because standard ADRs are listed and quotedin the same currency. The CME contract therefore is similar but notidentical to an ADR structure.One OSE futures contract is ¥17,000,000 in nominal for a Nikkei at¥17,000.51 If the market moves from ¥17,000 to ¥17,100, an investorholding one contract makes ¥100,000. If the same investor holds aCME position instead, the nominal is $85,000 ( $5  ¥17,000), and forthe same market move the total pro®t is $500. This calculation mayappear ¯awed because we apparently extract a dollar nominal from aprice quoted in yen.49
The discount should de®nitely be measured more accurately with simultaneous data.But, as we mentioned earlier, it may very well be the result of structural differencesbetween the two markets.50Trading volume on the CME contract averages less than 2,000 contracts per session.Accounting for the difference in nominal, this is equivalent to 1,000 OSE contracts,which is tiny: the OSE customarily trades more than 25,000 contracts a day.51¥17,000,000 = ¥17,000  ¥1,000. ¥1,000 is the point value.
CHAPTER 3 FUTURES AND RELATED INSTRUMENTS139
Figure 3-6 Price Differential on the SIM and the OSE(Source: Compiled by author from Datastream data.)
140
THEORY AND TOOLS
The source of the possible confusion is the convention to expressmarket prices with a currency sign. Under that convention, a pricequoted in yen appears as ¥17,000. This is a strict representation ofreality for a stock because the shares can be truly acquired at thatprice, but it is inadequate for a futures contract because there is noacquisition underlying a transaction. Indeed, the quoted price of afutures contract is dimensionless, acquiring a dimension exclusivelywhen multiplied by a point value. In the case of the CME contract,the price is 17,000 units, each of these units in turn being ``exchangeable'' for $5 in cash. Therefore, the contract itself is ``exchangeable'' for$85,000 in cash, which essentially means that if its price went to 0instantaneously, the holder would have to pay $85,000.This long conversation is necessary to understand the mechanicsunderlying the CME behavior with respect to the $/¥ exchange rate. Infact, we proved that the holder of a CME position is not exposed to anyvariation in exchange rate, only to a variation in price. By extension, thisexplains why the quoted price of the contract is equal to that of the OSEfutures.52 As an illustration, Figure 3-7 shows the closing price difference between the two futures in 1999. The average difference is ¥29.5,but we cannot make any signi®cant conclusion from this ®gure becauseof the important time difference between the closing prices: The CME istrading on U.S. timeÐthat is, with a 12-hour shift from Japan.53 It is fairto say, however, that the average amplitude of this differential and theapparent symmetry above and below the horizontal axis indicate thatthe CME and OSE are reasonably tracking each other.This is not the end of the story, however, because trading theNikkei 225 in Chicago does indeed create an exposure to the exchangerate, but in the particular situation in which an investor is also tradingthe OSE contract. Consider, for example, the following position: long 1OSE at ¥17,000, short 2 CME at the same price. Assuming the Japanesemarket and the CME both go up to ¥17,100 the next day, this position ismaking ¥100,000 on one leg, and losing $1,000 on the other leg. Wecannot conclude as to the pro®tability of the whole operation until weknow the current exchange rate.5452
By contrast, consider a Japanese stock quoted ¥1,000 in Japan. Its ADR listed in theUnited States would trade at $9.09 if the exchange rate were ¥110 for $1. In contrast, ifthe OSE Nikkei 225 futures trade at ¥17,000, the CME trades at the same price.53An interesting question, however, would be to explore to what extent the CMEfollows moves initiated in Osaka or anticipates variations to come to Osaka thenext day. Regardless of the answer, if it is stable enough through time, there maybe an arbitrage opportunity.54Note that we need the rate after the move, not when the position is actually taken.
CHAPTER 3 FUTURES AND RELATED INSTRUMENTS141
Figure 3-7 Price Differential CME/OSE(Source: Compiled by author from Datastream data.)
142
THEORY AND TOOLS
Assume this rate is ¥110 for $1. The position is then losing ¥10,000or $90.9 depending on which currency we want to focus on. The nextday, if both contracts come back to ¥17,000, the position loses ¥100,000and makes $1,000 back and is even. The general formula to describe theP&L is therefore:P$  ¥1,000  POSE
¥17,000=f¥=$
$5  2  PCME
¥17,000
orP¥  P$f¥/$  ¥1,000  POSEf¥/$
¥17,000)
$5  2  (PCME
¥17,000) 
with self-explanatory notations.Essentially each bracket represents a domestic P&L. The exchangerate intervenes only because at some point one of them needs to berepatriated through a foreign exchange conversion.However, reality does not necessarily match this simple description because of margin calls. For example, consider an investor trading both on the CME and OSE on two separate accounts in theUnited States and Japan. If the market is going up, the excess depositavailable from the OSE long is not directly available to cover thede®cit for the short on the CME. Therefore, the investor faces additional margin requirements with associated ®nancing costs. In fact, ifthe position is large enough to consume signi®cant amounts of collateral on each side, the investor may want to effectively transferliquidity back and forth between the accounts regularly. These¯ows have a very important consequence: They transform the P&Lfrom unrealized to realized, effectively creating a foreign exchangeexposure. Consider again the previous spread position, with bothfutures closing at ¥17,100. Assume that the investor is based in theUnited States, and he or she decides to transfer the pro®t of ¥100,000to the United States by selling ¥100,000 against $909.1 at ¥110/$1.Effectively, the account in yen is emptyÐexcept for the initial marginrequirementÐand the U.S. account shows a loss of $909.1 $1,000 =$90.9. The next day the market comes back to ¥17,000, and bothfutures close there; however, the exchange rate moves to ¥105/$1.The OSE position shows a loss of ¥100,000, and the other leg a pro®tof $1,000. This time the investor has to cover the shortfall on the OSEaccount, and he or she buys ¥100,000 for $952.4 at ¥105/$1. Overall,even if both markets have come back to their original level, the U.S.account is left with a loss of $90.9 + ($1,000 ± $952.4) = $43.3.Therefore, the existence of intermediary ¯ows has resulted in a
CHAPTER 3 FUTURES AND RELATED INSTRUMENTS
143
foreign exchange loss of $43.3 despite the fact that the two contractshave the same index underlying and no exposure in and of themselves to foreign exchange.Generally speaking, even if the P&L generated by differences in theexchange rate remains unrealized, it exists at all times because of thetwo distinct treasury needs, in yen and in dollars. This becomes apparent if we consider, for example, the variation in P&L only resultingfrom a change in f¥/$:f ¥/$  110 ) P$ 
$90.9,
P¥ 
$10,000
f ¥/$  130 ) P$ 
$230.8,
P¥ 
$30,000
A depreciation of the yen compared to the dollar results in a potentiallossÐand therefore margin callsÐeven in the absence of a marketmovement. If we wanted to hedge this exposure, we would have toenter a foreign exchange position such that a variation from ¥110/$1 to¥130/$1 would generate ¥20,000.In fact, the exact formulation of a foreign exchange hedge for thisarbitrage is a nontrivial exercise because the problem depends now onmultiple stochastic variables, the exchange rate, and the futures prices.We will not enter into unnecessary details here, but it is important torealize that despite the similarities in de®nitions and trading prices, thetwo Nikkei 225 contracts are truly distinct.
TRADINGThe variety of order types available to futures traders is similar to thatavailable to stock traders. On electronic markets, the situation is therefore very straightforward: Futures are only one more regular instrument to trade. For the S&P 500, however, certain types of theoreticallyef®cient orders do not translate in practice into precise executionsbecause of the nature of the ¯oor market. For example, opening orclosing orders are extremely dif®cult to execute, and brokers on the¯oor will accept such orders on a best-effort basis only. They cannotguarantee any price, so the average executed price for an entire ordermay well be extremely different from the of®cial opening or closingprices. The same phenomenon occurs with market orders. The execution of a sizable order at market may be virtually ``all over the place.''At the same time, because orders ¯ow through brokers, it is possible for a customer to require speci®c strategies or combinations. This
144
THEORY AND TOOLS
added ¯exibility is unavailable in an electronic system in which ordersusually have to be kept simple and elementary.The net effect is nevertheless a lack of predictability in execution,magni®ed when orders grow in size or when the market gets particularly volatile. Accordingly, many traders will prefer to work theirorders one by one, using small sizes and price limits rather than givingbrokers autonomy in execution.
Real-Time Information
Even if real-time information for futures is theoretically equivalent tothat available for stocks, there are important drawbacks when thefuture is not traded electronically. For example, bid-ask prices are provided in real time on the S&P 500 futures index, but they can hardly betrusted. The best and only way to get a reliable market quote is to getsomebody on the ¯oor on a phone line. And this is not necessarily asatisfactory solution because regardless of who gives a quote, the nature of the marketplace makes it impossible to know precisely wherethe market is during volatile sessions.This is even more true for market depth available from brokers onthe ¯oor, which it is absolutely useless. There is indeed an incredibleliquidity in that market, but the bulk of it is not visible: Orders get®lled and absorbed by the crowd as they appear, but it is virtuallyimpossible at any given time to predict what will be the impact of afairly large transaction.Beyond common data available on stocks, there is one piece ofinformation particular to derivatives and extremely useful: the openinterest. It indicates the total number of contracts outstanding for thewhole market.55 It is not a real-time number, but computed by theexchange every day. Consider, for example, the S&P 500 open interest for the ®rst and second expirations over 1999 as shown in Figure3-8.This pattern of interrupted waves was clearly visible earlier in theintroduction, on all futures alike. Just before a futures contract is aboutto expire, its successor gains momentum and the combined open interest shows a sharp spike. The reasons behind this spike can be multiple,but clearly there is a systematic excess exposure concentrated aroundexpiration dates. We will come back to that phenomenon for a moredetailed analysis when studying index arbitrage.55
Sometimes more details are available. In Japan, for example, this ®gure is also published weekly broken down by member ®rms.
CHAPTER 3 FUTURES AND RELATED INSTRUMENTS145
Figure 3-8 Open Interest, S&P 500(Source: Compiled by author from Datastream data.)This chart indicates the open interest for the nearest two expirations. For example, before the March contract expires, ®rstand second futures represent, respectively, March and June. On the day the March contract expires, ®rst and second cometo represent June and September, respectively.
146
THEORY AND TOOLS
OTHER FORMS OF FIRST-ORDER EXPOSUREFutures can be used to create a market exposure as if we were holdingstocks. Similarly, there exist other instruments that create ®rst-orderexposure, and this part presents some of them. We focus primarily oninstruments functionally identical to futuresÐthat is, without anyoption component.
Forward Contracts
A forward contract is exactly equivalent to a futures; the only differenceis that it is traded between two counterparts over the counter withoutthe convenience of a clearinghouse. This is typically a private agreement in every respect.56This has several important consequences:. The forward is not listed and is not reported to any regulatory
body.57 In other words, only the parties involved are aware ofthe transaction and its details.58. The characteristics of the contract are negotiated entirely betweenthe parties. In particular, the underlying, initiation price, expirationand settlement dates, and nominal are tailored to the needs of thetransacting traders. In practice, many forwards are traded becausethey cover maturities not available in the futures market. It is common, for example, to see one-year and two-year forwards on majorindices because it is dif®cult to ®nd the adequate liquidity in thefutureÐif it is even listed.. The whole purpose of listing futures is to remove the counterpartrisk by imposing the clearinghouse as an intermediary in all trans56
As such, it is the responsibility of each party to make sure that the contract includessatisfactory provisions, for example, with respect to credit risk. By and large legalenforcement is the most critical aspect of these transactions, and the current regulatory environment is considered by some to be inadequate and outdated for thatpurpose. For an examination of these issues, see, for example, Robert M.McLaughlin, Over-the-Counter Derivative Products, A Guide to Business and Legal RiskManagement and Documentation (New York: McGraw-Hill, 1998) or ``Over-theCounter Derivatives Markets and the Commodity Exchange Act,'' Report of thePresident's Working Group on Financial Markets (Washington, D.C.: GovernmentPrinting Of®ce, November 1999).57Like many other derivative instruments, it does not even appear on the balance sheeton the transacting parties.58Many of these transactions are traded through the mediation of a broker, and as such,they may be visible to the crowd. Even in that case, however, they are usually notsubject to any of®cial regulation.
CHAPTER 3 FUTURES AND RELATED INSTRUMENTS
147
actions. Forward contracts, therefore, are fully exposed to creditrisk and as such are totally dependent on the general credit agreements and ratings between the parties. These agreements may ormay not institute margin calls, and even if they do, their frequencymay be lower than that of a regular clearinghouseÐweekly versusdaily, for example. Nowadays the trend is towards generalizedmargin calls, in which both parties aggregate all their OTC contracts regardless of the underlying, and agree to be called on margin frequently on a net amount.In terms of market risk, futures and forwards are exactly identicalexcept naturally for margin calls. Because these ¯ows disappear, thereis no ®nancing cost associated with a forward position.59Consequently, a forward should be theoretically cheaper than a futurescontract: For the exact same characteristics, it is more advantageous tohold. However, this difference is occulted by the fact that the absenceof margin calls reactivates the impact of credit risk, even between thestrongest counterparts.60
Equity-Linked Swaps
An equity-linked swap (ELS) is one of a family of ®nancial instruments called swaps. In a swap, two counterparts have an agreementto exchange a certain number of ¯ows on a set of dates in thefuture.This de®nition is broad enough to include numerous applicationson equities, ®xed incomes, interest rates, foreign exchanges, and creditderivatives. We want to focus here exclusively on equity-linked swaps.These swaps involve the exchange of one leg pegged to the performance of a security or basket of securities, the other leg being the®nancing of this performance. Consider an investor trying to beexposed on General Electric (GE) for a year. Buying GE outright, say,at $100, requires $100 in capital.61 Depending on where this capital iscoming fromÐborrowing versus in-houseÐthe out¯ow is associated59
Also the leverage of a forward position is essentially in®nite because there is no upfront payment.60The problem of a possible price difference between futures and forwards has beenstudied extensively. The key consideration is the stochastic nature of interest rates,which has a critical impact on the ®nancing of margin calls. See, for example, SimonBenninga and Aris Protopapadakis, ``Forward and Futures Prices with MarkovianInterest-Rate Processes,'' Journal of Business, 67, 1994, pp. 401±421.61Or less on margin. However, the idea is the same: there is a signi®cant capital out¯owfor a straight purchase.
148
THEORY AND TOOLS
with actual interest payments or a capital cost. At the end of thisperiod, the investor realizes the full extent of price appreciation, plusthe accumulated dividends, if any were paid. The total gain is thereforethe price appreciation plus dividends minus ®nancing.Now assume that the same investor does not want to hold thestock himself. There are numerous reasons for doing so: Finding someone with a better access to the market or better ®nancing rate, or theneed to have this transaction outside his own book.62 He has to enteran agreement with a third party who will take the position and doexactly what he would have done. This agreement is typically an ELS,and therefore receiving the performance and dividends on GE requireshim to pay the ®nancing in return. At the same time, he avoids theinitial payment of $100.63By convention, the buyer of an ELS receives the performance ofthe underlying security. The payments are usually scheduled everythree months, at which time the price of the underlying instrumentis used to compute the performance, while the current prevailingthree-month interest rate is used on the ®nancing side. Dividendsare paid on the same dates regardless of when they were actuallyreceived.Pricing an ELS is not an easy exercise. It is interesting to note thatthere are mainly three parts in the process: interest rates, dividends,and market performance. Because the behavior of an ELS creates amarket exposure by de®nition, and because it has an expiry, it isequivalent to a futures contract. There is no futures contract on GE,and this is indeed one more advantage to trading an ELS: It creates aninstrument very similar to futures on securities that do not have anysuch contracts listed.64But not quite identical though. Pricing a future involves the samethree components: interest rates, dividends, and market exposure.However, the risks in holding a futures contract versus an ELS are62
ELSs are considered derivative products, and as such they are not recorded on thebalance sheet, unlike stocks.63Futures are called on margin every day, forwards never. ELSs are somewhere inbetween because intermediary ¯ows occur regularly but not daily. These ¯ows arenot referred to as ``margin calls''; however, they are functionally equivalent becausethe performance of the underlying is exchanged in full, effectively resetting the risk ofthe structure.64Note that ELSs are also very useful in the context of stock loans. If the seller of a swappurchases the securities from the buyer instead of going to the market, the wholetransaction becomes a stock loan. The seller essentially borrows the securities anddelivers cash in lieu of collateral.
CHAPTER 3 FUTURES AND RELATED INSTRUMENTS
149
Profit/Loss
KS*
Figure 3-9
Synthetic Futures Contract
not the same. The ELS has interest rate payments embedded in itsstructure, at a variable rate reset periodically. The futures contractdoes not have any of these payments, and neither does it includedividends. Therefore, an ELS and a futures contract are functionallyequivalent, but they are different in terms of ¯ows and peripheralrisks.
Synthetic Futures (Options)
If we combine a long call position with a short put, both havingsame strike and expiry, we get the pro®le at expiry shown in Figure3-9. This is exactly the pro®le generated by a long position in theunderlying security. Conversely, if we buy a put and sell a call ofthe same maturity and strike, we have built the equivalent of a shortposition.65The structure formed by the difference between a call and a put ofsame strike and maturity is called a synthetic futures contract, becausethe market exposure resulting from that position is equivalent to that ofa regular futures contract. There is one fundamental difference, however. The holder of a long position of a synthetic futures contract isshort a put. If the put is American, it can be exercised at any time priorto maturity. If it does get exercised, the put disappears, and so does thesynthetic future. Only the call remains, and the resulting payoff doesnot match that of a futures contract anymore. In this situation thewriter of the put has two choices: Either sell back the call, or replacethe put by another equivalent contract. Intuitively any of these opera65
Indeed, the put-call parity for European options states that C  Ke rt  P  S, whereKe rt represents the present value of the exercise price. Therefore, C P  S Ke rt :The structure ``call minus put'' is essentially functionally equivalent to a futurescontract.
150
THEORY AND TOOLS
tions has to be done at a particular price to ensure that the overallposition does not suffer a loss, which may or may not be possible. Infact, chances are that it is not; otherwise, the exercise would not havebeen pro®table in the ®rst place. Therefore, synthetic futures contractsbased on American options, as the ones trading on S&P 100, induce anadditional risk of early exercise.
4M ONEY M ARKETS
INTRODUCTIONThe term money market describes transactions related to the ¯ows anduses of money for a de®ned period of time. Typically, these are borrowing or lending operations of a given amount on terms negotiatedbetween two parties. These operations are critical because arbitrageurshave to borrow every dollar they put at risk by nature of their business.1It may appear strange, however, to consider money markets extensively in the context of equity arbitrage. There are two reasons for that.First, many arbitrage strategies call upon derivatives, notably futures,because derivatives are often the source of absolute convergenceopportunities. As opposed to stock, futures typically carry a numberof additional risks, for example, those related to interest rates andovernight ®nancing, and we need to be equipped to understand andmanage these risks appropriately. The second reason deals with theday-to-day funding of an arbitrage activity. Regardless of the instruments traded, treasury management is a critical part of the overallpro®tability.This chapter will examine the fundamental characteristics of thismarket and a variety of instruments related to it. It is the ®rst chapter inthis book to call upon advanced formalism recurrently, speci®cally¯ow diagrams. From the mechanics of the cash market, we introducethe notion of zero-coupon rates and explain why these rates have a1
This distinction between proprietary traders and fund managers was explored indepth in Chapter 1.
151
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
152
THEORY and TOOLS
particular role to play. We turn then to a certain number of derivativeinstruments essential to managing interest ratesÐnamely, swaps andshort-term interest rate futures.
MONEY MARKETS AND GOVERNMENTINSTITUTIONSThe creation of money and the monetary policy, as one would expect,are tightly regulated in a modern economy and are usually performedby a unique central entity, the central bank. Regardless of its name,structure, or legal status, it performs the same basic functions everywhere.2These regulatory functions apply to the amount of money and itscost in the economy, with the ultimate goal of ensuring price stability.The tools and levers a central bank has the latitude to use are diverse,but they are primarily of two sorts: policy-setting devices and openmarket operations. A policy-setting device is, for example, the generallevel of interest rates the bank applies when dealing with third parties.In the United States, this rate and other important benchmarks are®xed by the bank at the Federal Open Market Committee (FOMC),which also de®nes the stance of the Federal Reserve with respect tomacroeconomic conditions.3 Open-market operations, on the otherhand, typically encompass day-to-day activities in terms of amountsand characteristics of transactions in the marketplace.It is not necessary here to enter into lengthier details because all weneed is to identify the central bank as the lender of last resort. Major®nancial institutions are required to maintain an account and a certainlevel of reserves with the bank, and they may obtain or dispose ofliquidity when needed, for example, through short-term loans. For2
In the United States the actual printing of money is performed by Bureau of Engravingand Printing, under the responsibility of the Treasury Department, while the monetarypolicyÐthat is, the creation and management of creditÐis strictly under the supervisionof the Federal Reserve System. For a comprehensive description of the Federal ReserveSystem in the United States, see The Federal Reserve System, Purposes & Functions,(Washington D.C.: Board of Governors of the Federal Reserve System, 1994), availableonline at www.federalreserve.gov. For information on foreign central banks, seewww.boj.or.jp, www.bundesbank.de, www.banque-france.fr, www.bankofengland.co.uk, and www.ecb.int for the European Central Bank.3The stance indicates the direction of the fed efforts. Until the end of 2000, this indicatorhad evolved from ``Neutral'' to ``In¯ation,'' clearly pointing toward a more restrictivecredit policy and higher interest rates to ®ght in¯ationary pressures in the U.S. economy.
CHAPTER 4 MONEY MARKETS
153
all practical purposes, the national monetary policy is exogenous to ourconception of the equity market, which essentially means that there isno conditional relationship between the two.4
INTERBANK MARKETS AND INTEREST RATESThe above description is naturally very simpli®ed, but it is suf®cientbecause ®nancial institutions deal relatively infrequently with the central authority directly except for the maintenance of the mandatoryreserve requirements. Much more often they deal among themselvesto cover their need for liquidity, and these ¯ows constitute what wecall the interbank money market. In practice, each of these institutionsmaintains a treasury department that determines its ®nancing needs ona daily basis and manages cash excesses or shortfalls by entering transactions with another market participant.The interest rates in general vary primarily because of two majormechanisms. The central bank on one side manages the cost of moneythrough a set of reference rates, which we termed earlier policy-settingdevicesÐfor example, in the United States the Discount Rate for transactions with member banks and the prime rate as a base reference forgeneral-purpose, private bank loans. A change in these rates is theresult of a macroeconomic adjustment, for example, to counter in¯ationary pressures developing in the economy.At the same time interest rates react naturally to market conditionsÐthat is, to the prevalent supply-demand equilibrium formoney across the term structure.5 Except when dictated by the monetary policy it is trying to enforce, the central bank does not interferewith these mechanisms on a day-to-day basis and acts only as a sidelines player. Therefore, the money market is an interesting marketplacewhere by and large market forces drive prices and interest rates butwhere at the same time one particular player has the ultimate authorityand power to enforce its strategyÐand infrequently uses this power.4
In other words, a given move in the equity market does have the same probability tooccur regardless of the prevailing monetary policy, and vice versa. It does not mean,however, that the overall correlation is nil, which we know would be obviouslywrong. For a discussion of that last point, see, for example, Frank Smets, ``FinancialAsset Prices and Monetary Policy: Theory and Evidence,'' Working Paper No.47,September 1997, Bank of International Settlements.5The term structure denotes the whole set of interest rates from overnight to far maturities, typically 30 years. The set is also referred to as the yield curve.
154
THEORY and TOOLS
The term structure itself can be regarded as three distinct sets ofrates of somewhat different natures: overnight, under one year, andover one year. These rates differ primarily by the type of risk associatedwith each maturity, but also by the dynamics of each segment.Overnight ®nancing has very little credit risk and is essentially theresult of liquidity management. For transactions under one year, creditrisk is more important, but it is still fairly easy to monitor, and the needfor cash results essentially from predictable activity and forwardliquidity management. For time horizons over a year, credit exposurebecomes a major concern, and transactions are often the result of strategic ®nancing decisions. Taking the example of a non®nancial institution, the long-term capital structure typically involves long-termtransactions and instruments, for example, bonds, as opposed toshort- and medium-term ®nancing needs arising from continuingoperationsÐworking capital, for example, often managing with revolving credit lines.Because each segment serves different needs, the instrumentsinvolved are fundamentally different. Overnight is exclusively a cashtransaction because transacting institutions actually need to receive ordispose of a certain amount of cash. Short-term is most often also cashdriven, although other options are also available, such as swaps andinterest rate futures. As for long-term management in the context of atrading ¯oor, virtually all transactions are swaps because they do notinvolve cash and decrease the magnitude of the credit risk.6
CREDIT RISKThe issue of credit risk, although already important with respect toderivative products, becomes absolutely critical on money markettransactions. In contrast to a futures position, for example, a lender istypically fully exposed on the credit of his or her counterpart withoutthe safety net of a clearinghouse.This risk has two practical consequences for borrowers: Liquiditymay be dif®cult to obtain, and even if it is not, it may be expensive dueto relatively poor credit ratings. One convenient feature about theenvironment we focus on is that both concerns virtually disappear.6
In contrast, non®nancial institutions usually ®nance their long-term developmentthrough issuance of equity or debt rather than pure money market transactions orswaps. Again it is necessary to realize here that we focus on swaps because of theparticular context in which we are working.
CHAPTER 4 MONEY MARKET