Barclays Brazil a Guide to Local Markets - Finding Value in a Controlled Environ

Emerging Markets ResearchMay 2013

PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES AFTER PAGE 20.

Brazil Local MarketsFinding value in a controlled environment

Barclays | Brazil Local Markets

28 May 2013 1

CONTENTS

The fate of interventionism.......................................................................................................................... 2 Government bonds ........................................................................................................................................ 3 Interest rate market ....................................................................................................................................... 8 FX market ...................................................................................................................................................... 15 Local corporate debt (Brazilian debentures) ........................................................................................ 19 Taxation ......................................................................................................................................................... 20 Sources and references .............................................................................................................................. 21


28 May 2013 2

Brazil Local Markets: Finding value in a controlled environment This guide aims to provide an introduction to the Brazilian local markets. We discuss

government and local corporate bonds, the interest rate market, and the FX market and its derivatives. We describe the main instruments in the market and their characteristics; liquidity issues; transactions costs; and taxation.

Brazil has the largest financial market in LatAm and one of the most developed in EM. The government bond market, with USD910bn outstanding, has several instruments suitable for each type of investor. The cash market benchmarks the interest rate market, which is one of the most liquid local markets in EM. Liquidity is also ample in the local FX market the USD/BRL future instrument is one of the most active derivatives currency traded in EM.

The fate of interventionism After seven years of strong and continuous growth of real GDP per capita, the Brazilian acceleration episode fizzled out beyond 2010. Economic stabilization was sustained by an inflation targeting regime, a floating exchange rate, and fiscal responsibility. In our view, the microeconomic reforms implemented in the early years of President Lulas first mandate and strong positive terms-of-trade shocks were the driving forces behind the acceleration. However, the recent inability to restart the investment cycle when other Latin economies that are facing the same global uncertainties are delivering much stronger growth rates indicates that idiosyncratic issues are at play. Strong protectionism, interventionism, and the lack of a consistent long-term growth program are weighing on investment decisions. Moreover, the emphasis on short-term growth has limited the governments capacity to respond to structural problems.

FIGURE 1 Government debt securities: Market size ranking (as of 2012 year-end)

0

2

4

6

8

10

12

14

US

Japa

n

Italy UK

Fran

ce

Ger

man

y

Chi

na

Braz

il

Spai

n

Can

ada

Net

herla

nds

Belg

ium

Mex

ico

Aus

tral

ia

Turk

ey

Pola

nd

Aus

tria

Isra

el

S. A

fric

a

Swed

en

Port

ugal

USD tr

Source: World Bank-IMF, Barclays Research

Even though there were no formal changes in policy making in recent years, the Brazilian government modus operandi has in fact changed. The new normal in Brazil is a combination of low interest rates, a smaller primary surplus coupled with a more depreciated level of the currency. Sluggish global economic activity should make this stance possible without a build-up of significant inflationary pressures.


28 May 2013 3

But even on the inflation front, our view is that the crisis drove the BCB to allow inflation to float more freely in the upper bound of the target (4.5% +/-2%). Although the BCBs sole mandate is to keep inflation within the targets, we believe that its reaction function is expanding and also incorporating real GDP growth as well as limiting BRL appreciation.

To fulfill this new expanded objective, it has incorporated macro-prudential and credit-limiting measures to its toolkit. However, the 6.5% upper bound of the target remains a hard ceiling in our view; and, to us, the main risk to maintaining this new normal is that uncertainty could continue to weight on investments decisions, which will likely continue to dampen potential growth.

Government bonds According to World Bank-IMF, in 2012 Brazil had the eighth largest government debt securities market worldwide and the second largest in EM (Figure 1), just after China. As of April 2013, the outstanding was USD910bn based on the Brazilian Central Bank statistics. It is also one of the most developed markets in the EM universe. There are three groups of actively traded bonds: fixed rates (LTN and NTN-F), floating rates (LFT), and inflation-linked (NTN-B). In the past few years, NTN-Cs issuance (IGP-M inflation-linked bond) has been extinguished and the FX-linked bonds (NTN-D) were discontinued in 2002.

The great majority of the domestic bonded debt is issued through competitive auctions held by the National Treasury, with multiple prices (except the NTN-B and the LFT auctions, which use Dutch bid-pricing), through an electronic system. For each public auction, a National Treasury Regulation is announced, making the offerings public. Each participant (banks, brokers, distributors, and other institutions registered in the Selic) is allowed to submit up to five bids. The other types of issuance are direct, used to meet specific requirements defined by law, and public offerings to individuals. The traditional auctions are usually held on Thursdays. The NTN-B auctions typically take place every other Tuesday. Public bond exchange and purchase auctions are also held and normally occur on Wednesday.

Other types of auctions include purchase auctions and exchange auctions. In the former, the National Treasury use the instrument to acquire securities transacted in the market in order to smooth maturities and provide liquidity to the secondary market. In the exchange auctions, the National Treasury offers new securities and receives, as counterpart, other securities transacted in the market, which are previously defined in each auction legal authorization.

Once issued, the bonds can be freely traded between the parties, forming the secondary market of government bonds. The Brazilian government bonds are predominantly traded in OTC market, with registration and settlement taking place at the Special System for Settlement and Custody (SELIC). The bonds are often traded in calls arranged by brokers and usually occur twice a day (morning and afternoon). There is segmentation in calls by type of bonds (i.e., one for fixed-rate bonds (LTN and NTN-F) and one for inflation-linked bonds, NTN-B).

LFT Letra Financeira do Tesouro LFT is a floating-rate Treasury bill and may be traded with a discount or a premium. Therefore, it can pay more for less than the effective Selic rate. It is priced as followed using a convention of Brazilian business days:

( )2521d

rd

PCP+

=


28 May 2013 4

And =

+=dtMTM

dtbasei

iSelicVPC252/1

1001

Where:

P = Price

V = Nominal value

PC = Corrected price

rd = Discount rate

d = Business days to maturity

Selic = Accrued annual Selic rate between the trade date and the maturity date.

LTN Letra do Tesouro Nacional The National Treasury bill is a short-term (from 2.0 months to 3.5years), zero-coupon fixed rate bill. It is priced as a conventional zero-coupon bond using a convention of Brazilian business days:

( )2521d

r

VP+

=

Where:

P = Bond price

V = Nominal value (usually BRL 1,000)

r = Effective annual rate (252 days)

d = Business days to maturity

FIGURE 2 LTN

Bond (Maturity) Coupon Yield to maturity Mod duration BRL bn USD bn

LTN (07-01-2013) 0 7.7 0.1 68.3 34.1

LTN (10-01-2013) 0 8.0 0.3 11.1 5.5

LTN (01-01-2014) 0 8.2 0.6 68.5 34.2

LTN (04-01-2014) 0 8.3 0.8 44.7 22.3

LTN (07-01-2014) 0 8.5 1.0 56.0 28.0

LTN (01-01-2015) 0 8.7 1.5 80.2 40.1

LTN (04-01-2015) 0 8.8 1.7 37.9 19.0

LTN (07-01-2015) 0 9.0 1.9 6.1 3.1

LTN (01-01-2016) 0 9.2 2.4 92.9 46.4

LTN (07-01-2016) 0 9.3 2.8 47.2 23.6

LTN (01-01-2017) 0 9.5 3.3 13.7 6.8

Total 526.7 263.2

Outstanding

Note: As of May 23, 2013. Source: Bloomberg, Barclays Research


28 May 2013 5

NTN-F Nota do Tesouro Nacional Serie F National Treasury note F Series is a long-term, fixed-rate coupon note (from 1y to 10y) and is priced as follows:

( )( ) ( )

++

+

+=

=252/

1252/

2/1

11

11)1(* d

n

td rr

CtVP

Where:

n = Number of coupon payment dates

d = Number of business days between the trade date and the coupon payment date t

Ct = Coupon defined on the issuance

V = Nominal value

r = Effective annual rate (252 days)

FIGURE 3 NTN-F


NTN-F (01-01-2014) 10 8.2 0.5 38.8 19.4

NTN-F (01-01-2015) 10 8.5 1.4 4.8 2.4

NTN-F (01-01-2017) 10 9.3 2.8 73.7 36.8

NTN-F (01-01-2018) 10 9.5 3.4 16.0 8.0

NTN-F (01-01-2019) 10 9.7 3.9 3.2 1.6

NTN-F (01-01-2021) 10 9.9 4.8 32.6 16.3

NTN-F (01-01-2023) 10 10.1 5.6 24.8 12.4

Total 194.0 96.9

Outstanding


NTN-B/NTN-C Nota do Tesouro Nacional Serie B/C The Treasury used to issue two inflation-linked securities: NTN-Bs and NTN-Cs. The former have their principal indexed to IPCA (the official national consumer price index). They usually have semi-annual payments of fixed-rate coupons on the indexed principal, although there have been some zero coupon bonds issued with indexed principal (available only in public offerings to individuals). NTN-Cs were similar to NTN-Bs, but with principal indexed to IGP-M.

Until 2005, the market for NTN-Cs was substantially larger than that of the NTN-Bs. However, demand for IPCA-linked securities has been increasing, given IPCAs central role within the inflation-targeting regime. Furthermore, from a supply perspective, the combination of the currency devaluation in 1999 and the high FX pass-through of the IGPM led the Treasury to shift toward IPCA-linkers. In December 2006, NTN-Cs issuance has been extinguished and, as of April 2013, NTN-Bs account for about 90% of the total outstanding amount of inflation-linked securities (BRL700bn). Liquidity is often poor for NTN-Cs, as a sizeable portion of the outstanding bonds are held by buy-and-hold pension funds, which also have long-term IGPM liabilities acquired in the past.


28 May 2013 6

NTN-B, on the other hand, trades up to USD 2.0bn on a daily basis. NTNs are quoted on a yield basis using the Brazilian business/252-day count convention and annual compounding. All IPCA linkers have 6% real coupons. However, due to the local convention,

the effective coupon c (paid every 6 months) is given by: ( ) 11' 21 += cc , where c is the annual coupon.

Linkers have their principal indexed from a base date that does not coincide with the issuance date; it is set at July 15, 2000, to all NTN-Bs. Therefore, newly issued bonds start with a large inflation adjustment and a nominal invoice payment necessary to acquire a bond that is materially above par. The yield to price formula is given by:

+

++

= =

n

itnti

t

rrc

IIP

10 )1(1

)1(``1000

Where t, ti and tn are the times (Brazilian business/252-convention) to settlement date,

coupon dates and the maturity date, respectively; ( ) 11' 21 += cc is the effective coupon; 0I is the inflation index at the base date;

'tI is the current index level; r is the

quoted yield; and P is the current price of the bond.

Both inflation indices (IGP-M and IPCA) tI are updated only once a month and evolve as a step function. To adjust the current price of the bonds correctly, one needs to account for the accrued inflation from the last date the index was updated to the settlement date of the bond (generally T+1). The market convention is to use the official Brazilian Association of Financial and Capital Market Companies (ANBIMA) inflation forecast pro rata, so we have:

( ) NnAtt iII /' 1+= where n is the number of Brazilian business days between the evaluation date and the last day of the previous IPCA period coverage; N is the number of Brazilian business days between the last day of the previous IPCA period coverage and the last day of the next IPCA

period coverage; and Ai is inflation as projected by ANBIMA. Special attention should be

paid to the dates when there are releases of other inflation indices, since they are generally correlated with IPCA or IGPM or both. ANBIMA inflation projection might change according to other data releases, affecting the value of the linkers.

IPCA and IGP-M Inflation Brazil developed several inflation indices during its high inflation period. The most important are IPCA (BZPIIPCA Index in Bloomberg) and IGPM (IBREIGPM Index in Bloomberg). The IPCA (December 1993 = 100), calculated by the national statistics agency (IBGE), is the official national consumer price index (and the measure of inflation targeted by the central bank). IBGE publishes it around the 10th day of each calendar month covering the period of the previous calendar month. In other words, the February index, released in March, reflects average prices during February, and the m/m change for February represents the full-month February average compared with that for January.

IBGE announced in late 2011 the new weighting structure for the IPCA inflation index valid as of 2012. The index was constructed based on the latest consumption survey, taken in 2008-09, and reflects the consumption patterns of households with incomes of 1-40x the minimum wage. As is standard in CPI index calculations, the index weights are fixed. However, IBGE-reported weights move slightly each month, reflecting the changes in relative prices.


28 May 2013 7

Food/beverages, transportation and housing have the largest shares on the IPCA. The importance of the food and transportation components is exacerbated by their high level of volatility, as they are affected by swings in international food and energy prices. But with the government controlling fuel prices, transportation has a smaller role in the fluctuation of inflation. Geographical coverage comprises 11 metropolitan areas, with So Paulo having by far the biggest weight of about one-third of the IPCA.

The IGP-M index (August 1994 = 100) published by the private Getulio Vargas Foundation measures a broader set of prices. It consists of three measures: wholesale prices (60% of the total); consumer prices (30% of the total); and construction costs, both materials and labour (10% of the total). The IGP-M is also published monthly, around the 30th day of each month. Instead of calendar months, it covers a period from the 21st day of a given month through the 20th of the following month. The consumer price component tends to behave similarly to the IPCA, but the wholesale price component is considerably more volatile, partly because of the prevalence of raw foods in the index and partly because of exchange rate movements, which can affect tradable goods prices significantly. As a result, inflation, as measured by the IGP-M, fluctuates more widely than IPCA inflation. BRL changes have a faster and higher pass-though into IGP-M than into IPCA.

FIGURE 4 NTN-C


NTN-C (07-01-2017) 6 3.0 3.5 8.9 4.5

NTN-C (04-01-2021) 6 3.7 6.2 19.2 9.6

NTN-C (01-01-2031) 12 4.0 9.8 37.4 18.7

Total 65.5 32.7

Outstanding


FIGURE 5 NTN-B


NTN-B (08-15-2014) 6 2.9 1.2 49.8 24.9

NTN-B (05-15-2015) 6 3.1 1.8 58.0 29.0

NTN-B (08-15-2016) 6 3.5 2.9 69.2 34.6

NTN-B (05-15-2017) 6 3.6 3.5 35.4 17.7

NTN-B (08-15-2018) 6 3.7 4.4 35.9 17.9

NTN-B (08-15-2020) 6 3.9 5.7 44.7 22.4

NTN-B (08-15-2022) 6 4.1 7.0 50.9 25.5

NTN-B (08-15-2024) 6 4.2 8.1 36.4 18.2

NTN-B (08-15-2030) 6 4.4 10.9 13.7 6.9

NTN-B (05-15-2035) 6 4.5 12.8 30.1 15.0

NTN-B (08-15-2040) 6 4.5 14.3 27.1 13.5

NTN-B (05-15-2045) 6 4.5 15.6 61.0 30.5

NTN-B (08-15-2050) 6 4.6 16.4 70.9 35.4

Total 583.2 291.4

Outstanding



28 May 2013 8

NTN-D Nota do Tesouro Nacional Serie D National Treasury note D Series is a FX-linked coupon note, which was discontinued in 2002.

Bloomberg references: BLFT : LFT; BLTN : LTN; BNTNF : NTN-F; BNTNB : NTN-B; BNTNC : NTN-C; AUCR BZ: Brazil Auction Results

Interest rate market The Selic overnight rate is the volume-weighted average rate of one-day operations backed by federal government securities. It is also the Brazilian base interest rate, and its target is set at the Monetary Policy Committee (Copom) meetings. The overnight Selic rate is calculated as:

FIGURE 6 Local debt composition

FIGURE 7 Non-resident position (% of the domestic debt)

NTN-B35%

LTN29%

LFT22%

NTN-F11%

NTN-C3%

Other0%

51,2

15,8

6,72,4 1,5

12,9

0

10

20

30

40

50

60

NTN-F LTN NTN-B LFT Others Total

%

Note: As of April 2013. Source: BCB, Barclays Research Note: As of March 2013. Source: BCB, Barclays Research

FIGURE 8 Local debt average maturity

FIGURE 9 Local bonds average daily traded volume

87 85

42

2518

49

0102030405060708090

100

NTN-B NTN-C NTN-F LFT LTN Total

Months

Local debt average maturity

2,1 2,0

0,50,4

0,0

0,5

1,0

1,5

2,0

2,5

LTN NTN-B NTN-F LFT

USD bn

12 months average Note: As of March 2013. Source: BCB, Barclays Research Note: Until March 2013. Source: BCB, Barclays Research


28 May 2013 9

=

=

= n

ii

i

n

ii

V

rVSelic

1

1

Where Vi = ith Transaction volume

ri = ith Transaction rate

n = Number of daily transactions in the Selic

The CDI is a bond issued by financial institutions which back the transactions in the interbank market. Thus, a CDI is issued on the settlement of each transaction in the interbank market. One-day CDI transactions are called CDIs over, which are compounded on a daily basis using a 252-business day year, or 21 business days per month.

DI futures The DI futures contract works like a swap from floating rate into fixed rate. It is the most-liquid interest rate instrument in the Brazilian market and is listed on the Brazil Mercantile & Futures Exchange (BM&F Bovespa). The DI future underlying asset is the DI rate effective up to the contracts expiration date, as measured by the capitalized daily DI over rates from the first trading day to the last.

The price of one contract is BRL 100,000.00 discounted by the interest rate, and the rate is expressed as an effective rate per annum based on a 252-business day year. Each contract has a minimum price fluctuation of 0.1bp (for expirations in the first three contracts) and 1bp beyond that. It expires on the first business day of the contract month, and the last trading day is the business day preceding the expiration date. This particular rate convention has been inherited from the hyper-inflation times, when inflation ran above 1% per day.

DI futures contracts are always available, with expiration falling in the first four months subsequent to the current month and thereafter for each first month of a calendar quarter (January, April, July, and October) following the maturity calendar of the cash market (LTN and NTN-F). The DI contracts liquidity is closely related with the cash market structure, hence, January contracts are usually the most liquid.

At the end of each trading day, a settlement price is calculated and compared with that of the contract expiration. The difference is the daily settlement paid from one investor to another. The daily settlement value for a short position in one contract is calculated according to the following formula (settlement value for a long position is the negative of short position value):

( )PSPS tt = - For positions opened on the current day

( )

+=

2521

11 1 tttt DISPSPS - For positions opened on a previous day

Where St = Daily settlement value in t; SPt = Contract settlement price in t;

The trading price, P, is calculated as follows:

( ) 2521

000,100d

rP

+

=


28 May 2013 10

Where r = Traded interest rate in pp; d = Number of business days between the trading day and the day before the expiration date; and DIt-1 = DI rate on the business day preceding the day to which the trade corresponds.

The positions outstanding after the last settlement price are cash-settled by the BM&F Bovespa on the expiration date by registering an offsetting transaction for the same number of contracts. The cash settlement takes place on the following business day.

Margins are required for all investors holding open positions. Margin values shall be updated daily by the BM&F based on margin calculation criteria for futures contracts, and the following assets can be used to meet margin calls: cash, gold, shares of the Financial Investment Fund (FIF), and, upon prior approval by the Exchange, federal government bonds, private sector securities, letters of credit, shares of stocks, and equity fund units.

Transactions costs Basic commission rate (BCR): Regular trading = 3.0%, day trading = 1.5%. For contracts

cash settled upon expiration date, the BCR will be the same as the one for the last trading day.

Settlement fee: The value of the BCR on the last trading day.

Exchange fee: 1% of the BCR.

Registration fee: A fixed value established by the BM&F.

Common members shall pay no more than 75% of the BCR and the settlement fee, and 75% of other trading costs.

Institutional investors shall pay 75% of the exchange fee.

Trading costs shall be paid on the business day following the trading day.


28 May 2013 11

FIGURE 10 DI futures as of May-23-2013

Contract Rate Contract price Bus days to maturity Open interest Volume Volume/open interest

Jun-13 7.28 99,832.80 6 660,638 74,535 11.3%

Jul-13 7.53 99,253.37 26 6,595,625 305,850 4.6%

Oct-13 7.93 97,252.43 92 709,841 39,275 5.5%

Jan-14 8.11 95,287.39 156 3,037,199 297,650 9.8%

Apr-14 8.22 93,423.77 217 771,837 27,045 3.5%

Jul-14 8.34 91,542.31 278 877,578 33,755 3.8%

Oct-14 8.44 89,528.96 344 87,494 1,500 1.7%

Jan-15 8.55 87,533.08 409 1,651,417 485,730 29.4%

Apr-15 8.65 85,664.66 470 367,297 9,305 2.5%

Jul-15 8.81 83,701.57 531 117,506 12,650 10.8%

Oct-15 8.90 81,738.40 596 46,577 1,525 3.3%

Jan-16 9.01 79,803.61 659 936,509 86,350 9.2%

Apr-16 9.06 78,052.05 720 66,384 1,055 1.6%

Jul-16 9.16 76,160.75 783 445,926 11,800 2.6%

Oct-16 9.19 74,389.50 848 21,881 235 1.1%

Jan-17 9.30 72,533.44 910 1,249,998 371,025 29.7%

Apr-17 9.34 70,838.56 973 36,874 3,575 9.7%

Jul-17 9.40 69,167.98 1,034 34,775 535 1.5%

Oct-17 9.40 67,621.13 1,098 7,170 100 1.4%

Jan-18 9.49 65,903.54 1,159 129,711 1,370 1.1%

Apr-18 9.50 64,450.16 1,220 4,375 0 0.0%

Jul-18 9.54 62,872.97 1,283 590 0 0.0%

Oct-18 9.58 61,311.51 1,347 160 0 0.0%

Jan-19 9.67 59,684.02 1,409 49,245 495 1.0%

Apr-19 9.66 58,411.82 1,470 1,315 0 0.0%

Jul-19 9.69 56,994.64 1,532 1,075 0 0.0%

Oct-19 9.72 55,527.97 1,598 120 0 0.0%

Jan-20 9.80 53,978.14 1,662 36,550 530 1.5%

Apr-20 9.80 52,754.01 1,724 1,120 0 0.0%

Jul-20 9.84 51,424.21 1,785 3,250 0 0.0%

Oct-20 9.93 49,906.22 1,850 1,860 25 1.3%

Jan-21 9.98 48,570.93 1,913 256,074 27,900 10.9%

Jan-22 10.10 43,768.30 2,164 28,149 535 1.9%

Jan-23 10.21 39,389.64 2,415 125,815 3,850 3.1% Source: Bloomberg, Barclays Research

DI options DI options are European options on one-day DI futures contracts. The holder of a DI call (put) option has, at the expiration date, the right to buy (sell) one DI futures contract at the strike price. The options are quoted in option premium, in BRL, up to two decimal places. The DI options series are:

1. The underlying contract expires three months after the option expiration date;

2. The underlying contract expires six months after the option expiration date;

3. The underlying contract expires one year after the option expiration date;


28 May 2013 12

4. The BM&F specifies the underlying contract expiration date.

The most-liquid contract months are those beginning a calendar quarter (January, April, July, and October). DI options expire on the first business day of the contract month, which is also the last trading day. On this day, the BM&F does not allow the opening of new positions and day trading. Premiums are cash settled on the first business day immediately subsequent to the trading day.

Upon exercise, the call (put) option holder buys (sells) the underlying DI futures contracts from the writer. This transaction is then transformed into a long (short) position in DI rate, thus, the short (long) position in price P is as follows:

( )2521000,100

dere

P+

=

Where Pe = Exercise settlement value in P;

re = Option strike price in interest rate;

d = Number of trading days between the exercise date and the day before the underlying contract expiration date.

All writers are required to hold margin accounts in accordance with BM&F regulations. The following assets are eligible to meet margin calls: cash, gold, and, upon prior approval by the Exchange, federal government bonds, private securities, letters of credit, equities, and equity fund units.

IDI The average one-day Interbank Deposit Rate Index (IDI) tracks the daily returns of the DI rate. The index is used essentially as an underlying asset on call and put IDI options and is calculated as follows:

+= 1100

11

ttt

iIDIIDI

Where IDIt = IDI value on date t;

FIGURE 11 DI yield curve as of May 23, 2013

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

0 1 2 3 4 5 6 7 8

Years-to-Maturity Source: Bloomberg, Barclays Research


28 May 2013 13

IDIt-1 = IDI value on date t-1;

it-1 = DI rate expressed in pp per day, on date t-1 to seven decimal places.

On the first day of the transaction, the index is set at 100,000.00, accruing the DI rate from the previous day until the final day of the transaction.

IDI options IDI options are Asian options on interest rates. The payoffs from these options are dependent upon the average short-term rate over the transaction period. They are similar to European options in the sense that exercise is available only upon expiration. Hence, if a positive cash settlement should result, IDI options are automatically exercised. They are used essentially as hedge against interest rate exposure by the banks, hedge funds, and large corporations.

The option is quoted as the premium in IDI points, with each index point worth BRL1.00. The strike price corresponds to the IDI in BRL, which is released by the BM&F. The expiration of IDI options is available on all months. Options expire on the first business day of the option month, and trades until the last business day of the previous month. IDI options are the most liquid in the BM&F.

The cash settlement of premiums comes about on the business day following the trading day according to:

MPPSV =

Where PSV = Premium settlement value for each contract;

P = Option premium;

M = Value, in BRL, of each contract point, established by the BM&F at BRL1.00.

The cash settlement of positions upon exercise is calculated as follows:

( )SPDISV S =

Where SV = Cash settlement value upon exercise for each contract;

SP = Strike price;

IDIs = IDI value on the expiration date.

Transaction costs Basic commission rate: Regular trading = 2.25%, day trading = 1.1%, and exercise =

1.1%.

Settlement fee: 1.1% of exercise value

Exchange fee: 0.9% of the BCR

Registration fee: Established by the BM&F.

Common members shall pay no more than 75% of the BCR and 75% of the registration and exchange fees.

Institutional investors shall pay 75% of the registrations and exchange fees.

Interest rate swaps In the Brazilian market, swaps are OTC instruments registered on the BM&F. On the expiration date, the settlement value is calculated as follows:


28 May 2013 14

( ) ( )ttt AIFIVAIFIVSV 21 =

Where SV = settlement value on date t;

IV = Initial value of the swap, in BRL;

IF1t = Accumulated indexation factor of the first instrument, in which the swap buyer (seller) is long (short), on date t;

IF2t = Accumulated indexation factor of the second instrument, in which the swap buyer (seller) is short (long), on date t.

There is usually no daily settlement of accounts, as is the case with futures contracts. In the case of swaps, there is usually only one payment, which occurs on the expiration date. If a party chooses to trade with a guarantee feature, in which the BM&F guarantees the party against default risk, the BM&F requires that its counterparty maintain a margin account. The BM&F accepts cash, federal bonds, gold, shares of the Financial Investment Fund, and, upon prior approval by the Exchange, private securities, letters of credit, equities, and equity fund units.

IPCA-DI swap IPCA-DI swap is the most-liquid swap in the BM&F Bovespa and is the most active market among brokers. For this contract, one party pays an IPCA-indexed leg and receives a floating rate (DI). The IPCA is released on a monthly basis by the National Bureau of Statistics and Geography (IBGE).

Pre-DI swap Pre-DI swap is an interest rate swap in which one party pays a fixed rate (Pre) and receives a floating rate (DI), and the counterparty, the opposite. It works similar to a DI futures contract, but without the daily settlement of accounts. Liquidity is very poor.

IGPM-DI swap IGPM-DI swap is an interest rate swap in which one party pays an IGPM-indexed leg and receives a floating rate (DI). The IGPM is released on a monthly basis by the Getlio Vargas Foundation (FGV), and for this reason, IGPM-DI swaps must expire in no more than 30 calendar days.

USD-DI Swap USD-DI swaps are the most-liquid FX swaps. For this contract, one party pays a USD-linked leg and receives a floating rate (DI). The underlying BRL/USD rate is the one traded at the free rate foreign exchange market for cash delivery, is settled in two days (D+2), and calculated and disclosed by the Brazilian Central Bank. The official rate is released on the PTAX800, option 5, and offer or bid rates are accepted in the swap contract.

Bloomberg references

BMEF: BM&F page

BTMM BZ: Brazil treasury and money markets

ODA CT: DI futures table

IDIX3 OMON: IDI options monitor

PREDIXXX : Pre-DI swap, where XXX is the tenor of the contract in a daily basis

IGPDIXXX : IGPM-DI swap, where XXX is the tenor of the contract in a daily basis

DOLDIXXX : USD-DI swap, where XXX is the tenor of the contract in a daily basis


28 May 2013 15

FX market The official USD/ BRL spot rate for most financial operations in the Brazilian market is the PTAX rate, which is calculated as the volume-weighted average rate in the interbank market. The Brazilian Central Bank is responsible for the calculation and disclosure of the PTAX rate.

USD/BRL spot The USD/BRL pronto is a BM&F USD spot market. The USD/BRL spot rate is also traded over the counter. USD/BRL trades should be closed at the best available market prices. The minimum volume for this is USD50,000 and the maximum is USD10,000,000. Settlements of floor-traded transactions are available on the first (t+1) and the second (t+2) business day following the trading day. t+2s are the only transactions with significant trading volume, having the same settlement period as OTC trades. Moreover, most of the interbank market liquidity is on the USD/BRL casado (which is the difference between the first USD/BRL future and spot rate) and not in the USD/BRL pronto.

USD/BRL futures Within the Brazilian market, the USD/BRL future contract is the most-liquid FX instrument listed on the BM&F. The underlying asset of a USD/BRL futures contract is the average BRL/USD offer rate for cash delivery, which is released by the central bank. The market is very liquid but is highly concentrated on the first contract month, usually accounting for nearly 80% of the total market open interest and more than 90% of volume.

Contracts are quoted in BRL per USD1,000 to three decimal places, with a minimum price fluctuation of BRL0.50. Each contract has a value of USD50,000 and all months, up to a maximum of 24 contract months, are available for trading. Expiration of the contract occurs on the first business day of the contract month, with the business day preceding the expiration representing the last trading day.

USD/BRL futures contracts are required to settle daily at the end of each session based on the days settlement price, and cash trades are settled on the following business day. For the first two contract months, the settlement price is calculated as the average price for all trades within the last 15 minutes of the session. This price may also be settled based on an arbitrated price by the BM&F. For all other contract months, the settlement price is established on the closing call.

FIGURE 12 USD/BRL future

1,60

1,70

1,80

1,90

2,00

2,10

0

200

400

600

800

1.000

1.200

jan/12 abr/12 jul/12 out/12 jan/13 abr/13

Volume (k, 20bd MA) Open Interest (k, 20bd MA) USD/BRL 1st Future (RHS)

Source: Bloomberg, Barclays Research


28 May 2013 16

The variation margin of a long position in one BRL/USD futures contract is calculated as follows:

( ) 50= PSPDS tt - For positions opened on the current day

( ) 501 = ttt SPSPDS - For positions opened on the previous day

Where DSt = Daily settlement value in time t;

SPt = Contract settlement price in time t;

P = Trading price.

As each contract is quoted on a USD1,000 basis, the daily settlement is multiplied by 50, therefore, it is worth USD50,000. Those positions outstanding after the last settlement price are cash-settled by the BM&F. This occurs on the expiration date by registering an offsetting transaction for the same number of contracts. Cash settlement takes place on the same day as the expiration date. The cash settlement value is calculated through the following formula:

( ) 501000 = USDSV Where SV = Cash settlement value for one contract;

USD = The average BRL/USD offer rate for cash delivery (underlying asset).

Margins are required for all investors holding open positions and follow the same criteria as the DI futures.

Transaction costs Basic commission rate: Regular trading = 0.12%, day trading = 0.06%

Exchange fee: 1.47% of the BCR.

Registration fee: A fixed value established by the BM&F.

Common members shall pay no more than 75% of the trading costs.

Institutional investors shall pay 75% of the fees.

Trading costs shall be paid on the day of business following the trading day.

USD/BRL options BRL/USD options are traded on the BM&F and are European currency options, thus having automatic exercise upon expiration. The underlying asset is the BRL/USD rate for cash delivery, which is settled in two days (D+2); traded in the foreign exchange market; and calculated and published by the central bank through the PTAX800, option 5, closing offer rate. The option is quoted as the option premium in BRL per USD1,000 to three decimal places. The BRL/USD option contract size is USD50,000. The options expire on the first business day of the contract month, the last trading day is the last business day of the preceding month.

Premiums are cash settled on the first business day subsequent to the trading day, as follows:

50= PSV

Where SV = Premium settlement value per contract;


28 May 2013 17

P = Option premium.

Upon exercise, the proceeds are credited to the option holder and debited to the seller. The exercise cash settlement for each contract is calculated as follows:

( )[ ] 501000 = KUSDEV Where EV = Exercise cash settlement value per contract;

USD = BRL/USD rate (underlying asset) on the day before the expiration date;

K = Strike price.

The BM&F requires that all option writers hold margin accounts and follow the same criteria of BRL/USD futures.

DDI futures and FRA The DDI futures contract or Cupom Cambial works in the same manner as a USD-DI swap. The underlying asset is the spread between the accumulated DI rate and the BRL/USD PTAX rate variation from the business day preceding the trade date and the last trading day. The major difference between a DDI futures contract and the USD-DI swap is that the first is traded in the BM&F and the other is an OTC product. Moreover, it also worth highlighting that liquidity in the DDI market is on the Cupom Cambial FRA, not in the DDI. By the end of the day, the Cupom Cambial FRA becomes two legs of DDI, but liquidity is mainly on the FRA. The market trades the FRA to reduce the PTAX/ FX swap risk.

The price of each DDI futures contract corresponds to USD100,000 discounted at the spread mentioned above. Based upon 360 days, this spread is expressed as a percentage per annum, up to three decimal places. Contract months are available in months that start a quarter, as well as in the first four months subsequent to the current quarter. DDI futures expire on the first business day of the contract month, with the last trading day being the last business day of the month preceding the contract month.

As with DI and USD/BRL futures, DDI futures require a daily settlement of accounts, also known as the variation margin. Trades are quoted in rate, which means an investor hoping for a spread increase between the DI rate and the USD/BRL variation should take a long position in DDI futures. For the purpose of settlement, long and short positions quoted in rate are transformed into short and long positions in price, respectively.

The variation margin of a short position (in rate, hence long in UP) in one DDI futures contract is calculated as follows:

( ) 1= ttt USDPSPS - For positions opened on the current day

( )[ ] 11 = ttttt USDIFSPSPS - For positions opened on the previous day

Where tS = Daily settlement value in time t;

tSP = Contract settlement price in time t;

1tUSD = BRL/USD Ptax rate in time t-1;

P = Trading price, calculated as:


28 May 2013 18

1360

000,100

+

=nr

P

Where

r = Traded interest rate in pp;

n = Number of calendar days between the trade date and the last trading day.

Ft = Indexation factor in time t, calculated as follows:

( )

kt

t

m

jjt

t

USDUSD

DIF

= +

=1

1

2521

1

Where

DIt-j = DI rate on the j-eth business day preceding the trade date t;

m = Number of reserves between t and the previous trade date;

USDt-k= BRL/USD Ptax rate on the day prior to the last trading session preceding the variation margin date.

If St is positive, the investor with the long position shall pay the daily settlement value to the seller. Cash settlement takes place on the following business day and the settlement price is cash-settled by the BM&F on the date of expiration by registering an offsetting transaction for the same number of contracts.

Margins are required for all investors holding open positions. Margin values shall be updated daily by the Exchange, based upon margin calculation criteria for futures contracts.

Transaction costs Basic commission rate (BCR): Regular trading = 4%, day trading = 2%. For contracts

cash-settled upon the date of expiration, the BCR shall be the same as that for the last trading day.

Exchange, registration, and permanence fees are charged by the Exchange, and calculated by the BM&F.

Common members shall pay no more than 75% of the trading costs.

Institutional investors shall pay 75% of the fees.

Trading costs shall be paid on the day of business following the trading day.

Bloomberg references BRL : BRL Spot

UCA CT: BRL/USD futures table

EVA CT: DDI futures table

GDA CT: FRC contracts table

DCY OMON: BRL/USD options monitor

BRL VOLC: BRL volatility comparison


28 May 2013 19

Local corporate debt (Brazilian debentures) Brazilian debentures are tradable local corporate debt securities issued by Brazilian companies. In the last three years, approximately BRL180bn of debentures (BRL80bn of which was in 2012) has been issued, but daily liquidity is still poor. In general, debenture spreads over government bonds are not as attractive as in the USD bond market, although that is partially a function of the shorter average tenor in the debentures market. However, a key attraction of the debentures market is that the issuer base has very little overlap with the USD-denominated corporate bond market (we count only six issuers that are present in both), thus offering access to dozens of credits not available in the latter.

The market for corporate debentures in Brazil is still underdeveloped, with limited interest from foreign investors. This largely reflects low liquidity and the fact that only a handful of issues currently provide income tax and IOF exemption for foreigners (from which they do benefit when buying local government debt).

In late 2010, however, the Brazilian government announced a set of measures to encourage long-term financing in Brazil (Law 12,431/2011 Art. 1 and 2, and MP 7,632/2011) by creating incentives to foster investment projects in the country. The measures were structured in two main parts: tax incentives for long-term corporate debentures earmarked for investment projects and the creation of a fund to stimulate the liquidity of those bonds in the secondary market (although this fund never became operational).

Through those measures, households and foreign investors purchasing local corporate debentures that meet certain criteria became exempt from income taxes and the IOF tax (6% previously levied on FX transactions required to bring foreign currency onshore). The main criteria for qualification are that securities must be either fixed-rate or linked to IPCA or TR (but not those indexed to DI), have a minimum duration of four years and have the use of proceeds linked to an investment project.

These measures were expected to attract foreign investors and increase trading liquidity in this market, much the same way that tax exemption for foreign investors is credited with helping foster the development of the local government debt market since 2006. Moreover, they should ease some long-term savings constraints in the economy. So far, however, there are few signs that the measures have had the desired effect (only a handful of debenture issues so far have obtained proper qualification for the full tax exemptions).

FIGURE 13 Brazilian fixed income market

FIGURE 14 Private fixed income market: Exposure by type of return

Govt Bonds54%

CDs25%

Corporate Debt15%

Other Priv. Cred. Instr.

6%

89%

2%2%

1%

6%

1%11%

DI Fixed-RateTR-Linked Selic-linkedInflation-linked Other

Source: Anbima, Barclays Research Source: Anbima, Barclays Research


28 May 2013 20

For debentures that do not qualify for tax exemption based on the above criteria, investors pay 15% income tax if not domiciled in tax havens and 15-22.5% if domiciled in a tax haven (they pay 2.5pp less for every six months of additional holding period, down to the limit of 15%). In addition, they pay an IOF tax on debentures trading (this is not the same IOF tax that is levied on incoming FX transactions) done within the first 30 days from purchase, which is levied as percentage of realized total return starting at 97% for a 1-day holding period and falling linearly to zero after day 30. Local funds (pension funds and asset managers) are exempt from income taxes and IOF on debenture trading, as these are levied at the individual, not the fund level.

According to ANBIMA, the fixed income market (private and government) is USD1.8bn (as of April 2013) and the government has by far the largest presence, accounting for 54% of the market share. The rest is largely concentrated in CDs and corporate debt, which comprise 25% and 15%, respectively, of the fixed income market (Figure 13). The majority of private fixed income market (89%) is linked to the DI rate (Figure 14), while the rest is concentrated in inflation-linked securities, which comprise 6% of the private fixed income market.

In terms of trading and settlement, foreign investors need to set up a 2689 account and appoint a custodian and legal/tax representative locally, a process that typically takes 2-5 days. Alternatively, they can get exposure to debentures through credit-linked notes (CLN) or total return swaps (TRS), both of which are subject to IOF tax. Settlement through CETIP is T+1, and since the index is not known upfront, investors agree on a spread on the trading date and settle based on the index as of the settlement date.

Taxation Local residents in Brazil pay withholding tax of 15-22.5% on the income from bonds, with the precise bracket depending on the holding period (22.5% if held for less than 180 days; 15% for periods above 720 days; and intermediate rates for holding periods in between). Since early 2006, the withholding income tax rate applicable to sovereign local bonds has been set to zero for foreign investors who are not in tax havens (see www.receita.fazenda.gov.br for a list of these). Thus, qualifying foreign investors are exempt from withholding taxes. Non-resident investors domiciled in tax havens are taxed at the same rates as local investors.

We note that a zero tax rate is different from a non-existent tax. Any new tax in Brazil has to be approved by Congress , with all the associated political cost. Therefore, it is much simpler for the Executive to raise a rate when the tax already exists. The IOF tax on foreign capital flows is a good example. In October 2009, the government raised the IOF tax for fixed income to 2% from 0%; in October 2010, it raised it again to 4%, and hiked it to 6% less than 30 days later. The 6% IOF tax is levied on the settlement of exchange operations when the money enters the country to be invested in the Brazilian financial and capital markets. The tax is now levied on all fixed-income inflows (except long-term earmarked infrastructure debentures) and is collected only on the way in foreign direct investments has always been exempt of the IOF tax, and in December 2011, the government reduced to zero the IOF tax levied on foreign equity inflows from 2.0%. There is no discrimination between long- and short-term flows.

In July 2011, the government also announced a new IOF tax on local USD derivatives markets. It is now levied on all derivatives contracts whose settlement is influenced by FX changes (i.e., USD options, futures and FRAs), so it will not be applied to local deposit rates, commodities or other contracts. The 1% IOF is also levied on domestic investors to prevent increases in short USD positions. Specifically, acquisition or sale of an exchange derivative, when it results in the rise of the short position or reduction of the long position that is higher than USD10mn in one day, there is 1% IOF tax on the notional value of the operation.


28 May 2013 21

So, for example, if an increase of USD11mn occurs in the short position, the 1% will be applied to USD1mn.

These measures were aimed at containing BRLs appreciation, given government concern with the performance of the industrial sector and growth in the country. At current levels of the BRL, however, we do not expect new FX measures.

Taxation Summary (Foreign investors who are not in tax havens)

Income tax 15% on capital gains and other income earned on money market instruments, including

CDs, corporate bonds and fixed income funds.

10% on swaps and equity funds.

Exempt on capital gains and income earned on government local bonds (or funds with at least 98% of the AUM in government bonds), earmarked infrastructure debentures (or funds with at least 85% of the AUM in earmarked infrastructure debentures), venture capital funds, and derivatives traded in currencies and equities.

IOF Tax 6% IOF tax on foreign capital flows.

1% on the notional value of contracts on acquisition or sale of FX derivatives when it results in the rise of the short position or reduction of the long position.

Short-term transactions on government bonds, fixed Income investment funds and bank deposits. 1% per day on (1-d/30), where d is the number of days between investment and the remittance of funds, charged over profits from fixed income investments. Levied on investments unwound within 30 days of the investment date.

Exempt earmarked infrastructure debentures (or funds with at least 85% of the AUM in earmarked infrastructure debentures), FIP/FIC-FIP/FIEE, acquisition or subscription of stocks in public offerings, stock and derivatives, in exchange venue.

Sources and references Brazilian Central Bank: http://www.bcb.gov.br/?ENGLISH

National Treasury: https://www.tesouro.fazenda.gov.br/en

The BM&F Bovespa Mercantile & Futures Exchange:

http://www.bmfbovespa.com.br/en-us/home.aspx?idioma=en-us

Federal Revenue and Customs Administration: http://www.receita.fazenda.gov.br

CVM Securities and Exchange Commission: http://www.cvm.gov.br/ingl/indexing.asp

ANBIMA - National Banks Association: http://portal.anbima.com.br/Pages/home.aspx

IBGE Brazilian Institute for Geography and Statistics: http://www.ibge.gov.br/english/

FGV Getulio Vargas Foundation: http://portal.fgv.br/en

IPEAData - Economic Research Database: http://www.ipeadata.gov.br/

Brazil: Excellence in Securities Transactions: http://www.bestbrazil.org.br/


28 May 2013 22

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