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Derivatives Seminar

Derivatives Seminar. Judson W. Russell, Ph.D., CFA. CONFIDENTIAL. DRAFT. Use of Derivatives. In general, financial derivatives can be divided into three groups: Risk Management Hedging strategies to limit market exposure Monetization Strategies

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Derivatives Seminar

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  1. Derivatives Seminar Judson W. Russell, Ph.D., CFA CONFIDENTIAL DRAFT

  2. Use of Derivatives In general, financial derivatives can be divided into three groups: • Risk Management • Hedging strategies to limit market exposure • Monetization Strategies • Obtaining liquidity against financial positions • Investment Strategies • Risk Diversification • Return Enhancement Structures • Positive Carry Transactions

  3. The Nature of Derivatives • A derivative is an instrument whose value depends on the values of other more basic underlying variables (usually traded assets). • “A derivative is a contingent claim that may be used to transfer risk from someone who has it, but doesn’t want it to someone who wants it, but doesn’t have it”. –The Economist

  4. Interest Rate Derivatives 10-year Treasury Yield

  5. FX Derivatives $US/Pound Sterling

  6. Commodity Derivatives Dollar Per Barrel of Crude

  7. Derivatives Defined • Forward Contract • A financial contract to buy or sell an asset at a certain future time for a certain price (the delivery price). • No cash flows are exchanged until the delivery date. • Futures Contract • A financial contract to buy or sell an asset at a certain time in the future for a certain price (the delivery price). • The financial contract is marked-to-market. • Option • A contract granting the right to buy or sell an asset at a stated price over a specified period. • Call option – contract granting the right to buy • Put option – contract granting the right to sell • Swap • A contract between two or more parties to exchange sets of cash flows over a period in the future. • The parties that agree to the swap are known as counterparties. • The two basic kinds of swaps are interest rate swaps and currency swaps.

  8. Ways Derivatives are Used • To hedge risks • To speculate (take a view on the future direction of the market) • To lock in an arbitrage profit • To change the nature of a liability or an investment.

  9. Forwards & Futures

  10. Forward Contracts • A forward contract is an agreement to buy (long) or sell (short) an asset at a certain time in the future for a certain price (the delivery price). • It can be contrasted with a spot contract which is an agreement to buy or sell immediately • The forward price may be different for contracts of different maturities. • As we move through time the delivery price does not change, but the forward price for a contract may change. • It is traded in the OTC market • Forward contracts are available on a variety of products (equity, rates, fx, commodities, etc)

  11. Forward Contracts on Interest Rates: Forward Rate Agreements (FRAs) • The primary time deposit instrument globally is the Eurodollar, which is a dollar deposited outside the United States. • Banks borrow dollars from other banks by issuing Eurodollar time deposits, which are essentially short-term unsecured loans. • The primary market for Eurodollar deposits is in London and earns LIBOR—which is considered to be the best representative rate on a dollar borrowed by a private, high-quality borrower. • Eurodollar example: • Suppose the Royal Bank of Scotland needs to borrow $10 million for 30 days. It receives a quote from Barclays of 1.25%. If RBS takes the deal it will owe $10,000,000 x [1+0.0125/(30/360)] = $10,010,416.67.

  12. Foreign Exchange Chart for New Sol / US Dollar

  13. Foreign Exchange Quotes for New Sol / US Dollar What are the bid/offer prices for the 3-month forward? BID OFFER 2.7865 + 0.002998 = 2.789498 2.7880 + 0.006002 = 2.794002 In general, the forward rate = spot rate [(1+rp)/(1+rus)] Current 3-month rates are 1.074% and 0.30313% on annual basis respectively.

  14. Example • Suppose that the Treasurer of a Peruvian corporation knows that the corporation will pay USD 10 million in six months and wants to hedge against exchange rate moves. • How much will the corporation pay, in new sol, for the forward contract? 14

  15. Example • Suppose that the Treasurer of a Peruvian corporation knows that the corporation will pay USD 10 million in six months and wants to hedge against exchange rate moves. • How much will the corporation pay, in new soles, for the forward contract? • 2.7880 + 0.0115 = 2.7995 new soles per dollar… • 27.995 million new soles are required

  16. Profit Price of Underlying at Maturity, ST Profit from a Long Forward Position New Sol Depreciates + 0 K, delivery price K = 2.7995:USD - New Sol Appreciates

  17. Concept Check • The treasurer of a company expects to receive a cash inflow of $15,000,000 in 90 days. The treasurer expects short-term interest rates to fall during the next 90 days. In order to hedge against this risk, the treasurer decides to use an FRA that expires in 90 days and is based on 90-day LIBOR. The FRA is quoted at 1.5%. At expiration, LIBOR is 1.25%. Assume that the notional principal on the contract is $15,000,000. • Indicate whether the treasurer should take a long or short position to hedge interest rate risk. • Using the appropriate terminology identify the type of FRA used here. • Calculate the gain or loss to the company as a consequence of entering the FRA.

  18. Options

  19. A call option is an option to buy a certain asset by a certain date for a certain price (the strike, or exercise, price) A put is an option to sell a certain asset by a certain date for a certain price (the strike, or exercise, price) Options

  20. Profit ($) 30 20 10 Terminal stock price ($) 30 40 50 60 0 70 80 90 -5 Long Call Profit from buying a European call option on stock X: option price = $5, strike price = $60

  21. Profit ($) 70 80 90 5 0 30 40 50 60 Terminal stock price ($) -10 -20 -30 Short Call Profit from writing a European call option on stock X: option price = $5, strike price = $60

  22. Profit ($) 30 20 10 Terminal stock price ($) 0 60 70 80 90 100 110 120 -7 Long Put Profit from buying a European put option on stock X: option price = $7, strike price = $90

  23. Profit ($) 7 Terminal stock price ($) 60 70 80 0 90 100 110 120 -10 -20 -30 Short Put Profit from writing a European put option on stock X: option price = $7, strike price = $90

  24. Payoff Payoff K K ST ST Payoff Payoff K K ST ST Payoffs from OptionsWhat is the Option Position in Each Case? K = Strike price, ST = Price of asset at maturity A. C. D. B.

  25. Positions in an Option & the Underlying Suppose that we combine an option position with either a long or short position in the underlying asset. Long Stock + Long Put = Combination 0 0 0 K ST ST ST

  26. Positions in an Option & the Underlying Profit Profit K ST ST K (a) (b) Profit Profit K K ST ST (c) (d)

  27. Option Strategies • Spreads • Created from two or more calls or two or more puts • Straddles • Created from a long call and a long put with the same strike price and expiration date. • Strangles • Created from a long call and a long put, but with different strike prices

  28. Bull Spread Using Calls What is the motivation for this trade? Profit ST K1 • K2

  29. Profit K ST A Straddle Combination What is the motivation for this trade?

  30. A Strangle Combination What is the motivation for this trade? Profit K1 K2 ST

  31. Concept Check • Long strangle (long call, long put) • Long straddle (long call, long put) • Long call • Long put • Bull Spread (with call options) • Short put • Short call • Short straddle (short call, short put) • Match the strategy to the graph. • Label the missing graph appropriately.

  32. Swaps

  33. Currency Swap • Each party makes interest payments to the other in different currencies. • Consider a U.S. retailer which does not have an established presence in Brazil, but has decided to begin opening a few stores and needs 100 million reals to proceed. The company is well-known in the U.S. and can raise money relatively cheaply in USD. The company issues a five-year US$60 million bond at a rate of 2.75%. It then enters into a 5-year swap in which the bank will pay the retailer 2.75% in US dollar and the retailer will make payments in reals at a fixed rate of 3.25%. • Step 1. Retailer pays bank $60 million, Bank pays retailer 100 million reals (assumes exchange rate of BRL 1.667:$1) • Step 2. Every six months for the next three years: • Retailer pays the bank (0.0325)(180/360)100 million reals = 1,625,000 reals • Bank pays the retailer (0.0275)(180/360)$60 million = $825,000 • Step 3. At end of five years: • Retailer pays the bank 100 million reals, Bank pays retailer $60 million

  34. Currency Swap Cash Flows Received by Retailer 100 m BRL $825k USD $825k USD $825k USD $825k USD $60.825m USD $825k USD $60 m USD 1, 625 m BRL 1, 625 m 1, 625 m 1, 625 m 1, 625 m 101, 625 m BRL Received by Bank

  35. Interest Rate Swap • Interest rate swaps allow corporations to manage interest rate exposure. • In a rising interest rate environment, corporations that are net borrowers want to lock in fixed rates (while rates are still low). • In a falling interest rate environment, interest rate swaps allow corporations that are net borrowers to take advantage of falling rates by getting in on the floating side. • Interest rate swaps allow investors to swap into floating rates if they believe rates will rise. • If interest rates are rising, a company with floating-rate debt can undertake a swap to pay fixed and receive floating, which avoids the transaction costs of refinancing.

  36. Cash Flows to GE(GE receives float, pays fixed) An agreement by GE to receive 6-month LIBOR & pay a fixed rate of 1.271% per annum every 6 months for 3 years on a notional principal of $100 million ---------Millions of Dollars--------- LIBOR FLOATING FIXED Net Date Rate Cash Flow Cash Flow Cash Flow Jan. 18, 2011 0.25438% July, 2011 0.4559% +0.127 –0.6355 –0.5085 Jan., 2012 1.0490% +0.2280 –0.6355 -0.4075 July, 2012 1.4800% +0.5245 –0.6355 -0.1110 Jan., 2013 2.2100% +0.7400 –0.6355 +0.1045 July, 2013 2.5500% +1.1050 –0.6355 +0.4695 2.8000% +1.2750 –0.6355 +0.6390 Jan., 2014

  37. Fixed Rate Payment Calculation • Swaps typically trade on a 30/360 day count convention. The formula for determining the net fixed rate payment is: • Fixed rate payment = (Swap fixed rate – LIBOR t-1)(# of days/360)(notional principal) • For example, referring to the July 2012 information from the previous example we use the January 2012 LIBOR reference rate (1.049% p.a.) as well as the fixed rate (1.271% p.a.). • Fixed rate payment = (1.271% – 1.049%)(180/360)($100 million) = $111,000, that is the fixed rate payer pays $111,000. • This should be intuitive since you’ve locked in 1.271% which is higher than the prevailing LIBOR rate.

  38. Valuation of an Interest Rate Swap • Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond. • Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs).

  39. Valuation in Terms of FRAs • Each exchange of payments in an interest rate swap is an FRA. • The FRAs can be valued on the assumption that today’s forward rates are realized.

  40. Swaps & Forwards • A swap can be regarded as a convenient way of packaging forward contracts. • The “plain vanilla” interest rate swap in our example consisted of 6 FRAs. • The “fixed for fixed” currency swap in our example consisted of a cash transaction and 5 forward contracts. • The value of the swap is the sum of the values of the forward contracts underlying the swap. • Swaps are normally “at the money” initially • This means that it costs nothing to enter into a swap • It does not mean that each forward contract underlying a swap is “at the money” initially

  41. Asset Swaps • An asset swap is a combination of a bond (the asset) with an interest-rate swap contract. • The swap contract swaps the coupon of the bond into a payoff stream of Libor plus a spread. Usually, the bond is a fixed-coupon bond and the interest-rate swap is a fixed-for-floating swap (pay fixed, receive float for the investor). • The asset swap is not a credit derivative in the strict sense, because the swap is unaffected by any credit events. It is a portfolio of a bond and a swap contract.

  42. Asset Swaps • The asset swap’s main purpose is to transform the pre-default payoff streams of a bond into Libor plus the asset swap spread. The investor still bears the full default risk and if a default should happen, the swap will still have to be serviced or to be unwound at market value. • Asset swap packages are popular and liquid instruments in the bond market, and sometimes it is easier to trade an asset swap package than the underlying bond alone. • A large number of traded asset swaps contain additional, more complex structural features that are either designed to strip out unwanted structural features from the underlying asset or to enhance yield.

  43. Asset Swaps Receives Par at Maturity What Type of Asset Swap to Choose? x% Semi Bond FIXED x% Bond Bank INVESTOR LIBOR +/– y bps Buys Bond at Dirty Price

  44. Asset Swaps: U.S. Dollar Swap Curve and U.S. Treasury Curve U.S. Dollar Swap Curve ---------------- On-the-run Treasury Curve ________

  45. Asset Swaps Par/Par • In a Par/Par asset swap, the swap provider pays or receives from the investor the difference between the dirty price of the bond and par. This is done so the floating rate is earned on “par” proceeds (i.e., floating rate +/- spread is the true return). • All the parameters of the bond are matched exactly in the swap, including the fixed rate which is set equal to the coupon on the bond and is swapped to LIBOR +/- Spread. • The investor locks in the yield to maturity while at the same time effectively hedging the interest rate risk. Buys Bond at Dirty Price Dirty Price - Par 4.25% Semi Bond FIXED 4.25% on Par Bond INVESTOR Bank LIBOR and Spread Receives Par at Maturity

  46. Swaptions

  47. Strategies and Applications Using Swaptions • A swaption is an option to enter into a swap. There are swaptions to enter into equity, currency, and commodity swaps—but we’ll focus on swaptions to enter into interest rate swaps since this is the largest swaption market. • Payer swaption allows the holder to enter into a swap as the fixed-rate payer. • Receiver swaption allows the holder to enter into a swap as the fixed-rate receiver. • The buyer of a swaption pays a premium at the start of the contract and receives the right to enter the swap. • The increased depth of the LatAm local markets has boosted trading. Investors are more commonly using interest rate options to better manage risk exposure in LatAm local markets, to take directional or to take volatility views. We’ll see examples of this in our strategy modules.

  48. Strategies and Applications Using Swaptions • Suppose the underlying asset is a three-year swap with semiannual payments with LIBOR as the underlying floating rate. • A payer swaption allows entry into this swap as the fixed-rate payer, suppose the exercise rate is 1.75%. • At expiration, let’s assume that three-year, semiannual pay LIBOR swaps have a fixed rate of 2.0%. • If the holder exercises the swaption, it enters a swap, agreeing to pay a fixed rate of 1.75% and receive a floating rate of LIBOR flat.

  49. Strategies and Applications Using Swaptions • Using an Interest Rate Swaption in Anticipation of a Future Borrowing • Suppose a company takes out a floating-rate loan. In the course of planning, the company finds that it must borrow 1.9 billion Colombian pesos (COP1900-$1USD = $1 mill USD) in one year at the floating rate of LIBOR plus 250 bps. • The loan will require semiannual payments for two years and the company plans to swap the loan into a fixed-rate loan, using the going rate at the time the loan is taken out. • The company is concerned that rates will rise before it takes out the loan. A bank offers a swaption to the company. Specifically, for a cash payment upfront of COP24,225 million ($12,750 USD), the company can obtain the right to enter into the swap in one year as a fixed-rate payer at a rate of 4%. The net effect is to pay 4% fixed plus the 250 bps for 6.5% total which is better than current local market quote.

  50. Strategies and Applications Using Swaptions • Using an Interest Rate Swaption in Anticipation of a Future Borrowing • Today COP24,225 million ($12,750 USD) Swaption Seller Company Payer swaption, expires in 1 year that enables it to enter into a two-year, semiannual pay COP swap to pay fixed and receive LIBOR

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