Objectives. Hedging. Definition of Derivative. Definition of Derivative. Fundamental Building Blocks of Derivatives

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Dorothy Parks
3 years ago
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1 Objectives At the end of this session, students should: Have an enhanced awareness of why companies hedge. Be able to define derivative as well as understand the four common types of derivatives and their uses as hedging instruments. Hedging Definition of Derivative Examples of Risk Exposures in the Cash Market risk in commodities Interest t t rate risk in investments/borrowings t i Foreign exchange rate risk in cross border investments/borrowings or other anticipated transactions How can these risk exposures be addressed? A financial instrument or other contract with all of the following characteristics: (1) It has one or more underlying, and one or more notional amounts or payment provisions, or both (2) It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors (3) Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. Definition of Derivative Fundamental Building Blocks of Derivatives Derivative Underlying Notional Amount Stock option Stock price Number of shares Currency forward Exchange rate Number of currency units Commodity future Commodity yprice Number of commodity units Interest rate swap Interest index Dollar amount Forwards Physical/Financial Futures Swaps Options Calls Puts 1

2 Common Terminology Forward Contracts Long position A long position makes money if prices increase and conversely, loses money if prices decrease Short position A short position makes money if prices decrease and conversely, loses money if prices increase A contract that obligates one counterparty to buy, and the other to sell, a specific underlying and notional amount at a specific date in the future. A forward market exists for a multitude of underlyings, including agricultural and physical commodities, currencies and interest rates. Buyer Seller Settlement, Maturity or Expiration Contract Size Forward Contract (Invoice Amount) Value of a Purchased Forward Contract - Long Position Value of a Sold Forward Contract - Short Position s s es Contract Contract es s Decline s Rise s Decline s Rise Forward Contract - Characteristics Forward Contract - Closing Out a Forward Contract Terms and conditions are negotiated Illiquid market Credit risk Unregulated market (not exchange-traded) Entering into an offsetting transaction Making (taking) physical delivery Cash settlement 2

3 Futures Contract - Standardized Forward Contract Futures Contract - Standardized Terms All provisions in the contract are standardized except for the price Lower credit risk Liquid market Regulated market (exchange-traded) Examples: Wheat Sugar Gold Corn Lt sweet crude Yen Oats Heating oil NYSE index Soybeans Unleaded gas Electricity Lumber Natural gas Propane The standard terms of a futures contract typically include: A description of the underlying asset Quantity and quality of the underlying asset. Time and place of delivery Method of payment Swap Contract - Characteristics Swap Contract Contractual agreement between two parties Exchange of cash flows Payments based upon price fluctuations in an underlying Notional principal amount - hypothetical principal amount upon which cash flows are calculated Typically, one of the cash flow streams is fixed and the other is referenced to an index that varies over time. Interim payments are generally netted, with the difference being paid by one party to the other. Swap Contract - Fixed Payor Swap Contract A swap contract is essentially a series of forward contracts Swaps have several advantages including: 1) Flexibility. 2) Low transaction costs. Long Position

4 Swap Contract Example Summary Swap Term Sheet Swaps have several disadvantages including: 1) Locate appropriate counterparty 2) Illiquidity 3) Credit risk Floating Payor: Investment Bank Fixed Payor: XYZ Company Basis (underlying): 3 - month LIBOR Notional Amount: $2 million Term: October 29 through September 211 Fixed Rate: 7.% Option Contracts Option Attributes Call option Option to buy Put option Option to sell Buyer Holder has the right to exercise the option; Buyer pays premium to acquire right Seller Writer is obligated to perform at the buyer s discretion; Writer is paid up front a fixed sum (premium) to incur obligation Insurance Buyer (holder) pays a premium for the right to be compensated in the event of a specified occurrence Seller (writer) receives the premium and is obligated to compensate the policy holder in the event of a specified occurrence Asset to Holder Contingent Liability to Writer Option Contracts - Characteristics Option Valuation Multiple underlyings Bonds, equities, currencies and commodities OTC/Exchange Traded Credit risk Liquidity Intrinsic value Time premium Duration of the option Implied volatility Interest trates Asset yield 4

5 Buy a Call - Right to Buy Buying a Put - Right to Sell s s Cost of Cost of Breakeven Breakeven Begin Winning Begin Winning Falls Rises Falls Rises Sell Call Sell Put Begin Losing Begin Losing Received Breakeven Break Even Received es es Falls Rises Falls Rises Call Options Put Options Call Option Profit Strike Bought Profit Put Option Break-Even Point Bought Income Break-Even s ASSET PRICE Received Paid ASSET PRICE Put Option Sold Strike Call Option Sold 5

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DERIVATIVE ADDITIONAL INFORMATION

DERIVATIVE ADDITIONAL INFORMATION I. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES A. Definitions and Concepts 1. Derivative Instrument A "derivative instrument" is a financial instrument that "derives"