Futures Options and Swaps PPT MBA FINANCE

Futures, Options, and Swaps
Purposes of these derivatives

Hedge price movements in cash markets Increase completeness of markets
Repackage cash flows in many ways that are attractive to investors
Speculation in market prices (this makes pricing efficient)
Financial futures markets

Sale or purchase of securities now for future delivery (also currencies)
CBOT started GNMA futures in 1975. Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME) are leaders. Now T-bills, T-notes, large CDs, Euro CDs, GNMAs, S&P500 Index, NYSE Index, and others These contracts are very standardized, use wellknown financial securities, and are growing in international exchanges around the world.
Futures markets
Financial Futures
Organized exchanges
CBOT, CME use trading pits (open outcry system) Margins as low as 0.2 percent (can borrow more than 99 percent of futures contract!! - $2,500 for$1 million T-bill) -- this minimizes costs of hedging. Clearinghouse guarantees performance of other party to contract Normally, close out with offsetting position before maturity Marked-to-market daily
Differ from forward contracts

No organized exchange to guarantee payment -- agreement between parties involved only -- over-the-counter Not marked-to-market daily (unwind profits or losses at maturity)
Financial Futures
Foreign currency hedging started before financial futures due to highly volatile currency movements in the early 1970s.
For example, British govt securities may have higher yield that U.S. govt securities Problem: British pound may decline in value (relative to U.S. dollar) causing a loss of yield gains in British securities. Solution: Go short (sell) in pounds. If pounds do decline in value over time, buy at lower price and fill earlier sell orders to make profit in futures market for British pounds. Result is to eliminate currency risk and earn yield on British securities.
Stock index futures

No delivery possible here
Delivery in cash on settlement date (e.g., for S&P 500 Index, take $500 times value of contract at maturity).
Short Position in a 90-day T-Bill Futures Contract with $1,000,000 Denomination.

Assumption: That interest rates increase over the next 90 days. Price Sell (say 98) Price Buy (say 96)
Profit of 2 or $20,000
0 = Now Time
90 days from now
Discussion: No delivery of T-bills is required on the settlement date 90 days from now. The futures exchange automatically buys and sells T-bills for you at settlement. You can unwind or settle prior to the maturity of the contract if you want. The same principles apply to currencies -- e.g., the value of the pound falls over the next 90 days.
Long Position in a 90-day T-Bill Futures Contract with $1,000,000 Denomination.

Assumption: That interest rates decrease over the next 90 days. Price Sell (say 98) Price Buy (say 96)
Profit of 2 or $20,000
0 = Now Time
90 days from now
Discussion: If interest rates instead increase over the next 90 days, there will be losses each day in this long position. Due to marked-to-market accounting by the exchanges, the losses must be paid immediately. This is true to a short futures position also -- if interest rates decrease instead of increase over time, losses must be paid each day this occurs.
Options
Definition:
Right but not obligation to buy or sell at a specified price (striking price) on or before a specified date (expiration date).
Call option: Right to buy -- pay premium

to seller for this right. Put Option: Right to sell -- pay premium to seller for this right. Note: Seller of option must buy or sell as arranged in the option, so the seller gets a premium for this risk. The premium is the price of the option. The Black-Scholes option pricing model can be used to figure out the premium (or price) of an option. Premiums related to price and volatility of securities. Long position: The buyer of the option, who gains if the price of the option increases. Short position: The seller of the option, who earns the premium if the option is not exercised (because it is not valuable to the buyer of the option).
Option Payoffs to Buyers

Payoff
Call Option
Gross payoff Net payoff
Buy for $4 with exercise price $100

$100 $104
Price of security
Premium = $4 Payoff Net payoff
Put Option
Buy put for $5 Gross profit with exercise price of $40.

$40
$35
Premium = $5 Price of security NOTE: Sellers earn premium if option not exercised by buyers.
Hedging with Interest Rate Swaps

BEFORE
Firm 1
Fixed rate assets Variable rate liabilities
Firm 2
Variable rate assets Fixed rate liabilities
Note: Exchange interest payments, not the principal or so-called notational values of the debt contracts.
AFTER
Firm 1
Fixed assets Fixed liabilities
Firm 2
Variable assets Variable liabilities
oStarted in 1981 in Eurobond market. oLong-term hedge oPrivate negotiation of terms oDifficult to find opposite party oCostly to close out early oDefault by opposite party causes loss of swap oDifficult to hedge interest risk due to problem of finding exact opposite mismatch in assets or liabilities
Interest Rate SWAP

13.1% Bank
Bank makes debt payments
Libor
Firm A
Libor + 1% 12%
Firm B
Starting conditions: Firm B borrows fixed rate 12% bonds (AAA bonds with no premium for risk)
Starting conditions: Firm A borrows floating rate bank loan at Libor + 1% (premium for risk)
Results (A) Firm A has total or all-in fixed rate obligation of 12% + 0.1%(bank service fee + 1.0%(premium over Libor) = 13.1% (B) Firm B has floating rate obligation
Hedging Strategies
Use swaps for long-term hedging. Use futures and options for short-term hedges. Use futures to lock-in the price of cash positions in securities: e.g., a corp. treasurer has a payroll due in 5 days and wants to fix the value of marketable securities being held to meet the payroll -- a short hedge gives downside price protection in this case. Use options to minimize downside losses on a cash position and take advantage of possible profitable price movements in your cash position: e.g., you have a cash position in bonds and believe that interest rates are equally likely to rise than fall -- -- you could buy by a put option on bonds -- if rates do rise, you are in the money on the option and offset losses in the cash position in bonds -- however, if rates fall, you do not exercise the option and make price gains on the cash position in bonds. Use options on futures to protect against losses in a futures position and take advantage of price gains in a cash position. Use options to speculate on price movements in stocks and bonds and put a floor on losses.
Hedging Strategies
Options are more costly than futures in terms of transactions costs, so futures are used more frequently in hedging. Futures and options are primarily hedging (risk reduction) vehicles, but they do expose the firm to some amount of management risk -- more specifically, an employee suffering losses in these contracts may react by taking even larger risks to make up for the losses, with the possibility of large losses due to high leverage (borrowed funds) that could damage the firm. Futures have potential liquidity risk because they are marked-to-market daily and losses must be paid immediately. Forward contracts do not have this problem, as not marked-to-market daily. Futures contracts have basis risk to the extent that prices of the derivative securities (e.g., T-bills) do not move over time in the same way as other asset prices. If you held junk corporate bonds, basis risk is significant, as the T-bills and junk bond prices are less than perfectly correlated over time. Forward contracts reduce this problem, as you can use any asset as the derivative (i.e., forward contracts in junk bonds are used to hedge cash positions in junk bonds). Large banks today provide risk management services to firms that includes hedging advice and management of hedging services.

Futures Options and Swaps PPT MBA FINANCE

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What are some common uses of derivatives?

What are some common uses of derivatives?

How do futures contracts work?

How do futures contracts work?

Futures, Options, and Swaps

Purposes of these derivatives

Speculation in market prices (this makes pricing efficient)

Financial futures markets

Differ from forward contracts

Stock index futures

Short Position in a 90-day T-Bill Futures Contract with $1,000,000 Denomination.

90 days from now

Long Position in a 90-day T-Bill Futures Contract with $1,000,000 Denomination.

90 days from now

Call option: Right to buy -- pay premium

Option Payoffs to Buyers

Gross payoff Net payoff

Buy for $4 with exercise price $100

Premium = $4 Payoff Net payoff

Buy put for $5 Gross profit with exercise price of $40.

Hedging with Interest Rate Swaps

Interest Rate SWAP

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