Derivatives and RM.ppt

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Derivatives & Risk Management

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Introduction

Like options, forward and futures contractsare derivative securities. Derivative security is a financial security that is a

claim on another security or underlying asset.

Derivatives can be used to speculate on pricechanges in attempts to gain profit or they canbe used to hedge against price changes inattempts to reduce risk. In both cases, wewill compare strategies using options versususing futures.





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Example of using a forward orfutures contract

COP Ltd., a canola-oil producer, goes longin a contract with a price specified as $395per metric tonne for 20 metric tonnes to be

delivered in September. The long position means COP has a contract

to buy the canola. The payment of$395/tonne ● 20 tonnes will be made in

September when the canola is delivered.



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Futures and Forwards

Unlike option contracts, futures andforwards commit both parties to thecontract to take a specified action

The party who has a short position in thefutures or forward contract hascommitted to sell the good at thespecified price in the future.

Having a long position means you arecommitted to buy the good at thespecified price in the future.



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Futures and Forwards

No money changes hands betweenthe long and short parties at theinitial time the contracts are made

Only at the maturity of the forward orfutures contract will the long party paymoney to the short party and the short

party will provide the good to the longparty.



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The initial margin requirement

Both the long and the short partiesmust deposit money in theirbrokerage accounts.

Typically 10% of the total value of thecontract

Not a down payment, but instead a

security deposit to ensure the contractwill be honored



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Initial Margin Requirement – Example

Manohar has just taken a long position in afutures contract for 100 ounces of gold tobe delivered in January. Magda has just

taken a short position in the same contract.The futures price is $380 per ounce.

The initial margin requirement is 10%



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Marking to market

At the end of each trading day, all futurescontracts are rewritten to the new closingfutures price. I.e., the price on the contract is changed.

Included in this process, cash is added orsubtracted from the parties’ brokerageaccounts so as to offset the change in thefutures price. The combination of the rewritten contract and

the cash addition or subtraction makes theinvestor indifferent to the marking to marketand allows for standardized contracts fordelivery at the same time to trade at the sameprice.



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Hedging with Futures

For some business or personal reason, youeither need to purchase or sell theunderlying asset in the future.

Go long or short in the futures contract andyou effectively lock in the purchase or saleprice today. The net of the marking tomarket and the changes in futures prices

results in you paying or receiving theoriginal futures price

I.e., you have eliminated price risk.



Types of Hedging

Long Hedge

Short Hedge

Cross Hedge

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Speculating with Futures

Speculating involves going long (orshort) in a futures contract when theunderlying asset is NOT needed to be

purchased (or sold) in the future timeperiod. Enter into the contract, profit or lose due

to futures price changes and marking to

market, do an offsetting position to getout of the contract and take the moneyfrom the brokerage account.



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Should hedging or speculating bedone?

Speculating: If the market is informationally efficient,then the NPV from speculating should be 0.

Hedging: Remember, expected return is related torisk. If risk is hedged away, then expected return will

drop. Investors won’t pay extra for a hedged firm just

because some risk is eliminated (investors can easilydiversify risk on their own).

However, if the corporate hedging reduces costs thatinvestors cannot reduce through personaldiversification, then hedging may add value for theshareholders. E.g., if the expected costs of financialdistress are reduced due to hedging, there should bemore corporate value left for shareholders.



What is an option?

The option is a right to buy 100 shares, or tosell 100 shares.

Every option has four specific features:

1. It relates to a specific stock or othersecurity, called the “underlying” security.”

2. It is a right to buy (call) or sell (put), andevery option controls 100 shares of stock.

3. A specific “strike” price is the fixed priceat which the option can be exercised.

4. Every option has a fixed expiration date.After that date, the option is worthless.

Option – an

intangible rightbought or soldby a trader tocontrol 100shares of a

security; itexpires on aspecific date inthe future.



Type of option

There are two types of options, callsand puts.

A call grants its owner the right, but not the obligation, to

buy 100 shares of stock.

This right relates to a specific underlying security, at afixed strike price, and expires on a specified date inthe future.

Options can be bought (a long position) or sold (a shortposition). When you sell an option, you grant theoption right to the person on the other side of thetrade.





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Option Premium

Option Premium primarily consists of twocomponents- Intrinsic Value and Time Value.

Option price/ premium= Intrinsic value + Time value

The intrinsic value of an option is equal to the amount

by which the option is in-the-money i.e. the amountan option buyer will realize make (the option sellerwill loose), before adjusting the premium, if heexercises the option instantly

Only in-the-money options have intrinsic value and all

out-of-the-money or at-the-money options have zerointrinsic value

Intrinsic value of an option can never be negative



Option Premium- Extrinsic Value

The time value of an option is the component whichtakes care of future risk for seller of an option.

This value depends on time to expiration of the optionand volatility in the prices of the underlying asset

Mathematically, time value of an option is equal todifference between option premium and its intrinsicvalue

In case of out-of-the-money option or at-the-moneyoption, the entire premium is the time value of an option

Time value of an option cannot be negative

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What are the three steps of corporaterisk management?

1. Identify the risks faced by the firm.

2. Measure the potential impact of the identifiedrisks.

3. Decide how each relevant risk should be handled.

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What can companies do to minimizeor reduce risk exposure?

Transfer risk to an insurance company by payingperiodic premiums.

Transfer functions that produce risk to third parties. Purchase derivative contracts to reduce input and

financial risks. Take actions to reduce the probability of occurrence

of adverse events and the magnitude associated

with such adverse events.

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SWAP

SWAP is a derivative instrument in which counterparties exchange cash

flows of one party's financial instrument for those of the other party's

financial instrument.

Exchange of one security for another to change the maturity (bonds),

quality of issues (stocks or bonds), or because investment objectives havechanged.

If firms in separate countries have comparative advantages on interest

rates, then a swap could benefit both firms. For example, one firm may

have a lower fixed interest rate, while another has access to a lower

floating interest rate. These firms could swap to take advantage of thelower rates.





What is Currency SWAP

A swap that involves the exchange of principal andinterest in one currency for the same in anothercurrency.

For example, suppose a U.S.-based company needs to

acquire Swiss francs and a Swiss-based company needsto acquire U.S. dollars. These two companies couldarrange to swap currencies by establishing an interestrate, an agreed upon amount and a common maturitydate for the exchange.



FEATURES

Currency swaps are over-the-counter derivatives

and are closely related to interest rate swaps.

Unlike interest rate swaps, currency swaps can

involve the exchange of the principal.



USES

To secure cheaper debt (by borrowing at thebest available rate regardless of currency andthen swapping for debt in desired currencyusing a back-to-back-loan)

To hedge against (reduce exposure to)exchange rate fluctuations

Convert liability/investment from one currencyto another



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For example, a firm with fixed-rate debt thatexpects interest rates to fall can changefixed-rate debt to floating-rate debt.

In this case, the firm would enter into a payfloating/receive fixed interest rate swap.

Interest Rate Swaps



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Bank A is a AAA-rated international bank located in the U.K.that wishes to raise $10,000,000 to finance floating-rateEurodollar loans.

Bank A is considering issuing 5-year fixed-rate Eurodollarbonds at 10 percent.

It would make more sense for the bank to issue floating-rate notes at LIBOR to finance the floating-rate

Eurodollar loans.

Example



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Company B is a BBB-rated U.S. company. It needs$10,000,000 to finance an investment with a five-yeareconomic life, and it would prefer to borrow at a fixed rate.

Firm B is considering issuing 5-year fixed-rate Eurodollarbonds at 11.75 percent.

Alternatively, Firm B can raise the money by issuing 5-year floating rate notes at LIBOR + ½ percent.

Firm B would prefer to borrow at a fixed rate.

Example



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The borrowing opportunities of the two firms are shown in thefollowing table.

COMPANY B BANK A DI FFERENTIAL

F ixed rate 11.75% 10% 1.75%

F loating rate LIBOR + 0.50% LIBOR 0.50%

Example



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Derivatives and RM.ppt

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