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Global FX: Markets, Language, and Conventions Foreign Exchange Workshop: Section 1A

Derivatives 101. February 2014. CONFIDENTIAL. DRAFT. Global FX: Markets, Language, and Conventions Foreign Exchange Workshop: Section 1A. Agenda. Derivatives 101 Workshop. 1. By the end of this session, participants should understand: the history and nature of derivative securities

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Global FX: Markets, Language, and Conventions Foreign Exchange Workshop: Section 1A

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  1. Derivatives 101 February 2014 CONFIDENTIAL DRAFT Global FX: Markets, Language, and ConventionsForeign Exchange Workshop: Section 1A

  2. Agenda Derivatives 101 Workshop 1

  3. By the end of this session, participants should understand: the history and nature of derivative securities the basic structural features and definitions of forwards, futures, options, and swaps the motivation for buyers and sellers of these securities practical applications for derivatives. Course Objectives 3

  4. Agenda 4

  5. The Nature of Derivatives • A derivative is an instrument whose value depends on the values of other more basic underlying variables (usually traded assets). • “A derivative is a contingent claim that may be used to transfer risk from someone who has it, but doesn’t want it to someone who wants it, but doesn’t have it”. –The Economist 5

  6. Evolution of Interest Rate Derivatives 10-year Treasury Yield Source: Bloomberg, Bank of America Merrill Lynch 6

  7. Evolution of FX Derivatives $US/Pound Sterling Source: Bloomberg, Bank of America Merrill Lynch 7

  8. Evolution of Commodity Derivatives Dollar Per Barrel of Crude Source: Bloomberg, Bank of America Merrill Lynch 8

  9. Derivatives Defined • Forward Contract • A financial contract to buy or sell an asset at a certain future time for a certain price (the delivery price). • No cash flows are exchanged until the delivery date. 9

  10. Derivatives Defined • Futures Contract • A financial contract to buy or sell an asset at a certain time in the future for a certain price (the delivery price). • The financial contract is marked-to-market. 10

  11. Derivatives Defined • Swap • A contract between two or more parties to exchange sets of cash flows over a period in the future. • The parties that agree to the swap are known as counterparties. • The two most common types of swaps are interest rate swaps and currency swaps. 11

  12. Derivatives Defined • Option • A contract granting the right to buy or sell an asset at a stated price over a specified period. • Call option – contract granting the right to buy • Put option – contract granting the right to sell 12

  13. Derivatives Markets • Exchange traded • Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading • Contracts are standard and there is virtually no credit risk 13

  14. Derivatives Markets Source: World Federation of Exchanges, 2013 WFE Market Highlights 14

  15. Derivatives Markets - Stocks Source: World Federation of Exchanges, 2013 WFE Market Highlights 15

  16. Derivatives Markets - Index Source: World Federation of Exchanges, 2013 WFE Market Highlights 16

  17. Derivatives Markets – Interest Rate Source: World Federation of Exchanges, 2013 WFE Market Highlights 17

  18. Derivatives Markets – Commodity Source: World Federation of Exchanges, 2013 WFE Market Highlights 18

  19. Derivatives Markets • Over-the-counter (OTC) • A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers. • Contracts can be non-standard and there is some small amount of credit risk. • Financial institutions often act as market makers for the more commonly traded instruments. • A market maker is always prepared to quote both a bid price (a price at which they are prepared to buy) and an ask price (a price at which they are prepared to sell). 19

  20. Derivatives Markets – OTC Derivatives Amounts outstanding of over-the-counter (OTC) derivatives By risk category and instrument In billions of US dollars Source: Bank for International Settlements, Annual Survey, November 2013 20

  21. Derivatives Markets – Ways Derivatives Can Be Used • To hedge risks • To speculate (take a view on the future direction of the market) • To lock in an arbitrage profit • To change the nature of a liability or an investment. 21

  22. Agenda 22

  23. Forward Contract • A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price). • It can be contrasted with a spot contract which is an agreement to buy or sell immediately • The forward price may be different for contracts of different maturities. • As we move through time the delivery price does not change, but the forward price for a contract may change. • It is traded in the OTC market 23

  24. Forward Contract Concept Check: What are the bid/offer prices for the 2-month forward? 24

  25. Forward Contract Source: Bloomberg, January 28, 2013 25

  26. Forward Contract – Concept Check • Suppose that the Treasurer of a U.S. corporation knows that the corporation will pay £1 million in six months and wants to hedge against exchange rate moves. • How much will the corporation pay, in dollars, for the forward contract based on the quotes below? 26

  27. Profit Price of Underlying at Maturity, ST Forward Contract – Concept Check : Long Forward + 0 K, delivery price K = $1.6546/GBP - 27

  28. Profit Price of Underlying at Maturity, ST Forward Contract – Short Forward + 0 - 28

  29. Forward vs. Futures Contract • Forward • Private contracts that trade OTC • Unique specifics to satisfy the parties involved • Some credit risk is present • No cash transactions until delivery date • Futures • Trade on an organized exchange • Standardized contracts • Performance of contract guaranteed by clearinghouse • Margin money posted…mark-to-market daily at settle price • Government regulation of futures market 29

  30. Agenda 30

  31. Interest Rate Swap • Interest rate swaps allow corporations to manage interest rate exposure. • In a rising interest rate environment, corporations that are net borrowers want to lock in fixed rates (while rates are still low). • In a falling interest rate environment, interest rate swaps allow corporations that are net borrowers to take advantage of falling rates by getting in on the floating side. • Interest rate swaps allow investors to swap into floating rates if they believe rates will rise. • If interest rates are rising, a company with floating-rate debt can undertake a swap to pay fixed and receive floating, which avoids the transaction costs of refinancing. 31

  32. Interest Rate Swap Application • Suppose a firm has a utilized revolving line of credit with a bank that requires semi-annual interest payments of LIBOR plus 25 basis points. The firm see the screen below with the market view of LIBOR going forward and decides to hedge against rising rates using a pay fixed interest rate swap on $100 million notional. The 3-year swap requires semi-annual settlement and has a swap fixed rate of 0.946097%. 32

  33. Interest Rate Swap Application $100 million notional, semi-annual, 0.946097% fixed ---------Dollars--------- LIBOR FLOATING FIXED Net Date Rate Cash Flow Cash Flow Cash Flow Jan 30, 2014 0.33200% Jul 30, 2014 +166,922.22 –473,048.50 –306,126.28 $100,000,000 x [0.332000% x (181/360) = $166,922.22 uses ACT/360 $100,000,000 x [0.946097% x (180/360)] = $473,048.50 uses 30i/360 33

  34. Interest Rate Swap Application ---------Dollars--------- LIBOR FLOATING FIXED Net Date Rate Cash Flow Cash Flow Cash Flow Jan 30, 2014 0.33200% Jul 30, 2014 0.42437% +166,922.22 –473,048.50 -306,126.28 Jan 30, 2015 0.61379% +216,900.33 –473,048.50 -256,148.17 Jul 30, 2015 0.89853% +308.598.93 –473,048.50 -164,449.57 Jan 29, 2016 1.40161% +456,754.85 –470,420.45 -13,665.60 Jul 29, 2016 1.93679% +708,591.72 –473,048.50 +235,543.22 +995,294.44 –475,676.55 +519,617.89 Jan 30, 2017 34

  35. Interest Rate Swap Application 35

  36. Interest Rate Swap Application 36

  37. Interest Rate Swap Example Financial Institution earns spread of 0.8392 bps p.a. 0.937705% 0.946097% 1.625% Firm A F.I. Firm B LIBOR+0.25% LIBOR LIBOR Firm A issued a bond paying 1 5/8% annually. This firm wants to pay floating and has swapped to receive fixed at 0.937705% creating a floating rate instrument where Firm A pays Libor + 68.7295 bps. Firm B pays Libor + 25 bps on a loan and wants to pay fixed. With the swap, Firm B pays fixed rate of 0.946097% and receives Libor flat. The fixed cost to Firm B is 0.946097% plus 25 bps or 1.196097% 37

  38. Currency Swap Example • Suppose a firm can raise money at an advantageous rate in the U.S., but needs the funds to be denominated in pound sterling. The company can issue dollar-denominated debt, convert the principal to pound sterling, make payments in pound sterling and receive dollar interest to service its debt issue. • For example, suppose the firm agrees to pay 2% on a sterling principal of £10,000,000 & receive 1% on a US$ principal of $16,500,000 every year for 5 years. • In an interest rate swap the principal is not typically exchanged. • In a currency swap the principal is exchanged at the beginning and the end of the swap. 38

  39. The Cash Flows Dollars Pounds $ £ Year ------millions------ 2014 –16.50 +10.00 + 0.165 2015 –0.20 + 0.165 –0.20 2016 2017 + 0.165 –0.20 + 0.165 –0.20 2018 2019 +16.165 -10.20 39

  40. Typical Use of Currency Swap • Conversion from a liability in one currency to a liability in another currency • Conversion from an investment in one currency to an investment in another currency 40

  41. Swaps and Forwards • A swap can be regarded as a convenient way of packaging forward contracts. • The “plain vanilla” interest rate swap in our example consisted of 6 FRAs. • The “fixed for fixed” currency swap in our example consisted of a cash transaction and 5 forward contracts. • The value of the swap is the sum of the values of the forward contracts underlying the swap. • Swaps are normally “at the money” initially • This means that it costs nothing to enter into a swap • It does not mean that each forward contract underlying a swap is “at the money” initially 41

  42. Agenda 42

  43. Options • A call option is an option to buy a certain asset by a certain date for a certain price (the strike, or exercise, price) • A put is an option to sell a certain asset by a certain date for a certain price (the strike, or exercise, price) 43

  44. Profit ($) 30 20 10 Terminal stock price ($) 30 40 50 60 0 70 80 90 -5 Long Call Profit from buying a European call option on stock X: option price = $5, strike price = $60 44

  45. Profit ($) 70 80 90 5 0 30 40 50 60 Terminal stock price ($) -10 -20 -30 Short Call Profit from writing a European call option on stock X: option price = $5, strike price = $60 45

  46. Profit ($) 30 20 10 Terminal stock price ($) 0 60 70 80 90 100 110 120 -7 Long Put Profit from buying a European put option on stock X: option price = $7, strike price = $90 46

  47. Profit ($) Terminal stock price ($) 7 60 70 80 0 90 100 110 120 -10 -20 -30 Short Put Profit from writing a European put option on stock X: option price = $7, strike price = $90 47

  48. Payoff Payoff K K ST ST Payoff Payoff K K ST ST Payoffs from OptionsWhat is the Option Position in Each Case? Option Concept Check K = Strike price, ST = Price of asset at maturity A. C. D. B. 48

  49. Combinations of Options and Underlying Asset Suppose that we combine an option position with either a long or short position in the underlying asset. Long Stock + Long Put = Combination 0 0 0 K ST ST ST 49

  50. Combinations of Options and Underlying Asset Profit Profit K ST ST K (a) (b) Profit Profit K K ST ST (c) (d) 50

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