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Eksamen Derivatives (CASE 3 (Explain FRA, Futures, Swaps and Options (Why…

- - - - Difference between american and european
      - ex-dividend date -> PV of dividend vs PV of time value
      - You surrender time value
    - - Exercise early is actually wanted if a stock has fallen by alot (say 90%). A stock can not go lower than zero, but can have a heavy rise. So a put holder is close to his maximum gain.
  - - - Advantages
        
        No initial deposit is necessary if the institution is already known to the company
        
        Fees for arranging the forward start deposit will be nil or very low
        
        No interim cash flows
        
        The arrangement exactly hedges the risk
      - Disadvantages
        
        Not negotiable
        
        Once the contract is signed you cannot get out of the contract if the interest rate changes to a more favourable rate in the future
    - - Advantages
        
        There is no principal sum involved in FRA. All that is paid is the interest rate differential
        
        No default risk of either party
        
        As an off-balance-sheet finance, the FRA transaction need not be disclosed in the balance sheet
        
        Provides a perfect hedge
      - Disadvantages
        
        Once the agreement is entered into you cannot get out of it
        
        If the rate moves in the opposite direction, any gain that could be made will have to be handed over to the other party
    - - Advantages
        
        The only way to benefit is if the interest rate moves in favour of the depositor
        
        There is no requirement to exercise the option
        
        Guarantees a minimum rate on the deposit
      - Disadvantages
        
        Could prove to be very expensive
        
        Initial cash outflow involved
- - - - What are the components of it?
      - How are they incurred?
      - Who pays them?
    - - Why is this important?
- - - - Eliminate exposure to interest rate changes
      - Gives companies certainty and control over their interest rate obligations
      - Can get lower funding rate
      - No upfront payment
    - - Counterparty risk
  - - - swap commodity indicies
    - - Locking in a fixed price over a longer period than offered by futures contract
    - - Low liquidity for commodities
      - Seasonality issues with commodities
      - Low quality of information
      - Time involved setting up the contract due to complexity
  - - - The swap will be priced against LIBOR, so the bank should hedge using a LIBOR based product. The futures market contains eurodollar LIBOR contracts.
      - The swapnote futures contract
    - - Find a futures contract that matches the commodity
      - or, cross-hedge and hope the two contracts perform in line