Académique Documents
Professionnel Documents
Culture Documents
JQY
Risk Management
In business, risk management involves
identifying events that could have adverse
financial consequences and then taking actions
to prevent and/or minimize the damage caused
by those events.
Risk Management has gradually evolved from a
narrow insurance-based discipline to traditional
financial activities.
JQY
JQY
Source: Kit Sadgrove, The Complete Guide to Business Risk Management, 2nd edition
JQY
JQY
Derivatives
Financial innovation that allows investors to manage risks.
Securities whose values are determined by the market price or
interest rate of some other asset (underlying asset)
Common underlying assets:
Equities
Indexes
Bonds
Physical Assets
Interest Rates
May be used to hedge risk or to profit from
speculation.
Potentially risky, especially for inexperienced investors.
JQY
Types of Derivatives:
Forward Commitments represents a commitment or a
binding promise to buy or sell an asset or make a payment in
the future
Forward Contracts
Futures Contracts
Swaps
JQY
Over-the-counter derivatives
JQY
Classification of Derivatives
JQY
Derivatives to be studied:
JQY
Forward Contracts
Futures Contracts
Swaps
Options
Structured Notes
Inverse Floaters
Other Exotic Contracts
Forward Contracts
Forward Contract
A bilateral private contract under which one party agrees to
buy a commodity at a specific price (agreed today) on a
specific future date; and the other party agrees to make the
sale.
Not traded in an exchange. It is traded over-the-counter.
Physical delivery occurs
Underlying assets can be anything, or any instrument (eg:
bonds, equities, indices, or portfolio of those already stated)
Entail both market risk and credit risk
JQY
Forward Contracts
Deliverable Forward Contract
It specifies that the long (buyer) will pay a certain amount at a
future date to the short (seller), who will deliver a certain amount
of an asset.
Early Termination
Entering into a new forward contract with the opposite position, at
the then-current expected forward price
May be done with the existing counterparty (eliminates default
risk) or a new counterparty (must consider default risk)
JQY
Forward Contracts
End Users of Forward Contracts
Often a corporation hedging an existing risk
LIBOR
EURIBOR
Europe Interbank Offered Rate
Equivalent for short-term Euro denominated bank deposits (loans to
banks)
JQY
JQY
Reading FRAs
60-day FRA on a 90-day LIBOR
Settlement or expiration is 60 days from now
Payment at settlement is based on 90-day LIBOR,
60 days from now.
Is also referred to as 2-by-5 FRA or 2x5 FRA
JQY
JQY
JQY
Futures Contracts
Similar to a forward contract, but it is a standardized contract
traded through the futures exchange. There is a third party
clearinghouse that acts as counterparty on all contracts.
Regulated by the government
More liquid than forward contracts
Lower transaction costs than forward contracts
Usually done for commodities (underlying asset)
Marked to market on a daily basis, and entails virtually no
physical delivery
Entail only market risk. Credit risk is passed on to the
clearinghouse. Clearinghouse doesnt take market risk as it
only takes offsetting positions.
JQY
Financial Futures
A contract that is used to hedge against fluctuating interest rates,
stock prices, and exchange rates.
Speculation
With futures, it involves betting on future price movements.
Hedging
Using transactions to lower risks. Firms or individuals do this to
protect against a price change that would otherwise negatively
affect profits.
JQY
Perfect Hedge = occurs when the gain or loss on the hedged transaction
exactly offsets the loss or gain on the unhedged position.
JQY
Futures Contracts:
Delivery Open
Month
High
Low
Settle
Change
High
Low
Open
Interest
Sept.
Sept.
109-00
109-00
110-04
110-04
108-27
108-27
110-02
110-02
37
37
112-12
112-12
96-07
96-07
367,016
367,016
Dec.
107-30
107-30
108-29
108-29
107-27
107-27
108-28
108-28
37
37
111-04
111-04
96-06
96-06
96,216
96,216
Dec.
JQY
Initial margin
The deposit required to initiate a futures position.
Maintenance margin
Set by Feds,
may be
increased by
brokerage
Variation margin
Funds needed to bring ones account back to the initial
margin amount
Margin calculations
Based on daily settlement price , the average of the prices for
JQY trades during a closing period set by the exchange.
Marking-to-market
Process of adding gains to or subtracting losses from
the margin account daily, based on the change in
settlement prices from one day to the next.
Trades cannot take place at prices that differ from the
previous days settlement price by more than the price
limit and are said to be limit down (up) when the new
equilibrium price is below (above) the minimum
(maximum) price for the day.
JQY
JQY
JQY
Eurodollar
Based on 90-day LIBOR
Settles in cash and the minimum price change or one
tick is 0.01%, ($25 per $1 million contract)
Treasury Bond
Traded for t-bonds that matures in more than 15 years, is a
deliverable contract, have a face value of $100,000 and quoted as
percentages or fractions of 1% (1/32nds) of face value
Gives the short a choice of bonds to deliver
Uses conversion factors to adjust the contract price for the bond
that is delivered. Long pays the futures price at expiration x
conversion factor.
JQY
JQY
JQY
JQY
Swap
Two parties agree to exchange obligations to make specified payment
streams.
A series of forward contracts
Not per se, an exchange of one asset for another. Rather, its an
exchange of obligations.
Are custom instruments, largely unregulated, dont trade in
secondary markets, and are subject to default (counterparty) risk
No money is exchanged at inception, and periodic payments are
netted, except currency swaps.
Effects of swaps due to standardized contracts:
Standardized contracts lower the time and effort involved in
arranging swaps, thus lowering transaction costs.
Standardized contracts led to a secondary market for swaps,
increasing the liquidity and efficiency of the swaps market.
Examples:
Plain Vanilla Interest rate swap
Equity returns swap
Currency swap
JQY
4.5%
5.0%
5.5%
6.0%
JQY
Equity Swaps
The returns payer makes payments based on
returns of a stock, portfolio, or index, in
exchange for fixed or floating rate payments.
If stock, PTF, or index declines in value, the
returns payer receives the interest payment & a
payment based on the percentage decline in
value.
JQY
JQY
Currency Swap
Used to secure cheaper debt and to hedge against exchange rate fluctuations.
It is less expensive than issuing debt in foreign currency coz own currency is not known to
foreign land. This is especially applicable for companies that wants to have operations in
a foreign land.
Borrow USD
Borrow AUD
BB (US)
9%
8%
AA (AUS)
10%
7%
Assume that 1 USD = 2 AUD. Each party goes to his own bank. BB borrows 1m USD at
9% (interest of USD90k), and AA borrows 2m AUD at 7% (interest of AUD140k)
3 Important Dates:
Swap Initiation- notional principal is swapped at initiation
Gives 1m USD
BB (US)
AA (AUS)
Gives 2m AUD
BB (US)
AA (AUS)
Pays USD 100k (1m x 10%)
JQY
Currency Swap
3 Important Dates:
Interest Payments to respective banks
AA pays 140k AUD to Bank, but he gets 160 AUD from BB, so he gains 20,000
AUD
BB pays 90k USD to Bank but he gets 100 USED from AA, so he gains 10,000
USD
Swap Termination
Gives 2m AUD
BB (US)
AA (AUS)
Gives 1m USD
JQY
JQY
Structured Notes
A debt obligation derived from another debt obligation.
They are securities whose cash flow characteristics depend
upon one or more indices or that have embedded forwards
or options, or securities where an investors investment
returns and issuers payment obligations are contingent on,
or highly sensitive to, changes in the value of the underlying
assets, indices, interest rates, or cash flows.
Example: Collateralized Debt Obligation is a type of
structured asset-backed security.
JQY
Inverse Floaters
A note in which the interest paid moves counter to market
rates.
Example: Usually, interest rate on your bond is 1% + prime
rate. So if prime rate is 4%, interest rate on your note will
be 5%.
For inverse floaters, if interest rate in economy falls, bond
yield will rise. (Example: if interest rate of economy is 3%,
and bond interest rate is 4%. If economy rate goes to 2%,
bond interest rate goes to 5%
Benefits: to enhance yield when economy rates fall.
JQY
Options
A contract that gives its holder the right, but not
the obligation, to buy (or sell) an asset at some
predetermined price within a specified period of
time.
Its important to remember:
It does not obligate its owner to take action.
It merely gives the owner the right to buy or sell
an asset.
JQY
Options
Option writer = seller of an option.
Call Option
Gives the holder of the call option the right, but not the
obligation, to buy an asset at a particular price within a
specified period of time.
Put Option
Gives the holder of the put option the right, but not the
obligation, to sell an asset at a particular price within a
specified period of time.
JQY
Options:
Four possible Options:
JQY
Kinds of Options:
European Options
Can be exercised only at the options expiration
date.
American Options
Can be exercised at any time up to the options
expiration date.
These are more valuable than European options.
JQY
Option Terminologies
Exercise (or strike) price the price stated in the option
contract at which the security can be bought or sold.
Option price option contracts market price.
Expiration date the date the option matures.
Exercise value the value of an option if it were exercised
today (Current stock price - Strike price).
JQY
Option Terminologies
Covered option an option written against stock held in an
investors portfolio.
Naked (uncovered) option an option written without the
stock to back it up.
In-the-money call a call option whose exercise price is less
than the current price of the underlying stock.
Out-of-the-money call a call option whose exercise price
exceeds the current stock price.
Long-term Equity AnticiPation Securities (LEAPS) - similar to
normal options, but they are longer-term options with
maturities of up to 2 1/2 years.
JQY
Options Moneyness:
CALL OPTION
PUT OPTION
In the money
(Option holder
WILL Exercise)
At the money
(Option holder is
indifferent)
Stock/Market Price =
Strike/Exercise Price
Stock/Market Price =
Strike/Exercise Price
JQY
Moneyness Illustration:
Consider a September 40 call and a September
40 put, both on a stock that is currently selling
for $37 a share. Calculate how much these
options are in or out of the money.
JQY
Option example
A call option (option to buy) with an exercise
price of $25, has the following values at these
prices:
Stock price
$25
30
35
40
45
50
JQY
Exercise or
Intrinsic value
of option
Market price
of Option
Option
Premium/
Time Value
$25.00
30.00
$25.00
25.00
$0.00
5.00
3.00
7.50
3.00
2.50
35.00
40.00
25.00
25.00
10.00
15.00
12.00
16.50
2.00
1.50
45.00
50.00
25.00
25.00
20.00
25.00
21.00
25.50
1.00
0.50
JQY
Exercise or
Intrinsic Value
of option
Market
price of
Option
Option
Premium/
Time Value
$30.00
25.00
$25.00
25.00
$0.00
0.00
3.00
7.50
3.00
7.50
20.00
25.00
5.00
12.00
7.00
15.00
10.00
5.00
25.00
25.00
25.00
10.00
15.00
20.00
16.50
21.00
25.50
6.50
6.00
5.50
JQY
JQY
JQY
Option
value
30
25
20
15
Market
price
10
Stock
5
5
JQY
10
15
20
25
30
Exercise
value
35
40 45
Price
50
JQY
Stock Price
Exercise Price
Term-to-maturity
Variability of the stock price (Volatility)
Risk-free rate
JQY
Steps:
30
35
50
35
15
20
15
(computed as 15/20)
0.75
30 x 0.75
22.50
0.00
50 x 0.75
37.50
15.00
15.00
15.00
JQY
Steps:
3.
4.
JQY
Ending Value of
Stock in PTF
MINUS Ending
Value of Option in
PTF
Ending Total
Value of the PTF
30 x 0.75
22.50
22.50
50 x 0.75
37.50
15.00
22.50
JQY
d1
t
d 2 d1 - t
JQY
Use the B-S OPM to find the option value of a call option
with P = $27, X = $25, rRF = 6%, t = 0.5 years, and 2 =
0.11.
ln($27/$25 ) [(0.06 0.11 )] (0.5)
2
d1
0.5736
(0.3317)(0.7071)
d 2 0.5736 - (0.3317)(0.7071) 0.3391
From Appendix C in the textbook
N(d1 ) N(0.5736) 0.5000 0.2168 0.7168
N(d 2 ) N(0.3391) 0.5000 0.1327 0.6327
JQY
-rRF t
[N(d2 )]
-(0.06)(0.5)
V $27[0.7168] - $25e
[0.6327]
V $4.0036
JQY
JQY
Benefits of Derivatives:
Provide price information (price discovery).
Allows risk to be managed and shifted among
market participants.
Reduce transaction costs because investors are
already able to manage risks.
JQY
Criticisms of Derivatives:
Likened to gambling because of the high
leverage involved in derivatives payoffs.
Too risky especially to investors with limited
knowledge of complex instruments.
JQY