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Investments Chapter 19: Futures, Options and other Derivatives

Derivatives A derivative security is a financial asset that derives its value from another asset. A derivate is also known as a ‘contingent claim’, because its value is contingent on characteristics of the underlying security.

Use of Derivatives Investors use derivative contracts in four basic strategies: 1. Hedging. 2. Speculating. 3. Arbitrage. 4. Portfolio diversification.

Arbitrage Arbitrage - arises if an investor can construct a zero investment portfolio with a sure profit. Since no investment is required, an investor can create large positions to secure large levels of profit. In efficient markets, profitable arbitrage opportunities will quickly disappear.

Forward Contracts: I An agreement to exchange goods for cash at a pre-specified future date. The seller of a forward contract has a short position: an obligation to deliver the goods. The buyer of a forward has a long position: an obligation to buy the goods.

Forward Contracts: II Exhibit 19.2 Payoff diagrams for a forward contact Source: From Introduction to Investments , 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.

Swaps An agreement between two counterparties to exchange payments based on the value of one asset in exchange for payments based on the value of another asset. Four major types of swaps: 1. Interest-rate swaps. 2. Credit swaps. 3. Currency swaps. 4. Commodity swaps.

Interest-rate Swap Counterparties exchange interest payments that depend on pre-specified interest rates: Exhibit 19.4 Plain vanilla interest-rate swap agreement

Credit Swap Designed to exchange default risk. Two categories of credit swaps: 1. Default swaps Only default (=credit) risk is exchanged. 2. Total return swaps A combination of an interest-rate swap and a default swap.

Currency and Commodity Swaps Currency swaps Involves the exchange of different currencies, at pre-specified points in time. Commodity swaps Involves the exchange of cash based on the value of a specified commodity, at pre- specified points in time.

The Swap Bank A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer. As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

An Example of an Interest Rate Swap Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. It would make more sense to the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

An Example of an Interest Rate Swap Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent (higher risk). 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.

An Example of an Interest Rate Swap The borrowing opportunities of the two firms are:

An Example of an Interest Rate Swap Bank A The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years Swap Bank LIBOR – 1/8% 10 3/8%

An Example of an Interest Rate Swap Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of - 10 3/8 + 10 + ( LIBOR – 1/8 ) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap. 10% ½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Swap Bank Bank A LIBOR – 1/8% 10 3/8%

An Example of an Interest Rate Swap Company B The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼%

An Example of an Interest Rate Swap They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - ( LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating. LIBOR + ½% Here’s what’s in it for B: ½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Swap Bank Company B 10 ½% LIBOR – ¼%

An Example of an Interest Rate Swap The swap bank makes money too. ¼% of $10 million = $25,000 per year for 5 years. LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼ Swap Bank Company B Bank A 10 ½% LIBOR – ¼% LIBOR – 1/8% 10 3/8%

An Example of an Interest Rate Swap Swap Bank Company B Bank A B saves ½% A saves ½% The swap bank makes ¼% 10 ½% LIBOR – ¼% LIBOR – 1/8% 10 3/8%

An Example of a Currency Swap Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds. This will give them exchange rate risk: financing a sterling project with dollars. They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.

An Example of a Currency Swap If they can find a British MNC with a mirror-image financing need, they may both benefit from a swap. If the spot exchange rate is S 0 ($/ £) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

An Example of a Currency Swap Consider two firms A and B: firm A is a U.S . – based multinational and firm B is a U.K . – based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

An Example of a Currency Swap Firm B Swap Bank Firm A $9.4% $8% £12% £11% $8% £12%

An Example of a Currency Swap $8% £12% Firm B Swap Bank Firm A $9.4% A’s net position is to borrow at £11% A saves £.6% £11% $8% £12%

An Example of a Currency Swap $8% £12% Firm B Swap Bank Firm A $9.4% B’s net position is to borrow at $9.4% B saves $.6% £11% $8% £12%

An Example of a Currency Swap $8% £12% Firm B The swap bank makes money too: 1.4% of $16 million (= 9.4% - 8%) financed with 1% of £10 million (=11% - 12%) per year for 5 years. Swap Bank Firm A $9.4% £11% $8% £12%

An Example of a Currency Swap $8% £12% Firm B The swap bank makes money too: -1% of £10 million = -£100,000 = -$160,000 per year for 5 years. The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap). 1.4% of $16 million = $224,000 per year for 5 years. Swap Bank Firm A $9.4% £11% $8% £12%

Futures Contracts An agreement to exchange goods (or a variable amount of money) for an agreed amount of cash at some future date, and at a predetermined price or rate.

Futures vs. Forward Contracts Futures contracts are traded on financial exchanges and have standardized conditions. Forwards are OTC contracts and do not have standardized conditions. Futures are marked to market, hence their cash-flow pattern is different from forwards, which are not marked to market. Because of this marking to market, futures contracts also have less credit risk than forwards.

Options An option gives its holder the right to buy or sell a specified amount of an underlying asset at a pre-determined price. Two basic types of options: - Call options (right to buy). - Put options (right to sell).

Option Definitions: I Strike Price (also Exercise Price) The predetermined price at which the holder of an option has the right to buy or sell the underlying asset. Expiration Date (also Maturity Date) The date on which an option expires, or ceases to exist when the option is not exercised.

Option Definitions: II Intrinsic Value The value of an option if it is exercised immediately, unless this value is negative, in which case the intrinsic value is zero:

Payoff Diagrams Payoff diagrams at expiration can be constructed as follows: 1. Determine the intrinsic value of the option. 2. Add (or subtract) the option premium that has been received (paid).

Payoff Diagrams: An Example Exhibit 19.14 Payoff diagram for buying a put option (long put)

Investment Strategies Using Derivatives: I Simple strategy: Exhibit 19.19 Payoff diagram: buying a stock and a put option

Investment Strategies using Derivatives: II More complex strategies: 1. Spreads. 2. Straddles. 3. Strangles.

Financial Engineering New, innovative financial instruments based on derivatives principles have become available on the OTC markets since the 1980s and 1990s. Examples: 1. Exotic options. 2. Options on futures and swaps. 3. Credit spread options. 4. CAT bonds. 5. Weather derivatives.

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