Professional Documents
Culture Documents
Deliver Tives
Deliver Tives
& Swaps
Introduction to Derivatives
Currency Forwards and Futures
Currency Options
Interest Rate Swaps
Currency Swaps
Unwinding Swaps
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Introduction
A derivative (or derivative security) is a financial
instrument whose value depends on the value of other,
more basic underlying variables/assets:
Share options (based on share prices)
Foreign currency futures (based on exchange rates)
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Definition of Futures and Forwards
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Futures versus Forwards
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Futures Contract - Example
Specification of the Australian Dollar futures contract
(International Money Market at CME)
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Futures - Marking to Market
Futures contracts are “marked to market” daily.
Generates cash flows to (or from) holders of foreign
currency futures from (or to) the clearing house.
Mechanics:
Buy a futures contract this morning at the price of f0,T
At the end of the day, the new price is f1,T
The change in your futures account will be:
[f1,T - f0,T] x Contract Face Value = Cash Flow
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Purpose of Marking to Market
Daily marking to market means that profits and losses
are realized as they occur. Therefore, it minimizes the
risk of default.
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Marking to Market – Example
Trader buys 1 AUD contract on 1 Feb for USD0.5000/
AUD
USD value = 100,000 x 0.5000 = USD 50,000.
0 $ Spot
1.80 2.00
A$ 1.90/US$
Forward/Futures
Rate
-
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Basics of Options
Options give the option holder the right, but not the
obligation to buy or sell the specified amount of the
underlying asset (currency) at a pre-determined price
(exercise or strike price).
The buyer of an option is termed the holder, while the
seller of the option is referred to as the writer or
grantor.
Types of options:
Call: gives the holder the right to buy
Put: gives the holder the right to sell
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0
Basics of Options
An American option gives the buyer the right to
exercise the option at any time between the date of
writing and the expiration or maturity date.
A European option can be exercised only on its
expiration date, not before.
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Basics of Options
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Basics of Options
Maturity month
One call option gives the holder the right to purchase
€62,500 for $56,250 (= €62,500 × $0.90/€)
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0
Options Trading
Buyer of a call:
– Assume purchase of August call option on Swiss francs
with strike price of 58½ ($0.5850/SF), and a premium
of $0.005/SF.
– At all spot rates below the strike price of 58.5, the
purchase of the option would choose not to exercise
because it would be cheaper to purchase SF on the open
market.
– At all spot rates above the strike price, the option
purchaser would exercise the option, purchase SF at the
strike price and sell them into the market netting a
profit (less the option premium).
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0
Options Trading
Writer of a call:
– What the holder, or buyer of an option loses, the writer
gains.
– The maximum profit that the writer of the call option can
make is limited to the premium.
– If the writer wrote the option naked, that is without owning
the currency, the writer would now have to buy the currency
at the spot and take the loss delivering at the strike price.
– The amount of such a loss is unlimited and increases as the
underlying currency rises.
– Even if the writer already owns the currency, the writer will
experience an opportunity loss.
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0
Options Trading
Buyer of a Put:
– The basic terms of this example are similar to those just illustrated
with the call.
– The buyer of a put option, however, wants to be able to sell the
underlying currency at the exercise price when the market price of
that currency drops (not rises as in the case of the call option).
– If the spot price drops to $0.575/SF, the buyer of the put will
deliver francs to the writer and receive $0.585/SF.
– At any exchange rate above the strike price of 58.5, the buyer of
the put would not exercise the option, and would lose only the
$0.05/SF premium.
– The buyer of a put (like the buyer of the call) can never lose more
than the premium paid up front.
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0
Options Trading
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0
Option Pricing & Valuation
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Option Pricing & Valuation
Call Put
at the money ST – X = 0 X – ST = 0
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Option Pricing & Valuation
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0
Option Pricing & Valuation
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Forwards versus Options
$0.90
.
$0.75
Value of Forward/Put Option at Expiration
$0.60
$0.45
$0.30
$0.15
$0.00
-$0.15
-$0.30
Value of Forward Sale at Expiration
-$0.45
Value of Put at Expiration
-$0.60
-$0.75
-$0.90
$0.10
$0.20
$0.30
$0.70
$0.80
$1.00
$1.10
$1.50
$1.60
$1.70
$0.00
$0.40
$0.50
$0.60
$0.90
$1.20
$1.30
$1.40
$1.80
Spot Rate at Expiration
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What are Swaps?
Swaps are contractual agreements to exchange
or swap a series of cash flows.
These cash flows are most commonly the
interest payments associated with debt service.
– If the agreement is for one party to swap its fixed
interest rate payments for the floating interest rate
payments of another, it is termed an interest rate swap.
– If the agreement is to swap currencies of debt service
obligation, it is termed a currency swap.
– A single swap may combine elements of both interest
rate and currency swaps.
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What are Swaps?
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What are Swaps?
There are two main reasons for using swaps:
1. A corporate borrower has an existing debt service
obligation. Based on their interest rate predictions
they want to swap to another exposure (e.g. change
from paying fixed to paying floating).
2. Two borrowers can work together to get a lower
combined borrowing cost by utilizing their
comparative borrowing advantages in two different
markets.
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What are Swaps?
For example, a firm with fixed-rate debt that
expects interest rates to fall can change fixed-rate
debt to floating-rate debt.
In this case, the firm would enter into a pay
floating/receive fixed interest rate swap.
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Swap Bank
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Example of an Interest Rate Swap
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Example of an Interest Rate Swap
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Example of an Interest Rate Swap
Bank A has an absolute advantage in borrowing
relative to Company B
Nonetheless, Company B has a comparative
advantage in borrowing floating, while Bank A has a
comparative advantage in borrowing fixed.
That is, the two together can borrow more cheaply if
Bank A borrows fixed, while Company B borrows
floating.
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Example of an Interest Rate Swap
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Example of an Interest Rate Swap
COMPANY B BANK A TOGETHER
Borrow preferred
11.75% LIBOR LIBOR + 11.75%
method
Borrow opposite
LIBOR + 0.50% 10% LIBOR + 10.50%
and swap
POTENTIAL SAVINGS: 1.25%
Swap
Bank
10 3/8%
LIBOR – 1/8%
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Example of an Interest Rate Swap
Swap
Bank
10 3/8%
LIBOR – 1/8% Why is this swap
Bank desirable to Bank A?
A With the swap, Bank A
10% pays LIBOR-1/2%
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
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Example of an Interest Rate Swap
Swap
Bank
10 ½%
The swap bank makes this LIBOR – ¼%
offer to Company B: You
pay us 10 ½ % per year on Company
$10 million for 5 years, B
and we will pay you
LIBOR – ¼ % per year on
$10 million for 5 years.
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Example of an Interest Rate Swap
Swap
Bank
10 ½%
Why is this swap LIBOR – ¼%
desirable to Company B?
Company
With the swap, Company B
B pays 11¼% LIBOR + ½%
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Example of an Interest Rate Swap
10 3/8 % Bank 10 ½%
Bank Company
A B
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Example of an Interest Rate Swap
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The QSD
The Quality Spread Differential (QSD) represents the
potential gains from the swap that can be shared
between the counterparties and the swap bank.
There is no reason to presume that the gains will be
shared equally.
In the above example, Company B is less credit-worthy
than Bank A, so they probably would have gotten less
of the QSD, in order to compensate the swap bank for
the default risk.
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Currency Swaps
Since all swap rates are derived from the yield curve in
each major currency, the fixed-to-floating-rate interest rate
swap existing in each currency allows firms to swap across
currencies.
The usual motivation for a currency swap is to replace
cash flows scheduled in an undesired currency with flows
in a desired currency.
The desired currency is probably the currency in which the
firm’s future operating revenues (inflows) will be
generated.
Firms often raise capital in currencies in which they do not
possess significant revenues or other natural cash flows (a
significant reason for this being cost).
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Currency Swaps
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Example continued..
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Example continued..
Company A is the U.S.-based MNC and Company B is
a U.K.-based MNC.
Both firms wish to finance a project of the same size in
each other’s country (worth £10,000,000 or
$16,000,000 as S = 1.60 $/£). Their borrowing
opportunities are given below.
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
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A’s Comparative Advantage
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B’s Comparative Advantage
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Potential Savings
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Differential (B-A) 2.0% 0.4%
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Example of a Currency Swap
Swap
Bank
i$=8% i$=9.4%
i£=12%
i£=11%
i$=8% Company Company i£=12%
A B
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Differential (B-A) 2.0% 0.4%
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Example of a Currency Swap
Swap
Bank
i$=8% i$=9.4%
i£=12%
i£=11%
i$=8% Company Company i£=12%
A B
A’s net position is to borrow at i£=11%
$ £
A saves i£=0.6%
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Differential (B-A) 2.0% 0.4%
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Example of a Currency Swap
Swap
Bank
i$=8% i$=9.4%
i£=12%
i£=11%
i$=8% Company Company i£=12%
A B
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Example of a Currency Swap
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Unwinding a Swap
Discount the remaining cash flows under the swap
agreement at current interest rates, and then (in the case
of a currency swap) convert the target currency back to
the home currency of the firm.
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Unwinding a Swap
Suppose in the previous example, Company A wanted
to unwind its (5 year) currency swap with the Swap
Bank at the end of Year 3. Assume that at Year 3, the
applicable dollar interest rate is 7.75% per annum, the
applicable pound interest rate is 11.25% per annum,
and S=1.65 $/£.
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Unwinding a Swap
There are two years of interest payments and repayment of face
values remaining.
For Company A:
Paying 11% p.a. on £10,000,000
Receiving 8% p.a. on $16,000,000
Must return £10,000,000 and receive $16,000,000 at end