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MASTER OF SCIENCE IN BANKING AND INVESTMENT

FINANCIAL ENGINEERING AND ALTERNATIVE INSTRUMENTS

Overview of Structured Products:


 A derivative instrument or a structured product is one for which the ultimate pay off
to the investor depends directly on the value of another security or commodity.
 At the broadest level, there are only two kinds of derivatives available namely;
(i) Forwards and futures contracts
(ii) Option contracts

Types of Derivative Position

Forward / Futures Contracts Option Contracts

Calls Puts
1. Long position (Buyer)
2. Short position (i.e. Seller)
3. Long position 5. Long position
4. Short position 6. Short position

The above diagram means that;


 An investor can enter into a transaction as either the long position (i.e. buyer) or the
short position (i.e. the seller).
* It is important to recognize that every derivative arrangement that an investor
might hold in his or her portfolio can be viewed in terms the 6 positions or as a
combination of positions above.
 For instance an equity investor can use derivatives to his/her portfolio against general
declines in the stock market.
 Such strategies involve;
1. Shorting and equity index forward contract i.e selling an equity contract forward
and
2. Buying an equity index “collar” agreement i.e. A combination of the purchase of a
put option (position 5) and the sale of a call option (position 4).
 In addition to the market for bonds instruments, a market has developed for futures
contracts related to these bonds.
 The futures contracts allow the holders to buy or sell a specified amount of a given
bond issue at a stipulated price.

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 There are two known major futures exchanges in the USA i.e. Chicago Board of
Trade (CBOT) and Chicago Merchantile Exchange (CME)
 To most investors, the forward contract is the most basic derivative product available.
 The future date on which the transaction is expected to be concluded or consummated
is called the Contracts’ Maturity (Expiry) date.
 The predetermined price at which the trade takes place is the forward contract price.
 There must always be two parties (called counterparties) to a forward transaction.
 The eventual buyer (long position), who pays the contract price and receives the
underlying security, and the eventual seller (or short position) who delivers the
security for a fixed price.

Forward and Futures Markets:


Forward contracts are not securities in the traditional sense.
They are more appropriately viewed as trade agreements negotiated directly between two
parties for a transaction that is scheduled to take place in the future.

Illustration:
Suppose that on 31st July, the long position in the bond forward contract is obligated to
pay US$1000 for a bond that is worth US$1,050 today.

Required:
Should the investor exercise the contract?

Solution:
Yes, the investor should exercise the contract since contract exercise price is less than the
market price of $1,050.

 This will result in a profitable settlement for the long position in the contract since
he/she will be able to acquire the bond for $50 less than the Current Market Value.
 The short position must deliver the bond on 31 st July and lose $50 on his/her forward
position.
 In case the bond prices decline before 31 st July and fall below $1000, then the short
position would stand to benefit.
 The cardinal rule in the forward market is to “buy low and sell high” in order to make
profit.
 Forward contracts are usually negotiated in the “Over the Counter Market”.
 This means that forward contracts are agreements between two private parties, one of
which is often a derivative’s intermediary such as a commercial or an investment
bank.
 Forward contracts are not traded through a formal security (Stock Exchange) or
Commodity Exchange Market.

The advantages of the forward contracts are;


(i) The terms of the contract are completely flexible according to what two mutually
consenting counterparties agree to.

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(ii) The arrangements do not usually require collateral, instead the long and short
positions sometimes trust each other to honour their commitments at the maturity
date.
 When the spot price in future exceeds the contract price, the forward buyer’s gain is
Spot Price – Contract Price.
 When the spot price in the future is less than the contract price, the future buyer’s loss
is contract price spot price.
 The pay off to the seller of the forward contract is the minor image of the pay off of
the forward contract.
 The gain of the buyer is the loss of the seller and vice versa.

Profit Profit

P
C C P

Loss Loss

C = Contract Price
P = Actual Price

The disadvantages are that;


(i) Forward contracts involve credit (default risk)
(ii) Forward contracts are often illiquid meaning that it might be difficult and costly to
exit the contract before it matures.
The illiquidity is mainly brought about by the contract’s flexibility because the
more specifically the agreement is tailored to the needs of a particular individuals
the less marketable it is to other investors.
The pay offs for the forward buyer (long position) and a forward seller (short
position) are as follows;

 Futures contracts on the other hand tend to solve this problem by standardizing the
terms of the agreement e.g. expiry date, identity and amount of the underlying asset.
 Futures contracts can be traded in a centralized market called the Futures Exchange
because it is standardized and homogeneous.
 Futures contracts can be traded at the prevailing market price.
 The futures contracts require both counterparties to post collateral and margins to
protect themselves against possibility of default.
 The collateral or margin is deposited with the Futures Clearing House and are marked
to market.
 Marked to market means that values of the futures contract are adjusted daily to take
into account daily changes in the price of the underlying assets.

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 The underlying assets often experience volatile price movements which are of great
interest to both buyers and sellers because of the great potential to make or lose
money.

Key Differences Between Forwards and Futures:


(i) A forward contract is a tailor-made contract (terms are negotiated between the
buyer and the seller), whereas a futures contract is a standardized contract (i.e.
quantity, date and delivery conditions are standardized).
(ii) While there is no secondary market for forward contracts, the futures contracts are
traded on organized exchanges.
(iii) Forward contracts usually end with deliveries, whereas futures differences are
settled at the Futures Contracts with differences.
(iv) Usually no collateral is required in a forward contract. In a futures contract,
however, a margin and or collateral is required.
(v) Forward contracts are settled on maturity date, whereas futures contracts are
marked to market on a daily basis. This means that the profits and losses on
futures contracts are settled daily.

Illustration of Marked to Market:


Suppose on Monday morning an investor takes a long position in a futures contract that
matures on Friday afternoon. The agreed upon price is Shs.100,000=. At the close of
trading on Monday, the futures price rises to Shs.105,000=.
The marking-to-market feature means that three things would occur;
(i) The investor would receive a cash profit of Shs.5,000=
(ii) The existing futures contract with a price of Shs.100,000= would be cancelled.
(iii) The investor would receive a new futures contract at Shs.105,000=.

 The marking-to-market feature implies that the value of the features contract is set to
zero at the end of each trading day.
 The settlement is done through the Clearing Houses to avoid counterparty risk.

Types of Financial Futures:


There are 3 types of financial futures namely;
(i) Market Index Futures (Stock Index Futures)
(ii) Currency Futures
(iii) Interest Rate Futures

Market Index Futures (Stock Index Futures)


The Market Index Futures were first introduced in 1982 and are directly related with the
stock market price movements.
It is one of the most successful financial innovations of the financial market.
Stock Index Futures are intended to provide a hedge against stock market movements in
portfolio or individual assets.

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Stock Index Futures are often used to convert entire stock portfolios into synthetic risk
less positions to exploit an apparent mis-pricing between stock in cash and futures
markets.
This strategy is known as stock index arbitrage.
Examples of stock index futures include Dow Jones Industrial Average, Standard and
Poor’s 500, Standard Poor’s Midcap 400, Russell 2000, Nikkei 225 (Japan), CAC 40 (
France), DAX 30 (German) and FT-SE 100 (England).
The stock index futures have the following characteristics:-
(i) It is an obligation and not an option
(ii) Settlement value depends on;
(a) The value of the stock index and the price at which the original contract is
struck and;
(b) The difference between the index value at the last closing day of the
contract and the original price of the contract.
(iii) The basis of the stock index futures is the specified stock market index. i.e. No
physical delivery of stock is made (S&P500).

Standard and Poor Contract is the most popular stock index futures.
Here, the obligation is to deliver cash equal to 500 times the difference between stock
index value at the close of the last trading day of the contract and the price at which the
future contract was struck at the settlement date.

For example;
If the contract is struck at the S&P stock index level at 400 and the stock index is 410 at
the end of the settlement date. Then the payment that has to be made is equal to
(410-400) x 500 = 5,000.

Second Illustration
An investor planned in February to buy stock in June and decided to hedge against his
eventual price, increasing with rising market prices by entering the long position of June
2005 S&P500 contract.

With the settlement price of 1078.90 for this contract shown in the display as 107890, he
has obligated himself to the theoretical purchase of 250 shares of S&P 500 on the third
Friday of June for $269725 (i.e. 1078.90 x 250). The minimum price movement is 0.10
points, which equals $25 (i.e.0.10 x 250).
If the actual level of S&P index on the contract settlement date turned out to be $1081.10,
determine the amount of gain to the investor.

Solution:
Minimum price movement = 0.10 which equal $25
The price movement = 1081.10 – 1078.90 = 2.2
Therefore, 2.2 ÷ 0.10 = 22 ticks
22 x 25 = 550
The long position would gain $550.

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The potential users of stock index futures contracts are speculators, investors, arbitragers
and portfolio managers. These contracts are used mainly to hedge against future declines
in portfolios or against future increases in prices.

Example:
An investor owns a well-diversified portfolio that has the current market value of
$220,000. He enters into a futures stock index of S&P 500 at the stock index level of
420, which rose to 455 at the end of one month’s period. The portfolio value of the
investor declined to $208,000.

Required:
Determine the overall position of the investor at the end of one month’s period.

Solution:
(i) Determine the value of the stock index futures contract
500 (Ending stock index level – Beginning stock index level)
= 500(450 – 420)
= 500 x 30
= $15,000

(ii) Add Gain on stock index futures contract to portfolio value


= 15,000 + 208,000
= $223,000

The gain in the futures contracts offsets in the portfolio value.

Currency Futures:
 These are agreements entered into by counterparties for exchange of currencies.
 The largest such market is operated by banks and specialized brokers, maintaining
close communications with each other throughout the world. Substantial amounts of
money are involved. Typical rates are quoted in the financial press.
 For example, currency futures contracts traded on the international marketing market
of the Chicago Merchantile Exchange requires the seller to deliver Pounds Sterling
£2,500,000 to the buyer on a specified date for a number of US dollars agreed upon in
advance.
 Clearing procedures allow positions to be covered.
 These transactions rarely result in actual delivery of foreign currency.
 Markets for currency futures attract both hedgers and speculators.
 Hedgers wish to reduce or possibly eliminate risk associated with planned future
transfers of funds from one country to another.
 Speculators hope to profit from a difference between the current rate for future
exchange and the actual spot rate in the future.
 Contrary to particular opinion, many institutions take speculative positions, besides
engaging in hedging operations for themselves and/or their customers.

Interest Rate Parity:

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Interest Rate Parity is the relationship that must exist in an efficient market between the
spot and forward exchange rates between two countries and the interest rates in those
countries.
 Determination of future or forward exchange rates is done using the concept of
Interest Rate Parity.
 Using US dollars and UK pound sterling, the relationship is obtained by using;
 US spot exchange rate
 The interest rate in the US
 Interest rate in the UK and;
 The forward exchange rates are determined.

The diagram below shows the Relationship between Interest Rates and Exchange Rates:

Spot Exchange Rate

$Ds = 1£
1USD Now 1GBP Now
Borrowing Borrowing
and 1$ now = 1GBPnow and
Lending $(1+rs later = £(1+rf) later Lending
in the in the
US USD Later GBP Later UK

$Df = £1

Forward Exchange Rate

Df = 1 + r$ Ds OR
1 + r£

Df - Ds = r$ - r£

Where Df = US$ Forward Rate


Ds = US$ Spot Rate
Vs = US$ Interest Rate
r£ = GBP Interest Rate

 This is known as the interest rate parity theorem, which holds that the percentage
difference between forward and spot exchange rates will be equal to the difference
between interest rates in the two countries.
 The settlement of the currency futures will depend on the difference between the
forward rate, which was agreed on in advance, and the ruling spot rate in the future.

Example:

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A US Dollar investor enter into a futures contract to deliver £2.5m in 3 months. The
current US interest rates are 3% and UK 4%. The current exchange rate is US$1.8 per
1GBP.
You are required to determine if the currency futures contract is beneficial to the investor.

Solution:
Determine the current value of £2.5m x 1.8 = US$4.5m

Forward Rate = 1 + r$ 1.8


1 + r£

- 1.03 1.8
1.04

∴ Forward Rate = 1.7827

∴ 1.7827 x 2.5 = $4.46m

Df – Ds = Df = 1.7827
Ds Ds = 1.800

∴ 1.7827 - 1.800
1.800

= -0.96 1%

∴This means that inflation in UK is expected to exceed that of US by about 1% and


therefore it would be beneficial for the US investor to enter into the currency futures
because he would cover his position by investing the USD4.5 for the period and
purchasing UK£ at 4.46m.

Interest Rate Futures:


 Interest rate futures contracts are derivatives in which the underlying securities are the
fixed income securities issued by the central governments.
 Examples of such futures include Treasury Bill futures, Eurodollar futures, Treasury
bond futures, Treasury note futures, Agency note futures, etc.
 Treasury Bill futures, as well as the Eurodollar futures contracts are the futures
contracts whose underlying instrument is a short-term debt obligation.
 Treasury Bill futures contracts are traded on the international money market and are
based on a 13-week (91 day) treasury bills with a face value of US$1million.
 More specifically, the seller of a Treasury Bill futures contract agrees to deliver to the
buyer at the settlement date a Treasury Bill with 13 weeks remaining to maturity and
a face value of US$1 million.

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 The futures price is the price at which the Treasury Bill will be sold by the short and
purchased by the long.
 The Treasury bill could be newly issued 13 week Treasury Bill or a Treasury Bill
which was issued one year ago but with only 13 weeks remaining to maturity.
 Treasury Bills are quoted in the cash market in terms of annualized yield on a bank
discount basis as follows;

Yd = D x 360
F t

Where;
Yd = Annualized Yield on a bank discount basis (Expressed as a decimal)
D = Discount, which is equal to the difference between the face value and the
price of a bill maturing in t days.
F = Face Value
t = Number of days remaining to maturity

 The discount D is obtained by;


D = Yd x F x t/360

 In contrast, the Treasury Bills futures contract is quoted on an index basis related to
the yield on a bank discount basis as follows;
 Index Price = 100 – (Yd x 100)
 For example, if Yd = 8%, the index price = 100 – (0.08 x 100)
= 100 – 8 = 92
 Given the price of the futures contract, the yield on a bank discount basis for the
futures contract is determined as follows;

Yd = 100 – Index Price


100

Illustration:
The Index Price for a Treasury Bill futures contract is given as 92.52. You are required to
determine the yield on the bank discount basis for this Treasury Bill futures contract.

Yd = 100 – Index Price x 100


100

Yd = 100 – 92.52 x 100 = 7.48%


100

 The invoice price that the buyer of US$1million face value of 13 weeks Treasury
Bills must pay at settlement is found by first computing the discount as follows;

D Yd x 1,000,000 x t/360

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Where t = 91 days (i.e. number of days to maturity of a 13 week Treasury Bill)

 The Invoice Price = 1,000,000 – D

Example:
Assume the Treasury Bill Futures Contract with an index price of 92.52 and the yield on
a bank discount basis is 7.48%

Determine the discount for the 13-week Treasury Bill to be delivered with 91 days to
maturity.
D = Yd x F x t/360
= 0,0748 x 1,000,000 x 91/360
= $18,907 = 78

The invoice price is;


1,000,000 – 18,907.78
= $981,092 = 22

 The minimum index price fluctuation or “tick” for this futures contract is 0.01.
 A change of 0.01 for the minimum index price translates into a change in the yield on
a bank discount basis of one basis point (0.0001).
 A change of one basis point will change the discount, and therefore the invoice price
by 0.0001 x 1,000,000 x t/360
 For a week Treasury Bill with 91 days to maturity, the change in the discount is

0.0001x 1,000,000 x 91/360 = 25.28


 For a 13 week Treasury bill with 90 days to maturity, the change in the dollar
discount would be $25.
 Despite the fact that a 13-week Treasury Bill typically has 91 days to maturity, market
participants commonly refer to the value of a basis point to this futures contract as
$25 = 00.

FORWARD RATE AGREEMENTS (FRA)


 An FRA is defined as contract between the buyer and the seller where the buyer
commits himself/herself to pay the seller the contract interest on a notional sum over
the stipulated period.
 FRA is an interest rate derivative instrument.
 While its primary function is to hedge the interest rate risk, it is also used as a trading
instrument by market makers and other investors.
 The notional amount is neither borrowed nor lent.
 An FRA is used to;
(a) Lock in a borrowing rate
(b) Lock in a lending rate
(c) Speculate on future levels of interest rates
 While the borrower locks in the borrowing rate, the lender/investor locks in the
lending/investing rate

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 FRA, therefore, protects the investor against the fall in interest rates and the borrower
against the rise in interest rates.

A Typical FRA Quote:


An FRA is quoted as “9.00-9.50” on “2x5” or “2Vs5” pr “2-5” UGX i.e. “9.00-950” on
“2x5” on ….

Meaning;
(i) FRA is being sold at 9.50% by the market maker (i.e. FRA can be purchased at
9.5% - equivalent to locking in borrowing rate by a market taker)
(ii) FRA is bought at 9% by the market maker (i.e. FRA can be sold at 9% -
equivalent to locking in investment rate by a market maker)
(iii) The period of the contract begins 2 months from now and ends 5 months from
now i.e. the contract lasts for 3 months.
(iv) The notional sum is UGX100m
(v) The difference between the buying and selling rate is the spread or profit margin
of the FRA dealers.

The above quote means that suppose a corporate wishes to raise UGX100m in 2 months
time for a period of 3 months, money markets being volatile, he is not sure how the
interest rates are going to behave in 2 months time.

 He, therefore wants to budget his interest cost today, so he goes to the FRA dealer and
they agree on particular rates for his borrowing requirement.
 At the start of the period, the corporate borrows UGX100m at the current rate.
 If the current rate is higher than the rate contracted under FRA, the FRA dealer
reimburses the difference to the corporate so that his effective cost of borrowing is the
contract rate fixed under the FRA.
 If the market rate is lower than the contract rate, the corporate must pay the difference
to the FRA dealer computed on the notional amount of the underlying contract again
bringing his effective borrowing rate to the one contracted under the FRA.
 While we have analyzed the transaction from the corporate order, the reciprocal effect
for the FRA dealer is that he has locked in his investment or lending rate through the
contract.

An Illustration:
MBA Plc enters into an FRA contract with an FRA dealer who makes the following quote
“9.00-9.50” on “2Vs5” UGX100m.
Assuming MSC Plc borrows at 10% market rate or 9% market rate. You are required to
determine the compensation at 10% or 9% and who will be compensated.

Solution:

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The equation for compensation is as follows:

Notional Sum x No.of days x Spread x 1__


365 or 360 100 1+MR x No.of days
365 or 360
Interest Amount
PV Discount Factor

Where;
Notional sum is the amount being borrowed
Spread = Difference between the buying and selling interest rates
MR = Market Interest Rate

365 Days is for UGX


360 Days is for USD

Notional Sum x 91 x Spread x 1__


360 100 1+MR x 91
360
Interest Amount
PV Discount Factor

Where MBA borrows at 10%


The compensation will be 1.024931

100,000,000 x 91 x 0.5 x 1__


365 100 (1+ 0.1 x 91
365

Interest Amount PV Discount Factor

= 124657.53 x 1___
1.024931

= 124657.53 x 0.975675

= 121,625

Where;
Notional Sum is the amount being borrowed
Spread = Difference between buying and selling rates
MR = Market Interest Rate

100,000,000 x 91 x 0.5 x 1__


360 100 (1+ 0.1 x 91

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360

Interest Amount PV Discount Factor

= 100m x 91 x 0.5
360 100

= 126388.89 x 1____
1.025277

= 126388.89 x 0.97546
= UGX 123,273.00

MBA /MSc Plc will borrow UGX100m from the money market at 10% and will seek
compensation for the higher borrowing cost of 50bps from the seller (FRA Dealer)
brining his effective borrowing cost to 9.5%.

When the borrowing is at 9%, the compensation to the dealers = 0.022438

100m x 91 x 0.5 x 1______


365 100 1 + 0.09 x 91
365
= 124657.53 x 1___
1.022438

= 124657 = 53 x 0.978054

= 121,922

When MSc Plc borrows at 9% the compensation will be

100m x 91 x 0.5 x 1______


360 100 1 + 0.09 x 91
360

= 126,388.89 x 1___
1.02275

= 126,388.89 x 0.977756

= 123,577

When MBA/MSc Plc borrows UGX100m in the money market at 9%, he will have to
compensate the seller (FRA Dealer) UGX 121,922/123,577 for borrowing at a lower cost
than the contract cost of 9.5% bringing his effective borrowing cost to 9.5%

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Pricing of an FRA
 An FRA is priced through implied forward rates in an available interest rates futures
market in the relevant currency.
 The pricing of an FRA has to reflect the FRA dealer’s capability to hedge the
transaction through the futures market.
 Forward interest rates can be derived from the current yield curve particularly the
spot yield curve.
 The expectations theory states that long term spots rates are the average of short term
spot rates and expected future short term rates.
 Forward interest rates can be derived using the following equation;

(1 + Rn-m) = (1 + Rn)n - 1
(1 + Rm)m

Where; R is the interest rate maturities m, n or n-m as the case may be (m being smaller
than n).

Illustration:
Assume that 1 year spot interest rate is 5% 2 year spot rate is 6% and 3 years spot rate is
7%.
Determine the Forward Rates for 1 year rate, 1 year forward and 1 year rate 2 years
forward.

1 year Rate 1 year Forward = (1 + 0.06)2 - 1


(1.05)
= 1.1236 - 1
1.05
= 1.070095 – 1
= 0.07009 x 100
= 7%

1 year Rate 2 years Forward = (1 + 0.07)3 - 1


(1 + 0.06)2

= 1.255043 - 1
1.1236

= 1.090284 – 1

= 0.90284 x 100

Approx. 9%

Interest Rate SWAPS

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An Interest Rate Swap is a bilateral agreement to exchange a sequence of interest
payments of differing characteristics based on a notional principal amount that is never
exchanged.
 Interest Rate Swap is a derivative instrument, which is primarily a hedge instrument.
 The most common type of SWAP is where one party agrees to pay the other party
fixed interest payments at designated dates for the life of the contract.
 This party is referred to as the Fixed Rate Payer
 The other party who agrees to make interest rate payments that float with some
reference rate (usually the Libor, London Inter-bank offer Rate) is referred to as the
Floating-Rate Payer.
 The frequency with which the interest rate that the floating rate payer must pay is
called Reset Frequency.

Illustration:
Suppose for the next 5 years X agrees to pay Y 10% per year while Y agrees to pay X 6
month’s LIBOR (reference rate). X becomes a fixed rate payer and a floating rate
receiver, while Y becomes a floating rate payer and fixed rate receiver. Assuming the
notional principal is UGX50m and payments are exchanged every 6 months, X will pay
10%x50mx½ = UGX2.5m to Y and assuming the LIBOR rate is 7%, Y will pay
7%x50mx½ = 1.75m to X.
Market participants can use an interest SWAP to alter the cashflow character of assets or
liabilities from a fixed rate basis to a floating rate basis and vice versa.

Illustration on Converting Floating Rate Liability to a Fixed Rate Liability:


Outflow on original loan : LIBOR + 0.5 (Fixed)
Inflow from the SWAP Dealer : LIBOR
Outflow to the SWAP Dealer: 7%
Net outflow: 7 + 0.5 (Fixed)

Thus, the borrower has converted his floating rate liability into a fixed rate liability and is
insulated against the interest rate rise during the remaining tenor of the loan.

Diagrammatic Representation of Interest Rate SWAP

SWAP Dealer

Bank
LIBOR Floating Fixed 7%

Pays
Receives LIBOR + 0.5%
Customer

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The above illustration means that the customer borrowed at a floating rate from the bank
i.e. LIBOR + 0.5%
The customer is worried that future LIBOR rates might rise, making his interest cost
expensive. The borrower is interested in converting his floating interest rate liability into
a fixed rate liability.

 The SWAP dealer agrees to pay the borrower LIBOR and expects the borrower to pay
him a fixed rate of 7%, hence converting his liability into a fixed rate liability.
 The borrower pays the BANK LIBOR (which he received from the SWAP Dealer)
plus the mark up of 0.5%.
 His liability therefore becomes a net fixed rate of 7.5% throughout the remaining
period of the contract.
 The receiver of the fixed leg of the SWAP is the SWAP seller and the payer of the
fixed leg of the SWAP is the SWAP buyer.
 Interest SWAPs help market participants to hedge against adverse movements in
interest rates and also taking advantages of opportunities available for improving
interest returns or cutting interest costs.

Therefore, interest rate Swaps can be used to;


(i) Lock or unlock the interest costs
(ii) Lock or unlock interest returns
(iii) Manage assets and liabilities
(iv) Trade

SWAP QUOTES AND MARKET MAKING


 A typical Market Making Swap dealer will give two-way quotes, which indicates the
fixed rate the Swap dealer is ready to pay and receive on a Swap.
 Every tenor of a Swap has its own price depending on the credit rating of the counter
party.
 The most simple quote for say a 5 year Swap is 5.55 – 5.60, meaning that a Swap
dealer is ready to pay 5.55% fixed rate and receive Libor or ready to receive 5.60%
fixed rate and pay Libor.

Example of Swap Rate Schedules:


Tenor Pay Receive
2 years TN2 + 30 TN2 + 33
3 years TN3 + 40 TN3 + 44
5 years TN5 + 42 TN5 + 47

TN2 + 30 means the yield of a 2 year Treasury note plus 30 basis points.
i.e. a Swap price has two components namely Treasury Yield and the Spread.
This means any market taker would have to find out the yield of a two-year treasury not
to arrive at the rate of a two-year interest rate Swap, etc.

OPTIONS

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 An option is the right but not an obligation to buy or sell an underlying asset on a
specified date at a specified price.
 Three parties are involved in option trading namely option seller, option buyer and
the broker.
 The option-seller or option writer is a person who grants someone else the option to
buy or sell. He receives a premium on its price.
 The option buyer pays a price to the option writer to induce him to write the option.
 The securities broker acts as an agent to find the option buyer and the seller and
receives a commission or a fee for it.
Types of Options:
A Call Option:
This is an agreement that gives the holder the right but not an obligation to buy an
underlying asset within a certain period at a specified price called the exercise price.
The call option contract provides the following details;
(i) The name of the company whose shares are to be bought
(ii) The number of shares to be purchased
(iii) The exercise/purchase price or the strike price of the shares to be bought
(iv) The expiry date i.e. the date on which the contract or option expires.

Illustration:
An investor paid UGX50,000 to purchase a call option which expires on December 32,
2005 to buy 1,000 shares of Uganda days whose market price if 2,570. The strike price is
UGX2,800.
You are required to determine;
(i) When the investor is in money and determine the maximum gain of the investor.
(ii) When he is out of money and determine the maximum loss to the investor
(iii) The maximum benefit and loss to the seller of the call option

Put Options:
A put option is an agreement that grants the holder the right but not an obligation to sell
an underlying asset within a certain period at a specified price.
(i) The number of the company shares to be sold
(ii) The number of shares to be sold
(iii) The selling price or the striking price
(iv) The expiry date of the option.

Illustration:
An investor buys a put option at UGX100,000 which expires on December 31, 2005 to
sell 1,000 shares of DFCU whose current market price is UGX1,810. The exercise price
is UGX2,400.
You are required to determine;
(i) When the investor is in money and determine his maximum gain
(ii) When the investor is out of money and determine his maximum loss
(iii) The maximum gain/loss of the option writer

The Options Market:

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Trading in options takes place in organized Stock Exchanges and Options Contracts are
standardized.
(i) Each option has a fixed striking price, matures at specific times through the year.
(ii) The performance of the option contract is guaranteed by the Stock Exchange.
(iii) The stock exchange provides information regarding the price, volume and any
other related details such as the underlying assets being traded in.

Determinants of Options Prices:


 The option price is the value of the right of holding the option for the buyer and
consequently the cost of the obligation placed on the seller.
 This value consists of two components:-

1. Intrinsic Value or Expiry Value


Call option:
Intrinsic Value = Stock Price – Strike Price
This is the gain that the option holder can obtain by exercising the option now.

2. Put option Intrinsic Value = Strike Price – the stock price.


Time – Value
This is the value of the unexpired life of the option.

Intrinsic Value:
 This is conventionally the difference between the strike price and the spot price
 Based on this, options are popularly classified into;
(a) At the money. This is where the strike price equals the spot rate.
(b) In the money. This is where the strike price is better than the spot rate for the
holder.
(c) Out of the money. This is where the strike price is worse than the spot rate for
the holder.

We can note that;


(i) No option can have a negative intrinsic value since even if the option is out of the
money, the holder is under no obligation to exercise it.
(ii) No option would be priced lower than its intrinsic value since if it were, the
holder can make a risk free gain by buying the option and selling/buying the asset
in the outright market.

Example;
An investor with a call option at a strike price of UGX9,500 and a spot rate of the
underlying asset is UGX10,000.
You are required to determine its intrinsic value

Solution:
Spot rate of the asset = 10,000

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Call option strike price = 9,500
Intrinsic value 500

Intrinsic value is popularly measured relative to the spot price (i.e. price between the
strike price and spot price of the underlying asset in the market.

Time Value;
Time value of an option = Premium – Intrinsic Value
Time value is the additional amount of premium that the option buyer is willing to pay
over the intrinsic value, for the unexpired life of the option.

Premium is the difference between the intrinsic value and the market price of the call
option.
 The time value of an option is closely related to its intrinsic value
 In case of out of money and in money options, the time value represents the
probability of the option moving in the money during its life.
 The greater this probability, the greater the time value.

In the Money Option:


In the money option, the time value is the measure of the uncertainty over the option
being exercised.
 i.e. the probability of the option becoming out of the money
 For an option which is deep in the money whose exercise is virtually certain, the
option buyer would be willing to pay nothing more than the intrinsic value.
 The option writer would also not demand much more than the intrinsic value, since he
can hedge himself in an outright market.
 Therefore, the time value of an option diminishes as the option gets progressively in
the money.
 The uncertainty over the exercise of an option is highest where the option is at the ….
and consequently time value is also maximum when the option is at the money.

Factors Affecting the Value of a Call Option:


1. The market price of an underlying asset.
For a given strike price, the higher the stock price, the higher will be the call
option price.
2. The strike price
The higher the strike price, the lower will be the call option price because the
amount of gain is limited.
3. Option Period:
The longer the option period, the higher will be the option price.
The longer option period gives greater chance for the stock price to increase
above the exercise price.
4. Stock Volatility:

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If the stock price is volatile, there is a probability of rise in price and gain. At the
same time there is the risk of fall in price and incurring loss.
The chances affect the owner of the call option to a lesser degree than the owner
of the stock because, if there is a rise in price, he stands to gain and if there is a
fall in price, his loss is limited.
Hence, the value of the call option is high.

5. Interest Rates
When interest rates are higher, the value of the strike price would be lower and at
the same time the call price would be higher. The influence of interest rate
depends upon its own variability and its relationship with the stock prices.
6. Dividends:
The call option price is lower at the ex-dividend date compared to the pre-
dividend date. The change in stock prices during the ex-dividend period would be
lower, hence, the call price would also be lower.

Read about;
(i) Gains / losses to the option buyer and option writer
(ii) Black Scholes option pricing model.

OPTION FINANCING
 Option financing provides a variance from the traditional methods of
financing.
 The main focus of option financing is to make the traditional means of
financing more attractive so that the firm can find it easier and cheaper to
raise funds.

Types of Option Financing:


There are 3 main types of option financing;
i. Warrants
ii. Convertible Debentures
iii. Exchange Loans

Warrants:
 A warrant is defined as an option to buy shares in a company at a stated price
usually within a stated period.
 The option to acquire the company stock is normally tied to issuance of debt
by the company.
 The mechanism is worked out in such a way that investors who purchase
debt securities of the company are at the same time given an option to
acquire a number of shares in the company for every debt security held.

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 The investor can exercise the option to acquire shares when this exercise is
beneficial to the investor.
 If it is anticipated that the share prices of the company will increase in future,
then the investor acquiring the debt security in the company stands to gain.
 Warrants are commonly issued as “Sweeteners” with an issue of debt stock.

Example:
MTN issues 10% unsecured loan stock 2009/2014 as part of its efforts to raise
funds for its expansion programmes. Accompanying the loan stock are
subscription rights (warrants) on the basis that holders of UGX100,000 loan
stocks could subscribe for up to 100 shares in MTN at a price of UGX1,800 per
share. The option can be exercised anytime between 2009 and 2014.

Required:
Determine when the investor should exercise the option.

Solution:
Investors will exercise their rights if it is profitable to do so.
The warrants issued by MTN would be worth exercising if the share price of MTN
rises beyond UGX1,800, e.g. if the share price rises to UGX2,200, then the value
of the warrant would be;

MP – SP

Where; MP = Market Price


SP = Strive Price
2,200 – 1,800
= 400

If the share price fell below Ug.Shs.1,800, the warrant would be worthless.
The value of the warrant can also be measured as the Present Value (PV) of the
difference between the future price of the share and the exercise price of the
warrant which can be expressed as;
Pw = Mo (1+g)n
(1 + K)n

Where ;
Pw = Price/Value of the warrant
Mo = Current market price of the share, which is prompting the warrant to
be exchanged.
K = Cost of capital appropriate to the warrant’s risk class.
g = Expected growth rate of the share
n = Number of years left to expiry of the warrant.

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In the MTN example, assume the cost of capital is 20% and the expected growth
rate of the share is 10%, determine the price of the warrant.

= 2,200(1+10%)4
(1+20%)4
= 2,200(1.1)4
(1.2)4
= 2,200(1.4641)
2.0736
= 3221.02
2.0736

= 1,553.35

Therefore the price of the warrant = UGX 1,553.35.

This means that if the investor has to wait up to the expiry period to exercise the
warrant, the present value of his warrant would be worth more than the exercise
price of Ug.Shs.1,800 and therefore exercise the warrant.

Convertible Securities:
 These are fixed income securities e.g. debentures, bonds, preference shares,
which at the option of the holder may be converted into shares in the
company under specific terms.

 The conversion takes place at a conversion price and a conversion ratio.

 A conversion ratio is the number of ordinary shares to which an investor


holding fixed income securities is entitled.

 A conversion price is the price at which each investor actually acquires the
shares.

Illustration:
Assume MTN issues a bond whose face value is Ug.Shs.100,000 and the
investor has an option to convert these bonds into 40 shares of the company at
an agreed future date.

The conversion price would be;

CP = Face Value of the Bond_________


No. of shares to which the investor is entitled

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= 100,000
40

= UGX 2,500
The investor would exercise the option as soon as the market price of the shares
exceed the conversion price of UGX 2,500 as this would be the most beneficial
point of making the conversion.

While the Conversion Ratio would be ;

CR = Face Value of the Bond


Conversion Price

= 100,000
2,500

= 40 shares

The conversion price and conversion ratio are normally fixed or revised in such a
way that the debt holder would have a net gain or benefit when the option is
exercised.

Note that;
In convertible securities, no new or additional funds are raised except that debt
financing is converted to equity. The leverage position improves, making it easy
to raise additional funds.

Conversion Value of Convertible Debentures


 For an investor considering converting the debenture at sometime in future,
the yield he can expect to receive can only be determined by forecasting the
expected share price.

 The value of the shares to be received at the time of conversion can be


expressed as;

Ct = PO(1+g)n R

Where;
Ct = Conversion Value at time t
PO = Share price today
g = Estimated annual percentage rate of growth of the share
price
R = Number of shares to be received on conversion of one
debenture
n = The number of years to conversion.

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Example;
Using the previous example of the current share price being UGX 2,200, face
value of debentures being 100,000 and the conversion price being UGX 2,500,
growth rate of the share is 10% and the number of years remaining the expiry is
4 years.

Determine the conversion value of the convertible debentures

Solution:
Conversion Ratio = 100,000 = 40
2,500

Therefore, Ct = 2,200(1.1)4 x 40
= 2,200 x 1.4641 x 40

= UGX 128,840.80

The conversion value is higher than the face value of the bond and therefore, the
conversion is worth exercising.

In addition to receiving shares at a date in the future if and when the conversion
is exercised, the holder also receives intervening period interest on the
debenture.

Therefore, the total value is; TV = I1 + I2 + … + In + PO(1+g)n R

Where; TV = Total value to debenture holder


In = Interest paid on the debenture up to year n

Advantages of Convertible Securities


i. It enables the financial manager to avoid cash outflow at the time when
the debt matures.
ii. Financing of the firm can be done at a low cost because the conversion
option enables loans to be raised at below normal interest rates.
iii. They are attractive alternative source of financing when share prices are
depressed. Convertible Securities offer a “back door” share issue method.
iv. They make loans self liquidating i.e. when loans are converted to shares
the problem of repayment disappears.
v. Small and medium firms find use of convertible securities easier to attract
investors as they act as sweeteners in buying securities in the company.

Exchange Loans:
This is when a firm issues debt securities and gives investors an option to
acquire shares in another company.

Illustration:

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Assuming DFCU Ltd has shares in DFCU Bank. If DFCU bank is growing fast
and wishes to expand or diversify its operations into mortgages, it can issue
bonds to investors worth say Ug.Shs.10 billion with an option for the investors to
acquire shares in DFCU Ltd.

Similarities and Differences:


 The difference between warrants and convertible securities is that warrants
entitle their holders to acquire shares in the company, hence new funds are
raised while convertible securities enable their holders to convert its financial
instruments from debt to equity securities, hence no new funds are generated
except that the leverage of the firm improves, enabling them to borrow more.

 The difference between Warrants and Exchange Loans is that for warrants,
the option is given to the debt holders to acquire ordinary shares within the
same company at a stated price and date. While for exchange loans, the
option is given to the debt instrument holders to acquire shares in another
sister company.

Credit Default Swaps (CDS)


 A CDS is a credit derivative contract between two parties.

 It is a bilateral contract to transfer credit risk from one party to the other.

 For example (i.e) one party buys credit protection (protection buyer) from
another party (protection seller) to cover a possible loss of the face value on
an asset following a credit event, which could either be default or bankruptcy.

 A CDS is, therefore, a contract in which the protection buyer makes a series
of payments to the protection seller in exchange for a pay off or a single
payment of the face value of the underlying asset (a bond or a loan) in case
the bond or loan goes into default or the issuing company goes into the
bankruptcy.

 This is profitable for banks during boom economic period and a disaster
during recession like now. The magnitude of a possible problem is not yet
known.

Illustration:
An investor buys a CDS from Bank X where the underlying asset is a bond from
company Y. The investor pays periodic premium legs to X until maturity in case of
no credit event. But if company Y defaults on its debt obligation and does not
repay for example coupons, the investor will receive a one-off payment from

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Bank X and the CDS contract is terminated. If the investor actually owns a bond
from Y company, the CDS can be thought of as hedging. Investors can also buy
CDS contracts referencing Y company bond without actually owning any Y
company debt. This is for speculative purposes, betting against the solvency of
Y Company in order to make money if it fails. against the solvency of Y company
in order to make money if it fails

Protection Buyer (Investor)

t1 t2 t3 t4 Credit Event

to Protection Seller tn
Bank X

In the above diagrammatic illustration, the protection buyer pays premium


legs in periods t1 to t4 when no credit event has occurred and would have
continued paying up-to maturity/expiry tn in case no credit event occurs.

 In case of a credit event after t4, the protection seller pays a protection leg,
which is a one-off payment equivalent to the face value of the underlying
asset such as the bond

If the reference entity (Company Y) defaults, one of the two things can happen;

i. Either the investor delivers a defaulted asset to Bank X for a payment of


the par value. This is known as physical settlement.

ii. Or Bank X pays the investor the difference between the par value and the
market price of the specified underlying asset (bond or loan). This is
known as cash settlement (this is when the protection buyer is
speculated).

The price or spread of a CDS is the annual amount the protection buyer must
pay the protection seller over the length of the contract, expressed as a
percentage of the notional amount.

Illustration:

26
If the notional sum of the bond is US$ 10 million and the investor pays US$
50,000 per annum as a premium leg, therefore, the price or spread of the CDS is

Premium Leg x 100


Notional Value

= 50,000 x 100
10,000,000

= 0.5%

The premium leg payments continue until either the CDS contract expires or until
Y company defaults.
A company with a higher CDS spread is considered more likely to default by the
market, since a higher fee is being charged to protect this against happening and
vice versa.

Uses of a CDS

Some of the main applications of the CDS are;

i. The CDS has revolutionalised the credit market and made it easy to short
credit risk. This is very useful for those investors wishing to hedge current
credit exposure or those wishing to take a bearish credit view.

ii. CDS are customizable in terms of maturity, seniority and currency.


However, deviation from the market standard may incur a liquidity cost.

iii. CDS can be used to take a spread view on credit just as with a bond. An
investor can unwind his CDS contract (sell it) in order to realize some
mark-to market gain or loss owing to changes in the CDS spread.

iv. Liquidity in the CDS market can be better than the cash market (trading in
bonds) due to the fact that a physical asset does not need to be sourced,
meaning that it is generally easier to transact in large round sizes with the
CDS.

v. Like most financial derivatives, CDS can be used by investors for hedging,
arbitrage and speculation.

It is used for hedging if the investor is holding the underlying asset, arbitrage if
there is mispricing in the credit risk or spreads and speculation when the investor
bets on possible default or insolvency of the bond issuer.

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Pricing and Valuation of the CDS

Pricing of the CDS is based on two models.

i. The Probability Model


ii. No Arbitrage Model by Darrel Duffie and also by Hull and White.

1. Probability Model
This model takes into account the present value of a series of cash flows
weighted by their probability of non-default.

This method suggests that Credit Default Swaps should trade at a considerably
lower spread than corporate bonds.

Under this model, CDS is priced using 4 inputs;

a) The issue premium


b) The recovery rate (percentage of notional repaid in the even to a default)
c) The credit curve for the reference entity (company issuing the bond) and
d) The LIBOR curve.

If default never occurred, the price of a CDS would simply be the sum of the
discounted premium payments.

So the CDS pricing models have to take into account the possibility of a default
occurring sometime between the effective date and the maturity date of the CDS
contract.

If we assume that defaults can only occur on one of the payment dates, then the
contract could end by;

a) Either it does not have any default at all, and so the premiums payments
are
made and the contract survives until the maturity date,

OR

b) A default occurs on the first, second, third or fourth payment date. To price
the
CDS we now need to assign probabilities to the 5 possible outcomes (i.e.
outcome in (a) and 4 outcomes in b)), then calculate the present value of
the pay off for each outcome.

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The present value of the CDS is then simply the present value of the 5 pay offs
multiplied by their probability of occurring.

PV at Default time t1 (1 – P1) N(1 – R) δ1

at default time t2 +P1(1 – P2) N(1 – R) δ2 - NC δ1


4

at default time t3 + P1P2(1 – P3) N(1 – R) δ3 - NC (δ1+ δ2)


4

at default time t4 + P1P2P3(1 – P4) N(1 – R) δ4 - NC (δ1+ δ2 + δ3)


4

No default-P1P2P3P4(δ1 + δ2 + δ3 + δ4) NC
4
Where;
P1 = Probability of default in period t i (can be calculated using the
credit spread curve)
R = Recovery Rate
N = Notional Amount
C = Premium of the CDS
δ1 = Discount Factors

Description Premium Payout PV Default Payout Probability


PV
Default at time t1 0 N(1 – R) δ1 1 – P1
Default at time t2 + NC δ1 N(1 – R) δ2 P1(1 – P2)
4
Default at time t3 + NC (δ1 + δ2) N(1 – R) δ3) P1P2(1 – P3)
4
Default at time t4 + NC (δ1 + δ2 + δ3) N(1 – R) δ4) P1P2 P3(1 – P4)
4
No Default - NC (δ1 + δ2 + δ3 +δ4) 0 P1 x P 2 x P3 x P 4
4

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2. No Arbitrage Model
The Duffie approach is frequently used by the market to determine theoretical
prices.
Under the Duffie construct, the price of the credit default swap can be derived by
calculating the asset swap spread of a bond. If a bond has a spread of 100, and
the swap spread is 70 basis points, then a CDS contract should trade at 30,
i.e.100 – 70. However, there are some technical reasons why this will not usually
be the case, and this may or may not present an arbitrage opportunity for the
investor. The difference between the theoretical model and the actual price of a
credit default swap is known as the basis.

Criticisms
i. Critics of huge credit default swap market have claimed that it has been
allowed to become too large without proper regulation.

ii. Because all contracts are negotiated, the market lacks transparency.

iii. There are claims that CDS exacerbated the 2008 global financial crisis by
hastening the demise of companies such as Lehman Brothers and AIG.

In the case of Lehman Brothers, it is claimed that the widening of the


bank’s CDS spread reduced confidence in the bank and ultimately gave it
further problems that it was not able to overcome in that US$ 400 billion
notional value of CDS protection, which had been written on the Bank
needed a net payout of US$366 billion to the protection buyers, resulting
in its bankruptcy.

iv. It is estimated that the CDS market has grown to US$62 trillion against
corporate debt of about US$17 trillion. This could be a recipe for further
global financial crisis.

United States (US) authorities are working on an establishment of a


central exchange or clearing house for CDS trades to mitigate counter
party risks of default.

v. One-Off Major Expenditure


A single non-recurring item of expenditure such as repayment of a large
loan on maturity or purchase of an exceptionally expensive item may
create a cash flow problem.

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