Chapter 13. Financial Derivatives

1. Chapter 13. Financial Derivatives • Futures contracts • Options contracts • Swaps

2. About derivatives • assets that derive value from an underlying asset • futures • options • swaps

3. I. Futures contracts • contract for a trade in the future, specify terms today • asset to be traded = underlying • when traded = settlement date • how much for asset = futures price

4. 2 counterparties • buyer (long position) -- obligated to buy the underlying, at the futures price, on settlement date • seller (short position) -- obligated to sell underlying, at the futures price, on settlement date

5. futures price • lock in price today for future trade • spot price • price of underlying asset today

6. value of a futures position depends on how futures price compares to spot price

7. 2 types investors • hedgers • face risk due to fluctuating asset prices (own or buy asset) • use futures contracts to lock in a price & manage risk • example • airlines & fuel prices

8. speculators • do not own or buy asset • use futures to profit from beliefs about changing prices • take on risk w/ futures contracts

9. example 1: Southwest Airlines • risk: fluctuating fuel prices • rising price: higher costs • falling price: lower costs • hedge this risk: • long position in fuel futures • buyer at $1/gallon

10. if spot price rises to $1.21/gallon • long position gains value • if spot price falls to $.93/gallon • long position loses value • either way, SW has locked in fuel costs

11. example 2: A1 S&L • risk: fluctuating interest rates • hedge this risk: • short position in Tbill contracts • lock in sale price for Tbills • $98 per $100 of FV

12. when rates rise • Tbill price falls, (to $96) • short position gains • when rates falls • Tbill price rises, (to $100) • short position loses • futures position offsets banking losses/gains

13. In Futures Contracts: • rising spot price is good for the buyer, bad for the seller • falling spot price is bad for the buyer, good for the seller

14. note • price changes are a “zero sum game” • one counterparty is always the “loser” • always an incentive for one to default whether price rises or falls

15. Exchanges • CME, CBOT, NYFE • regulated by CFTC • contracts must have unique economic purpose • trading at pits on trading floor • open outcry auction • also electronic routing--Globex

16. exchange functions • standardize contracts • underlying, date, price • no customized contracts • promotes liquidity -- more buyers/sellers per contract -- buyers/sellers agree on terms

17. exchange acts as a clearinghouse • all trades go through exchange • protects buyers/sellers from default

18. Seller CME Buyer • buyer & seller contracts are w/ exchange, not each other

19. how does exchange control its risk? • margin accounts for buyer & seller • deposit initial margin • daily adjustment to equity based on price movements • if losses too large -- margin call -- must put up cash to get back to initial margin

20. II. Options contracts • 2 counterparties • buyer has RIGHT to buy/sell the underlying • at strike price • up to or at maturity • writer has obligation to sell/buy if buyer chooses to

21. call option • buyer has right to buy • put option • buyer has right to sell • buyer pays writer a premium for this right • if buyer chooses to buy/sell, then option is exercised

22. option contracts involve 3 prices • P, price of underlying • X, strike price of contract • Qc/Qp, option premium

23. American options • exercised any time up to maturity • European options • exercised only at maturity

24. when will an option be exercised? • if P>X • a call option will be exercised • (in the money) • a put option will not • (out of the money)

25. if P < X • a call option is out of the money • a put option is in the money

26. example: Google • Mar 2005 contract • X = $175 • Qc = 2.60, Qp = 2.60 • (P on 3/15 : $174.99) • suppose P = $177

27. call option payoffs • P = $177, X = $175 • P > X • call option is in the money • buyer: P - X - Qc • 177-175-2.60 = -.60 • writer: X - P + Qc • .60

28. note buyer does not have positive payoff • but if did not exercise, would lose $2.60

29. put option payoffs • put is out of the money • buyer: -Qp • = -2.60 • writer: Qp • = 2.60

30. futures vs. options • futures contracts are 2-sided obligations • options contracts are 1-sided obligations • risk is not symmetric • options are insurance, not hedging

31. II. Options markets • traded on exchanges • CBOE, NYSE, AMEX • regulated by SEC, CFTC

32. OCC • standardization • X • maturity: Mar, Jun, Sep, Dec • guarantee contracts • buyer pays Qc/Qp up front • writer keeps margin account

33. Factors affecting Qc, Qp • P • X • time to maturity • volatility of P

34. P, price of the underlying • if P rises, • then P>X more likely • Qc rises • Qp falls • If Google price rises to $175 from $180 • Qc will rise, Qp will fall

35. X, strike price • if X is higher • then less likely than P > X • Qc will be lower • Qp will be higher • X=$175, Qc = $2.60 • X=$180, Qc = $.90

36. time to maturity • longer time to maturity, P more likely to fall a lot or rise a lot • greater profit potential for buyer • greater risk for writer • both Qc & Qp will be higher

37. volatility of P • if P fluctuates a lot, • P more likely to fall a lot or rise a lot • greater profit potential for buyer • greater risk for writer • both Qc & Qp will be higher

38. III. Interest Rate Swaps • custom arrangement • between financial institutions • swap payments periodically • based on interest rates • based on exchange rates

39. Plain vanilla swap (interest rates) • 2 counterparties • fixed rate payer • floating rate payer • pmt. = rate x notional principal • principal is not exchanged • only the interest pmt.

40. example: A1 S&L and Ed’s finance • swap • $1 million notional principal • swap annually for 10 years • A1 will pay Ed 6% • Ed will pay A1 Tbill + 2%

41. end of year 1 • Tbill rate = 4.5% • A1 owes (.06)(1 mil) = $60,000 • Ed owes (.045+.02)(1 mil) = $65,000 • so Ed pays A1 $5,000

42. end of year 2 • Tbill rate = 3.7% • A1 owes (.06)(1 mil) = $60,000 • Ed owes (.037+.02)(1 mil) = $57,000 • so A1 pays Ed $3,000

43. note • A1 benefits when rates rise • Ed benefits when rates fall

44. What’s the point? • A1 S&L faces interest rate risk • swap gains offset losses when interest rates rise • Ed’s finance? • may have more rate-sensitive assets • or may be speculating on falling rates

45. Swap risks • risk of counterparty default • leaves other party unprotected • liquidity concerns • custom swaps do not have a secondary market