the derivatives market - fd ch 1

7/28/2019 The Derivatives Market - FD Ch 1

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Financial Derivatives Market

Introduction


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Introduction A Derivative is a financial product the value of

which is derived from the value of underlying

asset. Commonly used derivatives are:

Stock Futures

Stock Forwards

Stock Options

Swaps

Financially Engineered products


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Stock Futures It is a standardized agreement to

deliver or receive a specified stock at

specified price and the date.

They are traded on organizedexchanges.


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Futures versus Forwards Futures

Standardized specific sizedcontract

It has a standard maturitydate

It is marked to market everyday (Margin Requirements)

Clearing exchange is thecounterparty

Always traded on exchange

Only 5% contracts settled byactual delivery

Forwards

Customized contract

It can have any maturitydate

Delivery and payment at thetime of maturity

It is a contract between twoparties

It is traded on OTC

Contracts are settled byactual delivery


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Futures versus Forwards (Contd) Futures

It is regulated by FuturesTrading Commission

It entails brokerage fees onbuy and sell orders

Margins are required for allparticipants in the market

Negligible Credit risk asexchange is the counterparty

Forwards

It is self regulating.

It is based on bid askspreads.

Margins not required

Credit risk is borne by eachparty.


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Stock OptionsACalloption is an option to purchasea

stated number of units of underlying

stock at a specified price per unit duringa specific period of time.

APutoption is an option to sella stated

number of units of underlying stock at aspecified price per unit during a specificperiod of time.


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Option Terminology Following are the terms generally used

for Options: Price (premium) of the option (OP)

Time to Expiration (T)

Exercise Price or Strike Price (X)

Spot rate at the time of purchase of option S(o)

Spot Rate Today S(1)

Spot Rate at the time of Expiry S(x)


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Buy Call Option


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Buy Call Option


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Sell Call Option


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Sell Call Option


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Buy Put Option


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Buy Put Option


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Sell Put Option


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Sell Put Option


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Option Pricing and Valuation Theoretically, option comprises of two

components:

A) Intrinsic Value: It is the amount by which option isin the money (S1 X). It equals the immediateexercise value of the option.

B) Time Value: An option value over and above its

intrinsic value. During the time remaining before anoption expires, the spot rate can move so as to makeexercising option profitable.


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Option Pricing and Valuation

(Contd) An American option only has positive Time

value until the expiry date.

European option, increase in Time toMaturity may not have any value, as it canbe only exercised at the time of expiry.

At expiration, an Option can have only the

Intrinsic value. (No Time value). Intrinsic value has relationship with Exercise

price.


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Pricing of Options on Exercise

Date Price of a Call Option:

C(N) = Max [0, S (N) X]

Greater of zero or intrinsic value of option Price of a Put Option:

P(N) = Max [0, X S (N)]

Greater of zero or intrinsic value of option

S (N) = Spot price on Exercise date


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Speculating with Call Option Profit from a Call Option: Buyers

perspective:

Profit = S1 X OP for S1 > X Profit = - OP for S1 X

Profit = OP for S1


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Example of Speculation with Call

Option Suppose S1 = 45.00

Profit from a Call Option: Buyers perspective:

Then Profit = 45.00 43.50 0.30= Rs. 1.20

Profit from a Call Option: Writers perspective:

Then Profit = - (45.00 43.50 0.30)

= - Rs. 1.20


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Speculating with Put Option Profit from a Put Option: Buyers

perspective:

Profit = X S1 OP for S1 < X Profit = - OP for S1 >= X

Profit from a Put Option: Buyersperspective: Profit = - (X S1 OP) for S1 < X

Profit = OP for S1 >= X


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Factors affecting Option Premium Existing Spot price relative to Strike

price

Strike or Exercise Price

Time to expiration

Volatility of the currency


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Swaps Swap is an agreement between two or

more parties to exchangesets of

cash flowsover a period in future. Two basic kinds of Swaps

Interest rate swap

Currency swap


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Characteristics of Swap market Swap agreements are customized to meet the needs

of the counterparties.

Privacy is maintained in these transactions.

Counterparties can select currencies, amounts,maturity dates etc.

Swap market does not face much regulation.

Problem of counterparty default exists. Each party must find a counterparty to take the

opposite position.

Termination of contract requires acceptance by

counterparties.


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Interest Rate Swap It is an arrangement whereby one party exchange

one set of interest rate payment for another. Theinterest rates are calculated on notional values of

Principals.

Provision of Swap include:

Notional Principal value.

Fixed interest rate to be exchanged for another rate.

Formula type of index used to determine floating rate. Frequency of payments quarterly, yearly etc.

Life time of the swap.


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Interest Rate SwapPlain Vanilla Swap Example

A large firm pays a fixed interest rate to its bondholders,

while a smaller firm pays a floating interest rate to itsbondholders. Notional amount of Principal remains thesame.

The two firms could engage in a swap transaction which

results in the larger firm paying floating interest rates tothe smaller firm, and the smaller firm paying fixedinterest rates to the larger firm. No exchange ofPrincipal takes place.


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Plain Vanilla Swap

Plain Vanilla Swap Example (contd)

Big Firm Smaller

Firm

Bondholders Bondholders

LIBOR50 bp

8.05%

8.05% LIBOR +100 bp


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Plain Vanilla Swap


A facilitator might act as an agent in the

transaction and charge a 15 bp fee for the

service.


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Plain Vanilla Swap (Contd)


Big Firm Smaller

Firm

Bondholders Bondholders

8.05% LIBOR +100 bp

Facilitator

LIBOR -50 bp

8.05% 8.20%

LIBOR -50 bp


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Various Types of Interest Rate

Swaps Plain Vanilla Swap:Fixed rate for Floating rate.

Forward Swap:It involves exchange of interest ratepayments that does not begin until a specified futurepoint in time. Fixed for floating rate swap.

Callable swap:Party making the fixed rate paymentshas the right (option) to terminate swap prior to itsmaturity.

Puttable swap:Party making the floating ratepayments has the right (option) to terminate swapprior to its maturity.


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Swaps Extendable swap:Agreement contains a feature

which allows fixed for floating party to extend theswap period.

Equity swap:Involves exchange of interest paymentslinked to the change in stock index. Swap of fixedinterest rate of 7% for appreciation in BSE indexeach year for four years.

Zero coupon to floating:Fixed rate payer makes abullet payment at the end and floating rate payermakes periodic payments.


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Swaps Rate Capped Swap:Exchange of fixed rate payments

for floating rate payments and floating rates arecapped. An upfront fees is paid for capping.


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Price Determinants of IR Swaps Prevailing market interest rates, higher

the rates lower is the price.

Availability of counterparty.

Creditworthiness of the counterparty.

Expected Political risk


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Usefulness of IR Swaps Different accessibility to different

markets for borrowings purposes.

Quality rating of the Companies (AAA,BB etc.)

Hedging: Lock in Interest rates


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Interest Rate Products Interest rate Cap: This offers payments in periods

when a specified interest rate exceeds a specificceiling (cap) interest rate. A fee is charged upfront by

the offering party (bank).

Example on page 212

Interest Rate Floor:This offers payments inperiods when a specified interest rate falls below a

specified interest rate (floor). A fee is chargedupfront by the offering party (bank).

Example on page 212


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Interest Rate Products Interest rate Collar: This involves purchase of an

interest rate cap with a simultaneoussale of aninterest rate floor. Fees is received on sale of Floor

from one party which can be used to pay onpurchase of Cap to another party.

Example on Page 213(Do at Home)


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Currency Swaps These are agreements whereby currencies

are exchanged at specified exchange rates

and at specified intervals. One major difference between Interest Rate

swaps and Currency swap is that with acurrency swap, there is always an exchange

of Principal amounts at the beginning and atmaturity at a predetermined exchange rate.

Example on page 214.


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Suppose a U.S. MNC wants to finance a

10,000,000 expansion of a Britishplant.

They could borrow dollars in the U.S.where they are well known and

exchange the dollars for pounds. This will give them exchange rate risk:

financing a sterling project with dollars.

They could borrow pounds in theinternational bond market, but pay apremium since they are not as wellknown abroad.


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An Example of a Currency Swap If they can find a British MNC with a

mirror-image financing need they may

both benefit from a swap.

If the spot exchange rate is S0($/) =$1.60/, the U.S. firm needs to find a

British firm wanting to finance dollarborrowing in the amount of$16,000,000.


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An Example of a CurrencySwapConsider two firms A and B: firm A is a

U.S.based multinational and firm B is aU.K.based multinational.

Both firms wish to finance a project ineach others country of the same size.Their borrowing opportunities are given

in the table below.$

Company A 8.0% 11.6%

Company B 10.0% 12.0%


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$9.4%

$

Company A 8.0% 11.6%Company B 10.0% 12.0%

Firm

B

$8% 12%

Swap

Bank

Firm

A

11%

$8%

12%


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An Example of a CurrencySwap

$8% 12%

$


Firm

B

Swap

Bank

Firm

A

11%

$8% $9.4%

12%

As net position is to borrow

at 11%

A saves .6%

An Example of a Currency


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$8% 12%

$


Firm

B

Swap

Bank

Firm

A

11%

$8% $9.4%

12%

Bs net position is toborrow at $9.4%

B saves $.6%

An Example of a Currency


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$8% 12%

$


Firm

B

The swap bank makes

money too:

At S0($/) = $1.60/, that

is a gain of $124,000 per

year for 5 years.The swap bank faces

exchange rate risk,

but maybe they canlay it off (in another

swap).

1.4% of $16 millionfinanced with 1% of

10 million per year

for 5 years.

Swap

Bank

Firm

A

11%

$8% $9.4%

12%


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Assignment Revise All the PPTs.

Read Chapter 1.

Do Exercise after Chapter 1.

the derivatives market - fd ch 1

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