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.