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• Market risk
• Liquidity
INVERSE FLOATERS
• FRN is a fixed income security that makes coupon payments that
are tied to a reference rate.
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.
FORWARD RATE AGREEMENT (FRA)
3 months 3 months
1 months 3 months
3 months 6 months
Interest differential
=(Settlement rate − Contract rate) × (Days in contract period/360) × Notional amount
Settlement amount
= Interest differential / [1 + Settlement rate × (Days in contract period / 360)]
COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA
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.
COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA
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
COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN 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.
COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA
• 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
COMPUTATION FOR THE SETTLEMENT AMOUNT OF AN FRA
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.
• 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
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:
= $9,000/ $6,000
= 1.5 x 100 = 150%
= $1,000 - $200
: = $800
2nd Scenario: the underlying asset drops by $6 the very
same day:
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
𝞭2 = 0.09
OPM Illustration
21 0.09
ln 21 + 0.05+ 2 (0.36)
𝑑1 = = 0.19
0.3(0.6)
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
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”
PROBLEM
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:
$ 600,000
Without the contract, USA Company will receive:
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:
$ 600,000
Without the contract, USA Company will receive:
USB Company will receive the payment of $600,000 from USA Company