Oct Fin mag
-
Upload
cmdfromnagpur -
Category
Documents
-
view
222 -
download
0
Transcript of Oct Fin mag
7/27/2019 Oct Fin mag
http://slidepdf.com/reader/full/oct-fin-mag 1/5
Top Stories: International
Know Your Basics:
A SIMSREE Finance Forum Initiative | Issue 40
FIN-O-PEDIA
et’s Talk FINANCE!!
SYDENHAM INSTITUTE OF MANAGEMENT STUDIES, RESEARCH &
ENTREPRENEURSHIP EDUCATION
2012
Know Your Basics:
x Purchasing Power
Parity
x Credit Default Swap
7/27/2019 Oct Fin mag
http://slidepdf.com/reader/full/oct-fin-mag 2/5
Know Your Basics:
Purchasing Power Parity:
What is PPP?
It’s a method for calculating the correct value of a currency which may differ from its
current market value. Purchasing power parity (PPP) is helpful when comparing living
standards in different countries, as it indicates the appropriate exchange rate to use when
expressing incomes and prices in different countries in a common currency. Correct value
means the exchange rate that would bring demand and supply of a currency into
equilibrium over the long-term. The current market rate is only a short-run equilibrium. It
says that goods and services should cost the same in all countries when measured in a
common currency under the assumption that duties, curbs, etc are neglected. It is theexchange rate that equates the price of a basket of identical traded goods and services in
two countries. PPP is often very different from the current market exchange rate. Some
economists argue that once the exchange rate is pushed away from its PPP, trade and
financial flows in and out of a country can move into disequilibrium, resulting in potentially
substantial trade and current account deficits or surpluses. Because it is not just traded
goods that are affected, some economists argue that PPP is too narrow a measure for
judging a currency’s true value. They prefer the fundamental equilibrium exchange rate
(FEER), which is the rate consistent with a country achieving an overall balance with the
outside world, including both traded goods and services and capital flows.
The relative version of PPP is calculated as:
Where:
"S" represents exchange rate of currency 1 to currency 2
"P1" represents the cost of good "x" in currency 1
"P2" represents the cost of good "x" in currency 2
Example:
A chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00 in a U.S. city
when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both chocolate
bars cost US$1.00.)
7/27/2019 Oct Fin mag
http://slidepdf.com/reader/full/oct-fin-mag 3/5
3 | P a g e
Know Your Basics:
GDP (Purchasing Power Parity):
A nation's GDP at purchasing power parity (PPP) exchange rates is the sum value of all goods
and services produced in the country valued at prices prevailing in the United States. This is
the measure most economists prefer when looking at per-capita welfare and when
comparing living conditions or use of resources across countries. The measure is difficult to
compute, as a US dollar value has to be assigned to all goods and services in the country
regardless of whether these goods and services have a direct equivalent in the United States
(for example, the value of an ox-cart or non-US military equipment); as a result, PPP
estimates for some countries are based on a small and sometimes different set of goods and
services.
India’s GDP (purchasing power parity): $4.463 trillion (2011 est.) (3rd Biggest in the world)
Relevance of PPP:
The concept of PPP is useful in comparing quality or standard of living in different countries
which may not be possible if one just looked at per capita income. A lower income may
allow a good quality of life in a country of prices is low. For instance, a haircut may cost lot
more in London than in Delhi. The major shortcoming of PPP exchange rates is that these
are difficult to measure.
7/27/2019 Oct Fin mag
http://slidepdf.com/reader/full/oct-fin-mag 4/5
4 | P a g e
Know Your Basics:
Credit Default Swap:
A swap designed to transfer the credit exposure of fixed income products between parties.
A credit default swap is also referred to as a credit derivative contract, where the purchaser
of the swap makes payments up until the maturity date of a contract. The buyer of a credit
default swap receives credit protection, whereas the seller of the swap guarantees the
credit worthiness of the debt security. In doing so, the risk of default is transferred from the
holder of the fixed income security to the seller of the swap. For example, the buyer of a
credit default swap will be entitled to the par value of the contract by the seller of the swap,
should the third party default on payments. By purchasing a swap, the buyer is transferring
the risk that a debt security will default.
Example:
Suppose Bob holds a 10-year bond issued by company XYZ with a par value of $1,000 and a
coupon interest amount of $100 each year. Fearful that XYZ will default on its bond
obligations, Bob enters into a CDS with Steve and agrees to pay him income payments of
$20 (similar to an insurance premium) each year commensurate with the annual interest
payments on the bond. In return, Steve agrees to pay Bob the $1,000 par value of the bond
in addition to any remaining interest on the bond ($100 multiplied by the number of years
remaining). If XYZ fulfils its obligation on the bond through maturity after 10 years, Steve
will make a profit on the annual $20 payments.
Why it matters?
A credit default swap protects bondholders and lenders against the risk that the borrower
will default. The lender's insuring counterparty takes on this risk in return for income
payments. In this respect it is important for the insuring counterparty to fully assess the
swap's risk/return feature to ensure it is receiving fair compensation vis-à-vis the level of
risk.
7/27/2019 Oct Fin mag
http://slidepdf.com/reader/full/oct-fin-mag 5/5
5 | P a g e
Know Your Basics:
Role in 2008 crisis: AIG is an insurance company. It is America’s one of the largest insurance company. One of
its functions is to insure bonds against default (CDS). As the sub-prime mania continued with
everyone buying the mortgage backed CDOs, they also wanted to buy insurance in the form
of credit default swaps in case some of the mortgages defaulted. This transferred the risk of
the bonds defaulting to the seller of the credit default swaps, in this case AIG. When
defaults started on the mortgages sellers also made money by owning the credit default
swaps, something like shorting a stock, you think it will go down and you short it. Owning
these credit default swaps was a way of shorting the sub-prime mortgage market. AIG
collected the premiums on all of these credit default swaps insurance and happily sold andsold and sold the credit default swaps to all. Even as foreclosures increased and it was
apparent there was a problem, AIG continued to sell the swaps for the premiums. By the fall
of 2008, AIG was losing billions of dollars per day.