Topic 5 - Managing w Derivatives

Question 1

derivative

Answer 1

A derivativeis a financial instrument whose value is derivedfrom the value of some other underlying asset, rate or index

Derivatives are used for risk management

Question 2

Risk management encompasses two different types of activities:

Answer 2

Those with an exposure to risk can use derivatives to reduce risk –this is referred to as hedging 
Others can use derivatives to voluntarily take on risk in the expectation of increased return –this is refer to as speculating

Question 3

There are four basic types of derivatives –

Answer 3

forward contracts, futures contracts, options and swaps

Question 4

Banks use derivatives in a number of ways

Answer 4

To hedge an existing exposure to risk 
To profit through speculation and arbitrage 
To act as market makers by offering to enter into various derivative contracts (e.g. forward rate agreements and swaps) with their client

Question 5

forward contract

Answer 5

A forward contract is similar to any contract to buy and sell an asset, except that the date on which the asset changes hands, and the price of the asset, are set in advance when the contract is agreed to

Question 6

Forward contracts Effect on risk

Answer 6

A forward contract locks in a price that is immune from market fluctuations, eliminating price risk
A party to a forward contract eliminates the possibility of downside risk (the risk that prices will move in an unfavourable direction) but also eliminates upside risk (the risk that prices will move in a favourable direction)

Question 7

ADVANTAGES OF FORWARD CONTRACTS

Answer 7

Forward contracts are very flexible –they can be tailored to meet the needs of the parties to the contract

There is no cash outlay until the goods are exchanged on the settlement date

Both parties to the contract can effectively eliminate risk without any cost if their exposures are perfectly matched

Question 8

DISADVANTAGES OF FORWARD CONTRACTS

Answer 8

Ideally, a party to a forward contract needs to find a counterparty with a matching, but opposite, exposure, and this may not be easy
It is difficult to unwind a forward contract if circumstances change
Both parties are exposed to default risk, because one of them will have an incentive not to comply with the contract because of changes in the price of the underlying asset

Question 9

FORWARD RATE AGREEMENTS

Answer 9

Forward Rate Agreements are used to “lock in” an interest rate that will be paid or received in the future
Anyone planning to borrow or lend in the future knows the current rate and the expected future interest rate, but does not know the actual interest rate they will pay or receive
Hence, they are exposed to interest-rate risk

f one party is exposed to rising interest rates (i.e. a future borrower) and another is exposed to falling rates (i.e. a future lender) they can eliminate interest-rate risk by agreeing on the rate that they want to be exposed to in the future

The party that is hedging against an increase in interest rates is referred to as the buyer of the FRA, and the party hedging against a fall in rates is the seller of the FRA

The FRA is separate from the actual lending or borrowing

The parties to the FRA may be lending to and borrowing from each other, but not necessarily – if they do, this is a completely separate arrangement

Question 10

Example
Three months from now you will need to borrow $1,000,000 for 6 months –this is called a 3 x 9 FRA The current 6-month bank bill swap rate is 4.5% You expect the interest rate to be 4.8% in 3 months

1. Do you buy or sell an FRA to lock in this interest rate? 2.How much compensation will be paid if the interest rate in 3 months is 5.0%?
2. When does settlement take place?
3. Do you pay or receive this amount?

Answer 10

1.Do you buy or sell an FRA to lock in this interest rate? An intending borrower, protecting against an increase in interest rates, is said to be the buyerof an FRA.

2.How much compensation will be paid if the interest rate in 3 months is 5.0%
$975.61

3.When does settlement take place?
At the beginning of the intended borrowing period – three months from now.

4.Do you pay or receive this amount?
Interest rates have risen; hence you are compensated.

Question 11

DEFINITION OF FUTURES CONTRACTS

Answer 11

A futures contract is a forward contract that is standardised with respect to: 
the underlying asset, 
the size of the contract, and 
the settlement date,

and is traded on an exchange such as ASX 24 (formerly the Sydney Futures Exchange)

Futures can be used to hedge an exposure or speculate on the basis of expectations about future prices

Question 12

Hedgers and speculators buy or sell futures contracts on a futures exchange

Answer 12

Buying a future contract is a short-hand term that means entering into a contract to buy the underlying asset on the settlement date 

Buying a futures contract is also referred to as going longor taking on a long position in the contract 

Selling a future contract means entering into a contract to sell the underlying asset, and selling a futures contract is also referred to as going short or taking on a short positionin the contract

Question 13

HEDGING WITH FUTURES CONTRACTS

Answer 13

A hedger who is exposed to a fall in the price of a commodity in the physical market (e.g. a sheep farmer) might take on a futures position that will give him a matching profit in the futures market if wool prices do fall
This will involve selling futures, because futures prices are linked to the underlying asset price
If the price of wool (and hence the price of wool futures) falls, he can buy back the sold contracts at a lower price, making a futures profit

A hedger exposed to an increase in the price of a commodity in the physical market (e.g. a wool buyer) might take on a futures position that will give him a matching profit in the futures market if wool prices do rise
This will involve buying futures contracts
If the price of wool (and hence the price of wool futures) rises, he can sell the bought contracts at a higher price, making a futures profit to offset the loss in the physical market

Question 14

SPECULATING WITH FUTURES CONTRACTS

Answer 14

A speculator is someone who doesn’thave an existing exposure, but who thinks the price of an asset will increase or decrease and wants to profit from this expectation
He will buy or sell futures contracts, respectively
If the price of the asset (and hence the price of the futures contract) moves as expected, the speculator can sell or buy, respectively, the same number of contracts at a higher or lower price, respectively,and make a profit

Question 15

MARGIN REQUIREMENTS AND SETTLEMENT with Futures

Answer 15

The buyer or seller of a futures contract must place a sum of money, called an initial margin, into a margin account
The value of the futures position is marked to market every day, and the increase or decrease in the position is added to or subtracted from the account
If the account drops to half its initial value, it must be “topped up” to the initial value by the next trading day

Question 16

ADVANTAGES OF FUTURES CONTRACTS

Answer 16

Standardisation of contracts allows a liquid secondary market to develop
It is easy to establish
There is no exposure to default risk

Question 17

DISADVANTAGES OF FUTURES CONTRACTS

Answer 17

Because of standardisation, it is difficult to perfectly hedge an existing exposure –you may be faced with residual risk in terms of: 
the precise commodity, 
the size of the contract, or 
the maturity date

Also, there is an initial cash outlay, and possible ongoing cash outlays, in order to meet margin requirements

Question 18

DEFINITION OF OPTIONS

Answer 18

An optionis a contract that gives the buyer of the option the right, but not the obligation, to buy or sell a commodity at a set price on or before a particular date

Question 19

Option holder

Answer 19

The holder of an option is the person who has paid a premium to buy the option and has the choice as to whether or not it will be exercise

Question 20

Option writer

Answer 20

The writer is the person who creates the option However often an option is bought and sold, the writer remains responsible for complying with the contract if the holder decides to exercise it

Question 21

Buyers and sellers

Answer 21

Because an option is a security(it can be bought and sold in a secondary market during its life) there can be many buyers and sellers
The writer is the first person to sell the option
The holder is the last person to buy the option
Many others can fulfil the role of both buyer and seller over the life of the option

Question 22

Call and put options

Answer 22

A call option gives the holder the right to buy the underlying asset
A put option gives the holder the right to sell the underlying assets

Question 23

Exercise price

Answer 23

The exercise price (or strike price) is the predetermined price at which the underlying asset can be bought or sold (as the case may be)

Question 24

Maturity date

Answer 24

The maturity date is the date by which, or on which, the option must be exercised –after that date it is worthless

Question 25

Premium

Answer 25

The premium is the price paid by the buyer to the seller of the option, and is determined by the price and volatility of the underlying asset, the strike price, time to maturity and interest rates

Question 26

European and American options

Answer 26

A European option can only be exercised on the maturity date
An American option can be exercised any time up to the maturity date

Question 27

in-the-money

Answer 27

An option is said to be in-the-moneyif the relationship between the asset price and the strike price is such that, if the option was exercised now, it would result in a profit

Question 28

out-of-the-money

Answer 28

It is said to be out-of-the-money if exercising it now would result in a loss

Question 29

at-the-money

Answer 29

It is at-the-money if the strike price and the asset price are equal

Question 30

over-the-counter(OTC)

Answer 30

An over-the-counter(OTC) option is negotiated directly between the option buyer and the option writer

Question 31

Exchange traded options (ETOs

Answer 31

Exchange traded options (ETOs) are traded on an organised exchange such as ASX 24

Question 32

cap

Answer 32

A capis an option that gives the option holder (a variable rate borrower) a payoff equal to the difference between the prevailing interest rate and an agreed maximum (the level of the cap)

Question 33

floor

Answer 33

A floor is an option that gives the option holder (a variable rate lender) a payoff equal to the difference between the prevailing interest rate and an agreed minimum (the level of the floor)

Question 34

collar

Answer 34

A collar is a combination of a cap and a floor

A long collar means buying a cap and selling a floor 
This gives a borrower protection against high rates but reduces the overall cost –the premium received from selling the floor offsets the cost of the cap 
The borrower is protected from high rates but gives up the benefit of extremely low interest rates

A short collar means buying a floor and selling a cap This gives a lender protection against low rates but reduces the overall cost –the premium received from selling the cap offsets the cost of the floor 
The lender is protected from low rates but gives up the benefit of extremely high interest rates

Question 35

swap

Answer 35

A swapis an agreement to exchange one or more cash flows on a set date or dates in the future

Question 36

Thepurchasingagentforalargenaturalgas poweredelectricalgeneratingplantexpectsnaturalgaspricestofallsoon.Unfortunately,shemustsignacontractwiththegas distributorthisweekatwhatsheconsidersahighpriceforgas.Describehowshemightuseaforwardcontracttohedgetheplant’scostoffuel.

Answer 36

The purchasing agent should short a forward contract to deliver gas at the currentforwardpriceinthefuture.Ifthepricefallsbymorethancurrentmarketexpectations,as thepurchasingagentbelievesitwill,theplantwillbeabletodeliverthehigher‐pricedfuel andenterintothemarkettopurchasethefuel,atthenewlowermarketprice.

Question 37

Claudiowillreceivepaymentof$5,000,000inMayfromhisrichuncle’sestate.Heplansto investthefundshereceivesinlong‐termbondsbutheisworriedthatbondinterestrates willdeclinebetweennow(January)and15May.HowcanClaudiohedgethissituation usingthefuturesmarket?Bespecificabouttheposition(longorshort)andthecontracthe shoulduse.

Answer 37

Claudioshouldbuy$5millionfacevalue(50contracts)of10‐yearTreasurybondfutures ontheSFE.Ifinterestratesfall,Claudiowillhavetobuy10‐yearbondsatahigherpriceon15May.Tooffsetthispriceincrease,Claudiowillliquidatehisfuturespositionanduse thegainfromthehedgetopurchasethesamevolumeoftreasurybondsthathecould havepurchasedwith$5millioninJanuary,providedthereisnobasisrisk.Otherwisethe hedgemightnotworkquiteperfectly.Ifinterestratesrise,Claudiowillexperiencealoss onthefuturesposition,butwillbeabletobuythebondsinthemarketplaceatalower price.

Question 38

InlateMarch,acorporatetreasurerprojectstheneedfora$1millionbankloanstarting on11June.Thebankadvisesthattheratewillbe1%overthe3‐monthBBSWonthat date.TheBBSWiscurrently5.625%.ThetreasurerdecidesthathewillusetheJuneBABfuturestolockintheforwardborrowingrate.Thefuturesaretradingat94.35,implyinga yieldof5.625%(100.00–94.35).Whattransactionshouldthetreasurermaketolockina borrowingrateforthe3 monthperiodbeginning11June?Whatborrowingratewillhe achieve?

Answer 38

ThetreasurershouldsellJuneBABfuturesfordeliveryon11June.Heshorts(sells)BABfuturesatayieldof5.625%.Hecantheneitherissuebankbillsunderthetermsofthe futurescontract,orcloseouthisfuturescontractforcashsettlement.Eitherwayhe achievesaborrowingrateof5.625%underthefuturescontract.

Question 39

Whydoesincreasingtheunderlyingassetpriceincreasethevalueofthecalloption?

Answer 39

Anincreaseintheunderlyingassetpriceincreasesthechancethatthecalloptionwouldbeinthemoney,andthepayoffontheoption,thereforeincreasingthevalue ofthecalloption

Question 40

Whydoesincreasingtheunderlyingassetpricedecreasethevalueoftheputoption?

Answer 40

Anincreaseintheunderlyingassetpricereducesthechancethattheputoptionwillfinishinthemoney,andalsodecreasesthepayoffifitdidfinishinthemoney, thereforedecreasingthevalueoftheputoption.

Question 41

Whydoesincreasingthestrikepricedecreasethevalueofthecalloption?

Answer 41

Anincreaseinstrikepricedecreasesthechancethatthecalloptionwouldbeinthemoney,andthepayoffontheoption,thereforedecreasingthevalueofthecall option.

Question 42

Whydoesincreasingthevolatilityincreasethevalueoftheputoption?

Answer 42

Anincreaseinvolatilitygenerallyincreasesthechancethatthecalloptionwouldbeinthemoney1,andincreasesthechanceofhighterminalassetprices,therefore increasingthevalueofthecalloption.

Question 43

UsingoptionsonbankbillfuturestradedonASX24describetwooptionpositionsthatyou couldtakethatwouldhaveapositivepayoffintheeventthatinterestratesrise.

Answer 43

Youcouldsellacalloptiononthebankbillfutures.Wheninterestratesrise,bankbill futurespriceswillfallandtheoptionwillexpireout‐of‐the‐money.Youwillearnthe premium.Youcouldbuyaputoptiononbankbillfutures.Intheeventthatinterestrates rise,bankbillfuturespriceswillfallandyourputoptionwillexpirein‐the‐moneywitha positivepayoff.

Question 44

Discusstheprosandconsofusingoptionsversususingfuturescontractsforafinancial institutionaimingtosetthedurationgaptozero

Answer 44

Settingthedurationgaptozerocanbeachievedthroughtradinginfuturesaswesawin chapter13.Anothermethodwouldbetopurchaseoptions.Forexampleiftheduration gapispositivethentheinstitutionisexposedtoariseininterestrates–itwillsufferaloss inmarketvaluewheninterestratesrise.Soanoptionpositionthatwillcausetheduration ofassetstodecreaseorincreasethedurationofliabilitiesisneeded.Ifthedurationis positivethenthevalueoftheassetincreaseswithincreasinginterestrates.Thisistrueforashortcallonaninterestratefutures,oralongputonaninterestratefutures.Either positionwouldhavethedesiredeffectintermsofclosingthedurationgap.However, optionsmaynotbepreferredtofuturestoachievethis,becausethebankwillhavetopay thepremiuminthecaseofthelongput.Thetextbookdidnotdiscussthedurationofthe optionposition,butitisrelatedtothedeltaoftheoption.

Question 45

Inthistopicwehavecoveredfuturesandforwards,optionsandswaps.Compareand contrasttheseinstrumentswithrespectto:

(a) markingtomarketofcashflows
(b) abilitytohedgeagainstinterestrateriskforthefinancialinstitution
(c) creditriskexposureforthefinancialinstitutionintheirmarket‐makingfunction

Answer 45

(a) Futuresaremarkedtomarketeachdaybytheclearinghouse.Forwards,options andswapsareover‐the‐counterinstruments,andwhilethebankwillmarkthemto market (as the market maker) they will not be marked to market for the counterparty.Thiscreatesmorecounterpartyriskforthebank.
(b) Allthreeinstrumentscanbeusedtohedgeagainstinterestraterisk.Bankstendto useswaps,futuresandforwardstomicro‐andmacro‐hedge.Bankstendtobenet sellersofoptions,andwhilethecounterpartyisoftenacompanyusingtheinterest rateoptiontohedgeitsinterestrateexposure,bankstendtohedgetherisktheycreateinsellingoptionswitheitherfutures,forwardsorswaps(bydeltahedging).Oneofthereasonsthatoptionsarenotusedisthatthebankmustpayapremiumfortheoption,andthatmaynegateprofitthattheymakefromsellingoptionsinthe firstplace.Becauseswapsarelongerterminstrumentstheyareusedtomacrohedgethebalancesheet,particularlyifthedurationgapislarge.
(c) Creditriskexposureiscreatedwiththemarket‐makingfunctioninOTCforwards, options and swaps. Longer term swaps are the most sensitive to interest rate movements (for the same notional principal). Hence counterparty risk may be greatestforswaps.Bankshavecounterpartylimitstolimitthiscreditexposure.

Question 46

Abanksimultaneouslyentersatwo‐yearswapasthefixedratepayerat8.00%p.a.and another two‐year swap as the fixed rate receiver at 8.15% p.a., each with notionalprincipalof$10million.Howmuchprofitwillitmake(approximately)?

Answer 46

Theansweristheinterestdifferentialonthenotionalprincipaloverthetwoyears,given by0.0015 x10millionx2=$30,000.