Derivatives Risk Management
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DERIVATIVES, AND RISK MANAGEMENT, LEFT-HAND FINANCING, AND LEVERAGED BUYOUTGroup 1
Jerold SaddiPamela BernabeJuliet delos SantosJenelle CanonizadoElvin Lee
Learning Objectives:After this session the FINMAN students would be able to:Know all necessary concepts regarding derivativesKnow all various left-hand financing schemes, including their advantages and disadvantagesKnow the mechanics of Leveraged buyout, its use, its advantages and disadvantages
What are derivatives?
Are financial instrument that derive their value from contractually required cash flows from some other security or index.
What are the essential features of a derivative?A derivative is a financial instrumentValues changes in response to the changes in UNDERLYING variables.
No or minimum initial net investment
Settled at a future date by a net cash payment / settlement
What are the kinds/examples of derivatives?Option ContractForward ContractFutures ContractForeign Currency Exchange ContractInterest Rate Swap
Accounting for DerivativesAre to be considered as either assets or liabilities and should be reported in the balance sheet at fair value.Unrealized gain or loss from fedging transactions is presented depending on the type of hedging.Under the Fair Value hedge method part of incomeUnder Cash Flow Hedge Method part of EQUITY
For foreign entity investment:Changes in fair Value determined to be an effective hedge are recognized in EQUITY.The ineffective portion of the changes in fair value are recognized in EARNINGS IMMEDIATELY if the hedging instrument is a derivative.
Why do derivatives exist?Hedging - Pertains to designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item.
FORWARD CONTRACTAtransactionin which aselleragreesto deliver a specificcommodityto abuyerat some point in thefuture. Read more:http://www.investorwords.com/2060/forward_contract.html#ixzz1zDZdjqWa
Pamela BernabeCall/ put OptionsFinancial Futures
A derivatives financial instrument that specifies a contract giving its owner the right to buy or sell an asset at a fixed price on or before a given date.
Its also a unique type of financial contract because they give the buyer the right, but not the obligation, to do something.
The buyer uses the option only if it is adventageous to do so; otherwise the option can be thrown away
Give the marketplace opportunities to adjust risk or alter income streams that would otherwise not be available
Provide financial leverage
Can be used to generate additional income from investment portfoliosOPTIONS
Thales ancient Greek philosopherLOW STRIKEOLIVE SEASON HIGH
EXAMPLE Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the season's olive harvest would be larger than usual, and during the off-season he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out at much higher price than he paid for his 'option'.
OPTION TERMINOLOGYOption Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option. Option Buyer - One who buys the option. He has the right to exercise the option but no obligation. Call Option - Option to buy. Put Option - Option to sell.
OPTION TERMINOLOGYAmerican Option - An option which can be exercised anytime on or before the expiry date. Strike Price/ Exercise Price - Price at which the option is to be exercised. Expiration Date - Date on which the option expires. European Option - An option which can be exercised only on expiry date. Exercise Date - Date on which the option gets exercised by the option holder/buyer. Option Premium - The price paid by the option buyer to the option seller for granting the option.
CALL OPTIONSA call option gives you the right to buy within a specified time period at a specified price
The owner of the option pays a cash premium to the option seller in exchange for the right to buy
PRACTICAL EXAMPLE OF A CALL OPTION
CALL OPTIONS - ILLUSTRATIONAn investor buys one European Call option on one share of Neyveli Lignite at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.
PUT OPTIONSA put option gives you the right to sell within a specified time period at a specified price
It is not necessary to own the asset before acquiring the right to sell it
An investor buys one European Put Option on one share of Neyveli Lignite at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.
All exchange-traded options have standardized expiration datesThe Saturday following the third Friday of designated months for most options
Investors typically view the third Friday of the month as the expiration date
The striking price of an option is the predetermined transaction price In multiples of $2.50 (for stocks priced $25.00 or below) or $5.00 (for stocks priced higher than $25.00)
There is usually at least one striking price above and one below the current stock price
STANDARDIZED OPTION CHARACTERISTICS
Puts and calls are based on 100 shares of the underlying security
The underlying security is the security that the option gives you the right to buy or sell
It is not possible to buy or sell odd lots of options
STANDARDIZED OPTION CHARACTERISTICS
Forwards a contract that is customized between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price
Futures an agreement between two parties to buy or sell an asset to a certain time in the future at a certain price. - it is also a special types of forward contracts in the sense that the former standardized exchange-traded contracts.
SIMPLE EXAMPLEIf you agree in April with your Aunt Sue that you will buy two pounds of tomatoes from her garden for $5, to be delivered to you when they're ripe in July, you and Sue just entered into a futures contract.
A financial future is a futures contract on a short term interest rate (STIR). Contracts vary, but are often defined on an interest rate index such as 3-month sterling or US dollar LIBOR.
They are traded across a wide range of currencies, including the G12 country currencies and many others.
The assets often traded in futures contracts include commodities, stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also part of today's commodity markets. FINANCIAL FUTURES
Some representative financial futures contracts are:United States90-day Eurodollar *(IMM)1 mo LIBOR (IMM)Fed Funds 30 day (CBOT)Europe3 mo Euribor (Euronext.liffe)90-day Sterling LIBOR (Euronext.liffe)Euro Sfr (Euronext.liffe)Asia3 mo Euro yen (TIF)90-day Bank Bill (SFE)whereIMM is the International Money Market of the Chicago Mercantile ExchangeCBOT is the Chicago Board of TradeTOCOM is the Tokyo Commodity ExchangeSFE is the Sydney futures exchange
COMPARISON OF FUTURES AND FORWARD
FuturesForwardAmountStandardizedNegotiatedDelivery DateStandardizedNegotiatedCounter-partyClearinghouseBankCollateralMargin Acct.NegotiatedMarketAuction MarketDealer MarketCostsBrokerage and exchange feesBid-ask spreadLiquidityVery liquidHighly illiquidRegulationGovernmentSelf-regulatedLocationCentral exchangeWorldwide
ADVANTAGE AND DISADVANTAGE OF FINANCIAL FUTURESAdvantagesSmall Contract SizeEasy liquidationWell organized and stable market (no risk of default)
DisadvantagesLimited number of currencies (but think about how one futures might be a close hedge against another currency)Rigid contract sizeFixed expiration dates (but if you can get close, it doesnt matter all that much).
THERE ARE TWO TYPES OF ORGANIZATIONS THAT FACILITATE FUTURES TRADING:
ExchangeExchanges are non-profit or for-profit organizations that offer standardized futures contracts for physical commodities, foreign currency and financial products.
ClearinghouseA clearinghouse is agency associated with an exchange, which settles trades and regulates delivery. Clearinghouses guarantee the fulfillment of futures contract obligations by all parties involved.
AN EXAMPLE:90-DAY EURODOLLAR TIME DEPOSIT FUTURESEurodollar futures contracts are traded on the International Mone