Chapter 09 - Derivatives: Futures, Options, and Swaps

Chapter 9
Derivatives: Futures, Options, and Swaps

Chapter Overview

This chapter provides an introduction to derivatives, and examines both their uses and
abuses.

Reading this chapter will prepare students to:

Explain derivatives.
Understand how derivatives can be used to transfer risk.
Analyze the pricing of derivatives.

Important Points of the Chapter

Recent history has shown that derivatives are open to abuse; they were at the bottom of
the scandal that engulfed Enron and were also linked to the collapse of Long Term
Capital Management (the hedge fund). But when used properly, derivatives are
extremely helpful instruments that can be used to reduce risk, or as a form of insurance.

Application of Core Principles

Principle #2: Risk. Derivatives allow people to transfer risk, and this encourages them
to do things they would not otherwise do because in effect they provide a kind of
insurance.

Principle #1: Time. The longer the time to expiration, the more valuable an option.

Principle #2: Risk. The option premium increases with the volatility of the price of the
underlying asset.

Principle #2: Risk. The difference between the benchmark rate for a swap (the market
interest rate on a U.S. Treasury bond of the same maturity as the swap) and the swap rate
(the rate to be paid) is called the swap spread, and is a measure of risk. In recent years it
has attracted substantial attention as a measure of the overall risk in the economy
(systematic risk).

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Teaching Tips/Student Stumbling Blocks

Derivatives were first introduced back in Chapter 3; you may wish to review that
material.
The material on hedging and speculation was introduced in Chapter 5; you may
wish to review that material before beginning section II.
Give students a brief look at the action at the Chicago Board of Trade; part of the
movie Ferris Buellers Day Off (1986) was filmed there and showing that very
brief clip of the movie (its probably less than a minute) can really give them a
feel for the action in the pits.

Features in this Chapter

Lessons from the Crisis: Centralized Counterparties and Systemic Risk

Both a loss of liquidity and transparencies can threaten the financial system. One way to
keep markets functioning is to shift trading from over-the-counter transactions (OTC),
which occur between a single buy and a single seller, to a centralized counterparty, which
is an intermediary between buyers and sellers. When trading OTC, a firm can build up
significant risk without the other parties to the transactions knowing of the risk. A CCP
has the ability and incentive to monitor the riskiness of its counterparties. The CCP can
also standardize contracts and refuse to trade with a counterparty that may not be able to
pay. Further, a CCP limits its own risk through economies of scale.

Your Financial World: Should You Believe Corporate Financial Statements?

While financial statements must meet exacting accounting standards, that does not mean
they accurately reflect a companys true financial position. Unfortunately, the standards
are so specific that they provide a roadmap for the creation of misleading statements.
Investors should never trust an accounting statement that doesnt meet the standards set
forth by financial regulators and should look for companies that are open in their
financial accounting. Finally, investors should remember that diversification reduces
risk.

Your Financial World: Should You Accept Options as Part of Your Pay?

Many firms that offer options on their own stock to employees view options as a
substitute for wages. But while the options may have substantial value, there is a catch:
employees generally are not allowed to sell them, and may need to remain with the firm
to exercise them. Employees should think hard before trading salary for options;
investing in the same company that pays your salary is a risky business.

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Applying the Concept: What Was Long-Term Capital Management Doing?

Long-Term Capital Management, a Connecticut-based hedge fund, engaged in a large

number of complex speculative transactions, including interest rate swaps and options
writing. In the late 1990s its erroneous bet that interest rate spreads would shrink resulted
in losses of over $2.5 billion. The Federal Reserve Bank of New York formed a group of
banks and investment companies to purchase the company for fear that its collapse would
jeopardize the entire financial system.

In the News: AIG Still Faces Billions in Credit Losses

AIG, the insurer controlled by the US government, still faces billions in potential losses
on credit guarantees it provided for complex subprime mortgage securities. The crisis
stems from its activities in the market for credit default swaps, derivatives that function
as debt insurance, that were particularly heavy in guarantees for securities known as
collateralized debt obligations or bonds backed by debts such as sub-prime mortgages. In
November, the Federal Reserve Bank of New York set up a limited liability company
called Maiden Lane III, backed by AIG and the Federal Reserve. Maiden Lane III bought
many CDOs, but expected to continue to write off losses from these purchases.

Lessons of the Article: The article highlights the role of credit default swaps in the
collapse of AIG and, more broadly, the financial crisis of 2007-2009. OTC trading
of CDSs (See Lessons from the Crisis: Centralized Counterparties and Systemic
Risk) allowed AIG to take enormous risks that threatened the financial system as a
whole, until the US government rescued the firm in September 2008. Had AIG been
allowed to fail, the default could have triggered a wave of failures among its
creditors, including the large intermediaries who had purchased credit default
insurance from it.

Additional Teaching Tools

In AIGs Rescue Had Poisonous Effect, U.S. Panel Says (Update1), June 10, 2010,
Business Week reports that the government takeover of AIG has poisoned the
marketplace because now investors believe that the American taxpayer will fix
whatever problems come about.

At http://online.wsj.com/video/german-ban-stirs-suspicions/F0C8E8D5-56CA-4EA7-
9D16-82643A3A5D2F.html?KEYWORDS=credit+default+swaps, a Wall Street Journal
video discusses Germany's ban on the naked short selling of euro-zone bonds, credit
default swaps and certain equities that will keep market suspicions about Europe aroused
for a few days yet.

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Virtual Tools

Visit the Chicago Board of Trade on the web at: http://www.cbot.com/

The Commodity Futures Trading Commission oversees the futures industry and issues a
weekly report on the positions of both speculative and commercial market participants.
Visit them on the web at: http://www.cftc.gov/About/index.htm.

In response to the accounting scandals of recent years, Congress approved the Sarbanes-
Oxley Act of 2002. Learn more about the Act at http://www.soxlaw.com/.

Learn more about the Stock Option Accounting Reform Bill (H.R. 3574) introduced by
Rep. Baker on Nov. 21 and referenced in The Wall Street Journal story above on this
page from the web site of the House Committee on Financial Services:
http://financialservices.house.gov/news.asp?FormMode=release&id=510&NewsType=1

You can visit FASB on the web at: http://www.fasb.org/

For More Discussion

Many consumers who shop on line prefer to use a service like PayPal instead of entering
their credit card information. Does PayPal provide a service similar to the clearinghouse
described in the chapter? Discuss.

Chapter Outline
The Basics: Defining Derivatives
A. Derivatives are financial instruments whose value depends on (i.e., is derived
from) the value of some other underlying financial instrument or asset (these
include stocks or bonds as well as other assets).
B. A simple example is an interest rate futures contract, which is an agreement
between two investors that obligates one to make a payment to the other
depending on the movement in interest rates over the next year.
C. Such an arrangement is very different from the purchase of a bond for two
reasons:
1. Derivatives provide an easy way for investors to profit from price declines, as
opposed to the purchase of a bond, which is a bet that its price will increase.
2. In a derivatives transaction, one persons loss is always the other persons
gain.
D. Derivatives can be used to speculate on future price movements, but because they
allow investors to manage and reduce risk, they are indispensable to a modern
economy.

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E. The purpose of derivatives is to transfer risk from one person or firm to another,
providing a kind of insurance.
F. Derivatives increase the risk-carrying capacity of the economy as a whole,
improving the allocation of resources and increasing the level of output.
G. Derivatives also can be used to conceal the true nature of certain financial
transactions because they can be used to unbundle virtually any group of future
payments and risks.
H. Derivatives may be divided into three major categories: forwards and futures,
options, and swaps.
II. Forwards and Futures
I. Of all derivative financial instruments, forwards and futures are the simplest to
understand and the easiest to use.
J. A forward or forward contract is an agreement between a buyer and seller to
exchange a commodity or financial instrument for a specified amount of cash on a
prearranged future date.
1. They are very difficult to resell to someone else because they are
customized.
K. A future or futures contract is a forward contract that has been standardize and
sold through an organized exchange.
1. A futures contract specifies that the seller (the short position) will deliver
some quantity of a commodity or financial instrument to the buyer (the
long position) for a predetermined price.
2. No payments are made initially when the contract is agreed to.
3. The seller benefits from price declines in the price of the underlying asset,
while the buyer gains from increases.
L. Before anyone will buy or sell futures contracts there must be assurance that the
buyer and seller will meet their obligations; this is done through a clearing
corporation.
M. Margin Accounts and Marking to Market
1. To reduce the risk it faces, the clearing corporation requires both parties to a
futures contract to place a deposit with the corporation itself.
2. This is called posting margin in a margin account and the deposits (called the
initial margin) serve as a guarantee that when the contract comes due the
parties will be able to meet their obligations.
3. The clearing corporation also posts daily gains and losses on the contract to
the margin accounts of the parties involved; this is called marking to market.

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4. This ensures that both sides can meet their obligations; if the margin account
falls below a minimum the clearing corporation will sell the contracts and end
the persons participation in the market.
N. Hedging and Speculating with Futures
1. Futures contracts allow risk to be transferred between buyer and seller.
5. This transfer can be accomplished through hedging or speculation.
6. A futures contract fixes the price for both the seller and the buyer and so both
can use it as a hedge against unfavorable price movements.
7. Speculators are trying to make a profit by betting on price movements.
8. Futures contracts are popular tools for speculation because they are cheap.
9. An investor needs only a relatively small amount of funds (the margin, which
can be as low as 10 percent) to purchase a futures contract that is worth a great
deal.
10. For example, if the margin is $2,700 to purchase a $100,000 U.S. Treasury
bond, then the investment of $2,700 gives the investor the same returns as the
purchase of the bond; it is as if the buyer borrowed the balance ($97,300) at a
zero rate of interest.
11. Speculators can use futures to obtain very large amounts of leverage at a very
low cost.
B. Arbitrage and the Determinants of Futures Prices
2. On the settlement or delivery date the price of the futures contract must equal
the price of the underlying asset, otherwise there would be a risk-free profit.
3. Arbitragers simultaneously buy and sell financial instruments in order to
benefit from temporary price differences.
4. As a result of arbitrage, two financial instruments with the same risk and
promised future payments will sell for the same price.
5. If that were not true, arbitragers would buy and sell, changing demand and
forcing the prices to equality.
6. So long as there are arbitragers, on the day when a futures contract is settled,
the price of a bond futures contract will be the same as the market price of the
bond.
7. Before the settlement date, the futures price moves in lock step with the
market price of the bond.
III. Options
A. Puts, Calls, and All That: Definitions

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1. Like futures, options are agreements between two parties, a seller (option
writer) and a buyer (option holder).
2. Option writers incur obligations, while option holders obtain rights.
3. There are two basic options, calls (the right to buy) and puts (the right to sell).
4. A call option has a predetermined price (the strike price) and a specific date.
a) The writer of the call option must sell the shares if and when the
holder chooses to use the call option, but the holder is not obligated to
buy the shares.
b) The holder will buy (exercise the option) only if doing so is beneficial.
c) The holder could also sell the option to someone else at a profit.
B. Whenever the price of the stock is above the strike price of the call option, the
option is in the money. (If the prices are equal it is at the money and if the
price is less than the stock price it is out of the money.)
1. A put option gives the holder the right but not the obligation to sell the
underlying asset at a predetermined price on or before a fixed date.
a) The writer of the option is obliged to buy the shares if the holder
chooses to exercise the option.
b) Puts are in the money when the options strike price is above the
market price of the stock; they are out of the money when the strike
price is below the market price, and at the money when the two
prices are equal
2. Many options are standardized and traded on exchanges just like futures
contracts, and the mechanics of trading are the same.
3. There is a clearing corporation, but only writers of options are required to post
margin.
a) There are two types of options: American options can be exercised on
any date from the time they are written until the day they expire;
European options can only be used on the day they expire
b) The vast majority of options traded in the United States are American.
C. Using Options
1. Options transfer risk from the buyer to the seller so they can be used for both
hedging and speculation.
2. When used for hedging, a call option ensures that the cost of buying the asset
will not rise and a put option ensures that the price at which the asset can be
sold will not go down.

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a) Car insurance is like an American call option, sold by the insurance

company to the cars owner.
3. How options are used for speculation: if you believed that interest rates were
going to fall, you could bet on this by buying a bond (expensive), buying a
futures contract (cheap but risky), or by buying a call option on a U.S.
Treasury bond. If you are right, its value will increase; if you are wrong all
you lose is the price paid for the call option.
4. Purchasing a put option allows an investor to speculate on a decrease in the
price of an asset.
5. Sellers of options are speculators or are insured against any loss that may arise
because they own the underlying asset (market makers).
6. Options are versatile and can be bought and sold in many combinations.
7. Options can be used to construct synthetic instruments that mimic the payoffs
of virtually any other financial instrument.
8. Options allow investors to bet that prices will be volatile.
D. Pricing Options: Intrinsic Value and the Option Premium
1. An option price is the sum of two parts: the value of the option if it is
exercised (the intrinsic value) and the fee paid for the options potential
benefits (the time value of the option).
2. As the volatility of the stock price rises, the time value of the option rises with
it.
3. In general, calculating the price of an option and how it might change means
developing some rules for figuring out its intrinsic value and the time value of
the option.
4. Since the buyer is not obligated to exercise it, the intrinsic value of the option
depends only on what the holder receives if it is exercised.
5. The intrinsic value is the difference between the price of the underlying asset
and the strike price of the option, or the size of the payment, and it must be
greater than or equal to zero.
6. At expiration, the value of an option equals its intrinsic value, but prior to
expiration there is always the chance that the price will move.
7. The longer the time to expiration, the bigger the likely payoff when the option
does expire and thus the more valuable it is.
8. The likelihood that an option will pay off depends on the volatility of the price
of the underlying asset; the time value of the option increases with that
volatility.

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E. The Value of Options: Some Examples

1. At a given price of the underlying asset and time to expiration, the higher the
strike price of a call option, the lower its intrinsic value and the less expensive
the option.
2. At a given price of the underlying asset and time to expiration, the higher the
strike price of a put option, the higher the intrinsic value and the more
expensive the option.
3. The closer the strike price is to the current price of the underlying asset, the
larger the options time value.
4. Deep in-the-money options have lower time value. Because such an option is
very likely to expire "in the money," buying one is like buying the underlying
asset itself.
5. The longer the time to expiration at a given strike price, the higher the option
price.
IV. Swaps
A. Interest rate swaps are a type of derivative that allows government debt managers
to keep interest costs low while they manage revenues. Credit default swaps
(CDSs) are a form of insurance that allow a buyer to own a bond or mortgage
without bearing its default risk.
B. Understanding Interest Rate Swaps
1. Interest rate swaps are agreements between two counterparties to exchange
periodic interest rate payments over some future period, based on an agreed-
upon amount of principal, called the notional principal.
2. Notional principal is called that because the principal is not borrowed, lent, or
exchanged; it is just the basis for the calculations involved.
3. In the simplest type of interest rate swap the parties exchange a variable rate
for a fixed rate.
C. Pricing and Using Interest Rate Swaps
1. The benchmark rate for a swap is the market interest rate on a U.S. Treasury
bond of the same maturity as the swap.
2. The swap rate is the rate to be paid by the fixed-rate buyer.
3. The difference between the benchmark rate and the swap rate is called the
swap spread, and is a measure of risk.
4. In recent years it has attracted substantial attention as a measure of the overall
risk in the economy (systematic risk); when it widens it signals that general
economic conditions are deteriorating.

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5. Interest rate swaps are used by government debt managers and by those who
seek to reduce the risk generated by commercial activities (like banks that
have fixed-rate assets and variable-rate liabilities).
6. The primary risk in a swap is the risk that one of the parties will default.
7. Unlike futures or options, swaps are not traded on organized exchanges so
they are difficult to resell.
D. Credit Default Swaps
1. Credit default swaps (CDSs) is a credit derivative that allows lenders to ensure
themselves against the risk that a borrower will default.
2. The buyer of a CDS makes payments to the seller and the seller agrees to pay
if an underlying loan or security defaults.
3. CDS lasts several years and requires collateral be posted to protect against the
inability to pay either the buyer or seller.
4. CDSs contributed to the financial crisis in three ways
a) Fostering uncertainty about who bears the credit risk on a given loan
or security
b) Making the leading CDS sellers mutually vulnerable
c) Making it easier for sellers of insurance to assume and conceal risk
Appendix: Payoff Diagrams for Futures and Options
This appendix introduces payoff diagrams for options and futures contracts, and
explains how to use them. Combinations to customize risk are also illustrated in
terms of combining some of the figures presented.

Terms Introduced in Chapter 9

American option
arbitrage
call option
centralized counterparty (CCP)
credit-default swap (CDS)
derivatives
European option
fixed-rate payer
floating-rate payer
forward contract
futures contract
interest-rate swap
margin
notional principal

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put option
strike price
swap
swap spread
time value of an option

Lessons of Chapter 9
1. Derivatives transfer risk from one person or firm to another. They can be used in any
combination to unbundle risks and resell them.

2. Futures contracts are standardized contracts for the delivery of a specified quantity of
a commodity or financial instrument on a prearranged future date, at an agreed-upon
price. They are a bet on the movement in the price of the underlying asset on which
they are written, whether it is a commodity or a financial instrument.
a. Futures contracts are used both to decrease risk, which is called hedging, and to
increase risk, which is called speculating.
b. The futures clearing corporation, as the counterparty to all futures contracts,
guarantees the performance of both the buyer and the seller.
c. Participants in the futures market must establish a margin account with the
clearing corporation and make a deposit that insures that they will meet their
obligations.
d. Futures prices are marked to market daily, as if the contracts were sold and
repurchased every day.
e. Since no payment is made when a futures contract is initiated, the transaction
allows an investor to create a large amount of leverage at a very low cost.
f. The prices of futures contracts are determined by arbitrage within the market for
immediate delivery of the underlying asset.

3. Options give the buyer (option holder) a right and the seller (option writer) an
obligation to buy or sell an underlying asset at a predetermined price on or before a
fixed future date.
a. A call option gives the holder the right to buy the underlying asset.
b. A put option gives the holder the right to sell the underlying asset.
c. Options can be used both to reduce risk through hedging and to speculate.
d. The option price equals the sum of its intrinsic value, which is the value if the
option is exercised, and the time value of the option.
e. The intrinsic value depends on the strike price of the option and the price of the
underlying asset on which the option is written.
f. The time value of the option depends on the time to expiration and the volatility
of the price of the underlying asset.

4. Interest-rate swaps are agreements between two parties to exchange a fixed for a
variable interest rate payment over a future period.

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a. The fixed-rate payer in a swap pays the U.S. Treasury bond rate plus a risk
premium.
b. The flexible-rate payer in a swap normally pays the London Interbank Borrowing
Rate (LIBOR).
c. Interest-rate swaps are useful when a government, firm, or investment company
can borrow more cheaply at one maturity, but would prefer to borrow at a
different maturity.
d. Swaps can be based on an agreed-upon exchange of any two future sequences of
payments.

5. Credit-default swaps (CDSs) are a form of insurance in which the buyer of the
insurance makes payments (like insurance premiums) to the seller, who in turn agrees
to pay the buyer if an underlying loan or security defaults.
a. A CDS agreement often lasts several years and requires that collateral be posted
to protect against the inability to pay of the seller or the buyer of insurance.
b. Because financial institutions do not report CDS sales and purchases, it is not
clear who bears credit risk on a given loan or security.
c. Because CDS are traded over the counter, even traders cannot identify others who
take on concentrated risks on one side of a trade.

6. Derivatives allow firms to arbitrarily divide up and rename risks and future payments,
rendering their actual names irrelevant.

Conceptual Problems

1. An agreement to lease a car can be thought of as a set of derivative contracts.

Describe them.

Answer: When someone leases a car, he or she agrees to make a series of fixed
monthly payments; this is like a forward contract. At the end of the lease, the lessee
can purchase the car; this is like an option.

2. In spring 2002, an electronically traded futures contract on the stock index, called an
E-mini future, was introduced. The contract was one-fifth the size of the standard
futures contract, and could be traded on the 24-hour CME Globex electronic trading
system. Why might someone introduce a futures contract with these properties?

Answer: The size of the contracts allows small investors to purchase it. The fact that
the contracts can be traded 24 hours a day makes the contract more liquid and allows
investors to speculate using current information from markets around the world. It
also makes it more convenient for foreign investors to trade the contracts.

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3. A hedger buys a futures contract, taking a long position in the wheat futures market.
What are the hedgers obligations under this contract? Describe the risk that is
hedged in this transaction and give an example of someone who might enter into such
an arrangement.

Answer: The hedger has taken the long position, promising to purchase the wheat at a
fixed price on a future date. He is hedging against the risk that the price of wheat will
rise. Someone who anticipates needing wheat in the future, such as a miller or a
maker of breakfast cereals, might enter into such a transaction

4. A futures contract on a payment of $250 times the Standard and Poors 500 Index is
traded on the Chicago Mercantile Exchange. At an index level of $1,000 or more, the
contract calls for a payment of over $250,000. It is settled by a cash payment
between the buyer and the seller. Who are the hedgers and who are the speculators in
the S&P 500 futures market?

Answer: Hedgers are investors who own funds composed of stocks from the S&P
500; they will sell futures contracts to hedge against the risk that the market falls.
Speculators are trying to profit from movements in the market; they will sell futures if
they expect the market to fall, and buy futures if they expect the market to rise.

5. Explain why trading derivatives on centralized exchanges rather than in over-the-

counter markets helps to reduce systemic risk.

Answer: The presence of a centralized counterparty (CCP) increases transparency, as

the CCP has the ability and the incentive to monitor whether a trader is taking a large
position on one side of a trade. This reduces the vulnerability of the financial system
to the weakness of any one participant.
The CCP reduces its own risk through economies of scale. With large volumes of
transactions on both sides of a trade, its net exposure is relatively small.
The standardization of contracts traded through CCP also increases transparency
while the practice of marking to market quickly exposes a counterpartys inability to
pay, allowing for a timely resolution of the problem and the avoidance of knock-on
effects.

6. What are the risks and rewards of writing and buying options? Are there any
circumstances under which you would get involved? Why or why not? (Hint: Think
of a case in which you own shares of the stock on which you are considering writing
a call.)

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Answer: Because option buyers incur no obligations, their losses are limited to the
price paid for the option. Their potential gains, however, can be large. Sellers must
buy or sell the underlying asset at the strike price if the option is exercised, so their
losses are unlimited. When writing a call option, the seller can lose money if the
price of the underlying asset rises; however, if the seller owns the asset, then he or she
is insured against these potential losses and issuing a call option is not very risky.

7. Suppose XYZ Corporation's stock price rises or falls with equal probability by $20
each month, starting where it ended the previous month. What is the value of a three-
month at-the-money European call option on XYZs stock if the stock is priced at
$100 when the option is purchased?

Answer:
Value of option = Option price = Intrinsic value + Time Value of the Option
Intrinsic value = $0 as the option is at the money.
To calculate the time value of the option, list all the possible outcomes for the stock
price movement and identify those where the price goes up. If the stock price falls,
the option will not be exercised.

Month 1 Month 2 Month 3 Total

+20 +20 +20 +60
+20 +20 -20 +20
+20 -20 +20 +20
-20 +20 +20 +20
+20 -20 -20 -20
-20 +20 -20 -20
-20 -20 -20 -60
-20 -20 +20 -20

Each of the outcomes is equally likely and so occurs 1/8 of the time. Focusing on the
first four where the price goes up,
1 3
Time Value of the Option= * $60 * $20 $15
8 8
Option price = intrinsic value + time value of the option = $0 +$15 = $15

8. *Why might a borrower who wishes to make fixed interest rate payments and who
has access to both fixed- and floating-rate loans still benefit from becoming a party to
a fixed-for-floating interest rate swap?

Answer: If the company has a comparative advantage in borrowing in the floating

rate market, it can reduce its overall interest costs by borrowing at a floating interest
rate and entering a swap agreement where it makes fixed payments and receives

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payments that fluctuate with the interest rate. The net effect is that its payments are
fixed but, because it exploits its comparative advantage in the floating rate market
where it can borrow relatively cheaply, the overall cost is lower than borrowing
directly from the fixed rate market.

9. Concerned about possible disruptions in the oil stream coming from the Middle East,
the chief financial officer (CFO) of American Airlines would like to hedge the risk of
an increase in the price of jet fuel. What tools could the CFO use to hedge this risk?

Answer: The CFO could buy oil futures contracts, giving him or her a long position in
oil and so protecting against a price increase. Alternatively, he or she could buy oil
call options, which would confer the right to buy oil at the strike price on or before
the expiration date of the option.

10. *How does the existence of derivatives markets enhance an economys ability to
grow?

Answer: The existence of derivative markets increases the economys capacity to

carry risk by facilitating the transfer of risk to those best able to bear it. They allow
risks to be hedged more efficiently and at a lower cost by those who do not wish to
carry them. In the absence of these mechanisms to deal with risk, resources may not
be allocated efficiently, hindering the ability of the economy to grow.

11. Credit-default swaps provide a means to insure against default risk and require the
posting of collateral by buyers and sellers. Explain how these safe-sounding
derivative products contributed to the 2007-2009 financial crisis?

Answer: Credit default swaps (CDS) are traded over the counter and financial
institutions do not report their CDS purchases and sales. This contributed to a lack of
transparency about who bears the default risk, making the financial system more
vulnerable. (Recall core principle 3 from chapter 1 information is the basis for
decisions.) Traders could not identify who might have large one-sided positions,
making the system vulnerable to the collapse of one institution.
During the 2007-2009 crisis, AIG was a large player in the market for credit default
swaps. When the companys credit rating was downgraded, the additional collateral
requirements it faced brought it near to collapse, threatening the stability of the
financial system as a whole and prompting the intervention of the Federal Reserve.

Analytical Problems

12. Of the following options, which would you expect to have the highest option price?
a. A European 3-month put option on a stock whose market price is $90 where the
strike price is $100. The standard deviation of the stock price over the past 5
years has been 15%.

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b. A European 3-month put option on a stock whose market price is $110 where the
strike price is $100. The standard deviation of the stock price over the past 5
years has been 15%.
c. A European 1-month put option on a stock whose market price is $90 where the
strike price is $100. The standard deviation of the stock price over the past 5
years has been 15%.

Answer: Option Price = intrinsic value + time value of the option

We know that a put option is in the money if the strike price is higher than the market
price and that the time value of an option increases with the volatility of underlying
asset and the time to expiration.
Option A: In the money - intrinsic value = $10
Option B: Out of the money intrinsic value = 0
Option C: In the money intrinsic value = $10
Looking at the time value of the option, all three options have the same standard
deviation.
A has a longer time to expiration than C, so with the same intrinsic value and
volatility, has a higher option value.
A has the same standard deviation and time to expiration as B but a higher intrinsic
value, so A has a higher option value than B.
A should have the highest option price.

13. What kind of an option should you purchase if you anticipate selling $1 million of
Treasury bonds in one years time and wish to hedge against the risk of interest rates
rising?

Answer: You could purchase a put option that gives you (as the holder) the right but
not the obligation to sell the bonds at a price determined today. Therefore, if interest
rates rise and so the price of the bonds falls, you can exercise the option and sell the
bonds at the pre-determined price. If, on the other hand, interest rates fall, you can
let the option expire and enjoy the benefits of the increase in the price of the bonds.

14. You sell a bond futures contract and, one day later, the clearinghouse informs you that
it had credited funds to your margin account. What happened to interest rates over
that day?

Answer: Interest rates have risen. This reduced the price of the bonds and so as the
holder of the short position you have gained. As the clearinghouse marks to market
on a daily basis, this gain was posted to your margin account.

15. You are completely convinced that the price of copper is going to rise significantly
over the next year and want to take as large a position as you can in the market but
have limited funds. How could you use the futures market to leverage your position?

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Answer: You should buy as many one-year copper futures contracts as you can afford.
This will depend on the margin payment required. As the margin payment is a
fraction of the value of the contract, you will leverage your exposure to market
movements. The value of the futures contracts will rise in lockstep with the price of
copper.

16. Suppose you have $8,000 to invest and you follow the strategy you devise in question
15 to leverage your exposure to the copper market. Copper is selling at $3 a pound
and the margin requirement for a futures contract for 25,000 pounds of copper is
$8,000.
a. Calculate your return if copper prices rise to $3.10 a pound.
b. How does this compare with the return you would have made if you have
simply purchased $8000 worth of copper and sold it a year later?
c. Compare the risk involved in each of these strategies.

Answer:
a) With $8,000, you can afford to purchase one copper futures contract. At $3 a
pound, this is worth $75,000. The contract specifies that you will take delivery of
25,000 pounds at $3 a pound in one-years time. If the price in the market has
risen by then to $3.10, you make a profit of $2,500 on the $8,000 margin you
posted. This represents a return of 31.25% on your investment.
b) If you purchased copper directly at $3 a pound, you could have afforded 2,667
pounds. If you sold it one year later for $3.10, you would have gained $267, a
return of 3.3%.
c) Speculating in the futures market can bring high returns (in this case returns
almost ten times as large), but, as usual, these high returns come at the cost of
bearing greater risk. Suppose, for example, your hunch about copper prices was
incorrect and the price of copper fell to $2.90. You would have lost $2,500 over
the year. If you were very unfortunate and the price of copper fell to $2.65, you
would have wiped out your entire $8,000 and a bit more as well.
In comparison, if you bought the copper at $3 and after a year you sold it at $2.90,
you would have lost only $267. For your entire $8,000 to be wiped out, the price of
copper would have to fall to zero! And, of course, once you own the copper
(ignoring storage costs), you could always elect to hold onto it until the price rose
again.

17. *You are given the following information on three firms.

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Fixed Rate Floating Rate

Firm A 7% LIBOR+50 bps

Firm B 12% LIBOR+150 bps

Firm C 10% LIBOR+150 bps

(LIBOR, which stands for the London Interbank Offered Rate, is a floating interest
rate.) Firms A and B want to be exposed to a floating interest rate while Firm C
would prefer to pay a fixed interest rate. Which pair(s) of firms (if any) should
borrow in the market they do not want and then enter into a fixed-for-floating interest
rate swap?

Answer: Possible pairs: A and C or B and C

(As A and B both want floating, they wont engage in a fixed-for-floating swap with
each other.)
Next look at who has the comparative advantage in which market.
A versus C
A has a 3% advantage over C in the fixed rate market and a 1% advantage in the
floating rate market. Therefore, A has a comparative advantage in the fixed rate
market and wants floating. A and C can reduce their overall cost of funds by A
borrowing fixed, C borrowing floating and then entering into a fixed-for-floating
swap to exchange the exposures.
B versus C
C has a comparative advantage in the fixed rate market and wants fixed rate exposure.
Therefore, there is no benefit to the swap.
A and C are the only pair that should engage in a fixed-for-floating swap.

18. Suppose you were the manager of a bank that raised most of its funds from short-term
variable-rate deposits and used these funds to make fixed-rate mortgage loans.
Should you be more concerned about rises or falls in short-term interest rates? How
could you use interest-rate swaps to hedge against the interest-rate risk you face?
Answer: Given that you make interest payments based on short-term interest rates and
receive fixed-rate interest payments, you should be most concerned about increases in
short-term rates. You would have to make higher payments while the payments you
receive remain the same.

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You could hedge against this risk by entering into a fixed-for-floating interest rate
swap where you make payments based on a fixed interest rate and receive payments
that fluctuate with a reference floating interest rate. When interest rates rise, you
receive higher payments from the swap to offset the losses on your underlying
banking business.

19. *Basis swaps are swaps where, instead of one payment stream being based on a fixed
interest rate, both payment streams are based on different floating interest rates. Why
might anyone be interested in entering a floating-for-floating interest rate swap? (You
should assume that both payment flows are denominated in the same currency.)
Answer: In a basis swap, the two payment streams are referenced from different
floating rates and so can be used to hedge against movements in the spread between
these two rates. For example, suppose an institution raises funds by issuing
commercial paper and lends out the funds at interest rates based on the Treasury bill
rate. By entering into a basis swap where they receive a payment flow based on the
commercial paper rate and pay one based on the Treasury bill rate, they can hedge
against changes in the spread between these two rates.

* indicates more difficult problems

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