brussels 17 september 2002
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Brussels 17 September 2002. European Parliament Financial Services Forum Fundamentals of Derivative Contracts. David Mengle International Swaps and Derivatives Association and Fordham University Graduate School of Business. Three forms of derivatives activity. - PowerPoint PPT PresentationTRANSCRIPT
Brussels17 September 2002
European Parliament Financial Services Forum
Fundamentals of Derivative Contracts
David MengleInternational Swaps and Derivatives Association andFordham University Graduate School of Business
Three forms of derivatives activity
Futures are customized, exchange-traded derivatives contracts– Futures contracts– Exchange-traded options
Over-the-counter (OTC) are customized, privately-negotiated derivatives– Forwards
• Contracts to exchange something at an agreed time in the future at a price agreed upon today
– Swaps• Contracts between two counterparties to exchange cash flows on a
notional principal amount at regular intervals during a stated period– OTC options
• Contracts that give the buyer, in exchange for the payment of a premium, the right but not the obligation to buy or sell a specified amount of the underlying asset at a predetermined price at or until a stated time.
Structured securities combine securities with derivatives contracts
Situation 1: Interest rate risk
Situation
Client is a European bank that has made a 5-year €100 million loan at a fixed rate to a domestic corporation
Loan funded with one-year euro deposits
Client is concerned that euro interest rates will rise
Assets Liabilities
Loan (5-year fixed rate) €100 MM
Deposit (1-year Euribor)€100 MM
Interest rate risk
There is a mismatch between the term of the asset and that of the liability that funds the asset
The client here faces refinancing risk that the cost of rolling over (reborrowing) funds will rise relative to the returns on assets
Mismatches often occur because the investment and funding decisions are made by different parts of the firm
BankBank
5-yearfixed rate
Loan
Situation
Deposit
1-year Euribor
Net Funding Cost: 5-Year Swap Rate = 4.12%Net Funding Cost: 5-Year Swap Rate = 4.12%
Solution: Interest rate swap
DealerDealer
BankBank
EuriborSwapRate
(4.12%)
5-yearFixed Rate
1-yearEuribor
Deposit Loan
Swap: A contractual agreement between two counterparties to exchange cash flows on a notional principal amount at regular intervals during a stated period
The most common type of interest rate swap involves the exchange of a fixed rate cash flow for a floating rate cash flow
In an interest rate swap, the notional amount is never exchanged
Notional amount = €100 millionNotional amount = €100 million
Swap cash flows
Time Deposit Swap Net
0 100 -- -- 100
1 (EURIBOR) EURIBOR (4.12) (4.12)
2 (EURIBOR) EURIBOR (4.12) (4.12)
3 (EURIBOR) EURIBOR (4.12) (4.12)
4 (EURIBOR) EURIBOR (4.12) (4.12)
5 (100 + EURIBOR) EURIBOR (4.12) (104.12)
€ millions
Result of hedging with interest rate swap
Client has given up interest rate risk by locking in fixed swap rate (replaced risk with certainty)– Client will be protected from rising deposit rates,– But will not benefit if rates fall
Client assumes credit exposure to Dealer (and vice versa) over next five years
The Dealer does not charge the client a fee to enter the swap
8
Situation 2: Interest rate risk
A European corporation plans to borrow €100 million to fund its domestic expansion plans, but is not well known enough to issue fixed-rate bonds to the public
The corporation is able to borrow from its bank at a floating rate of 1-year Euro Libor plus 1.5 percent
The corporation can obtain synthetic fixed-rate financing by paying a fixed rate on an interest rate swap with its bank
Bank Corporation Dealer
€100 MM
Libor
4.12%(fixed)
Euriibor + 1.50%
5-year Euro swap rate = 4.12%Total annual funding cost to corporation = 4.12% + 1.50% = 5.62%
Situation 3: Currency risk
A European electrical company has contracted to sell US$100 million of power generating equipment to a U.S. electrical power producer, with delivery and payment occurring six months from today
Deal is profitable at current spot exchange rate (€1 = $0.97), but is concerned that the deal will become unprofitable if the euro falls relative to the U.S. dollar
Company is not willing to lock in an exchange rate today, however, because it want to profit if the U.S. dollar depreciates relative to the euro
Solution: Currency option
Options: Definitions
An option is a legal contract that gives the buyer, in exchange for the payment of a premium, the right but not the obligation to buy or sell a specified amount of the underlying asset at a predetermined price (strike price) at or until a stated time (maturity date).
Types of option– Call option is an option to buy– Put option is an option to sell
Maturity date is the time after which the option is no longer valid; also called expiration date
– European option can only be exercised at maturity date– American option can be exercised any time up to expiry Option
buyer or holder (long)
Currency option
The corporation bought a put option on the dollar with a strike price of 1.05 $/€ by paying a premium today
At the maturity of the option six months from today:– If the exchange rate is below 1.05 $/€, there will be no payment on the
option– If the exchange rate is above 1.05 $/€, the Dealer will compensate the
company in euros for the depreciation of the value of the receivable
DealerDealerElectrical Electrical companycompany
Payment if $/€ > 1.05(on Maturity Date)
US$100 MMReceivable
(in 6 months)
Up-front premium(on Trade Date)
Result of hedging with currency option
Client will be protected if dollar depreciates below 1.05 euro per dollar
Client will benefit from any appreciation of euro (net of premium)
Client assumes credit risk of default by Dealer
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Situation 4: Credit risk
A European bank enjoys profitable lending relationships with manufacturing corporations
The bank would like to diversify its exposure, however, and is particularly concerned that it has become more exposed to one borrower than it would like
The bank is reluctant, however, to reduce its exposure by selling the loans to other banks or by demanding immediate repayment of some of its outstanding loans
Solution: Credit derivative
Credit (default) swaps are the most basic form of credit derivative
Buyer pays premium for protection against default by reference credit
If reference credit(s) default (or other credit event occurs), buyer receives payout equal to one of the following:
– Physical settlement: Par value in return for delivery of reference obligation; or– Cash settlement: Post-event fall in price of reference obligation below par; or– Binary settlement: Fixed sum or percentage of notional
Results: – Credit swap hedges both default risk and credit concentration risk– Buyer trades credit risk of reference credit for counterparty credit risk of seller
X bp per annum
Contingent paymentProtection buyerProtection buyer Protection sellerProtection seller
Results of hedging with credit default swap
Protection buyer – Gives up exposure to default of reference credit without
removing reference asset from balance sheet– Takes on counterparty credit exposure to protection seller
• More precisely, protection buyer takes on risk of simultaneous default by reference credit and protection seller
Protection seller– Takes on exposure to reference credit without need for funding
underlying position
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Managing risks with OTC derivatives
End-users encounter financial risks in connection with their core business activities
– Corporations– Financial institutions– Governments and agencies
Dealers must manage the risks they take on from users by hedging– Other dealers– Inventories of the underlying risk– Futures and securities exchanges
Types of market participants– Hedgers seek to pass their risks on to others– Speculators seek to take on risks
Liquid markets are essential to the ability to manage risks effectively
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How dealers hedge the directional risk of swaps
CounterpartyCounterparty DealerDealer
Fixed rate
HedgeHedgeStrategyStrategy
Euribor
Dealer pays fixed and receives floating
Hedge strategy can consist of:
Offsetting swap
Buy treasury securities, financed with repurchase agreement
Buy Euribor futures
Leave position open
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How risks are passed on by dealers
Dealers manage many of their risks though offsetting transactions with other dealers– The other dealers often have user clients with offsetting risks
Dealers can pass their risks on to organized futures exchanges
Dealers can offset their risks through offsetting transactions in money, currency, and capital markets
– Liquid markets are those in which participants can easily pass on their risks with little of no effect on the market
– The existence of both hedgers and speculators in markets is necessary to ensure liquidity
User Dealer
Other markets
Futures
Other dealers
Other users
Other users
Other users
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Profile of derivatives participants
46%
43%
11%
Interest rate swaps
31%
42%
27%
Currency options
Credit derivatives
16%27%
57%
Non-financial institutions
Dealers
Other financial institutions
Source: Bank for International Settlements
20
Derivatives growth, 1987-2001
69,207
63,009
58,265
50,997
29,037
25,455
17,715
11,3058,477
5,3484,4523,4522,4771,656868
1987 1989 1991 1993 1995 1997 1999 2001
Notional principal outstanding, interest rate swaps and options and cross-currency swaps
Source: International Swaps and Derivatives Association
Brussels17 September 2002
European Parliament Financial Services Forum
Fundamentals of Derivative Contracts
David MengleInternational Swaps and Derivatives Association andFordham University Graduate School of Business