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1、Chapter 13,Financial Derivatives,13.1 Hedging,Engage in a financial transaction that reduces or eliminates riskLong position= buying of a security with the expectation that the asset will rise in value. Short position= agree to sell securities at future dateHedging risk involves engaging in a financ
2、ial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position,13.2 Interest-Rate Forward Contracts,Forward contracts : Agreements by two parties to engage in a financial transaction at a future (forward) point i
3、n timeInterest-rate forward contracts involve the future sale (or purchase) of a debt instrument.1)Specification of the actual debt instrument that will be delivered at a future date2)Amount of the debt instrument to be delivered3)Price (interest rate) on the debt instrument when it is delivered4)Da
4、te on which delivery will takes place,Long position Hedges by locking in future interest rate if funds coming in futureShort position Hedges by reducing price risk from change in interest rates if holding bonds,Pros and Cons of Forward Contracts,ProsFlexible: Can be as flexible as the parties involv
5、ed would likeCons1.Lack of liquidity: hard to find counterparty2.Subject to default risk: requires information to screen good from bad risk,13.3 Financial Futures Contracts and Markets,Similar to an interest-rate forward contract but differs in ways that overcome some of the liquidity and default pr
6、oblems.ExampleInterest Rate FuturesContract value-$10,000 1 point=$1,000Smallest change= 1/32 point=$31.25Bonds to be delivered=not callable and have at least 15 years to maturity,Long position: who buys a futures contract and thereby agrees to buy the bonds.Short position: who sells a futures contr
7、act and thereby agrees to sell the bonds. At the expiration date of a futures contract, the price of the contract converges to the price of the underlying asset to be deliveredi , long contract has loss, short contract has profit,Hedging with Financial Futures,Holding $5M of 6s 2030 Need to offset t
8、he long position in the bond with a short positions (selling a futures contract).NC=VA/VC=50If interest rates increase over the next year to 8% Value on March 2011 8% interest rate $4,039,640Value on March 2010 6% interest rate-$5,000,000Loss -$ 960,360,Hedging with Financial Futures (contd),Short p
9、osition in the futures contracts has value of $4,039,640(the value of the $5M in bonds after the interest rate rises)but the buyer of the futures contract agreed to payyou $5M on the maturity date.Your gain is $960,360,this has been a successful hedge.,13.3.1Organization of Trading in Financial Futu
10、res Markets,Organized exchangesRegulated by the Commodity Futures Trading Commission (CFTC)Ensure prices are not manipulatedRegisters and audits brokers, traders, and exchangesApproves proposed futures contracts to ensure they serve the public interestTrading has become internationalized and done 24
11、 hours a day,Table 1 Widely Traded Financial Futures Contracts in The United States,13.3.2Explaining the Success of Futures Markets,Futures more liquid: (1)Quantities delivered and delivery dates are standardized(2)A futures contract can be traded again at any time until delivery date.(3)Any Treasur
12、y bond that matures in more than fifteen years and is not callable for fifteen years is eligible for deliveryLimits the possibility of cornering the market,Explaining the Success of Futures Market (contd),2.Buyer and seller make the contract with a clearinghouseMargin requirement that is marked to m
13、arket every day3.Most futures contracts do not result in delivery of the underlying asset on the expiration dateReduces transaction costs,13.4 Options,Contracts that give the purchaser the option (right) to buy or sell the underlying financial instrument at a specified price (exercise or strike pric
14、e) within a specific period of time (term to expiration).The seller is obligated to buy or sell the financial instrument if the buyer of the option exercises the right to sell or buy.The buyer does not have to exercise the option.,Options,A premium is paid for the optionAmerican option can be exerci
15、sed at any time up to the expiration dateEuropean options can only be exercised on the expiration dateStock optionsFutures optionsMore liquid than debt instrument marketsRegulated by the SEC (stocks) and the CFTC (futures),A Simple Example,Suppose one buys an option contract.Right for buyer purchase
16、 100 shares of stock of IBM Time period - 3 monthsExercise price - 60 / per share Premium -5/ per share of stock,A Simple Example,Then by the expiration date, the possible profits or losses per share of stock for the buyer and the seller are as follows.,A Simple Example,A Simple Example,-5,+5,60,65,
17、Stock Price,Profit,Profit of Buyer,Loss of Seller,13.4.1 Options Contracts,Call option gives the owner the right to buy a financial instrument at the exercise price within a specific period of timePut option gives the owner the right to sell a financial instrument at the exercise price within a spec
18、ific period to time,13.4.2 Differences Between Options and Futures Contracts,1. For a futures contract the profits grow by an equal dollar amount for every point increase in the price of the underlying financial instrument (linear profit function)For the option contract profits do not always grow by
19、 the same amount for a given change in the price of the underlying financial instrument because of the protection afforded from losses (nonlinear profit function).,For call option(1) If P exercise price (in the money) make profitFor put option(1) If Pexercise price (out of money) loss=premium(2) If
20、P= exercise price (at the money) loss=premium(3) If P exercise price (in the money) make profit,Profits and Losses on Options Versus Futures Contracts,Differences Between Options and Futures Contracts (contd),2. Initial investment on the contracts differ3. Money changes hands daily in the futures ma
21、rket; only once for the option contract (when the option is exercised).,13.4.3 Pricing Option Premiums,1. The higher the strike price, everything else being equal, the lower the premium on call (buy) options and the higher the premium on put (sell) options2. The greater the term to expiration, every
22、thing else being equal, the higher the premiums for both call and put options3. The greater the volatility of prices of the underlying financial instrument, everything else being equal, the higher the premiums of both call and put options,13.5 Swaps,Financial contracts that obligate each party to th
23、e contract to exchange a set of payments (not assets) it owns for another set of payments owned by another partyCurrency swaps involve the exchange of a set of payments in one currency for a set of payments in another currencyInterest-rate swaps involve the exchange of one set of interest payments f
24、or another set of interest payments, all denominated in the same currency,13.5.1 Interest-Rate Swap Contracts,Interest rate swap specifiesInterest rate on the payments that are being exchangedType of interest paymentsThe amount of notional principalThe time period over which the exchanges continue,F
25、IGURE 2 Interest-Rate Swap Payments,13.5.2 Advantages of Interest-Rate Swaps,1. Large transactions costs from rearranging balance sheets are avoided2. Informational advantages are maintained3. Possible to hedge interest-rate risk over a very long horizon,13.5.3 Disadvantages of Interest-Rate Swaps,1. Swap markets suffer from a lack of liquidity2. Subject to default riskNeed for information about counterparties has thus attracted intermediariesInvestment banksLarge commercial banks,
