1. Fintech
Chapter 10: Futures, Forwards and Swaps

2. Futures, Forwards, Swaps
Financial Weapons of Mass Destruction

3. Futures, Forwards, Swaps
Derivatives: value of the instrument is based on or
“derived” from an underlying financial instrument
Linear payoffs: valuation of the derivative will move one for one with increases or decreases with the underlying instrument

4. Futures, Forwards, Swaps
Advantages: same economic exposure as underlying but greater liquidity, leverage, lower taxes, transaction costs
Shift risk
Forwards: delivery, OTC, counterparty exposure
Futures: exchange traded, CCP, usually no delivery
CCP: Central CounterParty
Swap: OTC, exchange cash based on reference

5. Futures Mechanics Listed by Exchange, not fungible between exchanges
Trading counterparties are anonymous
CCP
Futures Commission Merchant (Broker)
Margin: initial and variation
Default

6. CCP Commercial entities Buyer to all sellers, seller to all buyers
Rule book
Set margins
SIFI?

7. ICE Clearing Default Waterfall

8. Single Stock Futures Trade anonymously
Shares delivered at expiry, some cash settled
Margins
Theoretical price: FP = CP (1-FC)

9. Equity Swaps
Total Return Swaps
Inflation Swaps

10. Stock Index Futures Futures on market indexes
S&P 500 futures
Full size = $250 x index value
E-mini= $50 x index value
Used to hedge portfolios, new positions for indexed portfolios, allocation, speculation
Advantages: liquidity, leverage, taxes, transaction costs

11. Interest Rate Swaps Daily trading volume averages $1 trillion OTC
Dodd Frank requires SEF execution
2 parties agree to exchange cash flows
Difference between two rates-one fixed, one floating
Floating rate most often is LIBOR

12. Interest Rate Swaps Corporate finance hedging
Financial institution interest rate management
Speculation on rate changes
Market Making
Portfolio management- converting fixed to floating and vice versa; liquidity makes it cheap and convenient to gain/reduce exposure
Rate locks prior to bond sales-issuers can receive fixed in a IRS prior to issuing fixed rate bonds. They then issue the bonds and reverse the IRS.

13. Interest Rate Futures CME NYSE Euronext
Eurodollars futures most active

14. Hedging Example: Locking in an Interest Rate
Need to borrow $10 million 3 months in future
Rates might rise, so lock in now. LIBOR now 3%
Sell 10 Eurodollar contracts at 97
If LIBOR rises to 4%, Eurodollar will be 96
Buy back 10 Eurodollar at 96
Gain $25,000 on 10 contracts
This offsets the increased borrowing costs due to rise in LIBOR

15. Credit Default Swaps Non-linear payoff “Insurance” for bond holders
If bond issuer defaults, CDS seller pays
AIG was a big seller of CDS in 2000’s, but could not
pay when mortgage market crashed in 2008
Government bailed out AIG
New rules
CDS market recovering
Single names (one company)
Indexes

16. Hedging Example: Protecting a Bond Payment Stream with CDS
PM owns $100 million Company A bonds
PM fears A could downgrade or fail
PM pays 50 bp to counterparty
If A defaults, pays 60% of par
Counterparty pays 40% to PM

17. Fintech Applications Front Office Middle Office Back Office
Execution Platform
Portfolio Management
Pooled Investment Services
Middle Office
Business Intelligence
Market Data
Alternative Data
Back Office
Confirmation, Clearing, Settlement
Communications
AML/KYC/KYV
Chat Bots
Risk
Compliance, Reporting
Monitoring

18. OpenGamma
Blockchain
DTCC
Corda
Execution Venues

19. Corda Shared Ledger Comparison