DerivativesDerivatives

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

Common Derivatives7

Typically settled with net cash payments

Swaps

Futures

Forward Contracts

Symmetrical or Linear

Caps/Floors

Exchange-TradedOptions

OTC Options

Nonlinear

TYPES OF DERIVATIVE CONTRACTS

Symmetrical/Linear Contracts

• Track the change in the underlying price, both up and down

• You can gain or lose, symmetrically

Price of underlyingPrice of underlying

+

0

_

Value of Value of

contractcontract

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 AssetBuys the asset, for delivery and payment in the future

Wins if the price rises

SHORT POSITION --- Seller of AssetSells 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 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)

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

Forward Contract IllustrationSymmetric Return ProfileContract

Payoff

Expiration Date Price of Underlying Security

+

0

_

Short Short GainGain

Long Long LossLoss

Long Position Long Position GainGain

Short Position Short Position Loss LossContract Contract

PricePrice

Short ForwardShort Forward Long ForwardLong Forward

FUTURESTraded 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

Swaps

Futures

Forward Contracts

Symmetrical or Linear

Caps/Floors

Exchange-TradedOptions

OTC Options

Nonlinear

TYPES OF DERIVATIVE CONTRACTS

Nonlinear ContractsOption contracts, or those with option-like features

Upside gain with limited downside loss (or vice versa)

Value of underlyingValue of underlying

+

0

_

Value of Value of

contractcontract

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

In, Out, and On the Money25

In the Money

When it is more profitable for the holder to exercise the option than to transact directly in the optioned item

Out of the

Money

When it is not profitable for the holder to exercise the option compared to transacting directly in the optioned item

At the MoneyWhen the optioned item’s current market price equals the strike price

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.

Price Changes of Optioned ItemsHolder 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

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Holder WriterPrice of Optioned Item Puts Calls Puts CallsIncreases - Gain - LossDecreases Gain - Loss -

If option is AT the money:

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

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American OptionsCan be exercised any time during

the agreed-upon time period

European OptionsCan be exercised only on the

expiration date

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.

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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

Strike (exercise) Price

Call Option Illustration

Strike Price

Out-of-the-Money In-the-Money

ContractPayoff

Expiration Date Price of Underlying Security

+

0

_

Sold CallSold Call Purchased CallPurchased Call

Put Option --- ExampleSmith 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.

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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)

Put Option Illustration

Strike Price

In-the-Money Out-of-the-Money

ContractPayoff

Expiration Date Price of Underlying Security

+

0

_

Sold PutSold Put Purchased PutPurchased Put

Put and Call Options with Price Relations

In, Out, or At the MoneyPrice Relation Puts Calls

Strike price > Price of optioned item In OutStrike price < Price of optioned item Out InStrike price = Price of optioned item At At

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Amount that the option is in the

money

Option Price = Option’s Intrinsic Value + Option’s Time Value

Also called the premium

Excess of the premium over the

option’s intrinsic value

Multiplier Effect of Call Options

  $ Return Cost % Return

Option Purchase $287 $ 138 208%Stock Purchase 875 4,550 19%

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Option holders can benefit from constructive ownership of large quantities of stock with a small investment through options.

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

Other Types of OptionsSwaptions (option on swap)Swaptions (option on swap)

Captions/Floortions (option on a cap or floor)Captions/Floortions (option on a cap or floor)

Futures Options (option on futures)Futures Options (option on futures)

Split-fee Options (options on options)Split-fee Options (options on options)

Exotic Options (look-back, Asian, etc.)Exotic Options (look-back, Asian, etc.)

Embedded Options -- options embedded in other Embedded Options -- options embedded in other instruments (e.g., prepayment, ARM caps, etc.)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

Client Counterparty

Pay LIBOR @ 7%(if LIBOR > 7%)

Paid at inception

$2 million premium

5 Year Interest Rate Cap - $100mm Notional

Result: effectively puts a cap on borrowing cost offloating rate debt financing

Derivatives can be used to counter risk associated with

unfavorable rate/price changes by using them as a hedge

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”

FASB 133/138 Key Concepts

SFAS 130 - Nature and Use of Comprehensive Income

Comprehensive income (CI) Includes all changes in owners’ equity other than those

resulting from transactions with owners

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Other comprehensive income (OCI) Includes items that bypass net income and are

carried directly to stockholders’ equity

CI = Net income + Other comprehensive income

OCI =

Current rate method foreign currency

translation adjustments

Gains and losses on derivatives used in certain hedging

situations

Unrealized gains and losses on

available-for-sale securities

+ +

Reporting Changes in Fair Value

Hedge’s effectiveness guides reporting:

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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

Fair Value HedgesTwo 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

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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

Cash Flow Hedge MechanicsFair 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

Client Counterparty

6 Mo. LIBOR

Paid semi-annually

Paid Semi-Annually

6.5% Fixed Rate

5 Year Interest Rate Swap - $100mm Notional

Why would a client enter into this transaction?

Interest Rate Swap Example (cont’d)

Client Counterparty

6 Mo. LIBOR

Paid Semi-Annually

Paid Semi-Annually

6.5% Fixed Rate

5 Year Interest Rate Swap - $100mm Notional

XYZ Bank$100 mm

5yr.Loan

Interest @6 Mo. LIBOR

Result: client effectively convertsits 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

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 EffectivenessPer SFAS 133, Management must:

1. Explicitly assess the derivative’s hedge effectiveness2. 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

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Hedge Effectiveness MeasureChange 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.

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To report the decline in soybean inventory: $0.20 × 100,000 = $20,000

To recognize the increase in value of the futures contract:$0.17 × 100,000 = $17,000

Loss on hedging 20,000 Commodities inventory   20,000

Investment in futures 17,000 Gain on hedging   17,000

Hedge Effectiveness Measure = $17,000 ÷ ($20,000) = –85%