CH 18

CHAPTER 18
DERIVATIVES AND RISK MANAGEMENT

BENEFITS AND
CRITICISMS OF
DERIVATIVES
RISK MANAGEMENT
▪ The most important purpose of the derivatives market
▪ Financial derivatives provide a powerful tool for limiting risks that
individuals and firms face in the ordinary conduct of their business.
INVESTORS:
IMPROVE MARKET
EFFICIENCY
▪ Derivatives provide an
alternative for investing in
the underlying assets.
PRICE DISCOVERY
▪ Futures, forwards and swaps provide valuable information about the
prices of the underlying assets.
▪ Options provide information on the price volatility of the underlying assets.
COMPLEXITY
▪ This means that sometimes the parties that use them don't understand
them well.
▪ They are often used improperly, leading to potentially large losses.
DIRECTION AND MARKET TIMING
▪ Investors must accurately predict the direction in which the market or
index will move (up or down) and the minimum magnitude of the move
during a set period of time.
LIFESPAN
Derivatives are "time-wasting" assets. As each day passes and the
expiration date approaches, you lose more and more "time" premium and
the option's value decreases.
STRUCTURED NOTES
• A debt obligation derived from another debt obligation.
• It is a debt obligation that contains an embedded derivative
component that adjusts the security’s risk/return profile.
• a debt security.
Underlying Pieces
Bond Component Derivative Component
• Provide principal protection • Provide exposure to any asset

class.
Potential Risks
• Market risk
• Liquidity
INVERSE FLOATERS
• FRN is a fixed income security that makes coupon payments that
are tied to a reference rate.
• Interest rises, value of coupon would increase.

AN INVERSE FLOATER:
• A note in which the interest rate paid moves counter to market
rates.
• Also known as inverse floating rate note.
• Adjusts its coupon payment as the interest rate changes.
• If interest rates in the economy rose, the interest rates paid on an
inverse floater would fall, lowering its cash interest payments.
• Exceptionally vulnerable to increases in interest rates.
• If interest rates fall, value of inverse floaters increases.
Exotic Options
Types of exotic options:
• Chooser option
• Barrier options
• Asian options
• Digital options
• Compound options
FORWARD RATE AGREEMENT (FRA)
An over-the-counter contract between two parties who want to

protect themselves against future movements in interest rates.
The buyer is borrowing and the seller is lending a notional sum at

a fixed interest rate (the FRA rate) and for a specified period of
time starting at an agreed date in the future.
INTEREST RATES BORROWER LENDER
will PAY the

will be protected,
difference
will have a GAIN
will PAY the

will have a GAIN
difference
WAITING PERIOD The period comprised between the spot date (d1)
and the settlement date (d3)
CONTRACT PERIOD The time between the settlement date and maturity
date of the notional loan. This period can go up to 12
months.
Date when the FRA is

negotiated Contract period begins
the notional loan is
deemed to expire
when the transaction is carried out as
soon as practical. Usually 2 days after
trade date
FD-the reference rate is determined
For example:
if a borrower of an FRA wished to hedge against a rise in rates to
cover a three-month loan starting three months time, she would
transact a three-against-six month FRA (3 x 6)– this is referred to
as a three-sixes FRA- and it means a three-month loan beginning
in three months time
WAITING PERIOD CONTRACT PERIOD
3 months 3 months
Spot date Settlement date Maturity date

Ones-fours FRA (1 x 4)- it means a three-month loan in one month time
1 months 3 months

Three-nines FRA (3 x 9)- it means a six-month loan in three months time
3 months 6 months

COMPUTATION
FOR THE SETTLEMENT AMOUNT
OF AN FRA
The amount to be exchanged on settlement date

COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA
Step 1 – Calculation of the interest differential

The interest differential is the result of the comparison between the FRA
rate and the settlement rate. It is calculated as follows:
Interest differential
=(Settlement rate − Contract rate) × (Days in contract period/360) × Notional amount
Step 2 – Calculation of the settlement amount
Settlement amount
= Interest differential / [1 + Settlement rate × (Days in contract period / 360)]
A corporation learns that it needs to borrow $1M in six-months time for a six month period.
Let us further assume that the 6-month Libor currently is at 0.89465%, but the company’s
treasurer thinks it might rise as high as 1.30% over the forthcoming months. The treasurer
choses to buy a 6x12 FRA in order to cover the period of 6 months starting 6 months from
now. He receives a quote of 0.95450% from his bank and buys the FRA for a notional of
$1M on April 8, 2016.
On the fixing date (October 10, 2016) the 6-month LIBOR fixes at 1.26222%, which is the
settlement rate applicable for the company's FRA.
As anticipated by the treasurer, the 6-month Libor rose during the 6-month waiting
period, hence the company will receive the settlement amount from the FRA seller.
6 x 12 FRA
Trade date- April 8, 2016 Notional Amount- $1M
Spot date- April 10, 2016 Contract rate- .95450%
Fixing date- October 10, 2016 Settlement rate- 1.26222%
Settlement date- October 12, 2016
Maturity date- April 12, 2017 Contract Period – 182 days
Step 1
Interest differential= (settle. rate- contract rate) x (days in contract period/360)x Not. amt
= (1.26222% - .95450%) x (182/360) x $1M
= $1,555.70
Step 2
Settlement amount= int. diff / [1 + settle. Rate x (days in contract period/360)]
= $1,555.70 / [1 + 1.26222% x (182/320)]
= $ 1,545.83
As anticipated by the treasurer, the 6-month Libor rose during the 6-month waiting
period, hence the company will receive the settlement amount from the FRA seller.
• If settlement rate > contract rate, the FRA buyer receives the settlement amount
• If contract rate > settlement rate, the FRA seller receives the settlement amount
• If settlement rate = contract rate, no settlement amount is being paid
6 x 12 FRA
Trade date- April 8, 2016 Notional Amount- $1M
Spot date- April 10, 2016 Contract rate- .95450%
Fixing date- October 10, 2016 Settlement rate- 1.26222%
Settlement date- October 12, 2016
Maturity date- April 12, 2017 Contract Period – 182 days
Step 1
Interest differential= (settle. rate- contract rate) x (days in contract period/360)x Not. amt
= (1.26222% - .95450%) x (182/360) x $1M
= $1,555.70
Step 2
Settlement amount= int. diff / [1 + settle. Rate x (days in contract period/360)]
= $1,555.70 / [1 + 1.26222% x (182/320)]
= $ 1,545.83
LENDER BORROWER
$ 1,545.83
BY: BELGICA, TZIPORAH BIANCA G.
RISKS
USING FUTURES
WHAT IS HEDGE?
• A hedge is an investment to reduce the risk of
adverse price movements in an asset. Normally, a
hedge consists of taking an offsetting position in a
related security, such as a future contract.
Situations in which aggregate risks can be reduced

by derivatives transactions between two parties
known as counterparties.
WHAT IS FUTURES CONTRACT?
• Standardized contracts that are traded on
exchanges and are “marked to market” daily,
but where physical delivery of the underlying
asset is never taken.
• Can be establish a long(or short) position n
the underlying commodity/asset.
• Definite agreement on the part of one party to
buy something on a specific date at a specific
price, and the other party agrees on the same
terms.
WHAT IS FUTURES CONTRACT?
Forward contracts have two limitations:
1. Illiquidity
2. Counter-party risk
Future contracts are designed to address these

limitations.
FEATURES OF FUTURES
CONTRACT
• Standardized contracts:
1. Underlying commodity or asset
2. Quantity
3. Maturity
• Traded on exchange
• Guaranteed by the clearing house – little counter-party
risk
• Gains/losses settled daily – marked to market
• Margin account required as collateral to cover losses
CLASSES OF FUTURES
A.Commodity Futures
> A contract that is used to hedge against price
changes for input materials
B. Financial Futures
> A contract that is used to hedge against
fluctuating interest rates, stock prices, and
exchange rates
LONG AND SHORT HEDGES
Long Hedges Short Hedges
• Appropriate when you • Appropriate when you
know you will purchase know you will sell an
an asset in the future asset in the future &
and want to lock in the want to lock in the
price price
• Futures contracts are • Futures contract are
bought in anticipation sold to guard against
of price increases price decline
Basis Risk
• Basis is the difference between spot
price & futures price
• Basis risk arises because of the
uncertainty about the basis when
the hedge is closed out
Long Hedge
• Suppose that
F1 : Initial Futures Price

F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future purchase of an asset by entering into a
long futures contract
• Exposed to basis risk if hedging period does not match
maturity date of futures
Long Hedge
• Cost of Asset = Future Spot Price - Gain on Futures
Gain on Futures = F2 - F1
Future Spot Price = S2
• Cost of Asset= S2 - (F2 - F1)
• Cost of Asset = F1 + Basis2
Basis2 = S2 - F2
• Future basis is uncertain

• Therefore, effective cost of asset hedged is uncertain
Short Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
• You hedge the future sale of an asset by entering
into a short futures contract
Short Hedge
• Price Realized = Gain on Futures + Future Spot Price
Gain = F1 - F2
• Price Realized = S2 + (F1 - F2 )
• Price Realized = F1 + Basis2
Basis2 = S2 - F2
Price Realized = Cost of Asset

LONG AND SHORT HEDGES
• Cost of Asset • Price Realized = Gain on Futures +
= Future Spot Price - Gain on Future Spot Price
Futures 1.Gain = F1 - F2
1. Gain on Futures = F2 - F1
2. Future Spot Price = S2
2. Future Spot Price = S2
• Price Realized = S2 + (F1 - F2 )
• Cost of Asset= S2 - (F2 - F1)
• Price Realized = F1 + Basis2
• Cost of Asset = F1 + Basis2
Basis2 = S2 - F2 Basis2 = S2 - F2
Example
• Hedging period 3 months
• Futures contract expires in 4 months
• We’re exposed to basis risk
• Suppose F1 = $105 and S1 =100
• Current basis = 100 - 105 = -5
• Basis in 3 months is uncertain
• If F2 = 110 and S2 = $102
• What is basis in 4 months?
A. LONG HEDGE
Cost of Asset = Future Spot Price - Gain on Futures
Gain on Futures = F2 - F1
Cost of Asset = $102 – ( $110 – $105)

= $97
B. SHORT HEDGE
Price Realized = Gain on Futures + Future Spot Price
Gain = F1 - F2
Price Realized = ($105 – $110) + $102

= $97
RECORDING OF PROFITS AND LOSSES
Assume that the spot price of gold is

$400, and that a three-period futures
contract on gold has a price of $415.
TIME PERIOD GOLD FUTURES BUYER’S SELLER’S
CONTRACT FUTURES CF FUTURES CF
1 $420 $5 -$5
2 $430 $10 -$10
3 $425 -$5 $5
Net $10 -$10
The net cash flow from the seller to the

buyer is $10.
Computation for savings
from LONG HEDGING and
SHORT HEDGING, MARGIN
ACCOUNT BALANCES, GAIN
(LOSS) and VARIATION
MARGIN
VILLACENCIO, Marie Ann A.
Problem 1 (Long hedging)
• An aluminum refiner wants to hedge its anticipated October aluminum demand of
60,000 lbs. per month. It is currently July 1st.
• Each contract is for 26,000 lbs. The initial margin is $10,750 and the maintenance
margin is $8,500.
60,000 lbs.
1 contract = 26,000 lbs x 2
= 52,000 lbs.
Initial cash flow (using initial margin):
2 x 10,750 = 21,500 x 3 mos.
= $64,500
Assume the price of aluminum is currently $1.50/ lb and the average aluminum prices
for the next 3 months are $1.25 (August), $1.00 (Sept.), $0.80 (Oct.). How much did your
firm save compared to the current price?
Aluminum Savings:
Current Price = $1.50/lb
Aluminum savings in Aug. = 60,000($1.50-$1.25)
= $15,000
• Aluminum savings in Sept. = 60,000($1.50-$1.00)

= $30,000
• Aluminum savings in Oct. = 60,000($1.50-$0.80)
= $42,000
Total gain on aluminum savings = $87,000

Assume the futures price of the following 3 months are:
Aug. - $0.8974
Sept. - $0.8798
Oct. - $0.7658
Assume the futures contract closed at the following prices:

Aug.- $0.6813, Sept. - $0.4140, Oct.- $0.0999.
How much did you lose on your futures contracts?
Futures (Aug.) = 52,000($0.6813-$0.8974)

= -$11,237.20
• Futures (Sept.) = 52,000($0.4140-$0.8798)
= -$24,221.60
• Futures (Oct.) = 52,000($0.0999-$0.7658)
= -$34,626.80
Total loss on futures = $70,085.60

PROBLEM 2 (Short hedging)
• On August an aluminum producer wants to hedge approximately 250,000 lbs. of his
October production to guard against the possibility of falling prices.
• So he short hedges by selling 40 October aluminum futures contracts at $1.38/lb.
Both cash and futures prices have subsequently fallen.
• On October 1, when the producer sells aluminum to the local terminal, the price he
receives is $1.25/lb.
• The producer offsets his hedge, by purchasing October aluminum futures at $1.30/lb.
The transaction looks like this:
CASH MARKET FUTURES MARKET BASIS

Aug. Receives cash forward Sells Oct. aluminum -.10
(Oct.) bid at $1.28/lb. futures at $1.38/lb.
Oct. Sells cash aluminum at Buys Oct. aluminum -.05
$1.25/lb. futures at $1.30/lb.
The hedger sold aluminum for cash on the forward market at $1.25, and
$1.38 - $1.30 = 0.08 cents gain on the futures position.
And so it was as if he sold the commodity for $1.33. (1.25+0.08=1.33)
(1.33+1.25)/2 = $1.29 average sales price
Prices increase: (Short hedge)
Prices increase: (Short hedge)
CASH MARKET FUTURES MARKET BASIS

Aug. Receives cash forward (Oct.) bid at Sells Oct. metal futures at -.05
$1.30/lb $1.35/lb
Oct. Sells cash aluminum at $1.35/lb Buys Oct. metal futures at -.10
$1.45/lb
CHANGE $0.05/lb gain $.10/lb loss .05 loss
The hedge sold aluminum for cash on the forward market at $1.30,
lost 10 cents on the futures position,
so $1.30 – 0.10 = $1.20
(1.20+1.35)/ 2 = $1.275 average sales price
Margin Account
• Margin Account – is a brokerage account in which the broker lends the customer cash
to purchase securities. The loan in the account is collateralized by the securities and
cash.
• To use a margin account, an investor needs to post a certain amount of cash,
securities or other collateral, known as the initial margin requirement. (50%)
• Initial margin is the percentage of the purchase price of securities (that can be
purchased on margin) that the investor must pay for with his own cash or marginable
securities.
• Maintenance margin is the minimum amount of equity that must be maintained in a
margin account.
According to the Federal Reserve Board’s Regulation T, when buying on margin:
1. The minimum margin, which states that a broker can’t extend any credit to
accounts with less than $2,000 in cash or securities is the first requirement.
2. An initial margin of 50% is required for a trade to be entered
3. The maintenance margin says that you must maintain equity of at least 30% or be
hit with a margin call.
Problem 3 (Margin)
• You open a margin account and deposit $5,000.
• You sell short 1,000 shares of XYZ stock for $10 per share. The proceeds of the sale,
$10,000, is deposited in your account.
• There is now $15,000 in your account. However, you still only have $5,000 equity in
your account, because the $10,000 of short-sale proceeds is from borrowed securities.
• Scenario 1 – The stock price declines to $6 per share, so the 1,000 shares that you
sold short is currently worth $6,000. Thus:
Equity = Account value – Market Value of Shorted Security

= $15,000 – $6,000
= $9,000
Margin = Equity/ CMV (Current Market Value of shorted security)
= $9,000/ $6,000
= 1.5 x 100 = 150%
Net profit= 10,000 – 6,000 = $4,000 minus brokerage commissions

and any dividends that had to be paid while the stock was
borrowed.
Scenario 2 – The stock price rises to $12.00 per share, thus it will cost you $12,000 to
buy back the shares now.
Equity = $15,000 – $12,000

=$3,000
Margin = $3,000/ $12,000

=.25 x 100 = 25%
Current margin < 30%

25% < 30%, you will be subjected to a margin call.
Net loss = $10,000 - $12,000 = $2,000 plus brokerage commissions and

any dividends that had to be paid while the stock was borrowed
Variation Margin
• It is an additional amount of cash you are required to deposit to your
futures trading account after your futures position have taken sufficient
losses to bring it below the maintenance margin. (Margin account <
Maintenance Margin level)
• Also known as Mark to Market Margin
• Futures traders are typically required to provide variation margin

through “Margin Calls”
• Margin Call – when the broker tells you how much cash needs to be
provided in order to meet variation margin requirement.
• Variation Margin = Initial Margin – Margin Balance
Problem 4 (Variation Margin)
Zoro bought one futures contract and made $1,000 in initial margin requirement of $10.
Assuming the position has a maintenance margin requirement of $5 ($5 x 100 = $500)
1st Scenario: the underlying asset drops by $8 the very same day:
$10-$8= $2 x 100 = $200 margin balance
Variation Margin = Initial margin – margin balance
= $1,000 - $200
: = $800
2nd Scenario: the underlying asset drops by $6 the very
same day:
$10-$6= $4 x 100 = $400 margin balance
Variation Margin = $1,000 - $400

= $600
Valuation of
Options Using
Riskless Hedge
and Black-
Scholes Option
Pricing Model
Riskless Hedge
It is a hedge in which an investor buys a stock and
simultaneously sells a call option on that stock and ends up
with a riskless position.
1. Assumptions of the example
 Stock price: P40
 Exercise price: P35
 Ending Stock price: P30 or P50
 Risk-free rate: 8%
2. Find the range of values at expiration
Ending Option
Ending Stock Price Strike Price Value
Value
P30 – P35 = 0
P50 – P35 = P15
R: P20 P15
3. Equalize the range of payoffs for the
stock and the option.
Ending Ending
Ending Stock
Value of Value of
Price
Stock Option
P30 × 0.75 = P22.50 0

50 × 0.75 = 37.50 P15
R: P20 P15.00 P15
4. Create a riskless hedge investment.
Ending Ending Ending
Ending Value of Value of Total
Stock Stock in Option in Value of
Price the the the
Portfolio Portfolio Portfolio
P30 × 0.75 = P22.50 + 0 = P22.50

50 × 0.75 = 37.50 + -P15 = 22.50
5. Pricing the call option
 Find the present value of the ending total value of the
portfolio using the risk-free rate:
PV = P22.50/1.08 = P20.83
 Find the cost of the stock in the portfolio:
0.75(P40) = P30
 Price of option = Cost of stock – PV of portfolio
= P30 – P20.83 = 9.17
Black-Scholes Option Pricing Model
(OPM)
It is derived from the concept of a riskless hedge, this
model calculates the value of an option as the difference
between the expected PV of the terminal stock price and
the PV of the exercise price.
OPM Assumptions
 The stock underlying the call option provides no dividends or other
distributions during the life of the option.
 There are no transaction costs for buying or selling the stock or the
option.
 The short-term, risk-free interest rate is known and is constant during the
life of the option.
 Any purchaser of a security may borrow any fraction of the purchase
price at the short-term, risk-free interest rate.
 Short selling is permitted, and the short seller will receive immediately
the full cash proceeds of today’s price for a security sold short.
 The call option can be exercised only on its expiration date.
 Trading in all securities takes place continuously, and the stock price
moves randomly.
OPM Equations
−𝑟𝑓𝑟 𝑡
 V=P[N(𝑑1 )]-X𝑒 [N(𝑑2 )]
𝑃 𝞭2
ln + 𝑟𝑓𝑟 + 𝑡
 𝑑1 =
𝑋 2
𝞭 𝑡
 𝑑2 =𝑑1 −𝞭 𝑡
Legend
 V = current value of the call option
 P = current price of the underlying stock
 N(𝑑1 ) = probability that a deviation less than 𝑑1 will occur in a
standard normal distribution
 X = exercise price of the option
 e = 2.7183
 𝑟𝑓𝑟 = risk-free interest rate
 t = time until the option expires (the option period)
 ln(P/X) = natural logarithm of P/X
 𝞭2 = variance of the rate of return on the stock
OPM Illustration
Given:
 P = P21
 X = P21
 t = 0.36 year
 𝑟𝑓𝑟 = 5%
 𝞭2 = 0.09
OPM Illustration
21 0.09
ln 21 + 0.05+ 2 (0.36)
𝑑1 = = 0.19
0.3(0.6)
𝑑2 = 0.19-0.3 0.36 = 0.01
V = 21[N(0.19)]-21(0.98216)[N(0.01)]
= 21(0.5753)-20.625(0.504)
= 12.081-10.395
= P1.686
SWAPS
COMPUTATION OF GAIN (LOSS)
AND SETTLEMENT PRICE
SWAPS
• two parties agree to exchange obligations to make
specified payment streams
• an exchange of obligations
• based on a notional amount of principal
• percentage payments are based on a floating rate,

fixed rate, or the return on an equity index or
portfolio.
TERMS
NOTIONAL PRINCIPAL: amount used
to calculate periodic payments
FLOATING RATE: usually LIBOR
TENOR: time period covered by swap
SETTLEMENT DATES: payment due dates
EFFECTS OF SWAPS DUE TO
STANDARDIZED CONTRACTS
• standardized contracts lower the time and
effort involved in arranging swaps
– thus lowering transaction costs
• standardized contracts led to a secondary
market for swaps
– increasing the liquidity and efficiency of the
swaps market
CHARACTERISTICS OF SWAP
CONTRACTS
• custom instruments
• not traded in any organized
secondary market
• largely unregulated
• subject to default risk
• most participants are large
institutions
• private agreements
• difficult to alter or terminate
EXAMPLES
INTEREST EQUITY
SWAP SWAP
CURRENCY
SWAP
SWAPS
• except in the case of a
currency swap, no money
changes hands at the
inception of the swap and
periodic payments are
netted (the party that owes
the larger amount pays the
difference to the other)
IN A NUTSHELL
 When A loans money to B for a fixed
rate of interest and B loans the same
amount to A for floating rate of interest,
it is an interest rate swap
 When one of the returns streams is
based on a stock portfolio or index
return, it's an equity swap
 When the loans are in two different
currencies, it's a currency swap
INTEREST RATE SWAP
“fixed-for-floating (or vice versa)
interest-rate swap”
NOTE: notional principal is

generally not swapped at the beginning or
end of the swap (both loans are in same currency and amount)
INTEREST RATE SWAP
net payment by the FIXED RATE PAYER:
= (Fixed – Float or LIBOR) x (n / 360) x notional

principal
net payment by the FLOAT RATE PAYER:
= (Float or LIBOR – Fixed) x (n / 360) x notional

principal
REMEMBER
FIXED RATE > FLOATING RATE
(+)
= floating rate payer pays (outflow)
FLOATING RATE > FIXED RATE (-)
= floating rate payer receives
(inflow)
INTEREST RATE SWAP
• interest payments are netted
• on settlement dates, both interest payments are
calculated and only the difference is paid by the
party owing the greater amount
• floating rate payments are typically made in
arrears; payment is made at end of period based on
beginning-of-period LIBOR
KAPIT enters into a $1,000,000 quarterly pay
plain vanilla interest rate swap as the fixed-
rate payer at a fixed rate of 6% based on a
360-day year. The floating-rate payer, LANG,
agrees to pay 90-day LIBOR plus a 1%
margin; 90-day LIBOR is currently 4%.
90-day LIBOR rates are:

 4.5% 90 days from now
Calculate the amounts KAPIT pays or receives

90, 270, and 360 days from now.
EQUITY SWAP
BUYER SELLER
• can gain the economic • can reduce or eliminate
exposure to certain the market risk of
equity or index market his/her portfolio without
without physically selling the assets
owning such assets • gain stable returns
EQUITY RETURN SWAP
• RETURNS PAYER: makes payments based
on returns of a stock, portfolio, or index, in
exchange for fixed or floating rate
payments
• If the (3) declines in value:
━ RETURNS PAYER receives the interest
payment & a payment based on the
percentage decline in value
EQUITY RETURN SWAP
EQUITY RETURN PAYER
 receives interest payment
 pays any positive equity return
 receives any negative equity
INTEREST PAYER
 pays interest payment
 receives positive equity return
 pays any negative equity return
EQUITY RETURN SWAP
EQUITY RETURN IS BASED ON:
– individual stock
– stock portfolio
– stock index
•CAN BE capital appreciation or total return including

dividends
Assume that LORDE and TABANG enter
into a one-year total return swap in which
one party receives the LIBOR, in addition
to a fixed margin of 2%. On the other
hand, the other party receives the total
return of the S&P’s Index on a principal
amount of $ 1,000,000. After one year, if
LIBOR is 3.5% and the S&P 500
appreciates by 15%, LORDE pays
TABANG 15% and receives 5.5%.
The payment is netted at the end of the swap with TABANG
receiving the payment of 95,000.
1,000,000 x (15% - 5.5%) = $95,000

Assume that S&P 500 falls by 15%, rather than
appreciating by 15%.
LORDE would receive 15% in addition to the LIBOR rate

plus the fixed margin.
The payment netted to LORDE would be

$ 1,000,000 x (15% + 5.5%) = $ 205,000
 Ms. Smith enters into a 2-year $10
million quarterly swap as the fixed
payer and will receive the index return
on the Standard & Poor’s 500 index.
The fixed rate is 8%, and the index is
currently at 986. At the end of the next
three quarters, the index level is: 1030,
968, and 989.
Calculate the net payment for each of

the next three quarters and identify
the direction of the payment.
 2-year, $10 million quarterly-pay equity swap
 Equity return = S&P 500 Index
 Fixed rate = 8%
 Current index level = 986
Q1: S&P 500 = 1030 Return = 4.46%

Q2: S&P 500 = 968 Return = — 6.02%
Q3: S&P 500 = 989 Return = 2.17%
 Index return payer pays (+) receives ( - ):
 Q1: 4.46% — 2.00% = 2.46%
$246,000 net payment
 Q2: —6.02% — 2.00% = —8.02%
—$802,000 net payment
 Q3: 2.17% — 2.00% = 0.17%
$17,000 net payment
CURRENCY SWAP
• used to secure cheaper debt and to
hedge against exchange rate
fluctuations
• less expensive than issuing debt in
foreign currency
• especially applicable for companies
that wants to have operations in a
foreign land
CURRENCY SWAP
The notional principal

is actively swapped
twice: beginning and
termination of swap.
TERMINATION OF SWAP
• enter into an offsetting swap, sometimes
through swaption (MOST COMMON)
• mutual agreement to terminate the swap
(involves making or receiving
compensation most of the time)
• selling the swap to a 3rd party with consent
of the original counterparty (RARELY)
Bond Forward Contract, Equity
Index Forward Contract, LIBOR-
based loan, and Currency
Forward Contract
Settlement Price and Gain (Loss) Computations
Bond Forward Contract
The basic characteristics of a forward contract on a bond are very much
like those of equity. A bond pays a coupon similar to an equity paying a
dividend. The differences are:
 Bonds mature; this means that contracts must also mature before the
maturity date.
 Bonds can have calls and convertibility.
 Bonds have a default risk, which means the contract must include
remedies for this risk in case it occurs.
Computation
A forward contract covering a $10,000,000 face value of T-bill that will

have 100 days to maturity at contract settlement is priced at 1.96 on a
discount yield basis . Compute the dollar amount the long must pay at
settlement for the T-bill.
Answer:
Actual discount = 1.96%(100/360) = 0.5444%
Settlement price = $10,000,000(1-0.5444%) = $9,945,560
Long’s gain/Short’s loss = $10,000,000-$9,945,569 = $54,440
EQUITY INDEX FORWARD
CONTRACT
• A contract for the purchase of an individual
stock, a stock portfolio or a stock index at
some future date
EXAMPLE:
Assume that a client owns IBN at 100 and
wants to sell IBN stock in six months to
raise some cash. The client can enter into
an equity forward in which he will receive
a price of 125.
EXAMPLE 2:
If the dealer quotes P15,000 for six
securities in your portfolio and you decide
to enter into a contract, how much will
you receive at the expiration of the
contract?
EXAMPLE 3:
You contact a dealer who gives you a quote of
P5,000 on a forward contract for P170,000,000
to settle the index. If the index were to drop by
2%, your portfolio would lose P3,400,000.
Because you entered into a forward contract
with the dealer to sell the index, you benefit
from the market decline of 2% to the tune of
P3,400,000 (P170,000,000x2%)
LONDON INTERBANK OFFERED
RATES ( LIBOR)
Subtitle
• Used as the first step in calculating interest rate on various
loans throughout the world.
• Based on 5 currencies: USD, EUR, JPY, GBP, CHF
• Serves on seven maturities: overnight, week, I,2,3,6 and
12 months.
• Eurodollars deposit is the term used
for deposits in large banks outside
U.S denominated in U.S dollars.
• Lending rate on dollar-denomination • LIBOR= Principal x (LIBOR
between banks is called LIBOR. RATE/360) X Actual number of days
in interest period
• Quoted as an annualized rate based
on 360-day per year.
• LIBOR used as a reference rate for
floating rate U.S dollar-denominations
worldwide.
• Compute the amount that must be • P= $ 3,500,000
repaid on a $1,000,000 loan for 30
• Interest Period= 3 months
days, if its 30- day LIBOR rate is 6%.
• LIBOR rate= 8%
LIBOR= Px(LR/360)x number of days

LIBOR=P x (LR/360)x number of days
=$1,000,000 x (6%/360) x 30
=$ 3,500,00 x (8%/360) x 90
=$ 5,000 + 1,000,000
=$ 70,000 + 3,500,000
=$ 1,005,000
=$ 3,570,000
CURRENCY
FORWARD
CONTRACT
CURRENCY FORWARD CONTRACT
An agreement between two parties to exchange a fixed amount of

one currency for another currency at an agreed upon future date
Example: PHP to USD
The exchange rate for the future transactions is fixed in advance at

the time of signing the agreement
CURRENCY FORWARD CONTRACT
PROBLEM
USA Company (based in USA) just delivered an order to a customer

in Germany and is expecting to receive a payment of €30,000,000 in
90 days.
USA Company entered into a cash settlement currency forward
contract with USB Company at the current exchange rate of $1.23 per
euro.
At settlement, the market exchange rate is $1.25 per euro.
What is the amount of the payment to be received or paid by USA

Company?
USB Company wants to buy the €30,000,000 from USA Company.
USB Company is the LONG.
USA Company is the one who will receive the payment for these
euros. USA Company is the SHORT.
Under the terms of the contract, USA Company will receive:
€30,000,000 x $1.23/€ = $ 36,900,000
$ 600,000
Without the contract, USA Company will receive:
€30,000,000 x $1.25/€ = $ 37,500,000
USA Company entered the contract as short because they thought that
rates would fall in the future, but instead the rate rose.
USB Company entered the contract as long because they thought that
rates would rise, as they did.
Because the rates are in favor of USB Company, they are to receive the
payment of $600,000
Remember:
If you are better off without the contract, then it is

you who will have to pay.
If you are not better off without the contract, then

it is you who will be receiving the payment.
Under the terms of the contract, USA Company will receive:
€30,000,000 x $1.23/€ = $ 36,900,000
$ 600,000
Without the contract, USA Company will receive:
€30,000,000 x $1.21/€ = $ 36,300,000
USB Company will receive the payment of $600,000 from USA Company

CH 18

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CHAPTER 18

DERIVATIVES AND RISK MANAGEMENT

Bond Component Derivative Component

• Provide principal protection • Provide exposure to any asset

• Interest rises, value of coupon would increase.

An over-the-counter contract between two parties who want to

The buyer is borrowing and the seller is lending a notional sum at

INTEREST RATES BORROWER LENDER

will PAY the

will PAY the

Date when the FRA is

Spot date Settlement date Maturity date

Ones-fours FRA (1 x 4)- it means a three-month loan in one month time

WAITING PERIOD CONTRACT PERIOD

Spot date Settlement date Maturity date

Three-nines FRA (3 x 9)- it means a six-month loan in three months time

WAITING PERIOD CONTRACT PERIOD

Spot date Settlement date Maturity date

The amount to be exchanged on settlement date

Step 1 – Calculation of the interest differential

Step 2 – Calculation of the settlement amount

Situations in which aggregate risks can be reduced

Future contracts are designed to address these

F1 : Initial Futures Price

• Future basis is uncertain

Price Realized = Cost of Asset

Cost of Asset = $102 – ( $110 – $105)

Price Realized = ($105 – $110) + $102

Assume that the spot price of gold is

The net cash flow from the seller to the

• Aluminum savings in Sept. = 60,000($1.50-$1.00)

Total gain on aluminum savings = $87,000

Assume the futures contract closed at the following prices:

Futures (Aug.) = 52,000($0.6813-$0.8974)

Total loss on futures = $70,085.60

The transaction looks like this:

CASH MARKET FUTURES MARKET BASIS

CASH MARKET FUTURES MARKET BASIS

Equity = Account value – Market Value of Shorted Security

Net profit= 10,000 – 6,000 = $4,000 minus brokerage commissions

Equity = $15,000 – $12,000

Margin = $3,000/ $12,000

Current margin < 30%

Net loss = $10,000 - $12,000 = $2,000 plus brokerage commissions and

• Futures traders are typically required to provide variation margin

$10-$6= $4 x 100 = $400 margin balance

Variation Margin = $1,000 - $400

P30 × 0.75 = P22.50 0

P30 × 0.75 = P22.50 + 0 = P22.50

𝑑2 = 0.19-0.3 0.36 = 0.01

• based on a notional amount of principal

• percentage payments are based on a floating rate,

NOTE: notional principal is

= (Fixed – Float or LIBOR) x (n / 360) x notional

net payment by the FLOAT RATE PAYER:

= (Float or LIBOR – Fixed) x (n / 360) x notional

90-day LIBOR rates are:

Calculate the amounts KAPIT pays or receives

•CAN BE capital appreciation or total return including

1,000,000 x (15% - 5.5%) = $95,000

LORDE would receive 15% in addition to the LIBOR rate

The payment netted to LORDE would be

Calculate the net payment for each of