1. Institutions & Derivative Instruments
Financial Markets,
Institutions & Derivative Instruments
ECO 473 – Money & Banking – Dr. D. Foster

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

3. “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 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%.

4. “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.

5. 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.

6. “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.

7. “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.

8. 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.
Actions raise market liquidity for non-speculators!!

9. Case: Barings Bank to 1995
1992 – Nick Leeson becomes a trading manager at Baring Securities in Singapore.
Charged with executing client option orders and arbitraging price differences between SIMEX and Osaka exchanges.
Took “speculative positions” in futures linked to Nikkei 225 and Japanese gov’t. bonds.
Hid losses in an unused error account: $400 m. – 1994 and $1.4 b. – 1995
Fled Singapore; arrested in Germany.

10. 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).

11. The Credit Default Swap
First one in 1995 (J.P. Morgan)
By 2008, $45 trillion in value.
As speculation – buy & sell to manage risk.
You don’t need to own bond!
Done OTC.
Party-to-party transaction.
Settlement/liquidity issues.
Build a virtual bond portfolio.
Insider trading issue . . .

12. Case: AIG & Credit Default Swaps
Rather than hedge risk, took on risk.
Sold CDS on $500 billion of assets; $80 bill. of MBS.
Besides CDS, also engaged in securities lending.
Used income for illiquid, riskier, long-term investments (MBS).
$1 trillion in assets; lost $100 billion.
Unpaid collateral obligations rise as prices fall.
Downgrading of their credit = must pay obligations.
Sept – UST & Fed provide $180 billion bailout.
Feb – Loans repaid. A $22 billion profit?

13. Institutions & Derivative Instruments
Financial Markets,
Institutions & Derivative Instruments
ECO 473 – Money & Banking – Dr. D. Foster