Transcript Derivative

Derivatives
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
Derivative = Contract
Agree today to pay a certain price for a
commodity (or other “underlying”) in the
future
Derivative Market
Past two decades, derivative
trading has grown into a
trillion dollar market
Players
• Professionals (Banks &
Broker-Dealers)
• Corporations
• Institutional Investors
USE OF DERIVATIVES
SPECULATIVE INVESTMENTS
HEDGE AGAINST RISK
ASSOCIATED WITH ANOTHER
TRANSACTION
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Common Derivatives
Typically settled with net cash payments
TYPES OF DERIVATIVE
CONTRACTS
Symmetrical or Linear
Nonlinear
Forward Contracts
OTC Options
Futures
Exchange-Traded
Options
Swaps
Caps/Floors
Symmetrical/Linear Contracts
• Track the change in the underlying price,
both up and down
• You can gain or lose, symmetrically
+
Value of
contract
0
_
Price of underlying
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
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
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)
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)
Forwards and Futures
Terms
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)
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
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
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
Valuing Forwards & Futures
In the 2nd month the forward price of coffee
increases to $1.60
– BeanTrader’s loss of $.05 is discounted 2 months
using an appropriate discount rate. This is the
contract’s fair value, a liability
– Coffee Co has a fair value gain (asset) of same
amount
Contract
Payoff
Forward Contract Illustration
Symmetric Return Profile
+
Short
Gain
Long Position
Gain
Long
Loss
Short Position
Loss
0
Contract
Price
Short Forward
Long Forward
_
Expiration Date Price of Underlying Security
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
TYPES OF DERIVATIVE
CONTRACTS
Symmetrical or Linear
Nonlinear
Forward Contracts
OTC Options
Futures
Exchange-Traded
Options
Swaps
Caps/Floors
Nonlinear Contracts
Option contracts, or those with option-like features
Upside gain with limited downside loss (or vice
versa)
+
Value of
contract
0
_
Value of underlying
Option
Represents a right, rather than
obligation, to either buy or sell
some quantity of a particular
underlying
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
In the
Money
At the Money
Out of
the
Money
When it is more profitable for
the holder to exercise the option
than to transact directly in the
optioned item
When the optioned item’s
current market price equals the
strike price
When it is not profitable for the
holder to exercise the option
compared to transacting directly
in the optioned item
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
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
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
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
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 item’s price affect the option’s
intrinsic value only if option is at or in the money
If option is AT the money:
Price of Optioned Item
Increases
Decreases
Holder
Puts
Calls
Gain
Gain
-
Writer
Puts
Calls
Loss
Loss
-
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Option Contracts
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
Smith writes and sells to Jones a $120 a call option for 100 shares
of Merck stock, exercisable at the stock’s current market price of
$60 per share and expiring in 90 days.
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
Strike
(exercise) Price
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
Contract
Payoff
Call Option Illustration
+
Sold Call
Purchased Call
0
Strike Price
Out-of-the-Money
In-the-Money
_
Expiration Date Price of Underlying Security
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Put Option --- Example
Smith writes and sells to Jones for $120 a put option for 100
shares of Merck stock, exercisable at the stock’s current market
price of $60 per share and expiring in 90 days.
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)
Put Option Illustration
Contract
Payoff
+
Sold Put
Purchased Put
0
Strike Price
In-the-Money
Out-of-the-Money
_
Expiration Date Price of Underlying Security
Put and Call Options with Price
Relations
Price Relation
Strike price > Price of optioned item
Strike price < Price of optioned item
Strike price = Price of optioned item
In, Out, or At the Money
Puts
Calls
In
Out
Out
In
At
At
Option Price = Option’s Intrinsic Value + Option’s Time Value
Also
called the
premium
Amount that the
option is in the
money
Excess of the premium
over the option’s
intrinsic value
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Multiplier Effect of Call Options
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Investor purchases a call contract for 100 shares of Apple
Computer stock with a $50 exercise price that expires in
90 days for $138. The investor also purchases 100 shares
of Apple stock at $45.50 per share.
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
Option Purchase
Stock Purchase
$ Return
Cost
% Return
$287
875
$ 138
4,550
208%
19%
Option holders can benefit from constructive ownership of large
quantities of stock with a small investment through options.
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.)
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
Interest Rate Caps
Purpose --- protect against rising interest rates
on a company’s variable rate loans
Is a call option
In the money
 When the variable rate rises above the cap’s
strike price, writer of the cap pays the holder the
difference in interest between the holder’s
variable rate and the cap rate
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Interest Rate Cap Example
5 Year Interest Rate Cap - $100mm Notional
Pay LIBOR @ 7%
(if LIBOR > 7%)
Counterparty
Client
$2 million premium
Paid at inception
Result: effectively puts a cap on borrowing cost of
floating rate debt financing
Derivatives can be used to
counter risk associated with
unfavorable rate/price changes
by using them as a hedge
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”
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
Current rate method
Unrealized gains
Gains and losses
foreign currency + and losses on + on derivatives used
OCI =
translation
available-for-sale
in certain hedging
adjustments
securities
situations
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Reporting Changes in Fair Value
Hedge’s effectiveness guides reporting:
Gains and losses
reported in current
earnings
Gains and losses on the
hedge instrument and
hedged item reported in
earnings in same reporting
period
TYPES OF HEDGES
• FAIR VALUE HEDGES
• CASH FLOW HEDGES
• FOREIGN CURRENCY HEDGES
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Fair Value Hedges
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
 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
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
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
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
Interest Rate Swap --- Example
5 Year Interest Rate Swap - $100mm Notional
6 Mo. LIBOR
Paid semi-annually
Client
Counterparty
6.5% Fixed Rate
Paid Semi-Annually
Why would a client enter into this transaction?
Interest Rate Swap Example (cont’d)
5 Year Interest Rate Swap - $100mm Notional
6 Mo. LIBOR
Client
Paid Semi-Annually
Counterparty
6.5% Fixed Rate
Paid Semi-Annually
Interest @
6 Mo. LIBOR
XYZ Bank
$100 mm
5yr.
Loan
Result: client effectively converts
its borrowing cost to 6.5% fixed
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
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
Per SFAS 133, Management must:
1. Explicitly assess the derivative’s 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
 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
High Effectiveness and Hedge Effectiveness
Example
Conagra carries at cost 100,000 bushels of soybeans to be sold in 3
months on a local market. The current local market price is $5.50 a
bushel. Conagra enters a futures contract to sell 100,000 bushels in 3
months at $5.60 per bushel, a fair value hedge. The local market
price fell by $.20 to $5.30 and the futures price fell by $0.17 to $5.43.
To report the decline in soybean inventory:
$0.20 × 100,000 = $20,000
Loss on hedging
Commodities inventory
20,000
20,000
To recognize the increase in value of the futures contract:
$0.17 × 100,000 = $17,000
Investment in futures
Gain on hedging
17,000
17,000
Hedge Effectiveness Measure = $17,000 ÷ ($20,000) = –85%
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