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Futures, Options, and Swaps
• Purposes of these derivatives
  – Hedge price movements in cash markets
  – Increase completeness of markets
     • Repackage cash flows in many ways that are
       attractive to investors
  – Speculation in market prices (this makes
    pricing efficient)
• Financial futures markets
  – Sale or purchase of securities now for future
    delivery (also currencies)
     • CBOT started GNMA futures in 1975. Chicago
       Board of Trade (CBOT) and Chicago Mercantile
       Exchange (CME) are leaders.
     • Now T-bills, T-notes, large CDs, Euro CDs,
       GNMAs, S&P500 Index, NYSE Index, and others
     • These contracts are very standardized, use well-
       known financial securities, and are growing in
       international exchanges around the world.
Financial Futures
• Futures markets
  – Organized exchanges
     • CBOT, CME use trading pits (“open
       outcry” system)
     • Margins as low as 0.2 percent (can borrow
       more than 99 percent of futures contract!!
       -- $2,500 for$1 million T-bill) -- this
       minimizes costs of hedging.
     • Clearinghouse guarantees performance of
       other party to contract
     • Normally, close out with offsetting
       position before maturity
     • “Marked-to-market” daily
  – Differ from forward contracts
     • No organized exchange to guarantee
       payment -- agreement between parties
       involved only -- over-the-counter
     • Not marked-to-market daily (unwind
       profits or losses at maturity)
Financial Futures
• Foreign currency hedging started before
  financial futures due to highly volatile
  currency movements in the early 1970s.
   – For example, British gov’t securities may have
     higher yield that U.S. gov’t securities
      • Problem: British pound may decline in
        value (relative to U.S. dollar) causing a loss
        of yield gains in British securities.
      • Solution: Go short (sell) in pounds. If
        pounds do decline in value over time, buy
        at lower price and fill earlier sell orders to
        make profit in futures market for British
        pounds. Result is to eliminate currency risk
        and earn yield on British securities.
• Stock index futures
   – No delivery possible here
      • Delivery in cash on settlement date (e.g.,
        for S&P 500 Index, take $500 times value
        of contract at maturity).
Short Position in a 90-day T-Bill
   Futures Contract with $1,000,000
   Denomination.
                    Assumption: That interest rates
                    increase over the next 90 days.

Price Sell
(say 98)
                                                   Profit of 2
                                                   or $20,000
Price Buy
(say 96)



             0 = Now                          90 days
                              Time            from now
 Discussion: No delivery of T-bills is required on the
 settlement date 90 days from now. The futures exchange
 automatically buys and sells T-bills for you at settlement.
 You can unwind or settle prior to the maturity of the
 contract if you want. The same principles apply to
 currencies -- e.g., the value of the pound falls over the next
 90 days.
Long Position in a 90-day T-Bill
   Futures Contract with $1,000,000
   Denomination.
                    Assumption: That interest rates
                    decrease over the next 90 days.

Price Sell
(say 98)
                                                  Profit of 2
                                                  or $20,000
Price Buy
(say 96)



             0 = Now                         90 days
                             Time            from now
 Discussion: If interest rates instead increase over the next 90
 days, there will be losses each day in this long position. Due
 to marked-to-market accounting by the exchanges, the losses
 must be paid immediately. This is true to a short futures
 position also -- if interest rates decrease instead of increase
 over time, losses must be paid each day this occurs.
Options
• Definition:       Right but not obligation to buy or
  sell at a specified price (“striking price”) on or
  before a specified date (“expiration date”).
  – Call option: Right to buy -- pay “premium”
      to seller for this right.
  –   Put Option: Right to sell -- pay “premium” to
      seller for this right.
  –   Note: Seller of option must buy or sell as
      arranged in the option, so the seller gets a
      premium for this risk. The premium is the
      price of the option. The Black-Scholes option
      pricing model can be used to figure out the
      premium (or price) of an option. Premiums
      related to price and volatility of securities.
  –   Long position: The buyer of the option, who
      gains if the price of the option increases.
  –   Short position: The seller of the option, who
      earns the premium if the option is not
      exercised (because it is not valuable to the
      buyer of the option).
Option Payoffs to Buyers
 Payoff
                       Gross payoff
     Call Option
     Buy for $4 with                Net payoff
     exercise price $100


                      $100   $104
                              Price of security

   Premium = $4
Payoff
         Net payoff
                        Put Option
                              Buy put for $5
                 Gross profit with exercise
                              price of $40.

                $40
          $35

            Premium = $5 Price of security
NOTE: Sellers earn premium if option not
exercised by buyers.
Hedging with Interest
     Rate Swaps
BEFORE

   – Firm 1                      Firm 2
  Fixed rate assets           Variable rate assets
  Variable rate liabilities   Fixed rate liabilities

            Note: Exchange interest payments,
            not the principal or so-called notational
            values of the debt contracts.
AFTER

   – Firm 1                      Firm 2
  Fixed assets                   Variable assets
  Fixed liabilities    Variable liabilities

  oStarted in 1981 in Eurobond market.
  oLong-term hedge
  oPrivate negotiation of terms
  oDifficult to find opposite party
  oCostly to close out early
  oDefault by opposite party causes loss of swap
  oDifficult to hedge interest risk due to problem of
  finding exact opposite mismatch in assets or
  liabilities
Interest Rate SWAP

      13.1%        Bank              Libor

                Bank makes
                debt
                payments
Firm A                                 Firm B
             Libor + 1%        12%
Starting conditions:             Starting conditions:
Firm A borrows floating rate     Firm B borrows fixed
bank loan at Libor + 1%           rate 12% bonds
(premium for risk)               (AAA bonds with
                                 no premium for risk)
Results
 (A) Firm A has total or “all-in” fixed
     rate obligation of 12% +
     0.1%(bank service fee +
     1.0%(premium over Libor) =
13.1%
 (B) Firm B has floating rate obligation
Hedging Strategies
•   Use swaps for long-term hedging.
•   Use futures and options for short-term hedges.
•   Use futures to “lock-in” the price of cash positions in
    securities:
     – e.g., a corp. treasurer has a payroll due in 5 days and
        wants to fix the value of marketable securities being
        held to meet the payroll -- a short hedge gives downside
        price protection in this case.
•   Use options to minimize downside losses on a cash position
    and take advantage of possible profitable price movements
    in your cash position:
     – e.g., you have a cash position in bonds and believe that
        interest rates are equally likely to rise than fall -- -- you
        could buy by a put option on bonds -- if rates do rise,
        you are “in the money” on the option and offset losses
        in the cash position in bonds -- however, if rates fall,
        you do not exercise the option and make price gains on
        the cash position in bonds.
•   Use options on futures to protect against losses in a futures
    position and take advantage of price gains in a cash
    position.
•   Use options to speculate on price movements in stocks and
    bonds and put a floor on losses.
Hedging Strategies
•   Options are more costly than futures in terms of
    transactions costs, so futures are used more frequently in
    hedging.
•   Futures and options are primarily hedging (risk
    reduction) vehicles, but they do expose the firm to some
    amount of management risk -- more specifically, an
    employee suffering losses in these contracts may react by
    taking even larger risks to make up for the losses, with
    the possibility of large losses due to high leverage
    (borrowed funds) that could damage the firm.
•   Futures have potential liquidity risk because they are
    marked-to-market daily and losses must be paid
    immediately. Forward contracts do not have this
    problem, as not marked-to-market daily.
•   Futures contracts have basis risk to the extent that prices
    of the derivative securities (e.g., T-bills) do not move
    over time in the same way as other asset prices. If you
    held junk corporate bonds, basis risk is significant, as the
    T-bills and junk bond prices are less than perfectly
    correlated over time. Forward contracts reduce this
    problem, as you can use any asset as the derivative (i.e.,
    forward contracts in junk bonds are used to hedge cash
    positions in junk bonds).
•   Large banks today provide risk management services to
    firms that includes hedging advice and management of
    hedging services.

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Futures options and swaps ppt @ bec doms bagalkot

  • 1. Futures, Options, and Swaps • Purposes of these derivatives – Hedge price movements in cash markets – Increase completeness of markets • Repackage cash flows in many ways that are attractive to investors – Speculation in market prices (this makes pricing efficient) • Financial futures markets – Sale or purchase of securities now for future delivery (also currencies) • CBOT started GNMA futures in 1975. Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME) are leaders. • Now T-bills, T-notes, large CDs, Euro CDs, GNMAs, S&P500 Index, NYSE Index, and others • These contracts are very standardized, use well- known financial securities, and are growing in international exchanges around the world.
  • 2. Financial Futures • Futures markets – Organized exchanges • CBOT, CME use trading pits (“open outcry” system) • Margins as low as 0.2 percent (can borrow more than 99 percent of futures contract!! -- $2,500 for$1 million T-bill) -- this minimizes costs of hedging. • Clearinghouse guarantees performance of other party to contract • Normally, close out with offsetting position before maturity • “Marked-to-market” daily – Differ from forward contracts • No organized exchange to guarantee payment -- agreement between parties involved only -- over-the-counter • Not marked-to-market daily (unwind profits or losses at maturity)
  • 3. Financial Futures • Foreign currency hedging started before financial futures due to highly volatile currency movements in the early 1970s. – For example, British gov’t securities may have higher yield that U.S. gov’t securities • Problem: British pound may decline in value (relative to U.S. dollar) causing a loss of yield gains in British securities. • Solution: Go short (sell) in pounds. If pounds do decline in value over time, buy at lower price and fill earlier sell orders to make profit in futures market for British pounds. Result is to eliminate currency risk and earn yield on British securities. • Stock index futures – No delivery possible here • Delivery in cash on settlement date (e.g., for S&P 500 Index, take $500 times value of contract at maturity).
  • 4. Short Position in a 90-day T-Bill Futures Contract with $1,000,000 Denomination. Assumption: That interest rates increase over the next 90 days. Price Sell (say 98) Profit of 2 or $20,000 Price Buy (say 96) 0 = Now 90 days Time from now Discussion: No delivery of T-bills is required on the settlement date 90 days from now. The futures exchange automatically buys and sells T-bills for you at settlement. You can unwind or settle prior to the maturity of the contract if you want. The same principles apply to currencies -- e.g., the value of the pound falls over the next 90 days.
  • 5. Long Position in a 90-day T-Bill Futures Contract with $1,000,000 Denomination. Assumption: That interest rates decrease over the next 90 days. Price Sell (say 98) Profit of 2 or $20,000 Price Buy (say 96) 0 = Now 90 days Time from now Discussion: If interest rates instead increase over the next 90 days, there will be losses each day in this long position. Due to marked-to-market accounting by the exchanges, the losses must be paid immediately. This is true to a short futures position also -- if interest rates decrease instead of increase over time, losses must be paid each day this occurs.
  • 6. Options • Definition: Right but not obligation to buy or sell at a specified price (“striking price”) on or before a specified date (“expiration date”). – Call option: Right to buy -- pay “premium” to seller for this right. – Put Option: Right to sell -- pay “premium” to seller for this right. – Note: Seller of option must buy or sell as arranged in the option, so the seller gets a premium for this risk. The premium is the price of the option. The Black-Scholes option pricing model can be used to figure out the premium (or price) of an option. Premiums related to price and volatility of securities. – Long position: The buyer of the option, who gains if the price of the option increases. – Short position: The seller of the option, who earns the premium if the option is not exercised (because it is not valuable to the buyer of the option).
  • 7. Option Payoffs to Buyers Payoff Gross payoff Call Option Buy for $4 with Net payoff exercise price $100 $100 $104 Price of security Premium = $4 Payoff Net payoff Put Option Buy put for $5 Gross profit with exercise price of $40. $40 $35 Premium = $5 Price of security NOTE: Sellers earn premium if option not exercised by buyers.
  • 8. Hedging with Interest Rate Swaps BEFORE – Firm 1 Firm 2 Fixed rate assets Variable rate assets Variable rate liabilities Fixed rate liabilities Note: Exchange interest payments, not the principal or so-called notational values of the debt contracts. AFTER – Firm 1 Firm 2 Fixed assets Variable assets Fixed liabilities Variable liabilities oStarted in 1981 in Eurobond market. oLong-term hedge oPrivate negotiation of terms oDifficult to find opposite party oCostly to close out early oDefault by opposite party causes loss of swap oDifficult to hedge interest risk due to problem of finding exact opposite mismatch in assets or liabilities
  • 9. Interest Rate SWAP 13.1% Bank Libor Bank makes debt payments Firm A Firm B Libor + 1% 12% Starting conditions: Starting conditions: Firm A borrows floating rate Firm B borrows fixed bank loan at Libor + 1% rate 12% bonds (premium for risk) (AAA bonds with no premium for risk) Results (A) Firm A has total or “all-in” fixed rate obligation of 12% + 0.1%(bank service fee + 1.0%(premium over Libor) = 13.1% (B) Firm B has floating rate obligation
  • 10. Hedging Strategies • Use swaps for long-term hedging. • Use futures and options for short-term hedges. • Use futures to “lock-in” the price of cash positions in securities: – e.g., a corp. treasurer has a payroll due in 5 days and wants to fix the value of marketable securities being held to meet the payroll -- a short hedge gives downside price protection in this case. • Use options to minimize downside losses on a cash position and take advantage of possible profitable price movements in your cash position: – e.g., you have a cash position in bonds and believe that interest rates are equally likely to rise than fall -- -- you could buy by a put option on bonds -- if rates do rise, you are “in the money” on the option and offset losses in the cash position in bonds -- however, if rates fall, you do not exercise the option and make price gains on the cash position in bonds. • Use options on futures to protect against losses in a futures position and take advantage of price gains in a cash position. • Use options to speculate on price movements in stocks and bonds and put a floor on losses.
  • 11. Hedging Strategies • Options are more costly than futures in terms of transactions costs, so futures are used more frequently in hedging. • Futures and options are primarily hedging (risk reduction) vehicles, but they do expose the firm to some amount of management risk -- more specifically, an employee suffering losses in these contracts may react by taking even larger risks to make up for the losses, with the possibility of large losses due to high leverage (borrowed funds) that could damage the firm. • Futures have potential liquidity risk because they are marked-to-market daily and losses must be paid immediately. Forward contracts do not have this problem, as not marked-to-market daily. • Futures contracts have basis risk to the extent that prices of the derivative securities (e.g., T-bills) do not move over time in the same way as other asset prices. If you held junk corporate bonds, basis risk is significant, as the T-bills and junk bond prices are less than perfectly correlated over time. Forward contracts reduce this problem, as you can use any asset as the derivative (i.e., forward contracts in junk bonds are used to hedge cash positions in junk bonds). • Large banks today provide risk management services to firms that includes hedging advice and management of hedging services.