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Financial Instruments

Lecture Chapter 8 (Hull, Chapter 5)

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Contents
1. 2. 3. 4. 5. 6. 7.

The Financial Markets Long and Short Positions in Assets Derivatives Markets Plain Vanilla Derivatives Margins Non Traditional Derivatives Alternative Risk transfer
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Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

1. The Financial Markets (pages 83-84)


Exchange traded
Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading Contracts are standard; there is virtually no credit risk

Over-the-counter (OTC)
A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard; there is some small amount of credit risk

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

2. Long / Short Positions in Assets


Short selling Short selling involves selling securities you do not own Your broker borrows the securities from another client and sells them in the market in the usual way At some stage you must buy the securities back so they can be replaced in the account of the client
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Short Selling (continued)


You must pay dividends and other benefits the owner of the securities receives The cash flows from a short position that is entered into at time T1 and closed out at time T2 are the opposite of those from a long position where asset is bought at time T1 and sold at time T2,except that there may be a small fee for borrowing the asset

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Cash Flows from short sale and purchase of shares Table 5.2, page 85
Purchase of shares April May July Purchase 500 shares for $120 Sell 500 shares for $100 /share -$60,000 Short sale of shares Borrow 500 shares and sell them for $120 Pay dividend +60,000 -$500 -$50,000

Receive dividend +$500

+$50,000 Buy 500 shares for $100/share and replace borrowed shares to close short position -$9,500

Net Profit

+$9,500

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

3. Plain Vanilla Derivatives


Forwards Futures Swaps Options Exotics

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Forward Contracts
A forward contract is an agreement to buy or sell an asset at a certain price at a certain future time Forward contracts trade in the over-thecounter market They are particularly popular on currencies and interest rates
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Foreign Exchange Quotes for GBP August 27, 2008 (See page 87)
Bid 1.8356 1.8314 1.8237 1.8127 Offer 1.8360 1.8319 1.8242 1.8133

Spot 1-month forward 3-month forward 6-month forward

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Profit from a Long Forward Position


Profit

Price of Underlying at Maturity, ST

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Profit from a Short Forward Position


Profit

Price of Underlying at Maturity, ST

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Futures Contracts (pages 89-91)


Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Futures Contract continued


Contracts are settled daily (e.g., if a contract is on 200 ounces of December gold and the December futures moves $2 in my favor, I receive $400; if it moves $2 against me I pay $400) Both sides to a futures contract are required to post margin (cash or marketable securities) with the exchange clearinghouse. This ensures that they will honor their commitments under the contract.
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Comparison of forward and futures contract Table 5.3 page 91


Forward Private contracts between two parties Not standardized Usually one specified delivery date Settled at the end of contract Delivery or final cash settlement usually takes place Some credit risk Futures Traded on the exchange Standardized contract Range of delivery dates Settled daily Contract is usually closed out prior to maturity Virtually no credit risk

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Swaps
A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

An Example of a Plain Vanilla Interest Rate Swap


An agreement to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million Next slide illustrates cash flows

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Cash Flows for one set of LIBOR rates


(See Table 5.4, page 93)
---------Millions of Dollars--------LIBOR FLOATING FIXED Net Rate Cash Flow Cash Flow Cash Flow 4.2% 4.8% +2.10 2.50 0.40 5.3% +2.40 2.50 0.10 5.5% +2.65 2.50 +0.15 5.6% +2.75 2.50 +0.25 5.9% +2.80 2.50 +0.30 6.4% +2.95 2.50 +0.45

Date Mar.5, 2010 Sept. 5, 2010 Mar.5, 2011 Sept. 5, 2011 Mar.5, 2012 Sept. 5, 2012 Mar.5, 2013

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Typical Uses of an Interest Rate Swap


Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Quotes By a Swap Market Maker


(Table 5.5, page 94) Maturity 2 years 3 years 4 years 5 years 7 years 10 years Bid (%) 6.03 6.21 6.35 6.47 6.65 6.83 Offer (%) 6.06 6.24 6.39 6.51 6.68 6.87 Swap Rate (%) 6.045 6.225 6.370 6.490 6.665 6.850

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Options
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price) Options trade on both exchanges and in the OTC market
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

American vs European Options


An American option can be exercised at any time during its life A European option can be exercised only at maturity

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Exposure Diagrams Revisited

Negative slope indicate NeedOil exposed to Oil price, so need to do something to flatten the line

NeedOil uses oil in production process, when Price up => Cost up When Price down => cost down NeedOil profits are negatively related to oil Prices

Hedging Oil Price Risk with Call Options


NeedOil has oil price risk NeedOil DO NOT want to bear risk that it will have to pay more than $15 a barrel To reduce its oil price risk, NeedOil signs a contract with OPTCO:
OPTCO pays NeedOil in six months 250,000 x (Poil - $15) if Poil > $15 0 if Poil < $15 NeedOil pays OPTCO $100,000 today

Hedging Oil Price Risk with Call Options


What are NeedOils profits (ignore discounting)?
if oil price = $14 ==>
profits from operations profits from OPTCO contract total profits if oil price = $15 ==> profits from operations profits from OPTCO contract total profits if oil price = $16 ==> profits from operations profits from OPTCO contract total profits = $1,250,000 = -$100,000 = $1,150,000

= $1,000,000 = -$100,000 = 900,000

= $750,000 = $150,000 = $900,000

Hedging Oil Price Risk with Call Options

Hedging Oil Price Risk with Call Options

This illustrade total profits to NeedOil after engaging in the contract with OPTCO No matter what happen to Oil Price, expected profits will never fall below $900,000

Call Option Contracts


NeedOils contract with OPTCO is an example of a derivative contract, called a call option. A derivative contract is a contract whose payoff or value is derived from the value of some other asset or index. The asset on which the derivative contract is based is called the underlying asset A call option contract pays the purchaser of the option a positive amount if the underlying asset exceeds the exercise price. The option price is the amount paid for the option. For every call option buyer, there is a call option seller.

Payoff to Seller of the Call Option (mirror image of NeedOil)

Oil Price > $15 OPTCO loose money Limited gain Unlimited loss to OPTCO

Oil Price < $15 OPTCO make money

Put Options
Put option contract receives a positive payoff only if the value of the underlying asset falls below the exercise price

Determinants of the Price of Call and Put Options


An Increase in
the value of the underlying asset the exercise price the volatility in the return of the underlying asset the time to maturity interest rates

Call Option Price

Put Option Price

Increases Decreases

Decreases Increases

Increases Increases Increases

Increases Increases Decreases

Derivatives Building Box


Buy (long) Forward Buy a Call Buy a Put

Sell a Call

Sell a Put

Sell (short) Forward

Options vs Forwards
Forward contracts lock in a price for a future transaction Options provide insurance. They limit the downside risk while not giving up the upside potential For this reason options are more attractive to many corporate treasurers than forward contracts
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

5. Margins
The greater liquidity also is due in part to the method used to ensure performance. With OTC contracts, firms assess the default risk (or credit risk) prior to engaging in a contract With exchange traded contracts, default risk is reduced by using performance bonds, called margin daily marking to market

Example 1: Operation of margins for a long position in two gold futures


The initial margin is $2,000 per contract. Maintenance margin is $1,500 per contract. Contract is entered at June 5 at $900 and closed out at June 23 at $888.10 Calculations: Total initial margin = $2,000 per contract x 2 contracts = $4,000 Total Maintenance margin = $1,500 per contract x 2 contracts = $3,000

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

Operations Margins
Day Futures price Daily gain/ loss Cumulative gain / loss Margin account balance Margin call

900.00 June 5 June 6 June 9 June 10 June 11 June 12 June 13 June 16 June 17 June 18 June 19 June 20 June 23 897.00 896.10 898.20 897.10 896.70 895.40 893.30 893.60 891.80 892.70 887.00 887.00 888.10 (600) (180) 420 (220) (80) (260) (420) 60 (360) 180 (1,140) 0 220 (600) (780) (360) (580) (660) (920) (1,340) (1,280) (1,640) (1,460) (2,600) (2,600) (2,380)

4,000 3,400 3,220 3,640 3,420 3,340 3,080 2,660 4,060 3,700 3,880 2,740 4,000 4,220 1,260 1,340

6. Nontraditional Derivatives
1. 2. 3. 4.

Weather derivatives Oil derivatives Natural gas derivatives Electricity derivatives

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009

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7. Alternative Risk Transfer


grew out of a series of insurance capacity crises in the 1970s through 1990s that drove purchasers of traditional coverage to seek more robust ways to buy protection

Common Characteristics of ART Products


Alternative risk transfer (ART) refers to non-traditional insurance products ART often contain one or more of the following: High level of retention Span multiple years Involve multiple sources of risk Cover risk not traditionally covered by insurance contracts Involve capital market institutions and/or securities

Structured Debt Instruments


Catastrophe bonds risk-linked securities that transfer a specified set of risks from a sponsor to investors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake Catastrophe bonds emerged from a need by insurance companies to alleviate some of the risk they would face if a major catastrophe occurred. An insurance company issues bonds through an investment bank, which are then sold to investors. Payment of interest and/or principal are forgiven if a catastrophe occurs Examples:
Disney borrows money to cover losses from an earthquake in Japan, if earthquake occurs, debt is forgiven.