DERIVATIVES Presented by Sade Odunaiya Partner, Risk Management Alliance Consulting
DERIVATIVES u Introduction u Forward
Rate Agreements – FRA
u Swaps u Futures u Options u Summary
INTRODUCTION u
Financial Market Participants – Based on Time Horizon Borrower/Issuer u Lender/Investor u
– Trader – short short--term horizon for gain – Investor – long long--term for cash flow characteristics
– Based on Motivation
Investor – for income stream u Speculator – holds for expected gain u Arbitrageur – simultaneous sale & purchase for gain u Hedger – to protect against existing risks u
Brokers – act on behalf of a principal or on own account
INTRODUCTION u Financial
Market Instruments
– Investment instrument – traded spot or forward with exchange of principal – Contract for Difference – derived from the attributes of investment instruments but traded on a ‘notional’ ‘notional’ principal. Payments are for differences computed on the notional principal amount
INTRODUCTION u
Derivatives
– Security that derives its value from another asset or security
u
Financial derivative
– A financial instrument whose payoff depends on another financial instrument or security – Legally binding promise to perform some action in the future – Types FRA u Swaps u Futures u Options u
Forward Rate Agreement - FRA u Derived
from Forward Contracts
u Initiated
at one time; performance in accordance with agreed terms occurs at a subsequent time u Price is set @ time of contract with actual payment or delivery later u Examples are fwd foreign exchange contracts, fwd interest rate agreement, etc u FRAs
settle in differences based on notional principal & tenor
Forward Rate Agreement - FRA u Example
SWAPS Agreement between two parties to exchange sequences of cash flows over a period in the future u Anything can be swapped once there is mutual agreement – ‘custom nature’ u
u
2 basic financial instrument types: Interest rate u Currency swaps u
SWAPS u Example:
FUTURES u Futures
Contract
– Standardized forward contract u Quantity,
delivery date, delivery mechanism u Method of closing u Minimum & Maximum price fluctuation
– Exchange traded and regulated – Backed by a clearing house – Requires a Margin – good faith deposit – Daily settlement of gains and losses
FUTURES u Example:
OPTIONS u
Options – A contract whereby one party has a right and the other party has an obligation – For a specified period after which it lapses u
American & European variants
– Premium or price is paid ab initio – Two broad categories u u
Call – gives a right to buy & an obligation to sell Put – gives a right to sell & an obligation to buy
– Standardized and Traded on an exchange – Clearing house system – Requires posting of margins
OPTIONS u Example:
DERIVATIVES u Custom
made contracts
– FRA – Swaps u Standardized
– Futures – Options
or Exchange traded
DERIVATIVES u
APPLICATION – Market Completeness u
A market in which any and all identifiable payoffs can be obtained by trading securities available in the market
– Speculation – for knowledgeable traders to take calculated risks – Risk Management – a powerful tool for limiting risk – Trading efficiency – Use of derivatives rather than the underlying securities for the same return at a much lower cost
FORWARD RATE AGREEMENT (FRA) u u
Types: on interest or exchange rate On Interest rate – Fwd contract to borrow/lend money at a certain rate at some future date for an agreed tenor – No cash flow of principal at start & settlement – Long position – party that will borrow – Contract price – agreed interest rate u
LIBOR or EURIBOR
– Settlement date is Contract date – Long pays short, if contract rate > actual rate on settlement date – Short pays long, otherwise – Default risk on the difference to be paid/received
FORWARD RATE AGREEMENT (FRA) u Settlement
Amount is the discounted value of interest differential at actual price for the tenor of the agreement
Notional (floating – fwd)(days/360) Principal 1 + (floating)(days/360) where: days = no of days in loan term
FORWARD RATE AGREEMENT (FRA) u Illustration
– Consider an FRA that expires/settles in 30 days on a notional principal of $1mm. Forward rate is 5% on a 9090-day LIBOR – Assume actual LIBOR 3030-days from now (at expiration) is 6% – Compute the cash settlement @ expiration and identify who will be making payment
SWAPS Agreement to exchange a series of cash flows on periodic settlement dates over an agreed period of time u Series of FRAs u
– Custom made i.e. any mutually agreed cash flows can be swapped – No payment by either party @ initiation – No secondary market – Largely unregulated – Default risk is an important aspect – Participants are largely institutions
u
Zero sum game
SWAPS u Common
Types
– Interest rate – Currency
SWAPS - TYPES u
Interest rate swap – Notional principal in same currency for same amount – Trading fixed interest rate for floating interest rate or plain vanilla interest rate swap u u
Pay-fixed side: Party that wants floatingPayfloating-rate interest payment agrees to pay fixedfixed-rate interest Pay--floating side: Party that agrees to pay floating side Pay
– Floating rate is LIBOR based – Cash payment @ end of period & is based on net position Net fixed = swap fixed – LIBORt-1) no of dys (notional Rate paymt rate 360 principal) Note: +ve – fixed rate payer owes floating rate payer -ve - fixed rate payer is owed by floating rate payer
SWAPS - TYPES u
Currency Swap – One party makes payment denominated in one currency, while the other makes payment in another currency – Notional Principal Exchanged @ start using the exchange rate @ start u Returned at maturity in the same amount u
– Each party services the debt at the rate applicable to the currency received periodically – Full interest payments are exchanged without netting
SWAPS - TYPES u
Currency Swap – Illustration A US firm, Party A, wished to set up an Japanese operations and wants to finance the costs in Japanese Y. the firm finds that issuing Yen denominated debt is relatively more expensive as they are unknown in the Japanese market
Solution: Issue US$ debt & swap the cash flows for Japanese Yen
SWAPS - TYPES u4
types of currency swaps
– US$ – US$ – US$ – US$
fixed int rate for Jap Y fixed fixed int rate for Jap Y floating floating int rate for Jap fixed floating int rate for Jap floating
FUTURES u Comparison
with FRA
– Similarities u Either
deliverable or cash settlement u Priced to have zero value at time of contract
– Differences u Organized
exchange
u Regulation u Standardized u Single
clearinghouse
FUTURES u
Standardized Quantity u Delivery date u Delivery mechanism u Method of closing u Minimum & maximum price fluctuation u
– – – – u
Exchange traded and regulated Backed by a clearing house Requires a Margin – good faith deposit Daily settlement of gains and losses
Characteristics – Purchaser has contracted to buy i.e. long – Seller is ‘short’ as he’s contracted to sell
FUTURES - TYPES u
T-BILL FUTURES – – – – – –
$1 million 9090-day Quoted as 100 – discount yield (annualized) Settlement - in cash 1 basis point price change is $25 Not as important as before Heavily influenced by US Federal Reserve Board & monetary policies
FUTURES - TYPES u
EURODOLLAR FUTURES – Similar to TT-bill futures $1million 9090-day LIBOR u Price = 100 – Annualized LIBOR % u Settle in cash u Minimum price movement – 1 tick is $25 u
u
TREASURY BOND FUTURES – – – –
Treasury bonds with 15 yrs+ maturity Face value of $100,000 Deliverable contract Quoted as a % + fractions of 1% (1/32nd) of FV
FUTURES - TYPEs u STOCK
INDEX FUTURES
– Most popular stock index futurefuture-S&P500 – Settlement is in cash & based on a multiplier of 250 – Each contract is 250 times the level of index – Gain or loss of $250/ contract
FUTURES - TERMINATION u Delivery
– as per location on contract – Less than 1% u Cash
settlement
– Marked to market on delivery date u Offsetting
or reverse trade u Exchange for physicals – Off the floor of the exchange
OPTIONS An options contract gives the owner a right but no legal obligation to conduct a transaction involving an underlying asset at a predetermined price (exercise price) on a predetermined future date (exercise date) u Right will only be exercised if it is profitable prof itable to to do so u The writer (option (option writer) of an option is the seller u Buyers pays a option premium to the seller u
OPTIONS u
4 possible positions – – – –
u
Long call: the buyer of a call option Short call: the seller of a call option Long put: the buyer of a put option Short put: the seller of a put option
Two variants
– American – exercisable at any time up to & including the exercise date – European – exercised only on the exercise date – American option more valuable than European one – Same value on exercise date
OPTIONS u
Moneyness
– ‘In‘In-the the--money’ when the option has value i.e. +ve payoff u
For call option: spot price > exercise price
– ‘out out--of of--the the--money money’’ when the option will make a loss i.e. –ve payoff u
For call option: spot price < exercise price
– ‘at at--the the--money money’’ when neither loss or gain u
u
For call & put options: strike price = exercise price
An options intrinsic value is the amount by which the option is ‘in‘in-the the--money’ – Callv = Max(0, SS-X) – Putv = Max (0, X X--S)
OPTIONS u Illustration:
Consider a July 40 call and a July 40 put, both on a stock that is currently selling for $37/share. Calculate how much these options are inin- or outout-of of-the--money. the
OPTIONS u Option
Pricing is a function of the following: – Nature – call or put – Strike price relationship to spot price – Time to maturity – Volatility of price of underlying asset
SUMMARY Derivative instruments are a very fast growing sector of the financial market u They ensure market completeness and elimination of ‘free income’ in the financial market u Risk Managers use the market to manage the risks in their portfolio at minimal costs u Derivative instruments are here to stay!! u