Chapter 9 Derivatives Flashcards
Derivatives definitions
Instruments with a price which is depended upon or derived from one of more underlying financial values
Derivatives characteristics
- Used to hedge (credit) risk
- Can be traded on exchange or OTC
- Must be reported to trade repositories
Contracts for Difference (CFD)
Most derivatives are cash settled; no transfer of underlying value
Examples are: FRA, NDF and STIR Futures
Forward Rate Agreements (FRA)
- OTC derivative
- Traded on Money market
- 2 parties enter in a mutual obligation to settle the difference between an interest specified in the contract and the interest on fixing date.
- Hedging interest risk
Buyer of a FRA
Betting on an increase of the reference rate
Seller of a FRA
Betting on a reference rate that is lower than the contract rate on fixing date
FRA contract
1. Notional amount 2, Reference interest rate (EURIBOR/LIBOR) 3. Contract interest date 4. Fixing date 5. Settlement date 6. Underlying period 7. Who the buyer/seller is
Contract term FRA
Contract date to the fixing date
Underlying period FRA
Starts on settlement date
Fixing FRA
2 days before start date of underlying period (=trade date)
Settlement FRA
Start date of underlying period
Effective rate FRA
Always the forward rate
Money Market Future (STIR Future)
Same instruments as FRA but traded on a exchange
Standardized conditions STIR Future
- Underlying periods 1 or 3 months
- Contract amounts
- Daycount convention 30/360 over all currencies
- Start dates (IMM dates) Third wednesdays in March, Jun, Sep, Dec.
- Contract term is period before start date
Opening buy or sell
If a member has no other contracts and is selling/buying a future
Closing buy or sell
Later transacting the opposite transaction
- The first contract is offset
Exchange traded process
- Banks sends an order
- Exchange sends conf.
- Exchange sends details to CCP
- CCP sends details on value and margin payments to bank
- If the value decreased the bank has to make a payment to CCP margin account
MM Future Short Sterling
- Unit: GBP 500.000
- Tick: 1 bp
- Traded on NYSE ICE
MM Future Eurodollar
- Unit: USD 1 mio
- Tick: 0.5 bp (0.25 bp)
- Traded on NYSE ICE, CME , SGX
MM Future EURIBOR
- Unit: EUR 1 mio
- Tick: 0.5 bp
- Traded on NYSE ICE- Unit: GBP 500.000
- Tick: 1 bp
- Traded on NYSE ICE, EUREX, CME
MM Future EuroSwiss
- Unit: CHF 1 mio
- Tick: 1 bp
- Traded on NYSE ICE, CME
MM Future Euroyen
- Unit: JPY 100 MIO
- Tick: 0.5 bp
- Traded on TFX, CME
Price of MM Future
100 -/- implied forward rate
Price goes up if the forward rate goes down
Buyer of a STIR Future
Speculating on the fall in the interest rate
Seller of a STIR Future
Speculating on the rise in the interest rate
Implied forward rate
100- underlying benchmark rate (LIBOR, EURIBOR etc))
Last trading date STIR future
2nd working day before 3rd wednesday (11.00 am)
Exchange Delivery Settlement Price (EDSP)
Fixing price STIR Future
Interest rate swaps
- OTC contract in which 2 parties enter in a reciprocal oblogation to exchange coupons
- Used to covert a floating coupon for a fixed and viceversa
- Same function as FRA, but can be used over a longer period
Price of IRS
- Fixed rate
- Spread over the yield of government bonds
Buyer (Payer) of an IRS
- Pays the fixed rate
- Profits from increase
Seller (Receiver) of an IRS
- Pays to floating rate
- Profits from a drop
Cash flows of a receiver’s IRS
- Plain vanilla: Paying fixed, receiving floating
- ISDA: fixed coupons netted against floating
- Fully synchronized
Asset swap
Combination of a fixed rate bond and an IRS
Overnight index swap (OIS)
OTC derivative in which 2 parties agree to exchange interest payments in the same currency with the floating coupon based on an overnight interest rate index (EONIA, SONIA etc)
- Floating coupon is not paid daily but at the end of contract term or anually
Options
- Financial instruments that give one party a unilateral right to enter into a transaction at a specific future date: physical transfer
- To receive a payment if certain conditions are met at a future date: cash settlement
Why use options?
- Speculation: limited loss potential, unlimited profit potential
- Hedging: no opportunity loss, no obligation if the underlying position is uncertain
Call option
Right to buy
Put option
Right to sell
Strike price
Predetermined price or interest rate in an option contract
Cut-off times
- Interbank Europe, US: 10 am NY time
2. Interbank Pacific: 3 pm Tokyo
European expiration style
The buyer is only entitled to exercise his right on the expiry date
- OTC
American expiration style
Buyer can exercise his right at any time
- Stock exchange
Bermudan expiration style
Buyer can exercise his right on specific moments
Delta
The relationship between an absolute change in the option price and an absolute change in the underlying value
2. The chance that the option will be exercised-
Long straddle
An option strategy (more than 1 option)
Interest rate guarantee
Option on either a bought or sold FRA
Floor / CAP
Consists of a number of consecutive interest rate guarentees with the same exercise price
Collar
Buy a cap and sell a floor: long collar
Sell a cap, buy a floor: short collar
Swaption
Option for an IRS
