Money – A philosophical view

What is money or cash?
A philosophical view

We all know (at least these days) money as cash as legal tender (notes and coins) or as bank balances, credit limit on a card, digital currency (that is equivalent of money) or anything that stores value.

Typically money is liquid and fungible (1000 in your wallet is the same as the 1000 in my wallet, even if they are different serial number notes)

so how does one receive or pay money, in any form?
Cash – we hand over or receive the notes
Cheque – we instruct our bank to pay someone else or deposit a cheque drawn on us
Bank transfer – we authorize the bank to make a transfer
Credit cards – we are authorized by the issuer and hence entitled to pay for a purchase as we have been given authority up to a certain limit

The key point is money is nothing but the power of instruction over a store of value and is used to convert one store of value by using that instruction to purchase another store of value such as an asset (gold, property, stock, bonds, art, vehicles, etc.)

Theoretically if we want money the easy way is we instruct our bank to increase our balance! Unfortunately the bank will not accept our instruction 🙂

That is the key – money gives one the power to instruct. Cash notes are nothing but bearer cheques with the instruction provided by the central bank (e.g. RBI, Fed Reserve, Treasury, etc.)

Keeping this concept in mind, we can understand any currency, digital or bank based.

So e-wallets give one the power to instruct (for a transfer) after one has generated a balance by transferring from a bank or thru a credit card, etc.
E-wallets themselves may actually store the value in a bank !

The power to instruct comes from a bank (or the central bank), the wallet or the credit card issuer.

So all of us work to get more power to instruct !! 🙂

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Cashflows and Liquidity Management

Cash flows and Liquidity management – Securities Products

Each security has by its structure a set of associated cashflows. Most common products are cash securities.

Cash Securities

These typically have a set of cashflows that are created during the product life cycle. Some examples are:

  • Foreign Exchange (FX) – where there is a promise to exchange foreign currency cashflows
  • Fixed Income / Bonds  – the issuance of a bond and receiving cash, payment of periodical cashflows (coupon interest) and the repayment of the bond at maturity (just like a loan)
  • Equities – Issuance of equities by subscription and payment of cash and then the optional distribution of dividends. In case of buyback, payment of cash. Buy/Sale of equities result in cashflows (net of commissions, fees, exchange taxes, brokerage, etc.)
  • Loans – Lending / borrowing of a principal amount and payment of periodical interest and finally the repayment of the loan amount

Derivatives

Cashflows in derivative contracts are determined by the specific type and the underlying assets and are linked to events. There is a difference in the nature of  Exchange Traded and OTC derivatives.

  • Forward Rate Agreemnet (FRA) –  usually the cashflow will be settled based on the difference between the fixed rate and the floating rate that is determined on the specified date.
  • Futures – cashflows in exchange traded futures are typically the posting of initial margin and then the daily variation margin (based on mark-to-market MTM). Closing of the contract will also result in the cashflow in or out.
  • Options – The main cashflows are the premium cashflows at the start of the contract. On exercise there can be a cashflow, if cash settled, for the difference between strike price and market price
  • Swaps – fixed cashflows and floating cashflows (which are determined when the rates are fixed for each period). Swaps are derivatives and hence the notional face values do not result in cashflows. However, there could be collateral cashflows

What this means is that for every trade or contract the bank enters into, it can generate the future projected cashflows for the securitiy or contract – hence projected cashflows.

Let take a look at a few examples related to Cash Securities

Example

  1. Bonds

A bond is a borrowing and is a promise to repay it at maturity. In a simple bond, the interest payments are paid regularly (e.g. Six montly payments).

So once there is a bond contract, the projected cashflows are the remaining coupon interest cashflows (interest rate X principal amount) and the maturity amount cashflows (principal amount).

So at given time, all the open bond contract have associated future cashflows and all these can be stored and can be aggregated. The dates of these cashflows are know and hence can be aggregated by dates and currency.
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  1. Fx Spot

An FX spot contract is a contract for the exchange of two foreign currency cashflows at settlement date. A spot contract settles in T+2 days (trade date + 2 business days)

Lets have the bank enter into a spot contract to buy USD vs GBP.  Let say the spot rate is 1.41. The bank will receive 1.41 USD and deliver 1 GBP. If the total contract is for 1 million GBP, then on T+2 the bank will receive  $1.41 million and delivery GBP 1 million

The projected cashflows will then be

T+2

+1,410,000 USD

– 1,000,000 GBP

These entries are the actual  cashflows that will happen in the future. In this case in T+2 days

These cashflows are usually stored in a cashflow database.

All Fx spot contracts done on T will all be generating projected cashflows and the cashflow database can provide a collective view of all the cashflows that are to be paid / received on T+2 after netting.

 

MCX (Multi-commodity exchange of India) – A snapshot

The Multi Commodity Exchange of India Limited (MCX), is a commodity derivatives exchange that facilitates online trading, and clearing and settlement of commodity futures transactions. The Exchange, which started operations in November 2003. It is listed on the BSE. Currently with a market capitalization of ~Rs 5448 crores.

Most active products are

  • Crude oil
  • Zinc
  • Silver
  • Copper
  • Natural Gas
  • Lead
  • Crude Palm Oil
  • Cotton

Key commodities futures product are as below. Options on these are expected to be introduced soon.mcx products

 

Options on Commodities Futures

Sebi has allowed Derivative Exchanges to allow Options on Commodity Futures as per a circular on their website (13 June 2017).  See link  Sebi circular

In India there are four exchanges were commodity derivatives are traded.

Most contracts are futures (or forwards but since on exchange are futures 🙂 ).

Sebi now allows Options on the futures contracts. This allows for hedging. Also speculation.

Basic criteria is that the futures should have been in the top 5 in trading value over the past 12 months. Basically only liquid futures contracts are eligible.

There is also average daily turnover criteria for the futures over the past 12 months (agricultural Rs 200 crore, other 1000 crore)

Key features

European style exercise

Settlement will be to take the underlying long or short position.

Example

Long call will result in a long position in the future; Long put will result in short position in the future

Short call will result in a short position in the future; Short put will result in the a long position in the future

Position limits for options are separate from futures limits. Margining will be separate.

Due to exercise, the position limits of futures maybe breached. Two working days are allowed to bring these under the limit threshold levels

More on this.

India 10 year Govt bond yields

Bond yields in India

What this graph shows the interest yield on the 10 year Indian Government bond over the past 5 years. We can clear see that yields, after a bottom near 2013 of about 7.3%, have now (~2017) come to a value of 6.5% after hitting highs of 9%. This means that overall interest rates are down and is because of significant lower rate of inflation

india govt bond 10 y