DERIVATIVES Presented by Sade Odunaiya Partner, Risk Management Alliance Consulting

DERIVATIVES Introduction Forward Rate Agreements FRA Swaps Futures Options Summary

INTRODUCTION Financial Market Participants Based on Time Horizon Borrower/Issuer Lender/Investor Trader short-term term horizon for gain Investor long-term for cash flow characteristics Based on Motivation Investor for income stream Speculator holds for expected gain Arbitrageur simultaneous sale & purchase for gain Hedger to protect against existing risks Brokers act on behalf of a principal or on own account

INTRODUCTION Financial Market Instruments Investment instrument traded spot or forward with exchange of principal Contract for Difference derived from the attributes of investment instruments but traded on a notional principal. Payments are for differences computed on the notional principal amount

INTRODUCTION Derivatives Security that derives its value from another asset or security Financial derivative A financial instrument whose payoff depends on another financial instrument or security Legally binding promise to perform some action in the future Types FRA Swaps Futures Options

Forward Rate Agreement - FRA Derived from Forward Contracts Initiated at one time; performance in accordance with agreed terms occurs at a subsequent time Price is set @ time of contract with actual payment or delivery later Examples are fwd foreign exchange contracts, fwd interest rate agreement, etc FRAs settle in differences based on notional principal & tenor

SWAPS Agreement between two parties to exchange sequences of cash flows over a period in the future Anything can be swapped once there is mutual agreement custom nature 2 basic financial instrument types: Interest rate Currency swaps

FUTURES Futures Contract Standardized forward contract Quantity, delivery date, delivery mechanism Method of closing Minimum & Maximum price fluctuation Exchange traded and regulated Backed by a clearing house Requires a Margin good faith deposit Daily settlement of gains and losses

OPTIONS Options A contract whereby one party has a right and the other party has an obligation For a specified period after which it lapses American & European variants Premium or price is paid ab initio Two broad categories Call gives a right to buy & an obligation to sell Put gives a right to sell & an obligation to buy Standardized and Traded on an exchange Clearing house system Requires posting of margins

DERIVATIVES Custom made contracts FRA Swaps Standardized or Exchange traded Futures Options

APPLICATION DERIVATIVES Market Completeness A market in which any and all identifiable payoffs can be obtained by trading securities available in the market Speculation for knowledgeable traders to take calculated risks Risk Management a powerful tool for limiting risk Trading efficiency Use of derivatives rather than the underlying securities for the same return at a much lower cost

FORWARD RATE AGREEMENT (FRA) Types: on interest or exchange rate On Interest rate Fwd contract to borrow/lend money at a certain rate at some future date for an agreed tenor No cash flow of principal at start & settlement Long position party that will borrow Contract price agreed interest rate LIBOR or EURIBOR Settlement date is Contract date Long pays short, if contract rate > actual rate on settlement date Short pays long, otherwise Default risk on the difference to be paid/received

FORWARD RATE AGREEMENT (FRA) Settlement Amount is the discounted value of interest differential at actual price for the tenor of the agreement Notional (floating fwd)(days/360) Principal 1 + (floating)(days/360) where: days = no of days in loan term

FORWARD RATE AGREEMENT Illustration (FRA) Consider an FRA that expires/settles in 30 days on a notional principal of $1mm. Forward rate is 5% on a 90-day LIBOR Assume actual LIBOR 30-days from now (at expiration) is 6% Compute the cash settlement @ expiration and identify who will be making payment

SWAPS Agreement to exchange a series of cash flows on periodic settlement dates over an agreed period of time Series of FRAs Custom made i.e. any mutually agreed cash flows can be swapped No payment by either party @ initiation No secondary market Largely unregulated Default risk is an important aspect Participants are largely institutions Zero sum game

SWAPS Common Types Interest rate Currency

Interest rate swap SWAPS - TYPES Notional principal in same currency for same amount Trading fixed interest rate for floating interest rate or plain vanilla interest rate swap Pay-fixed side: Party that wants floating-rate interest payment agrees to pay fixed-rate interest Pay-floating side: Party that agrees to pay floating side Floating rate is LIBOR based Cash payment @ end of period & is based on net position Net fixed = swap fixed LIBOR t-1) no of dys (notional Rate paymt rate 360 principal) Note: +ve fixed rate payer owes floating rate payer -ve - fixed rate payer is owed by floating rate payer

SWAPS - TYPES Currency Swap One party makes payment denominated in one currency, while the other makes payment in another currency Notional Principal Exchanged @ start using the exchange rate @ start Returned at maturity in the same amount Each party services the debt at the rate applicable to the currency received periodically Full interest payments are exchanged without netting

SWAPS - TYPES Currency Swap Illustration A US firm, Party A, wished to set up an Japanese operations and wants to finance the costs in Japanese Y. the firm finds that issuing Yen denominated debt is relatively more expensive as they are unknown in the Japanese market Solution: Issue US$ debt & swap the cash flows for Japanese Yen

SWAPS - TYPES 4 types of currency swaps US$ fixed int rate for Jap Y fixed US$ fixed int rate for Jap Y floating US$ floating int rate for Jap fixed US$ floating int rate for Jap floating

FUTURES Comparison with FRA Similarities Either deliverable or cash settlement Priced to have zero value at time of contract Differences Organized exchange Regulation Standardized Single clearinghouse

Standardized FUTURES Quantity Delivery date Delivery mechanism Method of closing Minimum & maximum price fluctuation Exchange traded and regulated Backed by a clearing house Requires a Margin good faith deposit Daily settlement of gains and losses Characteristics Purchaser has contracted to buy i.e. long Seller is short as he s contracted to sell

FUTURES - TYPES T-BILL FUTURES $1 million 90-day Quoted as 100 discount yield (annualized) Settlement - in cash 1 basis point price change is $25 Not as important as before Heavily influenced by US Federal Reserve Board & monetary policies

FUTURES - TYPES EURODOLLAR FUTURES Similar to T-bill futures $1million 90-day LIBOR Price = 100 Annualized LIBOR % Settle in cash Minimum price movement 1 tick is $25 TREASURY BOND FUTURES Treasury bonds with 15 yrs+ maturity Face value of $100,000 Deliverable contract Quoted as a % + fractions of 1% (1/32 nd ) of FV

FUTURES - TYPEs STOCK INDEX FUTURES Most popular stock index future-s&p500 Settlement is in cash & based on a multiplier of 250 Each contract is 250 times the level of index Gain or loss of $250/ contract

FUTURES - TERMINATION Delivery as per location on contract Less than 1% Cash settlement Marked to market on delivery date Offsetting or reverse trade Exchange for physicals Off the floor of the exchange

OPTIONS An options contract gives the owner a right but no legal obligation to conduct a transaction involving an underlying asset at a predetermined price (exercise price) on a predetermined future date (exercise date) Right will only be exercised if it is profitable to o do so The writer (option writer) of an option is the seller Buyers pays a option premium to the seller

OPTIONS 4 possible positions Long call: the buyer of a call option Short call: the seller of a call option Long put: the buyer of a put option Short put: the seller of a put option Two variants American exercisable at any time up to & including the exercise date European exercised only on the exercise date American option more valuable than European one Same value on exercise date

OPTIONS Moneyness In-the-money when the option has value i.e. +ve payoff For call option: spot price > exercise price out-of-the-money when the option will make a loss i.e. ve payoff For call option: spot price < exercise price at-the-money when neither loss or gain For call & put options: strike price = exercise price An options intrinsic value is the amount by which the option is in-the-money Call v Put v = Max(0, S-X) = Max (0, X-S)

OPTIONS Illustration: Consider a July 40 call and a July 40 put, both on a stock that is currently selling for $37/share. Calculate how much these options are in- or out-of- the-money.

OPTIONS Option Pricing is a function of the following: Nature call or put Strike price relationship to spot price Time to maturity Volatility of price of underlying asset

SUMMARY Derivative instruments are a very fast growing sector of the financial market They ensure market completeness and elimination of free income in the financial market Risk Managers use the market to manage the risks in their portfolio at minimal costs Derivative instruments are here to stay!!

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