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Derivative: Forward, Future, and SWAP

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Financial Derivative

A financial instrument whose payoffs depend on another financial instrument or asset. i.e. forwards, futures, options, and swaps.

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Forward and Future Forward: A contract negotiated in the present that

gives the contract holder both the right and full legal obligation to conduct a transaction at a specific future time involving a specific quantity and type of asset at a predetermined price.

Forward is not an option: both parties are expected to hold up their end of the deal.

The buyer is to receive delivery of the good and pay for it.

The seller is to deliver the good and receive payment.

Future: A forward contract that has been highly standardized and closely specified.

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Example: Forward

t=0 t=T

Buyer (Seller) agrees to purchase (sell) an asset on

day T at $100,

Buyer (Seller) purchases (sells)

the asset on day T at $100.

The buyer reverses the trade at $105 before day T. He finds another buyer to take over his position, does he pay

(receive) anything? How much?

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Example: Future

Buyer (Seller) agrees to purchase (sell) an asset on T at $100. No cash flow

occurs except margin requirement.

On day 1, the future price declines to $99, the buyer pays the seller $1, and the future becomes:Buyer (Seller) agrees to purchase (sell) an asset on day T at $99.

t=0 t=Tt=1

Buyer may reverse trade by entering another future to sell

the asset at on going future price, thus offsetting his

previous position.

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Forward and FutureForward Future

Private Contracts - satisfying the

needs of the parties involved.

Standardized contract - common to

public

Do not trade on an organized

exhange (Low liquidity)

Trade on organized exhanges

(Liquiditiy)

Hard to make reverse position Easy to make reverse position

Have default risk

Performance is guaranteed by the

exchange's clearinghouse via

marked-to-market process

No cash transactions until the

delivery date.

Require to post the margin money to

fulfill their obligation (via

marked-to-market)

Usually not regulated Regulated by the government.

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Futures contracts features

Standardized contract terms:

– Underlying commodity or financial instrument

– Contract size– Maturity (expiration) date– Delivery/settlement procedure– Futures price

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Futures Contracts: Preliminaries

Standardizing Features:– Contract Size– Delivery Month

Daily resettlement– Minimizes the chance of default

Initial Margin – About 4% of contract value, cash or T-bills

held in a street name at your brokerage.

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Trading Mechanics

Clearinghouse - acts as a party to all buyers and sellers.– Obligated to deliver or supply delivery

Closing out positions– Reversing the trade– Take or make delivery– Cash settlement– Most trades are reversed and do not

involve actual delivery

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Trading Future with a Clearing house

Long position

Short position

ClearingHouse

Money

Commodity

Money

Commodity

The clearing house guarantees that traders in the future market will honor their obligations.

Clearinghouse acts as the buyer to every seller and the seller to every buyer.

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Margin and Trading Arrangements

Initial Margin - amount required when a futures contract is first bought or sold. IM deposited is to provide capital for absorbing losses.

Maintenance margin - an established value below which a trader’s margin may not fall.

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Margin and Trading Arrangements

Marking to Market - each day the profits or losses from the new futures price are reflected in the account.

Margin call: Notification to increase the margin level in a trading account

Reverse trades: A trade that closes out a previously established futures position by taking the opposite position.

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Speculator vs. Hedger

Traders can be either speculators ( meaning they accept the market’s risk in pursuit of profits) or hedgers (meaning they trade futures to reduce some pre-existing risk exposure)

Hedgers transfer price risk to speculators and speculators absorb price risk

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Hedger: Trader who seek to transfer risk by taking a futures position opposite to an existing position in the underlying assets.

Long hedger would be a firm who is short the asset (like a baker who has promised to deliver bread) and want to reduce their risk on direct material by buying the asset now (long in wheat) in the futures market.

Long hedge: Purchase of futures to offset potential losses from rising prices.

Hedging with Futures

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Hedging with Futures

Short hedger would be a firm who own the asset (like wheat) and want to reduce his risk by selling the asset now (short in wheat) in the futures market.

Short hedge: Sale of futures to offset potential losses from falling prices

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Speculating with Futures Speculator: traders who accept price risk by

going long or short to bet on the future direction of prices.

Long Position: A buyer in a future contract. A long position profits from a future price increase.

Short Position: A seller in a future contract. A short position profits from a future price decrease.

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Types of future contracts

Agricultural and metallurgical– Agricultural goods, oil, livestock, forest products,

textiles, foodstuffs, and minerals.

Interest rates– Started trading in 1975 and experienced

tremendous growth. – Now span almost the entire yield curve (able to

trade on any maturities)

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Types of future contracts Currencies

– Started trading in the early 1970s.– However, the forward market for FX in many times

larger than the future market.

Indexes– Started trading in 1982 and has become quite

successful.– Most index futures are for stock indexes.– Since trader can’t actually deliver the stock index

contracts, a reversing trade or a cash settlement is required at the end of trading.

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Contract Contract Size ExchangeAgricultural

Corn 5,000 bushels Chicago BOTWheat 5,000 bushels Chicago & KCCocoa 10 metric tons CSCE

OJ 15,000 lbs. CTNMetals & Petroleum

Copper 25,000 lbs. CMX Gold 100 troy oz. CMX

Unleaded gasoline 42,000 gal. NYMFinancial

British Pound £62,500 IMMJapanese Yen ¥12.5 million IMM

Eurodollar $1 million LIFFE

Types of future contracts

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Stock index futures and multiple

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Futures Markets

The Chicago Mercantile Exchange (CME) is by far the largest.

Others include:– The Philadelphia Board of Trade (PBOT)– The MidAmerica Commodities Exchange– The Tokyo International Financial Futures

Exchange– The London International Financial Futures

Exchange

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The Chicago Mercantile Exchange Expiry cycle: March, June, September,

December.

Delivery date 3rd Wednesday of delivery month.

Last trading day is the second business day preceding the delivery day.

CME hours 7:20 a.m. to 2:00 p.m. CST.

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Wall Street Journal Futures Price Quotes

OpenOpen High Low Settle Change High Low Interest

July 179 180 178¼ 178½ -1½ 312 177 2,837Sept 186 186½ 184 186 -¾ 280 184 104,900Dec 196 197 194 196½ -¼ 291¼ 194 175,187

Sept 117-05 117-21 116-27 117-05 +5 131-06 111-15 647,560Dec 116-19 117-05 116-12 116-21 +5 128-28 111-06 13,857

Sept 11200 11285 11145 11241 -17 11324 7875 18,530Dec 11287 11385 11255 11349 -17 11430 7987 1,599

Lifetime

Corn (CBT) 5,000 bu.; cents per bu.

TREASURY BONDS (CBT) - $1,000,000; pts. 32nds of 100%

DJ INDUSTRIAL AVERAGE (CBOT) - $10 times average

Expiry month

Opening price

Highest price that day

Lowest price that day

Closing price Daily Change

Highest and lowest prices over the lifetime of the contract.

Number of open contracts

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Basic Currency Futures Relationships

Open Interest refers to the number of contracts outstanding for a particular delivery month.

Open interest is a good proxy for demand for a contract.

Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

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Currency FuturesTime Action Profits Margin

Balance

Tue. Morning

Buy SF futures matures in two days at 0.75 $/SF. 125,000 SF per contract, I.M.=$1485, M.M.=$1100

Tue. Close

Future price rises to 0.755 $/SF

Wed. close

Future price rises to 0.743 $/SF

Thur. close

Future price drops to 0.74 $/SF Physical Delivery

0

1,485

6252,110

-1,500 610

1,100

-3751,100

725

490

375

$ weak, SF appre.

$ appre., SF weak

-1,250 385= =-1,250

Cal

l

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Swaps Contracts: Preliminaries

In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows or debt service obligations at periodic intervals.

Swap structure

1. Notional Principal: A reference amount against which the interest is calculated

2. Reference Rate: Who pay at what currency at what rate and receive at what currency at what rate?

3. Swap date: the milestone dates which both counterparties pay or receive the balance after swap.

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Swaps Contracts: Preliminaries

There are two major types of swaps:

– Single currency interest rate swap• “Plain vanilla” fixed-for-floating swaps

are often just called interest rate swaps.

– Cross-Currency interest rate swap• This is often called a currency swap;

fixed for fixed rate debt service in two currencies.

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Swaps Contracts: Major Types

9%

L+1.2%

Bank ZZ

Bank ZZ

Bank ZZ

Company A

Company A

Company A

9%

Notional

Notional

Interest-rate swap (Coupon swap) Company A swaps a 5-year $ obligation with a fixed rate of $9% into a 5-year $ obligation at a 6-month floating rate $LIBOR+1.2% with bank ZZ.

Notional

Notional

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Swaps Contracts: Major Types Currency swap (fixed-fixed swap)

Company A swaps a 5-year FF140 million obligation at FF9% into a 5-year $20 million obligation at $8% with bank ZZ

9%

Bank ZZ

Bank ZZ

Bank ZZ

Company A

Company A

Company A

9%

FF140

FF140

FF140

FF140

$20

$20

8%

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Swaps Contracts: Other Types Currency-interest rate swap

Company A swaps a SF debt of SF150 million at SF5% into a $ debt of $100 million at $LIBOR

Basis-rate swap (floating-floating swap)

Others: Differential swap (switch LIBOR swap), forward swap, zero swap, amortizing swap, commodity swap

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Important characteristics

– Off-balance sheet.

– Only the BALANCE of the two cash flows is exchanged on each payment date.

Swaps Contracts: Characteristics

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Reduce Costs ==> Comparative Advantage– An I/R swap example: The case of Unilever (UK) and

MIC (US) on $100 mil. 5 year interest rate swap

$Fix $Floating

Unilever (UK) 9% LIBOR+0.25%

MIC (US) 10% LIBOR+0.75%

1% 0.5%

• In what type of borrowing does the Unilever have a comparative advantage? Why? How about MIC?

• What is the maximum cost savings through a swap?

Swaps Contracts: Motivations

Max.Saving 0.50%

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Swap Motivations – Cost Reduction Suppose that a swap dealer offers the following

swap quotes– U pays Bank $LIBOR for $9%. – M pays Bank $9.15% for $LIBOR.

Bank ZZU$ 9%

M$ L+0.75%

$ L%

$ 9%

$ L%

$ 9.15%

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Swap Motivations – Cost Reduction

Bank ZZU$ 9%

M$ L+0.75%

$ L%

$ 9%

$ L%

$ 9.15%

What is the before-swap borrowing cost for each firm?

Fixed $9% for U and Float $ L+0.75% for M

What is the swap contract for each firm?

For U; Receive Fixed $9% and pay Float $ L%

For M; Pay Fixed $9.15% and Receive Float $ L%

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Bank ZZU$ 9%

M$ L+0.75%

$ L%

$ 9%

$ L%

$ 9.15%

What is the with-swap cost for each company?

What is the without-swap cost for each company?

What is the cost savings for each company?

What is the profit for the swap dealer?

Swap Motivations – Cost Reduction

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Bank ZZU$ 9%

M$ L+0.75%

$ L%

$ 9%

$ L%

$ 9.15%

Swap Motivations – Cost Reduction

With-Swap cost

$ L% $ 9.90%

Without-Swap cost

$ L+0.25% $ 10%

Cost Saving

$ 0.25% $ 0.10%

Profit for Swap Dealer

$ 0.15%

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Risk Management

– Interest rate swaps:• More useful when assets or liabilities cannot be

traded, as is the case for bank loans.• A sequence of futures contracts on bonds.

– Currency swaps:• Can be used to hedge the currency exposure of

assets and liabilities.

Swap Motivations – Risk Mgmt.

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Valuation of Swaps

Valuation in the Absence of Default Risk

– Initial value is zero:

– Values changes as interest rate and foreign exchange rate vary. Two approaches:

• A swap can be broken down into a series of forward currency and interest rate contracts for each flow.

• Bonds on Balance: Swaps can be treated as a portfolio of two bonds.