Financial Derivatives Spring Derivatives

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1 Derivatives A derivative is an obligation to accomplish a transaction in the future. Because the terms are specified in detail within the contract, the obligation derives its value from the underlying asset that would be bought or sold to fulfill the contract. Examples of widely-used derivatives include forward contracts, repurchase agreements, futures contracts, swaps, options, and swaptions. Derivatives are powerful tools that can be very useful in managing risk, if properly applied, but devastating if used carelessly or speculatively. A forward contract is an agreement for purchase, sale, or exchange of a specified asset (such as a load of wheat or a portfolio of bonds) for delivery at a specified place on a future date. Payment is made upon delivery at the price specified in the contract. The contract is a firm obligation, and there may be a deposit required. Buyers have a long position and sellers have a short position. Forward markets may be self-regulating and operate without organized exchanges. There are active global forward markets in energy and foreign exchange. A repurchase agreement is a form of forward contracting that is essentially a secured loan to a dealer in government securities. The investor buys part of the dealer s inventory and simultaneously arranges to sell it back later at a specified higher price. The length of time varies from a day to several months. There are also continuing contracts that are automatically renewed every day, but can be canceled by either party with as little as one day s notice. Also, there are reverse repurchase agreements in which an investor sells securities from its portfolio to a dealer and agrees buy them back later. Repurchase agreements are sometimes called RPs, repos, or buybacks. A futures contract is a form of forward contracting with a formal structure in which the parties contract with a clearinghouse, instead of each other, post margin money as collateral, and markto-market regularly. Trading takes place on organized exchanges. At the time the contract is created, no money changes hands between buyer and seller, and the contract itself has zero market value. Money required on margin is deposited to assure that the contract will be fulfilled, and any excess is returned upon completion of the contractual obligations. Obligations under a futures contract generally can be extinguished simply by taking an offsetting position with the clearinghouse (for example, a trader can close a long position by taking an offsetting short position with the same underlying asset and delivery date). Indeed, most contracts are settled for cash in this manner. A swap is an agreement to exchange cash flows in the future, based upon interest rates, equity returns, currency exchange rates, or some other economic variable. A simple interest rate swap, for example, may obligate a participant to pay interest at a variable rate and receive interest at a fixed rate, with the amount defined as a percentage of the notional principal specified in the contract. Thus a swap is like a series of forward contracts. Like forward markets, swap markets may be self-regulating and operate without organized exchanges. An option is an enhanced forward contract that does not require the option holder to fulfill the contract it is called an option because the holder may opt out of the agreed action. The option contract specifies the underlying asset, the exercise price, and the expiration date. An option to buy the underlying asset is a call option, and an option to sell the underlying asset is a put option. The holder of a call has the privilege of buying the underlying asset at the specified exercise price, but would desire to do so only if the exercise price were below the market price. Likewise, the holder of a put has the privilege of selling the underlying asset at the exercise Prof. Kensinger page 1

2 price, but would desire to do so only if the exercise price were above the market price. Because of the privilege of opting out of the obligation to buy or sell, an option is more valuable than a forward contract, and has a positive market value throughout its life. After expiration, however, it can no longer be used and has no value. A currency option is an option to exchange one currency for another at a specified exchange rate. A call option written on the U.S. Dollar in London, for example, gives the holder the privilege (but not the obligation) of buying U.S. Dollars in exchange for British Pounds at a specified exchange rate. Likewise, a put option written on the Pound in New York conveys the privilege of selling Pounds in exchange for Dollars at a specified rate. The twist is that this put option written in New York is the same thing as the call option written in London, when both have the same expiration date and any disparity in prices would present a lucrative but shortlived arbitrage opportunity. A swaption is an option to enter into, cancel, or extend a swap. The terms of the swap are established at the time the swaption is written and the holder has the right, but not the obligation, to fulfill the contract at a later date. A call swaption is an option to enter into a swap that, if exercised, involves receiving a fixed rate and paying a floating rate. A 5/2 call swaption, for example, allows the holder to receive fixed and pay variable in a three-year swap that begins two years later. A put swaption, if exercised, involves entering into a swap to receive a floating rate and pay a fixed rate. There are also futures and forward contracts on swaps, which obligate the participants to fulfill the specified contracts. The terms are like swaptions, but these contracts lack the privilege of opting out. Also, there are options on futures and futures on options. An option on a futures contract allows the holder to buy (in the case of a call) or sell (in the case of a put) a specified futures contract within a specified time. A futures contract on an option obligates the buyer to purchase a specified option at a specified time likewise, the seller of the futures contract is obligated to sell the specified option. Prof. Kensinger page 2

3 Swaps Swaps are agreements to exchange cash flows in the future. There are several types of swap, including interest rate swaps, currency swaps, and equity swaps. Two or more of these basic swaps can be combined to create a variety of custom swaps. An interest rate swap is a variation on forward contracting that is structured essentially as a loan in which the party in the swap lends a sum to the underwriter and the underwriter lends the same sum back to the party. This sum never really changes hands at all, and therefore is called the notional principal ( notional in this context means that the principal is imaginary). Only the subsequent cash flows, calculated the same way as interest payments, really occur. The underwriter may offset its risk with futures or options, or by arranging an offsetting swap with a counterparty, as in the illustrations below: Illustration of a floating-/fixed- rate swap: Variable Variable Party Fixed Fixed Counterparty Net: fixed variable Net: variable fixed If net is positive, underwriter pays party, and if net is negative, party pays underwriter. Example: Suppose the notional principal is $1,000,000, with the party paying LIBOR and receiving fixed at 6%, with semi-annual payments. Then suppose LIBOR is 6.5% at the time the first payment is due. The net would be.5% on an annual basis, or.25% with semi-annual payments. The party would pay the underwriter $2500. Prof. Kensinger page 3

4 Illustration of a floating-to-floating swap: Party T-bill LIBOR T-bill LIBOR Counterparty As a custom feature, such swaps may include caps, floors, or collars that place limits on the net payment. For example, the party might negotiate a cap on the T-bill rate paid out, a floor on the LIBOR rate received, or limits on both (which is a collar). The price for the underwriter s services could be expressed through explicit fees, or through premia paid by the party and counterparty over the base variable rate (for example, the party might pay T-bill plus 0.5% and receive LIBOR, with the counterparty paying LIBOR plus 0.5% and receiving T-bill, thus netting the underwriter 1% of the notional principal per year). Currency swaps developed from parallel loans that had become common by the 1960s. For example, suppose a U.S. parent company wants to make a loan to its German subsidiary, while at the same time there is a German parent company about to make a loan to its U.S. subsidiary. They could avoid some of the costs of international transfers by exchanging loan guarantees between the parents, and then letting the U.S. parent lend money to the U.S. subsidiary while the German parent lends to the German subsidiary, as illustrated below: Illustration of a parallel loan: United States U.S. Parent loan guarantees Germany German Parent Principal Debt service Principal Debt service U.S. Subsidiary of German Firm German subsidiary of U.S. Firm The net result for the U.S. Parent is that it lends dollars in the U.S. and receives deutschemarks in Germany through its subsidiary. It then pays debt service in deutschemarks at German interest rates, and receives debt service in dollars at U.S. rates. At the maturity of the loan, it repays the principal in deutschemarks and receives the principal in dollars. Prof. Kensinger page 4

5 In a straight currency swap, two companies borrow in their own countries and agree to pay each others debt obligations. For example, suppose a U.S. company needs to borrow German Marks, and a German company needs to borrow U.S. Dollars. Illustration of a straight currency swap: For purposes of illustration, suppose the current exchange rate is 1 = $1.50, principal is $1,500,000; and instead of borrowing in foreign markets each company takes a domestic loan while arranging a currency swap: 1. Initial exchange of principal is notional, because net is zero. Amounts reflect prevailing spot exchange rate. 2. Periodic payments are handled as net amounts, based on current exchange rates. 3. Final exchange of principal will be done at an exchange rate agreed to in the swap arrangement. The actual payments are the net amounts, based upon the current exchange rate at the time of payment. For example, if the dollar weakened and the exchange rate were $1 = 1.45, the U.S. company would pay 50,000, and the German company would receive 50,000. Currency/interest rate swaps can be created by combining straight currency swaps with interest rate swaps. Prof. Kensinger page 5

6 In an equity return swap, the party pays a fixed or variable interest rate, and receives the rate of return on a chosen equity index. Available indices include the S&P 500, S&P 100, MMI, plus various Japanese, European, and Latin American stock market indices. Custom indices and individual stocks are also available. Illustration of an equity return swap: Equity Index Return* Libor ± Spread *Equity index return includes dividends, paid out quarterly or reinvested In an equity asset allocation swap, the party trades the returns on one equity index for the returns on another equity index. Available indices include the S&P 500, S&P 100, MMI, plus various Japanese, European, and Latin American stock market indices. Custom indices and individual stocks are also available. Illustration of an equity asset allocation swap: Foreign equity index Return* A Foreign equity index Return* B *Includes dividends, paid out quarterly or reinvested Prof. Kensinger page 6

7 In an equity call swap, the party pays a fixed or variable interest rate periodically through the life of the swap, and receives the rate of appreciation on a chosen equity index at maturity of the swap. If the index drops, the investor receives nothing, but pays only the interest component of the swap. If the index rises, the maturity payment is based on the percentage increase in the index from the start of the swap until the maturity (for example, if the index increased from 100 to 110, the maturity payment to the investor would be 10% of the notional principal). Available indices include the S&P 500, S&P 100, MMI, plus various Japanese, European, and Latin American stock market indices. Custom indices and individual stocks are also available. Illustration of an equity call swap: Equity Index Price Appreciation* Libor ± Spread * No depreciation settlement at maturity In an equity asset swap, the party receives the rate of return on a chosen equity index, while paying the returns generated by a specified pool of assets (such as a bond portfolio or commercial real estate). Available indices include the S&P 500, S&P 100, MMI, plus various Japanese, European, and Latin American stock market indices. Custom indices and individual stocks are also available. Illustration of an equity asset swap: Asset Coupon Equity Index Return* Coupon *Includes dividends, paid quarterly or reinvested Prof. Kensinger page 7