DERIVATIVES

Presented by
Sade Odunaiya
Partner, Risk Management
Alliance Consulting
 DERIVATIVES

u Introduction

u Forward Rate Agreements – FRA

u Swaps

u Futures

u Options

u Summary
 INTRODUCTION
u Financial Market Participants
– Based on Time Horizon
u Borrower/Issuer
u Lender/Investor
– Trader – short
short--term horizon for gain
– Investor – long
long--term for cash flow characteristics
– Based on Motivation
u Investor – for income stream
u Speculator – holds for expected gain
u Arbitrageur – simultaneous sale & purchase for gain
u Hedger – to protect against existing risks

Brokers – act on behalf of a principal or on own

account
 INTRODUCTION
u Financial Market Instruments
– Investment instrument – traded spot or
forward with exchange of principal

– Contract for Difference – derived from

the attributes of investment instruments
but traded on a ‘notional’
‘notional’ principal.
Payments are for differences computed
on the notional principal amount
 INTRODUCTION
u Derivatives
– Security that derives its value from another
asset or security
u Financial derivative
– A financial instrument whose payoff depends
on another financial instrument or security
– Legally binding promise to perform some
action in the future
– Types
u FRA
u Swaps
u Futures
u Options
Forward Rate Agreement - FRA
u Derived from Forward Contracts
u Initiated at one time; performance in
accordance with agreed terms occurs at a
subsequent time
u Price is set @ time of contract with actual
payment or delivery later
u Examples are fwd foreign exchange
contracts, fwd interest rate agreement, etc
u FRAs settle in differences based on
notional principal & tenor
 SWAPS
u Agreement between two parties to
exchange sequences of cash flows over a
period in the future
u Anything can be swapped once there is
mutual agreement – ‘custom nature’

u 2 basic financial instrument types:

u Interest rate
u Currency swaps
 FUTURES
u Futures Contract
– Standardized forward contract
u Quantity,delivery date, delivery mechanism
u Method of closing

u Minimum & Maximum price fluctuation

– Exchange traded and regulated

– Backed by a clearing house
– Requires a Margin – good faith deposit
– Daily settlement of gains and losses
 OPTIONS
u Options

– A contract whereby one party has a right and the other

party has an obligation
– For a specified period after which it lapses
u American & European variants
– Premium or price is paid ab initio
– Two broad categories
u Call – gives a right to buy & an obligation to sell
u Put – gives a right to sell & an obligation to buy
– Standardized and Traded on an exchange
– Clearing house system
– Requires posting of margins
 DERIVATIVES
u Custom made contracts
– FRA
– Swaps

u Standardized or Exchange traded

– Futures
– Options
 DERIVATIVES
u APPLICATION
– Market Completeness
u A market in which any and all identifiable payoffs can
be obtained by trading securities available in the
market
– Speculation – for knowledgeable traders to
take calculated risks
– Risk Management – a powerful tool for limiting
risk
– Trading efficiency – Use of derivatives rather
than the underlying securities for the same
return at a much lower cost
FORWARD RATE AGREEMENT (FRA)
u Types: on interest or exchange rate
u On Interest rate

– Fwd contract to borrow/lend money at a certain rate at

some future date for an agreed tenor
– No cash flow of principal at start & settlement
– Long position – party that will borrow
– Contract price – agreed interest rate
u LIBOR or EURIBOR
– Settlement date is Contract date
– Long pays short, if contract rate > actual rate on
settlement date
– Short pays long, otherwise
– Default risk on the difference to be paid/received
FORWARD RATE AGREEMENT (FRA)

u Settlement Amount is the discounted

value of interest differential at actual
price for the tenor of the agreement

Notional (floating – fwd)(days/360)

Principal 1 + (floating)(days/360)

where: days = no of days in loan term

 FORWARD RATE AGREEMENT
(FRA)
u Illustration
– Consider an FRA that expires/settles in
30 days on a notional principal of
$1mm. Forward rate is 5% on a 90- 90-day
LIBOR
– Assume actual LIBOR 30-30-days from now
(at expiration) is 6%
– Compute the cash settlement @
expiration and identify who will be
making payment
 SWAPS
u Agreement to exchange a series of cash
flows on periodic settlement dates over an
agreed period of time
u Series of FRAs
– Custom made i.e. any mutually agreed cash
flows can be swapped
– No payment by either party @ initiation
– No secondary market
– Largely unregulated
– Default risk is an important aspect
– Participants are largely institutions
u Zero sum game
 SWAPS
u Common Types
– Interest rate
– Currency
 SWAPS - TYPES
u Interest rate swap
– Notional principal in same currency for same amount
– Trading fixed interest rate for floating interest rate or
plain vanilla interest rate swap
u Pay-fixed side: Party that wants floating-
Pay- floating-rate interest
payment agrees to pay fixed-
fixed-rate interest
u Pay--floating side: Party that agrees to pay floating side
Pay
– Floating rate is LIBOR based
– Cash payment @ end of period & is based on net
position
Net fixed = swap fixed – LIBORt-1) no of dys (notional
Rate paymt rate 360 principal)

Note:
+ve – fixed rate payer owes floating rate payer
-ve - fixed rate payer is owed by floating rate payer
 SWAPS - TYPES
u Currency Swap
– One party makes payment denominated in one
currency, while the other makes payment in
another currency
– Notional Principal
u Exchanged @ start using the exchange rate @ start
u Returned at maturity in the same amount

– Each party services the debt at the rate

applicable to the currency received periodically
– Full interest payments are exchanged without
netting
 SWAPS - TYPES
u Currency Swap – Illustration
A US firm, Party A, wished to set up an
Japanese operations and wants to finance
the costs in Japanese Y. the firm finds that
issuing Yen denominated debt is relatively
more expensive as they are unknown in
the Japanese market

Solution: Issue US$ debt & swap the cash

flows for Japanese Yen
 SWAPS - TYPES
u4 types of currency swaps

– US$ fixed int rate for Jap Y fixed

– US$ fixed int rate for Jap Y floating
– US$ floating int rate for Jap fixed
– US$ floating int rate for Jap floating
 FUTURES
u Comparison with FRA
– Similarities
u Either deliverable or cash settlement
u Priced to have zero value at time of contract

– Differences
u Organized exchange
u Regulation
u Standardized
u Single clearinghouse
 FUTURES
u Standardized
u Quantity
u Delivery date
u Delivery mechanism
u Method of closing
u Minimum & maximum price fluctuation

– Exchange traded and regulated

– Backed by a clearing house
– Requires a Margin – good faith deposit
– Daily settlement of gains and losses
u Characteristics
– Purchaser has contracted to buy i.e. long
– Seller is ‘short’ as he’s contracted to sell
 FUTURES - TYPES

u T-BILL FUTURES

– $1 million 90-
90-day
– Quoted as 100 – discount yield (annualized)
– Settlement - in cash
– 1 basis point price change is $25
– Not as important as before
– Heavily influenced by US Federal Reserve
Board & monetary policies
 FUTURES - TYPES
u EURODOLLAR FUTURES
– Similar to T-
T-bill futures
u $1million 90-
90-day LIBOR
u Price = 100 – Annualized LIBOR %
u Settle in cash
u Minimum price movement – 1 tick is $25

u TREASURY BOND FUTURES

– Treasury bonds with 15 yrs+ maturity
– Face value of $100,000
– Deliverable contract
– Quoted as a % + fractions of 1% (1/32nd) of
FV
 FUTURES - TYPEs
u STOCK INDEX FUTURES
– Most popular stock index future-
future-S&P500
– Settlement is in cash & based on a
multiplier of 250
– Each contract is 250 times the level of
index
– Gain or loss of $250/ contract
 FUTURES - TERMINATION
u Delivery
– as per location on contract
– Less than 1%
u Cash settlement
– Marked to market on delivery date
u Offsetting
or reverse trade
u Exchange for physicals
– Off the floor of the exchange
 OPTIONS
u An options contract gives the owner a
right but no legal obligation to conduct a
transaction involving an underlying asset
at a predetermined price (exercise price)
on a predetermined future date (exercise
date)
u Right will only be exercised if it is
profitable
prof itable to
to do so
u The writer (option
(option writer) of an option is
the seller
u Buyers pays a option premium to the
seller
 OPTIONS
u 4 possible positions
– Long call: the buyer of a call option
– Short call: the seller of a call option
– Long put: the buyer of a put option
– Short put: the seller of a put option
u Two variants
– American – exercisable at any time up to &
including the exercise date
– European – exercised only on the exercise date
– American option more valuable than European
one
– Same value on exercise date
 OPTIONS
u Moneyness
– ‘In-
‘In-the
the--money’ when the option has value i.e.
+ve payoff
u For call option: spot price > exercise price
– ‘out
out--of
of--the
the--money
money’’ when the option will make
a loss i.e. –ve payoff
u For call option: spot price < exercise price
– ‘at
at--the
the--money
money’’ when neither loss or gain
u For call & put options: strike price = exercise price
u An options intrinsic value is the amount by
which the option is ‘in-
‘in-the
the--money’
– Callv = Max(0, S-
S-X)
– Putv = Max (0, X
X--S)
 OPTIONS
u Illustration:

Consider a July 40 call and a July 40

put, both on a stock that is currently
selling for $37/share. Calculate how
much these options are in-
in- or out-
out-of
of--
the--money.
the
 OPTIONS
u Option Pricing is a function of the
following:

– Nature – call or put

– Strike price relationship to spot price
– Time to maturity
– Volatility of price of underlying asset
 SUMMARY
u Derivative instruments are a very fast
growing sector of the financial market
u They ensure market completeness and
elimination of ‘free income’ in the financial
market
u Risk Managers use the market to manage
the risks in their portfolio at minimal costs
u Derivative instruments are here to stay!!
THANK YOU
QUESTIONS???