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 $20,000Price 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 $20,000Price 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 = $4Payoff Net payoff Put Option Buy put for $5 Gross profit with exercise price of $40. $40 $35 Premium = $5 Price of securityNOTE: Sellers earn premium if option notexercised by buyers.
Hedging with Interest Rate SwapsBEFORE – 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 paymentsFirm A Firm B Libor + 1% 12%Starting conditions: Starting conditions:Firm A borrows floating rate Firm B borrows fixedbank 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.