Derivatives Markets Flashcards
What is risk management for organisations?
- Effective management of risk is essential for long-term survival of a company
- A large number of businesses fail because their BoD did not establish adequate risk management objectives and policies, or business managers did not implement and monitor risk management procedures and strategies
- A business must identify, measure and manage the wide range of risk exposures to which it is exposed
- Some risk exposures will be common to most businesses, others will vary depending on the nature of the business
What are some risk management strategies?
They can be external or internal
[Internal] - Deal with foreign risk including invoicing in a home currency, currency diversification
[External] - Implemented when available internal strategies will not be effective in achieving the desired risk management outcome
What is effective risk management?
IQEM
- Identifying exposures
- Quantifying exposures
- Evaluating exposures
- Managing exposures
What is a derivative?
A financial asset that is primarily designed to manage specific risk exposure. Its value is derived from the value of an underlying commodity or financial instrument that is traded in the physical markets
What are the four types of derivatives?
Forwards, futures, options and swaps
The basic risk management function of a derivative product is that it can lock in a price today that will apply at a specified future date - locking in a price today means the identified risk exposure is said to be hedged
Who are the users of derivative markets?
- Hedgers - use the market to lock in a future price and hence make their future cash flows more certain, have an underlying position in the asset [performed by equity fund managers]
- Speculators - using the market to bet on a price change, have no underlying position in the asset [performed by individual investors]
- Arbitrageurs - trade on mispricing between the derivatives and spot markets or between different derivative contracts to make a profit [performed by hedge fund]
What are the common risks to Hedge?
- Commodity price risk. e.g. gold
- Interest rate risk
- Currency risk
- Share market risk
What are the background to futures?
Futures vs Forward vs Spot
Spot - Price today, delivery today
Forward - Price today, delivery at a future date
Futures - Price today, delivery at a future date
What is a financial future?
- Bank Bills
Contract unit - $1m face value, 90 day bank-accepted bill
Delivery - physical
Quotation - 100 yield
Contract months - march, june, september and december up to 20 quarters ahead - Commonwealth Bond Futures
Contract unit - $0.1m face value, 6% pa coupon, paid semi-annually Commonwealth Government Bonds (3 year and 10 year)
Delivery - Cash settled
Quotation - 100 yield
Contract months - march, june, september, december up to 2 quarters ahead - Share Price Index Futures
Contract unit - $25 times the ASX 200 index
Delivery - Cash settled
Quotation - in the same form as the ASX 200 index
Contract months - march, june, september, december up to 6 quarters ahead
What is a hedger?
Selling Hedge - worried about a fall in price, so sell futures
If price falls, loses in the spot market but wins on the futures
If price rises, wins in the spot market but loses on the futures
Buying Hedge - worried about a rise in price, so buy futures
If price falls, wins in the spot market but loses on the futures
If price rises, loses in the spot market but wins on the futures
What is a speculator?
To bet on a price rise - buy futures
To bet on a price fall - sell futures
What is an arbitrageur?
Trade on mispricing between the futures and spot markets or between different futures contracts to make a profit
What are the backgrounds of an option?
An option contract gives the option buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a specified price, the exercise price, on or before a specified date
Call options are the right to buy the item in the option contract at the exercise price
Put options are the right to sell the item in the option contract at the exercise price
The buyer of an option must pay a premium to the seller, or writer, as their losses are limited buy they can profit from favourable price movements
Who are the users of option markets?
- Hedgers - Worried about a fall in price, so buy put options
If price falls, loses in the spot market but wins on the puts
If price rises, wins in the spot market but loses on the puts
Worried about a rise in price, so buy call options
If price falls, wins in the spot market but loses on the call
If price rises, loses in the spot market but wins on the call
- Speculators
To bet on a price rise - buy calls
To bet on a price fall - buy puts - Arbitrageurs
Trade on mispricing between the options and spot markets or between different option contracts to make a profit
What are the six variables relevant to the share option price?
- Share price (S)
- Exercise price (X)
- Standard deviation of return of share (o)
- Time to maturity (T)
- Riskfree Rate (Rf)
- Dividends (Div)
What is the relationship between the relevant variables to the share option price and the option prices
- When share prices increases (S), call increases and put decreases
- When exercise price increases (X), call decreases and put increases
- When standard deviation of return of share increases (o), call increases and put increases
- Time to maturity increases (T), call increases and put increases
- Riskfree Rate increases (Rf), call increases and put decreases
- Dividends increases (Div), call decreases and put increases
What are forward rate agreements (FRA’s)?
A forward rate agreement (FRA) allows a borrower to manage interest rate risk exposure
Like a futures contract it can lock in an interest rate today that will apply at a specified future date
However, it is more flexible to manage as there is no requirement to make margin payments
An FRA is a contractual agreement between two parties to lock in an FRA agreed rate at a future FRA settlement date based on a specified FRA contract period and a specified reference rate
What are the FRA terms?
The agreed rate is the fixed interest rate that is set at the beginning of the contract
The settlement date is the nominated date specified in the FRA when the parties to the contract will apply a specified reference rate
The contract period relates to the term of the interest rate protection being managed
A notional principal or face value needs to be specified
The reference rate is specified in the FRA and on the settlement date is compared to the agreed rate. The appropriate reference rate for a 3 month contract period could be the 3 month BBSW
An FRA that locks in an FRA agreed rate today that will apply in 2 months time (the FRA settlement date) and has a 3-month contract period will be expressed as 2Mv5M
How does a FRA work?
A FRA is not a borrowing or lending arrangement
There are two parties in a FRA and if on the settlement date the reference rate in the FRA is different from the FRA’s agreed rate then one of the parties will compensate the other party for the difference
Often one of the parties is a financial institution, such as a commercial bank or investment bank
The financial institution will provide a two-way quote for an FRA. The higher interest rate is the one that will be used on a borrowing hedge. The lower interest rate is the one that will be used on an investment hedge
e.g. A quote of 5.15 - 5.20 means an investment hedge rate of 5.15% and a borrowing hedge rate of 5.20%
What is a borrowing hedge?
When the agreed rate is less than the reference rate the bank compensates the borrower for having to borrow at the higher reference rate. When the agreed rate is more than the reference rate the borrower will have to pay the bank
What is an investment hedge?
When the agreed rate is greater than the reference rate the bank compensates the investor for having to invest at the lower reference rate. When the agreed rate is less than the reference rate the investor will have to pay the bank
EXAMPLE: Borrowing Hedge
If the agreed rate on a borrowing hedge is set at 5.25%pa and the reference rate is 5.5%pa, the bank will compensate the borrower for borrowing at 0.25%pa more than the agreed rate. If the interest rate had fallen below 5.25%pa the borrower would have to compensate the bank
EXAMPLE: Investment Hedge
If the agreed rate on an investment hedge is set a 4%pa and the reference rate is 3.75%pa, the bank will compensate the investor for investing at 0.25%pa less than the agreed rate. If interest rates had risen above 4%pa the investor would have to compensate the bank
EXAMPLE: Borrowing Hedge
Assume a 90Dv270D FRA with an agreed rate for borrowing of 5%pa and a nominal face value of $10m, at settlement the reference rate is 5.5%
Payment or receipt for customer can be calculated as the difference in price for two bank bills
Price @ agreed rate = $10m/(1+0.05180/365) = $9 759 358
Price @ reference rate = $10m/(1+0.055180/365) = $9 735 930
Therefore bank will pay $9 759 358 - $9 735 930 = $23 428 to customer
EXAMPLE: Investment Hedge
Assume a 30Dv120D FRA with an agreed rate for investing of 4%pa and a nominal face value of $20m, at settlement the reference rate is 4.5%
Payment or receipt for customer can be calculated as the difference in price for two bank bills
Price @ agreed rate = $20m/(1+0.0490/365) = $19 804 666
Price @ reference rate = $20m/(1+0.04590/365) = $19 780 518
Therefore investor will pay $19 804 666 - $19 780 518 = $24 148 to bank
What are swap contracts?
A swap is an over-the-counter financial product that allows parties to enter into a contractual agreement to exchange cash flows
A direct swap is where two parties enter into swap agreement with each other to manage exposure to a specific risk. It is possible to enter into an intermediated swap with a bank. The bank enters into separate swap agreements with the two parties who wish to manage specific risk exposures
The majority of swaps are intermediated as banks are able to make a liquid market in swap contracts and the counterparty to a swap is able to maintain commercial confidentiality by entering into a swap with a bank
Interest rate swaps facilitate the management of interest rate risk exposures by allowing the exchange of a series of interest payments associated with a notional principal amount
The notional principal is the underlying amount specified in the contract to be used to calculate the value of the contract
The main type of swap is a vanilla swap which is a fixed-for-floating interest rate swap. A basis swap is a floating-for-floating interest rate swap. The basis is the difference between the two variable reference rates
The variable reference rate may vary from one swap contract to another. For example, in Australia it may be BBSW while in London in may be LIBOR
One party agrees to pay an amount determined by a fixed interest rate (the swap rate) while the other party agrees to pay an amount determined by a variable reference rate. In reality, the parties will swap the net difference at each reset date in the swap
When the reference rate is higher than the swap rate the net difference is paid by the party paying the reference rate
When the reference rate is less than the swap rate the net difference will be paid by the party paying the swap rate
What is a hedging interest rate risk?
A corporation that has a variable rate loan might be worried about interest rates rising. To protect itself it enters into a vanilla swap with a bank. In the swap the corporation will pay the fixed swap rate while the bank will pay the variable reference rate
If interest rates increase then the corporation will have to make a larger interest payment on its loan but may receive the net difference on the swap
