A super-basic, ABCs-type primer on derivative valuations. Not meant to be exhaustive, but to introduce the topic to someone who is curious and wants to dip a toe into the topic of OTC Derivatives and start to get a feel for what they are and how they are used.
2. Who am I?
Hi, I’m Cassandra.
Some quick facts about me:
► 10 years in financial services: capital markets, buy-
side, ratings, technology vendors, and consulting
► Credit Suisse, Barclays, JP Morgan Chase (Asset
Management, Corporate & Investment Bank),
Moody’s, DTCC/Omgeo
► Worked in Operations, Compliance, Regulatory,
Product Control, IT as a project manager, product
manager, business analyst, and data change
manager
Outside of work
I cook, I like single malt scotches, and I finally have
the travel bug! (9 countries + Asia for 2015)
January 2015 DERIVATIVES VALUATION: THE BASICS2
LinkedIn: www.linkedin.com/in/cassandrajohn
Website: www.cassandrajohn.com
Email: cassandra.john@outlook.com
Twitter: @cabigail2
3. Agenda
January 2015 DERIVATIVES VALUATION: THE BASICS3
What is a Derivative?
Basic Pricing and Valuation
Risk Management
Fair Value Measurement
Current Topics in Derivatives
4. If it looks like a duck…
► A financial instrument that derives its value from a specific reference asset
(stocks, bonds, commodities, currencies, rates)
► Has no intrinsic value of its own
► Can be traded on:
♦ A financial exchange (CME, ICE, Eurex, CBOE, LIFFE)
♦ Over-the-counter
► Can be used for:
♦ “Speculation”, i.e., a guess that the specific reference asset will have a fluctuation which presents
a “profit opportunity”
♦ Hedging, i.e. insurance against the fluctuation of a specific reference asset to provide protection
against a loss
January 2015 WHAT IS A DERIVATIVE?4
5. Types of ducks
► Single Stock Future:
MSFT (Microsoft)
► Stock Index Options:
S&P 500 Index
► Commodity Future:
CBOT-Oats Mar 15 @ 307 6/8
► Vanilla Interest Rate Swap:
FIXED/FLOAT - 5.5%-LIBOR 6m
Reset 6m, Tenor 3 years, USD $10mm
January 2015 WHAT IS A DERIVATIVE?5
Type of Derivative Reference Asset
Equity
Single Stock, Portfolio (basket of
stocks), Stock Index
Commodity
Weather, Hogs, Corn, Soybean, Oil,
Gas, Carbon
FX
EUR/GBP, EUR/USD, AUD/NZD,
USD/JPY
Credit bonds
Asset-backed credit cards, car loans, mortgages
Bond Bond Portfolio, Inflation
Rates
Fed Fund, LIBOR 1-month, LIBOR 1-
year
6. Building Blocks of Pricing
Vanilla Interest Rate Swap (Fixed vs Float)
► Notional (not principle!) amount
► Fixed interest rate
► Floating interest rate
► Tenor (i.e. maturity date)
► Settlement frequency
► Discount Factor
January 2015 BASIC PRICING AND VALUATION6
REFERENCE
ASSETS
SETTLEMENT
FREQUENCY
Floating Leg Payments
Notional
Spread
Fixed Leg
Swap Rate
PV
(present
value)
+= ( )
7. Pricing versus Valuation
January 2015 BASIC PRICING AND VALUATION7
► Agree the PRICE at the beginning of the swap
♦ At the start of the swap, the value should always = 0
♦ Neither the buyer/seller of the swap should be “in” or “out” of money
► Determine VALUE throughout the lifetime of the swap
♦ Daily – Am I up or down from 0 at the end of each day?
♦ Monthly – Am I up or down from 0 for the month?
♦ Quarterly – Am I up or down from 0 for the quarter?
♦ On Reset – What must I pay or receive at the end of this settlement period?
► Calculate P&L (Profit & Loss) throughout the lifetime of the swap
♦ On Reset – What did I pay or how much did I receive after the last settlement
period?
♦ On Termination – What did I pay or how much did I receive for the full lifetime of this
swap +/- any early termination fees?
♦ On Expiration – What did I pay or how much I receive for the full lifetime of this
swap?
Guess
Indicative
Hard
Cash
8. Why Valuation Matters
January 2015 BASIC PRICING AND VALUATION8
As a Speculator and/or Dealer
► Am I on track to book an “unearned” profit or
loss due to speculation?
► Do I need to engage in hedging transactions for
my own speculative trading?
► Is it worth early termination to prevent
compounded losses?
As a Hedgor
► How effective is this transaction against the risk
that I am trying to mitigate?
► Do I need to engage in additional risk
mitigation activities to supplement an
ineffective hedge?
► Is it worth early termination prevent
compounded losses?
9. Definition of Fair Value
January 2015 FAIR VALUE MEASUREMENT9
Fair value is a “rational and unbiased estimate of the potential market price of a good, service, or asset”[1]
Important Considerations
► Valuation of an asset or liability for which a market price cannot be determined
► Fair Value = Rational Price; Market Value = Fair Value +/- divergence due to non-predictable
behavioral anomalies
► Assumes an asset that is carried on a mark-to-market basis (i.e., a historical cost is not available or is
not being used)
► Per IFRS (International Financial Reporting Standards) via IVS 2007 (International Valuation
Standards) it should be used in due diligence exercises (versus that of market value)
► Per FASB (Financial Accounting Standards Board) there are 3 categories for fair value assessments:
Levels 1, 2, and 3 [2]
[1] Fair value. (n.d.). Retrieved December 27, 2014, from http://en.wikipedia.org/wiki/Fair_value
[2] IFRS also has a 3 category- based fair value assessment system (IFRS 7) that is similar in structure and definition to the FASB standard
10. FAS 157: Fair Value Measures
January 2015 FAIR VALUE MEASUREMENT10
► Initially issued September 2006; subsequently subsumed into FASB ASC (Accounting Standards
Codification) Topic 820 (Fair Value Measurement)
► Applicable to US GAAP Accounting
Quoted prices in active
markets
Effectively liquid or cash
equivalent
Complete/considerable
market consensus
Severely limited/no use of
models for pricing
Valuation comes from
“market observability” or
comparables
Thinner, less liquid market
Market consensus on pricing
is not as strong
Usage of common/accepted
models (e.g. Black-Scholes,
market credit spreads, etc.)
Unobservable prices or
comparables
Highly illiquid market
Little to no market
consensus
High reliance on custom
models
Considered mark-to-
management
1 2 3STOCK FUTURE: MSFT IRS: USD 20YR LIBOR 6M LONGEVITY SWAP
Level 1 Level 2 Level 3
Extremely rational pricing Pricing subject to extreme irrationality
11. Types of Risks
January 2015 RISK MANAGEMENT11
Leverage
/
Notional
Value
COUNTERPARTYContractua
l
Margin/
CollateralMARKET
Politics,
Terrorism,
War,
Natural
Disasters
Market
Downturn ENVIRONMENTALHuman
Error
► Risk is inherent to all derivatives contracts
► Certain risks can be more easily accounted for
and/or mitigated:
♦ Margin / Collateral
♦ Leverage / Notional Value
♦ Contractual
► Certain risks cannot be easily accounted for
and/or mitigated:
♦ Politics, Terrorism, War
♦ Natural Disasters
♦ Human Error
12. Elliott Capital / Argentina
January 2015 CURRENT TOPICS IN DERIVATIVES12
Timeline of Events
► 2002: Argentina defaults on bonds
► 2002: Elliott Capital Management (ECM) bought the 2001 bonds
(at a discount) before/after the default
► Oct 2012: ECM, by issuing an injunction in Ghana based on
litigation court orders in the US and UK, seizes an Argentinian
navy ship
► 2013: Argentina declares that it will not be subject to US court
opinions – will not honor the litigation result to treat old and new
bonds as pari passu
► 2014: Lawsuits by Soros Capital Management and Hayman
Capital Management against BoNY for withholding payments
from Argentina on newer bonds due to Argentina’s failure to
comply
Contractua
l
Margin/
Collateral
Politics,
Terrorism,
War,
Natural
Disasters
13. Elliott Capital / Caesars Entertainment
January 2015 CURRENT TOPICS IN DERIVATIVES13
► Caesars Entertainment Corporation (CZR) is attempting to
restructure $18.4 billion in debt; company has been operating at
a loss since 2009
► Elliott Capital Management (ECM) owns at least 30% of a series
of Caesar’s bond; is encouraging trustee to sue the company to
put it into receivership
► ECM purchased CDS contracts prior to entering into negotiations
with Caesar related to the push to bankruptcy
► CZR 1 YR CDS price has doubled from 43.5% (Sep ‘14) to 79.5%
(Dec ‘14) – 1 year ago, price was 8.75% upfront
► CZR has skipped its most recent $225 million interest payments
on junior bonds to continue restructuring talks; the ISDA
determinations committee is now deliberating whether that
represents a “failure-to-pay” credit event which will trigger
payout on outstanding CDS contracts
Contractua
l
Margin/
Collateral
Market
Downturn
14. Downturn in Oil and Gas
January 2015 CURRENT TOPICS IN DERIVATIVES14
► Oil has a 5-week continuing loss; in June, oil (Brent crude) was at
$115 per barrel – current price is $59.45 a barrel on ICE
♦ Reduced demand in Europe, Asia, and the US due to
weakening economies + efficiency measures
♦ Production level up in the US and Canada due to drilling for
“hard crude” in the North Dakota / Albert shale formations
♦ OPEC continuing existing production levels despite
softening prices; this maintains the downward pressure on
prices
► Natural gas futures have dropped beneath the $3 USD per
million British thermal units (Btus) – lowest price since 2012
♦ Dropped 26% in December
♦ Largest one-month drop since July 2008
♦ Temperatures in the Eastern US above average for
December
♦ High production has removed previous existing shortage;
inventories remain high which will keep prices low
Contractua
l
Market
Downturn
Politics,
Terrorism,
War,
Natural
Disasters
16. For the Bookshelf
January 2015 ADDITIONAL READING16
Models.Behaving.Badly. by Emanuel Derman
The Man of Nunbers: Fibonacci’s Arithmetic Revolution by Keith J. Devlin
The Price of Everything by Eduardo Porter
Flash Boys: A Wall Street Revolt by Michael Lewis
Deals from Hell: M&A Lessons That Rise Above the Ashes by Robert F. Bruner