Upload
sabrina-kennedy
View
220
Download
0
Tags:
Embed Size (px)
Citation preview
DerivativesDerivatives
DefinitionDerivative --- a financial instrument or other Derivative --- a financial instrument or other contract deriving value from changes in the contract deriving value from changes in the price or rate of a related asset or liability price or rate of a related asset or liability
Total Value comes from: Underlying = Price, Rate or Index Notional = Quantity
Requires no initial net investment (or small net investment)
Requires or permits net settlement or de facto net settlement
Derivative = Contract
Agree today to pay a certain price for a commodity (or other “underlying”) in the future
Derivative Market
Past two decades, derivative trading has grown into a trillion dollar market
Players• Professionals (Banks &
Broker-Dealers)
• Corporations
• Institutional Investors
USE OF DERIVATIVES
SPECULATIVE INVESTMENTS
HEDGE AGAINST RISK
ASSOCIATED WITH ANOTHER TRANSACTION
Common Derivatives7
Typically settled with net cash payments
Swaps
Futures
Forward Contracts
Symmetrical or Linear
Caps/Floors
Exchange-TradedOptions
OTC Options
Nonlinear
TYPES OF DERIVATIVE CONTRACTS
Symmetrical/Linear Contracts
• Track the change in the underlying price, both up and down
• You can gain or lose, symmetrically
Price of underlyingPrice of underlying
+
0
_
Value of Value of
contractcontract
Forwards and Futures
Forward Contract: Executory contract obligating one party
to buy, and the other party to sell, a specific asset for a fixed price at a future date
Futures Contract:A forward contract traded on an exchange
Forwards and Futures
LONG POSITION --- Buyer of AssetBuys the asset, for delivery and payment in the future
Wins if the price rises
SHORT POSITION --- Seller of AssetSells the asset, for delivery and cash receipt in future
Wins if the price falls
Uses of Forwards and Futures• Sell forward/futures to hedge exposure to
falling prices:» Lock in profit margin on commodity inventory
» Lock in profit margin on future commodity sales/production with fixed cost structure
» Foreign currency receivables or revenue stream - sell currency forward to lock in dollar amount to be received
» In anticipation of a debt issuance, sell a US Treasury security forward to protect against rising interest rates (falling bond prices)
Uses of Forwards and Futures
• Buy forward/futures to hedge exposure to rising
prices:
» Raw materials used in manufacturing - lock in purchase
price to protect margins
» Foreign currency payables or forecasted cash outflows - buy currency forward to lock in dollar amount paid
» Institutional investor that anticipates buying a bond or other debt instrument – buy US Treasury security forward as a hedge against falling interest rates (rising bond prices)
Forwards and FuturesTerms
Forward Price/Rate --- Specified price in the contract
Forward Date --- Specified future date
Spot Rate --- Current price or rate for asset
Writer --- writes the contract to sell (short position)
Holder --- buyer of contract(long position)
Change in Value of Forward and Future Contracts
Measured by:
Difference between the Original Forward Rate and the Remaining
Forward Rate Discounted to Present Value
Forward Contract Example• Bean Trader agrees to sell 100,000 lbs of coffee beans
for $1.55 per pound (forward price) to Coffee Co for delivery three months from now.
• Bean Trader is seller or has “short” position and will benefit if the price of coffee beans falls
• Coffee Co is buyer or has “long” position, and will benefit if price increases
Forward Contract Pricing
Forward price of $1.55 is based on:
Current spot price of coffee (assumed to be $1.50) +Cost to carry to the maturity date
Cost to carry to maturity is the combination of– Interest Rates– Storage Costs
Valuing Forwards & Futures
In the 2nd month the forward price of coffee increases to $1.60
– BeanTrader’s loss of $.05 is discounted 2 months using an appropriate discount rate. This is the contract’s fair value, a liability
– Coffee Co has a fair value gain (asset) of same amount
Forward Contract IllustrationSymmetric Return ProfileContract
Payoff
Expiration Date Price of Underlying Security
+
0
_
Short Short GainGain
Long Long LossLoss
Long Position Long Position GainGain
Short Position Short Position Loss LossContract Contract
PricePrice
Short ForwardShort Forward Long ForwardLong Forward
FUTURESTraded on organized exchanges ---- Chicago Bd
of Trade, NY Mercantile Exchange, London International Financial Futures Exchange
Contracts are standardized in nature
Requires an initial deposit of funds with broker called a margin account
Contracts represent cash amounts settled only at delivery and must be marked to market each trading day --- no discounting required
Swaps
Futures
Forward Contracts
Symmetrical or Linear
Caps/Floors
Exchange-TradedOptions
OTC Options
Nonlinear
TYPES OF DERIVATIVE CONTRACTS
Nonlinear ContractsOption contracts, or those with option-like features
Upside gain with limited downside loss (or vice versa)
Value of underlyingValue of underlying
+
0
_
Value of Value of
contractcontract
Option
Represents a right, rather than obligation, to either buy or sell some quantity of a particular
underlying
Option Characteristics
Purchaser pays and seller receives, a premium up front
Purchaser enjoys upside potential with downside limited to premium paid
Seller bears downside risk with upside limited to the premium received
In, Out, and On the Money25
In the Money
When it is more profitable for the holder to exercise the option than to transact directly in the optioned item
Out of the
Money
When it is not profitable for the holder to exercise the option compared to transacting directly in the optioned item
At the MoneyWhen the optioned item’s current market price equals the strike price
Options Valuation
Dependent on:– Value of underlying– Strike price– Volatility in price of underlying– Time to expiration– American vs. European– Risk free interest rate
Black-Scholes model or binomial pricing model
Options Valuation
Intrinsic Value– Intrinsic value represents the value based solely
on the current price of the underlying compared to the option strike price.
– Defined as: Strike Price - Spot Rate
– If option is “in the money” it has intrinsic value; if “out of the money” intrinsic value is zero
Options Valuation
TIME VALUE– Attributed to expected intrinsic value at
expiration date
– Defined as: Current Value - Intrinsic Value – Based on statistical measure
– Mathematics for measuring can get very complicated
Options
• Call - A contract giving the holder the right, but not the obligation, to buy a specific asset for a fixed price during a specific period.
• Put - A contract giving the holder the right, but not the obligation, to sell a specific asset for a fixed price during a specific period.
Price Changes of Optioned ItemsHolder of a call ---Bets that the price of the optioned
item will rise
Call writer --- Bets against a price increase Takes the time value component of the premium to
compensate for the risk
Changes in optioned item’s price affect the option’s intrinsic value only if option is at or in the money
30
Holder WriterPrice of Optioned Item Puts Calls Puts CallsIncreases - Gain - LossDecreases Gain - Loss -
If option is AT the money:
Option Contracts One-sided contracts --- require performance only
when exercised
Options can be individual securities and indexes
Allows --- not require, the holder to buy (call) or sell (put) at an agreed-upon price during an agreed-upon time period or on a specified date
31
American OptionsCan be exercised any time during
the agreed-upon time period
European OptionsCan be exercised only on the
expiration date
Call Option Example
Smith writes and sells to Jones a $120 a call option for 100 shares of Merck stock, exercisable at the stock’s current market price of $60 per share and expiring in 90 days.
32
If stock price stays at or below $60: Jones will not exercise the right to buy Call will expire Jones has a loss of $120
If stock price rises above $60: Jones exercises the call by paying $6,000 for 100 shares worth
Jones may sell the call for the difference between the $6,000 exercise price and the higher market value
Strike (exercise) Price
Call Option Illustration
Strike Price
Out-of-the-Money In-the-Money
ContractPayoff
Expiration Date Price of Underlying Security
+
0
_
Sold CallSold Call Purchased CallPurchased Call
Put Option --- ExampleSmith writes and sells to Jones for $120 a put option for 100 shares of Merck stock, exercisable at the stock’s current market price of $60 per share and expiring in 90 days.
34
If stock price rises above $60: Jones will not exercise the right to sell Put will expire Jones loss is $120
If stock price falls to $57: Jones exercises the put by selling 100 shares worth $5,700 to Smith Barney for $6,000, or Jones may sell the put for at least $300 ($3 per share)
Put Option Illustration
Strike Price
In-the-Money Out-of-the-Money
ContractPayoff
Expiration Date Price of Underlying Security
+
0
_
Sold PutSold Put Purchased PutPurchased Put
Put and Call Options with Price Relations
In, Out, or At the MoneyPrice Relation Puts Calls
Strike price > Price of optioned item In OutStrike price < Price of optioned item Out InStrike price = Price of optioned item At At
36
Amount that the option is in the
money
Option Price = Option’s Intrinsic Value + Option’s Time Value
Also called the premium
Excess of the premium over the
option’s intrinsic value
Multiplier Effect of Call Options
$ Return Cost % Return
Option Purchase $287 $ 138 208%Stock Purchase 875 4,550 19%
37
Option holders can benefit from constructive ownership of large quantities of stock with a small investment through options.
Investor purchases a call contract for 100 shares of Apple Computer stock with a $50 exercise price that expires in 90 days for $138. The investor also purchases 100 shares of Apple stock at $45.50 per share.
If Apple stock rises to $54.25 before expiration: Option is in the money: $54.25 – $50.00 = $4.25 per option Option return = ($4.25 × 100) – $138 = $287 Stock return = ($54.25 - $45.50) x 100 = $875
Other Types of OptionsSwaptions (option on swap)Swaptions (option on swap)
Captions/Floortions (option on a cap or floor)Captions/Floortions (option on a cap or floor)
Futures Options (option on futures)Futures Options (option on futures)
Split-fee Options (options on options)Split-fee Options (options on options)
Exotic Options (look-back, Asian, etc.)Exotic Options (look-back, Asian, etc.)
Embedded Options -- options embedded in other Embedded Options -- options embedded in other instruments (e.g., prepayment, ARM caps, etc.)instruments (e.g., prepayment, ARM caps, etc.)
Caps and Floors
Cap– A contract that protects the holder from a rise
in interest rates or price increase beyond a certain point
Floor– A contract that protects the holder from a
decrease in interest rates or price decrease below a certain point
Interest Rate Caps
Purpose --- protect against rising interest rates on a company’s variable rate loans
Is a call option
In the money When the variable rate rises above the cap’s
strike price, writer of the cap pays the holder the difference in interest between the holder’s variable rate and the cap rate
40
Interest Rate Cap Example
Client Counterparty
Pay LIBOR @ 7%(if LIBOR > 7%)
Paid at inception
$2 million premium
5 Year Interest Rate Cap - $100mm Notional
Result: effectively puts a cap on borrowing cost offloating rate debt financing
Derivatives can be used to counter risk associated with
unfavorable rate/price changes by using them as a hedge
Hedging “Best Practices” Require:
• Entities must have written hedging policies for hedging and risk management activities
• Hedging relationships must be fully documented
• Hedges must be matched specifically to underlying risks
• Hedging relationships must be monitored throughout their life - must be “highly effective”
FASB 133/138 Key Concepts
SFAS 130 - Nature and Use of Comprehensive Income
Comprehensive income (CI) Includes all changes in owners’ equity other than those
resulting from transactions with owners
44
Other comprehensive income (OCI) Includes items that bypass net income and are
carried directly to stockholders’ equity
CI = Net income + Other comprehensive income
OCI =
Current rate method foreign currency
translation adjustments
Gains and losses on derivatives used in certain hedging
situations
Unrealized gains and losses on
available-for-sale securities
+ +
Reporting Changes in Fair Value
Hedge’s effectiveness guides reporting:
45
Gains and losses reported in current
earnings
Gains and losses on the hedge instrument and
hedged item reported in earnings in same reporting
period
TYPES OF HEDGES
• FAIR VALUE HEDGES
• CASH FLOW HEDGES
• FOREIGN CURRENCY HEDGES
Fair Value HedgesTwo Types:
1. Changes in the fair values of existing assets and liabilities
2. Firm Commitments ---- binding agreement with an unrelated party that:
Specifies all significant terms of the transaction
Includes a nontrivial disincentive for nonperformance
47
Accounting for Fair Value Hedges
Gain or loss Reported in earnings concurrent with the offsetting
loss or gain on the change in fair value of the hedged item attributable to the hedged risk
Hedged items that are firm commitments Firm commitment recognized as an asset or liability
Portion of total change in fair value of a hedge instrument due to other factors Enters earnings without offset
48
CASH FLOW HEDGES
Used to establish fixed prices or rates when future
cash flows could vary due to changes in prices or rates
Types: Forecasted Transactions Existing assets or liabilities with variable future cash flows
Cash Flow Hedge MechanicsFair Value of the Derivative
– Changes recorded in Other Comprehensive Income for effective portion
– Changes recorded in earnings for ineffective portion
No basis adjustment to the hedged asset or liability
Net effect?– Amounts in OCI recognized when the hedged
item impacts earnings
Swaps
• An agreement by two parties to exchange a series of cash flows in the future through an intermediary
• Typically interest rates or currencies, but may also involve commodities or equities as well
• Symmetrical or linear contracts
Interest Rate Swap --- Example
Client Counterparty
6 Mo. LIBOR
Paid semi-annually
Paid Semi-Annually
6.5% Fixed Rate
5 Year Interest Rate Swap - $100mm Notional
Why would a client enter into this transaction?
Interest Rate Swap Example (cont’d)
Client Counterparty
6 Mo. LIBOR
Paid Semi-Annually
Paid Semi-Annually
6.5% Fixed Rate
5 Year Interest Rate Swap - $100mm Notional
XYZ Bank$100 mm
5yr.Loan
Interest @6 Mo. LIBOR
Result: client effectively convertsits borrowing cost to 6.5% fixed
FAS 133 Documentation
For Cash Flow hedges, formal documentation of hedging relationship:
• Statement of objectives and strategy and nature of hedged risk
• Description of derivative hedging instrument• Description of hedged item with specific
identification• Describe how hedge effectiveness will be
assessed
Foreign Currency Hedges
Hedging exchange rate risk in a foreign currency available-for-sale (AFS) security
Gain or loss on both the hedging instrument and the hedged AFS security are reported in earnings
Creates an offset to the loss or gain on the hedging derivatives
55
Assessing Hedge EffectivenessPer SFAS 133, Management must:
1. Explicitly assess the derivative’s hedge effectiveness2. Identify how it intends to assess hedge effectiveness 3. Conclude that a derivative will be highly effective in
order to designate the derivative as a hedging instrument
Ineffective portion of a gain or loss on a hedge ---reported in earnings, creating earnings volatility
Gauging effectiveness Gauge initially, and, for hedge accounting to continue,
when earnings are reported and at least every three months thereafter
56
Measuring Hedge Effectiveness High effectiveness
Occurs when the derivative neutralizes or offsets between 80% and 125% of the fair value or cash flow changes that represent the risk being hedged
100% offset not required
57
Hedge Effectiveness MeasureChange in fair value of hedge instrument
Change in fair value of hedged item
Always negative because one value change is a gain and the other is a loss
High Effectiveness and Hedge Effectiveness Example
Conagra carries at cost 100,000 bushels of soybeans to be sold in 3 months on a local market. The current local market price is $5.50 a bushel. Conagra enters a futures contract to sell 100,000 bushels in 3 months at $5.60 per bushel, a fair value hedge. The local market price fell by $.20 to $5.30 and the futures price fell by $0.17 to $5.43.
58
To report the decline in soybean inventory: $0.20 × 100,000 = $20,000
To recognize the increase in value of the futures contract:$0.17 × 100,000 = $17,000
Loss on hedging 20,000 Commodities inventory 20,000
Investment in futures 17,000 Gain on hedging 17,000
Hedge Effectiveness Measure = $17,000 ÷ ($20,000) = –85%