FMI week 9 Derivative Markets

Derivatives overview

a financial contract between two parties which has a payoff determined by the price of underlying assets

Benefits

Allow risk to be shared among market participants

increase liquidity

transmit information

interest rate derivatives are large in size and mostly dealt with OTC

Forward and Future contracts

Forward contract

a binding agreement to buy or sell a specific quantity of some asset at predetermined price and date.

Zero cost

OTC market

Physical delivery by the short side to specific date and location or Cash settlement to send cheque with payoff amount.

Pros

Tailored to precisely meet the need

Uncertainty of future price is hedged by both parties

Cons

profitability is not certain

both parties subject to credit risk, when price move adversely

Future Contract

Collateral with marking to market for credit risks

Standardised

requires collateral(margin) must be maintained at acceptable level

gains and losses are paid daily via ASX clearing house, if not margin call will be made

highly customised, difficult to offset a position

risks

Margin risks: margin requirement may cause cash shortage, force investor liquidate.

Basis risk: ??

Options

options give the buyer the right, not obligation to buy/sell financial instrument at a predetermined price on or before a specific date.

Only long side can get to decide when/whether to exercise, put side has to accept and gets reversed payoff.

European options can be exercised only on expiration date T.

America options can be exercised any time up to T.

futures vs options

futures: both parties face same amount of risk, fair chance to win/lose.

options: give buyer downside price protection and upside potentials.

futures are free, options have positive premiums

Bonds with options

permit issuers/buyers the right, not obligation to change the bond before maturity.

Callable bonds

gives the issuer the right to buy the bond from the buyer at fixed strike price before bond maturity.

helps issuers hedge against declining interest rate, buy back and replace with low cost debt

Puttable bonds

permits buyer the right to sell the bond back to issuer at fixed strike price before bond maturity.

helps buyer hedge increasing interest rates, sell bond and reinvest in higher return project.

Call interest premium: difference in interest rate between callable and non-callable bonds. higher to compensate investors.

The put interest discount: difference between puttable and nonputtable bonds. lower due to benefit of investor protection.

Convertible bond

permits the buyer to convert it into equity at pre-specified conversion rate on permitted date.

most valuable when share market prices are rising and bond prices are declining.

for issuers: obtain better financial conditions, diminish liabilities. offer lower interest rate.

for buyers: defensive security

tend to be used by smaller firms with high growth rate and more financial leveraged.

Swap contract

two parties agree to exchange payment obligations on two underlying financial liabilities that are equal in notional principle amount but differ in payment patterns.

interest rate swap

Generic swap:

Basis swap: a swap of two different reference rate interest payments

a swap of a series of fixed interest rate payments for floating interest rate payments.

two parties swap their interest payment obligations

the principle amount is never actually transferred between counter parties.

reasons for interest rate swaps

Lower cost of funds

access gained to otherwise inaccessible debt market

Hedge interest rate risk exposures

profit margins locked in on economic transactions

equity swap contract: swaps floating interest rate to performance of a stock or market index. using Marking to market to reduce credit risks.