Transcript No Slide Title

Brussels
17 September 2002
European Parliament Financial Services Forum
Fundamentals of Derivative Contracts
David Mengle
International Swaps and Derivatives Association and
Fordham University Graduate School of Business
Three forms of derivatives activity
 Futures are customized, exchange-traded derivatives contracts
– Futures contracts
– Exchange-traded options
 Over-the-counter (OTC) are customized, privately-negotiated derivatives
– Forwards
• Contracts to exchange something at an agreed time in the future at a
price agreed upon today
– Swaps
• Contracts between two counterparties to exchange cash flows on a
notional principal amount at regular intervals during a stated period
– OTC options
• Contracts that give the buyer, in exchange for the payment of a premium,
the right but not the obligation to buy or sell a specified amount of the
underlying asset at a predetermined price at or until a stated time.
 Structured securities combine securities with derivatives contracts
Situation 1: Interest rate risk
Situation
 Client is a European bank that has made a 5-year
€100 million loan at a fixed rate to a domestic
corporation
 Loan funded with one-year euro deposits
 Client is concerned that euro interest rates will rise
Assets
Loan
(5-year fixed rate)
€100 MM
Liabilities
Deposit
(1-year Euribor)
€100 MM
Interest rate risk
Situation
1-year
Euribor
Deposit
5-year
fixed rate
Bank
Loan
 There is a mismatch between the term of the asset and that of the liability
that funds the asset
 The client here faces refinancing risk that the cost of rolling over
(reborrowing) funds will rise relative to the returns on assets
 Mismatches often occur because the investment and funding decisions
are made by different parts of the firm
Solution: Interest rate swap
Swap: A contractual agreement between two counterparties to
exchange cash flows on a notional principal amount at regular
intervals during a stated period
5-year
Fixed
Rate
1-year
Euribor
Deposit
Bank
Loan
Notional amount = €100 million
The most common
Euribor
type of interest rate
swap involves the
exchange of a fixed
rate cash flow for a
floating rate cash flow
Dealer
Swap
Rate
(4.12%)
In an interest rate
swap, the notional
amount is never
exchanged
Net Funding Cost: 5-Year Swap Rate = 4.12%
Swap cash flows
€ millions
Time
0
Deposit
100
Swap
--
Net
--
100
1
(EURIBOR)
EURIBOR (4.12)
(4.12)
2
(EURIBOR)
EURIBOR (4.12)
(4.12)
3
(EURIBOR)
EURIBOR (4.12)
(4.12)
4
(EURIBOR)
EURIBOR (4.12)
(4.12)
5
(100 + EURIBOR)
EURIBOR (4.12)
(104.12)
Result of hedging with interest rate swap
 Client has given up interest rate risk by locking in
fixed swap rate (replaced risk with certainty)
– Client will be protected from rising deposit rates,
– But will not benefit if rates fall
 Client assumes credit exposure to Dealer (and vice
versa) over next five years
 The Dealer does not charge the client a fee to
enter the swap
Situation 2: Interest rate risk
 A European corporation plans to borrow €100 million to fund its domestic
expansion plans, but is not well known enough to issue fixed-rate bonds to the
public
 The corporation is able to borrow from its bank at a floating rate of 1-year Euro
Libor plus 1.5 percent
 The corporation can obtain synthetic fixed-rate financing by paying a fixed rate on
an interest rate swap with its bank
Euriibor + 1.50%
Bank
Libor
Corporation
€100 MM
Dealer
4.12%
(fixed)
5-year Euro swap rate = 4.12%
Total annual funding cost to corporation = 4.12% + 1.50% = 5.62%
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Situation 3: Currency risk
 A European electrical company has contracted to sell
US$100 million of power generating equipment to a U.S.
electrical power producer, with delivery and payment
occurring six months from today
 Deal is profitable at current spot exchange rate (€1 = $0.97),
but is concerned that the deal will become unprofitable if the
euro falls relative to the U.S. dollar
 Company is not willing to lock in an exchange rate today,
however, because it want to profit if the U.S. dollar
depreciates relative to the euro
 Solution: Currency option
Options: Definitions
 An option is a legal contract that gives the buyer, in exchange
for the payment of a premium, the right but not the
obligation to buy or sell a specified amount of the underlying
asset at a predetermined price (strike price) at or until a stated
time (maturity date).
 Types of option
– Call option is an option to buy
– Put option is an option to sell
 Maturity date is the time after which the option is no longer
valid; also called expiration date
– European option can only be exercised at maturity date
– American option can be exercised any time up to expiry Option
buyer or holder (long)
Currency option
 The corporation bought a put option on the dollar with a strike price
of 1.05 $/€ by paying a premium today
 At the maturity of the option six months from today:
– If the exchange rate is below 1.05 $/€, there will be no payment on the
option
– If the exchange rate is above 1.05 $/€, the Dealer will compensate the
company in euros for the depreciation of the value of the receivable
Up-front premium
(on Trade Date)
Receivable
(in 6 months)
US$100 MM
Electrical
company
Dealer
Payment if $/€ > 1.05
(on Maturity Date)
Result of hedging with currency option
 Client will be protected if dollar depreciates
below 1.05 euro per dollar
 Client will benefit from any appreciation of
euro (net of premium)
 Client assumes credit risk of default by Dealer
Situation 4: Credit risk
 A European bank enjoys profitable lending relationships with
manufacturing corporations
 The bank would like to diversify its exposure, however, and is
particularly concerned that it has become more exposed to one
borrower than it would like
 The bank is reluctant, however, to reduce its exposure by selling
the loans to other banks or by demanding immediate repayment
of some of its outstanding loans
 Solution: Credit derivative
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Credit (default) swaps are the most basic
form of credit derivative
X bp per annum
Protection buyer
Contingent payment
Protection seller
 Buyer pays premium for protection against default by reference
credit
 If reference credit(s) default (or other credit event occurs), buyer
receives payout equal to one of the following:
– Physical settlement: Par value in return for delivery of reference obligation; or
– Cash settlement: Post-event fall in price of reference obligation below par; or
– Binary settlement: Fixed sum or percentage of notional
 Results:
– Credit swap hedges both default risk and credit concentration risk
– Buyer trades credit risk of reference credit for counterparty credit risk of seller
Results of hedging with credit default swap
 Protection buyer
– Gives up exposure to default of reference credit without
removing reference asset from balance sheet
– Takes on counterparty credit exposure to protection seller
• More precisely, protection buyer takes on risk of
simultaneous default by reference credit and protection
seller
 Protection seller
– Takes on exposure to reference credit without need for funding
underlying position
Managing risks with OTC derivatives
 End-users encounter financial risks in connection with their core business
activities
– Corporations
– Financial institutions
– Governments and agencies
 Dealers must manage the risks they take on from users by hedging
– Other dealers
– Inventories of the underlying risk
– Futures and securities exchanges
 Types of market participants
– Hedgers seek to pass their risks on to others
– Speculators seek to take on risks
 Liquid markets are essential to the ability to manage risks effectively
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How dealers hedge the directional risk of swaps
Dealer pays fixed and receives floating
Euribor
Counterparty
Dealer
Hedge
Strategy
Fixed rate
Hedge strategy can consist of:
 Offsetting swap
 Buy treasury securities, financed with repurchase agreement
 Buy Euribor futures
 Leave position open
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How risks are passed on by dealers
User
Dealer
Futures
Other
users
Other
dealers
Other
users
Other
markets
Other
users
 Dealers manage many of their risks though offsetting transactions with other dealers
– The other dealers often have user clients with offsetting risks
 Dealers can pass their risks on to organized futures exchanges
 Dealers can offset their risks through offsetting transactions in money, currency, and
capital markets
– Liquid markets are those in which participants can easily pass on their risks with little of no
effect on the market
– The existence of both hedgers and speculators in markets is necessary to ensure liquidity
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Profile of derivatives participants
11%
16%
27%
46%
43%
57%
Interest rate swaps
27%
31%
Credit derivatives
Dealers
Other financial institutions
42%
Currency options
Non-financial institutions
Source: Bank for International Settlements
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Derivatives growth, 1987-2001
69,207
63,009
Notional principal outstanding, interest
rate swaps and options and crosscurrency swaps
58,265
50,997
29,037
25,455
17,715
11,305
8,477
868
1987
1,656
2,477 3,452
1989
4,452 5,348
1991
1993
1995
1997
1999
2001
Source: International Swaps and Derivatives Association
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Brussels
17 September 2002
European Parliament Financial Services Forum
Fundamentals of Derivative Contracts
David Mengle
International Swaps and Derivatives Association and
Fordham University Graduate School of Business