Topic 5 - Managing w Derivatives

Question 1

derivative

Answer 1

A derivativeis a financial instrument whose value is derivedfrom the value of some other underlying asset, rate or index

Derivatives are used for risk management

Question 2

Risk management encompasses two different types of activities:

Answer 2

Those with an exposure to risk can use derivatives to reduce risk –this is referred to as hedging 
Others can use derivatives to voluntarily take on risk in the expectation of increased return –this is refer to as speculating

Question 3

There are four basic types of derivatives –

Answer 3

forward contracts, futures contracts, options and swaps

Question 4

Banks use derivatives in a number of ways

Answer 4

To hedge an existing exposure to risk 
To profit through speculation and arbitrage 
To act as market makers by offering to enter into various derivative contracts (e.g. forward rate agreements and swaps) with their client

Question 5

forward contract

Answer 5

A forward contract is similar to any contract to buy and sell an asset, except that the date on which the asset changes hands, and the price of the asset, are set in advance when the contract is agreed to

Question 6

Forward contracts Effect on risk

Answer 6

A forward contract locks in a price that is immune from market fluctuations, eliminating price risk
A party to a forward contract eliminates the possibility of downside risk (the risk that prices will move in an unfavourable direction) but also eliminates upside risk (the risk that prices will move in a favourable direction)

Question 7

ADVANTAGES OF FORWARD CONTRACTS

Answer 7

Forward contracts are very flexible –they can be tailored to meet the needs of the parties to the contract

There is no cash outlay until the goods are exchanged on the settlement date

Both parties to the contract can effectively eliminate risk without any cost if their exposures are perfectly matched

Question 8

DISADVANTAGES OF FORWARD CONTRACTS

Answer 8

Ideally, a party to a forward contract needs to find a counterparty with a matching, but opposite, exposure, and this may not be easy
It is difficult to unwind a forward contract if circumstances change
Both parties are exposed to default risk, because one of them will have an incentive not to comply with the contract because of changes in the price of the underlying asset

Question 9

FORWARD RATE AGREEMENTS

Answer 9

Forward Rate Agreements are used to “lock in” an interest rate that will be paid or received in the future
Anyone planning to borrow or lend in the future knows the current rate and the expected future interest rate, but does not know the actual interest rate they will pay or receive
Hence, they are exposed to interest-rate risk

f one party is exposed to rising interest rates (i.e. a future borrower) and another is exposed to falling rates (i.e. a future lender) they can eliminate interest-rate risk by agreeing on the rate that they want to be exposed to in the future

The party that is hedging against an increase in interest rates is referred to as the buyer of the FRA, and the party hedging against a fall in rates is the seller of the FRA

The FRA is separate from the actual lending or borrowing

The parties to the FRA may be lending to and borrowing from each other, but not necessarily – if they do, this is a completely separate arrangement

Question 10

Example
Three months from now you will need to borrow $1,000,000 for 6 months –this is called a 3 x 9 FRA The current 6-month bank bill swap rate is 4.5% You expect the interest rate to be 4.8% in 3 months

1. Do you buy or sell an FRA to lock in this interest rate? 2.How much compensation will be paid if the interest rate in 3 months is 5.0%?
2. When does settlement take place?
3. Do you pay or receive this amount?

Answer 10

1.Do you buy or sell an FRA to lock in this interest rate? An intending borrower, protecting against an increase in interest rates, is said to be the buyerof an FRA.

2.How much compensation will be paid if the interest rate in 3 months is 5.0%
$975.61

3.When does settlement take place?
At the beginning of the intended borrowing period – three months from now.

4.Do you pay or receive this amount?
Interest rates have risen; hence you are compensated.

Question 11

DEFINITION OF FUTURES CONTRACTS

Answer 11

A futures contract is a forward contract that is standardised with respect to: 
the underlying asset, 
the size of the contract, and 
the settlement date,

and is traded on an exchange such as ASX 24 (formerly the Sydney Futures Exchange)

Futures can be used to hedge an exposure or speculate on the basis of expectations about future prices

Question 12

Hedgers and speculators buy or sell futures contracts on a futures exchange

Answer 12

Buying a future contract is a short-hand term that means entering into a contract to buy the underlying asset on the settlement date 

Buying a futures contract is also referred to as going longor taking on a long position in the contract 

Selling a future contract means entering into a contract to sell the underlying asset, and selling a futures contract is also referred to as going short or taking on a short positionin the contract

Question 13

HEDGING WITH FUTURES CONTRACTS

Answer 13

A hedger who is exposed to a fall in the price of a commodity in the physical market (e.g. a sheep farmer) might take on a futures position that will give him a matching profit in the futures market if wool prices do fall
This will involve selling futures, because futures prices are linked to the underlying asset price
If the price of wool (and hence the price of wool futures) falls, he can buy back the sold contracts at a lower price, making a futures profit

A hedger exposed to an increase in the price of a commodity in the physical market (e.g. a wool buyer) might take on a futures position that will give him a matching profit in the futures market if wool prices do rise
This will involve buying futures contracts
If the price of wool (and hence the price of wool futures) rises, he can sell the bought contracts at a higher price, making a futures profit to offset the loss in the physical market

Question 14

SPECULATING WITH FUTURES CONTRACTS

Answer 14

A speculator is someone who doesn’thave an existing exposure, but who thinks the price of an asset will increase or decrease and wants to profit from this expectation
He will buy or sell futures contracts, respectively
If the price of the asset (and hence the price of the futures contract) moves as expected, the speculator can sell or buy, respectively, the same number of contracts at a higher or lower price, respectively,and make a profit

Question 15

MARGIN REQUIREMENTS AND SETTLEMENT with Futures

Answer 15

The buyer or seller of a futures contract must place a sum of money, called an initial margin, into a margin account
The value of the futures position is marked to market every day, and the increase or decrease in the position is added to or subtracted from the account
If the account drops to half its initial value, it must be “topped up” to the initial value by the next trading day

Question 16

ADVANTAGES OF FUTURES CONTRACTS

Answer 16

Standardisation of contracts allows a liquid secondary market to develop
It is easy to establish
There is no exposure to default risk

Question 17

DISADVANTAGES OF FUTURES CONTRACTS

Answer 17

Because of standardisation, it is difficult to perfectly hedge an existing exposure –you may be faced with residual risk in terms of: 
the precise commodity, 
the size of the contract, or 
the maturity date

Also, there is an initial cash outlay, and possible ongoing cash outlays, in order to meet margin requirements

Question 18

DEFINITION OF OPTIONS

Answer 18

An optionis a contract that gives the buyer of the option the right, but not the obligation, to buy or sell a commodity at a set price on or before a particular date

Question 19

Option holder

Answer 19

The holder of an option is the person who has paid a premium to buy the option and has the choice as to whether or not it will be exercise

Question 20

Option writer

Answer 20

The writer is the person who creates the option However often an option is bought and sold, the writer remains responsible for complying with the contract if the holder decides to exercise it

Question 21

Buyers and sellers

Answer 21

Because an option is a security(it can be bought and sold in a secondary market during its life) there can be many buyers and sellers
The writer is the first person to sell the option
The holder is the last person to buy the option
Many others can fulfil the role of both buyer and seller over the life of the option

Question 22

Call and put options

Answer 22

A call option gives the holder the right to buy the underlying asset
A put option gives the holder the right to sell the underlying assets

Question 23

Exercise price

Answer 23

The exercise price (or strike price) is the predetermined price at which the underlying asset can be bought or sold (as the case may be)

Question 24

Maturity date

Answer 24

The maturity date is the date by which, or on which, the option must be exercised –after that date it is worthless

Question 25

Premium

Answer 25

The premium is the price paid by the buyer to the seller of the option, and is determined by the price and volatility of the underlying asset, the strike price, time to maturity and interest rates

Question 26

European and American options

Answer 26

A European option can only be exercised on the maturity date An American option can be exercised any time up to the maturity date

Question 27

in-the-money

Answer 27

An option is said to be in-the-moneyif the relationship between the asset price and the strike price is such that, if the option was exercised now, it would result in a profit

Question 28

out-of-the-money

Answer 28

It is said to be out-of-the-money if exercising it now would result in a loss

Question 29

at-the-money

Answer 29

It is at-the-money if the strike price and the asset price are equal

Question 30

over-the-counter(OTC)

Answer 30

An over-the-counter(OTC) option is negotiated directly between the option buyer and the option writer

Question 31

Exchange traded options (ETOs

Answer 31

Exchange traded options (ETOs) are traded on an organised exchange such as ASX 24

Question 32

cap

Answer 32

A capis an option that gives the option holder (a variable rate borrower) a payoff equal to the difference between the prevailing interest rate and an agreed maximum (the level of the cap)

Question 33

floor

Answer 33

A floor is an option that gives the option holder (a variable rate lender) a payoff equal to the difference between the prevailing interest rate and an agreed minimum (the level of the floor)

Question 34

collar

Answer 34

A collar is a combination of a cap and a floor A long collar means buying a cap and selling a floor  This gives a borrower protection against high rates but reduces the overall cost –the premium received from selling the floor offsets the cost of the cap  The borrower is protected from high rates but gives up the benefit of extremely low interest rates A short collar means buying a floor and selling a cap This gives a lender protection against low rates but reduces the overall cost –the premium received from selling the cap offsets the cost of the floor  The lender is protected from low rates but gives up the benefit of extremely high interest rates

Question 35

swap

Answer 35

A swapis an agreement to exchange one or more cash flows on a set date or dates in the future

Question 36

The purchasing agent for a large natural gas powered electrical generating plant expects natural gas prices to fall soon. Unfortunately, she must sign a contract with the gas  distributor this week at what she considers a high price for gas. Describe how she might use a forward contract to hedge the plant’s cost of fuel. 

Answer 36

The  purchasing  agent  should  short  a  forward  contract  to  deliver  gas  at  the  current forward price in the future. If the price falls by more than current market expectations, as  the purchasing agent believes it will, the plant will be able to deliver the higher‐priced fuel  and enter into the market to purchase the fuel, at the new lower market price. 

Question 37

Claudio will receive payment of $5,000,000 in May from his rich uncle’s estate. He plans to  invest the funds he receives in long‐term bonds but he is worried that bond interest rates  will decline between now (January) and 15 May. How can Claudio hedge this situation  using the futures market? Be specific about the position (long or short) and the contract he  should use. 

Answer 37

Claudio should buy $5 million face value (50 contracts) of 10‐year Treasury bond futures  on the SFE. If interest rates fall, Claudio will have to buy 10‐year bonds at a higher price on 15 May. To offset this price increase, Claudio will liquidate his futures position and use  the gain from the hedge to purchase the same volume of treasury bonds that he could  have purchased with $5 million in January, provided there is no basis risk. Otherwise the  hedge might not work quite perfectly. If interest rates rise, Claudio will experience a loss  on the futures position, but will be able to buy the bonds in the market place at a lower  price. 

Question 38

 In late March, a corporate treasurer projects the need for a $1 million bank loan starting  on 11 June. The bank advises that the rate will be 1% over the 3‐month BBSW on that  date. The BBSW is currently 5.625%. The treasurer decides that he will use the June BAB futures to lock in the forward borrowing rate. The futures are trading at 94.35, implying a  yield of 5.625% (100.00 – 94.35). What transaction should the treasurer make to lock in a  borrowing rate for the 3 month period beginning 11 June? What borrowing rate will he  achieve? 

Answer 38

The treasurer should sell June BAB futures for delivery on 11 June. He shorts (sells) BAB futures at a yield of 5.625%. He can then either issue bank bills under the terms of the  futures contract, or close out his futures contract for cash settlement. Either way he  achieves a borrowing rate of 5.625% under the futures contract. 

Question 39

Why does increasing the underlying asset price increase the value of the call option? 

Answer 39

An increase in the underlying asset price increases the chance that the call option would be in the money, and the payoff on the option, therefore increasing the value  of the call option

Question 40

Why does increasing the underlying asset price decrease the value of the put option? 

Answer 40

An increase in the underlying asset price reduces the chance that the put option will finish in the money, and also decreases the payoff if it did finish in the money,  therefore decreasing the value of the put option. 

Question 41

Why does increasing the strike price decrease the value of the call option? 

Answer 41

An increase in strike price decreases the chance that the call option would be in the money, and the payoff on the option, therefore decreasing the value of the call  option. 

Question 42

Why does increasing the volatility increase the value of the put option? 

Answer 42

An increase in volatility generally increases the chance that the call option would be in the money1, and increases the chance of high terminal asset prices, therefore  increasing the value of the call option. 

Question 43

Using options on bank bill futures traded on ASX24 describe two option positions that you  could take that would have a positive payoff in the event that interest rates rise. 

Answer 43

You could sell a call option on the bank bill futures. When interest rates rise, bank bill  futures prices will fall and the option will expire out‐of‐the‐money. You will earn the  premium. You could buy a put option on bank bill futures. In the event that interest rates  rise, bank bill futures prices will fall and your put option will expire in‐the‐money with a  positive payoff.  

Question 44

Discuss the pros and cons of using options versus using futures contracts for a financial  institution aiming to set the duration gap to zero

Answer 44

Setting the duration gap to zero can be achieved through trading in futures as we saw in  chapter 13. Another method would be to purchase options. For example if the duration  gap is positive then the institution is exposed to a rise in interest rates – it will suffer a loss  in market value when interest rates rise. So an option position that will cause the duration  of assets to decrease or increase the duration of liabilities is needed. If the duration is  positive then the value of the asset increases with increasing interest rates. This is true for a short call on an interest rate futures, or a long put on an interest rate futures. Either  position would have the desired effect in terms of closing the duration gap. However,  options may not be preferred to futures to achieve this, because the bank will have to pay  the premium in the case of the long put. The textbook did not discuss the duration of the  option position, but it is related to the delta of the option.

Question 45

In this topic we have covered futures and forwards, options and swaps. Compare and  contrast these instruments with respect to:    (a) marking to market of cash flows  (b) ability to hedge against interest rate risk for the financial institution  (c) credit risk exposure for the financial institution in their market‐making function

Answer 45

(a)   Futures are marked to market each day by the clearing house. Forwards, options  and swaps are over‐the‐counter instruments, and while the bank will mark them to  market  (as  the  market  maker)  they  will  not  be  marked  to  market  for  the  counterparty. This creates more counterparty risk for the bank.     (b)   All three instruments can be used to hedge against interest rate risk. Banks tend to  use swaps, futures and forwards to micro‐ and macro‐hedge. Banks tend to be net  sellers of options, and while the counterparty is often a company using the interest  rate option to hedge its interest rate exposure, banks tend to hedge the risk they create in selling options with either futures, forwards or swaps (by delta hedging). One of the reasons that options are not used is that the bank must pay a premium for the option, and that may negate profit that they make from selling options in the  first place. Because swaps are longer term instruments they are used to macrohedge the balance sheet, particularly if the duration gap is large.    (c)   Credit risk exposure is created with the market‐making function in OTC forwards,  options  and  swaps.  Longer  term  swaps  are  the  most  sensitive  to  interest  rate  movements  (for  the  same  notional  principal).  Hence  counterparty  risk  may  be  greatest for swaps. Banks have counterparty limits to limit this credit exposure. 

Question 46

A bank simultaneously enters a two‐year swap as the fixed ratepayer at 8.00% p.a. and  another  two‐year  swap  as  the  fixed  rate  receiver  at  8.15%  p.a.,  each  with  notional principal of $10 million. How much profit will it make (approximately)? 

Answer 46

The answer is the interest differential on the notional principal over the two years, given  by 0.0015  x 10 million x 2 = $30,000.