associatetitleagency.thecountrybankofneedham.com

Deck

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for one day, two business days hence. There can be signific changes in this differential on a day-to-day basis.

2. The daily swaps will be based off the current spot rate. As the spot rate moves, there will be working capital adjustments that can affec the profitability of the position. This spot risk can, however, he hedged through the establishment of spot positions.
3. The distortions in cashflow due to the differing rates used on the daily spot-next swaps make it hard from a cashflow standpoint to determine if a profit or loss is being made on the position. As a result, daily mark-to-market profit and loss calculations must be done.
4. As previously mentioned, the forward dealer could roll the cash position by using longer-dated swaps, such as one week or one month. If a one-week swap was at 35 points discount, for instance, the numbers would suggest to go that route. Daily swaps would only generate a discount of 28 points (7 days x 4 points per day).

Dealing Offsetting Forward Contracts. The second way of managing the forward position is, of course, for the dealer to deal an offsetting forward immediately, and try to make money basis the bid-and-offer spread. With a swap in which the three months are bought at 310 points discount, the cash flows and profit are 1000 DEM, as shown in Exhibit 10.10.

The dealer originally sold the USD at 300 points discount and subsequently bought them at 310 discount.
In this situation, the daily profit and loss statement will show that the dealer made 10 points, or 1000 DEM. The dealer, however, does not Exhibit 10.10. Deal Offsetting 90-Day Swap and Make Bid-and-Offer Spread
Swap
Value
no.
Swap side
date
Rate
USD, DEM, bought/(sold) bought/(sold)
1-b Buy Spot

2-s Sell Spot

1.7950 1,000,000 (1,000,000)
(1,800,000) 1,795,000
Net 0
(5,000)
1-s 35 Sell
3 months 1.7700 2-b
(1,000,000) 1,770,000
Buy 3 months 1.7640
1,000,000 (1,764,000)
Net 0 *6,000 Net Profit 0 1,000

How Price Makers Trade the Markets

Exhibit 10.8.

Rolling Cash Position One Day Using a Spot-Next Swap
Swap No.

Swap side

Value date

Rate USD, DEM, bought/(sold) bought/(sold)

1-b Buy 2-s Sell
Spot Spot
1.8000 1.8000
1,000,000 (1,000,000)
(1,800,000) 1,800,000
Net
0 2-b Buy

Spot +1 1.7996 1,000,000 (1,799,600)
natively, it can be rolled forward for a week or even a month at a time, if the dealer so chooses. Using a daily roll, the swap would consist of a spot sale of USD (2-s) at 1.8000 DEM/USD and a spot-next purchase of USD (2-b) at 1.7996. The results are shown in Exhibit 10.8.

In doing this swap of selling spot and buying the day after spot, the dealer has rolled the 1 million long USD cash position from spot value to one day beyond spot.

However, the dealer is long USD at a lower rate of 1.7996, which amounts to a gain of 4 points (.0004). If this daily roll was done for the 90-day period until the maturity date was reached on the forward sale contract, the long USD position would have an effective rate of 1.7640.

Original rate
Less: Gains on daily rolls (90 x .0004)
Effective rate on long USD position
1.8000 .0360 1.7640As shown in Exhibit 10.9, when the final purchase ticket with an effective rate of 1.7640 that is generated with these daily swaps settles against the original three-month sale at 1.7700, a 6000 DEM profit will have been made.

In looking at the example, a few points should be noted.

1. The daily rolls are not likely the 4 points every day. The interest differentials applicable to this spot text swap are the interest rates.

Exhibit 10.9.

Rolling Cash Position 90 Days Using a Spot-Next Swap USD, DEM, bought/(sold) bought/(sold)

Swap No.

Swap side

Value date

Rate 90-b Buy

1-s Sell

3 months 1.7640 3 months 1.7700
1,000,000 (1,000,000) (1,764,000) 1,770,000 Net

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Exhibit 10.5. Calculating Spot Profit and Loss Based on a Closing Rate of 2.0100 Day
Transaction DEM amount Rate
USD amount 1
Bought USD (2,000,000) 2.0000
Sold USD 1,990,000 1.9900

Bought USD 1,000,000 (1,000,000)
(1,000,000) 2.0000 500,000
Revaluation 1,005,000 2.0100

Net (5,000) (500,000) rates, and a profit and loss analysis is done on the basis of what would have resulted had the position been liquidated at the closing rates.

Assume the closing rate was 2.0100 DEM/USD. The profit and loss would be a loss of 5000 DEM, as outlined in Exhibit 10.5.

Given a closing rate of 2.0100 DEM/USD, the trader lost 5000 DEM. However, it must be recognized that the revaluation does not change the actual position of the trader, which is long 500,000 USD.

The revaluation simply serves to determine the trader’s profit and loss up to that point. Based on that revaluation rate, the trader lost money on the day.

The rate chosen for the revaluation is significant in that differing rates will generate different profit and loss results. For example, a closing rate of 2.0200 would show the trader breaking even. However, it must be remembered that the rate at which a position is revalued at the end of one day is also the rate at which the trader’s position is valued at the start of the next day’s trading.

A revaluation at 2.0100 is less favorable than a rate of 2.0200 for the trader from the standpoint of today’s profit and loss (P&L).

However, it is equally more favorable when the next day’s results are determined. To prevent games from being played, revaluation of daily P&Ls should be done using a consistent source of rates. While traders can have input into the revaluation rate, they should not be able to unilaterally set the rate.

One risk of allowing traders to set their own revaluation rates is that they could artificially hide losses for an extended period of time. In addition, if a trader in a major loss position tries to get out of it without anybody knowing, the losses usually seem to increase, instead of decrease. An objective and consistent revaluation system is thus warranted. Industry practice is usually to obtain the revaluation rates at the same time of day every day from the same sources, whether they be the closing rates from selected Reuters pages, selected broker(s), other banks, or the central bank.

A further dimension of the spot trader’s P&L concerns the overnight position. In the above case, the trader went home on day 1 long 500,000

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