Economics 330

Money and BankingLecture 18

Prof. Menzie Chinn

TAs: Chikako Baba,

Deokwoo Nam

Chapter 13 (7/e, 8/e Alt.)

Financial Derivatives

Hedging

Hedge: engage in a financial transaction that reduces or eliminates risk

Basic hedging principle:Hedging risk involves engaging in a financial transaction that offsets a long position by taking a short position, or offsets a short position by taking a additional long position

Interest-Rate Forward MarketsLong position = agree to buy securities at future dateHedges by locking in future interest rate if funds coming in

futureShort position = agree to sell securities at future dateHedges by reducing price risk from change in interest rates

if holding bondsPros1. FlexibleCons1. Lack of liquidity: hard to find counterparty2. Subject to default risk: requires information to screen

good from bad risk

Financial Futures MarketsFinancial Futures Contract1. Specifies delivery of type of security at future date2. Arbitrage at expiration date, price of contract = price

of the underlying asset delivered3. i , long contract has loss, short contract has profit4. Hedging similar to forwards

Micro vs. macro hedge

Traded on Exchanges: Global competitionRegulated by CFTC

Success of Futures Over Forwards1. Futures more liquid: standardized, can be traded again,

delivery of range of securities2. Delivery of range of securities prevents corner3. Mark to market and margin requirements: avoids

default risk4. Don’t have to deliver: netting

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Widely Traded Financial Futures Contracts

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Widely Traded Financial Futures Contracts

Hedging FX Risk

Example: Customer due 10 million DM in two months, current DM=$11. Forward contract to sell 10 million euros for

$10 million, two months in future

2. Sell 10 million of euro futures

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OptionsOptions ContractRight to buy (call option) or sell (put option)

instrument at exercise (strike) price up until expiration date (American) or on expiration date (European)

Hedging with OptionsBuy same # of put option contracts as would sell

of futuresDisadvantage: pay premiumAdvantage: protected if i , gain if i Additional advantage if macro hedge: avoids accountingproblems, no losses on option when i

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Profits and Losses: Options vs. Futures

$100,000 T-bond contract,1. Exercise price of 115,

$115,000.2. Premium = $2,000

Factors Affecting Premium

1.Higher strike price lower premium on call options and higher premium on put options

2.Greater term to expiration higher premiums for both call and put options

3.Greater price volatility of underlying instrument higher premiums for both call and put options

Interest-Rate Swap Contract

1. Notional principle of $1 million

2. Term of 10 years

3. Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Co.

Hedging with Interest-Rate SwapsReduce interest-rate risk for both parties1.Midwest converts $1m of fixed rate assets to

rate-sensitive assets, RSA , lowers GAP2.Friendly Finance RSA , lowers GAP

Advantages of swaps1.Reduce risk, no change in balance-sheet2.Longer term than futures or options

Disadvantages of swaps1.Lack of liquidity2.Subject to default risk

Financial intermediaries help reduce disadvantages of swaps