5/10/2011

Financial risks

• Price risk
• Interest rate risk
• Credit / Default risk
Derivatives and Risk
• Foreign currency risk
Management
(Adapted from Prof. Dani Salazar’s Slides)
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What is a financial derivative? Uses of derivatives

A derivative is an instrument • Hedge

whose value depends on the • Arbitrage
values of other more basic • Speculate

underlying variables.

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Basic forms of derivatives What is a forward contract?

• It is an agreement to buy or sell an asset

Commitments Contingents
at a certain time in the future for a certain
price
• Over the counter securities
Forwards Options
• Forward contracts are popular on
currencies and interest rates
Futures

Swaps
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Futures contract Swaps

• An agreement to buy or sell an asset at a • Promise to exchange cash flows at

certain time in the future for a certain price
• Futures are exchange-traded.
• Examples of underlyings of futures
contract: commodities, interest rates
various future time periods.
• Cash flows maybe based on different
underlyings such as return on equity
markets, return on bonds markets, etc.

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Options Commitments versus contingents

• A call option is an option to buy a certain
asset by a certain date for a certain price
(the strike price)
• A put option is an option to sell a certain
asset by a certain date for a certain price
(the strike price)
• A commitment contract gives the holder
the obligation to buy or sell at a certain
price
• A contingent gives the holder the right to
buy or sell at a certain price. Such rights
are exercised only when it is beneficial to
the holder of the right.

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Roadmap

• For each of the basic form of derivative,

the following subtopics will be discussed:
– Nature
– Pricing
– Pay-off
– Valuation
F
– Application
FORWARDS AND FUTURES

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Difference between Forwards and

Forwards
Futures
• A forward contract is an agreement to
buy (long position) or sell (short position) Forward Futures
an asset in the future at an agreed price Private contract between two Traded on an exchange
parties
(delivery price) today
Not standardized Standardized
• The asset could be a stock, a foreign Usually one specified delivery Range of delivery dates
date
currency, another financial instrument
Settled at end of contract Settled daily
(e.g. bond) Delivery or final settlement usual Usually closed out prior to
maturity
Some credit risk Virtually no credit risk

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Price versus value Forward price

• For futures or forward, price is the contracted rate f0(T) = S0 (1+r)T

of future purchase.
• It is the future value of the underlying. Definition:

• Value is similar to profit from the forward or f0(T) = Forward price at time 0.
futures contract.
• At date of contract, value of forward and futures is zero. S0 = Spot price of the underlying at time 0.
• Why?

r = risk-free rate

T = Number of days before expiration

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Example Forward price of Equity

The spot price of gold is 600. The one year f0(T) = (S0 – D) (1+r)T
interest rate is 5%. What should be the Definition:
forward price of a gold forward to be
delivered one year from now. f0(T) = Forward price at time 0.
S0 = Spot price of the underlying stock at
In our examples, S=600, T=1, and r=0.05 time 0.
so that D = Present value of dividends to be
F = 600(1+0.05) = 630 received prior to expiration of forward
r = risk-free rate
T = Number of days before expiration

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Forward price of Equity Forward price of foreign currency

f0(T) = (S0 – D) (1+r)T f0(T) = S0 (1+r1)T /(1+r2)T

Definition:
Example:
S0 = Spot price of ABC stock is P10. f0(T) = P / $ (1+rP)T /(1+r$)T
D = ABC declared cash dividends of P2 to
Definition:
be paid 30 days from today. PV of P1.99
r = 30 - 60 days zero-coupon rate is 6% p.a f0(T) = Forward price at time 0.
T = 60 days S0 = Spot price of the underlying currency at
time 0.
f0(T) = (10 – 1.99) (1+6%)60/360 r = risk-free rate
f0(T) = 8.088 T = Number of days before expiration
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Example Pay-off

f0(T) = P / $ (1+rP)T /(1+r$)T • On the date of expiration, the long pays

Definition:
the forward price (F).
• And receives delivery of the underlying
f0(T) = Forward price at time 0. (Stm).
S0 = Spot price of peso is P 46 = $1.
rP = 30 days peso zero-coupon bond is 3%. Mathematically:
r$ = 30 days peso zero-coupon bond is 1%. Pay-off = Stm – F
T = 30 days

f0(T) = P 46/ $1 (1+3%)30/360 /(1+1%)30/360 If S > F, the long is a net receiver.

f0(T) = 46.075 If S < F, the short is a net payor.
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Profit from a Profit from a

Long Forward Position Short Forward Position

Profit Profit

Price of Underlying Price of Underlying

K at Maturity, ST K at Maturity, ST

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What is the value of a forward? Value of forward at time 0

Vt(T) = St - f0(T)/(1+r1) T-t Vt(T) = St - f0(T)/(1+r1) T-t

Definition Vt(T) = 600 - 630/(1+5%) 1
f0(T) = Forward price at time 0. Vt(T) = 600 – 600
S0 = Spot price of the underlying at time t. Vt(T) = 0
r = risk-free rate Definition

t- T= time to expiration f0(T) = Forward price at time 0 = 630.

S0 = Spot price of the underlying at time t = 600.
r = risk-free rate = 5%
t- T= time to expiration = 1 year

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Value of forward 6 months from

now when spot is 610.
Vt(T) = St - f0(T)/(1+r1) T-t
Vt(T) = 610 - 630/(1+5%) 6/12
Vt(T) = 610 – 614.82
Vt(T) = - 4.82
Definition

f0(T) = Forward price at time 0 = 630.

S0 = Spot price of the underlying at time t = 610. SWAPS
r = risk-free rate = 5%
t- T= time to expiration = 30 days

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Nature Examples:

• A swap is an agreement to exchange cash • Plain vanilla interest rate swap

flows at specified future times according to • Foreign currency swap
certain specified rules • Equity swap
• Equity for bond swaps

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Uses of an Interest Rate Swap Valuation of an Interest Rate Swap

• Converting a liability from

– fixed rate to floating rate
– floating rate to fixed rate
• Converting an investment from
– fixed rate to floating rate
– floating rate to fixed rate
• Portfolio of bonds = Difference between
the Value of a fixed-rate bond and the
value of a floating-rate bond
• Portfolio of forwards = Values of
different cash flows at different periods.

FVTPL - Swaps

A speculator is expecting interest rates to go down. On Period 180 day

January 1, he entered in a 2 year plain-vanilla interest
treasury rates
January 1, 2003 3%
rate swap to receive a fix interest rate of 6% and pay
June 30, 2003 4%
floating equivalent to 180-day treasury rate + 3%. The
December 31, 2003 2%
nominal principal is P5 Million. The counterparties
agreed to swap every June 30 and December 31. The
180-day treasury on January 1 is 3%.
FVTPL - Swaps

FVTPL - Swaps Swap

FVTPL - Swaps
June 30
Value of Swap
180-day treasury rate= 3%.
Date of inception
Point of view of the speculator.
(3%+3%)X P5M [fl]
Value of fixed income investment P 5 Million
Counter-
coupon rate: 6% Speculator
Party
floating rate: 3% + 3%
6% X P5M [fix]
Value of floating rate borrowings ( 5 Million)
Value of swaps - 0 - No payment on June 30, first swap period

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Swap
FVTPL - Swaps Value of Swap FVTPL - Swaps
December 31 On Balance Sheet Date (December 31)
180-day treasury rate= 4%. 180-day interest rate = 2%
Point of view of the speculator.

(4%+3%)X P5M X 6/12[fl] Value of fixed income investment P 5.048 Million

Counter-
coupon rate: 6%
Speculator discounting rate: 2% + 3%
Party

6% X P5M X 6/12 [fix] Value of floating rate borrowings ( 5 Million)

Value of swaps P 0.048 Million
Speculator is net payor of P25K
Therefore, the swap is a derivative asset
to the speculator.

Swap
Principal 5,000,000.00 June 30, Y2
market rate 5% 180-day treasury rate= 2%.

coupon 6%
remaining swap period 2 (2%+3%)X P5M X 6/12[fl]
Counter-
Speculator
Party

PV of principal 4,759,071.98 6% X P5M X 6/12[fix]

PV of interest 289,113.62 Speculator is net receiver of P25K

PV of fixed income 5,048,185.60
FVTPL - Swaps
Value of Fixed Income Investment

Currency swaps Uses of a Currency Swap

• Counterparties swapped principal at the • Conversion from a liability in one currency

beginning of the contract. to a liability in another currency
• Interest are paid periodically based on the
currency received and agreed upon • Conversion from an investment in one
interest rate. currency to an investment in another
• Counterparties return the principal at the currency
end of the swap contract.

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Valuation of Currency Swaps

Like interest rate swaps, currency

swaps can be valued either as the
difference between 2 bonds or as a
portfolio of forward contracts

OPTIONS

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Options Option Positions

• A call is an option to buy

• A put is an option to sell
• A European option can be exercised only
at the end of its life
• An American option can be exercised at
any time

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Long Call
Short Call
Profit from buying one European call option: Profit from writing one European call option: option
option premium = $5, strike price = $100. premium = $5, strike price = $100
Profit ($)
30 Profit ($)
5 110 120 130
20 0
70 80 90 100 Terminal
10 -10 stock price ($)
Terminal
70 80 90 100 stock price ($)
0 -20
-5 110 120 130
-30
Profit = Spot – Exercise price – premium paid Profit = Exercise price + premium paid - Spot

Profit = – premium paid Profit = + premium paid

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Long Put Short Put

Profit from buying a European put option: option Profit from writing a European put option: option
premium = $7, strike price = $70 price = $7, strike price = $70
30 Profit ($) Profit ($)
Terminal
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20 40 50 60 stock price ($)
0
70 80 90 100
10 Terminal
stock price ($) -10
0
40 50 60 70 80 90 100 -20
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-30
Profit = Exercise price - Spot – premium paid Profit = Spot + premium paid – Exercise price

Profit = – premium paid Profit = + premium paid

Payoffs from Options Terminology: Moneyness :

K = Strike price, ST = Price of asset at

maturity

Payoff Payoff
 At-the-money option
K  In-the-money option
K ST ST  Out-of-the-money option

Payoff Payoff
K
K ST ST

Simple Option Pricing Factors affecting option value

 Price of underlying
X
c = ( S0 − ) or 0  Strike price or exercise price
(1 + r ) t  Time to maturity (life of option)
X  risk-free interest rate (corresponding to
p=( − S 0 ) or 0 option maturity; continuously
(1 + r ) t compounded)
 volatility of asset price

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References:

• Hull, John. 2007. Fundamentals of

Futures and Options Markets, 6th Edition
• Brooks, Robert. Don Chance. 2008.
Derivatives and Risk Management Basics

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