Chapter 9 Flashcards
What is a derivative? What are examples?
Financial instrument whose value is derived from the value and characteristics of an underlying financial item
Option contracted futures and swaps
What is the hedge efficiency?
Gain (loss) on the hedging instrument/ gain (loss) on hedged item
What is a forward contract?
Binding agreement to exchange a set amount of goods at a set future date at a price agreed today
Bespoke agreement between two parties referred to as “over the counter”
What is a futures contract and what is standardised about it?
Is a standardised contract to buy or sell a specific amount of a commodity, currency or financial instrument at a particular price on a stipulated future date.
Contract size
Maturity date
Traded on centralised exchanges
Why do you hedge shareholdings and what are the types of financial instruments used to hedge them?
May hold large portfolios of shareholdings in other companies
Concern is that share prices fall and they can hedge against this using following financial instruments:
Index futures
Share options
Index options
What are index futures?
Whag are the hedging steps?
Cash settled futures based on the value of stock index (FTSE 100) can be used to hedge a portfolio of shares
Each contract is for notional value of index value multiplied by £10 ie contract for 4500 is £45,000
Buying index future is similar to agreeing to buy the index constituent shares at a set price
When you close out the futures you get a net cash payment or receipt (no shares change hands)
Setup of hedge:
Sell index futures
Choose futures date (based on when you want to hedge to)
Note the futures price
Calculate no of future contracts: share portfolio value/futures level x£10
Outcome of hedge:
Close out futures by buying same number of contracts (gain or loss on futures
(Futures level at start - current futures level) x # contracts x £10
Calculate gain or loss on portfolio
What are the pros and cons of index futures?
Pros:
Hedges away downside risk of share prices falling
Can close out futures position at any time
Cons:
Standardised contracts so may over and under hedge the value of share portfolio
Only an appropriate hedge if the share portfolio is similar to the index
Removes upside potential
Must post initial merging to the exchange at the start
Must post variation must if you make losses on the futures position
Basis risk (difference between spot index level and futures level before futures maturity date) leads to hedge not being 100% efficient
What is an option?
What does it offer the choice between?
What must the buyer do?
Is an agreement giving the buyer of the option:
The right to buy but not obligation
To buy (call) or to sell (put) a specific quantity of something (eg shares in a company)
At a set price (strike or exercise price) within a stated period.
Choice between:
Exercising option
Allowing option to lapse
Must pay a premium now to buy the option
What can the options be?
What can options be for?
What does in the money, at the money or out of the money mean?
Over the counter (specific and bespoke) or traded (standardised and traded on exchanges
For:
The right to apply for newly issued shares (share options)
The right to buy or sell existing shares (pure options)
In money: generate a profit if exercised today
At money: if exercise price = current spot price)
Out of money: loss would be made if contract exercised today
What components make up the value of the option?
Intrinsic value: what option would be worth if exercised today.
Time premium: is the difference between the total value (=premium) and the intrinsic value driven by:
Time to expiry: longer time to expiry, more valuable the option
Volatility of underlying: higher the volatility the greater the option value
What are the hedging steps for index options?
Set up:
Buy put index options
Choose strike level and maturity date (based on when you want to hedge until)
Calculate number of contracts: share portfolio value/strike level x£10
Pay premium = points x £10 x # no of contracts
Outcome of hedge:
Choose whether to exercise option
Calculate gain or loss on options if exercise = (strike level - current spot index level) x # contracts x £10
Calculate gain or loss on portfolio
Deduct premium
What are the pros and cons of index options?
Pros:
Protects from downside risk and allows buyer to benefit from upside (by letting option lapse if share prices rise)
Cons :
Standardised contracts so may under or over hedge
Only an appropriate hedge if share portfolio is similar to index
Option premiums can be expensive
What are the four methods of hedging interest rate risk?
Forward rate agreements
Interest rate futures
Interest rate options
Interest rate swaps
What are the four risks from interest rate movements c
Having fixed rate debt in times of falling interest rates
Liquidity - can a company find the cash to repay a loan when it reaches its redemption rate?
Interest is paid at all times in a term loan, whereas you only pay interest on an overdraft when overdrawn
Depositing at variable rates in times of falling interest rates / fixed rates debt in times of rising interest rates
What are the five methods of reducing interest rate risk?
Pooling of assets and liabilities
Forward rate agreements
Interest rate futures
Interest rate options
Interest rate swaps
What does pooling of assets and liabilities mean
Some interest rate risks may cancel out where there are assets and liabilities which both have exposure to interest rate changes
What is a forward rate agreement?
What are the hedging steps?
FRAs are contracts which fix the effective rate of interest to be paid on future borrowing
FRAs settle on the start date on the underlying loan (no amounts actually lent as part of FRA - still need to borrow from bank
Borrowers but FRAS lenders sell FRAs
Borrower pays FRA fixed rate and receive the spot (benchmark) rate (one net settlement)
5.75-5.70 means you can borrow at the fixed rate at 5.75 and get a deposit rate of 5.70
A 3-6 starts in 3 months, lasts 3 months
The interest rates which banks will be willing to set for FRAs will reflect their current expectations if interest rate movements
Hedging steps:
Set up:
Buy FRA if borrowing in the future
Outcome of hedge:
(When borrowing starts)
Net settlement of FRA =
(Spot rate - FRA rate) X nominal value x #cmonths /12
Borrrow money from bank at spot rate
What are the hedging steps of a forward rate agreement?
Pros:
Hedges away downside risk
Tailored to investor (so won’t be over or under hedged)
Cons:
Usually only available on loans >500k
Usually for >1 year
Removes any upside potential
Difficult to exit (if date or size of borrowing changes)
What are interest rate futures?
What are the hedge steps?
Similar to FRAs but are standardised and traded on stock exchanges
Mature at the end of march, June, sept, dec. lending starts when futures contract expires
Three month interest rate futures have contract size of 500k
Futures price = 100-r (r is fixed interest rate)
Buying futures. Is akin to agreeing to receive fixed rate interest and selling futures is akin to agreeing to make fixed interest payment s
Borrower sell futures now and buy futures on date borrowing starts
Lenders buy futures now and sell futures on the date their lending starts.
Set up:
Sell futures if borrowing
Choose maturity date (as close to borrow start date as possible)
Calculate no of contracts = borrowing notional value / 500k x (borrowing period/3)
Outcome of hedge:
Close out futures by buying same number of contracts gives a gain or loss on futures =
(Sell price - buy price)/100 x # contracts x 500k x 3/12
Borrow spot rate from bank
What are the pros and cons of interest rate futures?
Hedges away downside risk
Can close out position at any time (more flexible than FRAS)
Cons:
Removes upside potential
Standardised contracts so may over or under hedge
Basis risk (difference between spot rate and futures rate before futures maturity date) may lead to hedge not being 100% efficient
Must post margin (collateral) to the exchange
What are interest rate options?
What is the interest rate guarantee?
Grants the buyer of tbe option of a right but not the obligation to borrow/lend at an agreed interest rate at a future maturity date
On date of expiry of option, buyer must decide whether or not to exercise right
There is a premium
IRG: refers to an interest rate option which hedges the interest rate for a single period of up to one year.
What are traded interest rate options? Related to interest rate options?
What are the hedging steps?
Are available as options on interest rate futures which give the holder the right to:
Buy (call) or sell (put) one futures contract
On or before the expiry of the option
Borrowers buy puts
Lenders buy calls
Hedging steps:
Set up:
Buy put options (if borrowing)
Choose strike price (based on 1 - maximum rate you want to pay)
Choose maturity date (as close to borrow start date as possible)
Calculate no of contracts = borrowing notional value / 500k x borrowing period/3
Pay premium = # contracts x 500k x preniumc% x 3/12
Outcome of hedge:
If rates rise above rate implied by strike price exercise option:
Sell futures at strike price
Close out futures by buying same number of contracts - gain on futures =
(Sell price - buy price) / 100 x # contracts x 500k x 3/12
Borrow money from bank at spot rate
If rates fall below rate implied by strike price: let option lapse
Borrow money from bank at spot rate
What are the pros and cons of traded interest rate options?
Pro:
Protects from downside risk and allows buyer to benefit from upside by letting put option lapse if interest rates fall
Cons:
Option premiums can be expensive and must be paid now
May over or under hedge just to standardised contracts
Basis risk (difference between spot rate and futures rate before futures maturity date) may lead to hedge not being 10”% efficient
What is an interest rate swap?
OTC whereby the parties to the agreement exchange interest rate commitments.
A agree this pay the interest on party B’s loan, while party B reciprocates by paying interest on party As loan
The two parties must swap interest which has different characteristics. One party must want fixed interest payments c the other must want floating interest pahments.
How do you calculate savings on interest rate swaps?
If the difference between the fixed rates which two parties can borrow at and the variable rates which the two parties can borrow at are no equal, then it will be beneficial for them to enter into an IR swap.
Set out the rates each company would pay (with no swap) and could pay (if they did the opposite) and work out the total rate in each case
Calculate the total potential benefit finding the difference between the two totals in part 1
Split this potential saving between the two parties as instructed in the question
Calculate the overall effective rate with a swap for each party by deducting their share of the saving from the rate they would pay if there was no swap
Use this end result to calculate the two legs of the swap.
What are the pros and cons of interest rate swaps?
Pros:
Can either provide fixed or floating interest
Can be either longer term than FRAs/ futures/ options
Can be used to achieve lower borrowing costs for each counter party
Cons:
If you swap to pay fixed interest you lose upside potential of variable rates
If you swap to pay floating interest you risk impact of rate rises
There is a risk that the swap counterparty defaults
There is a risk that the swap might make our sccohnts appear misleading
