MishkinSerletis The Economics of Money Banking and Financial

Learning Objectives 1. Distinguish among forwards, futures, options, swaps, and credit derivatives 2. Discuss the success of the financial derivatives market 3. Explain how managers of financial institutions use financial derivatives to manage interest-rate and foreign exchange risk 4. Outline the dangers of derivatives Copyright © 2014 Pearson Canada Inc. 14 -2

Hedging • Hedge – engage in a financial transaction that reduces or eliminates risk • Long position – taking a position associated with the purchase of an asset • Short position – taking a position associated with the sale of an asset Copyright © 2014 Pearson Canada Inc. 14 -3

Hedging (cont’d) • Basic hedging principle: – Hedging risk involves engaging in a financial transaction that offsets a long position by taking a additional short position, or offsets a short position by taking a additional long position Copyright © 2014 Pearson Canada Inc. 14 -4

Forward Contracts and Markets • A forward contract is an agreement between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now. • Forward contracts are traded over-the-counter (OTC) • Two types discussed: – interest-rate forward contracts – forward contracts foreign currencies Copyright © 2014 Pearson Canada Inc. 14 -5

Interest Rate Forward Contracts • An interest rate forward contract involves the future sale (purchase) of a debt instrument Contract specifies • – – specification of the debt instrument amount of the instrument to be delivered the price (interest rate) on the instrument when it is delivered the date when delivery takes place Copyright © 2014 Pearson Canada Inc. 14 -6

Interest-Rate Forward Markets • Long position = agree to buy securities at future date • Hedges by locking in future interest rate if funds coming in future • Short position = agree to sell securities at future date • Hedges by reducing price risk from change in interest rates if holding bonds Copyright © 2014 Pearson Canada Inc. 14 -7

Pros and Cons of Forward Contracts • Pros – flexible (can be used to hedge completely the interest rate risk) • Cons – lack of liquidity: hard to find a counterparty to make a contract with – subject to default risk: requires information to screen good from bad risk Copyright © 2014 Pearson Canada Inc. 14 -8

Financial Futures Markets Financial futures are classified as 1. Interest-rate futures 2. Stock index

Interest-Rate Futures Contracts 1. Specifies delivery of type of security at future date 2. Arbitrage at expiration date, price of contract = price of the underlying asset delivered 3. If i , long contract has loss, short contract has profit 4. Hedging similar to forwards Copyright © 2014 Pearson Canada Inc. 14 -10

Interest-Rate Futures Contracts (cont’d) • At the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered • The elimination of riskless profit opportunities in the futures market is referred to as arbitrage • A micro hedge occurs when the institution is hedging the interest rate for a specific asset it is holding • A macro hedge is when the hedge is for the entire portfolio Copyright © 2014 Pearson Canada Inc. 14 -11

Financial Futures Markets • Organization and Trading – CBOT, Chicago Mercantile Exchange, Montreal Exchange, London International Financial Futures Exchange, Marché à Terme International de France – Open interest: number of contracts outstanding • Globalization of financial futures markets – contracts traded in other countries virtually identical to those traded in the United States – movement to 24 -hour-a-day trading in financial futures – Globex electronic trading platform Copyright © 2014 Pearson Canada Inc. 14 -12

Explaining the Success of Futures Markets • • – – Futures: liquid standardized can be traded again delivery of range of securities Margin requirement Marked to market: avoids default risk Do not have to deliver: netting Copyright © 2014 Pearson Canada Inc. 14 -13

Widely Traded Financial Futures Contracts in the United States Copyright © 2014 Pearson Canada

Stock Index Futures Contracts • Stock index futures were designed to manage stock market risk and are now among the most widely traded of all futures contracts • The S&P Index measures the value of 500 of the most widely traded stocks in the United States • Price quotes for this contract are also quoted in terms of index points – change of 1 point represents a change of $250 in the contract’s value Copyright © 2014 Pearson Canada Inc. 14 -15

Stock Index Futures Contracts (cont’d) • Stock index future contracts differ from most other types of financial futures contracts in that they are settled in cash delivery rather than delivery of a security • Cash settlement gives a high degree of liquidity • For the S&P 500 Index contract, at the final settlement date, the cash delivery due is $250 x the index Copyright © 2014 Pearson Canada Inc. 14 -16

Options • A call option is an option that gives the owner the right (but not the obligation) to buy an asset at a prespecified exercise (or strike) price within a specified period of time • Since a call represents an option to buy, the purchase of a call is undertaken if the price of the underlying asset is expected to go up Copyright © 2014 Pearson Canada Inc. 14 -17

Options (cont’d) • The buyer of a call is long in a call and the writer is short in a call • The buyer of a call has to pay a premium in order to get the writer to sign the contract and assume the risk Copyright © 2014 Pearson Canada Inc. 14 -18

Options (cont’d) • There are two types of option contracts: 1. American options that can be exercised any time up to the expiration date 2. European options that can be exercised only on the expiration date • Stock options • Financial futures options (futures options) Copyright © 2014 Pearson Canada Inc. 14 -19

The Payoff from Buying a Call • Assume that you hold a European call on an asset with an exercise price of X and a call premium of α - if at the expiration date, the price of the underlying asset, S, is less than X, the call will not be exercised, resulting in a loss of the premium - at a price above X, the call will be exercised - at a price between X and X + α, the gain would be insufficient to cover the cost of the premium - at a price above X + α, the call will yield a net profit - at a price above X + α, each $1 rise in the price of the asset will cause the profit of the call option to increase by $1 Copyright © 2014 Pearson Canada Inc. 14 -20

The Payoff from Writing a Call • The payoff function from writing the call option is the mirror image of the payoff function from buying the call • The writer of the call receives the call premium, α, and must stand ready to sell the underlying asset to the buyer of the call at the exercise price, X, if the buyer exercises the option to buy Copyright © 2014 Pearson Canada Inc. 14 -21

Profits from Buying and Writing a Call Option Copyright © 2014 Pearson Canada Inc.

Summary • The value of a call option, C, at expiration with asset price S (at that time) and exercise price X is C = max (0, S - X) • The value of a call option (intrinsic value) at maturity is S - X, or zero, whichever is greater • If S > X, the call is said to be in the money, and the owner will exercise it for a net profit of C - α • If S < X, the call is said to be out of the money and will expire worthless • A call with S = X is said to be at the money (or trading at par) Copyright © 2014 Pearson Canada Inc. 14 -23

Buying and Writing Puts • A put option gives the owner the right (but not the obligation) to sell an asset to the option writer at a pre-specified exercise price • A put represents an option to sell, it is worth buying a put when the price of the underlying asset is expected to fall • The owner of a put is said to be long in a put and the writer of a put is said to be short in a put • The buyer of a put option will have to pay a premium (called the put premium) in order to get the writer to sign the contract and assume the risk Copyright © 2014 Pearson Canada Inc. 14 -24

The Payoff from Buying a Put • Consider a put with an exercise price of X and a premium of β • At a price of X or higher, the put will not be exercised, resulting in a loss of the premium • At a price below X - β, the put will yield a net profit • Between X - β and X, the put will be exercised, but the gain is insufficient to cover the cost of the premium Copyright © 2014 Pearson Canada Inc. 14 -25

The Payoff from Writing a Put • The payoff function from writing a put is the mirror image of that from buying a put • The writer of a put receives the put premium, β, up front and must sell the asset underlying the option if the buyer of the put exercises the option to sell Copyright © 2014 Pearson Canada Inc. 14 -26

Profits From Buying and Writing a Put Option Copyright © 2014 Pearson Canada Inc.

Summary • The value of a put option, P, at the expiration date with exercise price X and asset price S (at that time) is P = max (X - S, 0) • The value of a put at maturity is the difference between the exercise price of the option and the price of the asset underlying the option, X - S, or zero, whichever is greater • If S > X, the put is said to be out of the money and will expire worthless • If S < X, the put is said to be in the money and the owner will exercise it for a net profit of P - β. • If S = X, the put is said to be at the money Copyright © 2014 Pearson Canada Inc. 14 -28

Futures Options An example: • Option on a June Canada Bond futures contract • Buy the futures contract at 115 ( costs $115, 000) • Purchaser has to pay $115 000 for $100 000 face value of long-term Canada bonds on delivery at the end of June • Sold contract means you will deliver the $100 000 of bonds at the end of June and will be paid $115 000 Copyright © 2014 Pearson Canada Inc. 14 -29

Profits and Losses on Options Versus Futures Contracts Copyright © 2014 Pearson Canada Inc.

Factors Affecting Option Premium 1. Higher strike price – – lower premium on call options higher premium on put options 2. Greater term to expiration – higher premiums for both call and put options 3. Greater price volatility of underlying instrument – higher premiums for both call and put options Copyright © 2014 Pearson Canada Inc. 14 -31

Interest Rate Swaps • Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments it owns for another set of payments owned by another party • Two kinds of swaps: – currency swaps – interest-rate swaps • Interest-rate swaps – the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency Copyright © 2014 Pearson Canada Inc. 14 -32

Interest-Rate Swap Payments Copyright © 2014 Pearson Canada Inc. 14 -33

Advantages of Interest Rate Swaps • Advantages of interest rate swaps – Reduce risk, no change in balance-sheet – Longer term than futures or options • Disadvantages of interest rate swaps – Lack of liquidity – Subject to default risk Copyright © 2014 Pearson Canada Inc. 14 -34

Credit Derivatives • Credit derivatives offer payoffs on previously issued securities. • Three Types: 1. Credit Options 2. Credit Swaps 3. Credit-Linked Notes Copyright © 2014 Pearson Canada Inc. 14 -35