Guide to Brazilian Local Markets

Emerging Markets ResearchJ.P. Morgan Securities Inc.November 24, 2004

Guide to Brazilian Local Markets

• In this report we describe the main concepts and financial productsin the Brazilian local market

• Local market investors have access to real (BRL) products or dollar-linked instruments, cash and derivatives with settlement in reais

• The government’s main goal, and challenge, is to extend the durationof fixed rate debt, while it continues to reduce dollar-linked debt

Brazil’s local markets merit attention for its sheer size (public domesticdebt market is BRL780 billion), its liquidity, and the prospect of durationextension and increased international integration. Although Brazilianmarkets can be very deep, foreign access is still constrained by somecapital controls, and taxation issues need attention. This guide is divided intwo parts. The first part discusses foreign investor access to Brazilian localmarket and describes the main conventions and basic concepts on whichthe financial products are based. It then tackles tax treatment of non-resident investors and subsidiaries.

The second part of this guide focuses on the products available for tradingOTC and in the Futures Exchange (BMF). They include governmentbonds, swaps and futures, which always settle in reais but can be indexedto inflation or the exchange rate. At the end of the section, we list theJPMorgan Reuters and Bloomberg pages that provide indicative pricing, aswell as useful websites where foreign investors will find relevantinformation about the local market regulations.

www.morganmarkets.com

Drausio GiacomelliAC

(212) [email protected]

Felipe Pianetti(212) [email protected]

The certifying analyst(s) is indicated by the notation “AC.” See last page of thereport for analyst certification and important legal and regulatory disclosures.

We thank Rodrigo Ortiz for his invaluable research assistance.

Contents2 Part 1: Regulatory framework for foreign

investors

3 Taxation overview

4 Benchmarks

6 Inflation indices

8 Interest rate conventions

10 Appendix 1: Some special cases on taxation

11 Appendix 2: Some revenue taxes

11 Appendix 3: Useful Web addresses

12 Part II: Product overview

14 LTN (zero coupon - fixed rate bonds)

16 LFT (floating rate bonds)

18 NTN-F (fixed rate notes)

20 NTN-B and NTN-C (inflation-linked bonds)

23 NTN-D and NBC-E (dollar-linked bonds)

25 USD/BRL spot market

27 USD/BRL future contract

30 Futures: DI contracts

32 DDI future contract

35 Swaps

38 Appendix 1: Useful web addresses

38 Appendix 2: JPMorgan Indicative PricingSource

Emerging Markets ResearchGuide to Brazilian Local Markets

Drausio GiacomelliAC (1-212) 834-4685 Felipe Pianetti (1-212) 834-4043

[email protected] [email protected]

2 November 24, 2004

Part IRegulatory framework for foreign investorsThe Brazilian Central Bank Resolution 2689 defines the rules for foreigninvestments in Brazil. This Regulation applies to non-resident investments inEquities, Fixed Income and Foreign Exchange local markets. A non-residentinvestor is a person, corporation, fund or institutional investor with residence, headoffice or domicile outside Brazil. Exhibit 1 shows the main points of the Resolution.

The basic steps a non-resident investor needs to follow are: 1) registration withthe Brazilian Securities and Exchange Commission (CVM); and 2) theappointment of legal and tax representatives in Brazil.

Upon registration with CVM, the investor is ready to make a spot USD/BRL fxtransaction in order to invest in the local market. After quoting and closing thefx trade with the JPMorgan salesperson, the investor would transfer the agreedUSD to JPMorgan’s account and instruct her local legal representative (who iseffectively the counterpart of JPMorgan in the fx transaction) to receive thecorresponding amount of BRL, which is then transferred from JPMorgan to theinvestor’s legal representative in Brazil.

Under the new Brazilian Payment System the funds in local currency areavailable on the same day of the fx transaction. Then, the investor just needs toinform the JPMorgan salesperson which assets they want to buy and instructtheir representatives to exchange BRL for those assets with JPMorgan.

Transactions by the non-resident investor may only involve authorized stocks,commodities, futures exchanges and over-the-counter markets regulated by theCVM, or via a registration, settlement and custody system accredited by theCentral Bank of Brazil. All products discussed in the second section of thisguide meet this requirement.

Exhibit 1: Resolution 2689Before commencing operations, an investor shall:

a) Appoint legal and tax representatives in the country. The legal representative is responsible for signingfx contracts, executing payments and receipts for settlements and providing all documentation andinformation to the Brazilian authorities. The tax representative is responsible for all taxes that may beapplied to the transactions;

b) File a registration form with the Brazilian Securities and Exchange Commission (CVM) and apply for anID number (RDE), which will identify all future local investments;

c) Foreign funds shall enter through the Commercial Rate Exchange market (defined in the next section)and make investments in instruments and operating modes of financial and capital markets available toa resident investor;

d) Investors have a free choice of portfolio composition among equities, fixed income and foreign exchangeinstruments; there are no restrictions on investors switching positions between financial products.




November 24, 2004 3

Taxation overviewThe legal FX channel used by non-resident investors to tap the local market definesthe tax treatment they will face. Investments can be made in two different ways:

Commercial (Free) Rate Exchange MarketUnder Central Bank Resolution 2689, investment under this channel can onlyoccur after registration of the non-resident investor’s account with the BrazilianSecurities and Exchange Commission (CVM) and with the Central Bank. Alegal representative is also required to monitor the investor’s transactions andcomply with the Tax rules. Below, we provide a summary of the taxes levied oninvestors’ transactions under the Commercial Rate Exchange Market:

Income tax: 15% on capital gains and other income earned on money marketinstruments, including government bonds and CDs. Income from swaps andequity funds is taxed at 10%. Capital gains and other income earned withderivatives traded in exchanges and equities are exempt. Funds entering Brazilfrom “tax haven” countries, however, are subject to the rules applicable toresident investors (see below ‘Floating rate exchange market’).

IOF tax: Applicable to investments unwound within 30 days of inception at a1% per day on (1-n/30) of the income from fixed income investments (where nis the number of days between the investment and the remittance of funds).Example: suppose that an investor withdrew his investment 15 days after theinception, earning an income of $100. The IOF levied would be: (15 * 1%) *($100 * (1 – 15/30)) = $7.5. In general:

CPMF tax: 0.38% levied only on the arrival and departure of the funds, not oninternal transactions. Financial resources used exclusively in operations withequities and contracts referenced to equities or equity indices are exemptedfrom this tax.

Floating Rate Exchange MarketThis market comprises transactions related to tourism, donations, and transferof assets, international credit cards, shot-term loans, and CC5 accounts.Accordingly, this vehicle is not intended for portfolio investors. Alltransactions under this alternative must be monitored by a legal representativein Brazil. The legal basis Central Bank Circular 2677 regulates investmentsthrough the Floating Market. From a fiscal perspective, non-resident andresident are treated alike under this channel.

−××

3001.0

2nnincome

The different application of the CPMF tax makes the Commercial ExchangeRate Market much more attractive for non-resident investors.




4 November 24, 2004

Investments through the Floating Rate can occur after a deposit account in localcurrency is opened at one of the banks authorized to operate on the floating rateexchange market. Currently, there is no limit to transfers of funds by foreigninvestors to their local accounts. However, the remittance of funds to thecountry of origin by non-financial foreign investors must be effected through afinancial institution. Moreover, transfers of funds exceeding BRL10 millionmust be accompanied by corroborating documents provided by the bankresponsible for the deposit account. Below, we provide a summary of the taxeslevied on investors’ transactions under the Floating Rate Exchange Market:

Income tax: 20% on capital gains and other income earned on Equity, FixedIncome and Swap trades.

IOF tax: Same as for commercial market.

CPMF tax: 0.38% on every transaction, except for trades in equity andequity indices.

BenchmarksSelic rateThe Selic rate is the Central Bank controlled repo rate on public bonds (seeChart 1 on the following page). It serves as 1) the interest cost of governmentcredit between a trade date and the next business day; 2) the rate set by theCentral Bank for borrowing and lending money to banks; and 3) the rate atwhich floating rate government bonds accrue on a daily basis. This rate istraded every working day on a business/252 exponential convention (known asthe Central Bank convention).

CDI rateThe CDI rate is the rate for overnight interbank CDs. It is the interest cost ofinterbank credit between a trade date and the next business day, and the rate atwhich the floating legs of the interbank swaps accrue. This rate is traded everyworking day on a business/252 exponential convention. Before theimplementation of the New Brazilian Payment System in 2002, the CDI rateused to be the interbank interest rate between T+1 and T+2, for a trade date T. Itis noteworthy that the CDI usually trades below the Selic rate (Chart 1), whichinitially may seem a bit unusual. However, tight interbank credit constraints andthe fact that the CDI is the main funding rate for the banking system keep theformer slightly below the Seilc (see Chart 2 on the following page).

PTAX rateThe PTAX rate is the fx rate defined as the weighted average of all USD/BRL(commercial rate) transactions in Brazil’s foreign exchange market as reportedto the Central Bank through the Sisbacen network in a given day. This rate isthe reference rate for the settlement of several instruments in the local market,including futures, swaps and government bonds, for which the offered side ofthe market is used. The offer side is assumed to be the weighted average of thetrades plus four pips (0.0004 BRL/USD).




November 24, 2004 5

PTAX 800 released by Central BankOn May 14, 2004 the weighted average of the USD/BRL spot market was 3.0978. Therefore, thePTAX-800 offered side, which is the reference exchange rate for contracts expiring on that day, wasset as 3.0982 ( = 3.0978 + 0.0004).

The PTAX is defined according to the provisions of Resolution 1690 of the National Monetary Council asthe average offered rate calculated by the Central Bank of Brazil. It is published on Reuters and Bloombergon a daily basis.

Chart 2: Selic versus CDIspread, bp

-50

-40

-30

-20

-10

0

10

20

30

40

50

SELIC-CDI

Source: JPMorgan

Chart 1: Historical evolution of the Selic Rate%

15.0

17.0

19.0

21.0

23.0

25.0

27.0

Jan 3, 00 Aug 9, 00 Mar 21, 01 Oct 26, 01 Jun 10, 02 Jan 13, 03 Aug 21, 03 Mar 26, 04 Nov 3, 04

SELIC

Source: JPMorgan

15.0Jan 3, 00 Aug 9, 00 Mar 21, 01 Oct 26, 01 Jun 10, 02 Jan 13, 03 Aug 21, 03 Mar 26, 04 Nov 3, 04




6 November 24, 2004

Inflation indicesIn Brazil, a number of different inflation indices are calculated and publishedby several institutions on varying schedules. We provide below basicinformation about the main indices that are most commonly followed by themarket and used in the design of derivative contracts.

National Consumer price index (IPCA)Source: National Statistics Agency (IBGE)

Description: Monthly indices (1991=100) compiled from a weighted averageof 11 regional consumer price indices, based on consumption patterns ofhouseholds with incomes between 1 and 40 times the minimum wage. The pricecollection period spans from day 1 to day 30 of the reference month.

Timing: Usually released in second week of the following month.

Seasonal/focus: Not seasonally adjusted. Focus is on headline and coremeasures. The trimmed mean (which excludes the downward and upwardoutliers) and the calculation excluding food and administered prices aremeasures most closely followed by the market and the monetary authority.

Revisions: None.

Comments: This is the official inflation index targeted by the Central Bank toguide the monetary policy. A preview with the same methodology is alsoreleased (IPCA-15), which is calculated for the 30 days leading up to the midpoint of the reference month.

General price index (IGP-10 / IGP-M / IGP-DI)Source: GetúlioVargas Foundation (FGV)

Description: A nation-wide monthly composite index (1989=100) of wholesaleprices, consumer prices (based on the consumption pattern of households withincome between 1 and 33 times the minimum wage), and construction costs.Price indices are published both for the headline and the main components. Theweights of these components in the headline are: wholesale prices, 60%;consumer prices, 30%; construction costs, 10%. The IGP-DI is based on theinflation for the whole month, but there are also two previews that were created(IGP-10 and IGP-M). IGP-M is based on prices collected over a period from the21st day of the previous month through the 20th of the reference month. TheIGP-10 is based on prices from the 11th of previous month through 10th ofcurrent month.

Timing: released between the 5th and 10th day after the end of reference period.

Seasonal/focus: Not seasonally adjusted.




November 24, 2004 7

Revisions: None.

Comments: The IGP indices are the only source of information on wholesaleprices at the national level. It is used to adjust utility prices subject to indexedcontracts. Given the high participation of commodity prices in the wholesaleindex, this inflation measure is more susceptible to exchange rate volatility.

Consumer price index – São Paulo (IPC-FIPE)Source: FIPE- São Paulo University - Economic Research Institute

Description: A weekly release reflecting the four-week moving average ofretail price increases in the city of São Paulo based on consumption patterns ofhouseholds with incomes equivalent to between 2 and 20 times the minimum wage.

Timing: Published weekly, usually three days after the end of the pricecollection period.

Seasonal/focus: Not seasonally adjusted. Focus is on month-over-monthchange in the four-week average.

Revisions: None.

Comments: Although limited to Sao Paulo, this index is closely watched bymarkets due to its weekly frequency.

Chart 3: Historical IPCA and IGP-M inflation indexes% YoY

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

Aug 95 Jun 96 Apr 97 Feb 98 Dec 98 Oct 99 Aug 00 Jun 01 Apr 02 Feb 03 Dec 03 Oct 04

IPCA YoY

IGP-M YoY

Source: JPMorgan




8 November 24, 2004

Interest Rate ConventionsDespite recent efforts by the Central Bank and market participants to unify thevarious ways of expressing returns in the local market, many day-countconventions still exist. The variety of day-counts used locally, however, onlymakes comparison of assets’ returns more difficult. The conventions can bedivided in two categories:

1. Conventions in the Brazilian local marketsa) BusinessDays/252 exponential

• Used for Selic, CDI, government bonds and most futures contracts

• Does not accrue on weekends or holidays

• Accrual given by:

(1+rate)^(Business days/252)-1

b) ActualDays/360 exponential

• Used for some government bonds

• Accrues on weekends and holidays


(1+rate)^(Actual days/360)-1

c) Discount under Par Value

• Used for floating rate government bonds

• Does not accrue on weekends or holidays

• Discount given by:

(Par Value/Market Value)^(252/Business days)-1

Where Business Days is the remaining life of the bond

d) Percentage of CDI rate or Selic rate

• Largely used to measure funds performance

• % given by:

(Daily accrual/Benchmark daily accrual)-1

Conventions in the local USD marketa) ActualDays/360 linear

• Used for USD interest rate swaps and futures



(1+rate x Actual Days/360)-1




November 24, 2004 9

b) ActualDays/365 exponential

• Used for some USD government bonds



(1+rate)^ (ActualDays/365)-1

Exhibit 2: Example of different conventionsConsider a DI Future contract which expires on January 2nd 2007. If the interest rate implied by its price is17.67% on trade date November 17th, the relationship between unitary price and yield is given by:

Pu = 100,000.00 / (1+y)^(533/252)

Pu = R$ 70,882.06

Since there are 533 business days to maturity, the final value of the contract is R$ 100,000.00 and itfollows the business 252 day count convention.

Now, consider a DDI Future contract (local dollar interest rate future) which expires on August 2nd 2004. Ifthe interest rate implied by its price is 5.00% on trade date July 12th, the relationship between unitary priceand yield is given by:

Pu = 50,000.00 / [1+y * (21/360)]

Pu = USD49,854.59




10 November 24, 2004

Appendix 1: Some special cases ontaxationTaxation on remittance of non-resident’s equity investment in local companiesBrazil has international accords with many countries to prevent double taxationon investments of non-residents. As a general rule, however, withholding tax isapplied in the following way:

Dividend remittance: Withholding tax (beginning on 1996 retained earnings)is not levied on dividends paid by local companies to non-resident shareholders,whether or not they are based in specified “tax haven” countries, even whenrepatriation occurs through an fx transaction.

Interest on capital: Interest on capital and interest on dividends paid toshareholders, however, are taxed at a 15% rate. Non-resident investors based in“tax haven” countries are subject to a withholding tax of 25% on these earnings.

Equity divestiture: Non-resident investors are allowed to repatriate theproceeds from the sale of an investment in a local company at any time.However, a 15% withholding tax on capital gains from the foreign capitalregistered with the Central Bank is applied, calculated in foreign currency.

Note that the Double Taxation Treaties Brazil maintains with a number ofcountries do not alleviate the tax rates above.

Withholding tax on interest payments on loans/debt issued by subsidiaryfirms in the international marketWithholding tax at a rate of 15% is levied on interest payments of loans/debt inthis case. In some cases, however, existing Double Taxation Treaties definedifferent tax rates.

Withholding tax on hedging transactions by non-resident Non-resident investors are exempt from withholding tax on gains fromtransactions aimed to hedge existing exposure to interest rates, foreignexchange and commodity prices in the international markets.




November 24, 2004 11

Appendix 2: Some revenue taxesRecently, the government has introduced a non-cumulative mechanism thatavoids a cascading effect from the Cofins and PIS taxes, by means of tax credits.

CofinsThe Tax for Social Contribution is based on the gross revenues of localcompanies, including financial institutions. This tax is aimed at funding theGovernment’s social welfare programs. The current rate for the cumulativeregime (e.g., financial institutions) is 3%, while the current rate for the non-cumulative regime is 7.6%.

PISThis tax was designed to fund an employment insurance program. It is alsocharged on gross revenues. The current rate for the cumulative regime (e.g.,financial institutions) is 0.65%, while the current rate for the non-cumulativeregime is 1.65%.

Appendix 3: Useful web addressesBrazilian Central Bankhttp://www.bcb.gov.br

Federal Revenue Departmenthttp://www.receita.fazenda.gov.br

National Monetary Councilhttp://www.fazenda.gov.br

Brazilian Securities and Exchange Commissionhttp://www.cvm.gov.br

Brazilian Institute of Geography and Statisticshttp://www.ibge.com.br

BMF - Commodities and Futures Exchangehttp://www.bmf.com.br

ANDIMA - National Association of Financial Institutionshttp://www.andima.com.br

Cetip - Clearing house for private securitieshttp://www.cetip.com.br

Selic - Clearing house for public securitieshttp://www.selic.com.br





Part IIProduct OverviewIn this section, we introduce the main financial products available in theBrazilian onshore market. We first describe the government bonds, which areissued at fixed maturity dates instead of fixed maturities as in the US. They areactively traded in the secondary market and can be repoed, but are less liquidthan non-cash products. The most liquid instruments are the LTN (fixed-ratebonds) and the LFT (floaters), while the USD-linked securities like NTN-D andNBC-E have been phased out since 2003. Dollar-linked bonds were issued until2002 in order to tame currency volatility. Recently, with the markedimprovement in external accounts, the government actually has been able toredeem those bonds so as to reduce the sensitivity of Brazilian debt to fxmoves. After describing these bonds, we present the most traded derivativeproducts in Brazilian local markets—the BMF fixed income and fx futures. Thehighlight here is the DI futures market, with a daily turnover up to around $5billion. This piece provides an overview of the basic contract covenants,valuation, and pricing relationships across the main benchmarks.

Table 1: Brazil Local Fixed Income Market Investment OpportunitiesCurrency Credit Products

Futures Exchange & OTC • Interest rate futures: DI futures• Interest rate swaps: “prefixed” swaps• Inflation swaps: IGP-M, IPCA swaps

Government bond Market • fixed rate bonds: LTN, NTN-FBrazilian real (BRL) • floating rate bonds: LFT

• inflation-linked bonds: NTN-C, NTN-B• Repos

Corporate bond • Bank's locally issued bonds : CDBs• Corporate bonds

Futures exchange and OTC • Interest rate futures: FRCOnshore dollar (USD) • Interest rate swaps: dollar “coupon” swaps

Government bond market • fixed interest rate bonds: NBC-E, NTN-D





Table 2: Brazilian public domestic debt—federal bonds outstandingas of November 2004Issuer BRL million Total

Central BankNBCE 14,797 2%

National TreasuryLFT 452,145 58%LTN 133,539 17%NTN-F 1,571 0%NTN-C 74,707 10%NTN-D 17,062 2%NTN-B 25,405 3%Other 57,277 7%Total 776,503 100%

Table 3: Brazilian public domestic debt—indexationas of November 2004Type BRL million Total

Selic-linked* 420,466 54%BRL fixed rate 135,158 17%Inflation linked 118,755 15%US dollar-linked* 87,264 11%Other 14,861 2%Total 776,503 100%* Includes CB swaps

Chart 4: Evolution of debt composition

0%

10%

20%

30%

40%

50%

60%

Dec/99 Jun/00 Dec/00 Jun/01 Dec/01 Jun/02 Dec/02 Jun/03 Dec/03 Jun/04

BRL FIXED RATE SELIC LINKEDINFLATION LINKED USD LINKED

OTHER

Source: Central Bank and JPMorgan





LTN (zero coupon - fixed rate bonds)• Fixed rate, zero-coupon bond that trades at a discount

• As of November 2004, outstanding amount represented 17% of thepublic domestic debt

• Usually trades at a premium over the DI Futures curve

Letras do Tesouro Nacional (LTN) are zero-coupon Treasury Notes. The shareof LTN stands at about 17% of the domestic public debt outstanding as ofNovember 2004. It is the Treasury’s intention to increase this type of debt,while reducing the debt linked either to the BRL/USD exchange rate or to afloating interest rate. Recently, the Treasury has been able to reduce the dollar-linked debt, but most of this reduction came at the expense of increasing theoutstanding amount of the floating rate instruments.

The average maturity of the LTN has been extended over the last few years, butthere is still a long way to go (see Table 4 on the following page). The mainimpediment for faster progress in this direction is institutional. The mutual fundand pension fund industries are benchmarked to the overnight interbank rate(CDI) and they require a significant premium for duration extension—particularly when rate volatility is high.

The custody and clearing of these instruments are carried out by the Selic. Thepurchase of these bonds must be settled on the trade date. Short selling isallowed and a repo market exists for overnight and term agreements. Exhibit 3shows more details of this fixed-rate bond.

Liquidity constraints make LTN riskier during crisis periods when compared toBMF’s DI contracts, which seems to be one of the reasons why LTN trade at aspread over the DI curve (note that the swap spread is negative in Brazil).However, the persistence of the difference in returns of these similarinstruments is often attributed to perceived differences in credit risk. Althoughsome argue that the BMF is safer, the fact that BMF margin requirements canbe met with government bonds themselves should mitigate credit differences.More relevant, in our view—and in addition to liquidity—is the difference inthe funding rates between DI contracts and LTN bonds, which is lower for theformer (in other words, the LTN repo rate is greater than the CDI rate).

PricingThe LTN trades at a discount based on a Business/252 exponential day countconvention. Also, no coupons are paid throughout the life of the instrument.

where: PU is the unit price

y is the quoted yield

( )

+=

2521

1000n

yPU





For instance, for a contract with 54 days remaining to maturity, the 17% yieldrepresents a unit price given by:

PU = BRL 96,691.60

The table below shows that approximately 90% of the outstanding amount ofLTN will mature within a 1-year period.

Table 4: Distribution of LTN maturities, as of November 2004LTN up to 12-months up to 24-months up to 36-months up to 48-months Total

BRL million 122,464 133,539 133,539 135,110 135,110% 91% 99% 99% 100%Source: JPMorgan

( )

+=

25254

17.01

1000PU

Exhibit 3: LTNClearing: Primary market: Selic; Secondary market: Selic, BMF

Issuer: Treasury

Currency: BRL

Nominal value: BRL1000.00

Coupon: zero

Amortization: bullet

Interest accrual: fixed rate

Outstanding amount (% of domestic public debt): 17%

Settlement: T+1

LiquidityAverage daily volume: USD1.6 billion

Additional informationTaxation: residents: 20% on capital gain and coupon

non-residents: 15% on capital gainnon-residents from tax haven countries: 20% on capital gain and coupon

Foreign Investment: defined by Resolution 2689





LFT (floating rate bonds)• Floating-rate, zero-coupon bond that trades at a discount/premium

• As of November 2004, outstanding amount represented about 54% ofthe public domestic debt

• Accrues at the Selic rate on a daily basis

Letras Financeiras do Tesouro (LFT) are floating Treasury Notes, which areauctioned on a weekly basis to cover the Treasury’s budget deficit. The totalamount outstanding, as of November 2004, is BRL420 billion, which representsaround 54% of the public domestic debt. It is the Treasury’s intention to reducethe exposure to floating rate instruments, replacing it by fixed rate bonds. Thecustody and clearing of these instruments are carried out by the Selic.

The LFT’s accrual is given by the Selic rate on a daily basis. The principalamount is expected to be repaid at maturity and there is no coupon throughoutthe life of the bond. The bonds are issued close to par and the nominal value ofeach bond is BRL1,000.00. The outcome of the weekly auctions usually embeds asmall discount/premium in the primary market, according to perceived credit riskand liquidity conditions. The purchase of these bonds must be settled on the tradedate. Short selling is allowed and a repo market exists for overnight and termagreements. Exhibit 4 provides more details on the floating interest rate notes.

PricingThe market price of a LFT is usually expressed in terms of a percentagediscount over the accrual of the Selic rate applied to the Principal amount. Hereis an example:

Principal + accrual by Selic since issuance date: BRL1,583.80

Market value of the LFT: BRL1,579.68

Business days between trade date and maturity: 212

Alternatively,

%31.0168.579,180.583,1 212

252

=−

=teDiscountRa

( )68.579,1

%31.01

80.583,1

252212

=+

=PU





The table below shows the distribution of the outstanding maturities of thefloating rate notes, as of June 2004.

Table 5: Distribution of LFT maturities, as of November 2004LFT up to 12-months up to 24-months up to 36-months up to 48-months Total


The majority of the LFT is short-term, with maturity up to two years. Duringperiods of stress the government has bought back longer-term LFT or offeredterm repo with maturities typically up to 90 days.

Exhibit 4: LFTClearing: Primary market: Selic; Secondary market: Selic, BMF

Issuer: Treasury

Currency: BRL


Coupon: zero


Interest accrual: on business days by the current Selic rate

Outstanding amount (% public domestic debt): 54%

Settlement: T+1

LiquidityAverage daily volume: USD1.3 billion

Additional informationTaxation: residents: 20% on capital gain and accrual to par

non-residents: 15% on capital gain and accrual to parnon-residents from tax haven countries: 20% on capital gain and accrual to par






NTN-F (fixed rate notes)• Fixed-rate, coupon bond that trades at a discount

• As of November 2004, outstanding amount represented just 0.15% ofthe domestic public debt

• Key to the Treasury strategy aimed at lengthening domestic debt duration

The NTN-F is a BRL fixed rate, coupon-bearing Treasury note. The share ofNTN-F stands at a meager 0.15% of the domestic public debt outstanding as ofNovember 2004. As with the LTN, it is the Treasury’s intention to increase thistype of debt, while reducing the debt linked either to the BRL/USD exchangerate or to a floating interest rate.

Along with all the hurdles facing the LTN, the NTN-F has two additionalcaveats: a) the BRL yield curve has very low liquidity beyond the 18-monthtenor; and b) there is no culture among local players of trading fixed-rate,coupon-bearing bonds. Indeed, this instrument’s daily turnover is extremely low.

That said, the prospects for this kind of paper have brightened, as the inflationtargeting regime gains stature and the Central Bank succeeds in buildingcredibility. More recently, the solid performance of Brazilian external accountshas reduced fx volatility, which—in combination with an increasingly credibleCentral Bank—has paved the way for BRL yield curve extension.

PricingThe future value of each bond is BRL1,000.00 and coupons are usually 10%,paid semi-annually. The bond trades at a discount based on business/252exponential day-count convention. The first coupon is paid in full, irrespectiveof the number of days between the trade date and the first coupon date. Thecustody and clearing of these instruments is carried out by the Selic.

The pricing formula is as follows:

where:

i is the number of business days between trade date and the coupon paymentdate

y is the fixed interest rate paid over and above the inflation index variation

N is the notional value

( )

( )( )

( )2521 252

126

11

110.1Pr

T

T

T

ii

i y

N

y

Nice

++

+

−×

= ∑=

Price





Exhibit 5: NTN-FClearing: Primary market: Selic; Secondary market: Selic, BMF

Issuer: Treasury

Currency: BRL


Coupon: 10%, semi-annual


Interest accrual: fixed rate

Outstanding amount (% total public debt): 0.15%

Settlement: T+1

LiquidityAverage daily volume: not significant


non-residents: 15% on capital gainnon-residents from tax haven countries: 20% on capital gain and coupon






NTN-B and NTN-C (inflation-linked bonds)• Inflation-linked, coupon bonds that trades at a discount

• As of November 2004, outstanding amount represented 13% of thedomestic public debt

• Pension Funds are the main holders, which limits liquidity

Notas do Tesouro Nacional , series B and C (NTN-B and NTN-C), are TreasuryNotes whose payout is linked to a specific inflation index. The NTN-B provideshedge against changes in the IPCA inflation index, while NTN-C cash flow islinked to the IGP-M.

As of November 2004, inflation-denominated instruments accounted forapproximately 13% of the domestic public debt (3% NTN-B and 10% NTN-C).The Treasury has held buyback auctions on a monthly basis since September2003 in order to provide liquidity to this market.

In practice, each product yields the variation of its respective inflation indexplus a fixed interest rate. The payments to the holders are made in the form ofsemi-annual coupons and the principal amount at maturity, both of which areadjusted by the variation of the inflation index. The payment dates are definedas the first day of each 6-month period from maturity to trade date, i.e., the lastcoupon date coincides with the maturity of the bond. In the case of a nationalholiday on the payment date, settlement takes place on the next business day.

PricingThe market value of these instruments reflects not only the contractuallydefined fixed interest rate, but also current month’s inflation expectationreleased by National Association of Financial Institutions (ANDIMA).

The nominal value of each bond is BRL1,000.00 and coupons are usually 6%,paid semi-annually. Both the coupons and principal amount are first adjusted bythe effective variation of the inflation index since the issuance date before theyare settled in BRL. The day-count convention used for the pricing of this typeof security is business/252 exponential. The custody and clearing of theseinstruments is carried out by the Selic. The purchase of these bonds must besettled on the trade date.

The example below provides the pricing formula for a 6%-coupon NTN-C:

( )

( )( )

( )252252

126

11

06.1Pr tT

T

tT

titi

i

t

t

y

N

y

Nice −

=−

++

+

×

= ∑





where:

i is the number of business days between trade date ( t) and the couponpayment date

y is the interest rate quoted

t trading date

Nt is the notional value adjusted by the effective + residual inflation fromissuance date to t

Since the IGP-M and IPCA index is released on a monthly basis with a lag(unlike the daily release of the Chilean’s UF), it is necessary to factor in theexpected inflation for the current month, on a pro-rata basis. This is done viathe residual inflation (πR) defined below.

The nominal value is first accrued by the effective inflation index from issuanceof the bond to the last day of the previous month. This adjusted nominal valueis then accrued by the expected inflation released by ANDIMA, so as tocomplete the inflation adjustment. For instance, if the expected inflation for thecurrent month is 0.5%, the resulting adjusted nominal value at the margin (or inbetween the first and the last days of the current month) is given as follows:

where:ni – n0 is the number of calendar days between trade date and the first dayof the current month

nf – n0 is the number of calendar days of the current month

Table 6: Distribution of the NTN-B and C maturities, as of November 2004NTN-B up to 12-months up to 24-months up to 36-months up to 48-months Total

BRL million 0 3,846 3,846 3,846 25,405% 0% 15% 15% 15%Source: JPMorgan

NTN-C up to 12-months up to 24-months up to 36-months up to 48-months Total


( ) 0

0

%5.01 nnnn

R f

i

−−

+=π





Exhibit 6: NTN-B and NTN-CClearing: Primary market: Selic; Secondary market: Selic, BMFPrincipal amount: BRL1,000.00


Amortization: bulletInterest accrual: on calendar days

Outstanding amount (% domestic public debt): 6%

Settlement: T+1

LiquidityAverage daily volume: NTN-C = USD30 million


non-residents: 15% on capital gain and couponnon-residents from tax haven countries: 20% on capital gain and coupon

Foreign Investment: defined by resolution 2689





NTN-D and NBC-E (dollar-linked bonds)• USD-linked, coupon bonds that trades at a discount

• As of November 2004, outstanding amount represented 4% of thedomestic public debt

• These bonds are being phased out as the government aims to reduce FXvulnerability

Notas do Tesouro Nacional, serie D (NTN-D) and Notas do Banco Central,serie E (NBC-E) are the two main dollar-denominated government bonds,which together comprise 4% of the domestic public debt, while USD-linkedswaps and other bonds account for 7%. The chart on page 2 shows theevolution of USD-linked paper as a share of domestic public debt. Note that ithas dropped substantially. As of November 2004, around 11% of the domesticpublic debt was composed by dollar-denominated instruments, while in thebeginning of 1999, it accounted for more than 30% of the total.

NTN-D, NBC-EWhile NTN-D bonds were issued to cover the Treasury’s budget deficit, theNBC-E bonds were used by the Central Bank as an instrument to intervene inthe fx market. Starting in September of 2002, the Central Bank favored the useof fx swaps to intervene in the market. The improvement in the current accounthas allowed both the Treasury and the Central Bank to reduce the stocks of fxswaps and USD-linked bonds since 2003. The goal is to eliminate theseinstruments altogether.

Those bonds, although linked to the variation of the official PTAX rate, are paidand settled in local currency. The custody and clearing of these instruments arecarried out by the Selic.

Save for the issuer, these notes are both fixed-rate instruments with essentiallyidentical features. The coupons (generally 12%) can be traded separately fromthe principal, but this situation rarely happens. The nominal value of each bondis BRL1,000.00.

Both the coupons and principal amount are first adjusted by the variation of thePTAX rate released on the previous day before they are paid in BRL. Theconvention used for the pricing of this type of security is Actual/360exponential. Exhibit 7 on the following page shows more details of the maindollar-linked bonds.





The yield on an Actual/360 exponential convention can be inferred as followsfor a 12%-coupon bond:

Nt = Notional value adjusted by the PTAX variation from the issuance date to t

T = number of calendar days to maturity

i = number of calendar days

y = onshore US dollar-linked rate

Table 7: Distribution of the NTN-D and NBC-E maturities, as of November 2004NTN-D up to 12-months up to 24-months up to 36-months up to 48-months Total


NBC-E up to 12-months up to 24-months up to 36-months up to 48-months Total


( )( )

( )3601 360 11

2%12

Pr tT

T

tT

iti

i

t

t

y

N

y

Nice −

=−

++

+

×

= ∑Pricet

Exhibit 7: NTN-D and NBC-EClearing: Primary market: Selic; Secondary market: Selic, BMF

Issuer: NTN-D: Treasury; NBC-E: Central Bank

Currency: BRL




Interest accrual: on calendar days

Outstanding amount (% domestic public debt): 5%

Settlement: T+2 (primary auctions), trade date (secondary market)

LiquidityAverage daily volume: NBC-E = USD20 million


non-residents: 15% on capital gain and couponnon-residents from tax haven countries: 20% on capital gain and coupon






USD/BRL spot market• Still an OTC product, but registered in the Central Bank system

• Far less liquid than USD/BRL futures contracts

• The New Brazilian Payment System improved the settlement process

As a non-deliverable currency, the USD/BRL spot exchange rate is traded as anOTC in the domestic market, albeit the registration of the trades on the CentralBank system—Sisbacen—is mandatory. With the introduction of the BrazilianNew Payment System, the BMF Futures Exchange created its Forex ClearingHouse, which has contributed to reduce the settlement risk of the transactionsby requiring collateral and netting trades between two counterparts. However,in practice, market participants have the option to settle the trade on a gross ornet basis and in or out the BMF’s Clearing House. Still, most participants havenow decided to use the BMF’s Clearing House system. Within the ClearingHouse, trades are guaranteed to a certain level of volatility of the spot rate andthe effective counterpart to all participants is the BMF.

Investments by foreigners in the Brazilian domestic market was first regulatedthrough Federal Laws 4131 and 4390. In practice, however, the steps to befollowed by investors using the BRL/USD forex market are defined by theCentral Bank’s regulation called Consolidation of Exchange Norms (CNC).This regulation establishes the limits for the settlement of the trades andrequires that all Forex transactions be registered with the Central Bank systemand be accompanied by a pre-defined contract.

The forex transaction registered as “spot settlement” must be settled within twobusiness days from the trade date. However, the Central Bank also allows fortrades under the “future settlement” category, where transactions can be settledup to 60 days from trade date. Although amendments in the settlement date ofcontracts are allowed, those involving sale of USD for “future settlement”cannot be settled before the date originally agreed.

The Central Bank establishes that the exposure of any individual bank to theBRL/USD exchange rate cannot exceed 30% of the bank’s equity capital.

Officially, there are two segments in the Brazilian forex market:

Commercial Rate Exchange Market: Usually used for trade-relatedtransactions, such as import and export transactions, foreign currencyinvestments in Brazil, foreign currency loans to residents in Brazil andremittances abroad.

Floating (“Tourism”) Rate Exchange Market: Primarily designed and usedfor unilateral transfer of funds, this vehicle is not a formal alternative forinvestments.





Another important difference between those two segments is the fact that, whileboth operate at floating rates freely negotiated between the parties, thecommercial exchange market is restricted to transactions which require priorapproval of the Brazilian monetary authorities and the floating exchange marketis open to transactions defined in the current legislation but which do notrequire any such formal prior approval. Although the rates are similar, thecommercial rate is much more liquid.

Liquidity: The bulk of trading in the Brazilian exchange rate market isconcentrated in the USD/BRL futures (see USD/BRL future contract on page27). As a listed product, the USD/BRL future is traded in a more transparentenvironment.

Daily volume in the spot market has been around USD1 billion, while turnoverin the Futures can be as high as USD8 billion.

Taxation: Although dollar transactions are allowed in the interbank market,dollar accounts are not available and non-resident transactions settle in BRL.Under the Resolution 2689, the CPMF tax is levied only on the entry and exitof the registered funds, not on internal transactions. This special provision forinvestment by foreigners makes the Commercial Rate Exchange Market moreattractive than the Floating Rate Exchange Market.

Exhibit 8: USD/BRL exchange rateExchange rate regime: free-float, non-deliverable

Official Fixing: PTAX rate, which is the Central Bank’s official exchange rate fixing, defined as theweighted average of the intra-day’s spot transactions.

Price quotation: BRL value of USD1.00 with 4 decimal places

Onshore fx Markets available: Commercial and Floating Exchange markets

Settlement: T+2

Custody: Mandatory registration and custody is held at Sisbacen (Central Bank System)

Liquidity

Average daily volume: USD1.0 billion

Average transaction size: USD1-5 million

Average bid-ask spread: 20-40 pips

Additional information

Taxation: Depends on the underlying transaction






USD/BRL future contract• It settles in BRL

• The main instrument for short-term currency hedging

• Subject to daily margin adjustment

The underlying instrument of the USD/BRL Future contract is the USD/BRLspot exchange rate. The face value of the contract is USD50,000.00 and thequote price is the expected value in local currency for USD1,000 at maturity,with 3 decimal places. The final settlement of the contract is based on thePTAX (trade volume weighted average) rate of the last trading day, which is thelast business day of the month preceding the contract month. For instance, theUSD/BRL April Future (2004) expires on April 1 and, therefore, settlement isbased on the PTAX rate released on March 31. Exhibit 9 shows more detailson the contract.

Bid-ask spread is usually 2 pips (BRL 0.0002), which is much lower than theequivalent offshore NDF market, but liquidity is concentrated in the first maturity.

The contract is listed at the BMF Futures Exchange, and as such, subject to thedaily margin adjustment. All open positions are adjusted to the official closingprice defined by BMF at the end of each trading day. The difference from theofficial closing value is then credited to/debited from the investor’s marginaccount on the next day. The next day’s opening value of the positions is justthe official closing value of the previous day.

Maturities are generally available for up to one year, but decent liquidity can befound only in the first month. BMF restricts the number of authorized contractmonths to 24.

The relationship between the spot and future USD/BRL exchange rate can alsobe traded through the Forward Points contract on a daily basis. This strategyconsists of trading the USD/BRL future contract by means of a spread to beadded to the PTAX rate observed on the trade date. Therefore, at the end of atrading session, forward point transactions are transformed into a position in theUSD/BRL Future on the same number of contracts and of the same directionalnature (long or short).

Rollover of positionsSince liquidity is concentrated in the first contract month, most players need torollover their positions into the next contract month as the maturity approaches.Therefore, usually in the last week of the month, liquidity is channeled to the socalled “rollover market,” which is just a spread market involving the first twocontract months.





PricingAlthough some investors just follow a day-trading strategy, many hedgersdepend on the protection provided by the future contract for their mid/long-terminvestments. Therefore, it’s worth mentioning the main relationship between thespot USD/BRL exchange rate and the future contract.

As will be described subsequently, there is a market for the local USD interestrate. One of the differences between this rate and the corresponding LIBOR isthat the former is settled in local currency. Using the local USD interest rate,local BRL interest rate and the USD/BRL spot exchange rate, the expectedvalue of the USD/BRL spot exchange rate in the future is given by:

where:

y is the BRL interest rate, on a Bus/252 convention

d is the local USD interest rate, on a Act/360 conv

n is the number of business days to maturity

N is the number of actual days to settlement

fw is the one-day CDI forward rate between n-1 and the maturity day

In practice, however, care should be taken with the fact that the DI futurecontract—from which we take expectations for the BRL interest rate (y)—expiresone day after the USD/BRL future and the DDI future—from which we takeexpectations for the local USD interest rate. Therefore, in order to be consistentwe discount one overnight CDI rate from the unit price of the ID Future.

( )

( )fwN

d

yspotBRLfutureUSD

n

n

+×

×+

+×=

1360

1

1/

252

Forward Points contractAs an example, a Forward Points contract traded at 20 points is convertedinto a USD/BRL Future position at a price equal to PTAX rate plus 20 pips,in the end of the trading section.





Exhibit 9: USD/BRL futuresExchange: BMF – Futures Exchange

Underlying: the PTAX rate of the last trading day, which is the last business day of the month precedingthe contract month

Price quotation: BRL value of USD1,000 with 3 decimal places

Minimum price fluctuation: BRL 0.001

Maximum price fluctuation: 7.5% of the previous day’s settlement price

Contract size: USD50,000.00

Contract months: all months, limited to a maximum of 24 maturities

Expiration date: the first business day of the contract month

Last trading date: the last business day of month preceding the contract month

Daily margin account: the positions outstanding at the end of each session are adjusted according to theday’s settlement price (average price of all trades during the last 15 minutes of trading) and cash settled onthe following business day

Assets eligible for margin requirements: cash, gold, Federal bonds, private securities, letters of credit, stocks

LiquidityAverage daily volume: USD4-8 billion

Average open interest: USD12 billion

Additional informationTaxation: residents: 20% on capital gain

non-residents: exemptnon-residents from tax haven countries: 20% on capital gain






DI futures contracts• Listed at BMF Futures Exchange; requires daily margin adjustment

• The most liquid interest rate instrument available

• Liquidity still limited to about 18 months

The DI futures can be thought of as an overnight swap from floating interbankrates (CDI) into fixed rates (zero coupon). The underlying instrument of the DIfuture contract is thus the CDI between the trade date and the last trading dayof the contract. Apart from the daily margin requirements, the cash flow of thecontract (the fixed leg) resembles that of a zero coupon bond with face value ofBRL100,000.00. Bid-ask spreads are available in yield terms, on a business/252exponential convention. Exhibit 10 shows the details of the DI future contract.

Maturities are available quarterly on the months that initiate a new quarter. Thecontract always expires on the first business day of the month, which is used toname to the contract. For instance, the April DI future expires on April 1 and itsyield (expressed on an annual basis) reflects the expected compounded CDI ratefrom trade date through April 1 (annualized).

All open positions are adjusted to the official closing price defined by BMF atthe end of each trading day. The difference from the official closing value isthen credited to/debited from the investor’s margin account on the next day. Thenext day’s opening value of the positions is just the official closing value plusthe accrual given by the CDI rate observed on the trade date. Note that theseyields can easily change 20bp + in one trading day, which makes marginrequirements substantial in periods of choppy markets.

Liquidity beyond the Jan’06 DI is still limited, reflecting the short nature ofBrazil’s fixed rate market. In particular, Brazil’s longest fixed-rate paperoutstanding matures in July 2006. Note that, although the CDI moves in linewith the Selic (which is set in open market operations by the Central Bank), itmay deviate significantly from the official rate. At the time of this writing, thedifference was 5bp, but it reached 25bp just two months ago. This difference iskey in pricing (especially for the shorter tenors) and it tends to follow liquidityconditions and credit constrains in the interbank marketing.

PricingSimilarly to a US T-Bill, the DI future is traded as a discount instrument. However,the exponential interest rate convention requires the following pricing formulae:

( )

+=

2521

1000n

yPU





where:

PU is the unit price

y is the quoted yield

For instance, for a contract with 54 days to maturity, the 17% yield implies anunit price given by:

PU = 96,691.60

Reference yields can be found in JPMorgan’s Bloomberg (JBRL) and Reuters(JPMBR) pages. Note that, in Brazil, the DI yields tend to be lower than thebond yields. One possible reason is BMF’s perceived lower credit risk.However, the fact that BMF accepts government bonds as collateral mitigatesthe credit argument, in our view. Another reason, which we believe to besounder, is DI’s superior liquidity, which is significantly higher than that ofgovernment bonds. Finally, the LTN repo rate is usually higher than the CDI,which also helps to explain the difference.

( )

+=

25254

17.01

1000PU

Exhibit 10: DI Future contractExchange: BMF – Futures Exchange

Underlying: effective CDI rate from trade date to the last trading day

Contract size: BRL100,000.00

Unitary Price: the present value of BRL100,000.00

Price quotation: the effective CDI interest rate from trade date to the last trading day, on a business/252exponential convention

Minimum price fluctuation: 1 basis point

Contract months: the first four months subsequent to the trade date and the months that initiate a quarter


Last trading date: the business day preceding the expiration date

Daily margin account: the positions outstanding at the end of each session are adjusted according to theday’s settlement price and cash settled on the following business day


LiquidityAverage daily volume 6-month (2-year): USD5 billion (USD250 million)









DDI future contract• Main vehicle for fx exposure hedging

• Liquidity concentrated on the FRA market, through the FRC FutureContract

• Short-term DDI rates more exposed to fx moves due to PTAX settlementconvention

The DDI Future contract (or “Cupom Cambial”) is derived as the differencebetween the effective CDI rate and the PTAX variation in the period. In otherwords, it is a zero coupon dollar-linked future contract.

The effective CDI is the capitalized CDI rate verified on the period between thetrading day and the last day of the month that precedes the contract month (forexample, March 31 for the April contract). The PTAX rate variation isconsidered for the period between the business day preceding the trading dayand the last day of the month preceding the contract month. Note then that thePTAX and CDI tenors differ by one day, which affects the derived DDI rate,particularly for short tenors.

In practice, the contract provides hedging against changes in the local USDinterest rate, also called “fx coupon.” Exhibit 11 provides further details on thecontract.

The face value of the contract is USD50,000.00 and the quoting price is theinterest rate that represents the percentage difference in the variations definedabove, to two decimal places, on the Actual/360 linear convention.

According to the BMF’s rules, the DDI is traded on margin and marked-to-marketdaily. All open positions are adjusted to the official closing price defined byBMF at the end of each trading day. The difference from the official closing valueis then credited to/debited from the investor’s margin account on the next day.

Maturities are available for the first day of each new quarter (the benchmarks)and also for the first four months subsequent to the trade date. The contractalways expires on the first business day of the month. For instance, the AprilDDI Future (2004) expired on April 1.

Nevertheless, since the introduction of the FRC contract (“Cupom Cambial”forward rate agreement), the liquidity in the DDI Future has reducedconsiderably.





FRC structured transactionAs defined above, the DDI future reflects the local USD interest rate by takinginto account the fx variation based on the PTAX rate released on the businessday preceding the trading day. The resulting USD interest rate is called “dirty fxcoupon” (see box).

Since the USD/BRL spot rate at the moment of the trade may differsubstantially from the previous day’s PTAX, the resulting DDI dollar rate maybe distorted by this residual fx variation. In particular, if the BRL weakensversus the PTAX, the resulting short-term DDIs can become negative. Toovercome this, BMF created DDI FRAs, which are known as FRC or clean fxcoupons. The forward rate offsets the effect of the PTAX in the dollar ratecalculation.

BMF’s FRC (forward) contracts uses two DDI futures: The long leg is the DDIfuture that matches the maturity desired by the investors while the short leg isthe DDI future closest to trade date. For instance, if an investor wants to lock indollar rates from the beginning of the following month through the end of 2005,she would enter a January 2, 2006 FRC.

The so-called “clean fx coupon”, on a 252/Business exponential convention,can be calculated as follows:

where:

y is the BRL interest rate, on a Bus/252 exponential conv.

N is the number of business days to maturity

Dirty versus clean fx couponThe “dirty fx coupon” is the local USD interest rate priced off the PTAXrate, while the “clean fx coupon” is the local USD interest rate priced off theUSD/BRL spot rate.

( )

spotbrlusdfuturebrlusd

ynCleanCoupo

n

_/_/

1 252+=





Exhibit 11: DDI Future contractExchange: BMF – Futures Exchange

Underlying: the difference between the variations of the CDI rate and the PTAX rate

Price quotation: Local USD interest rate to 2 decimal places, on a Actual/360 Linear convention

Minimum price fluctuation: 1 basis point

Contract size: a value in BRL representing USD 50,000.00 at maturity

Contract months: the first four months subsequent to the trade date and the months that initiate a quarter


Last trading date: the last business day of month preceding the contract month

Daily margin account: the positions outstanding at the end of each session are adjusted according to theday’s settlement price and cash settled on the following business day


LiquidityAverage daily volume: USD10 billion









Swaps• Available as listed or OTC; with or without collateral; daily, periodically

or no margin adjustment

• Alternatives include cross-currency and inflation-adjusted swaps

• Flexibility permits “Percentage of the variable” or “Variable plus fixedinterest rate” modalities

Swaps in the Brazilian market are primarily traded as an OTC product andtransactions are registered at Cetip (non-profit clearing house), although thesetransactions are also available for registration at BMF—the Futures Exchange.One of the reasons that accounts for the higher volume of swap transactions inthe OTC relative to BMF is the limited access of corporations to the futuresexchange. In addition, banks prefer to use their mutual credit lines instead ofsetting capital aside to cover BMF risk.

In a swap, the parties must define the parameters that will provide the payout ofeach leg of the trade. The following types of parameters are the most common atCetip: interest rates, inflation indices, exchange rates, and stock baskets. Unlikesome types of swaps registered at BMF, the transactions in the OTC market arenot guaranteed by Cetip. The latter only provides the system that updates theswap value through standardized formulae, generates the reports to each party,and allows for the settlement within the New Brazilian Payment System.

In addition to the plain vanilla swaps just mentioned, investors can chooseamong other derivatives such as swaptions, term swaps, callable swaps, andswaps with barriers (knock-in, knock-out, and knock-in-out). Furthermore, theparameters used to value each leg in the swap can be capped to a specifiedpercentage or accrued by a fixed interest rate. Finally, the maturity and numberof periodic resets may be freely chosen. Exhibit 12 shows more details of theSwap contracts available at Cetip.

Under the BMF version of swap, a margin requirement is only applied to theparty whose counterpart has chosen to trade with the guarantee feature.





Formulae commonly used in swap pricingThe accrual of each leg on a swap depends on two types of adjustments:Percentage parameter - C (e.g., 102% of the CDI) and Additional spread - J(e.g., CDI + 0.30%, the later in annual 252 day count convention). Then, thevalue of a leg in a swap is given by:

V = Notional x C x J.

Find below the formulae for these adjustments for each type of parameter.

1) Floating Interest Rate (Ex: CDI)

2) Fixed Interest Rate (Ex: 19%, bus/252 exponential)

3) Exchange Rate (Ex: USD/BRL)

4) Inflation Indices (Ex: IGP-M)

Where

for all types of parameters

CDIn = CDI rate observed on day n

p = percentage rate applied to the CDI rate

i = additional interest rate to accrue over and above CDI

PTAXn = PTAX rate of previous business day of the valuation

PTAXo = PTAX rate of previous business day of the inception date

Πn = Inflation index of the previous month of the valuation

Πo = Inflation index of the previous month of the inception date

n = number of business days from trade date to maturity

( )∏

×

−++=

n pCDInC

1

2521

100111

1=C

+×

−= 1

1001

pPTAXPTAX

Co

n

+×

−= 1

1001

pC

o

n

ππ

252

1001

n

iJ

+=





Exhibit 12: SwapsUnderlying: the difference between accruals provided by the two parameters chosen

Cap/Floor: the swap can be tailored to resemble the payout of Caps and Floors, by means of barriers onthe swap value (knock-in, knock-out and knock-in-out)

Term Swap: the swap can be tailored to start on a future date

Callable: the swap can embed an option to be redeemed

Swaption: options on swap or term swap are also available

Maturity: freely chosen by the counterparts

Guarantee: Cetip does not act as a guarantor of the transaction. It only provides the system that updatesthe swap value through standardized formulae, generates the managerial reports to each party and allowsfor the settlement within the New Brazilian Payment System.

Redemption: swaps can be redeemed in total or partial amount at any time

Parameters available: CDI, Selic, Gold, USD/BRL, BRL/EUR, BRL/JPY, TJLP (BNDES long-term interestrate), IGP-M, IGP-DI, INPC, Stock index, etc.

Liquidity

Average daily volume: USD300-500 million


Additional information

Taxation: residents: 20% on capital gainnon-residents: 10% on capital gainnon-residents from tax haven countries: 20% on capital gain






Appendix 1: Useful web addressesBrazilian Central Bankhttp://www.bcb.gov.br

Federal Revenue Departmenthttp://www.receita.fazenda.gov.br

National Treasuryhttp://www.fazenda.gov.br

Brazilian Securities and Exchange Commitionhttp://www.cvm.gov.br

Brazilian Institute of Geography and Statisticshttp://www.ibge.com.br

BMF - Commodities and Futures Exchangehttp://www.bmf.com.br

JPMorgan Researchhttp://www.morganmarkets.com

Appendix 2: JPMorgan indicative pricingsourcesReutersJPMBS, JPMBR, JPMBV

BloombergJBRL

JPMorgan Emerging Markets Research Contact InformationJoyce Chang, Global Head of Emerging Markets Research, Foreign Exchange, and Commodities (1-212) 834-4203

[email protected]

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[email protected] VP, Economics (Brazil) (55-11) 3048-3634

[email protected] Assoc, Economics (Brazil) (55-11) 3048-3369

[email protected] Assoc, Economics (Argentina) (54-11) 4348-3405

[email protected] VP, Corporate Strategy (1-212) 834 4302

[email protected] VP, Corporate Strategy (1-212) 834-4711

[email protected] MD, Global Head of Quantitative Strategy (44-20) 7777-3020

[email protected] MD, Corporate Strategy (1-212) 834-4214

[email protected] VP, Corporate Strategy (Banks) (44-20) 7777-3582

[email protected] VP, Relative Value Strategy (1-212) 834-4439

[email protected] Assoc, Relative Value Strategy (1-212) 834-4210

[email protected] VP, Relative Value Strategy, (44-20) 7777-0070

[email protected] VP, Analytics (1-212) 834-7072

[email protected] VP, Index Management (1-212) 834-4153

[email protected] Assoc, Index Management (1-212) 834-4029



[email protected] Analyst, Analytics (1-212) 834-7037

[email protected] Assoc, Analytics (1-212) 834-7190

[email protected] VP, FX Strategist (1-312) 325-3164

EMERGING ASIA

[email protected] MD, Asian Economic Research (852) 2800-7000

[email protected] VP, Strategy/Economics (Emerging Asia and (65) 6882-2461the Philippines)

[email protected] VP, Strategy/Economics (Singapore, Thailand (65) 6882-2253and Taiwan)

[email protected] VP, Strategy (Asian local markets) (852) 2259-6208

[email protected] VP, Relative Value Strategy (852) 2800-8008

[email protected] VP, Economics (Malaysia, India and Indonesia) (65) 6882-2375

[email protected] VP, Economics (Korea) (82-2) 758-5509

[email protected] MD, Strategy/Economics (Greater China) (852) 2800-7006

[email protected] Assoc, Economics (China and Hong Kong) (852) 2800-7005

[email protected] Analyst, Strategy (Asian fx markets) (65) 6882-2216

[email protected] VP, Corporate Strategy (852) 2800-8001

[email protected] Assoc, Asian Strategy (852) 2800-8100

[email protected] Assoc, Economics (Indonesia and Philippines) (65) 6882-7143

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U.K. and European Economic Area (EEA): Investment research issued by JPMSL has been prepared in accordance with JPMSL’s Policies for Managing Conflicts of Interest inConnection with Investment Research. This report has been issued in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and MarketsAct 2000 (Financial Promotion) Order 2001 (all such persons being referred to as “relevant persons”). This document must not be acted on or relied on by persons who are not relevantpersons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEAcountries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction.

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Copyright 2004 JPMorgan Chase & Co. All rights reserved. Additional information available upon request. Revised November 12, 2004.

The analyst(s) denoted by an asterisk (“AC”) hereby certifies that: 1) all of the views expressed in this researchaccurately reflect his or her personal views about any and all of the subject securities or issuers; and 2) no part ofany of the analysts compensation was, is, or will be directly or indirectly related to the specific recommendationsor views expressed by the analyst(s) in this research.

Documents

Guide to Brazilian Local Markets