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Derivatives 101. February 2014. CONFIDENTIAL. DRAFT. Global FX: Markets, Language, and Conventions Foreign Exchange Workshop: Section 1A. Agenda. Derivatives 101 Workshop. 1. By the end of this session, participants should understand: the history and nature of derivative securities

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Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives 101

February 2014

CONFIDENTIAL

DRAFT

Global FX: Markets, Language, and ConventionsForeign Exchange Workshop: Section 1A


Global fx markets language and conventions foreign exchange workshop section 1a

Agenda

Derivatives 101 Workshop

1


Global fx markets language and conventions foreign exchange workshop section 1a

By the end of this session, participants should understand:

the history and nature of derivative securities

the basic structural features and definitions of forwards, futures, options, and swaps

the motivation for buyers and sellers of these securities

practical applications for derivatives.

Course Objectives

3


Global fx markets language and conventions foreign exchange workshop section 1a

Agenda

4


Global fx markets language and conventions foreign exchange workshop section 1a

The Nature of Derivatives

  • A derivative is an instrument whose value depends on the values of other more basic underlying variables (usually traded assets).

  • “A derivative is a contingent claim that may be used to transfer risk from someone who has it, but doesn’t want it to someone who wants it, but doesn’t have it”. –The Economist

5


Global fx markets language and conventions foreign exchange workshop section 1a

Evolution of Interest Rate Derivatives

10-year Treasury Yield

Source: Bloomberg, Bank of America Merrill Lynch

6


Global fx markets language and conventions foreign exchange workshop section 1a

Evolution of FX Derivatives

$US/Pound Sterling

Source: Bloomberg, Bank of America Merrill Lynch

7


Global fx markets language and conventions foreign exchange workshop section 1a

Evolution of Commodity Derivatives

Dollar Per Barrel of Crude

Source: Bloomberg, Bank of America Merrill Lynch

8


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Defined

  • Forward Contract

    • A financial contract to buy or sell an asset at a certain future time for a certain price (the delivery price).

    • No cash flows are exchanged until the delivery date.

9


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Defined

  • Futures Contract

    • A financial contract to buy or sell an asset at a certain time in the future for a certain price (the delivery price).

    • The financial contract is marked-to-market.

10


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Defined

  • Swap

    • A contract between two or more parties to exchange sets of cash flows over a period in the future.

    • The parties that agree to the swap are known as counterparties.

    • The two most common types of swaps are interest rate swaps and currency swaps.

11


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Defined

  • Option

    • A contract granting the right to buy or sell an asset at a stated price over a specified period.

    • Call option – contract granting the right to buy

    • Put option – contract granting the right to sell

12


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets

  • Exchange traded

    • Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading

    • Contracts are standard and there is virtually no credit risk

13


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets

Source: World Federation of Exchanges, 2013 WFE Market Highlights

14


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets - Stocks

Source: World Federation of Exchanges, 2013 WFE Market Highlights

15


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets - Index

Source: World Federation of Exchanges, 2013 WFE Market Highlights

16


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets – Interest Rate

Source: World Federation of Exchanges, 2013 WFE Market Highlights

17


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets – Commodity

Source: World Federation of Exchanges, 2013 WFE Market Highlights

18


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets

  • Over-the-counter (OTC)

    • A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers.

    • Contracts can be non-standard and there is some small amount of credit risk.

    • Financial institutions often act as market makers for the more commonly traded instruments.

      • A market maker is always prepared to quote both a bid price (a price at which they are prepared to buy) and an ask price (a price at which they are prepared to sell).

19


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets – OTC Derivatives

Amounts outstanding of over-the-counter (OTC) derivatives

By risk category and instrument

In billions of US dollars

Source: Bank for International Settlements, Annual Survey, November 2013

20


Global fx markets language and conventions foreign exchange workshop section 1a

Derivatives Markets – Ways Derivatives Can Be Used

  • To hedge risks

  • To speculate (take a view on the future direction of the market)

  • To lock in an arbitrage profit

  • To change the nature of a liability or an investment.

21


Global fx markets language and conventions foreign exchange workshop section 1a

Agenda

22


Global fx markets language and conventions foreign exchange workshop section 1a

Forward Contract

  • A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price).

  • It can be contrasted with a spot contract which is an agreement to buy or sell immediately

  • The forward price may be different for contracts of different maturities.

  • As we move through time the delivery price does not change, but the forward price for a contract may change.

  • It is traded in the OTC market

23


Global fx markets language and conventions foreign exchange workshop section 1a

Forward Contract

Concept Check:

What are the bid/offer prices for the 2-month forward?

24


Global fx markets language and conventions foreign exchange workshop section 1a

Forward Contract

Source: Bloomberg, January 28, 2013

25


Global fx markets language and conventions foreign exchange workshop section 1a

Forward Contract – Concept Check

  • Suppose that the Treasurer of a U.S. corporation knows that the corporation will pay £1 million in six months and wants to hedge against exchange rate moves.

  • How much will the corporation pay, in dollars, for the forward contract based on the quotes below?

26


Global fx markets language and conventions foreign exchange workshop section 1a

Profit

Price of Underlying

at Maturity, ST

Forward Contract – Concept Check : Long Forward

+

0

K, delivery price

K = $1.6546/GBP

-

27


Global fx markets language and conventions foreign exchange workshop section 1a

Profit

Price of Underlying

at Maturity, ST

Forward Contract – Short Forward

+

0

-

28


Global fx markets language and conventions foreign exchange workshop section 1a

Forward vs. Futures Contract

  • Forward

    • Private contracts that trade OTC

    • Unique specifics to satisfy the parties involved

    • Some credit risk is present

    • No cash transactions until delivery date

  • Futures

    • Trade on an organized exchange

    • Standardized contracts

    • Performance of contract guaranteed by clearinghouse

    • Margin money posted…mark-to-market daily at settle price

    • Government regulation of futures market

29


Global fx markets language and conventions foreign exchange workshop section 1a

Agenda

30


Global fx markets language and conventions foreign exchange workshop section 1a

Interest Rate Swap

  • Interest rate swaps allow corporations to manage interest rate exposure.

    • In a rising interest rate environment, corporations that are net borrowers want to lock in fixed rates (while rates are still low).

    • In a falling interest rate environment, interest rate swaps allow corporations that are net borrowers to take advantage of falling rates by getting in on the floating side.

  • Interest rate swaps allow investors to swap into floating rates if they believe rates will rise.

  • If interest rates are rising, a company with floating-rate debt can undertake a swap to pay fixed and receive floating, which avoids the transaction costs of refinancing.

31


Global fx markets language and conventions foreign exchange workshop section 1a

Interest Rate Swap Application

  • Suppose a firm has a utilized revolving line of credit with a bank that requires semi-annual interest payments of LIBOR plus 25 basis points. The firm see the screen below with the market view of LIBOR going forward and decides to hedge against rising rates using a pay fixed interest rate swap on $100 million notional. The 3-year swap requires semi-annual settlement and has a swap fixed rate of 0.946097%.

32


Global fx markets language and conventions foreign exchange workshop section 1a

Interest Rate Swap Application

$100 million notional, semi-annual, 0.946097% fixed

---------Dollars---------

LIBOR

FLOATING

FIXED

Net

Date

Rate

Cash Flow

Cash Flow

Cash Flow

Jan 30, 2014

0.33200%

Jul 30, 2014

+166,922.22

–473,048.50

–306,126.28

$100,000,000 x [0.332000% x (181/360) = $166,922.22 uses ACT/360

$100,000,000 x [0.946097% x (180/360)] = $473,048.50 uses 30i/360

33


Global fx markets language and conventions foreign exchange workshop section 1a

Interest Rate Swap Application

---------Dollars---------

LIBOR

FLOATING

FIXED

Net

Date

Rate

Cash Flow

Cash Flow

Cash Flow

Jan 30, 2014

0.33200%

Jul 30, 2014

0.42437%

+166,922.22

–473,048.50

-306,126.28

Jan 30, 2015

0.61379%

+216,900.33

–473,048.50

-256,148.17

Jul 30, 2015

0.89853%

+308.598.93

–473,048.50

-164,449.57

Jan 29, 2016

1.40161%

+456,754.85

–470,420.45

-13,665.60

Jul 29, 2016

1.93679%

+708,591.72

–473,048.50

+235,543.22

+995,294.44

–475,676.55

+519,617.89

Jan 30, 2017

34


Global fx markets language and conventions foreign exchange workshop section 1a

Interest Rate Swap Application

35


Global fx markets language and conventions foreign exchange workshop section 1a

Interest Rate Swap Application

36


Global fx markets language and conventions foreign exchange workshop section 1a

Interest Rate Swap Example

Financial Institution earns spread of 0.8392 bps p.a.

0.937705%

0.946097%

1.625%

Firm A

F.I.

Firm B

LIBOR+0.25%

LIBOR

LIBOR

Firm A issued a bond paying 1 5/8% annually. This firm wants to pay floating and has swapped to receive fixed at 0.937705% creating a floating rate instrument where Firm A pays Libor + 68.7295 bps.

Firm B pays Libor + 25 bps on a loan and wants to pay fixed. With the swap, Firm B pays fixed rate of 0.946097% and receives Libor flat. The fixed cost to Firm B is 0.946097% plus 25 bps or 1.196097%

37


Global fx markets language and conventions foreign exchange workshop section 1a

Currency Swap Example

  • Suppose a firm can raise money at an advantageous rate in the U.S., but needs the funds to be denominated in pound sterling. The company can issue dollar-denominated debt, convert the principal to pound sterling, make payments in pound sterling and receive dollar interest to service its debt issue.

  • For example, suppose the firm agrees to pay 2% on a sterling principal of £10,000,000 & receive 1% on a US$ principal of $16,500,000 every year for 5 years.

  • In an interest rate swap the principal is not typically exchanged.

  • In a currency swap the principal is exchanged at the beginning and the end of the swap.

38


Global fx markets language and conventions foreign exchange workshop section 1a

The Cash Flows

Dollars

Pounds

$

£

Year

------millions------

2014

–16.50

+10.00

+ 0.165

2015

–0.20

+ 0.165

–0.20

2016

2017

+ 0.165

–0.20

+ 0.165

–0.20

2018

2019

+16.165

-10.20

39


Global fx markets language and conventions foreign exchange workshop section 1a

Typical Use of Currency Swap

  • Conversion from a liability in one currency to a liability in another currency

  • Conversion from an investment in one currency to an investment in another currency

40


Global fx markets language and conventions foreign exchange workshop section 1a

Swaps and Forwards

  • A swap can be regarded as a convenient way of packaging forward contracts.

  • The “plain vanilla” interest rate swap in our example consisted of 6 FRAs.

  • The “fixed for fixed” currency swap in our example consisted of a cash transaction and 5 forward contracts.

  • The value of the swap is the sum of the values of the forward contracts underlying the swap.

  • Swaps are normally “at the money” initially

    • This means that it costs nothing to enter into a swap

    • It does not mean that each forward contract underlying a swap is “at the money” initially

41


Global fx markets language and conventions foreign exchange workshop section 1a

Agenda

42


Global fx markets language and conventions foreign exchange workshop section 1a

Options

  • A call option is an option to buy a certain asset by a certain date for a certain price (the strike, or exercise, price)

  • A put is an option to sell a certain asset by a certain date for a certain price (the strike, or exercise, price)

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Global fx markets language and conventions foreign exchange workshop section 1a

Profit ($)

30

20

10

Terminal

stock price ($)

30

40

50

60

0

70

80

90

-5

Long Call

Profit from buying a European call option on stock X: option price = $5, strike price = $60

44


Global fx markets language and conventions foreign exchange workshop section 1a

Profit ($)

70

80

90

5

0

30

40

50

60

Terminal

stock price ($)

-10

-20

-30

Short Call

Profit from writing a European call option on stock X: option price = $5, strike price = $60

45


Global fx markets language and conventions foreign exchange workshop section 1a

Profit ($)

30

20

10

Terminal

stock price ($)

0

60

70

80

90

100

110

120

-7

Long Put

Profit from buying a European put option on stock X: option price = $7, strike price = $90

46


Global fx markets language and conventions foreign exchange workshop section 1a

Profit ($)

Terminal

stock price ($)

7

60

70

80

0

90

100

110

120

-10

-20

-30

Short Put

Profit from writing a European put option on stock X: option price = $7, strike price = $90

47


Payoffs from options what is the option position in each case

Payoff

Payoff

K

K

ST

ST

Payoff

Payoff

K

K

ST

ST

Payoffs from OptionsWhat is the Option Position in Each Case?

Option Concept Check

K = Strike price, ST = Price of asset at maturity

A.

C.

D.

B.

48


Global fx markets language and conventions foreign exchange workshop section 1a

Combinations of Options and Underlying Asset

Suppose that we combine an option position with either a long or short position in the underlying asset.

Long Stock

+

Long Put

=

Combination

0

0

0

K

ST

ST

ST

49


Global fx markets language and conventions foreign exchange workshop section 1a

Combinations of Options and Underlying Asset

Profit

Profit

K

ST

ST

K

(a)

(b)

Profit

Profit

K

K

ST

ST

(c)

(d)

50


Global fx markets language and conventions foreign exchange workshop section 1a

Combinations of Options and Other Options

  • Spreads

    • Created from two or more calls or two or more puts

  • Straddles

    • Created from a long call and a long put with the same strike price and expiration date.

  • Strangles

    • Created from a long call and a long put, but with different strike prices

51


Global fx markets language and conventions foreign exchange workshop section 1a

Bull Spread Using Two Call Options

Long Call 1

Profit

K1

  • K2

ST

Short Call 2

What Would Be The Motivation For This Position?

52


Global fx markets language and conventions foreign exchange workshop section 1a

Profit

K

ST

Long Straddle Using Long Call and Long Put

Long Call

Long Put

What Would Be The Motivation For This Position?

53


Global fx markets language and conventions foreign exchange workshop section 1a

Long Strangle Using Long Call and Long Put, Different Strikes

Profit

Long Call

K1

K2

ST

Long Put

What Would Be The Motivation For This Position?

54


Global fx markets language and conventions foreign exchange workshop section 1a

Concepts to Consider

  • How can forwards and futures be used to help a company manage its exposure to exchange rates, interest rates, and commodity prices?

  • Name at least three ways that forwards differ from futures.

  • How are forward rate agreements (FRAs) related to interest rate swaps? Would you prefer to have a series of FRAs in place or one multi-year interest rate swap? How should these two approaches compare in pricing?

  • For long-term hedging, what are the pros and cons to using forwards, swaps, and options?

  • For short-term hedging, or for hedging an uncertain exposure, what are the pros and cons to using forwards, swaps, and options?

  • Design a strategy for hedging exposure to the Japanese yen for a company with operations in Japan and a reporting currency of the U.S. dollar during a period of a strengthening dollar. Utilize forwards, swaps, and options as three alternatives to hedge the firm’s exposure to yen.

55


Global fx markets language and conventions foreign exchange workshop section 1a

Conclusion

  • Derivatives can be used for either hedging or speculation: that is, they can be used either to reduce risk or to take risk.

  • Most of the losses that you read about have occurred because derivatives were used inappropriately. For instance, in some cases employees who had an implicit or explicit mandate to hedge their company’s risks decided instead to speculate.

  • The key lesson to be learned from the losses is the importance of internal controls.

  • That said, derivatives have been outstandingly successful in the management of risk and, when used appropriately, are extremely effective in safeguarding shareholder value.

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