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1

define a derivative

A derivative is a financial security that derives its value from an underlying asset.

The holder of a derivative product has the right to buy (or sell) the underlying asset at a certain point in the future at a price that is agreed upon today.

The returns from a derivative are based on changes in the value of the underlying asset

The holder of a derivative security does not own the underlying asset, they have a right to buy (or sell) in the future

2

Types of derivative products

Certificates or bonds
Futures
Forwards
Options
Swaps

3

how are derivative used

Derivatives can be used as a speculative investment or as a risk management product.
As a risk management product, the principle is: enter into a derivative position that is as perfectly and negatively correlated with your underlying position as possible
The result: when you lose $1 in the underlying asset, you will gain $1 in the derivative position, hence your overall cash flow position does not change (hedge)
The pitfall: when you gain $1 in the underlying asset, you will lose $1 in the derivative position(product)
In general, hedging using derivatives limit your downside risk but will also limit your upside gain

4

explain property certificates / bonds

Property certificates or bonds entitle the holder of the security to receive income periodically or an accumulated value at the expiry date.

Returns are calculated by the security being referenced (underlying asset) to a property index or a portfolio of properties.

For these type of products an investors can ‘short-sell’ these securities (i.e. selling the certificates before you have bought them).
This can provide a positive return for the investor if the certificates decline in value.

E.G. A PF that is ‘overweight’ in properties and concerned with a decline in property values, can short-sell certificates
Resulting in a hedge (risk reduction) of a decline in property values
The PF, however, must deposit funds with the issuer to cover any possible increases in the value of the certificates.
The opposite can also be done if PF is ‘underweight’ in property allocations for the fund.

5

explain future contracts

Futures contracts are standardised contracts that are traded through a formal exchange (e.g. Sydney Futures Exchange – Now owned by the ASX). This facilitates the management of risk exposures associated with commodities and financial assets
.
A futures contract is an agreement between two parties (with intermediary in-between) to buy or sell a specified asset at a specified date in the future at a price determined today.

Most futures contracts are not ‘delivered’ (or held to maturity), investors settle by payment in cash or by reversing the trade before maturity.

6

common exmaple of future contracts

property index
interest rate index futures

Its now 6 months time and property values have fallen by 5% (we will assume that the property index & the funds portfolio of properties are highly correlated, thus both fall by 5%)
The value of the funds properties is now $9.5m, a loss of $500,000.
However, the property index futures will have also fallen to 1,358.50 (i.e. 1,430 x 95%)
The fund can settle their futures contracts, the profit would be:
Change in value of index: 1,430 – 1,358.50 = 71.5 points (settle the contract)
Profit: (71.5 x $25) x 112 = $200,200
Net result: $200,200 (futures profit) - $500,000 = -$299,800
Equates to approx. 3% loss (compared to 5% if unhedged)

7

explain interest rate futures

Property funds can sell interest rate futures to hedge against rising interest rates on their variable rate loans
Interest rate futures are available on interest-bearing securities such as bank bills (short term 90/180 days) or government bonds (long term 2 years etc.)
If a PF enters into a contract to sell an interest rate futures, it will profit from an increase in interest rates which can compensate them for higher interest payments on their variable rate loans.
However, if market interest rates decline they will make a loss on their futures contracts, but these will be offset by the lower payments on their variable rate loans

Interest rate futures can therefore be used to roughly fix the payments on variable rate loans.
Interest rate futures are traded on an exchange and thus provide a cost effective way to hedge interest rate risk
The price of interest rate futures are quoted as 100 minus the interest rate
Example, June 2017 90 day bank bills futures were trading at 98.27 in April. This means the interest rate on these contracts is 1.73% pa

8

explain property index - futures

Only property index futures market in Australia is the A-REIT Index Futures.
The value of the futures is derived from the S&P/ASX200 A-REIT index (ASX Code XPJ Index)
In isolation these futures contracts can be used to speculate on index movements in the physical A-REIT index

As a risk management product, you can enter in to a futures contract to sell the property index in the future (at price set today) to protect against declines in property values
For example, a fund manager wants to lower the funds exposure to property for the next 6 months
The manager doesn’t want to sell a property now and purchase another one in 6 months time because of the transaction costs and the time (& costs) of finding a new property to purchase
It would be cheaper and easier to enter in to a futures contract to sell the underlying property index in the future

Property Index Futures - Example
Its now 6 months time and property values have fallen by 5% (we will assume that the property index & the funds portfolio of properties are highly correlated, thus both fall by 5%)
The value of the funds properties is now $9.5m, a loss of $500,000.
However, the property index futures will have also fallen to 1,358.50 (i.e. 1,430 x 95%)
The fund can settle their futures contracts, the profit would be:
Change in value of index: 1,430 – 1,358.50 = 71.5 points (settle the contract)
Profit: (71.5 x $25) x 112 = $200,200
Net result: $200,200 (futures profit) - $500,000 = -$299,800
Equates to approx. 3% loss (compared to 5% if unhedged

9

what is a swap

A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

For property main types of swaps:
Property swaps -agreements to swap the rights to income and capital gain from property investment with some other return

Interest rate swap - agreement between 2 parties to swap cash flow on a fixed interest rate and a floating interest rate

Contrast to futures which are traded on an exchange and standardised products, swaps are negotiated individually (mostly with an intermediary e.g. investment bank).
They are referred to as ‘over the counter’ products.

10

What is a ‘swap’ in relation to derivatives? Describe, with the use of a diagram, how an interest rate swap works.

A swap is an agreement to exchange cash flows at specified times according to specified rules. Ownership of the asset or principle of the loan are not swapped. Two main swaps in property are property swaps and interest rate swaps.
Fixed for Floating Interest Rate Swap


In this example the property fund has swapped their variable rate loan (secured loan) for a fixed rate loan.
The payments of interest are the only cash flows that are swapped.
The RED arrows shows how the Company would pay the interest cost at a variable rate to the Bank who then passes this on to the property fund who in turn pays the variable rate on their secured loan.
The BLACK arrows show that the property fund pays a fixed rate of interest to the Bank. The Bank would charge a margin on the fixed rate they receive from the property fund and pass the remaining fixed interest payment to the Company, who would in turn pay the coupons on their corporate bonds.
In reality all cash flows would be netted off so there is essentially only one payment made.

11

How does a derivative product get its value?

A derivative products value is determined by the value of the underlying asset. For example, if the underlying asset increases in the value the value of a derivative that gives the holder the right to buy will also increase. Therefore the returns from derivative are based on the returns of the underlying asset

12

What right does the holder of a derivative product have?

The holder of a derivative has the right to buy or sell the underlying asset at a certain point in the future at a price that is agreed upon today. The holder of a derivative does not own the underlying asset.

13

desribe feature of future contracts

A futures contact is a standardized contract traded on a formal exchange that gives the holder the right (and the obligation) to buy or sell the underlying asset at some point in the future at a price that is set today.

The purchaser of the futures contract is required to deposit a margin with the exchange to protect against losses that may be incurred from the contract (reducing risk of default).

Most futures contracts are settled by payment in cash of the profit or loss from the contract. Or by taking a reversing trade before maturity.

14

Identify and describe a two derivative products that can be used to manage interest rate risk.

Derivatives that can be used to manage interest rate risk include:
• Interest Rate Futures
• Interest Rate Swaps
• Interest Rate Options
• Interest Rate Caps and Collars
• Forward Rate Agreements

15

Identify and describe a two derivative products that can be used by a Property Fund to manage their exposure to a decline in property values.
ANSWER:

Derivatives that can be used to manage a decline in property values include:
• Property Certificate or Bonds
• Property Index Futures
• Property Index Options

16

What is an option in relation to derivatives?

An option contract gives the option holder the right, but not the obligation, to buy or sell a specified asset or financial instrument at a specified price on or before a specified date.

Due to the option holder having the right but not the obligation, they will pay a premium.

17

What is the major difference between a futures contract and an options contract?

The major difference between options and futures is the option holder has right but not the obligation. In other words, if it is unprofitable for the option holder to exercise their option, they will not exercise.

However, for a futures contract the holder has to buy or sell the underlying asset at maturity.

18

define the 2 types of options

The two types of options are call options and put options.
Call options give the option holder the right to buy the underlying asset or financial instrument specified in the option contract at the exercise price.

Put options give the option holder the right to sell the underlying asset or financial instrument specified in the option contract at the exercise price.

19

Describe an interest rate cap. How are the lender’s fees on an interest rate cap determined?

An interest rate cap is when a borrower pays the lender to put a ceiling on their variable interest rate loan. An interest rate cap allows loan interest rates to fluctuate up to a specified maximum rate during a set period.
In return for this cap on interest rates, the lender will charge a fee and is dependent on:
• How close the maximum rate is to market rate
• Whether the market is expecting increase (decrease) in rates
• The length of time the cap is in place

20

define interest rate collar

place boundry around a variable rate loan, rates can fluctuate between a max and min interest rate

Agreement to include a minimum rate reduces the fee charged by the lender.

21

what is an option and difference to futures

An option contract gives the option holder the right, but not the obligation, to buy or sell a specified asset or financial instrument at a specified price on or before a specified date.
The major difference between options and futures is the option holder has right but not the obligation.
Due to the option holder having the right but not the obligation, they will pay a premium.
The price specified in the contract is known as the exercise price or the strike price.
Options are like an insurance policy, if nothing happens you do not claim the insurance payout. If the event occurs (e.g. house burns down) you claim the payout. In return for this insurance coverage you pay a premium.

22

Define and describe a Forward Rate Agreement.

A Forward Rate Agreement (FRA) is an agreement between a financial institution and a borrower that if rates move above a specified rate (during the agreement period) the borrower is compensated by the bank with a lump sum.

If rates fall below a min specified rate the borrower must compensate the bank. The net effect of a FRA is that the loan becomes essentially fixed with a band.