Fintech Chapter 10: Futures, Forwards and Swaps

Futures, Forwards, Swaps Financial Weapons of Mass Destruction

Futures, Forwards, Swaps Derivatives: value of the instrument is based on or “derived” from an underlying financial instrument Linear payoffs: valuation of the derivative will move one for one with increases or decreases with the underlying instrument

Futures, Forwards, Swaps Advantages: same economic exposure as underlying but greater liquidity, leverage, lower taxes, transaction costs Shift risk Forwards: delivery, OTC, counterparty exposure Futures: exchange traded, CCP, usually no delivery CCP: Central CounterParty Swap: OTC, exchange cash based on reference

Futures Mechanics Listed by Exchange, not fungible between exchanges Trading counterparties are anonymous CCP Futures Commission Merchant (Broker) Margin: initial and variation Default

CCP Commercial entities Buyer to all sellers, seller to all buyers Rule book Set margins SIFI?

ICE Clearing Default Waterfall

Single Stock Futures Trade anonymously Shares delivered at expiry, some cash settled Margins Theoretical price: FP = CP (1-FC)

Equity Swaps Total Return Swaps Inflation Swaps

Stock Index Futures Futures on market indexes S&P 500 futures Full size = $250 x index value E-mini= $50 x index value Used to hedge portfolios, new positions for indexed portfolios, allocation, speculation Advantages: liquidity, leverage, taxes, transaction costs

Interest Rate Swaps Daily trading volume averages $1 trillion OTC Dodd Frank requires SEF execution 2 parties agree to exchange cash flows Difference between two rates-one fixed, one floating Floating rate most often is LIBOR

Interest Rate Swaps Corporate finance hedging Financial institution interest rate management Speculation on rate changes Market Making Portfolio management- converting fixed to floating and vice versa; liquidity makes it cheap and convenient to gain/reduce exposure Rate locks prior to bond sales-issuers can receive fixed in a IRS prior to issuing fixed rate bonds. They then issue the bonds and reverse the IRS.

Interest Rate Futures CME NYSE Euronext Eurodollars futures most active

Hedging Example: Locking in an Interest Rate Need to borrow $10 million 3 months in future Rates might rise, so lock in now. LIBOR now 3% Sell 10 Eurodollar contracts at 97 If LIBOR rises to 4%, Eurodollar will be 96 Buy back 10 Eurodollar at 96 Gain $25,000 on 10 contracts This offsets the increased borrowing costs due to rise in LIBOR

Credit Default Swaps Non-linear payoff “Insurance” for bond holders If bond issuer defaults, CDS seller pays AIG was a big seller of CDS in 2000’s, but could not pay when mortgage market crashed in 2008 Government bailed out AIG New rules CDS market recovering Single names (one company) Indexes

Hedging Example: Protecting a Bond Payment Stream with CDS PM owns $100 million Company A bonds PM fears A could downgrade or fail PM pays 50 bp to counterparty If A defaults, pays 60% of par Counterparty pays 40% to PM

Fintech Applications Front Office Middle Office Back Office Execution Platform Portfolio Management Pooled Investment Services Middle Office Business Intelligence Market Data Alternative Data Back Office Confirmation, Clearing, Settlement Communications AML/KYC/KYV Chat Bots Risk Compliance, Reporting Monitoring

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