Derivatives

Innovation

• Necessity was the mother of innovation

• A company should adopt to its customers' need (as well as the company’s needs) if the company desires to get rich or stay rich.

• A change in the financial environment will stimulate a search for innovation (and that they are likely to be profitable).

Paradigm Shift

• Changes in the economic environment (inflation and interest rates climbed sharply and became harder to predict, advancement in computer technology, and financial regulations)

• Old ways no longer profitable• Their products not selling anymore• No longer can acquire funds with

traditional financial instruments (without these, they would be out of business)

Financial Engineering

3 Types of financial innovation:

1. Responses to changes in demand conditions

• High interest rate fluctuations (interest rate risk)

• Uncertainty about interest rate, movement, and returns

• High volatility of interest rates

• Demand for anything that could reduce that risk, e.g. adjustable rate mortgages (T-Bills rate), financial products, and services

Financial engineering – to research and develop new products that would meet customer needs and prove profitable.

(cont’d)3 Types of financial

innovation:

2. Responses to changes in supply conditions

3. Avoidance of Regulations

Reserve requirement Restriction on interest

rates of deposits, e.g., eurodollar, CPs, NOW accounts, and SWEEP accounts.

Credit cards of banks

E-banking facilities

Financial Engineering

– are financial instrument– they get their value from something else

like the price of a cash instrument. *this price is called the underlying price *Example of cash instruments: company

shares, commodity stocks, foreign exchange

– the main use is to reduce risk for one party.

What is a Derivative?

Example:You are a clerk who availed of a

reimbursement plan (i.e., a subsidized MBA program) in your company.

The plan stipulated in the program says the company will reimburse 100% of the cost if your grade is “4.0”, 75% if “3.5”, 50% if “3.0”, 25% for “2.5”, and 0% if you fail the course.

Your right to claim the reimbursement is tied to the grade you earn.

The value of the reimbursement plan is derived from the grade you earn.

What is a Derivative?

Cont.

We also say that the value is contingent upon the grade you earn.

Thus, your claim for reimbursement is called a “contingent” claim.

Note: The term “contingent” and “derivatives” may be used interchageably.

What is a Derivative?

– Hedging (transferring risk by taking the opposite position in the underlying asset).

Uses of Derivatives

Ex.In a boxing match a month from now, you bet P1,000 that Pacquiao will win. This means that there is a 50% chance that you will win 100% and lose 100% of your “investment”.

To hedge your position, you decided to bet P250 on “Pacquiao’s” opponent with your friend. Your total investment now is P1,250. Should you win, you won P1,000 or a rate of return of 80% (1,000 ÷ 1,250). Should you loose, it’s not going to be 100% lost because you would win P250 or a rate of return of 20% (250 ÷ 1,250). In both cases, you win!

– Speculation and arbitrage

Uses of Derivatives

activity of buying and selling a derivative instrument with no corresponding transaction taking place in the underlying market

Speculation – is an attempt to profit by trading on expectations about price changes in the future.Note: In the Fx markets, one speculates by taking an open (unhedged) position in a foreign currency and then by closing that position after the exchange rate has moved in – one hopes – the expected direction.

Speculating in the Spot MarketExample :

S0: $1.5000/€

S1 (Forecast): $1.5100/€

Considering the above spot rate, how speculators profit if they believe that euro will improve (and dollar will deteriorate), say $1.5100/€ in the days or months to come?1. Today buy €1 at the spot rate of $1.5000/€.

2. Any day that the spot rate changed to $1.5100/€, sell the €1 immediately.

3. Profit = (1.5100 – 1.5000) = $0.01.

Speculating in the Forward Market

Example :

F30: $1.5200/€

S0: $1.5000/€

S30 (Forecast): $1.5300/€How speculators profit if they believe that euro will appreciate to, say $1.5300/€, after 30 days?

1. Today sign a forward contract “buying €1 in exchange for $1.5200”. Note that this step requires no outlay of cash (only fees or charges).

2. In 1 month, fulfill the forward contract, receiving €1 for a cost of $1.5200.

3. If at that time, the forecast come true, simultaneously sell the €1 in the spot market (i.e. S = $1.5300/€), receiving $1.5300.

4. Profit: $0.01 (1.5300 – 1.5200).

Speculating in the Option Market

Example :S0: $1.5100/€Call Option: $1.5300/€Maturity: 30 days

S30 (Forecast): $1.5200/€

How speculators profit if they believe that euro will deteriorate to, say $1.4900/€ after 30 days?1. Today buy euro and simultaneously sign a put option

contract “having the right, but not the obligation, to sell €1 in exchange for $1.5300”. This step requires a “front-end load” (i.e., a premium fee charged by the underwriter, say $0.01).

2. After 30 days, if the spot rate turned out to be $1.4900/€, exercise the put option contract, selling €1 in exchange for $1.5300.

3. Profit = {1.5300 – (1.5100 + 0.01)} = $0.01.

Is insurance a type of derivative?

Disney wanted to open a theme park in Tokyo but its shareholders do not want to bear the risk of an earthquake destroying the park.Sol.- They financed the park through the issuance of earthquake bonds- If an earthquake of at least 7.5 hit within 10 kms. of the park, the bonds are not repaid. There was also sliding scales for smaller quakes and larger ones that were located further away from the park.- For this type of bond, Disney paid LIBOR+310 basis point because of the special provision.

– They somehow allow investors to better control the risk they bear

– They can help eliminate idiosyncratic risk (i.e., risk of price change due to unique circumstances of a specific security).

– They can increase or decrease systematic risk (or market risk).

Why do we have derivatives and derivatives market?

– Reduce cash flow volatility– Operational strategies to reduce the effect

on firm value, underinvestment and financial distress.

– Tax incentives– Managerial incentives– Opportunity to spend less money to

control more of the asset.

Major Impact of Derivatives

• These techniques would help one investor minimize its loss but the best way to minimize loss is not to engage in these things.

• If you would want to engage yourself in these markets you should only use your idle money.

Notes on the use of derivatives

Controversies

• Massively leverage the debt in an economy which can cause recession or depression.

• It has large notional value.• Pose unsuitably high amounts of risk for

small or inexperienced investors.• Expose investors to counter-party risk.• Can result in large losses due to the use

of leverage.

1. OTC Derivatives– it is transacted directly between the

parties through an intermediary.

2. Exchange-Traded Derivatives– It is traded through an exchange or

intermediary.

Types of Derivatives

Major Classes of Derivatives

1. Forwards – an agreement to exchange currencies of different countries at a specified future date and at a specified forward rate.

2. Options – in Fx, a contract giving the purchaser the right, but not the obligation, to buy or sell a given amount of Fx at a fixed price per unit for a specified time period. Option to buy are “calls” and options to sell are “puts”.

3. Futures – exchange-traded agreements calling for future delivery of a standard amount of any good, e.g., Fx, at a fixed time, place, and price.

4. Swaps – the simultaneous purchase and sale of Fx, with the purchase being effected at once and the sale back to the same party to be carried out at a price agreed upon today but to be completed at a specified future date.

The Forward Contract

• Agreement by 2 parties to engage in a financial transactions at a future point in time. Maybe the 1st solution in interest rate risks.

• It locks in the future the price today.• Interest rate forward contract

(specification of the rate, amount, price, and date)Ex. A US bank to buy from a European bank $5 million worth of euros after 180 days at a specified forward rate.

The Currency Swap

• Agreement by 2 parties to exchange specific amounts of different currencies initially, and a series of interest payments on the initial cash flows are exchanged.

• Often, one party will pay a fixed exchange rate and the other a floating exchange rate (and other variations).

• At the maturity of the swap, the principal amount and interest are both exchanged in full.

Futures Contract – calls for the purchase and sale of an asset at some future date, but at a price which is fixed today.

2 Types:1. Commodity futures – a contract that is

hedged against price changes for input materials.

2. Financial futures – a contract used against fluctuating interest rates, stock prices, and exchange rates.

The Futures Contract

• American terms are used – payments are settled in dollars.

• Clearing house – all contracts are agreements between the client and the exchange clearing house, rather than between the two clients involved.

• Collateral and maintenance margin – the purchaser must deposit a sum as an initial margin or collateral (also known as “margin deposit”, typically 15%-25% of the contract’s size). A “maintenance margin” (also known as “maintaining balance”, typically 75% of the margin deposit) is required.

Commissions – fee or payment for brokers (broker's fees) to execute a round turn and only a single price is quoted.

• Margin call – additional deposits required to maintain the margin (typically, 5% of the contract’s size).

Futures: Key Concepts

Marked-to-market – daily, all changes in value are paid in cash daily (variation margin).

Settlement: Only 5% of all futures contracts are settled by the physical delivery of Fx between buyers and sellers. Most often, buyers and sellers offset their original position prior to delivery date by taking an opposite action (round turn).

• Settlement price – the contract price.• Standard maturity dates – contracts

mature on the 3rd Wednesday of January, March, April, June, July, September, October, or December.

Futures: Key Concepts

Historical Perspective

Wheat farmers

•Concerned about the price of wheat in the future

Millers

•Concerned about the price they have to pay

The risk would be reduced if they could established an earlier price.

• Initially, there were only two parties in the futures dealings

• Soon, middlemen entered the picture• Trading in the futures was established

(CBT – Chicago Board Trade – was the first established). Farmers sell futures there, millers could buy them there.

• Quickly, speculators entered the picture

Historical Perspective

Advantage: To overcome liquidity

1. The quantities delivered and delivery dates are standardized, e.g., $100,000 for delivery on March, June, September, and December issues.

2. After a future is bought and sold, it can be traded again unlike a forward contract.

3. Any type of treasury bond is deliverable that matures in 15 years and is not callable for 15 years.

4. Continuous trading.5. Most futures contracts do not result in the

delivery of the underlying asset on the expiration date because of the simultaneous holding of the long and short position. It means the trader would be delivering the bond to itself.

Hedger – wants to lock the priceNatural hedges – occur between the following:1. Cotton farmers and cotton mills2. Copper miners and copper fabricators3. Importers and foreign manufacturers (for

currency exchange rates)4. Oil producers and oil users

Speculator – bettor on the direction of the value of the asset; they are levelers, stabilizers of the market(Role of speculators: high leverage appealed to them)High leverage – small change in the prices of the underlying asset will produce a large change in the price of derivatives.

Disadvantages:

1. Highly leveraged2. Complicated, not understood by

many peopleSummary:Firms are obviously exposed to losses due to changes in prices of commodities, prices of securities fluctuation in interest rates.

Risks such as these can be mitigated by using derivatives.

8 Groups:

1. Grains and oilseed

2. Livestock and meat

3. Metal and petroleum

4. Wood

5. Food and fiber6. Debt

instrument7. Foreign

exchange8. Stock market

indicators

Stocks vs. Futures:

Key Concepts:

1. Margin Deposit (Good-faith deposit) – usually 10%-20% of the contract value.

2. Short hedge – sale of financial futures contract to hedge against the position investor currently needs.

No. of units:

1. Corns = 5,000 bushels

2. Metal = 100 tons

3. Soybeans = 60 lbs.

Stocks Futures1. Regulatory agency Exchange Commission Commodity Futures Trading Commission2. No. of shares Unlimited Limited3. Commission Front-end load Back-end load

Futures: The Mechanical Process

An investor who would hedge his position would seek a derivative instrument that guarantees a rate in the future, say £50,000 at 1.75/ £.

To serve both requirements (i.e., a guaranteed rate and changing rate) a system should be put in place. The difference in the current spot rate and the derivative’s rate should off-set each other for whatever gains or losses brought about by the change in exchange rate.

Example: £50,000, if guaranteed at $1.75/£ after 60 days, should provide a payment of $87,500 (from an investor).

In a marked-to-market set-up, the spot rate on the 60th day, say $2/£, should be the exchange rate applied on that day. Meaning a payment of $100,000 is needed, which is $12,500 more from what was “guaranteed”.

Clearly, one party benefits and one party is disadvantaged from this set-up. A futures contract compensates the “aggrieved (or losing) party” by paying him his losses. The “gaining” party, on the other hand, should “pay” every time he “wins” from the exchange rate change.

Futures: The Mechanical Process

By requiring a collateral or deposit, say 25% of the expected proceeds (i.e., $25,000 in a $100,000 contract size), from the buyer and seller, may solve the problem.

The buyer of £50,000 at $1.75/£ pays $87,500. If the rate goes up at $2/£, he pays $100,000 (instead of $87,500) “paying” an additional $12,500. To compensate him for this, his collateral or deposit should be increased by $12,500. So the buyer is paid every time E/R increased.

On the other hand, if rate comes down, say $1.50/£, he will only pay $75,000 (instead of $87,500) “saving” $12,500. Since this is the case, his collateral or deposit should be decreased by $12,500. So, the buyer pays every time E/R decreases.

Futures: The Mechanical Process

Long Position Holder and VM

• Long position holder – is the buyer of a commodity; gets paid when the price increases.

Illustration:Mario believes pound will rise, bought a September futures contract for £100,000 at settlement price of $1.50/£, taking a long position. If S0 changed to $1.51/£ at maturity (S1), the value of his position (or variation margin) is $1,000.

Sol.VMt (Long Position) = Notional Principal x (S1 – SP) =

=100,000 x (1.51 – 1.50) = $1,000

Short Position Holder and VM

• Short position holder – is the seller of the commodity; gets paid when the price decreases.

Illustration:Maria, on the other hand, believes pound will fall, sold a September futures contract for £100,000 at settlement price of $1.50/£, taking a short position. If S0 changed to $1.49/£ at maturity (S1), the value of her position is $1,000.

Sol. VMt (Short position) = – Notional Principal x (S1 – SP)

= –100,000 x (1.49– 1.50) = $1,000

Uses of futures contract on bonds, maturing securities,

and interest rates: rate and bond prices are inversely correlated

1. Bond portfolio manager hopes bond portfolio to go up (fear bond prices of going down)Hope Bond price up

Fear Bond price down

Short hedge gets paid when prices go down

2. Receiving cash for maturing securities

Hope Interest rate up

Fear Interest rate down Bond price up

Long hedge gets paid when prices go up

3. Mortgagor

Hope Interest rate down

Fear Interest rate up Bond price down

Short hedge gets paid when prices go down

Futures

• Sample of a Futures Contract:

No. of units: €50,000Settlement Price: $1.4915/€Broker’s fee: 2% of SizeMargin Deposit (MD):25% of SizeMaintenance Margin: 75% of MDMargin call: 5% of SizeMaturity: 1 yearS0: $1.4950/ €

No. of units: €50,000Settlement Price: $1.4915/€Broker’s fee: 2% of SizeMargin Deposit (MD): 25% of SizeMaintenance Margin: 75% of MDMargin call: 5% of SizeMaturity: 1 yearS0: $1.4950/ €

1. Size of the contract: $74,575 (50,000 x 1.4915)2. Broker’s fee: $1,492 ($74,575 x 0.02)3. Margin deposit: $18,644 ($74,575 x 0.25)4. Maintenance margin: $13,983 ($74,575 x 0.75)5. Margin call: $3,729 ($74,575 x 0.05)6. Contract value at S0: $74,750 (50,000 x 1.4950)

Computing for the Futures Details

No. of units: €50,000Settlement Price: $1.4915/€$74,575Broker’s fee: 2% of Size $1,492Margin Deposit (MD): 25% of Size

$18,644Maintenance Margin: 75% of MD

$13,983Margin call: 5% of Size$3,729Maturity: 1 yearS0: $1.4950/ €$74,750

Summary

• Using the previous example, the broker would require a margin deposit (i.e., $18,644) from an investor (ex. long position holder).

• The deposit should have a maintaining balance of $13,983.

• Every time it falls below this amount, the investor is required to deposit additional $3,729 (margin call).

Futures: The Mechanical Process

Scenario:• Assuming on the first day of trading, spot rate closed

at $1.5056/£, what is the contract value of the futures on that day, taking into consideration marked-to-market condition?Answer: $75,280Sol. Notional Principal x S1 = Contract Value (at S1) 50,000 x 1.5056 = $75,280

• On that day, how much is adjusted to the Margin Deposit? Answer: $705Sol. Notional Principal x (S1 – SP) = Variation Margin at S1

50,000 x (1.5056 – 1.4915) = $705

Note: Since, the rate went up, the long-position holder gets paid.

Futures: The Mechanical Process

Computing for the “k”• On the 1st trading day (S1), how much is the “k”

of the long-position holder in his deposit? Answer: $705

Sol. Notional Principal x (S1 – SP) = k (at S1) 50,000 x (1.5056 –1.4915) = $705

Computing for the IRR• In the first day, what is the IRR of the long-

position holder’s investment? Answer: 0.01%

Sol. (k ÷ total investment) x (n/360) = IRR (at S1)

[(705 ÷ ($18,644 + $1,492)] x (1/360) = 0.01%

Computing for k and IRR

• If on the second day of trading, spot rate closed at $1.5129/€, what will be the new value of the futures, taking into consideration marked-to-market condition?Answer: $75,645Sol. Notional Principal x S2 = Contract Value (at S2)

50,000 x 1.5129 = $75,645

• On the second day of trading, how much is adjusted to the Margin Deposit? Answer: $365Sol. Notional Principal x (S2 – S1) = VM (at S2)

50,000 x (1.5129–1.5056) = $365

Futures

• On the second day, how much is the accumulated k of the long-position holder? Answer: $1,070

Sol. k2 + k1 = Accum. k 365 + 705 = $1,070

• On the second day, what is the IRR of the long-position holder’s investment? Answer: 0.03%

Sol. Accum. k ÷ Total investment = IRR[1,070 ÷ (18,644 + 1,492)] x (2/360) = 0.03%

Futures

Margin call• When is the investor going to make an

additional deposit (or margin call)? Answer: If his account falls below $13,983.

Round turn

• If a futures contract can not be “expired”, how can I reverse my position? Answer: By making a “round turn”

Round turn – to apply for a reverse position.

Futures

Long Position Holder Deposit Ledger

Days Rates VM Margin call Round turn Balance Accum k IRR18,644

1 1.5056 705 19,349 705 0.01%2 1.5129 365 19,714 1,070 0.03%3 1.5376 1,235 20,949 2,305 0.10%4 1.5301 (375) 20,574 1,930 0.11%5 1.5415 570 21,144 2,500 0.17%6 1.5395 (100) 21,044 2,400 0.20%7 1.5738 1,715 22,759 4,115 0.40%

1,315 24,074 5,430 0.60%24,074 -

Long Position

8 1.6001

Short Position Holder Deposit Ledger

Days Rates VM Margin Call Round turn Balance Accum k IRR18,644

1 1.5056 (705) 17,939 (705) -0.01%2 1.5129 (365) 17,574 (1,070) -0.03%3 1.5376 (1,235) 16,339 (2,305) -0.10%4 1.5301 375 16,714 (1,930) -0.11%5 1.5415 (570) 16,144 (2,500) -0.17%6 1.5395 100 16,244 (2,400) -0.20%7 1.5738 (1,715) 14,529 (4,115) -0.40%8 1.6001 (1,315) 13,214 (5,430) -0.60%9 1.5925 380 3,729 17,323 (5,050) -0.53%

(1,300) 16,023 (6,350) -0.74%16,023 -

10 1.6185

Short Position