Derivatives Flashcards
Risk of derivatives
Involve greater illiquidity risk: 1) some have unlimited losses! The value of the derivative may fluctuate more than the underlying assets. 2) difficult to value 3) fund may be unable to terminate or sell its derivative positions.
Swaps
give a lender the ability to shift the investment exposure from one type of investment to another
Interest rate swaps involve the exchange of interest payments by the fund with another party. Ex. the trading of a variable interest like LIBOR + 2% for a fixed interest payment of 5%
ex. an exchange of floating rate payments for fixed interest rate payments with respect to a notional amount of principal.
If an interest rate swap intended to be used as a hedge negates a favorable interest rate movement, the investment performance of the fund would be less than what it would have been if the fund had not entered into the IRS.
CDS
What?
Like insurance, if someone does not pay the debt the insurance provider pays for it. CDS only generate income in the event of a default on the underlying debt security or other specified event.
How?
Company rated BB wanted to lend $1m from a Pension fund for a 20% interest in return. Issue is that pension funds must invest in the highest rated securities. One way that they end up investing in a BB company is by buying CDS from a provider like AIG (ex. AIG can insure 100 bps or 1% of the transaction between pension and company rated BB but does not need to set aside reserves, making the BB company look like their AA rating)
Why?
1) protection against a loan if lending to someone
2) side bet for HF to make money on the default of a company
3) use as a way to make lower rated securities acceptable to pension funds
Risks
1) like insurance but is not regulated like insurance good money if no one is defaulting, provider will be in trouble and their AA rating will be decreased, everyone who though they had AA do not. Involved heightened risk CDS may be illiquid and difficult to value, subject to the risk of it expiring worthless.
2) Seller- credit risk of the issuer of the obligation, leverage risk in the event of a default, risk of loss on securities to cover the fund’s expenses under the swap.
3) Buyer - subject to credit risk relating to the seller’s obligations in the event of default
Call Option
if you like a company expect the stock to go up
For a premium payment, the option holder has the right but not the obligation to buy or sell the underlying asset at a specified price at a specified date. Buying at a discount. If out of the money (i.e. underlying security decreased, remained the same, or failed to increase beyond the exercise price) lose the premium paid for it.
MBS
traditional way of getting loan is by going to the bank receiving cash in exchange for interest. In the old model, bank keeps payments itself. Innovation due to dependency on deposits to support loans banks sell loans to an investment bank, borrower pays the IB. IB sets up a special purpose entity / sep. corporation which it transfers to loans to and issues shares off of. IB gets fees on top of investor dollars. These shares are the MBS.
When interest rates increase, mortgage refinancing and prepayments slow, which lengthens the effective duration of these securities. Negative effect of interest rate increase on the market value of MBS is usually more pronounced than it is for other fixed income securities
ABS
backed by financial assets that are securitized like credit card receivables, home loans, auto loans
leverage
The notional value in excess of the assets needed taken to maintain the derivative. Measures the relative size of long and short positions in risky assets compared to the size of the portfolio.
Leverage can be created through borrowing (to meet redemption requests), purchasing securities on margin, reverse repo, and derivatives. Increases a fund’s losses when the value of its investments decline.
Forwards / Futures
Ex. farmer sells apples to a pie maker but the prices fluctuate all year round. They can get into an agreement on a future price of the asset allowing the farmer to set the price of the item to be sold and the buyer to set the price that the item will be purchased at at a future date
Futures are standardized forward contracts traded on an exchange that come with a “guarantee” that obligate a purchaser to take delivery and a seller to make delivery of a specific amount of an asset on a specified date at a specified price.
Risks
a) losing price on premium paid if the asset goes down in price and does not recover
b) inability to close contract due to lack of liquid secondary market
c) unlimited losses caused by unanticipated market movements
Put Option
If you do not like a company and do not have the stomach to short a stock, sell the option at a lower price. If the price goes up, can just let the option expire and lose on the premium paid for the option
Shorting
Borrowing stock and betting that it will go down in value, then buying back the stock at the lower price and give it back to the owner. Buying and selling in reverse order. When stock goes up, can lose unlimited amounts of money etc. if stock quadruples.
Security
ownership in a company that is tradable
