Derivatives

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Derivatives
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Definition

• Derivative --- a financial instrument or other
  contract deriving value from changes in the price
  or rate of a related asset or liability

• Total Value comes from
• Underlying Price, Rate or Index
• Notional Quantity
• Requires no initial net investment (or small net
  investment)
• Requires or permits net settlement or de facto
  net settlement

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Derivative Contract

• Agree today to pay a certain price for a
  commodity (or other underlying) in the future

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Derivative Market

• Past two decades, derivative trading has grown
  into a trillion dollar market

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Players

• Professionals (Banks Broker-Dealers)
• Corporations
• Institutional Investors

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USE OF DERIVATIVES

• SPECULATIVE INVESTMENTS
• HEDGE AGAINST RISK
• ASSOCIATED WITH ANOTHER TRANSACTION

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Common Derivatives
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Typically settled with net cash payments
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TYPES OF DERIVATIVE CONTRACTS
Symmetrical or Linear
Nonlinear
Forward Contracts
OTC Options
Futures
Exchange-Traded
Options
Swaps
Caps/Floors
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Symmetrical/Linear Contracts

• Track the change in the underlying price, both up
  and down
• You can gain or lose, symmetrically

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Value of contract
Price of underlying
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Forwards and Futures

• Forward Contract
• Executory contract obligating one party to
  buy, and the other party to sell, a specific
  asset for a fixed price at a future date
• Futures Contract
• A forward contract traded on an exchange

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Forwards and Futures

• LONG POSITION --- Buyer of Asset
• Buys the asset, for delivery and payment in the
  future
• Wins if the price rises
• SHORT POSITION --- Seller of Asset
• Sells the asset, for delivery and cash receipt in
  future
• Wins if the price falls

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Uses of Forwards and Futures

• Sell forward/futures to hedge exposure to falling
  prices
• Lock in profit margin on commodity inventory
• Lock in profit margin on future commodity
  sales/production with fixed cost structure
• Foreign currency receivables or revenue stream -
  sell currency forward to lock in dollar amount to
  be received
• In anticipation of a debt issuance, sell a US
  Treasury security forward to protect against
  rising interest rates (falling bond prices)

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Uses of Forwards and Futures

• Buy forward/futures to hedge exposure to rising
  prices
• Raw materials used in manufacturing - lock in
  purchase price to protect margins
• Foreign currency payables or forecasted cash
  outflows - buy currency forward to lock in dollar
  amount paid
• Institutional investor that anticipates buying a
  bond or other debt instrument buy US Treasury
  security forward as a hedge against falling
  interest rates (rising bond prices)

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Forwards and FuturesTerms

• Forward Price/Rate --- Specified price in the
  contract
• Forward Date --- Specified future date
• Spot Rate --- Current price or rate for asset
• Writer --- writes the contract to sell (short
  position)
• Holder --- buyer of contract(long position)

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Change in Value of Forward and Future Contracts

• Measured by
• Difference between the Original Forward Rate
  and the Remaining Forward Rate Discounted to
  Present Value

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Forward Contract Example

• Bean Trader agrees to sell 100,000 lbs of coffee
  beans for 1.55 per pound (forward price) to
  Coffee Co for delivery three months from now.
• Bean Trader is seller or has short position and
  will benefit if the price of coffee beans falls
• Coffee Co is buyer or has long position, and
  will benefit if price increases

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Forward Contract Pricing

• Forward price of 1.55 is based on
• Current spot price of coffee (assumed to be
  1.50)
• Cost to carry to the maturity date
• Cost to carry to maturity is the combination of
• Interest Rates
• Storage Costs

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Valuing Forwards Futures

• In the 2nd month the forward price of coffee
  increases to 1.60
• BeanTraders loss of .05 is discounted 2 months
  using an appropriate discount rate. This is the
  contracts fair value, a liability
• Coffee Co has a fair value gain (asset) of same
  amount

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Forward Contract IllustrationSymmetric Return
Profile
ContractPayoff
0 _
Short Gain
Long Position Gain
Long Loss
Short Position Loss
Contract Price
Expiration Date Price of Underlying Security
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FUTURES

• Traded on organized exchanges ---- Chicago Bd of
  Trade, NY Mercantile Exchange, London
  International Financial Futures Exchange
• Contracts are standardized in nature
• Requires an initial deposit of funds with broker
  called a margin account
• Contracts represent cash amounts settled only at
  delivery and must be marked to market each
  trading day --- no discounting required

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TYPES OF DERIVATIVE CONTRACTS
Symmetrical or Linear
Nonlinear
Forward Contracts
OTC Options
Futures
Exchange-Traded
Options
Swaps
Caps/Floors
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Nonlinear Contracts

• Option contracts, or those with option-like
  features
• Upside gain with limited downside loss (or vice
  versa)

0 _
Value of contract
Value of underlying
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Option

• Represents a right, rather than obligation, to
  either buy or sell some quantity of a particular
  underlying

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Option Characteristics

• Purchaser pays and seller receives, a premium up
  front
• Purchaser enjoys upside potential with downside
  limited to premium paid
• Seller bears downside risk with upside limited to
  the premium received

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In, Out, and On the Money
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When it is more profitable for the holder to
exercise the option than to transact directly in
the optioned item
In the Money
When the optioned items current market price
equals the strike price
At the Money
Out of the Money
When it is not profitable for the holder to
exercise the option compared to transacting
directly in the optioned item
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Options Valuation

• Dependent on
• Value of underlying
• Strike price
• Volatility in price of underlying
• Time to expiration
• American vs. European
• Risk free interest rate
• Black-Scholes model or binomial pricing model

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Options Valuation

• Intrinsic Value
• Intrinsic value represents the value based solely
  on the current price of the underlying compared
  to the option strike price.
• Defined as Strike Price - Spot Rate
• If option is in the money it has intrinsic
  value if out of the money intrinsic value is
  zero

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Options Valuation

• TIME VALUE
• Attributed to expected intrinsic value at
  expiration date
• Defined as Current Value - Intrinsic Value
• Based on statistical measure
• Mathematics for measuring can get very complicated

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Options

• Call - A contract giving the holder the right,
  but not the obligation, to buy a specific asset
  for a fixed price during a specific period.
• Put - A contract giving the holder the right, but
  not the obligation, to sell a specific asset for
  a fixed price during a specific period.

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Price Changes of Optioned Items
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• Holder of a call ---Bets that the price of the
  optioned item will rise
• Call writer --- Bets against a price increase
• Takes the time value component of the premium to
  compensate for the risk
• Changes in optioned items price affect the
  options intrinsic value only if option is at or
  in the money

If option is AT the money
Holder Holder Writer Writer
Price of Optioned Item Puts Calls Puts Calls
Increases - Gain - Loss
Decreases Gain - Loss -
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Option Contracts
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• One-sided contracts --- require performance only
  when exercised
• Options can be individual securities and indexes
•  
• Allows --- not require, the holder to buy (call)
  or sell (put) at an agreed-upon price during an
  agreed-upon time period or on a specified date

American Options Can be exercised any time during
the agreed-upon time period
European Options Can be exercised only on the
expiration date
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Call Option Example
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Strike (exercise) Price

• If stock price stays at or below 60
• Jones will not exercise the right to buy
• Call will expire
• Jones has a loss of 120

• If stock price rises above 60
• Jones exercises the call by paying 6,000 for
  100 shares worth
• Jones may sell the call for the difference
  between the 6,000 exercise price and the higher
  market value

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Call Option Illustration
ContractPayoff
0 _
Expiration Date Price of Underlying Security
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Put Option --- Example
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• If stock price rises above 60
• Jones will not exercise the right to sell
• Put will expire
• Jones loss is 120

• If stock price falls to 57
• Jones exercises the put by selling 100 shares
  worth 5,700 to Smith Barney for 6,000, or
• Jones may sell the put for at least 300 (3
  per share)

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Put Option Illustration
ContractPayoff
0 _
Expiration Date Price of Underlying Security
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Put and Call Options with Price Relations
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In, Out, or At the Money In, Out, or At the Money
Price Relation Puts Calls
Strike price gt Price of optioned item In Out
Strike price lt Price of optioned item Out In
Strike price Price of optioned item At At
Option Price Options Intrinsic Value
Options Time Value
Amount that the option is in the money
Also called the premium
Excess of the premium over the options intrinsic
value
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Multiplier Effect of Call Options
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If Apple stock rises to 54.25 before
expiration Option is in the money
54.25 50.00 4.25 per option
Option return (4.25 100) 138 287
Stock return (54.25 - 45.50) x 100 875
  Return Cost Return
Option Purchase 287 138 208
Stock Purchase 875 4,550 19
Option holders can benefit from constructive
ownership of large quantities of stock with a
small investment through options.
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Other Types of Options

• Swaptions (option on swap)
• Captions/Floortions (option on a cap or floor)
• Futures Options (option on futures)
• Split-fee Options (options on options)
• Exotic Options (look-back, Asian, etc.)
• Embedded Options -- options embedded in other
  instruments (e.g., prepayment, ARM caps, etc.)

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Caps and Floors

• Cap
• A contract that protects the holder from a rise
  in interest rates or price increase beyond a
  certain point
• Floor
• A contract that protects the holder from a
  decrease in interest rates or price decrease
  below a certain point

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Interest Rate Caps
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• Purpose --- protect against rising interest rates
  on a companys variable rate loans
• Is a call option
• In the money
• When the variable rate rises above the caps
  strike price, writer of the cap pays the holder
  the difference in interest between the holders
  variable rate and the cap rate

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Interest Rate Cap Example
5 Year Interest Rate Cap - 100mm Notional
Pay LIBOR _at_ 7 (if LIBOR gt 7)
Counterparty
Client
2 million premium
Paid at inception
Result effectively puts a cap on borrowing cost
of floating rate debt financing
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Derivatives can be used to counter risk
associated with unfavorable rate/price changes by
using them as a hedge
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FASB 133/138 Key Concepts

• Hedging Best Practices Require
• Entities must have written hedging policies for
  hedging and risk management activities
• Hedging relationships must be fully documented
• Hedges must be matched specifically to underlying
  risks
• Hedging relationships must be monitored
  throughout their life - must be highly effective

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SFAS 130 - Nature and Use of Comprehensive Income
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• Comprehensive income (CI)
• Includes all changes in owners equity other than
  those resulting from transactions with owners

CI Net income Other comprehensive income

• Other comprehensive income (OCI)
• Includes items that bypass net income and are
  carried directly to stockholders equity

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Reporting Changes in Fair Value
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• Hedges effectiveness guides reporting

Derivatives That Are Not Designated as Hedges
Derivatives That Are Designated as Hedges
Gains and losses on the hedge instrument and
hedged item reported in earnings in same
reporting period
Gains and losses reported in current earnings
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TYPES OF HEDGES

• FAIR VALUE HEDGES
• CASH FLOW HEDGES
• FOREIGN CURRENCY HEDGES

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Fair Value Hedges
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• Two Types
• 1. Changes in the fair values of existing assets
  and liabilities
• 2. Firm Commitments ---- binding agreement with
  an unrelated party that
• Specifies all significant terms of the
  transaction
• Includes a nontrivial disincentive for
  nonperformance

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Accounting for Fair Value Hedges
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Offset

• Gain or loss
• Reported in earnings concurrent with the
  offsetting loss or gain on the change in fair
  value of the hedged item attributable to the
  hedged risk
• Hedged items that are firm commitments
• Firm commitment recognized as an asset or
  liability
• Portion of total change in fair value of a hedge
  instrument due to other factors
• Enters earnings without offset

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CASH FLOW HEDGES

• Used to establish fixed prices or rates when
  future cash flows could vary due to changes in
  prices or rates
• Types
• Forecasted Transactions
• Existing assets or liabilities with
  variable
• future cash flows

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Cash Flow Hedge Mechanics

• Fair Value of the Derivative
• Changes recorded in Other Comprehensive Income
  for effective portion
• Changes recorded in earnings for ineffective
  portion
• No basis adjustment to the hedged asset or
  liability
• Net effect?
• Amounts in OCI recognized when the hedged item
  impacts earnings

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Swaps

• An agreement by two parties to exchange a series
  of cash flows in the future through an
  intermediary
• Typically interest rates or currencies, but may
  also involve commodities or equities as well
• Symmetrical or linear contracts

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Interest Rate Swap --- Example
5 Year Interest Rate Swap - 100mm Notional
6 Mo. LIBOR
Paid semi-annually
Counterparty
Client
6.5 Fixed Rate
Paid Semi-Annually
Why would a client enter into this transaction?
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Interest Rate Swap Example (contd)
5 Year Interest Rate Swap - 100mm Notional
6 Mo. LIBOR
Paid Semi-Annually
Counterparty
Client
6.5 Fixed Rate
Paid Semi-Annually
Interest _at_ 6 Mo. LIBOR
Result client effectively converts its
borrowing cost to 6.5 fixed
XYZ Bank 100 mm 5yr. Loan
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FAS 133 Documentation

• For Cash Flow hedges, formal documentation of
  hedging relationship
• Statement of objectives and strategy and nature
  of hedged risk
• Description of derivative hedging instrument
• Description of hedged item with specific
  identification
• Describe how hedge effectiveness will be assessed

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Foreign Currency Hedges
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• Hedging exchange rate risk in a foreign currency
  available-for-sale (AFS) security
• Gain or loss on both the hedging instrument and
  the hedged AFS security are reported in earnings
• Creates an offset to the loss or gain on the
  hedging derivatives

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Assessing Hedge Effectiveness
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• Per SFAS 133, Management must
• 1. Explicitly assess the derivatives hedge
  effectiveness
• 2. Identify how it intends to assess hedge
  effectiveness
• 3. Conclude that a derivative will be highly
  effective in order to designate the derivative as
  a hedging instrument
• Ineffective portion of a gain or loss on a hedge
  ---reported in earnings, creating earnings
  volatility
• Gauging effectiveness
• Gauge initially, and, for hedge accounting to
  continue, when earnings are reported and at least
  every three months thereafter

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Measuring Hedge Effectiveness
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• High effectiveness
• Occurs when the derivative neutralizes or offsets
  between 80 and 125 of the fair value or cash
  flow changes that represent the risk being hedged
• 100 offset not required

• Hedge Effectiveness Measure

Change in fair value of hedge instrument
Change in fair value of hedged item
Always negative because one value change is a
gain and the other is a loss
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High Effectiveness and Hedge Effectiveness Example
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To report the decline in soybean inventory
0.20 100,000 20,000
Loss on hedging 20,000  
Commodities inventory   20,000
To recognize the increase in value of the futures
contract 0.17 100,000 17,000
Investment in futures 17,000  
Gain on hedging   17,000
Hedge Effectiveness Measure 17,000 (20,000)
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