1. Derivatives Usage: The Basic Instruments

2. Derivatives G & K Chps. 6 and 14 Basic Terms and Definitions Futures Options Swaps

3. Futures Buy (Sell) a futures contract = commitment to buy (sell) later. Need to buy X in the future; Buy a futures contract today at an known price and you will “net” pay that price later. No monies exchanged now; Bilateral – Money exchanged later Exchange Traded – Daily settle

4. Basic Picture of Futures Profit Current Price Purchase Price of Contract Gain Loss Sold Futures Gain/Loss = Sale Price – Purch Price Profit Current Price Purchase Price of Contract Gain/Loss = Purch Price - Sale Price Bought Futures Gain Loss

5. Exchange-traded Interest Rate Futures Most Trade Price, not interest rate. Most at least $1 million face value Treasuries, EuroDeposits, Fed Funds, Munis, Foreign Floating Rates (LIBOR, PIBOR, etc.) WSJ, Reuters, Bloomberg CBOT (Treasuries, Munis, FF); CME (T-Bill, Euro$, Floating Rate)

6. Typical Bank Futures Invmt Portfolio T-Secs and Munis Interest Rates rise and not only do you hold poor coupons, but MV fell. Sell Futures (at current price), rates rise, spot (futures) prices fall. You settle (or buy back) position at a lower price, hopefully offsetting portfolio MV drop. Unrealized vs. Realized  Tax Issue

7. Simulation $10m Face of 8%, 1yr. USTs 10, $1m bonds Mature 6 days before end of each quarter Margin 15% of position value, marked against pledge, but held off-balance sheet. Futures changes run thru I/S

8. Simulation DW: Duration Weighted Market Value of Securities portfolio..68: adjustment for quarterly coupons/compounding vs. actual semi-annual of futures. N/M: Percent of year annual futures contract held (3mo of 1yr =.25) Number of Contracts = (Total DW Value of Securities x.68) x (N/M)

9. Options Right to buy (Call) or sell (Put) in future Can Sell (Write) Call or Put, or Buy Call or Put When Buying, pay cost (Premium) immediately. When Writing, receive premium immediately, but usually locked up until position repurch’d

10. Call Option Payoff Price Current Stock Price Stock Payoffs Payoff Price Option Exercise Price Call Option Payoffs Out of the Money In the Money Call Option Payoff = Max[ 0, S - X ]

11. Put Option Payoff Price Current Stock Price Stock Payoffs Payoff Price Option Exercise Price Put Option Payoffs In the Money Out of the Money Put Option Payoff = Max[ 0, X - S ]

12. Interest Rate Options Most of the trading done off the exchange floors The interest rate options market is Very large Highly efficient Highly liquid Easy to use

13. Interest Rate Cap (Cap/Floor Handout) An interest rate cap Is like a portfolio of European call options (caplets) on an interest rate On each interest payment date over the life of the cap, one option in the portfolio expires Is useful to firms with floating rate liabilities Caps the periodic interest payments at the caplet’s exercise price

14. Interest Rate Floor An interest rate floor Is related to a cap in the same way that a put is related to a call like a portfolio of European put options (floorlets) on an interest rate On each interest payment date over the life of the cap, one option in the portfolio expires Is useful to firms with floating rate assets Puts a lower limit on the periodic interest payments at the floorlet’s exercise price

15. Interest Rate Collar An interest rate collar is simultaneously long an interest rate cap and short an interest rate floor Sacrifices some upside potential in exchange for a lower position cost Premium from writing the floorlets reduces position costs

16. Swaps The most common type of interest rate swap is the fixed for floating rate swap One party makes a fixed interest rate payment to another party making a floating interest rate payment Only the net payment is made (difference check) The firm paying the floating rate is the swap seller The firm paying the fixed rate is the swap buyer

17. Swaps contracts Typically, the floating interest rate is linked to a market rate such as LIBOR or T-bill rates The swap market is standardized partly by the International Swaps and Derivatives Association (ISDA) ISDA provisions are master agreements

18. Swaps Participants The swap facilitator will find a counterparty to a desired swap for a fee or take the other side A facilitator acting as an agent is a swap broker A swap facilitator taking the other side is a swap dealer (swap bank) A plain vanilla swap refers to a standard contract with no unusual features or bells and whistles