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Emerging Markets Research

J.P. Morgan Securities Inc.


November 24, 2004
Guide to Brazilian Local Markets
In this report we describe the main concepts and financial products
in 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 governments main goal, and challenge, is to extend the duration
of fixed rate debt, while it continues to reduce dollar-linked debt
Brazils local markets merit attention for its sheer size (public domestic
debt market is BRL780 billion), its liquidity, and the prospect of duration
extension and increased international integration. Although Brazilian
markets can be very deep, foreign access is still constrained by some
capital controls, and taxation issues need attention. This guide is divided in
two parts. The first part discusses foreign investor access to Brazilian local
market and describes the main conventions and basic concepts on which
the 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 trading
OTC and in the Futures Exchange (BMF). They include government
bonds, swaps and futures, which always settle in reais but can be indexed
to inflation or the exchange rate. At the end of the section, we list the
JPMorgan Reuters and Bloomberg pages that provide indicative pricing, as
well as useful websites where foreign investors will find relevant
information about the local market regulations.
www.morganmarkets.com
Drausio Giacomelli
AC
(212) 834-4685
drausio.giacomelli@jpmorgan.com
Felipe Pianetti
(212) 834-4043
Felipe.q.pianetti@jpmorgan.com
The certifying analyst(s) is indicated by the notation AC. See last page of the
report for analyst certification and important legal and regulatory disclosures.
We thank Rodrigo Ortiz for his invaluable research assistance.
Contents
2 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 Pricing
Source
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
2 November 24, 2004
Part I
Regulatory framework for foreign investors
The Brazilian Central Bank Resolution 2689 defines the rules for foreign
investments in Brazil. This Regulation applies to non-resident investments in
Equities, Fixed Income and Foreign Exchange local markets. A non-resident
investor is a person, corporation, fund or institutional investor with residence, head
office 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 with
the Brazilian Securities and Exchange Commission (CVM); and 2) the
appointment of legal and tax representatives in Brazil.
Upon registration with CVM, the investor is ready to make a spot USD/BRL fx
transaction in order to invest in the local market. After quoting and closing the
fx trade with the JPMorgan salesperson, the investor would transfer the agreed
USD to JPMorgans account and instruct her local legal representative (who is
effectively the counterpart of JPMorgan in the fx transaction) to receive the
corresponding amount of BRL, which is then transferred from JPMorgan to the
investors legal representative in Brazil.
Under the new Brazilian Payment System the funds in local currency are
available on the same day of the fx transaction. Then, the investor just needs to
inform the JPMorgan salesperson which assets they want to buy and instruct
their 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 the
CVM, or via a registration, settlement and custody system accredited by the
Central Bank of Brazil. All products discussed in the second section of this
guide meet this requirement.
Exhibit 1: Resolution 2689
Before commencing operations, an investor shall:
a) Appoint legal and tax representatives in the country. The legal representative is responsible for signing
fx contracts, executing payments and receipts for settlements and providing all documentation and
information to the Brazilian authorities. The tax representative is responsible for all taxes that may be
applied to the transactions;
b) File a registration form with the Brazilian Securities and Exchange Commission (CVM) and apply for an
ID 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 to
a resident investor;
d) Investors have a free choice of portfolio composition among equities, fixed income and foreign exchange
instruments; there are no restrictions on investors switching positions between financial products.
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 3
Taxation overview
The legal FX channel used by non-resident investors to tap the local market defines
the tax treatment they will face. Investments can be made in two different ways:
Commercial (Free) Rate Exchange Market
Under Central Bank Resolution 2689, investment under this channel can only
occur after registration of the non-resident investors account with the Brazilian
Securities and Exchange Commission (CVM) and with the Central Bank. A
legal representative is also required to monitor the investors transactions and
comply with the Tax rules. Below, we provide a summary of the taxes levied on
investors transactions under the Commercial Rate Exchange Market:
Income tax: 15% on capital gains and other income earned on money market
instruments, including government bonds and CDs. Income from swaps and
equity funds is taxed at 10%. Capital gains and other income earned with
derivatives traded in exchanges and equities are exempt. Funds entering Brazil
from tax haven countries, however, are subject to the rules applicable to
resident investors (see below Floating rate exchange market).
IOF tax: Applicable to investments unwound within 30 days of inception at a
1% per day on (1-n/30) of the income from fixed income investments (where n
is the number of days between the investment and the remittance of funds).
Example: suppose that an investor withdrew his investment 15 days after the
inception, 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 on
internal transactions. Financial resources used exclusively in operations with
equities and contracts referenced to equities or equity indices are exempted
from this tax.
Floating Rate Exchange Market
This market comprises transactions related to tourism, donations, and transfer
of assets, international credit cards, shot-term loans, and CC5 accounts.
Accordingly, this vehicle is not intended for portfolio investors. All
transactions under this alternative must be monitored by a legal representative
in Brazil. The legal basis Central Bank Circular 2677 regulates investments
through the Floating Market. From a fiscal perspective, non-resident and
resident are treated alike under this channel.

,
_

,
_


30
01 . 0
2
n
n income
The different application of the CPMF tax makes the Commercial Exchange
Rate Market much more attractive for non-resident investors.
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
4 November 24, 2004
Investments through the Floating Rate can occur after a deposit account in local
currency is opened at one of the banks authorized to operate on the floating rate
exchange market. Currently, there is no limit to transfers of funds by foreign
investors to their local accounts. However, the remittance of funds to the
country of origin by non-financial foreign investors must be effected through a
financial institution. Moreover, transfers of funds exceeding BRL10 million
must be accompanied by corroborating documents provided by the bank
responsible for the deposit account. Below, we provide a summary of the taxes
levied on investors transactions under the Floating Rate Exchange Market:
Income tax: 20% on capital gains and other income earned on Equity, Fixed
Income and Swap trades.
IOF tax: Same as for commercial market.
CPMF tax: 0.38% on every transaction, except for trades in equity and
equity indices.
Benchmarks
Selic rate
The Selic rate is the Central Bank controlled repo rate on public bonds (see
Chart 1 on the following page). It serves as 1) the interest cost of government
credit between a trade date and the next business day; 2) the rate set by the
Central Bank for borrowing and lending money to banks; and 3) the rate at
which floating rate government bonds accrue on a daily basis. This rate is
traded every working day on a business/252 exponential convention (known as
the Central Bank convention).
CDI rate
The CDI rate is the rate for overnight interbank CDs. It is the interest cost of
interbank credit between a trade date and the next business day, and the rate at
which the floating legs of the interbank swaps accrue. This rate is traded every
working day on a business/252 exponential convention. Before the
implementation of the New Brazilian Payment System in 2002, the CDI rate
used to be the interbank interest rate between T+1 and T+2, for a trade date T. It
is noteworthy that the CDI usually trades below the Selic rate (Chart 1), which
initially may seem a bit unusual. However, tight interbank credit constraints and
the fact that the CDI is the main funding rate for the banking system keep the
former slightly below the Seilc (see Chart 2 on the following page).
PTAX rate
The PTAX rate is the fx rate defined as the weighted average of all USD/BRL
(commercial rate) transactions in Brazils foreign exchange market as reported
to the Central Bank through the Sisbacen network in a given day. This rate is
the reference rate for the settlement of several instruments in the local market,
including futures, swaps and government bonds, for which the offered side of
the market is used. The offer side is assumed to be the weighted average of the
trades plus four pips (0.0004 BRL/USD).
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 5
PTAX 800 released by Central Bank
On May 14, 2004 the weighted average of the USD/BRL spot market was 3.0978. Therefore, the
PTAX-800 offered side, which is the reference exchange rate for contracts expiring on that day, was
set as 3.0982 ( = 3.0978 + 0.0004).
The PTAX is defined according to the provisions of Resolution 1690 of the National Monetary Council as
the average offered rate calculated by the Central Bank of Brazil. It is published on Reuters and Bloomberg
on a daily basis.
Chart 2: Selic versus CDI
spread, 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
15.0
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
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
6 November 24, 2004
Inflation indices
In Brazil, a number of different inflation indices are calculated and published
by several institutions on varying schedules. We provide below basic
information about the main indices that are most commonly followed by the
market 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 average
of 11 regional consumer price indices, based on consumption patterns of
households with incomes between 1 and 40 times the minimum wage. The price
collection 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 core
measures. The trimmed mean (which excludes the downward and upward
outliers) and the calculation excluding food and administered prices are
measures most closely followed by the market and the monetary authority.
Revisions: None.
Comments: This is the official inflation index targeted by the Central Bank to
guide the monetary policy. A preview with the same methodology is also
released (IPCA-15), which is calculated for the 30 days leading up to the mid
point of the reference month.
General price index (IGP-10 / IGP-M / IGP-DI)
Source: GetlioVargas Foundation (FGV)
Description: A nation-wide monthly composite index (1989=100) of wholesale
prices, consumer prices (based on the consumption pattern of households with
income between 1 and 33 times the minimum wage), and construction costs.
Price indices are published both for the headline and the main components. The
weights of these components in the headline are: wholesale prices, 60%;
consumer prices, 30%; construction costs, 10%. The IGP-DI is based on the
inflation 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 the
21st day of the previous month through the 20th of the reference month. The
IGP-10 is based on prices from the 11th of previous month through 10th of
current month.
Timing: released between the 5th and 10th day after the end of reference period.
Seasonal/focus: Not seasonally adjusted.
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 7
Revisions: None.
Comments: The IGP indices are the only source of information on wholesale
prices at the national level. It is used to adjust utility prices subject to indexed
contracts. Given the high participation of commodity prices in the wholesale
index, this inflation measure is more susceptible to exchange rate volatility.
Consumer price index So Paulo (IPC-FIPE)
Source: FIPE- So Paulo University - Economic Research Institute
Description: A weekly release reflecting the four-week moving average of
retail price increases in the city of So Paulo based on consumption patterns of
households with incomes equivalent to between 2 and 20 times the minimum wage.
Timing: Published weekly, usually three days after the end of the price
collection period.
Seasonal/focus: Not seasonally adjusted. Focus is on month-over-month
change in the four-week average.
Revisions: None.
Comments: Although limited to Sao Paulo, this index is closely watched by
markets 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
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
8 November 24, 2004
Interest Rate Conventions
Despite recent efforts by the Central Bank and market participants to unify the
various ways of expressing returns in the local market, many day-count
conventions still exist. The variety of day-counts used locally, however, only
makes comparison of assets returns more difficult. The conventions can be
divided in two categories:
1. Conventions in the Brazilian local markets
a) 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
Accrual given by:
(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 market
a) ActualDays/360 linear
Used for USD interest rate swaps and futures
Accrues on weekends and holidays
Accrual given by:
(1+rate x Actual Days/360)-1
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 9
b) ActualDays/365 exponential
Used for some USD government bonds
Accrues on weekends and holidays
Accrual given by:
(1+rate)^ (ActualDays/365)-1
Exhibit 2: Example of different conventions
Consider a DI Future contract which expires on January 2nd 2007. If the interest rate implied by its price is
17.67% 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 it
follows the business 252 day count convention.
Now, consider a DDI Future contract (local dollar interest rate future) which expires on August 2nd 2004. If
the interest rate implied by its price is 5.00% on trade date July 12th, the relationship between unitary price
and yield is given by:
Pu = 50,000.00 / [1+y * (21/360)]
Pu = USD49,854.59
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
10 November 24, 2004
Appendix 1: Some special cases on
taxation
Taxation on remittance of non-residents equity investment in local companies
Brazil has international accords with many countries to prevent double taxation
on investments of non-residents. As a general rule, however, withholding tax is
applied 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 when
repatriation occurs through an fx transaction.
Interest on capital: Interest on capital and interest on dividends paid to
shareholders, 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 the
proceeds from the sale of an investment in a local company at any time.
However, a 15% withholding tax on capital gains from the foreign capital
registered with the Central Bank is applied, calculated in foreign currency.
Note that the Double Taxation Treaties Brazil maintains with a number of
countries do not alleviate the tax rates above.
Withholding tax on interest payments on loans/debt issued by subsidiary
firms in the international market
Withholding tax at a rate of 15% is levied on interest payments of loans/debt in
this case. In some cases, however, existing Double Taxation Treaties define
different tax rates.
Withholding tax on hedging transactions by non-resident
Non-resident investors are exempt from withholding tax on gains from
transactions aimed to hedge existing exposure to interest rates, foreign
exchange and commodity prices in the international markets.
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 11
Appendix 2: Some revenue taxes
Recently, the government has introduced a non-cumulative mechanism that
avoids a cascading effect from the Cofins and PIS taxes, by means of tax credits.
Cofins
The Tax for Social Contribution is based on the gross revenues of local
companies, including financial institutions. This tax is aimed at funding the
Governments social welfare programs. The current rate for the cumulative
regime (e.g., financial institutions) is 3%, while the current rate for the non-
cumulative regime is 7.6%.
PIS
This tax was designed to fund an employment insurance program. It is also
charged on gross revenues. The current rate for the cumulative regime (e.g.,
financial institutions) is 0.65%, while the current rate for the non-cumulative
regime is 1.65%.
Appendix 3: Useful web addresses
Brazilian Central Bank
http://www.bcb.gov.br
Federal Revenue Department
http://www.receita.fazenda.gov.br
National Monetary Council
http://www.fazenda.gov.br
Brazilian Securities and Exchange Commission
http://www.cvm.gov.br
Brazilian Institute of Geography and Statistics
http://www.ibge.com.br
BMF - Commodities and Futures Exchange
http://www.bmf.com.br
ANDIMA - National Association of Financial Institutions
http://www.andima.com.br
Cetip - Clearing house for private securities
http://www.cetip.com.br
Selic - Clearing house for public securities
http://www.selic.com.br
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
12 November 24, 2004
Part II
Product Overview
In this section, we introduce the main financial products available in the
Brazilian onshore market. We first describe the government bonds, which are
issued at fixed maturity dates instead of fixed maturities as in the US. They are
actively traded in the secondary market and can be repoed, but are less liquid
than non-cash products. The most liquid instruments are the LTN (fixed-rate
bonds) and the LFT (floaters), while the USD-linked securities like NTN-D and
NBC-E have been phased out since 2003. Dollar-linked bonds were issued until
2002 in order to tame currency volatility. Recently, with the marked
improvement in external accounts, the government actually has been able to
redeem those bonds so as to reduce the sensitivity of Brazilian debt to fx
moves. After describing these bonds, we present the most traded derivative
products in Brazilian local marketsthe BMF fixed income and fx futures. The
highlight here is the DI futures market, with a daily turnover up to around $5
billion. 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 Opportunities
Currency 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-F
Brazilian 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: FRC
Onshore dollar (USD) Interest rate swaps: dollar coupon swaps
Government bond market fixed interest rate bonds: NBC-E, NTN-D
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 13
Table 2: Brazilian public domestic debtfederal bonds outstanding
as of November 2004
Issuer BRL million Total
Central Bank
NBCE 14,797 2%
National Treasury
LFT 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 debtindexation
as of November 2004
Type 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 LINKED
INFLATION LINKED USD LINKED
OTHER
Source: Central Bank and JPMorgan
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
14 November 24, 2004
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 the
public domestic debt
Usually trades at a premium over the DI Futures curve
Letras do Tesouro Nacional (LTN) are zero-coupon Treasury Notes. The share
of LTN stands at about 17% of the domestic public debt outstanding as of
November 2004. It is the Treasurys intention to increase this type of debt,
while reducing the debt linked either to the BRL/USD exchange rate or to a
floating 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 the
outstanding amount of the floating rate instruments.
The average maturity of the LTN has been extended over the last few years, but
there is still a long way to go (see Table 4 on the following page). The main
impediment for faster progress in this direction is institutional. The mutual fund
and 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. The
purchase of these bonds must be settled on the trade date. Short selling is
allowed and a repo market exists for overnight and term agreements. Exhibit 3
shows more details of this fixed-rate bond.
Liquidity constraints make LTN riskier during crisis periods when compared to
BMFs DI contracts, which seems to be one of the reasons why LTN trade at a
spread over the DI curve (note that the swap spread is negative in Brazil).
However, the persistence of the difference in returns of these similar
instruments is often attributed to perceived differences in credit risk. Although
some argue that the BMF is safer, the fact that BMF margin requirements can
be met with government bonds themselves should mitigate credit differences.
More relevant, in our viewand in addition to liquidityis the difference in
the funding rates between DI contracts and LTN bonds, which is lower for the
former (in other words, the LTN repo rate is greater than the CDI rate).
Pricing
The LTN trades at a discount based on a Business/252 exponential day count
convention. Also, no coupons are paid throughout the life of the instrument.
where: PU is the unit price
y is the quoted yield
( )

,
_

252 1
1000
n
y
PU
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 15
For instance, for a contract with 54 days remaining to maturity, the 17% yield
represents a unit price given by:
PU = BRL 96,691.60
The table below shows that approximately 90% of the outstanding amount of
LTN will mature within a 1-year period.
Table 4: Distribution of LTN maturities, as of November 2004
LTN 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
( )

,
_

252
54
17 . 0 1
1000
PU
Exhibit 3: LTN
Clearing: 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
Liquidity
Average daily volume: USD1.6 billion
Additional information
Taxation: residents: 20% on capital gain and coupon
non-residents: 15% on capital gain
non-residents from tax haven countries: 20% on capital gain and coupon
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
16 November 24, 2004
LFT (floating rate bonds)
Floating-rate, zero-coupon bond that trades at a discount/premium
As of November 2004, outstanding amount represented about 54% of
the public domestic debt
Accrues at the Selic rate on a daily basis
Letras Financeiras do Tesouro (LFT) are floating Treasury Notes, which are
auctioned on a weekly basis to cover the Treasurys budget deficit. The total
amount outstanding, as of November 2004, is BRL420 billion, which represents
around 54% of the public domestic debt. It is the Treasurys intention to reduce
the exposure to floating rate instruments, replacing it by fixed rate bonds. The
custody and clearing of these instruments are carried out by the Selic.
The LFTs accrual is given by the Selic rate on a daily basis. The principal
amount is expected to be repaid at maturity and there is no coupon throughout
the life of the bond. The bonds are issued close to par and the nominal value of
each bond is BRL1,000.00. The outcome of the weekly auctions usually embeds a
small discount/premium in the primary market, according to perceived credit risk
and liquidity conditions. The purchase of these bonds must be settled on the trade
date. Short selling is allowed and a repo market exists for overnight and term
agreements. Exhibit 4 provides more details on the floating interest rate notes.
Pricing
The market price of a LFT is usually expressed in terms of a percentage
discount over the accrual of the Selic rate applied to the Principal amount. Here
is 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 . 0 1
68 . 579 , 1
80 . 583 , 1
212
252

,
_

te DiscountRa
( )
68 . 579 , 1
% 31 . 0 1
80 . 583 , 1
252
212

+
PU
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 17
The table below shows the distribution of the outstanding maturities of the
floating rate notes, as of June 2004.
Table 5: Distribution of LFT maturities, as of November 2004
LFT up to 12-months up to 24-months up to 36-months up to 48-months Total
BRL million 193,853 357,543 418,290 435,735 452,145
% 43% 79% 93% 96%
Source: JPMorgan
The majority of the LFT is short-term, with maturity up to two years. During
periods of stress the government has bought back longer-term LFT or offered
term repo with maturities typically up to 90 days.
Exhibit 4: LFT
Clearing: Primary market: Selic; Secondary market: Selic, BMF
Issuer: Treasury
Currency: BRL
Nominal value: BRL1000.00
Coupon: zero
Amortization: bullet
Interest accrual: on business days by the current Selic rate
Outstanding amount (% public domestic debt): 54%
Settlement: T+1
Liquidity
Average daily volume: USD1.3 billion
Additional information
Taxation: residents: 20% on capital gain and accrual to par
non-residents: 15% on capital gain and accrual to par
non-residents from tax haven countries: 20% on capital gain and accrual to par
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
18 November 24, 2004
NTN-F (fixed rate notes)
Fixed-rate, coupon bond that trades at a discount
As of November 2004, outstanding amount represented just 0.15% of
the 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 of
NTN-F stands at a meager 0.15% of the domestic public debt outstanding as of
November 2004. As with the LTN, it is the Treasurys intention to increase this
type of debt, while reducing the debt linked either to the BRL/USD exchange
rate or to a floating interest rate.
Along with all the hurdles facing the LTN, the NTN-F has two additional
caveats: a) the BRL yield curve has very low liquidity beyond the 18-month
tenor; and b) there is no culture among local players of trading fixed-rate,
coupon-bearing bonds. Indeed, this instruments daily turnover is extremely low.
That said, the prospects for this kind of paper have brightened, as the inflation
targeting regime gains stature and the Central Bank succeeds in building
credibility. More recently, the solid performance of Brazilian external accounts
has reduced fx volatility, whichin combination with an increasingly credible
Central Bankhas paved the way for BRL yield curve extension.
Pricing
The 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/252
exponential day-count convention. The first coupon is paid in full, irrespective
of the number of days between the trade date and the first coupon date. The
custody 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 payment
date
y is the fixed interest rate paid over and above the inflation index variation
N is the notional value
( )
( )
( )
( )252
1
252
12
6
1 1
1 10 . 1
Pr
T
T
T
i
i
i
y
N
y
N
ice
+
+

'

,
_

,
_

Price
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 19
Exhibit 5: NTN-F
Clearing: Primary market: Selic; Secondary market: Selic, BMF
Issuer: Treasury
Currency: BRL
Nominal value: BRL1000.00
Coupon: 10%, semi-annual
Amortization: bullet
Interest accrual: fixed rate
Outstanding amount (% total public debt): 0.15%
Settlement: T+1
Liquidity
Average daily volume: not significant
Additional information
Taxation: residents: 20% on capital gain and coupon
non-residents: 15% on capital gain
non-residents from tax haven countries: 20% on capital gain and coupon
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
20 November 24, 2004
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 the
domestic 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 Treasury
Notes whose payout is linked to a specific inflation index. The NTN-B provides
hedge against changes in the IPCA inflation index, while NTN-C cash flow is
linked to the IGP-M.
As of November 2004, inflation-denominated instruments accounted for
approximately 13% of the domestic public debt (3% NTN-B and 10% NTN-C).
The Treasury has held buyback auctions on a monthly basis since September
2003 in order to provide liquidity to this market.
In practice, each product yields the variation of its respective inflation index
plus a fixed interest rate. The payments to the holders are made in the form of
semi-annual coupons and the principal amount at maturity, both of which are
adjusted by the variation of the inflation index. The payment dates are defined
as the first day of each 6-month period from maturity to trade date, i.e., the last
coupon date coincides with the maturity of the bond. In the case of a national
holiday on the payment date, settlement takes place on the next business day.
Pricing
The market value of these instruments reflects not only the contractually
defined fixed interest rate, but also current months inflation expectation
released 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 by
the effective variation of the inflation index since the issuance date before they
are settled in BRL. The day-count convention used for the pricing of this type
of security is business/252 exponential. The custody and clearing of these
instruments is carried out by the Selic. The purchase of these bonds must be
settled on the trade date.
The example below provides the pricing formula for a 6%-coupon NTN-C:
( )
( )
( )
( )252 252
12
6
1 1
06 . 1
Pr
t T
T
t
T
t i
t i
i
t
t
y
N
y
N
ice

,
_

+
+

'

,
_

Emerging Markets Research


Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 21
where:
i is the number of business days between trade date (t) and the coupon
payment date
y is the interest rate quoted
t trading date
N
t
is the notional value adjusted by the effective + residual inflation from
issuance 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 Chileans UF), it is necessary to factor in the
expected inflation for the current month, on a pro-rata basis. This is done via
the residual inflation (
R
) defined below.
The nominal value is first accrued by the effective inflation index from issuance
of the bond to the last day of the previous month. This adjusted nominal value
is then accrued by the expected inflation released by ANDIMA, so as to
complete the inflation adjustment. For instance, if the expected inflation for the
current month is 0.5%, the resulting adjusted nominal value at the margin (or in
between 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 day
of 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 2004
NTN-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
BRL million 5,155 15,709 18,057 33,839 74,707
% 7% 21% 24% 45%
Source: JPMorgan
( )
0
0
% 5 . 0 1 n n
n n
R
f
i

+
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
22 November 24, 2004
Exhibit 6: NTN-B and NTN-C
Clearing: Primary market: Selic; Secondary market: Selic, BMF
Principal amount: BRL1,000.00
Coupon: 6%, semi-annual
Amortization: bullet
Interest accrual: on calendar days
Outstanding amount (% domestic public debt): 6%
Settlement: T+1
Liquidity
Average daily volume: NTN-C = USD30 million
Additional information
Taxation: residents: 20% on capital gain and coupon
non-residents: 15% on capital gain and coupon
non-residents from tax haven countries: 20% on capital gain and coupon
Foreign Investment: defined by resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 23
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 the
domestic public debt
These bonds are being phased out as the government aims to reduce FX
vulnerability
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-linked
swaps and other bonds account for 7%. The chart on page 2 shows the
evolution of USD-linked paper as a share of domestic public debt. Note that it
has dropped substantially. As of November 2004, around 11% of the domestic
public debt was composed by dollar-denominated instruments, while in the
beginning of 1999, it accounted for more than 30% of the total.
NTN-D, NBC-E
While NTN-D bonds were issued to cover the Treasurys budget deficit, the
NBC-E bonds were used by the Central Bank as an instrument to intervene in
the fx market. Starting in September of 2002, the Central Bank favored the use
of fx swaps to intervene in the market. The improvement in the current account
has allowed both the Treasury and the Central Bank to reduce the stocks of fx
swaps and USD-linked bonds since 2003. The goal is to eliminate these
instruments altogether.
Those bonds, although linked to the variation of the official PTAX rate, are paid
and settled in local currency. The custody and clearing of these instruments are
carried out by the Selic.
Save for the issuer, these notes are both fixed-rate instruments with essentially
identical features. The coupons (generally 12%) can be traded separately from
the principal, but this situation rarely happens. The nominal value of each bond
is BRL1,000.00.
Both the coupons and principal amount are first adjusted by the variation of the
PTAX rate released on the previous day before they are paid in BRL. The
convention used for the pricing of this type of security is Actual/360
exponential. Exhibit 7 on the following page shows more details of the main
dollar-linked bonds.
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
24 November 24, 2004
The yield on an Actual/360 exponential convention can be inferred as follows
for a 12%-coupon bond:
N
t
= 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 2004
NTN-D up to 12-months up to 24-months up to 36-months up to 48-months Total
BRL million 11,026 15,498 15,542 17,062 17,062
% 65% 91% 91% 100%
Source: JPMorgan
NBC-E up to 12-months up to 24-months up to 36-months up to 48-months Total
BRL million 2,163 11,077 14,797 14,797 14,797
% 15% 75% 100% 100%
Source: JPMorgan
( )
( )
( )360
1
360 1 1
2
% 12
Pr
t T
T
t
T
i
t i
i
t
t
y
N
y
N
ice

+
+

'

,
_

,
_

Price
t
Exhibit 7: NTN-D and NBC-E
Clearing: Primary market: Selic; Secondary market: Selic, BMF
Issuer: NTN-D: Treasury; NBC-E: Central Bank
Currency: BRL
Nominal value: BRL1000.00
Coupon: 12%, semi-annual
Amortization: bullet
Interest accrual: on calendar days
Outstanding amount (% domestic public debt): 5%
Settlement: T+2 (primary auctions), trade date (secondary market)
Liquidity
Average daily volume: NBC-E = USD20 million
Additional information
Taxation: residents: 20% on capital gain and coupon
non-residents: 15% on capital gain and coupon
non-residents from tax haven countries: 20% on capital gain and coupon
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 25
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 an
OTC in the domestic market, albeit the registration of the trades on the Central
Bank systemSisbacenis mandatory. With the introduction of the Brazilian
New Payment System, the BMF Futures Exchange created its Forex Clearing
House, which has contributed to reduce the settlement risk of the transactions
by requiring collateral and netting trades between two counterparts. However,
in practice, market participants have the option to settle the trade on a gross or
net basis and in or out the BMFs Clearing House. Still, most participants have
now decided to use the BMFs Clearing House system. Within the Clearing
House, trades are guaranteed to a certain level of volatility of the spot rate and
the effective counterpart to all participants is the BMF.
Investments by foreigners in the Brazilian domestic market was first regulated
through Federal Laws 4131 and 4390. In practice, however, the steps to be
followed by investors using the BRL/USD forex market are defined by the
Central Banks regulation called Consolidation of Exchange Norms (CNC).
This regulation establishes the limits for the settlement of the trades and
requires that all Forex transactions be registered with the Central Bank system
and be accompanied by a pre-defined contract.
The forex transaction registered as spot settlement must be settled within two
business days from the trade date. However, the Central Bank also allows for
trades under the future settlement category, where transactions can be settled
up to 60 days from trade date. Although amendments in the settlement date of
contracts 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 the
BRL/USD exchange rate cannot exceed 30% of the banks equity capital.
Officially, there are two segments in the Brazilian forex market:
Commercial Rate Exchange Market: Usually used for trade-related
transactions, such as import and export transactions, foreign currency
investments in Brazil, foreign currency loans to residents in Brazil and
remittances abroad.
Floating (Tourism) Rate Exchange Market: Primarily designed and used
for unilateral transfer of funds, this vehicle is not a formal alternative for
investments.
Emerging Markets Research
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Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
26 November 24, 2004
Another important difference between those two segments is the fact that, while
both operate at floating rates freely negotiated between the parties, the
commercial exchange market is restricted to transactions which require prior
approval of the Brazilian monetary authorities and the floating exchange market
is open to transactions defined in the current legislation but which do not
require any such formal prior approval. Although the rates are similar, the
commercial rate is much more liquid.
Liquidity: The bulk of trading in the Brazilian exchange rate market is
concentrated in the USD/BRL futures (see USD/BRL future contract on page
27). As a listed product, the USD/BRL future is traded in a more transparent
environment.
Daily volume in the spot market has been around USD1 billion, while turnover
in 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 exit
of the registered funds, not on internal transactions. This special provision for
investment by foreigners makes the Commercial Rate Exchange Market more
attractive than the Floating Rate Exchange Market.
Exhibit 8: USD/BRL exchange rate
Exchange rate regime: free-float, non-deliverable
Official Fixing: PTAX rate, which is the Central Banks official exchange rate fixing, defined as the
weighted average of the intra-days 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
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 27
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/BRL
spot exchange rate. The face value of the contract is USD50,000.00 and the
quote 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 the
PTAX (trade volume weighted average) rate of the last trading day, which is the
last business day of the month preceding the contract month. For instance, the
USD/BRL April Future (2004) expires on April 1 and, therefore, settlement is
based on the PTAX rate released on March 31. Exhibit 9 shows more details
on the contract.
Bid-ask spread is usually 2 pips (BRL 0.0002), which is much lower than the
equivalent 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 the
daily margin adjustment. All open positions are adjusted to the official closing
price defined by BMF at the end of each trading day. The difference from the
official closing value is then credited to/debited from the investors margin
account on the next day. The next days opening value of the positions is just
the official closing value of the previous day.
Maturities are generally available for up to one year, but decent liquidity can be
found only in the first month. BMF restricts the number of authorized contract
months to 24.
The relationship between the spot and future USD/BRL exchange rate can also
be traded through the Forward Points contract on a daily basis. This strategy
consists of trading the USD/BRL future contract by means of a spread to be
added to the PTAX rate observed on the trade date. Therefore, at the end of a
trading session, forward point transactions are transformed into a position in the
USD/BRL Future on the same number of contracts and of the same directional
nature (long or short).
Rollover of positions
Since liquidity is concentrated in the first contract month, most players need to
rollover 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 so
called rollover market, which is just a spread market involving the first two
contract months.
Emerging Markets Research
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AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
28 November 24, 2004
Pricing
Although some investors just follow a day-trading strategy, many hedgers
depend on the protection provided by the future contract for their mid/long-term
investments. Therefore, its worth mentioning the main relationship between the
spot USD/BRL exchange rate and the future contract.
As will be described subsequently, there is a market for the local USD interest
rate. One of the differences between this rate and the corresponding LIBOR is
that 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 expected
value 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 future
contractfrom which we take expectations for the BRL interest rate (y)expires
one day after the USD/BRL future and the DDI futurefrom which we take
expectations for the local USD interest rate. Therefore, in order to be consistent
we discount one overnight CDI rate from the unit price of the ID Future.
( )
( ) fw
N
d
y
spot BRLfuture USD
n
n
+

,
_

,
_

+
+

1
360
1
1
/
252
Forward Points contract
As an example, a Forward Points contract traded at 20 points is converted
into a USD/BRL Future position at a price equal to PTAX rate plus 20 pips,
in the end of the trading section.
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 29
Exhibit 9: USD/BRL futures
Exchange: BMF Futures Exchange
Underlying: the PTAX rate of the last trading day, which is the last business day of the month preceding
the 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 days 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 the
days settlement price (average price of all trades during the last 15 minutes of trading) and cash settled on
the following business day
Assets eligible for margin requirements: cash, gold, Federal bonds, private securities, letters of credit, stocks
Liquidity
Average daily volume: USD4-8 billion
Average open interest: USD12 billion
Additional information
Taxation: residents: 20% on capital gain
non-residents: exempt
non-residents from tax haven countries: 20% on capital gain
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
30 November 24, 2004
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 interbank
rates (CDI) into fixed rates (zero coupon). The underlying instrument of the DI
future contract is thus the CDI between the trade date and the last trading day
of the contract. Apart from the daily margin requirements, the cash flow of the
contract (the fixed leg) resembles that of a zero coupon bond with face value of
BRL100,000.00. Bid-ask spreads are available in yield terms, on a business/252
exponential convention. Exhibit 10 shows the details of the DI future contract.
Maturities are available quarterly on the months that initiate a new quarter. The
contract always expires on the first business day of the month, which is used to
name to the contract. For instance, the April DI future expires on April 1 and its
yield (expressed on an annual basis) reflects the expected compounded CDI rate
from trade date through April 1 (annualized).
All open positions are adjusted to the official closing price defined by BMF at
the end of each trading day. The difference from the official closing value is
then credited to/debited from the investors margin account on the next day. The
next days opening value of the positions is just the official closing value plus
the accrual given by the CDI rate observed on the trade date. Note that these
yields can easily change 20bp + in one trading day, which makes margin
requirements substantial in periods of choppy markets.
Liquidity beyond the Jan06 DI is still limited, reflecting the short nature of
Brazils fixed rate market. In particular, Brazils longest fixed-rate paper
outstanding matures in July 2006. Note that, although the CDI moves in line
with the Selic (which is set in open market operations by the Central Bank), it
may deviate significantly from the official rate. At the time of this writing, the
difference was 5bp, but it reached 25bp just two months ago. This difference is
key in pricing (especially for the shorter tenors) and it tends to follow liquidity
conditions and credit constrains in the interbank marketing.
Pricing
Similarly 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:
( )

,
_

252 1
1000
n
y
PU
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 31
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 an
unit price given by:
PU = 96,691.60
Reference yields can be found in JPMorgans Bloomberg (JBRL) and Reuters
(JPMBR) pages. Note that, in Brazil, the DI yields tend to be lower than the
bond yields. One possible reason is BMFs perceived lower credit risk.
However, the fact that BMF accepts government bonds as collateral mitigates
the credit argument, in our view. Another reason, which we believe to be
sounder, is DIs superior liquidity, which is significantly higher than that of
government bonds. Finally, the LTN repo rate is usually higher than the CDI,
which also helps to explain the difference.
( )

,
_

252
54
17 . 0 1
1000
PU
Exhibit 10: DI Future contract
Exchange: 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/252
exponential 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
Expiration date: the first business day of the contract month
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 the
days settlement price and cash settled on the following business day
Assets eligible for margin requirements: cash, gold, Federal bonds, private securities, letters of credit, stocks
Liquidity
Average daily volume 6-month (2-year): USD5 billion (USD250 million)
Average open interest: USD60 billion
Additional information
Taxation: residents: 20% on capital gain
non-residents: exempt
non-residents from tax haven countries: 20% on capital gain
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
32 November 24, 2004
DDI future contract
Main vehicle for fx exposure hedging
Liquidity concentrated on the FRA market, through the FRC Future
Contract
Short-term DDI rates more exposed to fx moves due to PTAX settlement
convention
The DDI Future contract (or Cupom Cambial) is derived as the difference
between the effective CDI rate and the PTAX variation in the period. In other
words, it is a zero coupon dollar-linked future contract.
The effective CDI is the capitalized CDI rate verified on the period between the
trading day and the last day of the month that precedes the contract month (for
example, March 31 for the April contract). The PTAX rate variation is
considered for the period between the business day preceding the trading day
and the last day of the month preceding the contract month. Note then that the
PTAX 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 USD
interest rate, also called fx coupon. Exhibit 11 provides further details on the
contract.
The face value of the contract is USD50,000.00 and the quoting price is the
interest rate that represents the percentage difference in the variations defined
above, to two decimal places, on the Actual/360 linear convention.
According to the BMFs rules, the DDI is traded on margin and marked-to-market
daily. All open positions are adjusted to the official closing price defined by
BMF at the end of each trading day. The difference from the official closing value
is then credited to/debited from the investors 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 contract
always expires on the first business day of the month. For instance, the April
DDI 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 reduced
considerably.
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 33
FRC structured transaction
As defined above, the DDI future reflects the local USD interest rate by taking
into account the fx variation based on the PTAX rate released on the business
day preceding the trading day. The resulting USD interest rate is called dirty fx
coupon (see box).
Since the USD/BRL spot rate at the moment of the trade may differ
substantially from the previous days PTAX, the resulting DDI dollar rate may
be distorted by this residual fx variation. In particular, if the BRL weakens
versus the PTAX, the resulting short-term DDIs can become negative. To
overcome this, BMF created DDI FRAs, which are known as FRC or clean fx
coupons. The forward rate offsets the effect of the PTAX in the dollar rate
calculation.
BMFs FRC (forward) contracts uses two DDI futures: The long leg is the DDI
future that matches the maturity desired by the investors while the short leg is
the DDI future closest to trade date. For instance, if an investor wants to lock in
dollar 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 coupon
The dirty fx coupon is the local USD interest rate priced off the PTAX
rate, while the clean fx coupon is the local USD interest rate priced off the
USD/BRL spot rate.
( )
spot brl usd
future brl usd
y
n CleanCoupo
n
_ /
_ /
1 252 +

Emerging Markets Research


Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
34 November 24, 2004
Exhibit 11: DDI Future contract
Exchange: 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
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 the
days settlement price and cash settled on the following business day
Assets eligible for margin requirements: cash, gold, Federal bonds, private securities, letters of credit, stocks
Liquidity
Average daily volume: USD10 billion
Average open interest: USD40 billion
Additional information
Taxation: residents: 20% on capital gain
non-residents: exempt
non-residents from tax haven countries: 20% on capital gain
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 35
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 fixed
interest rate modalities
Swaps in the Brazilian market are primarily traded as an OTC product and
transactions are registered at Cetip (non-profit clearing house), although these
transactions are also available for registration at BMFthe Futures Exchange.
One of the reasons that accounts for the higher volume of swap transactions in
the OTC relative to BMF is the limited access of corporations to the futures
exchange. In addition, banks prefer to use their mutual credit lines instead of
setting capital aside to cover BMF risk.
In a swap, the parties must define the parameters that will provide the payout of
each leg of the trade. The following types of parameters are the most common at
Cetip: interest rates, inflation indices, exchange rates, and stock baskets. Unlike
some types of swaps registered at BMF, the transactions in the OTC market are
not guaranteed by Cetip. The latter only provides the system that updates the
swap 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 choose
among other derivatives such as swaptions, term swaps, callable swaps, and
swaps with barriers (knock-in, knock-out, and knock-in-out). Furthermore, the
parameters used to value each leg in the swap can be capped to a specified
percentage or accrued by a fixed interest rate. Finally, the maturity and number
of periodic resets may be freely chosen. Exhibit 12 shows more details of the
Swap contracts available at Cetip.
Under the BMF version of swap, a margin requirement is only applied to the
party whose counterpart has chosen to trade with the guarantee feature.
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
36 November 24, 2004
Formulae commonly used in swap pricing
The 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, the
value 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
n = Inflation index of the previous month of the valuation
o = Inflation index of the previous month of the inception date
n = number of business days from trade date to maturity
( )

'

1
]
1

+ +
n
p
CDIn C
1
252
1
100
1 1 1
1 C

'

,
_

1
100
1
p
PTAX
PTAX
C
o
n

'

,
_

1
100
1
p
C
o
n

252
100
1
n
i
J
,
_

+
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
November 24, 2004 37
Exhibit 12: Swaps
Underlying: 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 on
the 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 updates
the swap value through standardized formulae, generates the managerial reports to each party and allows
for 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 interest
rate), IGP-M, IGP-DI, INPC, Stock index, etc.
Liquidity
Average daily volume: USD300-500 million
Average open interest: USD200 billion
Additional information
Taxation: residents: 20% on capital gain
non-residents: 10% on capital gain
non-residents from tax haven countries: 20% on capital gain
Foreign Investment: defined by Resolution 2689
Emerging Markets Research
Guide to Brazilian Local Markets
Drausio Giacomelli
AC
(1-212) 834-4685 Felipe Pianetti (1-212) 834-4043
drausio.giacomelli@jpmorgan.com felipe.q.pianetti@jpmorgan.com
38 November 24, 2004
Appendix 1: Useful web addresses
Brazilian Central Bank
http://www.bcb.gov.br
Federal Revenue Department
http://www.receita.fazenda.gov.br
National Treasury
http://www.fazenda.gov.br
Brazilian Securities and Exchange Commition
http://www.cvm.gov.br
Brazilian Institute of Geography and Statistics
http://www.ibge.com.br
BMF - Commodities and Futures Exchange
http://www.bmf.com.br
JPMorgan Research
http://www.morganmarkets.com
Appendix 2: JPMorgan indicative pricing
sources
Reuters
JPMBS, JPMBR, JPMBV
Bloomberg
JBRL
JPMorgan Emerging Markets Research Contact Information
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