Fintech Chapter 10 Futures Forwards and Swaps Futures

Fintech Chapter 10: Futures, Forwards and Swaps

Futures, Forwards, Swaps �Financial Weapons of Mass Destruction

Futures, Forwards, Swaps �Derivatives: value of the instrument is based on or “derived” from an underlying financial instrument �Linear payoffs: valuation of the derivative will move one for one with increases or decreases with the underlying instrument

Futures, Forwards, Swaps �Advantages: same economic exposure as underlying but greater liquidity, leverage, lower taxes, transaction costs �Shift risk �Forwards: delivery, OTC, counterparty exposure �Futures: exchange traded, CCP, usually no delivery �CCP: Central Counter. Party �Swap: OTC, exchange cash based on reference

Futures Mechanics �Listed by Exchange, not fungible between exchanges �Trading counterparties are anonymous �CCP �Futures Commission Merchant (Broker) �Margin: initial and variation �Default

CCP �Commercial entities �Buyer to all sellers, seller to all buyers �Rule book �Set margins �SIFI?

ICE Clearing Default Waterfall

Single Stock Futures �Trade anonymously �Shares delivered at expiry, some cash settled �Margins �Theoretical price: FP = CP (1 -FC)

Equity Swaps �Total Return Swaps �Inflation Swaps

Stock Index Futures �Futures on market indexes �S&P 500 futures � Full size = $250 x index value � E-mini= $50 x index value �Used to hedge portfolios, new positions for indexed portfolios, allocation, speculation �Advantages: liquidity, leverage, taxes, transaction costs

Interest Rate Swaps �Daily trading volume averages $1 trillion �OTC �Dodd Frank requires SEF execution � 2 parties agree to exchange cash flows �Difference between two rates-one fixed, one floating �Floating rate most often is LIBOR

Interest Rate Swaps �Corporate finance hedging �Financial institution interest rate management �Speculation on rate changes �Market Making �Portfolio management- converting fixed to floating and vice versa; liquidity makes it cheap and convenient to gain/reduce exposure �Rate locks prior to bond sales-issuers can receive fixed in a IRS prior to issuing fixed rate bonds. They then issue the bonds and reverse the IRS.

Interest Rate Futures �CME �NYSE Euronext �Eurodollars futures most active

Hedging Example: Locking in an Interest Rate �Need to borrow $10 million 3 months in future �Rates might rise, so lock in now. LIBOR now 3% �Sell 10 Eurodollar contracts at 97 �If LIBOR rises to 4%, Eurodollar will be 96 �Buy back 10 Eurodollar at 96 �Gain $25, 000 on 10 contracts �This offsets the increased borrowing costs due to rise in LIBOR

Credit Default Swaps �Non-linear payoff �“Insurance” for bond holders �If bond issuer defaults, CDS seller pays �AIG was a big seller of CDS in 2000’s, but could not pay when mortgage market crashed in 2008 �Government bailed out AIG �New rules �CDS market recovering �Single names (one company) �Indexes

Hedging Example: Protecting a Bond Payment Stream with CDS �PM owns $100 million Company A bonds �PM fears A could downgrade or fail �PM pays 50 bp to counterparty �If A defaults, pays 60% of par �Counterparty pays 40% to PM

Fintech Applications � Front Office � Execution Platform � Portfolio Management � Pooled Investment Services � Middle Office � Business Intelligence � Market Data � Alternative Data � Back Office � Confirmation, Clearing, Settlement � Communications � AML/KYC/KYV � Chat Bots � Risk � Compliance, Reporting � Monitoring

�Open. Gamma �Blockchain �DTCC �Corda �Execution Venues

Corda Shared Ledger Comparison