Explain Puts and Calls in relation to Option Contract

 

In the context of options contracts, puts and calls refer to two different types of options that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a predetermined period.

1.        Put Option: A put option is a contract that gives the holder the right to sell the underlying asset at a predetermined price (known as the strike price) on or before a specified date (Known as the expiration date). Put options are typically used by traders who anticipate a decline in the price of the underlying asset. If the rice of the asset falls below the strike price, the put option becomes valuable, allowing the holder to sell the asset at a higher price. If the price remains above the strike price, the put option may expire worthless, and the holder would not exercise the option.

2.        Call Option: A call option, on the other hand, is a contract that gives the holder the right to buy the underlying asset at a predetermined price (strike price) on or before the expiration date. Call options are usually used by traders who anticipate an increase in the price of the underlying asset. If the price of the asset rises above the strike price, the call option becomes valuable, enabling the holder to buy the asset at a lower price. If the price remains below the strike price, the call option may expire worthless, and the holder would not exercise the option.

Both put and call options have several important components:

Strike Price: The price at which the underlying asset can be bought or sold if the option is exercised.

Expiration date: The date at which the option contract expires and becomes invalid.

Premium: The price paid by the option buyer to the option seller for the right to buy or sell the asset. It represents the cost of the option contract.

Option Buyer (Holder):  The individual or entity that purchases the option and holds the right to exercise it.

Option Seller (Writer): The individual or entity that sells the option and is obligated to fulfill the terms of the contract if the option buyer decides to exercise it.

Options, including puts and calls, are widely used in financial markets for various purposes including speculation, hedging and risk management. Traders and investors analyze market conditions and use these options strategically to potentially profit from price movements or protect their existing positions.

CAMELS Rating

 CAMELS Rating: CAMELS is a recognized international rating system that bank supervisory authorities use in order to rate financial institutions according to six factors represented by its acronym.

Supervisory authorities assign each bank a score on a scale. A rating of one is considered the best and a rating of five is considered the worst for each factor.

The CAMELS rating system assesses the strength of a bank through six categories. The six components of CAMELS are:

• C—Capital adequacy

• A—Asset quality

• M—Management

• E—Earnings

• L—Liquidity

• S—Sensitivity to market risk

The CAMELS rating system is no doubt an essential tool for the identification of the financial strength and weakness of a bank by evaluation of the overall financial situation of the bank for any corrective actions to be taken.

Asset Liability Management (ALM)

 Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. It refers to using assets and cash flows to lower the firm’s risk of loss due to not paying a liability on time. Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting assets.

Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (Fixed or floating) and lend long term. Well-managed assets and liabilities can help you grow one’s business profits. This process is used to determine the risk on bank loan portfolios and pension plans. It also includes the economic value of equity.

Asset/Liability management is a long-term strategy to manage risk:

·        Asset/Liability management reduces the risk that a company may not meet its obligations in the future.

·    He success of bank loan portfolios and pension plans depends on asset/liability management processes.

·        Bank track the difference between the interest paid on deposits and interest earned on loans to ensure that they can pay interest on deposits and to determine what a rate of interest to charge on loans.

A comprehensive ALM policy framework focuses on bank profitability and long-term viability by targeting the net interest margin (NIM) ratio and Net Economic Value (NEV), subject to balance sheet constraints. Significant among these constraints are maintaining credit quality, meeting liquidity needs and obtaining sufficient capital.

Factoring

 

Factoring is a financial arrangement where a business sells its accounts receivable (invoices) to a factor at a discounted rate in exchange for immediate cash. The factor takes on the responsibility of collecting payments from the debtor (customer) and assumes the credit risk associated with the accounts receivable.

Features of Factoring:

1.     Cash flow Improvement: Factoring provides businesses with immediate cash by converting their accounts receivables into cash. Rather than waiting for customers to make payments, businesses receive a portion of the invoice value upfront from factor allowing them to meet their immediate financial needs.

2.     Credit Risk Transfer: By engaging in factoring, business transfers the credit risk associated with their accounts receivable to the factor. The factory assumes the responsibility of collecting payments from the customers, mitigating the reis of bad debts and non-payment to the business.

3.     Creditworthiness Focus: Factors assess the creditworthiness of the customers rather than the business itself. This is particularly beneficial for small and medium-sized businesses enterprises that may have limited credit history or face challenges in obtaining traditional financing. Factoring provides access to financing based on the creditworthiness of the customers.

4.     Accounts Receivable Management: Factors take on the task of managing and collecting payments from the customers. They have the expertise and resources to efficiently handle the collection process, which can save business time and effort. Factors typically provide services such as credit checking, invoicing and collections, relieving the business from these administrative tasks.

5.     Non-Recourse and Recourse Factoring: Factoring can be structured as non-recourse or recourse. In non-recourse factoring, the factor assumes the credit risk of non-payment by the customer and if the customer fails to pay, the loss is borne by the factor. In recourse factoring, the business retains the credit risk, and if the customer does not pay, the business is responsible for repurchasing the invoices from the factor.

Factoring is a flexible solution that can be tailored to the specific needs of business. It provides immediate cash flow, risk mitigation, and efficient accounts receivable management, allowing businesses to focus on their core operations and growth.

Statutory Reserve Requirement (SRR)

 Statutory Reserve Requirement (SRR) is a regulatory tool used by central banks to control and manage the liquidity and stability of the banking sector within a country. It refers to the portion of customer deposits that banks are required to hold as reserves in the form of cash or deposits with the central bank. The SRR is typically expressed as a percentage of the total deposit liabilities of the banks.

The key objectives of implementing a statutory reserve requirement are as follows:

1.     Monetary policy Control: The SRR enables central banks to influence the money supply in the economy. By adjusting the reserve requirement ratio, the central bank can increase or decrease the amount of funds available for lending and control the pace of credit expansion. A higher reserve requirement reduces the amount of funds that a bank can lend, thereby curbing excess liquidity and potential inflationary pressures. Conversely, a lower reserve requirement stimulates lending and encourages growth.

2.     Liquidity Management:  The SRR helps regulate the liquidity position of banks. By mandating that banks hold a certain portion of their deposits as reserves, the central bank ensures that banks maintain adequate liquidity buffers to meet depositor withdrawals and other obligations. This requirement safeguards the stability and solvency of the banking system and protects depositors’ interests.

3.     Controlling Excessive Credit Expansion: Setting a statutory reserve requirement acts as a prudential measure to limit excessive credit creation by banks. By imposing a reserve requirement, the central bank aims to prevent banks from lending beyond their capacity thereby mitigating the risk of excessive credit growth, asset bubbles and financial instability.

4.     Facilitating Monetary Transmission:  The SRR facilitates the smooth transmission of monetary policy decisions. When the central bank adjusts interest rates or undertakes other monetary policy measures, changes in the reserve requirement ratio help amplify or moderate the impact of these policy actions on bank lending and the broader economy. By influencing the cost and availability of funds for the banks, the SRR complements other monetary policy tools and enhances their effectiveness.

5.     Financial System Stability: Maintaining an adequate reserve requirement enhances the stability of the banking system. It ensures that banks have a sufficient cushion of liquid assets to weather potential liquidity shocks, manage deposit outflows, and meet their payment obligations. By promoting prudent liquidity management, the SRR contributes to the overall stability and resilience of the financial system.

Banks are typically required to comply with the reserve requirement on an ongoing basis, and failure to meet the requirement may result in penalties or other regulatory actions.

What are the Off-Balance Sheet Activities? Discuss them

 Off-balance Sheet (OBS) activities refer to financial transactions and arrangements that are not recorded on a company’s balance sheet but can still have a significant impact on its financial position, risk profile, and overall performance. These activities are typically contingent liabilities or contractual obligations that have the potential to affect the company’s future cash flows or financial obligations. Here are some common examples of off-balance sheet activities:

1.     Loan Commitments: Banks and financial institutions often issue loan commitments to provide credit facilities to customers in the future. These commitments represent potential loan disbursements that are not immediately recorded on the balance sheet.

2. Letters of Credit: Letters of credit are commonly used in international trade transactions. They are guarantees issued by banks on behalf of their customers to ensure payment to the seller upon meeting certain conditions. The bank’s obligation to make payment is contingent upon the fulfillment of the term and conditions outlined in the letter of credit. Although not recorded on the balance sheet, letters of credit represent potential liabilities for the issuing bank.

3.     Operating Lease: Companies often enter into operating lease agreements for various assets sch as buildings, equipment, or vehicles. Under operating leases, the lessee does not record the leased assets or the associated liability on the balance sheet. Instead, lease payments are expensed over the lease term. However, these lease obligations can have significant financial implications, particularly if they are long term and involve substantial commitments.

4.     Derivatives: Derivatives instruments, such as futures, options and swaps are financial contracts that derive their value from an underlying asset or benchmark. While the actual derivatives may not be recorded on the balance sheet, they can have a substantial impact on a company’s risk profile, cash flows, and financial performance. Derivatives are typically used for hedging purposes, but they can also be employed for speculative or investment purposes.

5.     Contingent Liabilities: Contingent liabilities arise from potential future obligations that depend on the occurrence or non-occurrence of specific events. Examples include legal claims, warranties, guarantees, and pending litigation. Although contingent liabilities are not initially recognized on the balance sheet, they can have a material impact on a company’s financial position if the contingent event occurs.

It is important to note that off-balance sheet activities can introduce additional risk and complexities to a company’s financial position and should be carefully monitored and managed. Regulatory authorities and accounting standards require disclosure of significant off-balance sheet activities to ensure transparency and provide stakeholders with a comprehensive view of a company’s financial 

Describes about Automated Clearing House

 Bangladesh Automated Clearing House (BACH), the new automated cheque processing system, will be responsible for the processing of cheque, credit and debit payment instruments. The BACH will affect the installation of systems and processes that support modern automated cheque processing utilizing Magnetic Ink Character Recognition (MICR) and Imaging Technologies.

The BACH component of the Remittance and payment partnership (RPP) project is managed and implemented in a fast-track manner, as it is expected to be the engine that will drive the remittance and payments process in promoting pro-poor economic growth. It establishes the infrastructure for a modern payments system, which could be part of a future e-Government Gateway to provide services to financial sector using the Internet.

 

BACH represents the overall system and facility that supports the exchange and settlement of payment items between participating Banks and the Bangladesh Bank

Describes about Banker’s acceptance

 A Banker’s acceptance is a financial instrument that is widely used in international trade and financial transactions. It is essentially a time draft or a short-term credit instrument that is guaranteed by a bank. Banker’s Acceptances are commonly used to facilitate commercial transactions, provide financing and serve as a form of payment or credit enhancement.

Here are some key features and characteristics of Banker’s Acceptance:

1.     Creation: Banker’s Acceptance is typically created when a buyer and a seller engage in a trade transaction, such as the sale of goods or services. The seller draws a draft or a bill of exchange, which is a written order directing the buyer to pay a specified amount on a future date. The draft is then accepted by a bank, meaning the bank guarantees the payment.

2.      Maturity: Banker’s Acceptance has a specific maturity date, which is the date on which the bank is obligated to pay the face value of the acceptance to the holder. The maturity period is typically short-term, usually ranging from 30 to 80 days, although it can vary depending on the terms of the specific acceptance.

3.     Trading and Liquidity: Banker’s Acceptance is actively traded in the secondary market, providing liquidity to investors and allowing them to manage their short-term cash flow needs. The secondary market trading of Banker’s Acceptance allows investors to buy and sell these instruments before their maturity, providing flexibility and access to funds.

4.     Risk and creditworthiness: Banker’s Acceptance carries some level of risk, primarily related to the creditworthiness of the accepting bank. The credit risk is mitigated by considering the financial strength and reputation of the bank involved. In addition, Banker’s Acceptance can be further enhanced by obtaining credit enhancements, such as letters of credit or guarantees from reputable financial institutions.

5.     Use in Financing: Banker’s Acceptances is commonly used as a form of financing in trade transactions. The seller, who holds the Banker’s Acceptance, can sell it at a discount to a financial institution or use it as collateral to obtain a short-term loan. This provides the seller with immediate access to funds while transferring the credit risk to the accepting bank.

Banker’s Acceptance plays a significant role in financing international trade and finance by providing a secure and widely accepted instrument for payment and credit in commercial transactions.

 

Describes Clean float and Dirty float of foreign exchanges rates, Difference between Clean float and dirty float

Clean float and dirty float are terms used to describe different exchange rate regimes and practices related to currency valuation and management. Here’s an explanation of each:

Clean Float: Clean Float, also known as a freely floating exchange rate refers to a situation where the exchange rate is determined purely by market forces of supply and demand without any intervention or control by government or central bank. Under a clean float system, the exchange rate fluctuates freely in response to economic factors such as inflation, interest rates, trade balances, capital flows, and market speculation. The government or central bank does not actively intervene in the foreign exchange market to influence the exchange rate. The exchange rate is solely determined by the interactions of buyers and sellers in the market.

Advantages of clean float:

·        Reflects market forces and economic fundamentals.

·        Allows for automatic adjustments to change in supply and demand.

·        Reduce the need for frequent intervention by the central bank.

·        Enhances market efficiency and transparency.

Disadvantages of clean float

·        Exchange rate volatility can create uncertainty for business and investors.

·        May lead to speculative movements and sudden exchange rate fluctuations.

·        Can affect import/export competitiveness due to unpredictable exchange rate movements.

Dirty Float: Dirty float, also known as a managed float or a floating exchange rate with intervention, is a system where the exchange rate is predominantly determined by market forces but with occasional intervention by the government or central bank may intervene in the foreign exchange market by buying or selling its currency to stabilize or manage the exchange rate within a certain range or to address specific economic objectives.

Intervention in the foreign exchange market can be done through various measures:

Direct intervention: The central bank actively buys or sells its currency in the foreign exchange market to influence the exchange rate.

Indirect intervention: The central bank may implement policies such as interest rate adjustments, capital controls, or reserve requirements to influence capital flows and indirectly impact the exchange rate.

Advantages of dirty float:

·        Allows some level of exchange rate stability and control

·        Provides a buffer against excessive exchange rate volatility

·        Can help manage external shocks and maintain competitiveness

·        Supports specific economic objectives, such as controlling inflation or promoting exports.

Disadvantages of dirty float:

·        Government or central bank intervention can create moral hazard and distort market signal

·        The timing and effectiveness of interventions can be challenging to determine.

·        Intervention may deplete foreign exchange reserves if not managed prudently

·        Can lead to conflicts or disputes with trading partners if perceived as currency manipulation

 

It is important to note that the distinction between clean float and dirty float is not always clear-cut as exchange rate regimes can lie on a spectrum between fully fixed and fully floating. Some countries may also adopt hybrid systems or make occasional interventions even within a clean float framework, depending on their specific economic circumstances and policy objectives.

Aspects	Clean Float	Dirty Float
Definition	Clean float refers to a system where the exchange rate is purely determined by market forces without any intervention or interference from the central bank or government	Dirty float refers to a system where the exchange rate is allowed to fluctuate but may be subject to occasional intervention or management by the central bank or government
Central Bank Intervention	No direct intervention or management by the central bank or government in the foreign exchange market	Central Bank may occasionally intervene in the foreign exchange market to stabilize or influence the exchange rate
Exchange Rate stability	Exchange rates are subject to market forces, leading to potentially higher volatility and fluctuations	Exchange rates may be influenced or stabilized by occasional central bank intervention, resulting in relatively more stable exchange rate
Market Forces	Market forces of supply and demand primarily determine the exchange rate	Market forces still play a role in determining the exchange rate, but occasional central bank interventions may influence it
Flexibility	Exchange rate movements are flexible and respond solely to market dynamics	Exchange rates may be subject to occasional adjustments or management by the central bank or government for policy reasons
Transparency	The exchange rate determination is transparent and based on market mechanisms	The exchange rate determination may be less transparent as the central bank’s occasional interventions may not be disclosed
Exchange Rate Stability and Predictability	Exchange rate may experience higher volatility and wider fluctuations, making it harder to predict future rates	Exchange rates may experience relatively more stability and predictability due to occasional central bank interventions
Government Influence	The government does not directly influence or manage the exchange rate	The government or central bank may have some influence or control over the exchange rate through occasional interventions.

 

Offshore Banking

 

Offshore Banking refers to the practice of establishing and operating a bank account or financial institution in a foreign jurisdiction with favorable financial regulations and tax benefits. Offshore banking has been historically associated with certain tax advantages, privacy, asset protection, and international business transactions.

Basically, an offshore bank is a bank located outside the country of residence of the depositor, typically in a low tax jurisdiction or tax haven that provides financial and legal advantages.

In Bangladesh, the use of offshore banking services is governed by various laws and regulations, including foreign exchange regulations, anti-money laundering laws, and tax laws. The Bangladesh Bank is responsible for overseeing and regulating offshore banking activities carried out by residents of Bangladesh.

The regulations in Bangladesh Place restrictions on residents’ ability to open and maintain offshore bank accounts without proper authorization or disclosure. Residents of Bangladesh are generally required to obtain prior approval from the Bangladesh Bank to open and operate offshore bank accounts.

Offshore banking in Bangladesh is primarily aimed at facilitating international trade and investment activities, remittances, and other foreign currency transactions. It provides a means for business and individuals to engage in cross-border transactions, access foreign currency transactions and manage international financial activities.

Offshore banking acts as a unique solution for banks across the globe to carry out international banking business involving foreign currency denominated assets and liabilities taking the advantages of low or non-existent taxes/levies and higher return on investment.

It is important to note that the specific rules, regulations and requirements related to offshore banking in Bangladesh may be subject to change over time. Therefore, individuals and businesses interested in offshore banking should consult with the relevant authorities, such as the Bangladesh Bank and seek professional advice to ensure compliance with the latest regulations and requirements.

Describes Secured overnight Financing Rate (SOFR)

The Secured overnight Financing Rate (SOFR) is a benchmark interest rate that serves ass a replacement for the London Interbank Offered Rate (LIBOR) in the United States. It is administered by the Federal Reserve Bank of New York and is based on transactions in the U.S Treasury repurchase agreement (repo) market.

SOFR reflects the cost of borrowing cash overnight collateralized by U.S Treasury securities. It is considered a robust and representative benchmark rate because it is based on a large volume of actual transactions in a highly liquid market.

The Secured Overnight Financing Rate is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

The SOFR is calculated as a volume-weighted median of transaction-level tri-party repo data collected from the Bank of New York Mellon as well as GCF Repo transaction data and data on bilateral Treasury repo transactions cleared through FICC’s DVP service, which are obtained from the U.S Department of the Treasury’s Office of Financial Research (OFR)

 

Here are some key features and characteristics of SOFR:

1.     Calculation: SOFR is calculated as a volume-weighted median of transaction-level tri-party repo data, bilateral Treasury repo transactions cleared through the Depository Trust and Clearing Corporation (DTCC), and General Collateral Finance GCF repo data.

2.     Overnight rate: SOFR is an overnight rate, reflecting the interest rate for borrowing or lending cash on an overnight basis. It is published each business day at approximately 8.00 a. am Eastern Time.

3.     Secured Rate: SOFR is a secured rate because it is based on collateralized transactions, where U.S Treasury securities are pledged as collateral. This differs from LIBOR, which is an unsecured rate.

4.     Risk free rate: SOFR is considered a risk-free rate as it is based on the U.S Treasury market, which is considered to have minimal credit risk.

The transaction from LIBOR to SOFR is part of a global effort to reform benchmark rates and establish more reliable and representative alternatives. The use of SOFR helps to mitigate the risks associated with LIBOR discontinuation and ensure a more stable and resilient financial system.

Dhaka Interbank Offered Rate

 The Dhaka Interbank Offered Rate (DIBOR) is an interest at which banks in Bangladesh offer to lend funds to one another in the interbank market. It serves as a reference rate for various financial transactions within the country.

DIBOR is calculated and published daily by the Bangladesh Foreign Exchange Dealers Association (BAFEDA). The rate is determined based on the submissions from a panel of participation banks which provide their estimated borrowing costs in the interbank market.  These submissions are then aggregated and DIBOR is calculated as the average or weighted average of these rates.

DIBOR is typically available for various tenors, including overnight, one week, one month, three months and six months. Each tenor represents the length of time for which banks are willing to lend funds to one another in the interbank market.

Bangladesh Bank Governor Atiur Rahman formally launched Dhaka interbank offer rate DIBOR, which will help banks get a benchmark interest rate or reference rate.  The governor said “An established benchmark rate is required for the buoyancy and transparency of any interbank market. Hopefully, this is a beginning towards the development of a liquid interbank term market in Bangladesh.”

As a widely recognized benchmark rate, DIBOR is used in Bangladesh for pricing a range of financial instruments, including loans, mortgages, and derivatives contracts. It provides a standardized reference rate for determining interest rates and serves as a basis for pricing various financial products in the country.

Commodity Derivatives in brief

Commodity derivatives are financial instruments that allow market participants to trade in commodities, such as gold, oil, wheat, and other raw materials, without having to take physical delivery of the underlying asset.

These derivatives typically take the form of futures contracts or options contracts, which give the buyer the right (but not the obligation) to buy or sell the underlying commodity at a specified price and time in the future.

Commodity derivatives are used by a variety of market participants, including producers, consumers, traders, and speculators, to manage price risk and to speculate on price movements in the underlying commodity market.

For example, a farmer may use commodity derivatives to hedge against a drop the price of his crop before it’s harvested, while a speculators may buy a futures contract in anticipation of rising prices.

For example, let’s assume that in April 2024 the farmer enters a futures contract with a miller to sell 5000 bushels of wheat at $4.404 per bushels in July. On the expiration date in July 2017, the market price of wheat falls to $4.350, but the miller has to buy at the contract, price of $4.404, which is higher than the prevailing market price of $4.350. Instead of paying $21750 (4.350*5000), the miller will pay $22,020 (4.040*5000) while the farmer recoups a higher than the market price.

However, had the price risen to $5 per bushel, the miller hedge would have allowed the wheat to be purchased at a $4.404 contract price versus the $5 prevailing price at July expiration date. The farmer, on the other hand, would have sold the wheat at a lower price than the $5 prevailing market price.

Duration and Option

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond’s duration is easily confused with its term or time to maturity because certain types of duration measurements are also calculated in years.

·        Duration measures a bond’s or fixed income portfolio’s  price sensitivity to interest rate changes

·        Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s price by its total cash flows.

·        Modified duration measures the price change in a bond given a 1% change in interest rates.

·        A fixed income portfolio’s duration is computed as the weighted average of individual bond durations held in the portfolio.

Duration is defined as the length of time that something lasts. When a film lasts for two hours, this is an example of a time when the film has a two hour duration. A measurement of bonds price sensitivity of changes in interest rates.

Options: Options are a form of derivative financial instrument in which two parties contractually agree to transact an asset at a specified price before a future date. An option gives its owner the right to either buy or sell an asset at the exercise price but the owners is not obligated to exercise (buy or sell) the option.

When an option reaches its expiration date without being exercised, it is rendered useless with no value. There are two types of options: calls and puts

·        Call options allow the option holder to purchase an asset at a specified price before or at a particular time.

·        Put options are opposites of calls in that they allow the holder to sell an asset at a specified price before or at a particular time.

For example, a stock options is for 100 shares of the underlying stock. Assume a trader buys one call option contract on ABC stock with a strike price of $25. He pays $150 for the option. On the option’s expiration date, ABC stock shares are selling for $35.

The holder of a call speculates that the value of the underlying asset will move above the exercise price (strike price) before expiry. Conversely, a holder of put option speculates that the value of the underlying asset will move below the exercise price before expiry.

Define cross rate

 A cross rate is a foreign currency exchange transaction between two currencies that are both valued against a third currency. In the foreign currency exchange markets, the U.S dollar is the currency that is usually used to establish the values of the pair being exchanged.

The calculation of cross rates involves the exchange market price made in two currencies which are then valued to a third currency. During the process, two transactions are being computed. The first being the individual trading their one specific currency (EUR, JPY, GBP) for that same equivalent value in U.S dollars. Once U.S dollars have been received, an exchange occurs again when the U.S dollars are traded for the second specific currency.