Derivative Financial Instruments ECO 473 – Money & Banking – Dr. D. Foster

Derivative Financial Instruments Forward contracts Future contracts Options Swaps Derivatives in . . . Interest rates Currency Stock Commodities Weather

“Purpose” of a Derivative Hedging/Insuring against adverse changes … You have $10 million in U.S. Treasuries, nominal yield is 5% and maturity date is 2022. But, you only want to hold them until 2019. Risk – If interest rates rise, the price will fall. Hedge – execute a forward contract, promising to sell bonds in 2019 at a price yielding 5.1%. OK, get out your calculators. What price are these bonds going to sell for in 2019? Assume that they are sold right after that year’s coupon has been redeemed.

“Purpose” of a Derivative Hedging/Insuring against adverse changes … You need to buy €5 million in 6 months, the current exchange rate is $1.33/ €. But, you think the dollar will depreciate by then. Risk – If the dollar falls, it costs more to buy €. Hedge – go “long” and agree to buy €, through a futures contract, at $1.36 each. If the actual price goes to $1.35, how are you affected? What if the actual price goes to $1.38?

Forward vs. Future Contract Variable in content. Settled at maturity date. Matching participants. Future: Standardized amounts and terms. Ongoing settlement cash flows. Active, liquid market. Default can’t hurt other party.

“Purpose” of a Derivative Hedging/Insuring against adverse changes … You need to buy €5 million in 6 months, the current exchange rate is $1.33/ €. But, you think the dollar will depreciate by then. Risk – If the dollar falls, it costs more to buy €. Alternative Hedge – buy a call option to purchase Euros at $1.40 each; exercise only if the rate moves higher than that.

“Purpose” of a Derivative Hedging/Insuring against adverse changes … You pay a variable return on $25 million worth of outstanding bonds. Risk – If interest rates rise, so do your costs. Hedge – execute an interest rate swap, to gain a fixed payment schedule, and reducing your exposure to interest rate changes.

Derivatives as speculative Bank agrees to buy bonds in one year at a price that earns 5% . . . thinking rates will fall. Buy/sell currency futures if you expect rates to move contrary to market. Buy options to leverage your investment. Would the derivatives market be improved if speculation was prohibited?

The Credit Default Swap Hedging against adverse changes.. You own $25 million worth of outstanding bonds. Risk – If the firm goes bankrupt . . . Hedge – buy a credit default swap, and make a fixed payment (insurance). If firm goes bust, the seller owes you for the bond (difference).

Derivative Financial Instruments ECO 473 – Money & Banking – Dr. D. Foster