1. 1 Derivative: Forward, Future, and SWAP

2. 2 Financial Derivative A financial instrument whose payoffs depend on another financial instrument or asset. i.e. forwards, futures, options, and swaps.

3. 3 Forward and Future Forward: A contract negotiated in the present that gives the contract holder both the right and full legal obligation to conduct a transaction at a specific future time involving a specific quantity and type of asset at a predetermined price. Forward is not an option: both parties are expected to hold up their end of the deal. The buyer is to receive delivery of the good and pay for it. The seller is to deliver the good and receive payment. Future: A forward contract that has been highly standardized and closely specified.

4. 4 Example: Forward t=0t=T Buyer (Seller) agrees to purchase (sell) an asset on day T at $100, Buyer (Seller) purchases (sells) the asset on day T at $100. The buyer reverses the trade at $105 before day T. He finds another buyer to take over his position, does he pay (receive) anything? How much?

5. 5 Example: Future Buyer (Seller) agrees to purchase (sell) an asset on T at $100. No cash flow occurs except margin requirement. On day 1, the future price declines to $99, the buyer pays the seller $1, and the future becomes: Buyer (Seller) agrees to purchase (sell) an asset on day T at $99. t=0t=Tt=1 Buyer may reverse trade by entering another future to sell the asset at on going future price, thus offsetting his previous position.

6. 6 Forward and Future

7. 7 Futures contracts features Standardized contract terms: –Underlying commodity or financial instrument –Contract size –Maturity (expiration) date –Delivery/settlement procedure –Futures price

8. 8 Futures Contracts: Preliminaries Standardizing Features: –Contract Size –Delivery Month Daily resettlement –Minimizes the chance of default Initial Margin –About 4% of contract value, cash or T-bills held in a street name at your brokerage.

9. 9 Trading Mechanics Clearinghouse - acts as a party to all buyers and sellers. –Obligated to deliver or supply delivery Closing out positions –Reversing the trade –Take or make delivery –Cash settlement –Most trades are reversed and do not involve actual delivery

10. 10 Trading Future with a Clearing house Long position Short position Clearing House Money Commodity Money Commodity The clearing house guarantees that traders in the future market will honor their obligations. Clearinghouse acts as the buyer to every seller and the seller to every buyer.

11. 11 Margin and Trading Arrangements Initial Margin - amount required when a futures contract is first bought or sold. IM deposited is to provide capital for absorbing losses. Maintenance margin - an established value below which a trader ’ s margin may not fall.

12. 12 Margin and Trading Arrangements Marking to Market - each day the profits or losses from the new futures price are reflected in the account. Margin call: Notification to increase the margin level in a trading account Reverse trades: A trade that closes out a previously established futures position by taking the opposite position.

13. 13 Speculator vs. Hedger Traders can be either speculators ( meaning they accept the market ’ s risk in pursuit of profits) or hedgers (meaning they trade futures to reduce some pre-existing risk exposure) Hedgers transfer price risk to speculators and speculators absorb price risk

14. 14 Hedger: Trader who seek to transfer risk by taking a futures position opposite to an existing position in the underlying assets. Long hedger would be a firm who is short the asset (like a baker who has promised to deliver bread) and want to reduce their risk on direct material by buying the asset now (long in wheat) in the futures market. Long hedge: Purchase of futures to offset potential losses from rising prices. Hedging with Futures

15. 15 Hedging with Futures Short hedger would be a firm who own the asset (like wheat) and want to reduce his risk by selling the asset now (short in wheat) in the futures market. Short hedge: Sale of futures to offset potential losses from falling prices

16. 16 Speculating with Futures Speculator: traders who accept price risk by going long or short to bet on the future direction of prices. Long Position: A buyer in a future contract. A long position profits from a future price increase. Short Position: A seller in a future contract. A short position profits from a future price decrease.

17. 17 Types of future contracts Agricultural and metallurgical –Agricultural goods, oil, livestock, forest products, textiles, foodstuffs, and minerals. Interest rates –Started trading in 1975 and experienced tremendous growth. –Now span almost the entire yield curve (able to trade on any maturities)

18. 18 Types of future contracts Currencies –Started trading in the early 1970s. –However, the forward market for FX in many times larger than the future market. Indexes –Started trading in 1982 and has become quite successful. –Most index futures are for stock indexes. –Since trader can ’ t actually deliver the stock index contracts, a reversing trade or a cash settlement is required at the end of trading.

19. 19 Types of future contracts

20. 20 Stock index futures and multiple

21. 21 Futures Markets The Chicago Mercantile Exchange (CME) is by far the largest. Others include: –The Philadelphia Board of Trade (PBOT) –The MidAmerica Commodities Exchange –The Tokyo International Financial Futures Exchange –The London International Financial Futures Exchange

22. 22 The Chicago Mercantile Exchange Expiry cycle: March, June, September, December. Delivery date 3 rd Wednesday of delivery month. Last trading day is the second business day preceding the delivery day. CME hours 7:20 a.m. to 2:00 p.m. CST.

23. 23 Wall Street Journal Futures Price Quotes Expiry month Opening price Highest price that day Lowest price that day Closing priceDaily Change Highest and lowest prices over the lifetime of the contract. Number of open contracts

24. 24 Basic Currency Futures Relationships Open Interest refers to the number of contracts outstanding for a particular delivery month. Open interest is a good proxy for demand for a contract. Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

25. 25 Currency Futures TimeActionProfitsMargin Balance Tue. Mornin g Buy SF futures matures in two days at 0.75 $/SF. 125,000 SF per contract, I.M.=$1485, M.M.=$1100 Tue. Close Future price rises to 0.755 $/SF Wed. close Future price rises to 0.743 $/SF Thur. close Future price drops to 0.74 $/SF Physical Delivery 0 1,485 625 2,110 -1,500 610 1,100 -375 1,100 725 490 375 $ weak, SF appre. $ appre., SF weak -1,250385 == -1,250 Call

26. 26 Swaps Contracts: Preliminaries In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows or debt service obligations at periodic intervals. Swap structure 1. Notional Principal: A reference amount against which the interest is calculated 2. Reference Rate: Who pay at what currency at what rate and receive at what currency at what rate? 3. Swap date: the milestone dates which both counterparties pay or receive the balance after swap.

27. 27 Swaps Contracts: Preliminaries There are two major types of swaps: –Single currency interest rate swap “ Plain vanilla ” fixed-for-floating swaps are often just called interest rate swaps. –Cross-Currency interest rate swap This is often called a currency swap; fixed for fixed rate debt service in two currencies.

28. 28 Swaps Contracts: Major Types 9% L+1.2% Bank ZZ Company A 9% Notional Interest-rate swap (Coupon swap) Company A swaps a 5-year $ obligation with a fixed rate of $9% into a 5-year $ obligation at a 6-month floating rate $LIBOR+1.2% with bank ZZ. Notional

29. 29 Swaps Contracts: Major Types Currency swap (fixed-fixed swap) Company A swaps a 5-year FF140 million obligation at FF9% into a 5-year $20 million obligation at $8% with bank ZZ 9% Bank ZZ Company A 9% FF140 $20 8%

30. 30 Swaps Contracts: Other Types Currency-interest rate swap Company A swaps a SF debt of SF150 million at SF5% into a $ debt of $100 million at $LIBOR Basis-rate swap (floating-floating swap) Others: Differential swap (switch LIBOR swap), forward swap, zero swap, amortizing swap, commodity swap

31. 31 Important characteristics –Off-balance sheet. –Only the BALANCE of the two cash flows is exchanged on each payment date. Swaps Contracts: Characteristics

32. 32 Reduce Costs ==> Comparative Advantage –An I/R swap example: The case of Unilever (UK) and MIC (US) on $100 mil. 5 year interest rate swap $Fix$Floating Unilever (UK)9%LIBOR+0.25% MIC (US)10%LIBOR+0.75% 1%0.5% In what type of borrowing does the Unilever have a comparative advantage? Why? How about MIC? What is the maximum cost savings through a swap? Swaps Contracts: Motivations Max.Saving 0.50%

33. 33 Swap Motivations – Cost Reduction Suppose that a swap dealer offers the following swap quotes –U pays Bank $LIBOR for $9%. –M pays Bank $9.15% for $LIBOR. Bank ZZ U $ 9% M $ L+0.75% $ L% $ 9% $ L% $ 9.15%

34. 34 Swap Motivations – Cost Reduction Bank ZZ U $ 9% M $ L+0.75% $ L% $ 9% $ L% $ 9.15% What is the before-swap borrowing cost for each firm? Fixed $9% for U and Float $ L+0.75% for M What is the swap contract for each firm? For U; Receive Fixed $9% and pay Float $ L% For M; Pay Fixed $9.15% and Receive Float $ L%

35. 35 Bank ZZ U $ 9% M $ L+0.75% $ L% $ 9% $ L% $ 9.15% What is the with-swap cost for each company? What is the without-swap cost for each company? What is the cost savings for each company? What is the profit for the swap dealer? Swap Motivations – Cost Reduction

36. 36 Bank ZZ U $ 9% M $ L+0.75% $ L% $ 9% $ L% $ 9.15% Swap Motivations – Cost Reduction With-Swap cost $ L%$ 9.90% Without-Swap cost $ L+0.25%$ 10% Cost Saving $ 0.25%$ 0.10% Profit for Swap Dealer $ 0.15%

37. 37 Risk Management –Interest rate swaps: More useful when assets or liabilities cannot be traded, as is the case for bank loans. A sequence of futures contracts on bonds. –Currency swaps: Can be used to hedge the currency exposure of assets and liabilities. Swap Motivations – Risk Mgmt.

38. 38 Valuation of Swaps Valuation in the Absence of Default Risk –Initial value is zero: –Values changes as interest rate and foreign exchange rate vary. Two approaches: A swap can be broken down into a series of forward currency and interest rate contracts for each flow. Bonds on Balance: Swaps can be treated as a portfolio of two bonds.