Brussels17 September 2002

European Parliament Financial Services Forum

Fundamentals of Derivative Contracts

David MengleInternational Swaps and Derivatives Association andFordham 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 Liabilities

Loan (5-year fixed rate) €100 MM

Deposit (1-year Euribor)€100 MM

Interest rate risk

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

BankBank

5-yearfixed rate

Loan

Situation

Deposit

1-year Euribor

Net Funding Cost: 5-Year Swap Rate = 4.12%Net Funding Cost: 5-Year Swap Rate = 4.12%

Solution: Interest rate swap

DealerDealer

BankBank

EuriborSwapRate

(4.12%)

5-yearFixed Rate

1-yearEuribor

Deposit Loan

Swap: A contractual agreement between two counterparties to exchange cash flows on a notional principal amount at regular intervals during a stated period

The most common type of interest rate swap involves the exchange of a fixed rate cash flow for a floating rate cash flow

In an interest rate swap, the notional amount is never exchanged

Notional amount = €100 millionNotional amount = €100 million

Swap cash flows

Time Deposit Swap Net

0 100 -- -- 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)

€ millions

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

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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

Bank Corporation Dealer

€100 MM

Libor

4.12%(fixed)

Euriibor + 1.50%

5-year Euro swap rate = 4.12%Total annual funding cost to corporation = 4.12% + 1.50% = 5.62%

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

DealerDealerElectrical Electrical companycompany

Payment if $/€ > 1.05(on Maturity Date)

US$100 MMReceivable

(in 6 months)

Up-front premium(on Trade 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

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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

Credit (default) swaps are the most basic form of credit derivative

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

X bp per annum

Contingent paymentProtection buyerProtection buyer Protection sellerProtection 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

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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

CounterpartyCounterparty DealerDealer

Fixed rate

HedgeHedgeStrategyStrategy

Euribor

Dealer pays fixed and receives floating

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

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

User Dealer

Other markets

Futures

Other dealers

Other users

Other users

Other users

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Profile of derivatives participants

46%

43%

11%

Interest rate swaps

31%

42%

27%

Currency options

Credit derivatives

16%27%

57%

Non-financial institutions

Dealers

Other financial institutions

Source: Bank for International Settlements

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Derivatives growth, 1987-2001

69,207

63,009

58,265

50,997

29,037

25,455

17,715

11,3058,477

5,3484,4523,4522,4771,656868

1987 1989 1991 1993 1995 1997 1999 2001

Notional principal outstanding, interest rate swaps and options and cross-currency swaps

Source: International Swaps and Derivatives Association

Brussels17 September 2002

European Parliament Financial Services Forum

Fundamentals of Derivative Contracts

David MengleInternational Swaps and Derivatives Association andFordham University Graduate School of Business