1. Risk Management with Financial Derivatives
Mishkin/Serletis
The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition
Chapter 14(basics)
Risk Management with Financial Derivatives

2. Learning Objectives
Distinguish among forwards, futures, options, swaps, and credit derivatives
Discuss the success of the financial derivatives market
Explain how managers of financial institutions use financial derivatives to manage interest-rate and foreign exchange risk
Outline the dangers of derivatives

3. Hedging Hedge Long position Short position
engage in a financial transaction that reduces or eliminates risk
Long position
taking a position associated with the purchase of an asset
Short position
taking a position associated with the sale of an asset

4. Hedging (cont’d) Basic hedging principle:
Hedging risk involves engaging in a financial transaction that offsets a long position by taking a additional short position, or offsets a short position by taking a additional long position

5. Forward Contracts and Markets
A forward contract is an agreement between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now.
Forward contracts are traded over-the-counter (OTC)
Two types discussed:
interest-rate forward contracts
forward contracts for foreign currencies

6. Interest Rate Forward Contracts
An interest rate forward contract involves the future sale (purchase) of a debt instrument
Contract specifies
specification of the debt instrument
amount of the instrument to be delivered
the price (interest rate) on the instrument when it is delivered
the date when delivery takes place

7. Interest-Rate Forward Markets
Long position = agree to buy securities at future date
Hedges by locking in future interest rate if funds coming in future
Short position = agree to sell securities at future date
Hedges by reducing price risk from change in interest rates if holding bonds

8. Pros and Cons of Forward Contracts
flexible (can be used to hedge completely the interest rate risk)
Cons
lack of liquidity: hard to find a counterparty to make a contract with
subject to default risk: requires information to screen good from bad risk

9. Financial Futures Markets
Financial futures are classified as
Interest-rate futures
Stock index futures
Currency futures

10. Interest-Rate Futures Contracts
Specifies delivery of type of security at future date
Arbitrage  at expiration date, price of contract = price of the underlying asset delivered
If i , long contract has loss, short contract has profit
Hedging similar to forwards

11. Interest-Rate Futures Contracts (cont’d)
At the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered
The elimination of riskless profit opportunities in the futures market is referred to as arbitrage
A micro hedge occurs when the institution is hedging the interest rate for a specific asset it is holding
A macro hedge is when the hedge is for the entire portfolio

12. Financial Futures Markets
Organization and Trading
CBOT, Chicago Mercantile Exchange, Montreal Exchange, London International Financial Futures Exchange, Marché à Terme International de France
Open interest: number of contracts outstanding
Globalization of financial futures markets
contracts traded in other countries virtually identical to those traded in the United States
movement to 24-hour-a-day trading in financial futures
Globex electronic trading platform

13. Explaining the Success of Futures Markets
liquid
standardized
can be traded again
delivery of range of securities
Margin requirement
Marked to market: avoids default risk
Do not have to deliver: netting

14. Widely Traded Financial Futures Contracts in the United States

15. Stock Index Futures Contracts
Stock index futures were designed to manage stock market risk and are now among the most widely traded of all futures contracts
The S&P Index measures the value of 500 of the most widely traded stocks in the United States
Price quotes for this contract are also quoted in terms of index points
change of 1 point represents a change of $250 in the contract’s value

16. Stock Index Futures Contracts (cont’d)
Stock index future contracts differ from most other types of financial futures contracts in that they are settled in cash delivery rather than delivery of a security
Cash settlement gives a high degree of liquidity
For the S&P 500 Index contract, at the final settlement date, the cash delivery due is
$250 x the index

17. Options
A call option is an option that gives the owner the right (but not the obligation) to buy an asset at a pre-specified exercise (or strike) price within a specified period of time
Since a call represents an option to buy, the purchase of a call is undertaken if the price of the underlying asset is expected to go up

18. Options (cont’d)
The buyer of a call is long in a call and the writer is short in a call
The buyer of a call has to pay a premium in order to get the writer to sign the contract and assume the risk

19. Options (cont’d) There are two types of option contracts:
American options that can be exercised any time up to the expiration date
European options that can be exercised only on the expiration date
Stock options
Financial futures options (futures options)

20. The Payoff from Buying a Call
Assume that you hold a European call on an asset with an exercise price of X and a call premium of α
if at the expiration date, the price of the underlying asset, S, is less than X, the call will not be exercised, resulting in a loss of the premium
at a price above X, the call will be exercised
at a price between X and X + α, the gain would be insufficient to cover the cost of the premium
at a price above X + α, the call will yield a net profit
at a price above X + α, each $1 rise in the price of the asset will cause the profit of the call option to increase by $1

21. The Payoff from Writing a Call
The payoff function from writing the call option is the mirror image of the payoff function from buying the call
The writer of the call receives the call premium, α, and must stand ready to sell the underlying asset to the buyer of the call at the exercise price, X, if the buyer exercises the option to buy

22. Profits from Buying and Writing a Call Option

23. Summary
The value of a call option, C, at expiration with asset price S (at that time) and exercise price X is
C = max (0, S - X)
The value of a call option (intrinsic value) at maturity is S - X, or zero, whichever is greater
If S > X, the call is said to be in the money, and the owner will exercise it for a net profit of C - α
If S < X, the call is said to be out of the money and will expire worthless
A call with S = X is said to be at the money (or trading at par)

24. Buying and Writing Puts
A put option gives the owner the right (but not the obligation) to sell an asset to the option writer at a pre-specified exercise price
A put represents an option to sell, it is worth buying a put when the price of the underlying asset is expected to fall
The owner of a put is said to be long in a put and the writer of a put is said to be short in a put
The buyer of a put option will have to pay a premium (called the put premium) in order to get the writer to sign the contract and assume the risk

25. The Payoff from Buying a Put
Consider a put with an exercise price of X and a premium of β
At a price of X or higher, the put will not be exercised, resulting in a loss of the premium
At a price below X - β, the put will yield a net profit
Between X - β and X, the put will be exercised, but the gain is insufficient to cover the cost of the premium

26. The Payoff from Writing a Put
The payoff function from writing a put is the mirror image of that from buying a put
The writer of a put receives the put premium, β, up front and must sell the asset underlying the option if the buyer of the put exercises the option to sell

27. Profits From Buying and Writing a Put Option

28. Summary
The value of a put option, P, at the expiration date with exercise price X and asset price S (at that time) is
P = max (X - S, 0)
The value of a put at maturity is the difference between the exercise price of the option and the price of the asset underlying the option, X - S, or zero, whichever is greater
If S > X, the put is said to be out of the money and will expire worthless
If S < X, the put is said to be in the money and the owner will exercise it for a net profit of P - β.
If S = X, the put is said to be at the money

29. Futures Options An example:
Option on a June Canada Bond futures contract
Buy the futures contract at 115 ( costs $115,000)
Purchaser has to pay $ for $ face value of long-term Canada bonds on delivery at the end of June
Sold contract means you will deliver the $ of bonds at the end of June and will be paid $

30. Profits and Losses on Options Versus Futures Contracts

31. Factors Affecting Option Premium
Higher strike price
lower premium on call options
higher premium on put options
Greater term to expiration
higher premiums for both call and put options
Greater price volatility of underlying instrument

32. Interest Rate Swaps
Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments it owns for another set of payments owned by another party
Two kinds of swaps:
currency swaps
interest-rate swaps
Interest-rate swaps
the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency

33. Interest-Rate Swap Payments

34. Advantages of Interest Rate Swaps
Reduce risk, no change in balance-sheet
Longer term than futures or options
Disadvantages of interest rate swaps
Lack of liquidity
Subject to default risk

35. Credit Derivatives
Credit derivatives offer payoffs on previously issued securities.
Three Types:
Credit Options
Credit Swaps
Credit-Linked Notes