Risk Management and Derivatives

1. Risk Management and Derivatives Antu Panini Murshid

2. Today’s Agenda • What are derivatives? • Futures contracts • Swaps futures and options • Forward exchange rates • Covered interest rate parity

3. What are Derivatives? • Unlike other assets derivatives are not a claim on a commodity or real asset • A derivative is an instrument whose value depends on the value of other underlying assets • Pork bellies, oil, other financial instruments • An increasing amount of trading takes place in markets where actual commodities and instruments of borrowing and lending are not traded

4. Examples of Derivatives? • Forward contracts • Futures contracts • Swaps • Options

5. Derivatives Risk Sharing or the “11-letter 4-letter-word” • Why use derivatives • To hedge risks • To speculate by taking a view on the future direction of the market • To lock in the rate of return or interest costs on borrowed funds (decide on terms today) • To change the nature of an investment without incurring transaction costs

6. Forward Contracts • A forward contract is an agreement where the terms of a future trade are decided upon today • This contrasts with a spot contract where the agreement is to buy or sell the asset immediately

7. Example • Wheat farmer plants crop in January and receives payment after harvest in July • Farmer expects to sell wheat to a miller for $10,000 • But price of wheat may fluctuate • Price of wheat ↑ farmer gains and miller loses • Price of wheat ↓ farmer loses and miller gains

8. Example • Both parties face uncertain prices. To minimize these uncertainties they may agree the terms of their trade now • By engaging in a forward transaction the farmer reduces the risk of a loss and the miller reduces the risk of a price fluctuation

9. Spot and Forward Exchange Rates • The spot rate is the rate at which one currency can be exchanged for another currency at the present time • The forward rate is the rate at which one currency can be exchanged for another at some future delivery date (beyond the spot delivery date), where the terms of the transaction are agreed upon today

10. Exchange Rate Risk • Forward exchange rates are used to hedge against exchange rate risk • Exchange rate risk is the effect of unanticipated exchange rate movements on profits

11. Example • US firm sells Japanese radios at $100 each • Firm will take delivery of radios in 30 days at an agreed price of ¥9000 each • Spot rate e=0.0105 → ¥9000 = $94.50 • Exchange rate risk: e=0.012→¥9000 = $108 • Forward rate F=0.0107→¥9000 = $96.30

12. Problems With Forward Contracts • Forward contracts contain terms specific to the particular buyer and seller in the exchange. This leads to illiquidity • Forward contracts are subject to default risk

13. Futures • Futures are standardized contracts between two parties to buy or sell an asset at a future date • Standardized contracts do not provide an exact match (amount or due date) • E.g. on the CME you can buy a contract of 12.5 million ¥ for delivery at a few specific dates • Standardized contracts have low transactions costs and increase liquidity

14. More on Futures • Futures derive their value from an underlying asset • This can be a financial asset or a commodity • The bulk of futures traded today are financial futures

15. More on Futures • Futures convey symmetric rights to buyers and sellers of futures • The buyer (long position) has the right and obligationto receivethe underlying instrument at the specified date and price • The seller (short position) has the right and obligationto deliver the underlying instrument at the specified date and price

16. Futures Trading • The buyer and seller of futures trade with each other anonymously • Traditionally these trades were carried out using the open outcry system where traders physically meet on the floor of the exchange • This is being replaced by electronic trading where computers match buyers and sellers

17. Settling Accounts • Although the buyer (seller) of a futures contract has the right to receive (deliver) the underlying instrument, rarely are these assets actually exchanged • Instead the “difference” is settled in cash by the exchange on a daily basis in accordance to the current spot price • This daily settlements of accounts is called marking to market

18. Futures Pricing • The futures price is not specified in the contract, rather on any given day, it is determined by the market • The futures price reflects the market’s expectations regarding the spot price of the underlying asset on the date of delivery • Clearly it must be the case then that the futures price and spot price converge as the time to delivery approaches

19. Example: Reducing Interest Rate Risk • A bank makes 1-yr loan at 6% fixed interest 6-month time deposits earn variable int. 4% If interest rate ↑ then a loss is incurred • Bank sells T-bill future (in March settle price for a September delivery $1million T-bill is 95.16) • If interest rate ↑ spot price<futures price (loss covered)

20. Swaps • Agreements in which two parties trade payment streams to guarantee that the inflows of payments will more closely match outflows • Swaps originated as instruments to hedge against interest risk, however, they are also used in the foreign exchange market to hedge against foreign exchange risk

21. Interest Rate Swaps(Source: Burton and Lombra. The Financial System and the Economy)

22. Currency Swaps

23. Options • Give the buyer the right, but not the obligation, to buy or sell an asset in the future at a predetermined price (strike price) • One party in the transaction has rights but no obligations and the other party has obligations but no rights

24. Put and Call Options • A put option gives the buyer the right to sell but not the obligation to sell an asset in the future at the strike price • A call option gives the buyer the right to buy but not the obligation to buy an asset in the future at the strike price

25. Covered Interest Rate Parity • Interest rates denominated in different currencies are the same once you “cover” yourself against possible currency changes • Covered interest parity condition implies that (1+i)=(1+if)F/e

26. Example • In January 1992 the rate on 3-month securities in the US was 4.19% • Rate on DM-denominated 3-month securities was 9.52% • Why the premium? • UCIP⇒%E(∆e)=-1.33% or 5.33% per year • The premium can be attributed to covered interest parity condition

27. Options Facing the Investor • The investor is faced with two strategies. • He could simply invest in US securities an in three months he would earn 1.048% interest. So on a one dollar investment he would earn $1.0148 • Alternatively he could convert his dollars to DM invest in Germany and reconvert his DM to dollars

28. Strategy Two Explained • 1. Convert $→DM at the spot rate e=0.6225 • 2. Invest 1.606 DM(=1/e) in DM-denominated security • 3. In 3 months interest earned would be 2.38% (=if/4), so he has 1.644 DMs • 4. Instead of selling at the spot rate in 3-months he could sell 1.644 DMs(=1+if/4)1/e forward at the forward rate F=0.6114 leaving him with $1.01048(=1+ if/4)F/e

29. Strategy Two Explained • Note the return on investments, whether the investor invests abroad or at home is the same ($1.0148), i.e. (1+if/4)F/e=(1+i/4) [This is just the covered interest rate parity condition]

30. Forward Premiums (or Discounts) • From CIPC: (1+if)F/e=(1+i) • Define 1+i=(1+if)(1+fp) • Then CIPC: (1+if) [1+(F-e)/e] = (1+if)(1+fp) [1+(F-e)/e] = (1+fp) ⇒ [(F-e)/e] = fp • Finally note that (1+if)(1+fp)≈1+if+fp, hence you can think of fp as the forward premium

31. Forward Exchange Rate and Expectations • Note that the uncovered interest rate parity condition is • (1+i)=(1+if)et+1/et • Recall that i≈if+%D(e) is just an approximation • To see this note that (1+i)=(1+if)[(et+1- et )/et +1] • Hence (1+i)=(1+if)[%D(e)+1]⇒ i≈if+%D(e) • Compare UCIP to CIPC: (1+i)=(1+if)Ft/et • Hence Ftis just your expectation of the future exchange rate (note that we are assuming that investors are risk neutral)