ACCOUNTING

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ACCOUNTING

© All Rights Reserved

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BENEFITS AND

CRITICISMS OF

DERIVATIVES

RISK MANAGEMENT

▪ The most important purpose of the derivatives market

▪ Financial derivatives provide a powerful tool for limiting risks that

individuals and firms face in the ordinary conduct of their business.

INVESTORS:

IMPROVE MARKET

EFFICIENCY

▪ Derivatives provide an

alternative for investing in

the underlying assets.

PRICE DISCOVERY

▪ Futures, forwards and swaps provide valuable information about the

prices of the underlying assets.

▪ Options provide information on the price volatility of the underlying assets.

COMPLEXITY

▪ This means that sometimes the parties that use them don't understand

them well.

▪ They are often used improperly, leading to potentially large losses.

DIRECTION AND MARKET TIMING

▪ Investors must accurately predict the direction in which the market or

index will move (up or down) and the minimum magnitude of the move

during a set period of time.

LIFESPAN

Derivatives are "time-wasting" assets. As each day passes and the

expiration date approaches, you lose more and more "time" premium and

the option's value decreases.

STRUCTURED NOTES

• A debt obligation derived from another debt obligation.

• It is a debt obligation that contains an embedded derivative

component that adjusts the security’s risk/return profile.

• a debt security.

Underlying Pieces

class.

Potential Risks

• Market risk

• Liquidity

INVERSE FLOATERS

• FRN is a fixed income security that makes coupon payments that

are tied to a reference rate.

AN INVERSE FLOATER:

• A note in which the interest rate paid moves counter to market

rates.

• Also known as inverse floating rate note.

• Adjusts its coupon payment as the interest rate changes.

• If interest rates in the economy rose, the interest rates paid on an

inverse floater would fall, lowering its cash interest payments.

• Exceptionally vulnerable to increases in interest rates.

• If interest rates fall, value of inverse floaters increases.

Exotic Options

Types of exotic options:

• Chooser option

• Barrier options

• Asian options

• Digital options

• Compound options

FORWARD RATE AGREEMENT (FRA)

FORWARD RATE AGREEMENT (FRA)

protect themselves against future movements in interest rates.

a fixed interest rate (the FRA rate) and for a specified period of

time starting at an agreed date in the future.

FORWARD RATE AGREEMENT (FRA)

will be protected,

difference

will have a GAIN

will have a GAIN

difference

FORWARD RATE AGREEMENT (FRA)

WAITING PERIOD The period comprised between the spot date (d1)

and the settlement date (d3)

CONTRACT PERIOD The time between the settlement date and maturity

date of the notional loan. This period can go up to 12

months.

FORWARD RATE AGREEMENT (FRA)

negotiated Contract period begins

the notional loan is

deemed to expire

when the transaction is carried out as

soon as practical. Usually 2 days after

trade date

FD-the reference rate is determined

FORWARD RATE AGREEMENT (FRA)

For example:

if a borrower of an FRA wished to hedge against a rise in rates to

cover a three-month loan starting three months time, she would

transact a three-against-six month FRA (3 x 6)– this is referred to

as a three-sixes FRA- and it means a three-month loan beginning

in three months time

WAITING PERIOD CONTRACT PERIOD

3 months 3 months

FORWARD RATE AGREEMENT (FRA)

1 months 3 months

FORWARD RATE AGREEMENT (FRA)

3 months 6 months

COMPUTATION

FOR THE SETTLEMENT AMOUNT

OF AN FRA

COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA

COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA

The interest differential is the result of the comparison between the FRA

rate and the settlement rate. It is calculated as follows:

Interest differential

=(Settlement rate − Contract rate) × (Days in contract period/360) × Notional amount

Settlement amount

= Interest differential / [1 + Settlement rate × (Days in contract period / 360)]

COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA

A corporation learns that it needs to borrow $1M in six-months time for a six month period.

Let us further assume that the 6-month Libor currently is at 0.89465%, but the company’s

treasurer thinks it might rise as high as 1.30% over the forthcoming months. The treasurer

choses to buy a 6x12 FRA in order to cover the period of 6 months starting 6 months from

now. He receives a quote of 0.95450% from his bank and buys the FRA for a notional of

$1M on April 8, 2016.

On the fixing date (October 10, 2016) the 6-month LIBOR fixes at 1.26222%, which is the

settlement rate applicable for the company's FRA.

As anticipated by the treasurer, the 6-month Libor rose during the 6-month waiting

period, hence the company will receive the settlement amount from the FRA seller.

COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA

6 x 12 FRA

Trade date- April 8, 2016 Notional Amount- $1M

Spot date- April 10, 2016 Contract rate- .95450%

Fixing date- October 10, 2016 Settlement rate- 1.26222%

Settlement date- October 12, 2016

Maturity date- April 12, 2017 Contract Period – 182 days

Step 1

Interest differential= (settle. rate- contract rate) x (days in contract period/360)x Not. amt

= (1.26222% - .95450%) x (182/360) x $1M

= $1,555.70

Step 2

Settlement amount= int. diff / [1 + settle. Rate x (days in contract period/360)]

= $1,555.70 / [1 + 1.26222% x (182/320)]

= $ 1,545.83

COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA

As anticipated by the treasurer, the 6-month Libor rose during the 6-month waiting

period, hence the company will receive the settlement amount from the FRA seller.

COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA

• If settlement rate > contract rate, the FRA buyer receives the settlement amount

• If contract rate > settlement rate, the FRA seller receives the settlement amount

• If settlement rate = contract rate, no settlement amount is being paid

COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA

6 x 12 FRA

Trade date- April 8, 2016 Notional Amount- $1M

Spot date- April 10, 2016 Contract rate- .95450%

Fixing date- October 10, 2016 Settlement rate- 1.26222%

Settlement date- October 12, 2016

Maturity date- April 12, 2017 Contract Period – 182 days

Step 1

Interest differential= (settle. rate- contract rate) x (days in contract period/360)x Not. amt

= (1.26222% - .95450%) x (182/360) x $1M

= $1,555.70

Step 2

Settlement amount= int. diff / [1 + settle. Rate x (days in contract period/360)]

= $1,555.70 / [1 + 1.26222% x (182/320)]

= $ 1,545.83

LENDER BORROWER

$ 1,545.83

BY: BELGICA, TZIPORAH BIANCA G.

RISKS

USING FUTURES

WHAT IS HEDGE?

• A hedge is an investment to reduce the risk of

adverse price movements in an asset. Normally, a

hedge consists of taking an offsetting position in a

related security, such as a future contract.

by derivatives transactions between two parties

known as counterparties.

WHAT IS FUTURES CONTRACT?

• Standardized contracts that are traded on

exchanges and are “marked to market” daily,

but where physical delivery of the underlying

asset is never taken.

• Can be establish a long(or short) position n

the underlying commodity/asset.

• Definite agreement on the part of one party to

buy something on a specific date at a specific

price, and the other party agrees on the same

terms.

WHAT IS FUTURES CONTRACT?

Forward contracts have two limitations:

1. Illiquidity

2. Counter-party risk

limitations.

FEATURES OF FUTURES

CONTRACT

• Standardized contracts:

1. Underlying commodity or asset

2. Quantity

3. Maturity

• Traded on exchange

• Guaranteed by the clearing house – little counter-party

risk

• Gains/losses settled daily – marked to market

• Margin account required as collateral to cover losses

CLASSES OF FUTURES

A.Commodity Futures

> A contract that is used to hedge against price

changes for input materials

B. Financial Futures

> A contract that is used to hedge against

fluctuating interest rates, stock prices, and

exchange rates

LONG AND SHORT HEDGES

Long Hedges Short Hedges

• Appropriate when you • Appropriate when you

know you will purchase know you will sell an

an asset in the future asset in the future &

and want to lock in the want to lock in the

price price

• Futures contracts are • Futures contract are

bought in anticipation sold to guard against

of price increases price decline

Basis Risk

• Basis is the difference between spot

price & futures price

• Basis risk arises because of the

uncertainty about the basis when

the hedge is closed out

Long Hedge

• Suppose that

F2 : Final Futures Price

S2 : Final Asset Price

• You hedge the future purchase of an asset by entering into a

long futures contract

• Exposed to basis risk if hedging period does not match

maturity date of futures

Long Hedge

• Cost of Asset = Future Spot Price - Gain on Futures

Gain on Futures = F2 - F1

Future Spot Price = S2

• Cost of Asset= S2 - (F2 - F1)

• Cost of Asset = F1 + Basis2

Basis2 = S2 - F2

• Therefore, effective cost of asset hedged is uncertain

Short Hedge

• Suppose that

F1 : Initial Futures Price

F2 : Final Futures Price

S2 : Final Asset Price

• You hedge the future sale of an asset by entering

into a short futures contract

Short Hedge

• Price Realized = Gain on Futures + Future Spot Price

Gain = F1 - F2

Future Spot Price = S2

• Price Realized = S2 + (F1 - F2 )

• Price Realized = F1 + Basis2

Basis2 = S2 - F2

LONG AND SHORT HEDGES

• Cost of Asset • Price Realized = Gain on Futures +

= Future Spot Price - Gain on Future Spot Price

Futures 1.Gain = F1 - F2

1. Gain on Futures = F2 - F1

2. Future Spot Price = S2

2. Future Spot Price = S2

• Price Realized = S2 + (F1 - F2 )

• Cost of Asset= S2 - (F2 - F1)

• Price Realized = F1 + Basis2

• Cost of Asset = F1 + Basis2

Basis2 = S2 - F2 Basis2 = S2 - F2

Example

• Hedging period 3 months

• Futures contract expires in 4 months

• We’re exposed to basis risk

• Suppose F1 = $105 and S1 =100

• Current basis = 100 - 105 = -5

• Basis in 3 months is uncertain

• If F2 = 110 and S2 = $102

• What is basis in 4 months?

A. LONG HEDGE

Cost of Asset = Future Spot Price - Gain on Futures

Gain on Futures = F2 - F1

Future Spot Price = S2

= $97

B. SHORT HEDGE

Price Realized = Gain on Futures + Future Spot Price

Gain = F1 - F2

Future Spot Price = S2

= $97

RECORDING OF PROFITS AND LOSSES

$400, and that a three-period futures

contract on gold has a price of $415.

TIME PERIOD GOLD FUTURES BUYER’S SELLER’S

CONTRACT FUTURES CF FUTURES CF

1 $420 $5 -$5

2 $430 $10 -$10

3 $425 -$5 $5

Net $10 -$10

buyer is $10.

Computation for savings

from LONG HEDGING and

SHORT HEDGING, MARGIN

ACCOUNT BALANCES, GAIN

(LOSS) and VARIATION

MARGIN

VILLACENCIO, Marie Ann A.

Problem 1 (Long hedging)

• An aluminum refiner wants to hedge its anticipated October aluminum demand of

60,000 lbs. per month. It is currently July 1st.

• Each contract is for 26,000 lbs. The initial margin is $10,750 and the maintenance

margin is $8,500.

60,000 lbs.

1 contract = 26,000 lbs x 2

= 52,000 lbs.

Initial cash flow (using initial margin):

2 x 10,750 = 21,500 x 3 mos.

= $64,500

Assume the price of aluminum is currently $1.50/ lb and the average aluminum prices

for the next 3 months are $1.25 (August), $1.00 (Sept.), $0.80 (Oct.). How much did your

firm save compared to the current price?

Aluminum Savings:

Current Price = $1.50/lb

Aluminum savings in Aug. = 60,000($1.50-$1.25)

= $15,000

= $30,000

• Aluminum savings in Oct. = 60,000($1.50-$0.80)

= $42,000

Assume the futures price of the following 3 months are:

Aug. - $0.8974

Sept. - $0.8798

Oct. - $0.7658

Aug.- $0.6813, Sept. - $0.4140, Oct.- $0.0999.

How much did you lose on your futures contracts?

= -$11,237.20

• Futures (Sept.) = 52,000($0.4140-$0.8798)

= -$24,221.60

• Futures (Oct.) = 52,000($0.0999-$0.7658)

= -$34,626.80

PROBLEM 2 (Short hedging)

• On August an aluminum producer wants to hedge approximately 250,000 lbs. of his

October production to guard against the possibility of falling prices.

• So he short hedges by selling 40 October aluminum futures contracts at $1.38/lb.

Both cash and futures prices have subsequently fallen.

• On October 1, when the producer sells aluminum to the local terminal, the price he

receives is $1.25/lb.

• The producer offsets his hedge, by purchasing October aluminum futures at $1.30/lb.

Aug. Receives cash forward Sells Oct. aluminum -.10

(Oct.) bid at $1.28/lb. futures at $1.38/lb.

Oct. Sells cash aluminum at Buys Oct. aluminum -.05

$1.25/lb. futures at $1.30/lb.

The hedger sold aluminum for cash on the forward market at $1.25, and

$1.38 - $1.30 = 0.08 cents gain on the futures position.

And so it was as if he sold the commodity for $1.33. (1.25+0.08=1.33)

(1.33+1.25)/2 = $1.29 average sales price

Prices increase: (Short hedge)

Prices increase: (Short hedge)

Aug. Receives cash forward (Oct.) bid at Sells Oct. metal futures at -.05

$1.30/lb $1.35/lb

Oct. Sells cash aluminum at $1.35/lb Buys Oct. metal futures at -.10

$1.45/lb

CHANGE $0.05/lb gain $.10/lb loss .05 loss

The hedge sold aluminum for cash on the forward market at $1.30,

lost 10 cents on the futures position,

so $1.30 – 0.10 = $1.20

(1.20+1.35)/ 2 = $1.275 average sales price

Margin Account

• Margin Account – is a brokerage account in which the broker lends the customer cash

to purchase securities. The loan in the account is collateralized by the securities and

cash.

• To use a margin account, an investor needs to post a certain amount of cash,

securities or other collateral, known as the initial margin requirement. (50%)

• Initial margin is the percentage of the purchase price of securities (that can be

purchased on margin) that the investor must pay for with his own cash or marginable

securities.

• Maintenance margin is the minimum amount of equity that must be maintained in a

margin account.

According to the Federal Reserve Board’s Regulation T, when buying on margin:

1. The minimum margin, which states that a broker can’t extend any credit to

accounts with less than $2,000 in cash or securities is the first requirement.

2. An initial margin of 50% is required for a trade to be entered

3. The maintenance margin says that you must maintain equity of at least 30% or be

hit with a margin call.

Problem 3 (Margin)

• You open a margin account and deposit $5,000.

• You sell short 1,000 shares of XYZ stock for $10 per share. The proceeds of the sale,

$10,000, is deposited in your account.

• There is now $15,000 in your account. However, you still only have $5,000 equity in

your account, because the $10,000 of short-sale proceeds is from borrowed securities.

• Scenario 1 – The stock price declines to $6 per share, so the 1,000 shares that you

sold short is currently worth $6,000. Thus:

= $15,000 – $6,000

= $9,000

Margin = Equity/ CMV (Current Market Value of shorted security)

= $9,000/ $6,000

= 1.5 x 100 = 150%

and any dividends that had to be paid while the stock was

borrowed.

Scenario 2 – The stock price rises to $12.00 per share, thus it will cost you $12,000 to

buy back the shares now.

=$3,000

=.25 x 100 = 25%

25% < 30%, you will be subjected to a margin call.

any dividends that had to be paid while the stock was borrowed

Variation Margin

• It is an additional amount of cash you are required to deposit to your

futures trading account after your futures position have taken sufficient

losses to bring it below the maintenance margin. (Margin account <

Maintenance Margin level)

• Also known as Mark to Market Margin

through “Margin Calls”

• Margin Call – when the broker tells you how much cash needs to be

provided in order to meet variation margin requirement.

• Variation Margin = Initial Margin – Margin Balance

Problem 4 (Variation Margin)

Zoro bought one futures contract and made $1,000 in initial margin requirement of $10.

Assuming the position has a maintenance margin requirement of $5 ($5 x 100 = $500)

1st Scenario: the underlying asset drops by $8 the very same day:

$10-$8= $2 x 100 = $200 margin balance

Variation Margin = Initial margin – margin balance

= $1,000 - $200

: = $800

2nd Scenario: the underlying asset drops by $6 the very

same day:

= $600

Valuation of

Options Using

Riskless Hedge

and Black-

Scholes Option

Pricing Model

Riskless Hedge

It is a hedge in which an investor buys a stock and

simultaneously sells a call option on that stock and ends up

with a riskless position.

1. Assumptions of the example

Stock price: P40

Exercise price: P35

Ending Stock price: P30 or P50

Risk-free rate: 8%

2. Find the range of values at expiration

Ending Option

Ending Stock Price Strike Price Value

Value

P30 – P35 = 0

P50 – P35 = P15

R: P20 P15

3. Equalize the range of payoffs for the

stock and the option.

Ending Ending

Ending Stock

Value of Value of

Price

Stock Option

50 × 0.75 = 37.50 P15

R: P20 P15.00 P15

4. Create a riskless hedge investment.

Ending Ending Ending

Ending Value of Value of Total

Stock Stock in Option in Value of

Price the the the

Portfolio Portfolio Portfolio

50 × 0.75 = 37.50 + -P15 = 22.50

5. Pricing the call option

Find the present value of the ending total value of the

portfolio using the risk-free rate:

PV = P22.50/1.08 = P20.83

Find the cost of the stock in the portfolio:

0.75(P40) = P30

Price of option = Cost of stock – PV of portfolio

= P30 – P20.83 = 9.17

Black-Scholes Option Pricing Model

(OPM)

It is derived from the concept of a riskless hedge, this

model calculates the value of an option as the difference

between the expected PV of the terminal stock price and

the PV of the exercise price.

OPM Assumptions

The stock underlying the call option provides no dividends or other

distributions during the life of the option.

There are no transaction costs for buying or selling the stock or the

option.

The short-term, risk-free interest rate 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.

Short selling is permitted, and the short seller will receive immediately

the full cash proceeds of today’s price for a security sold short.

The call option can be exercised only on its expiration date.

Trading in all securities takes place continuously, and the stock price

moves randomly.

OPM Equations

−𝑟𝑓𝑟 𝑡

V=P[N(𝑑1 )]-X𝑒 [N(𝑑2 )]

𝑃 𝞭2

ln + 𝑟𝑓𝑟 + 𝑡

𝑑1 =

𝑋 2

𝞭 𝑡

𝑑2 =𝑑1 −𝞭 𝑡

Legend

V = current value of the call option

P = current price of the underlying stock

N(𝑑1 ) = probability that a deviation less than 𝑑1 will occur in a

standard normal distribution

X = exercise price of the option

e = 2.7183

𝑟𝑓𝑟 = risk-free interest rate

t = time until the option expires (the option period)

ln(P/X) = natural logarithm of P/X

𝞭2 = variance of the rate of return on the stock

OPM Illustration

Given:

P = P21

X = P21

t = 0.36 year

𝑟𝑓𝑟 = 5%

𝞭2 = 0.09

OPM Illustration

21 0.09

ln 21 + 0.05+ 2 (0.36)

𝑑1 = = 0.19

0.3(0.6)

V = 21[N(0.19)]-21(0.98216)[N(0.01)]

= 21(0.5753)-20.625(0.504)

= 12.081-10.395

= P1.686

SWAPS

COMPUTATION OF GAIN (LOSS)

AND SETTLEMENT PRICE

SWAPS

• two parties agree to exchange obligations to make

specified payment streams

• an exchange of obligations

fixed rate, or the return on an equity index or

portfolio.

TERMS

NOTIONAL PRINCIPAL: amount used

to calculate periodic payments

FLOATING RATE: usually LIBOR

TENOR: time period covered by swap

SETTLEMENT DATES: payment due dates

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

CHARACTERISTICS OF SWAP

CONTRACTS

• custom instruments

• not traded in any organized

secondary market

• largely unregulated

• subject to default risk

• most participants are large

institutions

• private agreements

• difficult to alter or terminate

EXAMPLES

INTEREST EQUITY

SWAP SWAP

CURRENCY

SWAP

SWAPS

• except in the case of a

currency swap, no money

changes hands at the

inception of the swap and

periodic payments are

netted (the party that owes

the larger amount pays the

difference to the other)

IN A NUTSHELL

When A loans money to B for a fixed

rate of interest and B loans the same

amount to A for floating rate of interest,

it is an interest rate swap

When one of the returns streams is

based on a stock portfolio or index

return, it's an equity swap

When the loans are in two different

currencies, it's a currency swap

INTEREST RATE SWAP

“fixed-for-floating (or vice versa)

interest-rate swap”

generally not swapped at the beginning or

end of the swap (both loans are in same currency and amount)

INTEREST RATE SWAP

net payment by the FIXED RATE PAYER:

principal

principal

REMEMBER

FIXED RATE > FLOATING RATE

(+)

= floating rate payer pays (outflow)

FLOATING RATE > FIXED RATE (-)

= floating rate payer receives

(inflow)

INTEREST RATE SWAP

• interest payments are netted

• on settlement dates, both interest payments are

calculated and only the difference is paid by the

party owing the greater amount

• floating rate payments are typically made in

arrears; payment is made at end of period based on

beginning-of-period LIBOR

KAPIT 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, LANG,

agrees to pay 90-day LIBOR plus a 1%

margin; 90-day LIBOR is currently 4%.

4.5% 90 days from now

5.0% 180 days from now

5.5% 270 days from now

6.0% 360 days from now

90, 270, and 360 days from now.

EQUITY SWAP

BUYER SELLER

• can gain the economic • can reduce or eliminate

exposure to certain the market risk of

equity or index market his/her portfolio without

without physically selling the assets

owning such assets • gain stable returns

EQUITY RETURN SWAP

• RETURNS PAYER: makes payments based

on returns of a stock, portfolio, or index, in

exchange for fixed or floating rate

payments

• If the (3) declines in value:

━ RETURNS PAYER receives the interest

payment & a payment based on the

percentage decline in value

EQUITY RETURN SWAP

EQUITY RETURN PAYER

receives interest payment

pays any positive equity return

receives any negative equity

INTEREST PAYER

pays interest payment

receives positive equity return

pays any negative equity return

EQUITY RETURN SWAP

EQUITY RETURN IS BASED ON:

– individual stock

– stock portfolio

– stock index

dividends

Assume that LORDE and TABANG enter

into a one-year total return swap in which

one party receives the LIBOR, in addition

to a fixed margin of 2%. On the other

hand, the other party receives the total

return of the S&P’s Index on a principal

amount of $ 1,000,000. After one year, if

LIBOR is 3.5% and the S&P 500

appreciates by 15%, LORDE pays

TABANG 15% and receives 5.5%.

The payment is netted at the end of the swap with TABANG

receiving the payment of 95,000.

Assume that S&P 500 falls by 15%, rather than

appreciating by 15%.

plus the fixed margin.

$ 1,000,000 x (15% + 5.5%) = $ 205,000

Ms. Smith enters into a 2-year $10

million quarterly swap as the fixed

payer and will receive the index return

on the Standard & Poor’s 500 index.

The fixed rate is 8%, and the index is

currently at 986. At the end of the next

three quarters, the index level is: 1030,

968, and 989.

the next three quarters and identify

the direction of the payment.

2-year, $10 million quarterly-pay equity swap

Equity return = S&P 500 Index

Fixed rate = 8%

Current index level = 986

Q2: S&P 500 = 968 Return = — 6.02%

Q3: S&P 500 = 989 Return = 2.17%

Index return payer pays (+) receives ( - ):

Q1: 4.46% — 2.00% = 2.46%

$246,000 net payment

Q2: —6.02% — 2.00% = —8.02%

—$802,000 net payment

Q3: 2.17% — 2.00% = 0.17%

$17,000 net payment

CURRENCY SWAP

• used to secure cheaper debt and to

hedge against exchange rate

fluctuations

• less expensive than issuing debt in

foreign currency

• especially applicable for companies

that wants to have operations in a

foreign land

CURRENCY SWAP

is actively swapped

twice: beginning and

termination of swap.

TERMINATION OF SWAP

• enter into an offsetting swap, sometimes

through swaption (MOST COMMON)

• mutual agreement to terminate the swap

(involves making or receiving

compensation most of the time)

• selling the swap to a 3rd party with consent

of the original counterparty (RARELY)

Bond Forward Contract, Equity

Index Forward Contract, LIBOR-

based loan, and Currency

Forward Contract

Settlement Price and Gain (Loss) Computations

Bond Forward Contract

The basic characteristics of a forward contract on a bond are very much

like those of equity. A bond pays a coupon similar to an equity paying a

dividend. The differences are:

Bonds mature; this means that contracts must also mature before the

maturity date.

Bonds can have calls and convertibility.

Bonds have a default risk, which means the contract must include

remedies for this risk in case it occurs.

Computation

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-bill.

Answer:

Actual discount = 1.96%(100/360) = 0.5444%

Settlement price = $10,000,000(1-0.5444%) = $9,945,560

Long’s gain/Short’s loss = $10,000,000-$9,945,569 = $54,440

EQUITY INDEX FORWARD

CONTRACT

• A contract for the purchase of an individual

stock, a stock portfolio or a stock index at

some future date

EXAMPLE:

Assume that a client owns IBN at 100 and

wants to sell IBN stock in six months to

raise some cash. The client can enter into

an equity forward in which he will receive

a price of 125.

EXAMPLE 2:

If the dealer quotes P15,000 for six

securities in your portfolio and you decide

to enter into a contract, how much will

you receive at the expiration of the

contract?

EXAMPLE 3:

You contact a dealer who gives you a quote of

P5,000 on a forward contract for P170,000,000

to settle the index. If the index were to drop by

2%, your portfolio would lose P3,400,000.

Because you entered into a forward contract

with the dealer to sell the index, you benefit

from the market decline of 2% to the tune of

P3,400,000 (P170,000,000x2%)

LONDON INTERBANK OFFERED

RATES ( LIBOR)

Subtitle

• Used as the first step in calculating interest rate on various

loans throughout the world.

• Based on 5 currencies: USD, EUR, JPY, GBP, CHF

• Serves on seven maturities: overnight, week, I,2,3,6 and

12 months.

• Eurodollars deposit is the term used

for deposits in large banks outside

U.S denominated in U.S dollars.

• Lending rate on dollar-denomination • LIBOR= Principal x (LIBOR

between banks is called LIBOR. RATE/360) X Actual number of days

in interest period

• Quoted as an annualized rate based

on 360-day per year.

• LIBOR used as a reference rate for

floating rate U.S dollar-denominations

worldwide.

• Compute the amount that must be • P= $ 3,500,000

repaid on a $1,000,000 loan for 30

• Interest Period= 3 months

days, if its 30- day LIBOR rate is 6%.

• LIBOR rate= 8%

LIBOR=P x (LR/360)x number of days

=$1,000,000 x (6%/360) x 30

=$ 3,500,00 x (8%/360) x 90

=$ 5,000 + 1,000,000

=$ 70,000 + 3,500,000

=$ 1,005,000

=$ 3,570,000

CURRENCY

FORWARD

CONTRACT

CURRENCY FORWARD CONTRACT

one currency for another currency at an agreed upon future date

the time of signing the agreement

CURRENCY FORWARD CONTRACT

PROBLEM

in Germany and is expecting to receive a payment of €30,000,000 in

90 days.

USA Company entered into a cash settlement currency forward

contract with USB Company at the current exchange rate of $1.23 per

euro.

Company?

USB Company wants to buy the €30,000,000 from USA Company.

USB Company is the LONG.

USA Company is the one who will receive the payment for these

euros. USA Company is the SHORT.

Under the terms of the contract, USA Company will receive:

$ 600,000

Without the contract, USA Company will receive:

USA Company entered the contract as short because they thought that

rates would fall in the future, but instead the rate rose.

USB Company entered the contract as long because they thought that

rates would rise, as they did.

Because the rates are in favor of USB Company, they are to receive the

payment of $600,000

Remember:

you who will have to pay.

it is you who will be receiving the payment.

Under the terms of the contract, USA Company will receive:

$ 600,000

Without the contract, USA Company will receive:

USB Company will receive the payment of $600,000 from USA Company

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