Chapter 14 Financial Derivatives

© 2013 Pearson Education, Inc. All rights reserved.14-2 Hedging Engage in a financial transaction that reduces or eliminates risk Long position Short position Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position

© 2013 Pearson Education, Inc. All rights reserved.14-3 Interest-Rate Forward Contracts Agreements by two parties to engage in a financial transaction at a future (forward) point in time Specification of the actual debt instrument that will be delivered at a future date Amount of the debt instrument to be delivered Price (interest rate) on the debt instrument when it is delivered Date on which delivery will takes place

© 2013 Pearson Education, Inc. All rights reserved.14-4 Pros and Cons of Forward Contracts Can be as flexible as the parties involved would like Difficult to find a counterparty Subject to default risk

© 2013 Pearson Education, Inc. All rights reserved.14-5 Financial Futures Contracts and Markets Similar to an interest-rate forward contract but differs in ways that overcome some of the liquidity and default problems At the expiration date of a futures contract, the price of the contract converges to the price of the underlying asset to be delivered

© 2013 Pearson Education, Inc. All rights reserved.14-6 Application: Hedging with Financial Futures Holding $5M of 6s 2030 March s of 2030 are long term bond to be delivered in the CBT futures contract expiring in one year: March Interest is expected to stay at 6% for the next year so the 6s of 2030 and the futures contract are selling at par. Need to offset the long position in the bond with a short positions (selling a futures contract). If interest rates increase over the next year to 8% Value on March 8% interest rate $4,039,640 Value on March 6% interest rate-$5,000,000 Loss -$ 960,360

© 2013 Pearson Education, Inc. All rights reserved.14-7 Application: Hedging with Financial Futures (cont’d) Short position in the futures contracts has value of $4,039,640 (the value of the $5M in bonds after the interest rate rises) but the buyer of the futures contract agreed to pay you $5M on the maturity date. Your gain is $960,360, this has been a successful hedge.

© 2013 Pearson Education, Inc. All rights reserved.14-8 Organization of Trading in Financial Futures Markets Organized exchanges Regulated by the Commodity Futures Trading Commission (CFTC) –Ensure prices are not manipulated –Registers and audits brokers, traders, and exchanges –Approves proposed futures contracts to ensure they serve the public interest Trading has become internationalized and done 24 hours a day

© 2013 Pearson Education, Inc. All rights reserved.14-9 Table 1 Widely Traded Financial Futures Contracts in The United States

© 2013 Pearson Education, Inc. All rights reserved Explaining the Success of Futures Markets Quantities delivered and delivery dates are standardized A futures contract can be traded Any Treasury bond that matures in more than fifteen years and is not callable for fifteen years is eligible for delivery –Limits the possibility of cornering the market

© 2013 Pearson Education, Inc. All rights reserved Explaining the Success of Futures Markets (cont’d) Buyer and seller make the contract with a clearinghouse –Margin requirement that is marked to market every day Most futures contracts do not result in delivery of the underlying asset on the expiration date –Reduces transaction costs

© 2013 Pearson Education, Inc. All rights reserved Options Contracts that give the purchaser the option (right) to buy or sell the underlying financial instrument at a specified price (exercise or strike price) within a specific period of time (term to expiration). The seller is obligated to buy or sell the financial instrument if the buyer of the option exercises the right to sell or buy. The buyer does not have to exercise the option.

© 2013 Pearson Education, Inc. All rights reserved Options (cont’d) A premium is paid for the option American option can be exercised at any time up to the expiration date European options can only be exercised on the expiration date Stock options Futures options –More liquid than debt instrument markets Regulated by the SEC (stocks) and the CFTC (futures)

© 2013 Pearson Education, Inc. All rights reserved Options Contracts Call option gives the owner the right to buy a financial instrument at the exercise price within a specific period of time Put option gives the owner the right to sell a financial instrument at the exercise price within a specific period to time

© 2013 Pearson Education, Inc. All rights reserved Figure 1 Profits and Losses on Options Versus Futures Contracts

© 2013 Pearson Education, Inc. All rights reserved Differences Between Options and Futures Contracts For a futures contract the profits grow by an equal dollar amount for every point increase in the price of the underlying financial instrument For the option contract profits do not always grow by the same amount for a given change in the price of the underlying financial instrument because of the protection afforded from losses

© 2013 Pearson Education, Inc. All rights reserved Differences Between Options and Futures Contracts (cont’d) Initial investment on the contracts differ Money changes hands daily in the futures market; only once for the option contract (when the option is exercised).

© 2013 Pearson Education, Inc. All rights reserved Pricing Option Premiums The higher the strike price, everything else being equal, the lower the premium on call (buy) options and the higher the premium on put (sell) options The greater the term to expiration, everything else being equal, the higher the premiums for both call and put options The greater the volatility of prices of the underlying financial instrument, everything else being equal, the higher the premiums of both call and put options

© 2013 Pearson Education, Inc. All rights reserved Swaps Financial contracts that obligate each party to the contract to exchange a set of payments (not assets) it owns for another set of payments owned by another party Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency

© 2013 Pearson Education, Inc. All rights reserved Interest-Rate Swap Contracts Interest rate swap specifies –Interest rate on the payments that are being exchanged –Type of interest payments –The amount of notional principal –The time period over which the exchanges continue

© 2013 Pearson Education, Inc. All rights reserved Figure 2 Interest-Rate Swap Payments

© 2013 Pearson Education, Inc. All rights reserved Advantages of Interest-Rate Swaps Large transactions costs from rearranging balance sheets are avoided Informational advantages are maintained Possible to hedge interest-rate risk over a very long horizon

© 2013 Pearson Education, Inc. All rights reserved Disadvantages of Interest-Rate Swaps Swap markets suffer from a lack of liquidity Subject to default risk Need for information about counterparties has thus attracted intermediaries –Investment banks –Large commercial banks

© 2013 Pearson Education, Inc. All rights reserved Credit Derivatives Credit options –Right to receive profits tied either to the price of an underlying security or to an interest rate –Ties profits to changes in an interest rate such as a credit spread Credit swap –Increases diversification and lowers overall risk –Credit default swap Credit-linked notes –Combination of a bond and a credit option

© 2013 Pearson Education, Inc. All rights reserved APPLICATION Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? Allows financial institution to increase their leverage (AIG case) Banks have holdings of huge notional amounts of financial derivatives that greatly exceed the amount of bank capital –However, derivatives exposure at banks has not been a serious problem, even in the recent crisis.

© 2013 Pearson Education, Inc. All rights reserved APPLICATION Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? (cont’d) Conclusions: –Financial derivatives pose serious dangers to the financial system. –Some of these dangers have been overplayed. –Regulators would like to see more information disclosure about the exposure to derivatives contracts. –Derivatives need to have a better clearing mechanism (credit derivatives).