Ch 8 - Uses of derivatives

Question 1

Futures

Answer 1

based on an underlying financial instrument, rather than a physical commodity
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delivery rarely takes place – most deals are ‘cash settled’

Question 2

Give the 4 types of futures

Answer 2

1) BOND futures
2) ST Interest Rate futures
3) STOCK INDEX futures
4) CURRENCY futures
(Individual stock futures are also available in some markets)

Question 3

Margins

Answer 3

*initial margin -> deposit made when contract is first struck
*variation margin -> additional payments made daily to ensure that the clearing house’s exposure to credit risk is controlled (the exposure can increase after the contract is struck through subsequent adverse price movements) – clearing house protects itself by settling up profits & losses each day

Question 4

Explain why it is necessary for the exchange to require that companies trading futures contracts deposit margin when they trade.

Answer 4

Mainly to cover:
- current negative value of any o/s contracts
-an extra amount to cover any likely future volatility in the contract over a short period

Question 5

Bond futures

Answer 5

If it’s notional (total amount of a securities underlying asset) stock, there needs to be a linkage between it & the cash market.
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bonds which are eligible for delivery are listed by the exchange & a price paid by the receiving party is adjusted to allow for the fact that the coupon mayn’t be = to that of the notional bond which underlies the contract settlement

Question 6

ST interest rate futures

Answer 6

-quotation is structured in such a way that as interest rates fall, the price rises (inverse relationship)
-contract is based on the interest paid on a notional deposit for a specified period from the expiry of the future
-no principal/ interest changes hands (contract is cash settled), on expiry - the purchaser will have made a profit(or loss) related to the difference between the final settlement price & the original dealing price. the party delivery the contract will have made a corresponding loss (or profit)

Question 7

Stock index futures

Answer 7

contract provides for a notional transfer of assets underlying a stock index at a specified price on a specified date.

Question 8

Currency futures

Answer 8

contract requires delivery of a set amount of a given currency on the specified date

Question 9

What is the main use of a futures contract?

Answer 9

for a co. to ‘LOCK IN’ the value of assets or liabilities, or to guarantee the value of receipts & payments

Question 10

What is the use of a bonds future?

Answer 10

WHEN ISSUING BONDS:
lock in the current level of yields, it could sell some bond futures at the current price (would be unwound when the actual bond is issued)
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WHEN IT HAS A FIXED-RATE LOAN:
buy future contracts to hedge the risk of interest rates falling if it has a fixed-rate interest loan

Question 11

What is the use of a ST interest rate future?

Answer 11

WHEN IT HAS A FLOATING-RATE LOAN:
to protect it from the risk of rising interst rates
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if a co has raised capital by borrowing at floating interest rates, but wishes to fix its future interest payments, it can use these to fund any increase in the interest rate payable (but will have to pay over any interest saved if market rates fall)

Question 12

What is the use of a stock index future?

Answer 12

DURING A TAKEOVER:
a rise in the target co’s share price can cause an increase in the amount the predator company has to pay, the predator co can buy stock index futures to hedge this risk.

Question 13

What is the use of a stock index future?

Answer 13

TO FIX THE VALUES OF RECEIPTS (foreign) or PAYMENTS:

Question 14

Forwards

Answer 14

OTC = over-the-counter (i.e not exchange traded)
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if forward is moved to a clearing house immediately after it has been arranged > central-clearing (which reduces the credit risk of the forward for both parties)

Question 15

Options

Answer 15

buyer has right but not obliged whereas seller (writer) has an obligation
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writer of the option pays a margin to the clearing house & the buyer pays a premium to the writer

Question 16

Types of options

Answer 16

> CALL - right, but not the obligation to BUY a specified asset on a set date in the future for a specified price
PUT - right, but not the obligation to SELL a specified asset on a set date in the future for a specified price
AMERICAN - option that can be exercised on ANY DATE BEFORE its expiry
EUROPEAN - option that can only be exercised at EXPIRY
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traded options are available on individual equities & also on financial futures contracts

Question 16

What is the use of options?

Answer 16

eg. if a co. has borrowed at variable interest rates, they can purchase options to protect itself against increases in market interest rates. If rates fall the co. will only suffer the loss of the premium paid to purchase the options

Question 17

Swaps

Answer 17

def: contract between 2 parties under which they agree to exchange a series of payments according to a prearranged formula

Question 18

Characteristics of swaps

Answer 18

-one party is usually a bank & the other is a co. (parties involved are called counterparties)
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-swap is priced so that PVCF is slightly negative for the investor & positive for the issuing organisation - the difference represents the price the investor is prepared to pay for the advantages brought by the swap on the one hand, and the issuer’s expected profit margin on the other

Question 19

What type of risks does each counterparty to a swap face?

Answer 19

1) MARKET - risk that the market conditions will change so that the PV of the net outgo under the agreement increases
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2) CREDIT - risk that the other counterparty will default on its payment (if swap has a negative value to the defaulting party so the risk is not the same as the risk that the counterparty would default on a loan of comparable maturity.)

Question 20

Give the types of swaps

Answer 20

1) INTEREST RATE swaps:
one party agrees to pay to the other a regular series of fixed amounts for a certain item. In exchange, the 2nd party agrees to pay a series of variable amounts based on the level of ST interest rate. Both sets of payments are in the same currency.
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the fixed payments can be thought of as interest payments on a deposit at a fixed rate, while the variable payments are the interest on the same deposit at a floating rate. The deposit is purely a notional one; no exchange of principal takes place.
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2) CURRENCY swaps:
agreement to exchange a fixed series of interest payments & a capital sum in one currency for a fixed series of interest payments & a capital sum in another.

Question 21

Uses of swaps

Answer 21

2) REDUCING THE COST OF DEBT: if one co. has a comparative advantage in borrowing at a floating rate while another co. has a comparative advantage (difference in credit ratings in different LT & ST debt markets) in borrowing at a fixed rate, they can use an interest rate swap to reduce the total cost of financing & both benefit from a lower cost of debt.