Financial Derivatives Chapter 12

Chapter 12 Learning Objectives Define financial derivative Explain the function of financial derivatives Compare and contrast futures and forwards Define call, put, exercise (strike) price, option premium Distinguish between an American and European option Describe interest rate and credit default swaps Define LIBOR

Definition financial derivative: financial asset whose value is a function of the value of an underlying asset or index

Hedging versus Speculation

Forward Contract Agreement between a buyer and seller to make an exchange in the future at a predetermined price. Bespoke (tailor made) Example: farmer and miller agree in January that the farmer will sell bushels of wheat to the miller in September for $

Problems with Forward Contracts 1.Costly to find a counterparty and draw up agreement 2.Contract is illiquid 3.Counterparty risk—one side may renege on the agreement

Futures Contract Like a forward contract except 1.contract is standardized and traded on an exchange (e.g. Chicago Mercantile Exchange) 2.contract is liquid 3.counterparty risk is eliminated

Margin Requirements Both sides in a futures contract have to put down money as insurance against default. If the futures price goes up the short side (future seller) needs to increase the margin. If the futures price goes down the long side (future buyer) needs to increase the margin.

Option A contract that gives a counterparty the right but not the obligation to sell (in the case of a put option) or to buy (in the case of a call option) an underlying asset.

Features of an Options Contract Strike (or exercise) price: price at which the underlying is bought or sold Option premium: the amount that the buyer of the option needs to pay the seller of the option Expiration date: date after which the option cannot be exercised.

European options can be exercised only on the expiration date American options can be exercised at any point up until the expiration date

Call option example

Swap An exchange of cash flows. For example: Consider two neighbors: Ollie has an oil furnace and Gus has a gas furnace. On average they pay about the same for fuel. Ollie thinks oil prices will be high this winter, Gus think gas prices will be high. So they agree to pay each other’s bill throughout the winter months. That would be a swap.

Net cash flows Suppose in December Ollie’s bill is $1000 and Gus’s bill is $900 Gus would pay Ollie $100

Plain vanilla interest rate swap A borrower has a floating rate obligation but would prefer a fixed rate. The borrower can arrange a swap to transform the floating rate obligation into a fixed rate.

LIBOR London Interbank Offer Rate Many floating rate loans are tied to LIBOR so swaps are often expressed in terms of LIBOR

Interest rate swap example Longshore Corp borrows money from its bank at a floating rate: LIBOR + 5%. Longshore would be willing to pay a fixed rate of 7% but the bank does not want to be exposed to the interest rate risk. Shortway Corp can borrow in the bond market at a fixed rate of 5%. Longshore could pay Shortway 7% in exchange for LIBOR + 5%, or 2% in exchange for LIBOR. If LIBOR < 2%, Shortway makes money. In any case, Longshore is insured against a rise in LIBOR.

Credit Default Swap Short side receives a payment when the underlying bond is not in default Long side receives payments when the bond goes into default CDS is like insurance but unlike with insurance, one can enter into the contract even if one does not own the underlying Analogous to taking out fire insurance on a neighbor’s house

CDO Collateralized debt obligations Created from risky tranches of mortgage backed securities.

Synthetic CDO Created from credit default swaps. Buyer of the CDO is the short side in the CDS— they are paid as long as the underlying bonds are not in default. Seller of the CDO is the long side in the CDS— they are paid if the underlying bonds go into default.