...Chapter 9 Derivatives: Futures, Options, and Swaps Chapter Overview This chapter provides an introduction to derivatives, and examines both their uses and abuses. Reading this chapter will prepare students to: * Explain derivatives. * Understand how derivatives can be used to transfer risk. * Analyze the pricing of derivatives. Chapter Outline I. The Basics: Defining Derivatives A. Derivatives are financial instruments whose value depends on (i.e., is derived from) the value of some other underlying financial instrument or asset (these include stocks or bonds as well as other assets). B. A simple example is an interest rate futures contract, which is an agreement between two investors that obligates one to make a payment to the other depending on the movement in interest rates over the next year. C. Such an arrangement is very different from the purchase of a bond for two reasons: a. Derivatives provide an easy way for investors to profit from price declines, as opposed to the purchase of a bond, which is a bet that its price will increase. b. In a derivatives transaction, one person’s loss is always the other person’s gain. D. Derivatives can be used to speculate on future price movements, but because they allow investors to manage and reduce risk, they are indispensable to a modern economy. E. The purpose of derivatives is to transfer risk from one person or firm to another, providing a kind of insurance...
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...DERIVATIVES A derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is nearly endless. Thus, the real definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying. Some of the widely known underlying assets are: * Indexes (consumer price index (CPI), stock market index, weather conditions or inflation) * Bonds * Currencies * Interest rates * Exchange rates * Commodities * Stocks (equities) Categorization Derivatives are usually broadly categorized by the: * relationship between the underlying and the derivative (e.g., forward, option, swap) * type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives) * market in which they trade (e.g., exchange-traded or over-the-counter) * pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality) Another arbitrary distinction is between:...
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...agreement (FRA) is a forward contract that can be used to fix an interest rate for a future short-term loan or deposit. A FRA is not an actual short-term loan or deposit. In a FRA the buyer of the FRA agrees to pay a fixed rate of interest on the notional loan and in return to receive interest at the current market rate prevailing at the start of the notional loan period. On the contrary, the dealer of the FRA consents to get interest on the notional loan at the fixed FRA rate, and consequently to pay interest at the current market rate prevailing at begin of the notional loan period. Each company can buy more than one FRA to hedge the risk because of the increase in short-term interest rates. On the other...
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...comparison of hedging tools Forwards, futures, swaps Asset-liability matching Pricing and linkages among the tools Uses and abuses of options When to use, and when not to use Copyright ©2009 Ian H Giddy 4 Giddy | Hedging 2 What Hedging Instruments? What Protection Needed? Volatility & Direction Direction Complex risks Or arbitrage Exotics, Hybrids, structured notes OTC options, Caps and Floors Forwards, Futures, Swaps Copyright ©2009 Ian H Giddy 5 Tools for Hedging Petrobras has to pay for equipment from Japan, in Japanese yen, in 3 months Borrow and pay now? Use a forward contract/FX swap? Pay later at spot? Copyright ©2009 Ian H Giddy 6 Giddy | Hedging 3 Forward Contracts, Futures and Money Market Hedging Money market hedging: match currency of assets and liabilities Forwards: Agreement to exchange currencies at certain exchange rate in the future Futures: Exchange-traded contracts for notional future delivery, minimizing default risk via marking-tomarket Currency swap: match payments on foreign-currency debt Interest-rate swap: change floating cost to fixed Copyright ©2009 Ian H Giddy 7 A Typical Forward Exchange Contract We agree today to pay a certain price for a currency in the future JPY Sony Sony B of A B of A Copyright ©2009 Ian H Giddy 8 Giddy | Hedging 4 Forward Quotations Source: ft.com Copyright ©2009 Ian H Giddy 9 The FX Swap Hedge 3-month Swap 3-month Forward Contract l ...
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...of denomination ■ fixed or floating rate interest payments ■ indenture provisions ■ conversion features ■ seniority ■ maturity o Perfect mkt assumptions: -frictionless mkts -equal access to mkt prices -rational investors -equal access to costless information MM’s irrelevance proposition o With = access to perfect financial mkts, individuals can replicate any financial action that the firm can take o This leads to MM’s famous irrelevance proposition: -if financial mkts are perfect, then corporate financial policy is irrelevant The converse of MM’s irrelevance proposition o If financial policy is to increase value, then it must either -increase the firm’s expected future cash flows or -decrease the discount rate in a way that cannot be replicated by individual investors. Financial Mkt integration v Segmentation o In integrated financial mkts, real after tax rates of return on equivalent asset are = o Factors contributing to segmentation include: -prohibitive transactions costs -different legal and political systems -regulatory interference (eg barriers to financial flows) -different taxes -information barriers -home asset bias (a tendency to buy financial assets in the domestic market) -differential investor expectations Project valuation and the cost of capital ➢ Alternative approaches to project valuation -WACC: weighted average cost of capital -APV: adjusted present...
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...Financial Markets Lecture 6 Overview Futures, Options, Swaps Financial Derivatives Commodity Derivatives 1 Derivatives – Overview • Financial instrument or security whose payoffs depend on another instrument or security • Price of instrument a derivative of underlying security – Farmer who sows a crop in June, faces uncertainty over the price received at harvest time in September – Merchant/ consumer faces a price in September as well – Farmer, merchant negotiate on a price in June for settlement in September • Chicago Board of Trade 1848 • Yodoya rice futures in 1650 • Forwards, Futures, Options, Swaps 2 Derivatives - Definitions • Forwards – involves a contract initiated at one time, performance in accordance with the terms of the contract occurs at a subsequent future time • Futures – type of forward contract with standardized and closely specified contract terms – – – – Traded in organized exchange Standardized, specific quantity, delivery date, mechanism Performance guaranteed by clearinghouse Margins – good faith deposit with the exchange • Option – the right to purchase underlying good at a specific price until a specific date – Calls and Puts • Swaps – Agreement between two or more parties to exchange sequence of cash flows over a period in the future 3 Derivatives - Applications • Price risk elimination • Speculation • Market completeness • Information efficiency • Trading efficiency 4 Derivatives - Markets • Commodity Derivatives:...
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...Chapter 8: Foreign currency derivatives Futures contracts Options Chapter 9: Interest rate and currency swap Interest rate risk management FRAs Interest rate futures (not examinable) Swaps 2 Foreign Currency Derivatives Financial management of the MNE in the 21st century involves financial derivatives. These derivatives, so named because their values are derived from underlying assets, are a powerful tool used in business today. These instruments can be used for two very distinct management objectives: Speculation – use of derivative instruments to take a position in the expectation of a profit Hedging – use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow 3 1 Foreign Currency Derivatives Derivatives are used by firms to achieve one of more of the following individual benefits: Permit firms to achieve payoffs that they would not be able to achieve without derivatives, or could achieve only at greater cost Hedge risks that otherwise would not be possible to hedge Make underlying markets more efficient Reduce volatility of stock returns Minimize earnings volatility Reduce tax liabilities Motivate management (agency theory effect) 4 Foreign Currency Derivatives What are they? Forward contracts Futures contracts Options Swaps 5 Foreign Currency Futures A foreign currency (FX) futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign...
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...n the late 1990’s Enron held substantial investments in several high-tech companies. Many of these stocks soared in price after their initial public offering, which allowed Enron to report very large gains on its income statement.1 However, the stocks could not be sold and the gains realized in cash because the investments were subject to lock-up agreements.2 Enron’s Chief Financial Officer (CFO) and others realized it was likely these investments would experience significant drops in value before they could be sold, but the investments could not be hedged commercially. Therefore, the CFO designed transactions that would, from an accounting point of view, keep the anticipated losses out of Enron’s income statement. This paper explains Enron’s hedging transactions with special purpose entities (SPEs) that allowed the company to overstate its true economic profit.3 The paper first provides an overview of risk management and explains how particular derivatives used by Enron and other companies help manage risk. The paper then analyzes Enron’s unique hedging schemes and provides insights with respect to their structure as well as the motivation for their creation. In addition, this section of the paper describes how the SPEs were used to keep losses out of Enron’s financial statements, how investors in the SPEs were provided with massive financial returns on modest investments, and why Enron’s declining stock price ultimately exposed the questionable activities of the CFO and others...
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...Derivatives and Hedging Over recent years, the volatility in the financial markets has increased due to substantial changes domestically and internationally. This has given rise to increased financial price risks faced by both domestic and multi-national companies. Financial Derivatives are widely used by corporations to adjust to exposure to currency risk, interest rate risks, commodity price risks, and security holdings risk. Largely, companies are currently exposed to risks caused by unexpected movements in exchange rates and interest rates. Companies with a growing global presence are especially exposed to a wide range of financial risks, in particular foreign exchange risks and interest rate risk. Although, financial risks are the center of business operations of financial service firms, but they also impact the risk exposure of non-financial corporations. The management and supervision of these risks has become vital for the existence of companies in today’s unpredictable financial markets. The major financial risks that most firms are exposed to are interest rate risk, currency rate risk, commodity price risk, and security holdings risk. Interest rate risk is a very common type of risk, and result from a discrepancy in the sensitivity of a firms assets and liabilities to interest rate movements. On the other hand, currency risk exposure is virtually encountered by all firms, even if their exposure is not from a transaction or a translation risk. Many firms are...
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...FINANCIAL DERIVATIVES (A Future of Indian Financial Market) Dr. Ritu Kothiwal, Associate Professor, BIET, Hyderabad Contact No: 09246193330 Email Id: kothiwal55@gmail.com Mr. Ankur Goel, Research Scholar (Management), Mewar University, GZB. Contact No: 9917745990 Email Id: mrankurgoel@gmail.com. ABSTRACT Among all the innovations that have flooded the international financial markets, financial derivatives occupy the driver's seat. These specialized instruments facilitate the shuffling and redistribution of the risks that an investor faces. Thus aids in the process of diversifying ones portfolio. The volatility in the equity markets over the past years has resulted in greater use of equity derivatives. The volume of the exchange traded equity futures and options in most of the mature markets have seen a significant growth. It goes beyond that the local derivative in the emerging markets have witnessed widespread use of the derivative instrument for a variety of reasons. This continuous growth and development by the emerging market participants has resulted in capital inflows as well as helped the investors in risk protection through hedging. INTRODUCTION AND CONCEPT OF DERIVATIVES: Derivatives are financial contracts whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. The International Monetary Fund defines derivatives as "financial...
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...International Financial Management Assignment: Exchange Rate Risk Management As the world of business becomes increasingly global, multinational corporations (MNCs) are establishing the production and marketing operations in foreign countries. These MNCs face a variety of challenges. One of challenge faced by MNCs in foreign markets is fluctuations in currency exchange rates. Movements in exchange rates can cause instability in profit margins and significant losses to an MNC’s bottom line. Thus, exchange rate risk management is an integral part in MNC’s decisions about foreign currency exposure. Measuring and managing exchange rate risk exposure are important functions in reducing a MNC’s vulnerabilities from major exchange rate movements. In order to manage currency exchange rate risks, MNC often use financial instruments or currency derivatives. Required: 1. What are the types of exchange rate risks faced by the MNCs? 2. Understand the attempt for the use of foreign exchange derivatives (exchange rate risk management approaches) that can benefits the MNCs. Assignment required student to demonstrate professional skills in research, presentation and communication with full references and an appropriate bibliography. * Assignment should be completed using a word processor and should be no more than 10 pages, using Arial 12, single spaced. * Submission should be a single word document. * This is an independent assessment, and it is unlikely that students...
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...2013. To purchase furniture on January 31, with payment due on March 31, 2014. The derivatives is designated as a fair value hedge c. The forward contract was to hedge an anticipated purchase of furniture on January 30. The purchase took place on January 30. With payment due on March 31, 2014. The derivatives is designated as a cash flow hedge. The company uses the forward exchange rate to measure hedge effectiveness d. The forward contract was for speculative purposes only Problem 2 – Futures Peny One Inc. is a jewelry trading company. On November 1, 2013, Peny One Inc has 1,000,000 ounces of Gold carried at cost of $ 5,000,000 ($5 per ounce). Peny One Inc believes that the price of gold will decrease in the coming month due to bad economic recession. Therefore it decides to enter futures contract which has maturity date on March 31, 2014. In addition, Initial margin $ 0.05 per ounce is required to enter this contract. The following is the pricing information for the term of the futures: Date | Spot Price |...
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...Foreign exchange markets 3. Foreign exchange exposure management 4. Financial management of multinational corporations 5. Financial management of multinational corporations 6. Corporate Governance 7. Mergers & Acquisitions 8. Risikomanagement Prof. Dr. Streitferdt: International Financial Management 1 1. Prologue Discounting Calculating present value 0 t=1 t=2 t=3 2,000 t=0 4,500 3,000 t=4 t=5 3,500 6,000 How much would you be willing to pay for this stream of future cash flows, if the interest is at i = 5.65%? Why is the result today’s value of the future cash flows? What are the assumptions of this calculation? Prof. Dr. Streitferdt: International Financial Management 2 1. Prologue Discounting Calculating present value 10/28 10/14 6,000 0 How much would you be willing to pay for this stream of future cash flows, if the two week Euribor is at i = 5.65%? What makes this calculation different from the last slide’s calculation? How many days has a year? Prof. Dr. Streitferdt: International Financial Management 3 1. Prologue Discounting Interests for investments with less than one year maturity Interests are always quoted for one year: A company has in 2012 an overdraft credit of 100,000 € with interests of 6%. The credit is used for 75 days. 75 The company has to pay interests of 6% · · 100,000 €. days per year ...
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...A Handbook on Derivatives © Rajkumar .S Adukia B.com (Hons.), L.L.B, AICWA, FCA radukia@vsnl.com/rajkumar@gmail.com 093230 61049/ 093221 39642 www.carajkumarradukia.com If interested in receiving similar technical updates subscribe to carajkumarradukia-subscribe@yahoogroups.com PREFACE Derivatives have changed the world of finance as pervasively as the Internet has changed communications .Well they are everywhere nowadays. The most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors who are most able and willing to take it -- a process that has undoubtedly improved national productivity, growth and standards of living. Derivatives products provide certain important economic benefits such as risk management or redistribution of risk away from risk-averse investors towards those more willing and able to bear risk. Derivatives also help price discovery, i.e. the process of determining the price level for any asset based on supply and demand. All markets face various kinds of risks. This has induced the market par-ticipants to search for ways to manage risk. The derivatives are one ofthe categories of risk management tools. As this consciousness about risk management capacity of derivatives grew, the markets for derivatives...
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...SAMPLE FINAL EXAM PAPER SUBJECT NAME : Capital Markets SUBJECT NO. : 25741 TIME ALLOWED : Three (3) hours plus ten (10) min. reading time NOTES/INSTRUCTIONS TO CANDIDATES: Part A: 10 multiple choice questions worth 1 mark each (10 marks in total). • Encode your name and student number on the computer-coding sheet with a 2B grade pencil. • Record one answer to each multiple-choice question with a 2B grade pencil on the computer-coding sheet. Part B: 5 calculation questions worth 4 marks each (20 marks in total). • Answers to these questions must be written in the examination booklet provided. You must show your workings for the calculations. Unsubstantiated answers will be ignored. Part C: 5 short-answer questions worth 4 marks each (20 marks in total). • Answers to these questions must be written in the examination booklet provided. Note: Non-programmable calculators may be used. THE QUESTIONS IN THE FINAL EXAM WILL COVER ALL THE MATERIAL STUDIED IN LECTURES 7 TO 12 IN THE SUBJECT. THE QUESTIONS COULD BE SIMILAR TO SOME OF THESE SAMPLE QUESTIONS OR TOTALLY DIFFERENT. REVISE ALL MATERIAL IN THE LECTURE NOTES, REVISION QUESTIONS AND MULTIPLE CHOICE QUESTIONS ON UTSONLINE . Formulae The following formulae were used in topics 7, 8, 9, 10, 11 and 12. You are assumed to know how to use them. |Call IV = max.[S-X,0] |[pic] ...
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