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Chapter 18 – Derivatives and

Risk Management

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Risk Management
• Risk Management has gradually evolved from a
narrow insurance-based discipline to traditional
financial activities.
• Risk Management involves the management of
unpredictable events that have adverse
consequences for the firm.

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History of Risk Management – “Insurance”
• 2100 B.C. – “Bottomry” – from the Code of Hammurabi. (A form of naval
insurance whereby the owner of the vessel can borrow money to buy cargo, and
does not pay the debt if the ship is lost at sea – Pledging the boat’s bottom to
the lender).
• 17th to 18th Century – Insurance developed rapidly with the growth of British
commerce.
• 1735 – The first insurance company in the American colonies was
established.
• 1787 – Fire insurance corporations in NYC; 1794 – in Philadelphia.
• 1880’s – Appearance of Public Liability Insurance
• 1897 – Workmen’s Compensation Act in Britain (required employers to insure
employees against industrial accidents).
• Late 19th Century – Insurance that safeguards workers against sickness and
disability, old age, and unemployment.
• 1905-1912 – Worker’s Compensation Laws introduced in the USA. Social
insurance schemes proliferated worldwide.
• 1938 – Federal Crop Insurance Act
• After 1944 – Supervision and regulation of insurance corporations.
• Till then, insurance was still the main way companies manage risk.

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History of Risk Management
• 1956 – When exploration of the idea of risk management began.
HBR published “Risk Management: A new phase of cost control” by
Russell Gallagher. (Dr. Wayne Snider: “the professional insurance
manager should be a risk manager).
• 1960s and 1970s – First Age of Risk Management. Businesses
considered only the non-entrepreneurial risk (e.g. Security, fire,
pollution, fraud) Risk is treated reactively, like using insurance.
But insurance is only one way to protect the company. There are
many others.
• 1970s and 1980s – Second Age of Risk Management. Quality
assurance is introduced, heralded by the British Standards
Institution (BSI). Risk is treated in a proactive or preventable way.
• 1980s – Environmental risks is taken into account.
• 1995 – Third Age of Risk Management. Non-entrepreneurial and
Entrepreneurial risks (risks that a company is exposed to when it
engages in business) are considered.

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Ages of Risk Management

JQY Source: Kit Sadgrove, The Complete Guide to Business Risk Management, 2nd edition
Why might stockholders be indifferent to whether
or not a firm reduces the volatility of its cash
flows?

• Diversified shareholders may already be hedged


against various types of risk.
• Reducing volatility increases firm value only if it
leads to higher expected cash flows and/or a
reduced WACC.

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Risk Management – Does it add value to SHs?
• If the general premise that most investors hold well-diversified portfolio is true, then the answer is
theoretically NO.
• Recall the Corporate Value Model (page 326). Market Value of the Company = PV of expected
future FCF
• MV = FCF1/(1+WACC)^1 + FCFN/(1+WACC)^N
• Therefore, MV of shares depends on 2 variables, FCF and WACC. If and only if risk management
can increase expected FCF or decrease WACC can the market value of the stock increase.
• Suppose that you are in the business of buying and selling apples. The price now is P20 per apple.
You expect that the price is going to increase 10% for the next 5 years. So to manage risk, you
entered into an agreement with the supplier to buy apples at P20.50 per apple for the next 5 years.
• You have reduced risk, but have you added shareholders’ value? Remember that since 20.50 is
already known and therefore expected, The absolute amount of FCF won’t change.
• Recall that WACC = cost of debt + cost of preferred stock + cost of RE or common stock. If there is
no change in any of these components, or the capital structure remains the same, WACC will
remain the same. For cost of debt: If the supposed increase in the price of apples won’t cause
bankruptcy (if bankruptcy is imminent, kd must be reduced). For cost of equity: most investors
hold well diversified portfolios, so the relevant risk is non-diversified (systematic) risk. So even if
an increase in price of apples will lower your stock price, if you hold a well diversified portfolio,
any changes won’t be too significant. Thus, stock value won’t change significantly.

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Reasons why Companies Manage Risks
• Reduced volatility allows more Debt Capacity – to be able to take on more
debt. Reduces CF volatility and probability of bankruptcy, interest tax savings
lead to higher stock price. Remember that kd is less than ke or ks due to tax
savings, which leads to higher stock price.
• Maintaining optimal capital budget over time. Strive for the lowest WACC by
taking on more kd and cost of RE to avoid flotation costs.
• Reduced volatility minimize financial distress – CFs can fall below expected
levels. Risk management can alleviate this concern (through price tie-ups).
• Comparative advantages (in contrast with individual investor) in
hedging – lower transaction costs, asymmetric information, specialized skills
and knowledge
• Reduced volatility results to the reduction of borrowing costs (particularly
on swaps)
• Tax effects. Reduced volatility reduces the higher taxes that result
from fluctuating earnings. Stable earnings generally pay lower taxes than
companies with volatile earnings. (Tax credits, carryforward, carrybacks).
• For managers – they will try to employ risk management for earnings to stabilize,
so their bonuses will also be stable. Certain compensation schemes
reward managers for achieving stable earnings.

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Different Risks a firm may be exposed to
• Pure risks – risks that offer ONLY the prospect of a loss. There is no possibility
that a gain may occur. For example, fire hazard risk
• Speculative risks – there is a chance of a gain but there’s also a chance of a
loss. For example, investments in new projects.
• Demand risks – risk that demand for a firm’s products or services will go down.
• Input risks – risks that input costs will increase, and that these costs cannot be
transferred to the customer.
• Financial risks – risks resulting from financial transactions. For example, the
risks of interest rate fluctuation or exchange rate fluctuation.
• Property risks – risks that productive assets will be destroyed.
• Personnel risks – risks resulting from the actions of employees. For example,
strikes, theft, fraud.
• Environmental risks – risks of public outcry in case of pollution
• Liability risks – risks associated with product, service, or employee actions
(that may or may not lead to lawsuits)
• Insurable risks – risks that can be covered/mitigated by insurance (generally –
property, personnel, environmental, and liability)

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Process for managing risks
• Identify the risks faced by the firm
• Measure the potential effect of each risk
• Decide how to handle each relevant risk
▫ Transfer risk to the insurance company
▫ Transfer function that produces risk to a third party (agency)
▫ Purchase derivative contracts to reduce risk (hedge
risks)
▫ Reduce probability of adverse events
▫ If adverse events do occur, reduce magnitude of the loss
▫ Totally avoid the activity that gives rise to the risk (discontinue
products that may be subject to potential lawsuits).

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Derivatives
• Financial innovation that allows investors to manage risks.
• Securities whose values are determined by the market price or
interest rate of some other asset (underlying asset)
• Common underlying assets:
– Equities
– Indexes
– Bonds
– Physical Assets
– Interest Rates
• May be used to hedge risk or to profit from
speculation.
• Potentially risky, especially for inexperienced investors.

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Types of Derivatives:
• Forward Commitments – represents a commitment or a
binding promise to buy or sell an asset or make a payment in
the future
– Forward Contracts
– Futures Contracts
– Swaps
• Contingent Claims – payoffs occur if a specific event occurs.
It represents a right to buy or sell. It only has value if some
future event takes place (EG: if asset price > specified price)
– Callable and/or Convertible Bonds
– Warrants
– Options
• Standard Options – based on assets
• Exotic Options – based on futures or other derivatives
• Common types of options:
– Based on interest rate
– Asset-backed security
2 Broad Groups of Derivatives:
• Exchange-traded derivatives
– These are transacted via specialized derivatives exchanges
(CME Group, Korea Exchange, Eurex)
– Examples: Futures contracts and most options
– They are standardized, regulated, and backed by a
clearinghouse.
– They have relatively low default risk as such is shouldered by
the clearinghouse.
• Over-the-counter derivatives
– Traded/created by dealers and financial institutions in a
market with no central location.
– Examples: Forward contracts, swaps, and some options
(bond options)
– They are largely customized, unregulated and each contract
has a counterparty. They expose the owner of a derivative to
default risk (in case the counterparty does not honor his
commitment).
Classification of Derivatives
Common Derivatives in the Philippines
• HSBC Philippines:
▫ Cross-Currency Swaps
▫ Currency Options
▫ Interest Rate Swaps
• BDO
▫ Interest Rate Derivatives
▫ Credit Derivatives
• Metrobank
▫ Swaps
▫ Options
▫ Credit Derivatives

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Derivatives to be studied:
▫ Forward Contracts
▫ Futures Contracts
▫ Swaps
▫ Options
▫ Structured Notes
▫ Inverse Floaters
▫ Other Exotic Contracts

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Forward Contracts
• Forward Contract
▫ A bilateral private contract under which one party agrees to
buy a commodity at a specific price (agreed today) on a
specific future date; and the other party agrees to make the
sale.
▫ Not traded in an exchange. It is traded over-the-counter.
▫ Physical delivery occurs
▫ Underlying assets can be anything, or any instrument (eg:
bonds, equities, indices, or portfolio of those already stated)
▫ Entail both market risk and credit risk

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Forward Contracts
• Deliverable Forward Contract
▫ It specifies that the long (buyer) will pay a certain amount at a
future date to the short (seller), who will deliver a certain amount
of an asset.
• Forward Contract with Cash Settlement
▫ Does not require delivery of the underlying asset. Cash payment is
made at settlement date from one counterparty to the other, based
on the contract price and market price of the asset at settlement.
• Early Termination
▫ Entering into a new forward contract with the opposite position, at
the then-current expected forward price
▫ May be done with the existing counterparty (eliminates default
risk) or a new counterparty (must consider default risk)
Forward Contracts
• End Users of Forward Contracts
▫ Often a corporation hedging an existing risk
• Dealers of Forward Contracts
▫ Usually brokers, banks, or financial institutions originate then, taking
a long side in some contracts and a short side in others.
▫ They always allow for a spread in pricing to compensate for actual
cost, bearing default risk, and any unhedged price risk.
• Using bonds as the underlying asset
▫ Bonds have a maturity date, so the forward contract
must be settled before the bond matures.
▫ Quotations:
 Quoted in terms of the discount on zero-coupon bonds (T-bills)
 Quoted in terms of the YTM on coupon bonds (exclusive of accrued
interest)
▫ Corporate bonds: must contain special provisions to deal with
possibility of default and any call or conversion features
Bond Forward Contract
Illustration:
• A forward contract covering a $10 million face
value of T-bills that will have 100 days to
maturity at contract settlement is priced at 1.96
on a discount yield basis. Compute the dollar
amount the long must pay at settlement for the
T-bills.

When market interest rate increase, discount increase and T-


bill prices fall. Thus, if interest rates rise, the short gains,
and the long will have losses on the forward contract. If
interest rates fall, the long will gain on the forward contract,
and the short loses.
Equity Forward Contracts
• The underlying asset is a single stock, portfolio of
stocks, or stock index.
• Treatment is the same as other forward contracts.
• Portfolio of stocks as the underlying asset:
▫ The difference between a forward contract with one portfolio of
stocks as the underlying asset and several forward contracts with
each covering a single stock is that it has better pricing (because
overall administration/origination costs will be less for the
portfolio forward contract)
• Stock index as the underlying asset:
▫ Similar to that of a single stock as the underlying asset, except that
the contract will be based on a notional amount and will be very
likely a cash-settlement contract.
Equity Index Forward Contract
Illustration:
• A portfolio manager desires to generate $10
million 100 days from now from a portfolio that
is quite similar in composition to the S&P 100
index. She requests a quote on a short position
in a 100 day forward contract based on the index
with a notional amount of $10 million and gets a
quote of 525.2. If the index level at the
settlement date is 535.7, calculate the amount
the manager will pay or receive to settle the
contract.
Eurodollar, LIBOR, and EURIBOR
• Eurodollar deposits
▫ Deposits in large banks outside the USA, denominated in USD.
▫ Quoted as an add-on yield rather than on a discount basis.
• LIBOR
▫ “London Interbank Offered Rate”
▫ The lending rate on dollar-denominated loans between banks.
▫ Quoted as an annualized rate based on a 360-day year
▫ Used as an international reference rate for floating rate USD
denominated loans worldwide, quoted in 30-day, 60-day, 90-day,
180-day, or 360-day terms
• EURIBOR
▫ “Europe Interbank Offered Rate”
▫ Equivalent for short-term Euro denominated bank deposits (loans to
banks)
LIBOR-based Loan Illustration:

• Compute the amount that must be repaid on a


$1 million loan for 30 days if 30-day LIBOR is
quoted at 6%.
Forward Rate Agreement (FRA)
• A forward contract to borrow/lend money at a certain
rate at some future date.
• Cash settlement, but no actual loan is made at
settlement date.
• Serve to hedge the uncertainty about short-term rates
(eg: 30, 60, or 90 day LIBOR) that will prevail in the
future.
• If reference rates rise, the long (borrower)
gains and the short loses.
• If reference rates fall, the short (lender) gains
and the long loses.
Reading FRAs
• 60-day FRA on a 90-day LIBOR
▫ Settlement or expiration is 60 days from now
▫ Payment at settlement is based on 90-day LIBOR,
60 days from now.
▫ Is also referred to as 2-by-5 FRA or 2x5 FRA
Payment from the short to the
long at settlement on an FRA:

• Numerator = interest savings in percent


• Denominator = discount factor
FRA Cash Settlement Illustration:
• Consider an FRA that:
▫ Expires or settles in 30 days.
▫ Is based on a notional principal amount of $1 million.
▫ Is based on 90-day LIBOR.
▫ Specifies a forward rate of 5%

Assume that the actual 90-day LIBOR 30 days from


now (at expiration) is 6%. Compute the cash settlement
payment at expiration, and identify which party makes
the payment.
Currency Forward Contracts
• Specifies that one party will deliver a certain
amount of one currency at the settlement date in
exchange for a certain amount of another
currency.
• A single cash payment is made at settlement
based on the difference between the exchange
rate fixed in the contract and the market
exchange rate at the settlement date.
Currency Forwards Illustration:

• Velvet expects to receive EUR 50 million 3


months from now and enters into a cash
settlement currency forward to exchange these
euros for USD at USD 1.23 per euro. If the
market exchange rate USD 1.25 per euro at
settlement, what is the amount of the payment
to be received or paid by Velvet?
Futures Contracts
▫ Similar to a forward contract, but it is a standardized contract
traded through the futures exchange. There is a third party –
“clearinghouse” that acts as counterparty on all contracts.
▫ Regulated by the government
▫ More liquid than forward contracts
▫ Lower transaction costs than forward contracts
▫ Usually done for commodities (underlying asset)
▫ “Marked to market” on a daily basis, and entails virtually no
physical delivery
▫ Entail only market risk. Credit risk is passed on to the
clearinghouse. Clearinghouse doesn’t take market risk as it
only takes offsetting positions.

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Futures Contract can be
• Either deliverable or cash settlement
• Zero value at time the contract is entered into

Exchange sets minimum


price fluctuation called
“TICKS”. They also set daily
price limit, setting the
maximum price movement
allowed in a single day.
Futures Contracts:
Delivery Open High Low Settle Change High Low Open
Month Interest

Sept.
Sept. 109-00
109-00 110-04
110-04 108-27
108-27 110-02
110-02 37
37 112-12
112-12 96-07
96-07 367,016
367,016

Dec. 107-30 108-29 107-27 108-28 37 111-04 96-06 96,216


Dec. 107-30 108-29 107-27 108-28 37 111-04 96-06 96,216

Consider a 20 year semi-annual payment, 6% coupon rate 100,000 t-bonds.

Required:
1. Compute for the price of the bond one day ago.
2. Compute for the total value of the bonds.
3. Compute for the nominal interest rate of the bond today and one day ago.
4. Compute the value of the contract if interest rates fall by 0.3%, 2 months later.
5. Compute for the profit or loss (increase or decrease of contract value)

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Requirements:
• 1: Compute for the PV of the bonds today and one day ago.
• 2: Compute for the total value of the bonds.
• 3: Compute for the nominal annual interest rate today and one day ago.
• 4: Compute for the PV of the bonds using the new interest rate.
• 5: Compute for the profit/loss if interest rates fall by 0.3%.

Note:
• For Requirement 1, do Step 1.
• For Requirement 2, do Steps 1 and 2.
• For Requirement 3, do Steps 1 and 3.
• For Requirement 4, do Steps 3 and 4.
• For Requirement 5, do Steps 1, 3, 4, and 5.

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Solution:
• Step 1: Compute for the PV of the bonds today and one day ago.

Delivery Settle Change Open Interest


Month
Dec. 108-28 37 96,216

PV of Bond Today = {[108 + (28/32)]/100} x 100,000 = 108,875


Change in Bond Value = (37/32)/100 x 100,000 = 1,156.25
PV of Bond One Day Ago = 108,875 – 1,156.25 = 107,718.75 (REQ. 1)
• Step 2: Compute for the total value of the bonds.
Total Value of the Bonds = PV x No. of contracts outstanding
Total Value of the Bonds = 108,875 x 96,216 = 10,476 billion (REQ. 2)
• Step 3a: Compute for the nominal annual interest rate today. (Use YTM
Equation)
YTM = {{Annual PMT + [(FV – PV)/Annual N]} / [(40% x FV) + (60% x PV)]}}
YTM = {{6,000 + [(100,000 – 108,875)/20]} / (40% x 100,000) + (60% x 108,875)]}}
YTM = 5.28% or 5.3%

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Solution:
• Step 3b: Compute for the nominal annual interest rate one day ago.
(Use YTM Equation)
YTM = {{Annual PMT + [(FV – PV)/Annual N]} / [(40% x FV) + (60% x PV)]}}
YTM = {{6,000 + [(100,000 – 107,718.75)/20]} / (40% x 100,000) + (60% x
107,718.75)]}}
YTM = 5.37% (REQ. 3)

• Step 4. Compute for the PV of the bonds using the new interest rate.
(Use YTM Equation)
YTM = {{Annual PMT + [(FV – PV)/Annual N]} / [(40% x FV) + (60% x PV)]}}
(YTM Today – Change in Interest Rate) = {{6,000 + [(100,000 – PV)/20]} /
(40% x 100,000) + (60% x PV)]}}
(5.3% – 0.3%) = {{6,000 + [(100,000 – PV)/20]} / (40% x 100,000) + (60% x
PV)]}}
3% PV – [(100,000 – PV)/20] = 4,000; 60% PV – 100,000 + PV = 80,000
160% PV = 180,000; PV = 112,500 (REQ. 4)

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Solution:
• Step 5: Compute for the profit/loss if interest rate falls by 0.3%
• Profit(Loss) = PV of bonds using new interest rate – PV of bonds using
original interest rate
• Profit(Loss) = 112,500 – 108,875 = 3,625 Gain (REQ. 5)

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Hedging using futures
• Recall that when price increases, sellers lose. When price decreases, buyers lose.
• Long and short hedges are ways in which an investor can cut his losses.
• Long (buy) hedges
▫ Futures contracts are bought in anticipation of (or to guard against) price increases.
▫ You already have a short (sell) position, but you think that price will rise, so you make
a buy position to hedge against that risk.
▫ Example: You entered into a futures contract to sell 1000 bushels of wheat at P500k
next year. However, since wheat prices start to rise, you anticipated that the price of
wheat is going to rise to P800k. So, to hedge that risk, you enter into another
contract to buy 1000 bushels of wheat at P600k next year. In case the wheat price
becomes P800k. At least you lost only 300k – 200k = 100k.
• Short (sell) hedges
▫ Futures contracts are sold to guard against price declines.
▫ You already have a long (buy) position, but you think that price will fall, so you make a
sell position to hedge against that risk.
▫ Example: You entered into a futures contract to buy 1000 bushels of wheat at P500k
next year. However, since wheat prices start to fall, you anticipated that the price of
wheat is going to fall to P300k. So, to hedge that risk, you enter into another contract
to sell 1000 bushels of wheat at P400k next year. In case the wheat price becomes
P300k. At least you lost only 200k – 100k = 100k.

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Future Contracts “Terms”
• Futures margin deposit
▫ Deposits to ensure performance under contract terms. These
are not loans.
• Initial margin Set by Feds,
▫ The deposit required to initiate a futures position. may be
increased by
• Maintenance margin brokerage
▫ The minimum margin amount, and when margin falls below
this amount, it must be brought back to its initial level (Initial
margin)
• Variation margin
▫ Funds needed to bring one’s account back to the initial
margin amount
• Margin calculations
▫ Based on daily settlement price , the average of the prices for
trades during a closing period set by the exchange.
Marking-to-market
• Process of adding gains to or subtracting losses from
the margin account daily, based on the change in
settlement prices from one day to the next.
• Trades cannot take place at prices that differ from the
previous day’s settlement price by more than the price
limit and are said to be limit down (up) when the new
equilibrium price is below (above) the minimum
(maximum) price for the day.
Limit Move Illustration
• A futures contract has a daily price limit of 5 cents. It
settled at $5.53 yesterday. Today, traders wish to trade
at $5.60.
• No trades will take place today; however, settlement
price will be reported as $5.58. This is called a limit
move – a limit up.
• If traders wish to trade at or below $5.48, the price is
said to be limit down.
• No trade because of limit move = Locked Limit = a
situation where the equilibrium is either above or below
the prior day’s settle price by more than the permitted
(limit) daily price move.
Margin Balance Computation 1:
• On September 1, 2010, A agrees to sell a house to B
next year at P5 million. They agreed on cash
settlement. On September 2, the market value of the
house is P4.8 million. On September 3, the market
value of the house is P4.9 million, and on September
4, the market value of the house is P5.1 million. The
clearinghouse decides that initial margin will be 10%
of the notional principal, and maintenance margin will
be 80% of the initial margin.
• Calculate the margin balance of A and B for September
2, 3, and 4.
Margin Balance Computation 2:
• Consider a long position of five July wheat contracts,
each of which covers 5,000 bushels. Assume that the
contract price is $2.00 and that each contract requires
an initial margin deposit of $150 and a maintenance
margin of $100.
• Compute the margin balance for this position after a 2
cent decrease in price in Day 1, a 1-cent increase in
price in Day 2, and a 1-cent decrease in price on Day 3.
Termination of a Futures Contract:
• Offsetting trade (entering into an opposite position
in the same contract). The most common method.
• Cash Settlement (Cash payment at expiration)
• Delivery of the asset specified in the contract (less
than 1% of all contract terminations)
• An exchange for physicals (asset delivery off the
exchange) = an ex-pit transaction; an exception.
Types of Futures Contracts:
• Treasury Bill
▫ Based on a $1 million face value 90 day t-bill & settles in cash. One
tick is 0.01% ($25 per $1 million contract)
• Eurodollar
▫ Based on 90-day LIBOR
▫ Settles in cash and the minimum price change or one
“tick” is 0.01%, ($25 per $1 million contract)
• Treasury Bond
▫ Traded for t-bonds that matures in more than 15 years, is a
deliverable contract, have a face value of $100,000 and quoted as
percentages or fractions of 1% (1/32nds) of face value
▫ Gives the short a choice of bonds to deliver
▫ Uses conversion factors to adjust the contract price for the bond
that is delivered. Long pays the futures price at expiration x
conversion factor.
T-bill Futures Contract Illustration:
• A t-bill has a price quote of 98.52. How much is
the delivery price of the t-bill?
Types of Futures Contracts:
• Stock Index
▫ Do not allow for actual delivery.
▫ Have a multiplier that is multiplied by the index to calculate the
contract value, and settle in cash.
▫ S&P 500 index future is most popular, settlement is in cash and is
based on a multiplier of 250. Dow’s multiplier is 10, NASDAQ is
100
▫ Example: Suppose the S&P 500 index is at 1,088. A one month
futures contract on the index may be quoted at a price of 1,090.
Compute for the actual futures price.
• Currency
▫ Delivery of standardized amounts of foreign currency.
▫ Are set in foreign currency, and price is stated in USD/unit.
Swap
• Two parties agree to exchange obligations to make specified payment
streams.
• A series of forward contracts
• Not per se, an exchange of one asset for another. Rather, it’s an
exchange of obligations.
• Are custom instruments, largely unregulated, don’t trade in
secondary markets, and are subject to default (counterparty) risk
• No money is exchanged at inception, and periodic payments are
netted, except currency swaps.
• Effects of swaps due to standardized contracts:
▫ Standardized contracts lower the time and effort involved in
arranging swaps, thus lowering transaction costs.
▫ Standardized contracts led to a secondary market for swaps,
increasing the liquidity and efficiency of the swaps market.
• Examples:
▫ Plain Vanilla Interest rate swap
▫ Equity returns swap
▫ Currency swap
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Plain Vanilla Interest-rate swap
• Fixed-for-floating (or vice versa) interest-rate swap.
• Notional principal is generally not swapped
• Net payment by the fixed rate payer, based on 360 day
year:
▫ (Fixed – Float or LIBOR) x (# of days / 360) x notional
principal
• Net payment by the float rate payer, based on 360 day
year:
▫ (Float or LIBOR – Fixed) x (# of days / 360) x notional
principal
Interest Rate Swap Illustration:
• A enters into a $1,000,000 quarterly-pay plain vanilla
interest rate swap as the fixed rate payer at a fixed rate
of 6% based on a 360 day year. The floating-rate
payer agrees to pay 90-day LIBOR plus a 1% margin;
90-day LIBOR is currently 4%.
• The first swap payment is known at swap initiation.
• 90-day LIBOR rates are:
▫ 4.5% 90 days from now
▫ 5.0% 180 days from now
▫ 5.5% 270 days from now
▫ 6.0% 360 days from now
Calculate the amount A pays or receives 90, 180, 270, and
360 days from now.
Equity Swaps
• The returns payer makes payments based on
returns of a stock, portfolio, or index, in
exchange for fixed or floating rate payments.
• If stock, PTF, or index declines in value, the
returns payer receives the interest payment & a
payment based on the percentage decline in
value.
Equity Swap Illustration:
• Petunia enters into a 2 year $10 million quarterly swap
as the fixed payer and will receive the index return on
the S&P 500. The fixed rate is 8% and the index is
currently 986. At the end of the next three quarters,
the index level is 1030, 968, and 989.

Calculate the net payment for each of the next three


quarters and identify the direction of the payment.
Currency Swap
• Used to secure cheaper debt and to hedge against exchange rate fluctuations.
• It is less expensive than issuing debt in foreign currency coz own currency is not known to
foreign land. This is especially applicable for companies that wants to have operations in
a foreign land.
Borrow USD Borrow AUD
BB (US) 9% 8%
AA (AUS) 10% 7%

• Assume that 1 USD = 2 AUD. Each party goes to his own bank. BB borrows 1m USD at
9% (interest of USD90k), and AA borrows 2m AUD at 7% (interest of AUD140k)
• 3 Important Dates:
▫ Swap Initiation- notional principal is swapped at initiation
Gives 1m USD
BB (US) AA (AUS)
Gives 2m AUD

▫ Swap Interest Payments (to each other)


Pays AUD 160k (2m x 8%)
BB (US) AA (AUS)
Pays USD 100k (1m x 10%)
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Currency Swap
• 3 Important Dates:
▫ Interest Payments to respective banks
 AA pays 140k AUD to Bank, but he gets 160 AUD from BB, so he gains 20,000
AUD
 BB pays 90k USD to Bank but he gets 100 USED from AA, so he gains 10,000
USD

▫ Swap Termination
Gives 2m AUD
BB (US) AA (AUS)
Gives 1m USD
 AA pays back 2m AUD to the Australian Bank
 BB pays back 1m USD to the US Bank

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How to terminate swaps:
• Enter into an offsetting swap, sometimes
through swaption (most common)
• Mutual agreement to terminate the swap (likely
involves making or receiving compensation)
• Selling the swap to a 3rd party with consent of
the original counterparty (uncommon)
Structured Notes
• A debt obligation derived from another debt obligation.
• They are securities whose cash flow characteristics depend
upon one or more indices or that have embedded forwards
or options, or securities where an investor’s investment
returns and issuer’s payment obligations are contingent on,
or highly sensitive to, changes in the value of the underlying
assets, indices, interest rates, or cash flows.
• Example: Collateralized Debt Obligation is a type of
structured asset-backed security.

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Inverse Floaters
• A note in which the interest paid moves counter to market
rates.
• Example: Usually, interest rate on your bond is 1% + prime
rate. So if prime rate is 4%, interest rate on your note will
be 5%.
• For inverse floaters, if interest rate in economy falls, bond
yield will rise. (Example: if interest rate of economy is 3%,
and bond interest rate is 4%. If economy rate goes to 2%,
bond interest rate goes to 5%
• Benefits: to enhance yield when economy rates fall.

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Options
• A contract that gives its holder the right, but not
the obligation, to buy (or sell) an asset at some
predetermined price within a specified period of
time.
• It’s important to remember:
▫ It does not obligate its owner to take action.
▫ It merely gives the owner the right to buy or sell
an asset.

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Options
• Option writer = seller of an option.
• Call Option
▫ Gives the holder of the call option the right, but not the
obligation, to buy an asset at a particular price within a
specified period of time.
• Put Option
▫ Gives the holder of the put option the right, but not the
obligation, to sell an asset at a particular price within a
specified period of time.
Options:
• Four possible Options:
▫ Long Call – buyer (holder) of a call option
▫ Short Call – seller (writer) of a call option
▫ Long Put – buyer (holder) of a put option
▫ Short Put – seller (writer) of a put option
• Option Premium – the price paid for the option.
• Moneyness – determined by the difference between
the strike or exercise price and the market price of the
underlying stock.
Kinds of Options:
• European Options
▫ Can be exercised only at the option’s expiration
date.
• American Options
▫ Can be exercised at any time up to the option’s
expiration date.
▫ These are more valuable than European options.
Option Terminologies
• Exercise (or strike) price – the price stated in the option
contract at which the security can be bought or sold.
• Option price – option contract’s market price.
• Expiration date – the date the option matures.
• Exercise value – the value of an option if it were exercised
today (Current stock price - Strike price).

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Option Terminologies
• Covered option – an option written against stock held in an
investor’s portfolio.
• Naked (uncovered) option – an option written without the
stock to back it up.
• In-the-money call – a call option whose exercise price is less
than the current price of the underlying stock.
• Out-of-the-money call – a call option whose exercise price
exceeds the current stock price.
• Long-term Equity AnticiPation Securities (LEAPS) - similar to
normal options, but they are longer-term options with
maturities of up to 2 1/2 years.

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Option’s Moneyness:
CALL OPTION PUT OPTION
In the money Stock/Market Price > Stock/Market Price <
(Option holder Strike/Exercise Price Strike/Exercise Price
WILL Exercise)
At the money Stock/Market Price = Stock/Market Price =
(Option holder is Strike/Exercise Price Strike/Exercise Price
indifferent)
Out of the money Stock/Market Price < Stock/Market Price >
(Option holder Strike/Exercise Price Strike/Exercise Price
WILL NOT exercise)

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Moneyness Illustration:
• Consider a September 40 call and a September
40 put, both on a stock that is currently selling
for $37 a share. Calculate how much these
options are in or out of the money.
Option Simple Illustration:
• A, the writer of a call option, has a contract with B.
The price paid for the option is set at $800. Exercise
price is agreed to be $10,000. Suppose that the
market price is $11,500. Compute the gain or loss of A
and B.

• A, the writer of a call option, has a contract with B.


The price paid for the option is set at $800. Exercise
price is agreed to be $11,500. Suppose that the market
price is $10,000. Compute the gain or loss of A and B.
Option example
• A call option (option to buy) with an exercise
price of $25, has the following values at these
prices:

Stock price Call option price


$25 $ 3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50

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Determining call option exercise value
and option premium or time value
Stock Strike Exercise or Market price Option
price (S) price (X) Intrinsic value of Option Premium/
of option Time Value
$25.00 $25.00 $0.00 3.00 3.00
30.00 25.00 5.00 7.50 2.50
35.00 25.00 10.00 12.00 2.00
40.00 25.00 15.00 16.50 1.50
45.00 25.00 20.00 21.00 1.00
50.00 25.00 25.00 25.50 0.50

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Determining put option intrinsic value
and option premium or time value

Stock Strike Exercise or Market price Option


price (S) price (X) Intrinsic Value of Option Premium/
of option Time Value
$30.00 $25.00 $0.00 3.00 3.00
25.00 25.00 0.00 7.50 7.50
20.00 25.00 5.00 12.00 7.00
15.00 25.00 10.00 16.50 6.50
10.00 25.00 15.00 21.00 6.00
5.00 25.00 20.00 25.50 5.50
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How does the option premium change as
the stock price increases?
• The premium of the option price over the exercise
value declines as the stock price increases.
• This is due to the declining degree of leverage
provided by options as the underlying stock price
increases, and the greater loss potential of
options at higher option prices.

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Intrinsic Value Illustration:
• Consider a call option with a strike price of $50.
Compute the intrinsic value of this option for
stock prices $55, $50, and $45
• Compute for the option premium under the
three scenarios, if market price of the call
options are 5, 4, and 3, respectively.
Option
value Call premium diagram
30
25
20
15
Market
10 price
5 Stock
Exercise Price
value
5 10 15 20 25 30 35 40 45 50
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Option price depends on:
• Stock Price
• Exercise Price
• Term-to-maturity
• Variability of the stock price (Volatility)
• Risk-free rate

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OPM – Riskless Hedge
• We are to find the value of an option assuming a
riskless hedge.
• Riskless Hedge – a hedge where an investor
buys a stock and simultaneously sells a call
option on that stock, ending up with a riskless
position.
• Given: Stock price today = P40 per share;
Exercise price next year = P35 per share; True
market price = may either be 30 or 50. Assume
that discount interest is 8%.
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Steps:
1. Find the range.
Ending Stock Price Minus Strike Price Exercise Value of the
Option
30 35 0
50 35 15
20 15
(computed as 15/20) 0.75

2. Equalize range of payoffs for both the stock and option


Ending Stock Price x Ending Stock Value Exercise Value of the Option
factor (Ending Value)
30 x 0.75 22.50 0.00
50 x 0.75 37.50 15.00
15.00 15.00

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Steps:
3. Create a riskless hedged investment (Ending value of total portfolio
= regardless of whether the stock increases or decreases)
Ending Stock Ending Value of MINUS Ending Ending Total
Price x factor Stock in PTF Value of Option in Value of the PTF
PTF
30 x 0.75 22.50 0 22.50

50 x 0.75 37.50 15.00 22.50

4. Pricing the call option


PV of the Portfolio = 22.50 / (1.08)^1 = 20.83
Remember, stock NOW is worth P40.00. Cost of stock is P30.00,
because it costs 0.75(40) = 30 to purchase ¾ of a share.
Price of Option = Cost of Stock – PV Portfolio
Price of Option = P30.00 – P20.83 = 9.17

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Black-Scholes Option Pricing Model
• Developed by Fischer Black and Myron Scholes
in 1973.

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What are the assumptions of the Black-Scholes
Option Pricing Model?
• The stock underlying the call option pays no dividends
during the call option’s life.
• There are no transactions costs for the sale/purchase of
either the stock or the option.
• The short-term, risk-free interest rate (rRF) is known and is
constant during the life of the option.
• Any purchaser of a security may borrow any fraction of the
purchase price at the short-term risk-free interest rate.
• No penalty for short selling and sellers receive immediately
full cash proceeds at today’s price. (Short selling is
permitted)
• Option can only be exercised on its expiration date.
(European Options)
• Security trading takes place in continuous time, and stock
prices move randomly in continuous time.

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Using the Black-Scholes option pricing model
 2 
ln(P/X)  [rRF    t] Put-call parity requires that:
d1   2  Put = V - P + Xe-rT
σ t
Then the price of a put option
d 2  d1 - σ t is:
Put = Xe-rT N(-d2) - P N(-d1)

V  P[N(d1 )] - Xe-rRFt [N(d2 )]

V = Current value of the call option


P = current price
N(d1) = probability that a deviation less than d1 will occur in a standard normal distribution.
N(d1) and N(32) = represent areas under a standard normal distribution function.
X = exercise or strike price of an option
e = 2.7183
kRF = risk-free interest rate
t = time until the option expres
Ln(P/X) = natural logarithm of P/X
SD^2 = variance of the rate of return on the stock
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Use the B-S OPM to find the option value of a call
option with P = $27, X = $25, rRF = 6%, t = 0.5 years,
and σ2 = 0.11.

ln($27/$25)  [(0.06  0.11 )] (0.5)


d1  2  0.5736
(0.3317)(0.7071)

d 2  0.5736 - (0.3317)(0.7071)  0.3391

From Appendix A in the textbook


N(d1 )  N(0.5736) 0.5000  0.2168  0.7168
N(d2 )  N(0.3391) 0.5000  0.1327  0.6327

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Solving for the call option value
-rRFt
V  P[N(d1 )] - Xe [N(d 2 )]
-(0.06)(0.5 )
V  $27[0.7168] - $25e [0.6327]
V  $4.0036
Solving for the put option value
Put = Xe-rT N(-d2) - P N(-d1)
Put = [$25e^(-0.06x0.5)] x 0.3673) – ($27 x 0.2832)
Put = $8.9111 – $7.6464 = $1.2647
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How do the factors of the B-S OPM
affect a call option’s value?
As the factor increases … The option value …
Current stock price Increases
Exercise price Decreases
Time to expiration Increases
Risk-free rate Increases
Stock return volatility Increases

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How do the factors of the B-S OPM
affect a put option’s value?
As the factor increases … The option value …
Current stock price Decreases
Exercise price Increases
Time to expiration Increases
Risk-free rate Decreases
Stock return volatility Increases

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Benefits of Derivatives:
• Provide price information (price discovery).
• Allows risk to be managed and shifted among
market participants.
• Reduce transaction costs because investors are
already able to manage risks.
Criticisms of Derivatives:
• Likened to “gambling” because of the high
leverage involved in derivatives payoffs.
• Too risky especially to investors with limited
knowledge of complex instruments.