration in the credit standing) and reinvestment risk (if the
     borrower defaults, the bank is still funding the loan).
                          LOAN PRODUCT: COMMITMENT


n
.
\
    Description
                                                                                  d
    Represents a legal obligation of a lender to make funds available for a f ~ e period of
    time, subject to the borrower complying with prearranged terms and conditions, such
    as fmancial covenants like minimum net worth, leverage, etc.
    Pricing
    Pricing structure of the committed facility reflects 1) a market cost of funds, 2) credit
    of borrower, and 3) fees.
    1. Cost of Fundr:              Represents theoretical value of Morgan's funding cost.
                                   Three most commonly used base rates are:

                                   a) CD rate (adjusted for reserve requirement and FDIC
                                      charges, if applicable);
                                   b) Inter-bank market rate (e.g., LIBOR), adjusted for
                                      reserve requirement; and

                                   c) Morgan's Base Rate (Prime rate or a spread over
                                      Fed Funds).
    2 . Credit Spreaa?             Reflects the credit quality of the borrower, term
                                   (maturity) of the facility, and desired return-on-equity
                                   all dependent on the degree of competition from other
6                                  lenders.
    3. Fees:                       (Commitment, facility and administrative fees) The fees
                                   reflect both the return-on-equity requirement for the
                                   clients use of Morgan's balance sheet and any
                                   administrative costs to be recovered.
    Market Characteristics
    1. Over the past few years traditional investment grade clients were able to find
       cheaper funds by d i i t l y accessing the capital markets, thereby bypassing money
       center banks' more expensive committed facilities. Due to regulatory capital
       requirements imposed on 12/31/90 (BIS Capital Guidelines), banks have begun to
       increase spreads on all loans and commitments. In addition, the A2P2
       Commercial Paper (CP) market has shrunk due to a new SEC Rule imposing
       limitations on mutual fund's investments in CP with credit ratings lower than
       AlIP1.
    2. Banks maintained loan portfolio levels in the 1980's either by seeking out lending
       opportunities in "story" credit (e.g., providing bridge financing for leverage
       buyouts) with concomitant assumption of increased risk, or by expading into the
       retail client basis. Regulatory pressure imposed on bank's with large highly
       leveraged transaction loan (HLT)    portfolios, will decrease this type of lending in
       the 1990's.
     3. Loan sale programs may be adopted by banks in order to reduce credit exposure to
        a single client, although the loan sale market is still very illiquid at this point.
        Depending on the structure of the loan sales (via participation or assignment), a
        bank can transfer all rights and obligations associated with the credit facilities.
r\
.    Issuers
     Commercial banks and non-bank financial institutions.
     Investors
     Short and medium tern institutional investors (commercial banks included) through an
     active participation in loan purchase programs.
     Additional Information
     A commitment can be either revolving or non-revolving.
     Revolving:                        1. The borrower has the option to draw down a
                                          portion of the facility, repay it, and then
                                          reborrow throughout the commitment's life.
                                       2. The repayment of outstanding can either be
                                          bullet or amortizing with final repayment on the
                                          commitment's expiration date.
     Non-Revolving:                    1. The borrower may use the commitment amount
                                           only during the availability period. After the
                                           availability is over, any unused portion is
                                           automatically canceled.
                                       2. The repayment of outstanding can either be
                                                                            ..
                                          bullet or amortizing with final reoavment on the
                                          commitment's expGation date.
     Credit Risk
     There is risk that the client's credit rating will be downgraded. Also, since
     commitments are typically made for 1.3 or 5 years, the bank is locked into a price and
     credit spread for that period even if market conditions change.
     Market Risk
     Regulatory changes, such as HLT disclosure rules, as well as changes in the degree of
     competition in the market (new entrants or exiting lenders) effect the market's
     structure.
Financial Instruments I I
     (as of June 9,1993)
        FINANCIAL INSTRUMENTS 11

Financial Instruments 11 is a multi-media program designed to review and apply your
knowledge of Equities and Derivatives. It is divided into the following three sections:

                1.      the source (a review)
                2.      the challenge (you will be required to answer
                        45 out of 5 0 questions correctly in 30 minutes)
                3.      client situations (simulation of a three-day
                        on-the-job scenario)

When you are ready to begin, click on the Financial Instruments icon and follow the
directions. After inserting your diskette, you will be asked to enter your name and employee
number. If you do not know your employee number, use a number you will remember, since
you will need to enter it again if you choose to access and complete the program at another
time.

If at any point, your screen freezes, and you are unable to perform a specific action, you must
re-boot and start over. Remember, what you have already done will not be saved if you need
to re-boot.

At the end of the session, click on File...auit, which saves. using your name and employee
number unto the diskette. There will be a box located in each amphitheater where you should
deposit your diskette after your Financial Instruments 11 session. Do not submit vour diskette
until vou have com~leted   both Financial Instruments modules.

The Financial Instruments 11 multi-media program is available on the workstations located on
2/37Wall, 2/43Exchange, 14115Broad and the LRC. For the available LRC reserved times,
please see the Trainee Resource Handbook.

If you have any questions during Financial Instruments 11, there will be a Core Manager on
the floor for assistance.
                                          Table of Contents




Common Stock ....................................................................................        1
Preferred Stock ....................................................................................     3
Convertibles ........................................................................................    7
High Yield (Junk) Bonds .........................................................................        11
American Depositary Receipt (ADR) ............................................................           17
Swaps ...............................................................................................    21
Futures ..............................................................................................   29
Forward Rate Agreements (FRAs) ..............................................................            37
Options .............................................................................................    43
Caps and Floors ...................................................................................      49
Swaptions ..........................................................................................     53
                                              Common Stock


(a
L
     Description
     There are two broad categories of stock: common and preferred. Common stock is by far the more
     prevalent. Common stockholders supply permanent equity capital, giving them ownership in the
     company. They have voting power, elect the Board of Directors and, thereby, indirectly control
     management of the company. They have last claim on dividends and are the last to be paid out if
     bankruptcy forces the company to liquidate. Dividends are the disbursement of profits to the
     owners of the company. The Board of Directors sets the dividend rate.

     Market Characteristics
     Common stock is the most widely traded of all corporate securities, offering investors great
     liquidity. In the United States, each publicly-traded, incorporated business is required to declare at
     least one class of common shares as part of its initial capitalization
     The market distinguishes between inital public offerings (IPOs) and secondary offerings and
     trading. The first time a company decides to raise funds in the equity market, it must file with the
     Securites and Exchange Commission (SEC). When the SEC approves the request, it also
     authorizes the number of shares that the company can issue. The company is not obligated to offer
     the full amount authorized the first time it comes to market; it is free to keep some in reserve for
     future offerings. However, only the first offering is the IPO. All subsequent offerings, even if
     they come from this reserve of shares initially authorized by the SEC, are considered secondary
     offerings. An easy way to determine if an issue is an IPO is to check if the company already has
     public shares outstanding; if it does, the issue cannot be an IPO.

.L
     Additional Information
     Common stockholders have the right to maintain proportionate ownership in the company. Under
     many charters, a company must offer all new common shares to existing stockholders first. This
     privilege is known as the preemptive right
     Stockholders enjoy a limited liability, which means that an investor who owns shares in a company
     cannot be held responsible for its debts.
     There are four key dates related to receiving a dividend. The declaration date is the day that the
     company's Board of Directors announces the frequency, amount, payable date and record date of
     the dividend. The record date is used to determine who will receive a dividend: an investor who is
     listed on the books as owning shares as of that date will receive a dividend. The payable date is the
     date that the corporation will pay the dividend to the shareholders of record who are entitled to
     receive it However, to be the holder of record, you must buy the stock at least five business days
     before the record date to allow for settlement The first date that anyone buying the stock will not
     be eligible to receive the dividend is called the ex-dividend dote. Therefore, the ex-dividend date
     precedes the record date. For example, if the record date is Monday, September 27, investors who
     buy the stock on Monday, September 20th should settle on the 27th; thus, they will be holders of
     record on the 27th and will receive the dividend. If, however, they buy the stock on September
     21, the stock will not settle until September 28th. so they will not be holders of record on the 27th.
     Therefore, the ex-dividend date is the 2kt in this case.
     Not all stocks pay dividends. If a company issues stock with the intent to put all profits back into
     the company and, thus, not pay a dividend, the stock is considered a growth stock. In other cases,
W'
     the Board of Directors may decide to suspend (or reduce) the dividend and use those funds to keep
     the company viable.
     Maturity
     Common stock is issued with no maturity. It is valid as long as the company exists
r
\i
     Pricing
     The pricing of common stock is usually done on a ratio basis. Multiples of earnings or a multiple
     of the company's book value are two frequently used ratios.

     Credit risk
     Common stockholders are the last to be paid out in the event of bankruptcy--after the bond holders
     and other creditors, including holders of preferred shares.

     Market risk
     Equity is considered the riskiest asset class among publicly-traded secuiites--including government
     and corporate bonds, as well as preferred stock. Common stockholders have complete downside
     risk--they can lose the entire investment. In return, they have unlimited potential for gain.
     The value of a stockholder's ownership can be reduced through further equity offerings. For
     example, if a company has net profits of $100 which it has to share among 100 shares of stock
     each held by a different shareholder, each holder gets $1 per share. If, however, the company
     doubles the amount of shares by selling 100 more shares to 1CKl new shareholders but still has only
     $100 net profits to distribute, each holder now gets only 50$ per share. This process of reducing
     the value of holding due to increased numbers of shares is called tlillfrion.
r.
i
 i

     Issuers
     Only corporations issue stock. Incorpoi-ation is always within a specific state, and the number of
     shares is specified in the Certificate of Incorporation.
     Corporations need to raise funds to function. The first decision is whether they will raise the
     money as equity or as debt. The higher the ratio of equity to debt, the more flexible the company
     can be in responding to changes, and, thus, the higher their ratings are likely to be from the
     agencies.

     Investors
     Individuals invest in stocks both directly and through retail mutual funds. Pension funds and
     insurance companies also invest in the equity market. Historically, the stock market yields the
     highest investment returns--10% - 12%)on average over a 5 to 20 year time horizon--higher than
     bonds, commodities or real estate.
    Preferred        Stock

b   Description

    Preferred stock has the characteristics of both stocks and bonds, hut it is more like a bond
    than a stock. Like a bond, it has a fixed-rate, annual payment, usually paid quarterly and
    usually higher than the dividend rate on common stock. It is called preferred stock because
    its holders have the right to he paid their dividends ahead of the holders of common stock.
    No dividends, however, can he paid on preferred stock before the interest due bond
    holders has been paid. However, unlike dividends on common shares, the dividend on
    preferred stock does not vary with the fortunes of the company: the dividend is fixed at
    issuance and not subject to change by the Board of Directors as is the case with common
    stock. Therefore, the price of preferred shares does not move like that of common shares.
    In the case of bankmptcy, preferred holders will be paid out before holders of common
    stock. Holders of preferred stock have no voting rights and, thus, no say in the
    management of the company.

    Additional Information
    There are four types of preferred stock.
          Cumulutive preferred: if a company fails to pay dividends on cumulative preferred,
          the missed payments accumulate as arrearages. The shareholder has the right to
          receive all the accumulated back dividends before any dividends can be paid to the
          common shareholders.
         Adjustuble rute preferred: the dividend rate is reset periodically. In some cases, it
         may be as frequently as every 49 days, thus reducing interest rate risk associated with
         preferreds.
          Convertible preferred: holders have the right to convert their shares into another
          security--usually the common stock of the sxne issuer. The conversion ratio is set; it
          does not change with the market value of the preferred or common stock.
          Convertibility offsets the fact that straight preferred does not offer much growth
          potential to investors, since convertible preferred shares will reflect price changes in
          the underlying common stock, just like convertible bonds.
          Cullable prefrrred: this stock has a cill feature that gives the issuing company the
          right to recall its outstanding preferred stock and repay the stock's par value to
          shareholders. A company will most likely exercise this call provision when interest
          ntes in the general market are significantly lower than the dividend rate it is paying on
          an outstanding preferred issue.

    Maturity
    Like common stock and unlike bonds, preferred shares often do not mature and have no
    provision for redemption of them at any time at par value. If they have no maturity, they
    are called perpetual prefer~eds.Those that are issued with a maturity go out 30 to 40 years.
    Pricing

    Shuightpreferred: In most cases, the dividend yield on a stmight preferred will be close to
    what the company would have to pay on straight debt.
V

    Convertible preferred: There are two pricing issues with convertibles: the level of the
    coupon and the price at which the investor can convert the preferred into common stock.
    Usually, the coupon will be set 250 to 300 basis points below the rate the company would
    have to pay on straight debt. This is the "price" the investor pays for the right to convert.
    The price at which the investor can buy the stock and, thus, convert from a preferred
    shareholder to a common shareholder is call the conversion price and is usually set at some
    percentage over the current market price of the underlying common shares.

    Credit Risk
     Preferred stock carries ownership risks with very little opportunity for appreciation of
     capital. Firstly, long unpaid preferred dividends (arrearages) are seldom settled
    -satisfactorily. Secondly. preferred stock, because it has no maturity date, is not of the
     same quality as bonds, and it has greater price instability than bonds, yet it usually provides
     only slightly higher yield.

    Market Risk
    Credit risk is considered moderate to high--preferreds trade more with interest rates while
    convertible preferreds trade with the underlying common stock. Liquidity may also be an
    issue,

P
L
    Issuers
    Banks and utilities are natural issuers of preferred stock. Utilities will issue straight
    preferreds to offer their investor base an alternative investment while still providing their
    investors the stable fixed income stream they are accustomed to.
    Banks will issue convertible preferred because of the equity component: they need the
                                                                 s
    equity treatment on their balance sheets to meet v ~ r i o u capitalization requirements set forth
    by the regulatory agencies. In a recent trend, large industrial and cyclical companies (for
    example, the big three auto companies and U.S. airlines) have tapped the convertible
    preferred market. These issuers used preferred shares to shore up their balance sheets and
    equity bases as they weathered difficult economic and business cycles.

    Investors
     Preferreds are bought mainly hy institutional investors who want a higher return than the
     dividend on common stock would offer. They are especially attractive to investing
     corporations, who get a tax advantage from receiving dividends from mother corporation.
     Please note that the holder of a convertible preferred issue must consider how the
     underlying stock is trading. When the stock price is high;, the price of a convertible
     preferred will track the common stock price since it derives most of its value from the
     option to purchase the stock at below-market prices; when the stock price is low, the
     convertible will track interest rates because the equity component drops out 2s a source of
     the value of the security. As the equity component lessens in importance, the price will
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     also be influenced increasingly by the credit quality of the issue(r).
     Self-test: Common a n d Preferred Stock

     1. In the case of bankruptcy, list in order of priolity who gets paid out first.
V


          -common.shm holder
          -bond holder
             straight preferred stock holder

     2. An investor who is looking for capital appreciation, would most likely invest in:

          -common stock
          -preferred stock

     3. Assume your client is a corporate looking to invest some funds for the company. He
        wants current income as well as exposure (a position that will allow him to profit from
        an increase in stock prices) to the stock market. Which of these two securities would
        you suggest your client buy? State your redsons.

          -convertible preferred
          -straight preferred



     4.   Define these terms.

C         Ex-dividend date:


          Dilution:


          Arrearages:


          Limited liability:



     5.   Decide whether each statement below describes an initial pi~blicoffering (IPO) or
          secondary market trading.
          a. A company offers for sale stock it has warehoused.
          b. A company comes to the market with an equity deal. This is the first time they
             have come to the public markets.
          c. A company gets permission from the SEC to go public. They authorize 50 million
f'
V
             shares of which the company offers 20 million. They warehouse the rest.
          d. You have 500 shares of IBM which you sell.
                                                 5
     Self-test   - Common       a n d Preferred Stock: answers
     1. In the case of bankruptcy, list in order of priority who gets paid out first.
0
i,
          -3-common share holder
          -1-bond   holder
          -2-straight preferred stock holder

     2.   An investor who is looking for capital appreciation, would most likely invest in:
          -x-common     stock
          -  preferred stock .
                                                                                         it
          Remember preferred stock does not show much cupirul uppreciurion, beca~rse has u
          set coupon and cunnot benefit in ternts of increasing tlividmdfront price uppreciation
          in the stock.

     3. Assume your client is a corporate looking to invest some funds for the company. He
        wants current income as well as exposure (a position that will allow him to profit from
        an increase in stock prices) to the stock market. Which of these two securities would
        you suggest your client buy? State your reasons.
        -x-convertible preferred
        -   straight preferred
          Straight preferred gives very little exposure to the stock mrrrker. However, u
          convertible preferred does because i the price of the untlerlying stock appreciates
                                               f
          enough, the investor will convertfrom preferred into common stock.

     4.   Define these terms.

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4
          Ex-dividend date: The rlrrte ufrer which the buyer does nut recrivr the next clivicie~end
          due; the seller WLLYthe shureholrler ofrecord, thus, will receive it.
          Dilution: The process ofreducing the vcrlrre o f u holtiing by iincrecrsing rhe number of
          shares outstanding.
          Amearages: Unpaid diviclentls tlrre n (preferred)shareholder.
          Limited liability: Thefact that u shureholtler is not liublefor the cornnpr~rzy:~
                                                                                         tlebts.


     5 . Decide whether each statement below describes an initial public offering (IPO) or
           secondary market trading.
           a. A company offers for sale stock it has warehoused.
              Secondury morket--only the first ti~nethe conl/7af?vcomes ro ~iiarkrtcrrn be
                                                              is                         ~1~
              consirlered an IPO. An eosy way to rente~nber thut i rhef-r is ~ l r e r 1equily
                                                                   f
                          on                         be
              ountun~ling rhe con7pony, it co~otot on IPO.
           b. A company comes to the market with an equity deal. This is the first time they
              have come to the public markets. IPO
          c.   A company gets permission from the SEC to go public. They authorize 50 million
               shares of which the company offers 20 million. They warehouse the rest. IPO.
          d.   You have 500 shares of IBM which you sell. Srcontlo~y
                                                                   177~1.ker
          Convertibles

    -
    r\    Description
          Convertible debt consists of bonds or notes that can be convened by the investors at any
          time during the term of the debt into a specific number of shares of the common stock of
          the issuing company. As such, it represents a combination of a fixed income instrument
          and an equity option--the holder has the right to exchange the convertible for shares but is
          not obliged to do so. Both the issuing company and the investors usually expect the
          convertible bond to eventually convert. Therefore, there is an underlying assumption that
          the share price will rise over the life of the bond, since the purchase price of a share
          through conversion is set above the current price. Conversion can he at the investor's
          initiative, or it can be forced by the issuer under certain telms.
          The convertible specifies a conversion rate in terms of a ratio or a price. A conversioiz rutio
          states exactly how m n y shares of common stock can be obtained by surrendering the
          bond. Alternatively, the conversion rate may be expressed by the conversion price which
          is the price paid per share to acquire the underlying common stock through conversion.
                                                                              is
          Thus, if a $1000 bond can be converted into 20 shares, the r ~ t i o 20: 1 but the price is $50
          per share. The conversion vulue is the product of the conversion ratio and the current
          market value of the underlying shares. For example, if the market value of the shares in the
          example above were $40, the conversion value of the hond would be $800 for each $1000
          bond; if the shares were trading at $70, the conversion value would be $14(K).

          Additiorzal Information

    r'\
    a
          Convertible bonds typically permit the issuing company to call the bonds before maturity at
          some redemption premium or at par. The call provision is used either to redeem the bonds
          or to force the investors to conven their bonds into common stock. Investors will decide to
          convert their bonds only if the conversion value of the convertihle hond is above its
          redemption value. For example, assume the a company can call its convertible debt at
          105% of par and that the conversion value is $1400 per bond. Faced with a redemption
          value of $1050 and a conversion value of $1400, investors will certainly convert. By
          forcing investors to convert their bonds into common stock, the company can substitute
          normally lower dividend payments on common stock for higher coupon payments on
          convertible debt. Conversion of bonds to common stock is not considered a taxable event--
          there is no gain or loss for tax purposes.

          Pricing
          The conversion ratio is usually set at issuance, so that the price paid per share if one were
          to immediately convert the bond is greater than the current market price of the shares. For
          example, assume the shares were selling at $4O/share, but the bond, priced at $1000, had a
          conversion ratio of 20, making the immediate conversion price per share $50. The $10
          difference is the conversion prernium. Clearly, the purchaser of this issue would have to
          believe that the share price was going to appreciate more than 25% during the conversion
          period. When the price of the underlying shares is above the conversion price, the price of
          the convertible bond will tend to track the price of the shares closely. But when the price of
          the underlying shares is below the conversion price, the price of the convertihle will vary
h
          with interest rates like any fixed income instrument: if it has a below-market coupon, it will
          trade at a discount; if it has an above-market coupon, it will tnlde at a premlum.
    P
     Maturity
     Usually issued with a maturity date which can be anywhere between five and twenty-five
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     years. The conversion privilege usually lasts the life of the bond.

     Risk
     Convertible bonds are usually junior bonds; that is, subordinated debt. If the company's
     financial position deteriorates, the investor would have a worthless option and, perhaps, a
     worthless bond.

     Issuer
     A company may issue convertihle debt if it has a need for equity funding but views its
     current stock price as too low. In this way, the company seeks to issue equity at a
     premium and capture some of the stock price appreciation. Alternatively, a company may
     want to issue convertible debt if it has a need for debt funding hut views the coupon costs
     of straight debt as very expensive. A convertible feature embedded in a debt issue enahles
     the issuing company to set the coupon several percentage points below what it would be on
     a normal straight debt issue. Finally, the issuer gets to deduct the interest paid on the bond
     for income tax purposes.
     Convertibles may have disadvantages to the issuer. In the first place, the issuer cannot be
     sure it is raising equity capital when it issues a convertible: if the price of the stock does not
     increase, the convertible holders will not convert. Conversely, if the stock price increases a
     lot during the convertible period, the issuer will raise less money (because the conversion
     price will be below the market value, otherwise the investor would not convert) than it
     would have by waiting and going directly to the equity market.
U




     Investor
     When an investor buys a convertible, it is buying (1) the right to buy equity in the company
     at a fixed price in the future and (2) downside protection since it has a fixed income
     instrument which must repay principal at maturity and pays a coupon during its life.
     Since there is an equity component in the value of the convertible, the price of the
     convertihle will increase as the price of the stock incrxases. The investor could then sell the
     bond at a premium to capture this increase in the value of the underlying stock without
     actually converting. For this reason, fixed income investors who (1) want exposure to the
     equity market but who cannot buy stock (such as insurance companies) or (2) need current
     income but still want to achieve capital gains often buy convertibles.
     The investor pays for this exposure to the equity market by accepting a lower coupon than
     it would on a comparable, straight bond issue. A convertible, moreover, usually sells at a
     premium over the value of the underlying common stock at the time oi issue. If the
     anticipated growth in the value of the common stock is not realized, the purchaser will have
     sacrificed yield and may well also see the value of the convertible instrument fall s h q l y .
     Self-test    -   Convertibles


f\
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L
     1. Match these terms and definitions.
                              c o n v e r s i o n ratio
                              c o n v e r s i o n price
                              -     conversion premium

          a.   the amount you pay per share
          b.   the difference between today's price of the stock and price they are purchased at through
               conversion.
          c.   the number of shares you get when you convert

     2.    List two risks the issuer of a convertible assumes,




     3. List two risks the investor assumes when he buys a. convertible.




     4.    List three advantages to the issuer of a convertible
*'


     5 . There is a convertible with a 5% coupon and conversion p ~ i c e $30. Today the underlying
                                                                        of
         stock is trading at $20.
          a.     If the stock price rises to $40, will the convertible's price tmck the stock price or interest
                 rates?

          b.     If interest rates are 4.25% and the stock price is $15, will the convertible trade at a
                 discount or a premium?

          c.     What is the conversion premium?
        Self-test    -   Convertibles: answers
        1. Match these terns and definitions.
0   %
                            --
                            --
                               c conversion ratio
                               a conversion price
                            -b-conversion premium
             a.   the amount you pay per share
             b.   the difference between today's price of the stock and price they are purchased at through
                  conversion.
             c.   the number of shares you get when you convert

        2. List two risks the issuer of a convertible hond assumes.
           (I) that it will issue its shares too cheaply: ifthe price of the stock rises a lot, the company will
           have sold its shares at a bargain because the conversion price will now be significantly below
           the current market price
                                                                             we
              (2) that it will not increase its equity base us anticipute~l: assirme that the conipany wants
              equity but does not feel it is a good time to raise it. Since it still neerls cash, it issues a bond
              expecting thut the price of the stock will rise and the bond will convert. If the price does not
              rise, the investor will not convert and the issue will not get the increase in equity it desired.
        3. List two risks the investor assumes when he buys a convertible.
              Reduced current inconle and decreased value of its bond: if the stock rloes not rise as
              expected, then the investor has accepted a below-murket coupon; frrrther~nore,if the equity
              value drops our, the bond will also rlecreose in vulrre.
n
I
    J   4.    List three advantages to the issuer of a convertible.
                 -pays a lower coupon on a convertible than on straight rlebt
                 -interest paid is tax deductible
                                                                                                assuming the
                 -sells its equity at a higher price (the conversionprice) than it coulrl ro~luy,
                     stock price rises
        5 . There is a convertible with a 5% coupon and conversion price of $30. Today the underlying
            stock is trading at $20.
             a.   If the stock price rises to $40, will the convertible's price track the stock price or interest
                  rats'?
                  The stock, since the vr~ll.reofrhe convertible now cornr.sfi.oni rhe right to buy stock $30
                  when it is trrrtling at $40.
             b. If interest rates are 4.25% and the stock price is $15, will the convertible trade at a
                  discount or a premium'?
                  Prerniirm Since the share price is below rhe conversion price, the convertible will trade
                                                                                                     rutes, it will
                  1,ike u bond und be sensitive to interest rates. Since its conDon i.s obove ~nrrrket
                  trade at a premium.
             c.     What is the conversion premium*?$10 or 50%
         High     Yield     (Junk)      Bonds
f
'
-
    5-   Descriptiorz
         Most high yield bonds are corporate bonds, concentrated in the consumer products and
         industrial sectors of the corporate hond market. High yield bonds, also known as junk
         bonds, are considered speculative even though over time they have had a low default rate
         and have consistently offered an above-average return.
          Historically, companies that did not qualify for investment grade ratings could not issue
          debt in the public market--they had to rely on bank loans or private placements with
          insurance companies. In the mid-1970s. Drexel Burnham Lamhert concluded that the
          perceived risk was greater than the actual risk of default and began to i.~ssunon-investment
          grade bonds. The origi~~ul high yield market in 1977-78 consisted of small emerging
                                      issue
          companies and companies that were formerly investment grade. So, the high yield market
          consists both of bonds which were issued as non-investment grade and honds which have
          been downgraded from investment grade--these are the so-called "fallen angels". As of the
         -early 1990s. the refinancing of high coupon debt drives the new-issue, high-yield market
          today.
         Historically, virtually all high yield bonds had conventional structures (that is, the honds
         paid a constant coupon payment each semiannual period and returned par at the end). With
         the advent of leveraged buyouts (LBOs), three deferred coupon structures hecame more
         popular. These structures include PIK (pay-in-kind) dehentures, where the firm has the
         option to pay in additional securities rather than in cash; step-up honds, which initially pay
         a lower coupon and step up to a higher coupon; and "zero coupon" bonds or deferred
                                                                                      l
         interest bonds that pay no coupon for a period of time before the n o ~ m a coupon kicks in.
         Step-up bonds and "zero coupon bonds" initially sell at a discount. This deht was designed
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         to give firms an opportunity to realize asset sales and pay off bank debt before beginning to
         pay the subordinated bondholders.

         Bonds rated B a l or lower by Moody's or BB+ or lower hy Standard and Poor's are
         considered below investment grade.

         Market Characteristics
         The market is dominated hy issues rated single B. T h e outstandings in the public high
         yield market are in excess of $210 billion, with over 650 issuers accounting for over 1000
         issues. Issuers represent virtually every industry. In 1992-93, new junk hond issuance
         has been predominately driven by the refinancing of more expensive issues.

         Additiortal I~tformation
         In evaluating the overall return on high yield honds, in addition to the initial yield. you
         must consider the default risk, the recovery rate in the event of defiault, and call protection.
         When thinking about defirslt risk, one must consider when the default occurs if it occurs--
         the later it occurs the.higher the rate of retum because the investor has been receiving the
         higher coupon for a longer period. For conventional high yields bonds issued by start-up
         firms and companies that were once rated investment grade, the default risk would be
         expected to increase with time. For LBOs without deferred coupon structures, the riskiest
         period may he the early years, as issuers work to meet high interest payments on hoth
         public debt and hank debt. For LBOs with defer~ed      coupon structures, the riskiest
         period may he when the deferred coupon securities must begin to pay in cash. Recover?,
         rute also influences the total return on a high yield portfolio: when the bond def~ults,   what
         percentage of face is recovered. And, finally, another important variable in determining the
-        rate of return is the cull schetlulr. High yield honds zenerally tend to have weaker call
                          their higher gmde counterparts.
         protection t h ~ n
     Maturity
     Junk bonds tend to have a shorter maturity than investment-grade bonds. When junk
     bonds are used to finance a leveraged buyout, it is typically assumed that such financing
i
     will be needed for only five to ten years.

     Pricing
     Junk bond coupons are priced from 200 - 700 basis points over the Treasury curve. This
     ratio is often regarded a s a key to whether the bonds are under priced or overpriced in
     relation to the market. Small issues may be hard to sell at any price should the need arise.

     Credit Risk
     The perceived credit risk--the possibility that interest and repayment of principd will not
     occur as stated--is the source of value since the risk premium is built into the return.

     Market risk
     This market is relatively illiquid: most dealers currently ( spring, 1993) are unwilling to
     provide firm quotes on all but the top 7 5 issues. Average trade size ranges from $500,000
     to $3 million. Bidloffer spreads vary from 114 point on the most liquid issue to five+ point
     on some issues.

fl   Issuers
ii
     The original issue high yield market in 1977-78 consisted of small, emerging companies
     and companies that were formerly investment grade. Another source of instruments was
     the "fallen angelsM--issuesthat were originally investment grade but had been downgraded.
     As of the early 1990s. the refinancing of high coupon debt drives the new issue market.


     Investors
     Institutional investors (mutual funds, insurance clients) are the predominate investor group.
     Given the relative illiquidity of this market as well as its speculative nature, retail investors
     generally participate in this sector only through mutual funds.

     Investors should avoid raking a market timing. approach. Instead, they s h o ~ l dtake a
     fundamental approach, looking for issues whrch will still be able to pay out under
     unfavorable economic conditions.
    Self-test   -   High Yield
    1. Match the following items.
i'
                     -dilution
                     -fallen angel
                     -ex-dividend date
                     -payable date
                     j u n k bond
                     -IPO
                     -PIK
                     -LBO
                     -recovery rate

                financing a purchase of a firm with largely borrowed funds
                the day the dividend is paid
                an issue that was formerly investment g r ~ d e
                reducing the dollar value of a holding by increasing the total amount outstanding
                a bond with a rating below B a l or BB+
                paying the investor in "kind" rather than in money through a coupon
                funds raised by a company the first time it comes to the public market
                the amount paid out on a bond which defaults
                the day after which the seller receives the dividend, not the huyer
    2. When will the default risk likely be greater?
       a. Conventional high yield bonds issued either by start-up firms or hy companies once rated
          investment grade.
          - the coupon kicks in and cash payments are required
                when
          i n c r e a s e s with passage of time
          a       t issuance, decreasing with the passage of time
         b.     Bonds issued to finance LBOs
                - the coupon kicks in and cash p ~ y m m t are required
                 when                                        s
                -increases with the passage of time
                - issuance, decreasing with the pasage of time
                 at
         c.     Deferred payment bonds issued to tinance LBOs
                w h e n the coupon kicks in and cash payments are reyuired
                -   increases with the passage of time
                a     t issuance, decreasing with the p s s a g e of time

    3. In evaluating a high yield bond, an investor should consider the:
       -level    of call protection
       -likely    recovery rate
       -    default risk
P
i
i
       - of the ahove
            all
     4.   What are two sources of junk bonds:


r\
A


     5 . Assuming that seven-year Treasury rate is 6.5096, what range of return return could you
          expect to e m on a high yield bond7

          What other investment would you consider that would give you a similar risk-return profile?



     6 . Listed below are the ratings assigned by Moody's and Standard and PoorMs.Draw a line
         between the ratings that separate investment grade from speculative grade (junk).
                                                  AAA
                                                  AA+
                                                  AA
                                                  AA-
                                                  A+
                                                  A
                            A3
                            Baal                  BBB+
                            Baa2                  BBB
                            Baa3                  BBB-
                            Bal
                            BJ2                   BB
                            Ba3                   BB-


                                                   ccc+
                                                   CCC
                                                   CC
                                                   C
                                                   C1
     Self-test   -   High Yield: answers

r'
c.
     1. Match the following items.

                      -d-dilution
                      -c-  fallen angel
                       i
                      -- ex-dividend date
                         '



                      -b-  payable date
                      -e j u n k bond
                      -LIP0
                      -f- PIK
                      -a- LBO
                      -h-recovery rate
           a.    financing a purchase of a film with largely borrowed funds
           b.    the day the dividend is paid
           c.    an issue that was formerly investment grade
           d.    reducing the dollar value of a holding by increasing the total m o u n t outstanding
           e.    a bond with a rating below B a l or BB+
           f.    paying the investor in "kind" rather than in money through a coupon
           g. funds raised by a company the first time it comes to the puhlic market
           h. the amount paid out on a bond which defaults
           i. the day after which the seller receives the dividend, not tht: buyer

     2. When will the default risk likely be greater'?
        a. Conventional high yield bonds issued either by start-up firms or by companies once rated
           investment grade.
           - the coupon kicks in and cash payments are required
                when
           - -increases with passage of time
             x
           - issuance, decreasing with the pusage of time
                 at
          b . Bonds issued to finance LBOs
              - the coupon kicks in and cash payments are required
                    when
              i n c r e a s e s with the passage of time
              -x-at issuance, decreasing with the passage of time
          c.     Deferred payment honds issued to finance LBOs
                 -x w h e n the coupon kicks in and cash payments are required
                 -increases with the passage of time
                 - issuance, decre~singwith the passage of time
                  at
      3. In evaluating a high yield bond, an investor should consider the:
         - of call protection
             level
         - recovery rate
             likely
r\
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         -   default risk
         -x-all of the ahove
     4.   What are two sources of junk bonds:

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L
            ( I ) Fallen angels--bond that were inirinlly invesnnent grude which have been downgruded,
            (2) bonds that were originally issued us non-investment grade ( h e to the snucrure of the
            company and/or (3)s m l l , emerging companies (any nvo of these three).

     5.   Assuming that the seven-year Treasury rate is 6.50%. what range of return return could you
          expect to earn on a high yield bond?
             8.50 - 13.50% since junk bondr pay 200 to 700 basis poiilts over the comparable
             Treasury.

          What other investment would you consider that would give you a similar risk-return profile?
             Common stock As with a high yield bond, a large proportion if not all of your capitul
             investment is at risk. And wtih a 10%--12% return on average over a 5 - 15 year time
             horizon, the expected return is comparable

     6. Listed below an:the ratings assigned by Moody's and Standard and PoorMs.Drdw a line
        between the ratings that separate Investment grade from speculative grade (junk).
                            h                     AAA
                            Ail1                  AA+
                            Ad                    AA
                            Ad                    AA-
                            A1                    A+
                            A2                    A                      investment grade
                            A3                    A-
                            Baal                  BBB+
                            Baa2                  BBB
                            Baa3                  BBB-
                            Bal                   BB+
                            Ba2                   BB
                            Ba3                   BB-
                                                  B+                     speculative grade
                                                  B
                                                  B-
                                                  CCC+
                                                  CCC
                                                  CC
     American        Depositary         Receipt        (ADR)



     An American Depositary Receipt (ADR) is an SEC-registered security that represents shares of a
     non-U.S. company. The ADR is a means for U.S. investors to invest in non-U.S. equities with
     ease and at a cost savings compared with investing in the underlying foreign equity. As a holder of
     an ADR, one has the full economic and corporate rights as the holder of the foreign shares. ADRs
     trade in the U.S., just as any U.S. security, and settle in five business days.
     Morgan invented the ADR in 1927 at the request of brokers who wanted to invest in foreign
     securities but found it cumbersome. However, the ADR business has evolved from an investor-
     driven business to an issuer-driven business. The ADR has become instrumental in non-U.S.
     companies' U.S. equity strategy, and companies are now taking the initiative to establish ADR
     programs.
     Activity of the ADR programs is varied and depends on many factors: the fundamentals of the
     company, the attractiveness of the issuing company's home market and industry, performance of
     the home country currency and political stability of the country.

     Maturity
     L i e common stock, ADRs are issued in perpetuity as long as the issuing corporation is an on-
     going legal entity and the depositary h ~ n k trust company supports the issue:
                                                 or

r\
-    Pricing
     Pricing is highly dependent on the price of the underlying foreign security traded on its home
     exchange. However, ADRs are traded in the equity markets in the same way as common stock.

     Market Characteristics
     Some thinly-traded ADRs may have an illiquid market. Approximately 200 of the 880 ADRs
     available to U.S. investors are highly liquid issues. ADRs can he listed on any U.S. stock
     exchange as well as he traded OTC.

     Credit Risk
     Since ADR holders are indirect holders of the company (that is, the depositary hank holds the
     actual shares), their investment is fully at risk in the event of hankr~rptcyof that company. In this
     regard, as is the case with common stockholders, ADR holders usually have a lower priority upon
     dissolution than creditors such as bondholders.
     Issuers
     There are two types of ADRs: sponsored and unsponsored. Sponsored ADRs have only one U.S.
     depositary hank (such as Morgan Guaranty, Citibank, or The Bank of New York) which is
(?
 -   appointed by the issuer. There are certain advantages to holding sponsored ADRs, since the
     sponsoring bank is expected to keep investors informed of dividend, proxy and and other events
     related to equity ownership. Since the sponsoring bank will also list the ADR on the stock
     exchange, sponsored ADRs tend to have more liquidity than unsponsored ones. An unsponsored
     program is usually driven by investor interest and there is likely to be more than one depositary
     bank. There is no agreement between the hanks and the foreign corporation clearly delineating
     rights and responsibilities, so investors may not be informed on a timely basis about activities
     undertaken by the company. Morgan currently acts as ADR Depositary for 120 sponsored and 300
     unsponsored ADR programs.



     Pension funds, insurance funds, mutual funds, employee stock ownership plans and individuals.

     Market Risk
     ADR investments are affected by the same factors which impact the market value of the issuer's
     actual shares such as earnings, countly risk, foreign exchange fluctuations, supply and demand.
     Self-test   -   ADRs

     What is an ADR?




     Why would a U.S. investor be interested in one?




     Decide whether these statements apply to a sponsored (S) or unsponsored (U)program.


     - f m s offer ADRs in this stock
      many
     o n l y one firm offers an ADR in this firm
     -the    company sought out the ADR sponsor
     -investor     interest caused the ADR sponsor to offer the ADRs

P-
-.        as
     - a buyer you can expect the sponsor to keep you infolmed of dividend, proxy, and other
           events related to equity ownership
     -stock     will be listed
     e n h a n c e s liquidity
      Self-test   -   ADRs: answers


(?\   what is an ADR?
--    An SEC-registered security that represents shares of a non-U.S. company.




      Why would a U.S. investor be interested in one?

       Primarily, it permits m investor to invest in a foreign lnurkrt without all the operationul hassles of
       doing so: arranging for payment in a foreign currency, leurning the settlement co~~ventions,   finding
      - a custodian bmk % hold the shures or arrange for shipment of shares to the U.S. It also provides
                          ,
       liquidity, since ADRs are bought und sold here.



      Decide whether these statements apply to a sponsored (S) or unsponsored (U) program.


      -U-many firms offer ADRs in this stock
           S-only one firm offers an ADR in this firm
(7
 -    -
      -,$-the    company sought out the ADR sponsor
      -U-investor interest caused the ADR sponsor to offer the ADRs
      -S-as a buyer you can expect the sponsor to keep you informed of dividend, proxy, and other
           events related to equity ownership
       -S-stock will be listed
       -S-enhances liquidity
    Swaps
0
%
    Description
    A swap allows two parties to exchange cash flows with one set of characteristics for those with
    another set of characteristics on terms that are agreed on at the beginning of the swap. The most
    common exchange is to swap a set of floating rate flows for a set of fixed rate tlows. In basic
    interest rate swaps, principal is not exchanged, and fixed and floating payments are often netted.
    Because there is no obligation to exchange principal, swaps are off-balance sheet items.
    Swaps are used by borrowers to change the interest or currency risk profile on their debt and by
    investors to manage their return on investment.
             A borrowers raise funds in the market that is cheapest regardless of whether they want
             fixed or floating rate funds and then swap them into the kind of funding they want. The
             net cost is less than if they went directly to the market with the kind of funds desired.
             An investors can use swaps to act on an interest rate outlook. They can swap fixed
             coupon tlows into floating rate flows if they believe interest rates are going up and
             want to benefit from a rise in rates; they can also swap tloating flows into fixed to lock-
             in a rate if they believe rates will drop.

    Market Characteristics
    The most liquid segment of the market is swaps with maturities less than ten years versus either
    three- or six-month Libor. Increased usage of standardized documentation (ISDA
    documentation) has funher enhanced the market's liquidity.

    Additional Informatiotz
    Historically, swaps have heen arranged in two ways:
        Intermediated           Dealers act as the swap counterparty for their customers. Dealers hold
                                swaps in "inventory" until a counterpany is found to offset them.
        Brokered                Brokers hring the two parties together but rake no position in the swap.
                                This method is rare mainly hecause participants are reluctant to take
                                on unfamiliar credit risk.
    Major types of swaps are:
        Interest Rate Swap An agreement between two parties to exchange fixed rate interest
                           payments for floating rate payments in the same currency for a
                           specified period hased on a notional principal amount. These are
                           commonly referred to as "plain vanilla" swaps. There is no exchange
                           of principal.
        Index (hasis) Swap A variation on an interest rate swap hut in this case two parties
                           exchange a floating rate interest payment hased on one index for that
                           of one based on another index, for example, Lihor vs three-month
                           commercial paper. There is no exchange of principal.
   Currency Swap          An exchange of liabilities or assets which are denominated in different
                          currencies. In addition to swapping interest payments, there is an
                          exchange of principal at the beginning of the swap and at the final
                          maturity. Both payments will he at a fixed rate, for example the
                          parties will exchange fixed dollars for fixed Deutschemarks. The
                          exchange rate is agreed on at the outset of the swap agreement and is
                          used throughout its life.
   Cross Currency         A combination of an interest rate swap and currency swap. In this
   Interest Rate Swap     case, multiple currencies can be involved and the interest payments
                          can be a fixed for floating exchange or a floating for tloating
                          exchange.
   Non-par Swap           The payment flows on a non-par swap are different from current swap
                          market levels and, therefore, include a cash payment upfront to make
                          up the difference on a present value. pre-tax basis. If the client is
                          receiving an above-market rate, the client would pay the Bank; if the
                          client is receiving a below-market rate, the Bank would pay the client.
Some terminology is also key:
   Fixed-rate payer       The counterparty who agrees to pay the fixed rate (and receive
                          LIBOR) for the life of the swap.
   Fixed-rate receiver    The counterparty who agrees to receive the fixed rate.
   (or taker)

Pricing
Swaps in the U.S. are commonly quoted in terms of the fixed-rate leg which is expressed as a
basis point spread over the "hot run" Treasury security of similar maturity versus the short-term
index, most commonly Lihor. For example, a five-year swap exchanging a fixed payment of
9.00% s.a. against a payment of Libor tlat (when the 5-year Treasury is yielding 8.00% s.a.) is
quoted as having a price of "T+lOON. It is understood that the floating-rate leg is priced at three-
or six-month Libor flat. Bid-asked spreads usually range between 5 - 10 basis points p.a.
Currency swaps and interest rate swaps outside the U.S. are quoted as a single number rather
than a spread.

Maturity

Although the most liquid segment of the market is for swaps with maturities less than 10 years
versus either three- or six-month Libor, swaps can be done as far out as 30 years
     Credit Risk


r'
d
     Counterparties are exposed to each other's credit risk for the life of the contract. Credit exposurt:
     1s measured by the joint probability of an adverse movement ol'interest rates and a default of the
     counterparty. Consider ABC Insurance, a fixed rate payer in a five-year swap. Suppose that
     after one year interest rates fall and its counterparty defaults. ABC would stop making fixed-rate
     payments to the defaulting party, and it would have to find another counterparty for the                :

     remaining four years of its original swap. In the lower interest rate environment, the new
     counterparty would require a lower fixed-rate payment, so ABC would benetit from the default.
     If, however, rates had risen in the intervening year, ABC would now have to pay a higher fixed
     rate and, thus, it would experience a loss due to the default of the original counterparty.
     MGT is more exposed to the counterparty paying tixed than to the one paying floating, since the
     bank is relying on that payment to meet its obligation to a fixed rate receiver on another,
     offsetting swap. If interest rates have fallen the bank would suffer a loss, since it would not be
     able to match the original fixed-rate inflow that was being used to meet this obligation. If,
     however, rates have risen, the bank would benefit from the default. Nevertheless, the major risk
     to the bank is the cost of repbacing the swap at a disadvantagous rate.



     In the swap market, we should think of issuers/investors as dealers and clients. Within the client
     market, there are two major groups: investors and corporates. Investors use swaps as an efficient
     way to act on their view of the underlying market. Corporates use them to manage the risks
     which occur because of their capital structure or in the course of doing business. Classically,
     they use swaps to manage their assetlliahility mix.
                -
     Self-test Swaps
(1   1. Match these items.
-                                          a.   Plain vanilla swap
                                           b.   basis swap
                                           c.   currency swap
                                           d.   non-par swap
                                           e.   cross-currency swap

            - is set at an off-market rate.
             rate                                      For example, 5 year r ~ t e s 5% and the fixed rate
                                                                                   are
                    leg is set at 4.75%.
            a        fixed for floating exchange of flows

            - LIBOR versus prime swap
             a
            - fixed for floating, DM versus $ swap
             a
            -French franc versus dollar swap

     2. Decide whether the swap is brokered or intermediated.
                       a dealer puts two countelparties together but takes no position.
                                    s
                       a dealer h ~ exposure to both counterparties.
                       a dealer holds the swap in inventory until a counterparty is found.
                      a dealer has a position in the swap.

     3. What floating rate index is most commonly used in a swap?
     4. What is the most liquid maturity range for swaps?


     5. Decide whether you benefit or suffer from the default of your counterparty.
         a. You are paying fixed at 8% to a counterparty who defaults. Current rates are 6%.
            -    benefit -     suffer Why?


         b. You are receiving fixed at 4% from a counterparty who defaults. Rates are now 5%.
            -henefit        -suffer Why?


         c. You are receiving fixed at 7% from a counterparty who defaults. Rates are now 5%.
            -    benefit -       suffer Why?
      6 . An investor has a bond portfolio. She expects interest rates to full. To protect her position,

r-'
 -
         she could:
         a. sell the portfolio now
         b. swap her fixed flows for floating flows
         c. do nothing because falling rates increase the value of her portfolio
         d. a o r b

      7. An investor has a bond portfolio. She expects interest rates to rise. To protect her position,
         she could:
         a. sell the portfolio now
         b. swap her fixed flows for floating flows
         c. do nothing because rising rates increase the value of her portfolio
         d. a o r b

      8. A borrower is paying 8% on a five-year, fixed-rate borrowing. Libor is now 5.50% and
         expected to go lower. How could this borrower use a swap to capture this drop in rate?




      9. A borrower wants to pay fixed DM but can raise fixed rate dollars more cheaply. What steps
-
(1       could it take to capture its relative advantage in dollars but still end up paying in DM?
           -
  Self-test Swaps: Answers


r'.
-
  1. Match these items.

                                       a.   Plain vanilla swap
                                       b.   basis swap
                                       c.   currency swap
                                       d.   non-par swap
                                       e.   cross-currency swap
            rate
         -d- is set at an off-mzirket rate. For example, 5 year rates are 5% and the fixed rate
                leg is set at 4.75%.
         -a-a       fixed for floating exchange of flows

         -b-a       LIBOR versus prime swap
         -e-a       fixed for floating, DM versus $ swap

         -c-French franc versus dollar swap
  2. Decide whether the swap is hrokered or intermediated.

     -brokered-a          dealer puts two counterparties together but takes no position.
     -intermediated-a dealer hus exposure to both counterpxties.
     -intermediated-a dealer holds the swap in inventory until a counterparty is found.

     -intermediuted-a dealer has a position in the swap.

  3. What floating rate index is most commonly used in a swaps?-3- or 6-nio~ithLIBOR-
  4. What is the most liquid maturity range for swaps?-rrp        to ten years-

  5. Decide whether you benefit or suffer from the default of your counterparty.
      a. You are paying fixed at 8% to a counterparty who defaults. Current rates are 6%.
                -
         - benefit -
           x                  suffer why'?
     Because you will replc~ce s>vr~p (I lower rate ertvirorimenr untf pcry 6% instead of 8%
                             this   in
      b. You are receiving fixed at 4% from a counterparty who defaults. Rates are now 5%.
         -x-benefit     -    suffer why'?
                                                                           recrivr 5% instead of
      Because you will replace the swap rn a higher rcrte rnvironnimr c~ritl
      4%
      c. You are receiving fixed at 7% from a counterpafly who defaults. Rates are now 5%.
         b e n e f i t -x-suffer      Why?
      Because you will only receive 5% instecrd of 7% fit the lower rcrre envil-orininer
     6. An investor has a bond portfolio. She expects interest rates to fall. To protect her position,
        she could:
(7
-*
        a. sell the portfolio now
        b. swap her fixed tlows for tloating tlows
        c. do nothing because falling rates increase the value of h e r portfolio
        d. a o r b

     7. An investor has a bond portfolio. She expects interest rates to rise. To protect her position,
        she could:
        a. sell the portfolio now
        b. swap her fixed flows for floating flows
        c. do nothing because rising rates increase the value of her portfolio
        d. a o r b


     8. A borrower is paying 8% on a five-year, fixed rate borrowing. Libor is now 5.50% and
        expected to go lower. How could this borrower use a swap to capture this drop in rate?
        She is paying out fixed She could do fixed for flouting swap: receive fixed-rate flows to
        offset her fixed payments in whole or in part and mukejloaring puyn7ents. The all-in rate
        would be lower than her crirrentpayments.

     9. A borrower wants to pay fixed DM but can raise fixed rate dollars more cheaply. What steps
        could he take to capture its relative advantage in dollars but still end up paying in DM?
        He could raise fired dollars and then do a currency swap where he wo~illlreceive fixed
        dollars to offset his borrowing andpuy outfixed DM.
           Futures

 -         Description

           A futures contract is a standardized, binding agreement to buy or sell a commodity at an agreed
           upon price, quantity, and date. Originating as a forward contract market for wheat, the futures
           market expanded the scope of "commodities" trading to include financial instruments. The
           introduction of currency futures on the International Monetary Market (IMM) in 1970 was soon
           followed by a wide range of tinancbal futures.
           Futures contracts are usually traded in a "pit" within an organized exchange through an "open
           outcry" mode of trading (that is, bid and offer, price and volume are puhlicly announced).
           Although the transactions are consummated between buyers and sellers in a pit, the exchange
           always acts as counterparty to both buyers and sellers.
           Interest rate futures are sensitive to changes in interest rates. As such, they allow hedgers
           (corporate treasurers and investors) to protect themselves against an adverse change in interest
           rates, and they allow speculators to take positions where they can henefit from price moves. (A
           hedger has an underlying position in the cash market to protect; a speculator is merely looking to
           benefit from price movement.) This market allows hedgers to transfer the risk of future price
           fluctuations to "speculators". It is the speculator's willingness to assume risk that provides the
           market with liquidity.
           A speculator in interest rate futures is taking a bet on a change in interest rates. If a speculator
           thought rates were going down (and the price of the contract up), she would buy futures today
           and then sell them at a profit after rates had droppedlprices risen; she would sell futures short if
           she thought rates were rising and buy them back later for less, pocketing the difference.
:r\
 2
           A hedger has an underlying position to protect and fears that the change in rates will decrease the
           value of that position. So, a hedger would take an opposite and offsetting position in the futures
           market from the one she held in the cash market: if she were long bonds and would he hurt by a
           rise in rates (which would drive the dollar value of the portfolio down), she would sell futures
           short so her futures position would benefit from the rise in rates. The gain in futures would offset
           the loss in the bond portfolio, thus preserving the overall value of her position.

           Market Characlerbtics
           Futures are a leveraged instrument--by putting up only a few thousand dollars in margin the
           participant can control millions in face value. Once an account is opened, participants can get in
           and out of the market quickly, often executing large transactions without moving the market.
           This market reacts quickly and often leads the cash market.
           Futures contracts trade on organized exchanges like the Chicago Board of Trade and the Chicago
           Mercantile Exchange. The purpose of the exchange is to provide facilities where buyers and
           sellers can conduct business to enforce the rules under which trading is conducted. While the
           purchase and sale of the contracts is executed between tloor traders, all transactions ultimately
           involve another party--the clearinghouse. After the price is agreed upon in the pits, the
           clearinghouse becomes the "counterparty" to every transaction. While the clearinghouse does not
           actually deliver the instrument, it guarantees compensation should one party default. The
           obligations of the clearinghouse are themselves guaranteed collectively by all the members which
           effectively eliminates counterparty credit ~ i s k .
r\
 V
      \.
    Additiorzal I~zformatiort
    Contract Specificutions
w




                                                                                    month. Based on 8%




             Simple Delivery:       Delivering a specific instrument (e.g., T-Bill Contracts,
                                    Gold Futures Contracts).
             Cash Settlement:       Delivering cash instead of a physical security. Contracts
                                    that have cash settlement include the Eurodollar Futures,
                                    Municipal Bond Index Futures, and the S&P 500 Futures
                                    Conracrs.
             Basket Delivery:       Delivering any one of a hasket of commodities o r
                                    securities, a11 of which meet the criteria the exchange has
                                    estahlished for eligibility. For T-Note and T-Bond futures
                                    contracts, the quoted futures price assumes that a
                                     hypothetical 8% hond or note is delivered. A corivrrsion
                                    fi~ctoris used to equate a11 bonds regardless of their actual
                                    coupon or maturity.
     Regardless of the delivery method, on the last tradins day the final futures price is marked
     to the cash market price, so the futures prices convrrgr to the cash price.

     Maturity
     With futures, we think in terms of expiration, not mzturity. Although the Eurodollar
     futures contract can he traded out 5 years, each futures contract represents a contract on a
     forward three-month rate. And, although the note and hond contracts can he tmded out
     only up to nine months, each contract represents a forward price on a long-term instrument
     whose maturity can he as far as 30 years in the future.
     The price of the futures contract, just like that of a fixed income instrument, vanes inversely with
r'
 -   interest rates. Assuming the Eurodollar contract were priced at 95.00 and rates dropped, the price
     of the contract would go up. If you had hought the contract (were long), you would have made
     money and, at the end of the day, your broker would credit your margin account. If, however,
     you had sold the contract (were short), your margin account would be dehited to reflect the loss.
     Every basis point the ED contract moves means a gain or loss of $25; every 32nd move on the
     bond contracts means a gain or loss of $31.25.

     Credit Risk
     The exchange assumes the counterparty credit risk and guarantees the performance of the
     contracts. In return, it requires market participants to deposit an initial margin and to keep a
     maintenance margin. The level of the maintenance margin is adjusted daily, recognizing any gains
     or losses in individual futures position. This procedure, called "marking-to-market". limits the
     amount a participant can lose in any one day hecause the exchange will close out the account if the
     participant cannot meet margin calls. Because of margin requirements, clearinghouses are
     considered outstanding credits.

     Users
     Speculators and arbitragers, and corporate orland financial institutions to hedge price and interest
     rate risks.
                -
     Self-test Futures
(1   1. Match these items.
-                                               a.   $25
                                                b.   convergence
                                                c.   mark-to-market
                                                d.   31.25
                                                e.   basket delivery
                                                f.   simple delivery

            - expirationthe futures price and the cash price are the same
             at
            a       n     y one of a number of similar instruments can be delivered to fulfill the obligations
                        of the contract
            t       h    e value of each 32nd change in the price of the note or bond contract
            o n l y one instrument with a specific set of characteristics is eligible for delivery

            - value of each basis point change in the price of the ED or T-hill contract
             the
            - the end of the day, each participant must settle its account, paying losses and
             at
                        accepting gains
     2. Futures prices, like bond prices, move inversely with changes in interest rates. So, if you
        thought interest rates were rising and you were going to speculate in the futures market,
        would you want to be long or short futures? Why?
?O
     3. You buy ED futures when interest rate are 5%).meaning the price is 95.00 (price = 100 -
        interest rate). Rates rise to 5.25%. What is the new price of the futures contract'?


     4. You are long the ED futures contract at 95.45. You sell it at 95.50. Did you make or lose
        money? How much?



     5. You short the bond contract at 92-01. You buy it back at 92-03. Did you make or lose
        money? How much'?


     6. As a speculator, you believe interest rates will go down. To act on this view, would you buy
        or sell contracts? Why?
      7. As an investment manager you plan to buy bonds in the future. You fear rates will drop by
         the time you want to buy the bonds, making them more expensive. T o hedge yourself, would
         you buy or sell contracts? Why?
 -
't
 -.




      8. As an investment manager, you fear that rates are going up, thus decreasing the value of your
         bond portfolio. To protect yourself, you plan to hedge in the futures market. Would you buy
         or sell contracts? Why?




      9. You plan to borrow money in two months' time, and you fear interest rutes will be higher at
          that time. T o hedge yourself in the futures market, would you buy or sell futures? Why?
     Self-test   - Futures: answers
r\   1. Match these items.

                                                a.   $25
                                                b.   convergence
                                                C.   mark-to-market
                                                d.   31.25
                                                e.   basket delivery
                                                f.   simple delivery
            - -at expiration the futures price and the cash price are the same
             b

            -e-any    one of a number of similar instruments can be delivered to fulfill the
                    -
            obligations
                  of the contract
            -d-the         value of each 32nd change in the price of the note or bond contract
            -f-only                                                            is
                            one instrument with a specific set ofchar~cteristics eligible for delivery
            -a-the         value of each basis point change in the price of the ED or T-bill contract
            -c-at         the end of the day, each participant must settle its account, paying losses and a
                        accepting gains

     2. Futures prices, like bond prices, move inversely with changes in interest rates. So, if you
        thought interest rates were rising and you were going to speculate in the, Futures market,
        would you wanr to be long or short futuresz? Why'?
        You would wanr to be short futrrres: i f rutes rise, the price will go flown. Therefore, you will
        be able to brry back the futures ut a lower price than you sold thernfi~r,  moking (I profit.

     3. You buy ED futures when interest rate are 5%,meaning the price is 95.00 (price = 100 -
        interest rate). Rates rise to 5.25%). What is the new price of the futures contr~ct?
        The new price is 94.75 (100 - 5.25 = 94.75).
     4. You are long the ED futures conuact at 95.45. You sell it at 95.50. Did you make or lose
        money? How much'?
        Mude 5 basis points or $125.

     5. You short the bond contract at 92-01. You huy it back at 92-03. Did you make or lose
        money? How much?
        Lost 2 3Znds or $62.50

     6. As a speculator, you helieve interest rates will go down. To act on this view, would you buy
        or sell contracts'? Why?
         You woulrl briy the contrcrct. If rtltrs go ifown rhr price will r.ise, so yorr irmill be uble to briy
r\
 .       the contracts buckfir 1e.s.~thcin p~li  puilifi, rhni7, rhrii li7vkd7p money
7. As an investment manager you plan to huy honds in the future. Y ~ L I rates will drop hy
                                                                      fear
   the time you want to huy the honds, making them more expensive. To hedge yourself, would
   you buy or sell contracts? Why?
   You would buy contracts to benefit in the futures rnarkerfronz a drop in rutes: if rates drop,
   the price will go up so you can sell the contracts for ntore than yorr puid for them.
   Remember, you need to take a position in thefirtrrres market thut will benefit from what will
   hurt you in the bond nurrket. Since you will be hurt by a drop in rtltcs in the bond mnfirker,
                                                                         a         t
   you need to position yourselfin the firttrres market to benefitfro~iz rlrop i ~rates, which
   means you must buy.

8. As an investment manager, you fear that rates are going up, thus decreasing the value of your
   bond portfolio. To protect yourself, you plan to hedge in the futures rnarket. Would you buy
   or sell contracts? Why?
   I f rates go up, prices go down. To benefit from a drop in price in the frrtures riiarket, you
   must sell or be short the futures contracts. If the price goes down, you will be able to buy
   back the futures for less than you paid for them, thus nirrking u profit. which you would use to
   offset the decrease in value of your bondporlfolio.

                                                                r
9. You plan to borrow money in two months' time, and you f e ~ interest rxes will he higher at
   that time. To hedge yourself in the futures market, would you buy or sell futures? Why?
   Iffuture rates are higher,firrrrre prices are lower. To benefit in thefirtrrres market from a
   future drop in prices, you /nust sell contructs.
                                            Forward Rate Agreements (FRAs)

        -   Description
            A forward agreement is a contract between two parties, setting the future price of a commodity.
            An FRA is a forward agreement setting a future interest rate on a specified notional principal.
            An example will best explain how an FRA works. Assume MGT entered into an FRA to set a
            six-month borrowing to begin two months from now at 5.50%. Since an FRA only locks in a
            rate--it does not provide an investment or a borrowing--in two months' time, MGT would go to
            the market and borrow at the prevailing six-month rate. If six-month rates were 5.75% in two
            months' time, MGT would borrow at 5.75% and receive the 25 basis point difference from the
            FRA counterparty. If, however, rates were 5.25% in two months' time, MGT would borrow at
            5.25% and pay 25 bp to the FRA counterparty, again making its effective rate 5.50%. Note, that
            the FRA has insured the rate that MGT pays; the seller of the FRA is not involved in the
            transaction between MGT and the depositor. Furthermore, MGT is locked into that rate: it
            cannot benefit from a future drop in rates.
            Thus, if you wish to lock in a rate today on a future liability (that is, protect yourself against a
            rise is rates), you would buy an FRA since it will pay you if rates are above the contract rate: if
            the contract is for 4% and the actual future rate is 4.50%. you get paid by the FRA seller. If you
            wish to lock in a rate today on a future asset, (that is, protect yourself against lower rates in the
            future), you would sell an FRA: if the contract is for 4% and the actual future rate is 3.75%. you
            would get paid by the FRA counterparty. In summary,

            You want to pay X rate in   You are hurt by a rise in   On the fume date, you           You buy aFR4
            the future.                 rates.                      borrow at the market rate.
\f7                                                                 You receive the difference if
                                                                    the market rate is above the
    <
/                                                                   FRA rate; you pay the
                                                                    difference if the rate is below
I                                                                   theFRA.


            You want to eam X rate in   You are hurt by a drop in   On the future date, you invest You sell a FRA
            the future.                 rates.                      at the market rate. You
                                                                    receive the difference if the
                                                                    market rate is below the FRA
                                                                    rate; you pay the difference if
                                                                    the market rate is above the
                                                                    FRA rate.

            Market Characterkiics
            This is a relatively illiquid market because there is no central marketplace. So, an FRA can be
            reversed only by going back to the original counterparty unless the party who wants to end the
            contract is willing to take on the additional credit risk of an offsetting FRA with another
            counterparty.
            The FRA market in U.S. dollars is the largest.
         The key characteristic is the cash settlement which can be paid at either the beginning of the
         contract period or the end. Thus, in a 3 vs. 9, cash can be exchanged at either the end of 3
         months which is the beginning of the contract period or at the end of 9 months which is the end
         of the contract period. If payment is at the end of the period, the actual amount of cash
         exchanged is the market rate less the contract rate times the face value of the contract, adjusted
         for time. I payment occurs at the beginning of the period, in our example three months from
                   f
         now, this amount would be discounted back for the six-month period. Principal is never
         exchanged, only the cash value of the difference in the rates.

         Additional Information
         Since both FRAs and futures can be used to set a forward rate, that is, to hedge future borrowing
         or investment rates, one must compare them to understand how they differ. Futures are
         standardized contracts traded on an exchange. FRAs, by contrast, are over-the-counter and
         tailored to the specific needs of the two parties involved in terms of notional amounts, rates,
         reference rates and maturity. In addition, they do not mark-to-market, so there are no daily
         margin payments to be made or received. FRAs are less liquid than futures, since the contract is
         between two parties. And, because the agreement is between two parties, the credit risk is greater
         (See Credit Risk below).
         One other difference between futures and FRAs is the action you would take in each market to
         meet your needs. Assume that you have or will have a position that will be adversely affected by
         a rise in rates (drop in price). In the FRA market you would be a buyer: you wl be paid by the
                                                                                             il
         seller if rates are above the rate agreed upon in the contract In the futures you would be a seller:
         you will benefit from the rise in ratestdrop in prices by being short the futures contract (and
         buying it back later at a lower price), using this gain to offset the loss you will experience in your
         position in the cash market-whether it be a loss in the value of your bonds due to the rise in rates
         or an an increased cost of borrowing due to the rise in rates.
n
-        Maturity
I
         Most FRAs have a maturity of less than one year, although some go out as long as two years.
         FRA rates are quoted in terms of the starting time and ending time of the period, beginning now.
         So, prices of an FRA for a six-month rate starting 3 months from now would be referred to as a 3
         vs. 9.
         Pricing
         Two-way prices are the norm between market-makers and are quoted as a percentage per annum.
         The spread between the bid and offer varies but generally ranges between 5 and 10 basis points.
         Credit Risk
         An FRA implies a payment from one party to another and, thus, there is potential credit risk for
         both of the counterparties. However, principal amounts are not exchanged, hence the credit
         exposure on an FRA is relatively small when compared to the underlying notional value. The
         amount of credit exposure is related to interest rate movements during the contract period.
         Market Risk
         Changes in interest rates will benefit one party and be detrimental to the other.


         Banks, which are the biggest players in the FRA market, use them to remedy mismatches in the
    (?   short-term structure of their assets and liabilities.
                -
       Self-test ERAS
       1. Decide which is true of FRAs, futures or both
P..-
                    trades on an exchange
                    involves counterparty lisk
                    can be used to lock-in a future rate
                    can be tailored
                    are highly liquid
                    are contracts between two parties
                    are marked-to-market daily

       2. Today is March 1. Assume you enter into an FRA to receive 6'70 for six months from June 1
          to December 1. On June 1, the six-month rate is 5.50%. Select the correct sequence of
          events.
          a. You go to your FRA counterparty, give him your money on June 1 and receive your
             principal and interest hack on Decemher 1.
          b. You go to the market on June 1 and invest at 5.50% and claim 50 basis points
             compensation from your FRA counterparty. On December 1 you get back principal plus
             interest from your investment and receive a cash payment equal to 50 bp from the FRA
             counterparty.

       3. The most active maturity for the FRA market is
n
J -'   4. Today is March 1. A 4 vs 6 FRA begins                   and ends


       5. If you think future rates will he higher than they are tod3y and you want to lock-in today's
          lower rates, would you buy or sell tm FRA'! Why?




       6. If you think rites will be lower in the future and you want to lock-in today's higher rates,
          would you buy or sell an FRA? Why?
     7. You have a bond position. A rise in rates will hurt your position. Will you buy or sell futures
        to hedge (protect) your position'! Why?




     8. You have sold an FRA guaranteeing a future a t e of 6 % on an asset in three months' time. In
        three months, the rate is 6.25%. Will you pay or receive the 25 basis points?




     9. You have bought an FRA guaranteeing yourself a rdte of 4% in two months' time on a future
        liability. In two months, the rate is 4.35%. Will you pay or receive the 35 basis points?




     10. You bought an FRA guaranteeing 5% for a six-month period, starting in one month. In one
PI       month, the six-month mte is 4.88%. Will you pay or receive the 12 basis points'?
-.
             -
     Self-test FRAs: answers
     1. Decide which is true of FRAs, futures or both.
-
C\       fi~nrrestrades on an exchange
         FRAs involves counterparty risk
         both can he used to lock-in a future rate
         FRAT can be tailored
         fi~trrres are highly liquid
         FRAs are contracts between two panies
         fimrrer are marked-to-market &lily

     2. Today is March 1. Assume you enter into an FRA to receive 6% for six months from June 1
        to December 1. On June 1, the six-month rate is 5.50%. Select the correct sequence of
        events.
        a. You go to your FRA counterparty, give him your money on June 1 and receive your
           principal and interest back on Decernher 1.
        b. You go to the market on June 1 and invest at 5.50% and claim 50 hasis points
           compensation from your FRA counterpany. On Decemher 1 you get hack principal plus
           interest from your investment and receive a cash payment equal to 50 hp from the FRA
           counterparty.
            Remember, a FRA guuronrees u rare; it cloes not grrurontee nn invevtrnenr or a borrowing.
0
F
'
     3. The most active maturity for the FRA market is less rhon one \wnr

     4. Today is March 1. A 4 vs 6 FRA begins      Jolv 1   and ends Sent I    .


     5. If you think future rates will he higher than they are today and you want to lock-in today's
        lower rates, would you buy or sell an FRA'? Why?

        You would buy u FRA: i f you are correct and rates are higher, the FRA writer will pay you
        the difference between the controcted rule crnd the higher rnurkrt rare. If'yoll are wrong,
        however, und rates are lower than the controcted rcrre, you wooltl pay the FRA wrirer.

     6. If you think rates will be lower in the future and you want to lock-in today's higher rates,
        would you buy or sell an FRA? Why?
        You would sell the FRA: ifyou ore correct and rates are lower in rhr jr~trrre,the FRA writer
                                                                                r
        willpay you the difference between rhe conrrrrcted rute and rhe l o w ~ mrrrket rtlte.
         7. You have a bond position. A rise in rates will hurt your position. Will you buy or sell futures
            to hedge (protect) your position? Why?
    r\      You must sell fut~rrescontracts. Since u rise in rates will hurt the bond position, you need a
            position in the futures market that will benefit from a rise in ratesklrop in price.

         8. You have sold an FRA guaranteeing a 6% rate on an asset in three months' time. In three
            months, the rate is 6.25%. Will you pay or receive the 25 basis points?

            You will pay the 25 basis points. Through the FRA, you locked in a funlre rate of 6% on your
                                                              were
            asset regardless of where market rutes uct~~ally in three months' time. Since market
            rates were above 6%, the difference goes to the FRA counterpclriy who gut~ronteedthe 6%.
?
            If rates had been below the 6%, the counterpcrrty wo~rll hr~dto pciy yo~i..
                                                                   have
t

*        9. You have bought an FRA gullranteeing yourself a rate of 4% in two months' time on a future
            liability. In two months, the rate is 4.35%. Will you pay or receive the 35 basis points?
I
                                                                                        the
            You will receive the 35 basis points from the FRA writer. When you bo~rght FRA at 4%,
            you agreed to 4% regardless of what marker rates actually were. Since they were above 4%
            the FRA counterparty is obligated to pay you the 35 basis points, keeping your effective cost
            to 4%.

         10. You bought an FRA guaranteeing 5% for a six-month period, starting in one month. In one
             month, the six-month rate is 4.88%. Will you pay or receive the 12 basis points'?
            In this case, yo~iwol~ld pay the 12 basis points. Since you locket1 in a 5% cost offuntls on
            your liability through the FRA, you will borrow in the market at 4.88% and pay the FRA
            writer the 12 bp difference, making your effective cost of$~ntls5%.
         Options
    r\
         An option is the right, but not the obligation, to buy or sell a given security at a specified price
         called the exercise or strike price on or before the expiration date. For this light, the buyer of the
         option . . a ~remium.
                 pays
                     the'right to buy :                       a call option
                     the right to sell:                       a put option
                     the time until the expiration date:      the life of the option or the exercise period
                     exercise anytime:                        American option
                     exercise on expiration date only:        European option
                     buyer of the option:                     called the buyer
                     seller of the option:                    called the seller or the writer
         An option gives the buyer proteciion against adverse changes in the price of the underlying
         product, while still permitting participation in advantageous price changes. For example, assume
         an investor buys a European cull with a strike price of $120 on one share of stock. If, on the day
         the option expires, the price of the stock is $105, the investor will not exercise the option because
         it would rather pay $105 for it in the market than $120 through the option. But, if the price is
         $130, the investor will go to the seller of the option and demand one share of stock in return for
         $120. In this case, the seller will experience a $10 loss, since the market price is now $130.

         A call option is "in-the-money" when its strike price is less than the underlying asset, "at-the-
         money" when both are the same and "out-of-the-money" when the strike is more than the market
         price of the underlying asset. In the example above, the $120 call was in-the-money when the
         stock was at $130 and "out-of-the-money" when the price of the stock was $105.

         Maturity
         Exchange-traded options usually have maturities of less than two years arid usually have fixed
         expiration dates set at three month intervals--March June, September, and December. (Note:
                                                                                options are customized
         foreign exchange options expire at monthly intervals.) Over-the-co~~nrer
         for each client and can be written for up to ten years.

         Pricing
i        There are a number of factors that influence the price of an option, but it all comes down to how
         likely it is that the writer of the option will have to pay out. Since an option is always on an
         underlying product, such as a stock, its price or value is derived, in part, from the price of the
         underlying. You will pay more for an option:
                 (1) The closer the strike price is to the price of the underlying instrument. If you set the
                     strike on a call option at $1 1 0 rather than $120 when the stock is currently selling for
                     $100, the seller is more likely to have to pay out than if the strike were higher.
                 (2) The longer the life of the contract. Again, the longer the life, the more possihility
                     there is for the option to get into the money.
                 (3) The more price of the underlying moves around--that is, the more volatile it is. If the
                     price moves up and down a lot, there is more chance it will get into the money and the
                     seller will have to pay out.
              There exist three main parts to an option pice: intrinsic value; time value; and insurance vdue.

                     Intrinsic valrrr is the amount by which the option is in-the-money--the difference
                     between the strike and the price of the underlying.
                     Tirne vnlrre is the time remaining on an option contract before expiration. The
                     time value premium is greater the further the option is from expiration.
                    Insurance value results from the volatility of the underlying security--the fact that
                    the price of the underlying could fluctuate a lot but the huyer of the option can
                    only lose the premium.
             The most common option pricing model is the Black-Scholes Options Pricing model. which
             incorporates all these factors.

             Market Characteristics
',           Options are traded on a wide range of stocks, stock indices, commodities, currencies, interest
             rates, and futures contracts at exchanges throughout the world as well as over-the-counter (OTC).
             The Chicago Board Options Exchange (CBOE) market is now the second largest securities
             market in the world in terms of the US dollar value of underlying securities.

             Additional I~~forrnation
             Options are frequently used for hedging purposes to offset risk. Similar to insurance, the huyer
             pays a premium for the option and is protected if the market in the underlying asset moves
             adversely. Speculators trade options in anticipation of price moves without necessarily taking
             positions in the underlying asset.
J1
     *   -   Credit Risk
             Credit risk is minimized with exchange-tmded options because a clearinghouse serves as the
             counterparty to all option trades. The clearinghouse reconciles all payments, supervises the
             delivery process, and requires both buyer and seller to post an initial margin.

i            In the over-the-counter (OTC) market, however, the buyer of the option is exposed to the credit
             risk of the seller of the option: if the option goes into the money m d the buyer exercises the
             option, he is expecting the seller to pay-off. If the seller cannot fulfill its promise to pay. it is as
             if the buyer never bought the option and remained fully exposed. The seller's credit risk is
             limited to the amount of the premium which is usually paid within two days of purchase of the
             option.

             Market Risk
             Buyers of options can lose no more than the premium that they paid to buy the option. Sellers of
             options are exposed to unlimited risk.

             Issuers/lnvesturs
             Banks, su~ra-nationals,sovereigns, multinational companies, corporates. pension funds, and
             indivijuals.
              Options can be used by hedgers to offset the risk that the market in the underlying asset moves adversely.
              Speculators trade options in anticipation of price moves without necessarily taking positions in
     (1       the underlying asset.
               -
     Self-test Options
     1. Match these items.
(1
..            - call option
               a                                           a. exercise option only on expiration date
              - put option
               a                                           b. right to buy
              -European option                             c. amount option is in-the-money
              -American option                             d. right to sell
              -intrinsic value                             e. option can be exercised any time
              t i m e value                                f. comes from the volatility of the
                                                              underlying
              -insurance value                             g. comes from time remaining on the option



     2. Decide if the option is in-, at- or out-of-the-money.
          a      call option at 95 when the asset is priced at 100
          a      put option at 100 when the asset is pliced at 95
          - put option at 65 when the asset is priced at 87
           a
          - call option at 105 when the asset is priced at 105
           a
          a        call option at 130 when the asset is priced at 120



     3. Decide whether the buyer would exercise the option or let it expire unused.
          a.   Owns a call option on XYZ with a strike of 103. The price of XYZ is 110.
                   -Exercise
                   -Expire

          b.       Owns a put option on ABC at 115. ABC is trading at 120.
                   -Exercise
                   -Expire
      4. Under normal circumstances, which option would cost more (that is, is worth more)?
 -
('
 .*      A,,
         a. a call option with a strike of 110, one year to maturity, little volatility in the price of the
            underlying asset.
         b. a call option with a strike of 110, one year to maturity, a lot of volatility in the price of the
            underlying asset.

         CorD
         c. a put option with a strike of 100, three months to maturity, stable prices in the underlying
            asset.
         d. a put option with a strike of 110, three months to maturity, stable prices in the underlying
             asset.

         E or F
         e. a call option with a strike of 105, three months to maturity, stable underlying asset.
         f. a call option with a strike of 105, six months to maturity, stnhle underlying asset.

      5. You sell a call option for $10. If the market moves against you (that is, the price of the
n        underlying asset increases), your loss is
         l i m i t e d to $10
         -unlimited

      6. You buy a put option for $50. If the market moves against you (that is, the price of the
          underlying rises), your loss is
          -   limited to $50
          -unlimited
               -
    Self-test Options: answers

    1. Match these items.
           -b-a       call option                           a. exercise option only on expiration date
           -d-a       put option                            b. right to buy
           -a-European         option                       C. amount option is in-the-money
           -e-American         option                       d. right to sell
           -c-intrinsic value                               e. option can be exercised any time
           __g-time      value                              f. comes from the volatility of the
                                                               underlying
           --insurance value
            f                                               g. comes from time remaining on the option



    2. Decide if the option is in-, at- or out-of-the-money.
         -in-a       call option at 95 when the asset is priced at 100
         -in-a  put option at 100 when the asset is priced at 9 5
         -out-a put option at 65 when the asset is priced at 87
         -at-a  call option at 105 when the asset is priced at 105
         -out-a call option at 130 when the asset is priced at 120



    3. Decide whether the buyer would exercise the option or let it expire unused.
I        a.   Owns a call option on XYZ with a strike of 103. The price of XYZ is 110.
                x-  Exercise
                   -Expire

          b.       Owns a put option on ABC at 115. ABC is trading at 120.
                   -Exercise
                   -x-Expire
      4. Under nomial circumstances, which optioll would cost more (that is, is worth more)?
 P       A or B
         a. a call option with a strike of 110, one year to maturity, little volatility in the price of the
            underlying asset.
         b. a call option with a strike of 110, one year to maturity, a lot of volatility in the price of the
             underlying asset.

         CorD
         c. a put option with a strike of 100, three months to maturity, stable prices in the underlying
            asset.
         d. a put option with a strike of 110, three months to maturity, stahle prices in the underlying
            asset.

         E or F
         e. a call option with a strike of 105, three months to matulity, stuhle underlying asset.
         f. a call option with a strike of 105, six months to maturity, stable underlying asset.

      5. You sell a call option for $10. If the market moves against you (that is, the price of the

'Y'      underlying asset increases), your loss is
         - to $10
          limited
         -x-unlimited

      6. You buy a put option for $50. If the market moves against you (that is, the price of the
         underlying rises), your loss is
          -x-limited    to $50
          -    unlimited
        Caps and Floors



        Caps and floors are options and, as such, can be thought of as an insurance policy. They can be
        used by corporates and banks to hedge their exposure to adverse movements in interest rates. A
        cap pays its owner if floating rates rise above a pre-specified level on the rate reset date during
        the cap's life. A floor, on the other hand, pays its owner if the floating rate is below the strike
        price on the rate reset date. And, just like an insurance policy, the holder of a cap or floor pays
        an upfront premium for the protection.
         For example, assume the buyer wants a two-year cap on 3-month Lihor set at 5.50%. On each 3-
        month rate reset date for the next two years, the buyer would compare 3-month Libor and the
        strike price. In those cases where Libor is above 5.50%. the buyer will pay the current rate and
        claim the difference between the current market rate and 5.50% from the writer of the option,
L       making its effective rate 5.50%. The cap writer would pay the huyer at the end of the reset
        period, coinciding with the date the buyer has to make its Libor interest rate payment. Interest
        rates on days other than the rate-setting days have no influence at a11 on the agreement.

        Market Characteristics
        Most markets provide liquidity out to ten years, although the market tends to trade the one-to-
        five year maturities most actively.

    0   Additional I~zformation

                                                                                          s
        A cap has intrinsic value when rates rise above the strike rate. Therefore, c ~ p have value when
        rates are high and prices are low. A floor has value when rates fall below the strike rate. Thus,
        floors have value when rates are low and prices are high.
        Clients could also use an interest rate swap or the futures market to protect themselves against
        adverse moves in interest rates. However, a swap or a futures conlract locks the client into a
        fixed rate whereas the cap and floor oCfer protection of a future fixed rate while still permitting
        the client to participate in advantagous moves.
        The cap and floor market is also open to lower-rated corporates whose credit standing would not
        permit them to entcr the swap market. In a swap both parties have credit exposure to each other,
                                                                      t
        so a bank which does a swap tllkes on the credit risk of t h ~counterparty for the life of the swap.
        However, when a hank sells a cap or a floor to a corporation seeking interest rate protection, the
        bank's credit risk is limited to the period between the agreement of the contract and the payment
        of the premium; it is the buyer who assumes the credit risk of the counterparty in a cap and floor
        transaction. (See CI-editRisk below.)
          Pricing
          TO price a cap, it helps to think of it as a series of individual options on interest rates on specific
    C;\   dates in the future. For example. a two-year cap which resets every three months can be viewed
          as eight separate options. If the yield curve is upward sloping, it is likely that the more distant
          options will be in the money in the future--that is, they will have intrinsic value. The price of a
          cap is based on its projected intrinsic value, its time to maturity and the volatility of the
          underlying interest rate market.

          Maturity
          Most markets provide liquidity out to ten years, although the market tends to trade the one-to-
          five year maturities most actively.

          Credit Risk
          The seller of an option--the cap or the tloor--is only exposed to the buyer for the premium for the
'
I         period between the conclusion of the agreement and the payment of the premium. Otherwise,
          the buyer assumes all the credit risk, since he is relying on the seller of the cap or floor to pay
          him should interest rates he above the strike in the case of a cap or below the strike in the case of
          a floor.



          Corporations involved in leveraged buyouts, restructurings and real esr;lte deals are active buyers
    0     of interest rate caps to hedge the11 interest rate exposures. Financial institutions actively trade
          them for their own account.
               -
      Self-test Caps and Floors

r;\   I. if a client wants to protect itself against m adverse move in rates hut still take advantage of r
         favorable move, the best instrument to use would be
         s w a p s
         a       cap or a floor
         futures

         Why?




      2. The bank can enter into a two-year swap receiving fixed, paying floating or a two-year cap.
         Which instrument has the greatest credit risk for the hank? Why'?
(?




      3. You have bought a tloor with a strike rate of 5%.
         a. If the rate on the rate reset date is 610,
             - floor will pay you the 100 hasis point difference
              the
             - earn 6% and the tloor remains inactive
              you

          b. If the rate on the rate reset date is 4.7510,
             - floor will pay you the 25 basis point difference
              the
             - earn 4.75% and the floor remains inactive
              you

          c. The rate jumps down to 4% for several days but comes hack to 5% on the rate reset date.
              - floor will compensate you for the 100 hasis point drop
               the
f'            - the rate is 5% on ratc reset date, nothing happens
               since
    -
Self test Caps and Floors: answers

1. If a client wants to protect itself against an adverse move in rates but still take advantage of a
   favorable move, the best instrument to use would be
   s w a p s
   -x-a  cap or a floor
   futures

   Why?

                                                                                  move, they
   Although the swap and thejiitures contract can protectyolr aguin.vt un orlver.~e
   lock yoit into a rate so you cannot take uclvcmtoge of u fuvorcible move.



2. The bank can enter into a two-year swap receiving fixed, paying floating or a two-year cap.
   Which instrument has the greatest credit risk for the bank? Why?

   A swap. Once the client has puid us the premium on the cap, the bunk hos no credit
   exposure to the client It is the client who hus exposure to ids: i f rures go rrbove the strike
   rate, the client is expecting the bunk to prry. On u swrrp, however, the bunk has credit
   exposure to the client for the life of the swap, since it is expecting r~.fixerl payment from
                                                                                  rure
   them every three months for two years. If they default, the bonk will hrrve to replace the
   swap. I f rates have droppetf, the default will be disadvantrrgeous to the bank.



3. You have bought a floor with a strike rate of 5%.
   a. If the rate on the rate reset date is 6%,
        - floor will pay you the 100 basis point difference
         the
         x
        - -you earn 6% and the floor remains inactive

   b. If the rate on the rate reset date is 4.75%).
      - - floor will pay you the 25 basis point difference
         x the
      y o u earn 4.75% and the floor remains inactive

   c. The rare jumps down to 4% for several days but comes back to 5% on the rate reset date.
      t h e floor will compensllte yyo for the 100 basis point drop
      -x-since    the rate is 5% on rate reset date, the floor remains i~lactive
Swaptions

Description
A swaption is the right, but not the obligation, to enter into an interest rate swap as either the
payer or the receiver on the fixed side of the swap. If the buyer wants the option to receive
tixed, he would exercise the option when Utes fall below the exercise rate. locking-in an above-
market rate. If the buyer of the option wants to pay tixed, he would exercise when rates rise
above the strike rate to lock-in a below-market cost of funds. A swaption, like an interest rate
swap and a cap and a floor, is used to manage interest rate risk. It allows a corporate treasurer or
fund manager to hedge a future interest rate exposure while still being able to take part in
beneficial rate moves.

Market Characteristics
Swaptions are available in most currencies where there is a liquid interest rate swap market. It
has been an actively-traded market in the major currencies for the last three years, with the US
dollar, Deutschemark and Sterling dominating in that order. Typically, swaptions have a
maturity of under one year and are written on swaps with a three- to ten-year maturity and with a
notional or face value of $50 to $100 million.

Additional I~zformation
Since interest rate swaps and caps and tloors--like swaptions-are tools to manage interest rate
risk, one should compare the pros and cons of each instrument. Although a forward-starting
interest rate swap would also hedge a future interest rate exposure, it would lock in the future
rate and not allow the holder to take part in a beneficial change in rates. Although caps and
floors would allow their holders to panicipate in a beneticial change in rates while also providing
protection, both are more expensive than a swaption. Furthermore, caps and tloors are options
on short-term rates--usually three- or six-month Libor; a swaption is an option on longer term
rates: a swaption on a four-year swap is an option on four-year rates and so on.
The terminology used to describe swaptions tells you the length of the exercise period and the
tern of the underlying swap. The option to enter into a four year swap two years from now
would be called a "two into four" swaption. The following is a situation in which someone
would be interested in such.a swaption. Assume a corporate tredsurer needs to borrow money
for six years. Since floating rates are currently below fixed rates, she would like to Vake
advantage of these rates. However, she fears rates will rise in the next two years, so she would
like to fix the payments at a rate agreed upon now in a lower rate environment. Since she is not
sure that rates will rise, she does not want to lock herself into a future tixed ra~c.Therefore, she
would buy a swaption which expires in two years hence that would allow hcr to enter into a four
year swap. If, at the end of two years, rates are lower than the fixed rJte agreed upon in the
swaption, she would let it expire unused. If she had entered a forward-starting swap, she would
be obligated to pay the agreed-upon rate even if it were higher than the then-prevailing four-year
rate. A swaption allows her the freedom to choose whether or not to enter into the swap.
i
i        Pricing
'
         Like any option, the price of a swaption depends on the price of the underlying (the current and
    -I
    (    forward swap rates), the strike price, the maturity, the cost of funding the option and volatility.
         The only unknown is the volatility of the underlying interest nl~tes.
t

         Maturity
         Typically, swaptions have a maturity of under one y e x and are written on swaps with a three- to
         ten-year maturity and with a notional or face v ~ l u e $50 to $100 million.
                                                               of

         Credit Risk
         In an option product. the buyer of the option is exposed to.the credit worthiness of the seller for
         the life of the option whereas the seller is exposed to the buyer only until receipt of the premium.
         If a client buys an option from us, it is exposed to MGT for the life of the option; MGT, on the
         other hand, should only be exposed to the client for a few days--the time between when the
         contract is negotiated and the receipt of the premium.

         Investors
         Buyers include dealers who buy them and protit from the spread and investors and corporates
         who buy them to protect themselves against adverse moves in the underlying security.
1        Self test: Swaptions



            a. an option to cap an interest rate
            b. an option on a swap
            c. an option to put a floor under an interest rate

         2. A (forward-starting swap/ swaption) allows you to set a future rate today.

         3. A (forward starting swaplswaption) allows you to set a future rate today hut also allows you
            to take advantage of a beneficial change in rates.

                                                                 or
         4. Which of these instruments locks-in a future bol~owing lending rate'?
            -Swap
            -    Futures
            -    FRA
            -cap
            -floor
            -swaption
ip,
1'
     L
     1
         5. Which of these instruments allows you to protect yourself against adverse moves in future
            interest rates hut lets you keep the right to benefit from favorable moves'!
            -Swap
            -Futures
            -FRA
            -cap
            -floor
            -swaption
b
I
                  -
         Self-test Swaptions: answers


     -
    r\   I. A swaption is
            a. an option to cap anjnterest rate
            b. an option on a swap
            c. an option to put a floor under an interest rate

         2. A (forward starting swap1 swaption) allows you to set a future rate today.
            Note.: both are correct. Both let you set a rute: the swup obligates you to pay or receive the
            agreed-upon rate whereassthe swaption lets you choose whether or not to exercise the option
            andpay the agreed-upon rate or to go directly to the market--whichever is better.

         3. A (forward starting swaplswaption) allows you to set a future rate today but also allows you
            to take advantage of a beneficial change in rates.

         4. Which of these instruments locks-in a future h o ~ ~ o w i n g lending rate'?
                                                                       or
            -x-Swap
            -x-Futures

    L
             -floor
             -swaption
             Because each of these instrumerzts represents a contruct, yorr Lrre obliguted to pay or receive
             the contracted rute even if the actl~ul       rate
                                                   m~rrket would be to your udvant~~ge.

             Which of these instruments allows you to protect yourself against adverse moves in future
             interest rates but lets you keep the right to henefit from favorable moves'!
             -Swap
             -Futures
             -FRA
             -x-cap
             -x-floor
             -x-swaption
             These instruments will glrtrrcmtee yo11 a pre-agreed upon rute ifyo11chose to exercise the
             option. If; however, markets rates are in yolrr fuvor, yorr worrld let the option expire
             unexercisecl.
             Team Skills

             When any group is working on                         CONTENT
             task, there are two levels that can be               WHAT the group is working on
             seen: WHAT is being worked on, and
             HOW the group is going about work-                   PROCESS
             ing the process.                                     HOW the group is going about
                                                                  working on the task




                                                      Process



             Task Behaviors
                                              +            Interpersonal Behaviors
                                                                                  +
             Behaviors that focus on getting the           Behaviors that focus on attending to
             work of the group accomplished.               the needs of the group and individuals.
               settinglclarifying goals                         encouraging full participation
               defining and using problem-solving               establishing a friendly atmosphere
               methods                                          supportinglencouraging others
               defining and using decision-making               working to understand/clarify the
               models                                           viewpoints of others*
               establishing agendas*                            dealing with problematic behaviors
               checking for agreement*                          eliciting, giving and receiving feedback
             $ checking for understanding*                      managing conflict
               offering ideas/informatiodopinions               managing differences
               seeking ideas/information/opinions*               - opinions - culture
               establishing clear roles and                      - values         - gender
               responsibilities for members                     establishing norms, guidelines,
               pulling together/surnmarizing what has           standards*
               been covered                                     assessing and adjusting interpersonal
             * assessing progresstoward a goal                  processes .
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                                              Confidential
August 9,1995
Government Institutions




Government-Sponsored Enterprises
Client Relationship Management Presentation
Agenda


  Introduction

 Client Strategy
 - Rationale
 - Progress Report
  Casestudy

  Questions and Answers




                          Page 'I'
J.P. Morgan's GSE team
                                 Capital Markets                     IDM                             Sales
 -   Mark Wemer                                                      - Bill Demchak                  - Mark Sheridan
 -   Laurence Eng                    Melissa Babb                    - Richard Leibovitch            - John Stathis
 -   Harold Conte                                                    - Steven Koury                  - Lori Blake
 -   Edward McMahon              Central Banks                       - NickMorgan                    - Linda Gansman
                                 - Roberta Puschel                   - Balan Nair                    - Kathy Hay
 Corporate Trading Desk          - Margaret Campbell                 - Nick Stratopoulos             - Jackie Logan
 -Jim Curcio                                                                                         - Susan McGuire
                                 Credit                                                              - Nancy Wilson
                                 - Andrew Brown                                                      - Rudy Bruno
                                 - James Dwyer                                                       - Ann Case
                             I
                                 - Vicki Mace                    I                               I
                                                                                                     - Pattv Hand
 Legal and Compliance            Mortgages                           Research                        Structured Finance
 -Marc Baum                                                          - Jean-Louis Bravard            - Peggy Wallace
 -Travis Epes                    Residential                         - Nanette Abuhoff
 -John Rioux                     - Steve Sinacore                    - Paul Frean                    Swaps Marketing
                                 - Brad Craighead                    - John Paulsen                  - Rob Rossman
 Portfolio Advisory              - Rob Printz                        - Melissa Toth                  - Reuben Daniels
 - Art Djang                     - Ed Mikus                          - Leslie Winick                 - Jon Carmel
                                 Commercial
                                 - Michael Jungman
                                 - Jackie Brady




I
 Syndicate Desk                  Transaction Execution               FI & CM Management              Government Institutions
 - Bob Hugin                     - Maria Sramek                      - Peter H a n m k               - Tim Ryan
 - John Massad                   - Karen Giles                       - Tom Kalaris                   - Carly Chock
 - Myles Derieg                                                      - Maureen Hendricks             - Winthrop Watson
                                                                                                     - Katheryn Rosen
                                                                                                     - Courtney Ward
                      -
 International Team London                           -
                                 International Team Brussels                             -
                                                                     International Team Paris        International Team -Asia
  - Steve Heard                  - Pieter van Rosenburg              - Pierre Mirat                  - Martin Matsui
  - Paul Heam                                                                                        - Don Amstad
  - Adrian Carr                  International Team- Frankfurt                           -
                                                                     International Team Zurich       - Susumu Sezaki
  - Michael Lindsey              - Peter Schwicht                    - Peter Zuppinger               - Ted Takeda
I - Steve Parker             I                                   I                               I                              I
I                            I                                   I                               I                              I
                                                                                                                                Page 2
How J.P. Morgan benefits from strong
GSE relationships


  lmproved profitability from derivatives, "lay-up" funding programs, and
  asset sales

  Prestige of Global Bond issuance

  Inside look at new derivative and mortgage structures

  Improved league table position / 6 J@mc\&

  Recognition as dominant player in global fixed income business




                                                                            Page 3
GSE client plan overview
Government Institutions Defined a Series of Goals

   Become top 6 six dealer in terms of funding for each GSE
   - Set funding goals and build firm-wide consensus
   Attain leadership position in derivatives at each GSE

   Offer total customer service and broad range of product offerings

   Organize internal relationships

   Leverage existing J.P. Morgan strengths
   -  Reputation, international relationships/distribution, and derivatives




                                                                              Page 4
How Investment Banking assists efforts


  Provide firm-wide focus
  - Senior management attention when appropriate
  -  Research coverage

  Offer access to client representatives
  - One-on-one meetings or conference calls
  - Educational materials for investors
  - Special events
  Coordination of different product areas within firm
  -  (i.e., Capital Markets, Syndicate, Research, Credit, Swaps)
Example of multi-desk opportunities for
Government Institutions business

                                  -

         J.P. Morgan sells                                       Fannie MaelFreddie Mac
       Fannie MaelFreddie Mac                            rn    purchases whole loan or MBS
          mortgage product




                                                                                J.P. Morgan helps
                                                                                  to fund portfolio




                                                                            1
       Fannie MaelFreddie Mac                                  Fannie MaelFreddie Mac issues
      hedges mortgage portfolio
                                  4                             debt to fund mortgage portfolio
                                         J.P. Morgan sells
                                      Fannie MaelFreddie Mac
                                          hedging product




                                                                                                      Page 6
           J.P. Morgan has made progress at nearly every GSE
           GSE Debt Rankings by Concession

                J.P. Morgan's goal was to be in the Top 6 dealers for each GSE

                At mid-year, J.P. Morgan's dealer status is as follows:

                                    FFCB                       FHLB FHLMC                               FNMA                      SLMA

 Discount Notes                        #4                        NIA               #3                      #3*                        #4


 Term Funding                #4 - MTNs                            #2            Low**             Top 4 - SG                    Very Low
                          #22 - Other Issues                                                    #5-#I 0 - MTNs
                             #5 - Overall

 Swaps                                 NIA                     Top 3               #1                   Top 6                      Top 6
           Source: FFCB, FHLB, FHLMC, FNMA, SLMA, and Government Institutions estimates;
                   'Fannie Mae Discount Note ranking is for Overnight Discount Note Program only
                   "Freddie Mac views funding 1 year and in as part of short term program; J.P. Morgan has underwritten few longer term issues
JPMorgan
 :,
Several notable achievements are worth mentioning


  Lead managed 3 out of 6 Global Bonds issued by GSEs
  - Included on all but one Global Bond issued during Q1 and Q2
  Execute first mortgage portfolio hedges with Farm Credit District Bank

  Discount Notes
  -   Accepted into Fannie Mae Overnight Discount Note group
  -   Nominated as bookrunner for Freddie Mac Overnight Discount group
  -   Awaiting entrance into FHLB discount note program

  Achieved solid position as Freddie Mac's main swap counterparty

  Attained substantial increase in asset sales volume
           GSE Team should look forward to key opportunities
           in the last half of 1995


             FFCB
             - First Global Bond
             - Issuing and Paying Agent nomination
             -  Strategic advisory assignment for AgAmerica
             -  Additional portfolio hedges for Farm Credit District Banks

             FHLB
             -  Two Global Bonds
             -  Non-$ Global Bond
             -  Now$ Arbitrage Transactions
             -  Full membership in domestic discount note group

             FHLMC
             -  Two Global Bonds
             - Non-$ Global Bond
JPMorgan     -  Increased mortgage portfolio sales
GSE Team should look forward to key opportunities
in the last half of 1995, Cont'd.


  FNMA
  - Two to Four Global Bonds
  - Now$ Global Bond
  - Non-$ Arbitrage Transactions
  - Increased mortgage portfolio sales
  - Complete multifamily program

  SLMA
  -  Global T-Bill floater
  -  Increased underwriting participation
                                                                                '.

Case Study: Global bond issue


  Background
  -  J.P. Morgan has suggested to each GSE that we would like to lead
     manage a US$ Global Bond for them
  -  Each GSE, except for Fannie Mae, Sallie Mae and the Farm Credit
     Banks, has said that they have chosen other investment banks to
     lead their debut issue
          Fannie Mae is not sure about doing a Global Bond
          Farm Credit does not have the funding needs to drive a Global
          Bond issue
          Sallie Mae name has several credit issues associated with it and
          does not need fixed rate funding

  Situation
  - Freddie Mac's Treasurer has just called to say that J.P. Morgan was
      not selected, and that they will launch their debut issue in four weeks

				
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