Economics 434 Theory of Financial Markets

Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

Three Main Types of Derivatives • Options • Futures (Forwards) • Swaps

Futures • Different Method of Paying • Delayed Settlement • Like buying a house

Two Main Types of Futures(Depending Upon Settlement) • At maturity, futures owners get something • Either get actual commodity • Or, get “cash equivalent”

Settlement (in the “underlying”) • You get • Cattle, Gold, Silver, Yen • Whatever (?) • Exact amount as specified in “contract” regardless of price • Pay the original price of the futures contract

Imagine Gold • Imagine gold at $ 600, with risk free rate at 5 % • 100 ounces in futures contract means $ 600 times 100 ounces = $ 60,000 • If current gold price is $ 600, what is the three month futures price • Carry cost is 5 % times $ 600 times ¼ = $ 7.50 • Answer would be $ 607.50 • But, what about storage cost • If the future is $ 609, then storage costs are $ 1.50 per three month, or $ 6 per year

Settlement in “cash” • S&P 500 Futures • Most Stock Index Futures

First, What is the S&P 500 Future? • 500 Stocks • Weighted by Market Capitalization • Futures: Jun, Sep, Dec, Mch

Futures are “marked to market” • Every single day • If you can’t pay, they liquidate • No exceptions • Futures trade with limits • So, you can get locked into to an infinite loss

Swaps • Originated in the debt market • Borrowers “swapped” their obligations to their debtors • Fixed to floating; floating to fixed • Short to long maturities; long to short • Migrated to equities • Sometimes equities swapped for debt

A “Plain Vanilla” Swap • Imagine that UVA has sold long term debt at a fixed rate of 8 % • Imagine that BIG Industries has sold long term debt with a variable rate that is reset every year at the “target funds rate” on Jan 1st plus 100 basis points • Assume that last January this would be 4 ½ percent plus 100 basis pts (1 %) for a total of 5 ½%

“Plain Vanilla Swap”The Details Before the swap, are the payment obligations in 2012

What about 2013Suppose Target Funds Rate 1/1/13 is 7 ½%

In future years • On Jan 1, observe the new target funds rate, add 1 % and that is BIG’s obligation that becomes UVAs obligation • BIG’s obligation might go up or down depending upon where the target funds rate goes

Suppose BIG goes bankrupt • Then UVA is back to its 8 % funding and the swap is dissolved. • BIG is cooked, but UVA’s risk is not $ 100 million the loss of a potentially lower funding rate than 8 % • Similar story for BIG in case UVA goes bankrupt

But you can swap most anything for most anything • What you are swapping is not the “principal” of the transaction, but the economic results along the way • US equity versus Japanese equity swap, e.g. • US “large cap” versus US “small cap” • A bond portfolio versus a stock portfolio

The End

Economics 434 Theory of Financial Markets