Brussels 17 September 2002

1. Brussels 17 September 2002 European Parliament Financial Services Forum Fundamentals of Derivative Contracts David Mengle International Swaps and Derivatives Association and Fordham University Graduate School of Business

2. Three forms of derivatives activity • Futures are customized, exchange-traded derivatives contracts • Futures contracts • Exchange-traded options • Over-the-counter (OTC) are customized, privately-negotiated derivatives • Forwards • Contracts to exchange something at an agreed time in the future at a price agreed upon today • Swaps • Contracts between two counterparties to exchange cash flows on a notional principalamount at regular intervals during a stated period • OTC options • Contracts that give the buyer, in exchange for the payment of a premium, the right but not the obligation to buy or sell a specified amount of the underlying asset at a predetermined price at or until a stated time. • Structured securities combine securities with derivatives contracts

3. Situation 1: Interest rate risk Situation • Client is a European bank that has made a 5-year €100 million loan at a fixed rate to a domestic corporation • Loan funded with one-year euro deposits • Client is concerned that euro interest rates will rise Assets Liabilities Deposit (1-year Euribor) €100 MM Loan (5-year fixed rate) €100 MM

4. Interest rate risk Situation 1-year Euribor 5-year fixed rate Bank Deposit Loan • There is a mismatch between the term of the asset and that of the liability that funds the asset • The client here faces refinancing risk that the cost of rolling over (reborrowing) funds will rise relative to the returns on assets • Mismatches often occur because the investment and funding decisions are made by different parts of the firm

5. Dealer Solution: Interest rate swap Swap: A contractual agreement between two counterparties to exchange cash flows on a notional principal amount at regular intervals during a stated period 5-year Fixed Rate 1-year Euribor Loan Bank Deposit Notional amount = €100 million The most common type of interest rate swap involves the exchange of a fixed rate cash flow for a floating rate cash flow Swap Rate (4.12%) Euribor In an interest rate swap, the notional amount is never exchanged Net Funding Cost: 5-Year Swap Rate = 4.12%

6. Swap cash flows € millions TimeDeposit SwapNet 0 100 -- -- 100 1 (EURIBOR) EURIBOR (4.12) (4.12) 2 (EURIBOR) EURIBOR (4.12) (4.12) 3 (EURIBOR) EURIBOR (4.12) (4.12) 4 (EURIBOR) EURIBOR (4.12) (4.12) 5 (100 + EURIBOR) EURIBOR (4.12) (104.12)

7. Result of hedging with interest rate swap • Client has given up interest rate risk by locking in fixed swap rate (replaced risk with certainty) • Client will be protected from rising deposit rates, • But will not benefit if rates fall • Client assumes credit exposure to Dealer (and vice versa) over next five years • The Dealer does not charge the client a fee to enter the swap

8. Situation 2: Interest rate risk • A European corporation plans to borrow €100 million to fund its domestic expansion plans, but is not well known enough to issue fixed-rate bonds to the public • The corporation is able to borrow from its bank at a floating rate of 1-year Euro Libor plus 1.5 percent • The corporation can obtain synthetic fixed-rate financing by paying a fixed rate on an interest rate swap with its bank Euriibor + 1.50% Libor Bank Corporation Dealer €100 MM 4.12% (fixed) 5-year Euro swap rate = 4.12% Total annual funding cost to corporation = 4.12% + 1.50% = 5.62%

9. Situation 3: Currency risk • A European electrical company has contracted to sell US$100 million of power generating equipment to a U.S. electrical power producer, with delivery and payment occurring six months from today • Deal is profitable at current spot exchange rate (€1 = $0.97), but is concerned that the deal will become unprofitable if the euro falls relative to the U.S. dollar • Company is not willing to lock in an exchange rate today, however, because it want to profit if the U.S. dollar depreciates relative to the euro • Solution: Currency option

10. Options: Definitions • An option is a legal contract that gives the buyer, in exchange for the payment of a premium, the right but not the obligation to buy or sell a specified amount of the underlying asset at a predetermined price (strike price) at or until a stated time (maturity date). • Types of option • Call option is an option to buy • Put option is an option to sell • Maturity date is the time after which the option is no longer valid; also called expiration date • European option can only be exercised at maturity date • American option can be exercised any time up to expiry Option buyer or holder (long)

11. Currency option • The corporation bought a put option on the dollar with a strike price of 1.05 $/€ by paying a premium today • At the maturity of the option six months from today: • If the exchange rate is below 1.05 $/€, there will be no payment on the option • If the exchange rate is above 1.05 $/€, the Dealer will compensate the company in euros for the depreciation of the value of the receivable Up-front premium (on Trade Date) Electrical company Dealer US$100 MM Receivable(in 6 months) Payment if $/€ > 1.05 (on Maturity Date)

12. Result of hedging with currency option • Client will be protected if dollar depreciates below 1.05 euro per dollar • Client will benefit from any appreciation of euro (net of premium) • Client assumes credit risk of default by Dealer

13. Situation 4: Credit risk • A European bank enjoys profitable lending relationships with manufacturing corporations • The bank would like to diversify its exposure, however, and is particularly concerned that it has become more exposed to one borrower than it would like • The bank is reluctant, however, to reduce its exposure by selling the loans to other banks or by demanding immediate repayment of some of its outstanding loans • Solution: Credit derivative

14. Credit (default) swaps are the most basic form of credit derivative X bp per annum Protection buyer Protection seller Contingent payment • Buyer pays premium for protection against default by reference credit • If reference credit(s) default (or other credit event occurs), buyer receives payout equal to one of the following: • Physical settlement: Par value in return for delivery of reference obligation; or • Cash settlement: Post-event fall in price of reference obligation below par; or • Binary settlement: Fixed sum or percentage of notional • Results: • Credit swap hedges both default risk and credit concentration risk • Buyer trades credit risk of reference credit for counterparty credit risk of seller

15. Results of hedging with credit default swap • Protection buyer • Gives up exposure to default of reference credit without removing reference asset from balance sheet • Takes on counterparty credit exposure to protection seller • More precisely, protection buyer takes on risk of simultaneous default by reference credit and protection seller • Protection seller • Takes on exposure to reference credit without need for funding underlying position

16. Managing risks with OTC derivatives • End-users encounter financial risks in connection with their core business activities • Corporations • Financial institutions • Governments and agencies • Dealers must manage the risks they take on from users by hedging • Other dealers • Inventories of the underlying risk • Futures and securities exchanges • Types of market participants • Hedgers seek to pass their risks on to others • Speculators seek to take on risks • Liquid markets are essential to the ability to manage risks effectively

17. How dealers hedge the directional risk of swaps Dealer pays fixed and receives floating Counterparty Dealer Hedge Strategy Euribor Fixed rate • Hedge strategy can consist of: • Offsetting swap • Buy treasury securities, financed with repurchase agreement • Buy Euribor futures • Leave position open

18. How risks are passed on by dealers Futures Other users User Dealer Other dealers Other users Other users Other markets • Dealers manage many of their risks though offsetting transactions with other dealers • The other dealers often have user clients with offsetting risks • Dealers can pass their risks on to organized futures exchanges • Dealers can offset their risks through offsetting transactions in money, currency, and capital markets • Liquid markets are those in which participants can easily pass on their risks with little of no effect on the market • The existence of both hedgers and speculators in markets is necessary to ensure liquidity

19. Dealers Other financial institutions Non-financial institutions 11% 16% 27% 31% 27% 46% 43% 42% 57% Interest rate swaps Credit derivatives Currency options Profile of derivatives participants Source: Bank for International Settlements

20. Derivatives growth, 1987-2001 Notional principal outstanding, interest rate swaps and options and cross-currency swaps Source: International Swaps and Derivatives Association

21. Brussels 17 September 2002 European Parliament Financial Services Forum Fundamentals of Derivative Contracts David Mengle International Swaps and Derivatives Association and Fordham University Graduate School of Business