Financial Derivatives

Chapter 13

Financial Derivatives

© 2005 Pearson Education Canada Inc.


• Hedging• Forward and Future contracts• Options• Interest rate swap

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© 2005 Pearson Education Canada Inc. 13-3

Hedging

Hedge: engage in a financial transaction that reduces or eliminates risk

Basic hedging principle:Hedging risk involves engaging in a financial transaction that offsets a long position by taking a short position, or offsets a short position by taking a additional long position


Spot, Forward, and Futures Contracts

• A spot contract is an agreement (at time 0) when the seller agrees to deliver an asset and the buyer agrees to pay for the asset immediately (now)

• A forward contract is an agreement (at time 0) between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now

• A futures contract is similar to a forward contract and is normally arranged through an organized exchange (i.e., ME, CBT)The main difference between a futures and a forward contract is that the price of a forward contract is fixed over the life of the contract, whereas futures contracts are marked-to-market daily.


Interest-Rate Forward MarketsLong position = agree to buy securities at future dateHedges by locking in future interest rate if funds coming in

futureShort position = agree to sell securities at future dateHedges by reducing price risk from change in interest rates if

holding bondsPros1. Flexible (can be used to hedge completely the interest rate

risk)Cons1. Lack of liquidity: hard to find a counterparty to make a

contract with2. Subject to default risk: requires information to screen good

from bad risk


Example

• FNB to sell $5 million face value of 6s of 2023 Treasury bond at par one year from now.

• Use of forward contracts: lock profit from holding bond– Counter-party: to lock price for future investment

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Financial Futures Markets

Financial futures are classified as • Interest-rate futures • Stock index futures, and • Currency futures

Financial futures are traded in the Exchange (see Table 1)


Application

• Hedging with financial futures p.338

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Profits and Losses: Options vs. Futures

$100,000 Canada-bond contract,1. Exercise price of 115,

$115,000.2. Premium = $2,000



Payoff Function from Buying an Interest Rate Futures (see Fig. 13-1)

Consider the June Canada bond futures contract traded on the ME. If you buy this contract for 115, you agree to pay $115,000 for $100,000 face value of long-term Canada when they are delivered to you at the end of June. If at the expiration date the underlying Canada bond for the futures contract has a price of

– 110, meaning that the price of the futures contract also falls to 110, you suffer a loss of 5 points, or $5,000 (point A')

– 115, you would have a zero profit (point B')

– 120, you would have a profit on the contract of 5 points, or $5,000 (point C')


Payoff Function from Selling an Interest Rate Futures (see Fig. 13-1)

If you sell this contract for 115, you agree to deliver $100,000 face value of long-term Canada bonds for $115,000 at the end of June. If at the expiration date the underlying Canada bond for the futures contract has a price of

• 110, meaning that the price of the futures contract also falls to 110, you gain 5 points, or $5,000 (point A')

• 115, you would have a zero profit (point B')

• 120, you would have a loss on the contract of 5 points, or $5,000 (point C')


Option - Buying and Writing Calls

• A call option is an option that gives the owner the right (but not the obligation) to buy an asset at a pre specified exercise (or striking) price within a specified period of time.

• Since a call represents an option to buy, the purchase of a call is undertaken if the price of the underlying asset is expected to go up.

• The buyer of a call is said to be long in a call and the writer is said to be short in a call.

• The buyer of a call will have to pay a premium (called call premium) in order to get the writer to sign the contract and assume the risk.


Option – terms p.344

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Figure 13-1. Interest Rate Futures Options

An option contract on the ME's June Canada bond futures contract has the following key features:

• it has the same expiration date as the underlying futures contract

• it is an American option and so can be exercised at any time before the expiration date, and

• the premium of the option is quoted in points that are the same as in the futures contract, so each point corresponds to $1,000.


How Interest Rate Futures Options Work (see Fig. 13-1) Suppose that today you buy, for a $2,000 premium, a European call on the $100,000 June Canada bond futures contract with a strike price of 115. If at the expiration date the underlying Canada bond for the futures contract has a price of

• 110, the futures call will be out of the money, since S<X. It will expire worthless for a loss of $2,000 (point A)

• 115, the futures call will be at the money, but produces no gain or loss (point B)

• 120, the futures call will be in the money and will be exercised. You would buy the futures contract at the exercise price of 115 and then sell it for 120, thereby earning a 5-point gain ($5,000 profit) on the $100,000 Canada bond contract. Because you paid a $2,000 premium, however, the net profit is $3,000 (point C)


Figure 13-1. The Difference between Interest Rate Futures and Interest Rate Futures Options • the futures contract has a linear profit function --- there is a one-

to-one relationship between profits and the price of the underlying financial instrument

• the kinked profit curve for the option contract is nonlinear, meaning that profits don't always grow by the same amount for a given change in the price of the underlying financial instrument

• the reason for this nonlinearity is that the call option protects you from having losses that are greater than the amount of the $2,000 premium

• once the price of the underlying financial instrument rises above X, however, your profits on the call option grow linearly. They are, however, always less than the profits on the futures contract by exactly the $2,000 premium paid.


Interest Rate Swaps

In an interest-rate swap, two unrelated parties take out loans. Then they agree to make each other’s periodic interest payments.

The two parties do not exchange their debts or lend each other money, but simply agree to make each other’s periodic interest payments as if they had swapped debts.

This kind of swap is illustrated by the hypothetical example in the next slide.


Interest-Rate Swap Contract


Hedging with Interest Rate Swaps

Reduce interest-rate risk for both parties1. Midwest converts $1m of fixed rate assets to rate-sensitive

assets, RSA , lowers GAP2. Friendly Finance RSA , lowers GAP

Advantages of swaps1. Reduce risk, no change in balance-sheet2. Longer term than futures or options

Disadvantages of swaps1. Lack of liquidity2. Subject to default risk

Financial intermediaries help reduce disadvantages of swaps

Financial Derivatives

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