1. Introduction to Swaps, Futures and Options CHAPTER 03

2. Hedging Volatility Recall that volatility in returns is a classic measure of risk Volatility in day-to-day business factors often leads to volatility in cash flows and returns If a firm can reduce that volatility, it can reduce its business risk Instruments have been developed to hedge the following types of volatility – Interest Rate – Exchange Rate – Commodity Price

3. The Risk Management Process Identify the types of price fluctuations that will impact the firm Some risks are obvious, others are not Some risks may offset each other, so it is important to look at the firm as a portfolio of risks and not just look at each risk separately You must also look at the cost of managing the risk relative to the benefit derived Risk profiles are a useful tool for determining the relative impact of different types of risk

4. Forwards and Futures A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is a non-standardized agreement to transact involving the future exchange of a set amount of assets at a set price A futures contract is a standardized exchange traded agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily

5. Futures Markets Futures contracts are usually traded on organized exchanges Exchanges indemnify counterparties against credit (i.e., default) risk Futures are market to market daily – marked to market describes the prices on outstanding futures contracts that are adjusted each day to reflect current futures market conditions The five major U.S. exchanges are the CBOT, CME, NYFE, MACE, and KCBOT The principal regulator of futures markets is the Commodity Futures Trading Commission (CFTC)

6. Futures Markets Futures contract trading occurs in trading “pits” using an open- outcry auction among exchange members – floor brokers place trades for the public – professional traders trade for their own accounts – position traders take a position in the futures market based on their expectations about the future direction of the prices of the underlying assets – day traders take a position within a day and liquidate it before day’s end – scalpers take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading

7. Forward Contracts A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date Forward contracts are legally binding on both parties They can be tailored to meet the needs of both parties and can be quite large in size Positions – Long – agrees to buy the asset at the future date – Short – agrees to sell the asset at the future date Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations

8. Hedging with Forwards Entering into a forward contract can virtually eliminate the price risk a firm faces – It does not completely eliminate risk unless there is no uncertainty concerning the quantity Because it eliminates the price risk, it prevents the firm from benefiting if prices move in the company’s favor The firm also has to spend some time and/or money evaluating the credit risk of the counterparty Forward contracts are primarily used to hedge exchange rate risk

9. Option Contracts The right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date – Call – right to buy the asset – Put – right to sell the asset – Exercise or strike price –specified price – Expiration date – specified date Buyer has the right to exercise the option, the seller is obligated – Call – option writer is obligated to sell the asset if the option is exercised – Put – option writer is obligated to buy the asset if the option is exercised Unlike forwards and futures, options allow a firm to hedge downside risk, but still participate in upside potential Pay a premium for this benefit

10. Swaps A swap is an agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval An interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two counterparties – the swap buyer makes the fixed-rate payments – the swap seller makes the floating-rate payments – the principal amount involved in a swap is called the notional principal A currency swap is a swap used to hedge against exchange rate risk from mismatched currencies on assets and liabilities Credit swaps allow financial institutions to hedge credit risk

11. Swap Markets Swaps are not standardized contracts Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves The International Swaps and Derivatives Association (ISDA) is a 815 member association among 56 countries that sets codes of standards for swap documentation Example: – Company A can borrow from a bank at 8% fixed or LIBOR + 1% floating (borrows fixed) – Company B can borrow from a bank at 9.5% fixed or LIBOR +.5% (borrows floating) – Company A prefers floating and Company B prefers fixed – By entering into the swap agreements, both A and B are better off then they would be borrowing from the bank and the swap dealer makes.5%

12. Example: Interest Rate Swap PayReceiveNet Company APayReceiveNet Swap Dealer w/ALIBOR +.5%8.5%-LIBOR Company B8.5%LIBOR +.5% Swap Dealer w/B9%LIBOR +.5%-9%

13. Hedging Interest Rate Risk with Options Can use futures options Large OTC market for interest rate options Caps, Floors, and Collars – Interest rate cap prevents a floating rate from going above a certain level (buy a call on interest rates) – Interest rate floor prevents a floating rate from going below a certain level (sell a put on interest rates) – Collar – buy a call and sell a put The premium received from selling the put will help offset the cost of buying a call If set up properly, the firm will not have either a cash inflow or outflow associated with this position