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Derivatives

Peter Moles

DE-A2-engb 1/2016 (1012)


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Derivatives
Dr. Peter Moles MA, MBA, PhD
Peter Moles is Senior Lecturer at the University of Edinburgh Management School. He is an experienced
financial professional with both practical experience of financial markets and technical knowledge
developed in an academic and work environment.
Prior to taking up his post he worked in the City of London for international and money-centre banks.
During the course of his career in the international capital markets he was involved in trading, risk
management, origination, and research. He has experience of both the Eurobond and Euro money
markets. His main research interests are in financial risk management, the management of financial
distress and in how management decisions are made and the difficulties associated with managing complex
problems. He is author of the Handbook of International Financial Terms (with Nicholas Terry, published by
Oxford University Press) and is editor of the Encyclopaedia of Financial Engineering and Risk Management
(published by Routledge). He is a contributing author for The Split Capital Investment Trust Crisis (published
by Wiley Finance) and has written a number of articles on the problems of currency exposure in industri-
al and commercial firms.
First Published in Great Britain in 2004.
Peter Moles 2004
The rights of Peter Moles to be identified as Author of this Work has been asserted in accordance with
the Copyright, Designs and Patents Act 1988.
All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise
without the prior written permission of the Publishers. This book may not be lent, resold, hired out or
otherwise disposed of by way of trade in any form of binding or cover other than that in which it is
published, without the prior consent of the Publishers.
Contents

Introduction xi
Arrangement of the Course xii
Approach and Key Concepts xii
Assessment xiii

Acknowledgements xiv
PART 1 INTRODUCTION TO THE DERIVATIVES PRODUCT SET
Module 1 Introduction 1/1

1.1 Introduction 1/2


1.2 Arbitrage Relationships 1/8
1.3 Derivative Markets 1/17
1.4 Uses of Derivatives 1/19
1.5 Learning Summary 1/24
Review Questions 1/25
Case Study 1.1: Terms and Conditions of a Futures Contract 1/29
Case Study 1.2: Constructing a Derivative Security using Fundamental
Financial Instruments 1/29

Module 2 The Derivatives Building Blocks 2/1

2.1 Introduction 2/2


2.2 Forward Contracts 2/4
2.3 Futures Contracts 2/6
2.4 Swap Contracts 2/7
2.5 Option Contracts 2/9
2.6 Learning Summary 2/12
Review Questions 2/13
Case Study 2.1 2/16

PART 2 TERMINAL INSTRUMENTS


Module 3 The Product Set: Terminal Instruments I Forward Contracts 3/1

3.1 Introduction 3/2


3.2 The Nature of the Forward Contract 3/2
3.3 Using Forwards as a Risk-Management Instrument 3/11
3.4 Boundary Conditions for Forward Contracts 3/12
3.5 Modifying Default Risk on Forward Contracts 3/13

Derivatives Edinburgh Business School v


Contents

3.6 Learning Summary 3/27


Review Questions 3/28
Case Study 3.1: Interest-Rate Risk Protection 3/34
Case Study 3.2: Exchange-Rate Protection 3/35

Module 4 The Product Set: Terminal Instruments II Futures 4/1

4.1 Introduction 4/2


4.2 Futures Contracts 4/2
4.3 Types of Futures Transactions 4/13
4.4 Convergence 4/18
4.5 The Basis and Basis Risk 4/21
4.6 Backwardation and Contango 4/35
4.7 Timing Effects 4/37
4.8 CashFutures Arbitrage 4/40
4.9 Special Features of Individual Contracts 4/42
4.10 Summary of the Risks of Using Futures 4/46
4.11 Learning Summary 4/47
Review Questions 4/48
Case Study 4.1: The Use of Short-Term Interest-Rate Futures for Hedging 4/55

Module 5 The Product Set: Terminal Instruments III Swaps 5/1

5.1 Introduction 5/2


5.2 Interest-Rate Swaps 5/5
5.3 Cross-Currency Swaps 5/9
5.4 AssetLiability Management with Swaps 5/11
5.5 The Basics of Swap Pricing 5/17
5.6 Complex Swaps 5/29
5.7 The Credit Risk in Swaps 5/34
5.8 Learning Summary 5/41
Appendix 5.1: Calculating Zero-Coupon Rates or Yields 5/41
Review Questions 5/43
Case Study 5.1 5/49

PART 3 OPTIONS
Module 6 The Product Set II: The Basics of Options 6/1

6.1 Introduction 6/1


6.2 Types of Options 6/6
6.3 Option-Pricing Boundary Conditions 6/18
6.4 Risk Modification with Options 6/21

vi Edinburgh Business School Derivatives


Contents

6.5 Learning Summary 6/25


Review Questions 6/26
Case Study 6.1 6/31

Module 7 The Product Set II: Option Pricing 7/1

7.1 Introduction 7/1


7.2 Pricing the Option Liability 7/2
7.3 Multiperiod Extension of the Option-Pricing Method 7/8
7.4 PutCall Parity Theorem for Pricing Puts 7/12
7.5 Learning Summary 7/15
Appendix 7.1: Dynamic Replication of the Option Liability 7/16
Review Questions 7/19
Case Study 7.1 7/24

Module 8 The Product Set II: The BlackScholes Option-Pricing Model 8/1

8.1 Introduction 8/1


8.2 The BlackScholes Option-Pricing Formula for Calls 8/3
8.3 The BlackScholes Option-Pricing Formula for Puts 8/4
8.4 Properties of the BlackScholes Option-Pricing Model 8/4
8.5 Calculating the Inputs for the BlackScholes Option-Pricing Model 8/5
8.6 Using the BlackScholes Option-Pricing Model 8/12
8.7 Learning Summary 8/18
Review Questions 8/19
Case Study 8.1: Applying the BlackScholes Model 8/21
Case Study 8.2: The BlackScholes and Binomial Models 8/21

Module 9 The Product Set II: The Greeks of Option Pricing 9/1

9.1 Introduction 9/2


9.2 The Effect on Option Value of a Change in the Pricing Variables 9/3
9.3 Sensitivity Variables for Option Prices 9/3
9.4 Asset Price (U0) and Strike Price (K) / Delta (), Lambda () and Gamma () 9/5
9.5 Option Gamma () 9/13
9.6 Time to Expiry / Theta () 9/18
9.7 Risk-Free Interest Rate (r) / Rho () 9/24
9.8 Volatility () / Vega () 9/26
9.9 Sensitivity Factors from the Binomial Option-Pricing Model 9/29
9.10 Option Position and Sensitivities 9/33
9.11 Learning Summary 9/39
Review Questions 9/39

Derivatives Edinburgh Business School vii


Contents

Case Study 9.1: Option-Pricing Sensitivities 9/43

Module 10 The Product Set II: Extensions to the Basic Option-Pricing Model 10/1

10.1 Introduction 10/2


10.2 Value Leakage 10/2
10.3 Value Leakage and Early Exercise 10/8
10.4 Interest-Rate Options (IROs) 10/17
10.5 Complex Options 10/27
10.6 Learning Summary 10/31
Review Questions 10/32
Case Study 10.1: Applying the American-Style Put Adjustment 10/36
Case Study 10.2: Valuing an Interest-Rate Option 10/36

PART 4 USING DERIVATIVES AND HEDGING


Module 11 Hedging and Insurance 11/1

11.1 Introduction 11/2


11.2 Setting up a Hedge 11/7
11.3 Hedging Strategies 11/16
11.4 Portfolio Insurance 11/36
11.5 The Use of Options as Insurance 11/40
11.6 Learning Summary 11/47
Review Questions 11/48
Case Study 11.1: Hedging Interest-Rate Risk 11/56
Case Study 11.2: Hedging with Written Calls 11/56

Module 12 Using the Derivatives Product Set 12/1

12.1 Introduction 12/1


12.2 Case 1: British Consulting Engineers 12/4
12.3 Case 2: United Copper Industries Inc. 12/12
12.4 Learning Summary 12/33
Review Questions 12/33
Case Study 12.1 12/36

Appendix 1 Practice Final Examinations and Solutions A1/1


Examination One 1/2
Examination Two 1/13

viii Edinburgh Business School Derivatives


Contents

Appendix 2 Formula Sheet for Derivatives A2/1


1. Financial Basics 2/1
2. Covered Arbitrage 2/1
3. Cost of Carry Model 2/1
4. Implied Forward Rate 2/2
5. Forward Rate Agreement Settlement Terms 2/2
6. Synthetic Agreement for Forward Exchange Settlement Terms 2/2
7. Hedge Ratio 2/2
8. Fair Value of an At-Market Swap 2/2
9. Spot or Zero-coupon Rate (Zi) Derived from the Par-Yield Curve 2/3
10. Option Pricing 2/3
11. BlackScholes Option Pricing Model 2/3
12. Option Sensitivities 2/5
13. Adjustments to the Option Pricing Model 2/6
14. Hedging 2/8

Appendix 3 Interest Rate Calculations A3/1


Time-Value-of-Money (TVM) 3/1
Simple Interest 3/2
Bank Discount 3/3
Bonds 3/5
Yield (internal rate of return (IRR)) 3/5
Computing Zero-Coupon Rates 3/7

Appendix 4 Answers to Review Questions A4/1


Module 1 4/1
Module 2 4/8
Module 3 4/11
Module 4 4/19
Module 5 4/28
Module 6 4/38
Module 7 4/43
Module 8 4/51
Module 9 4/55
Module 10 4/60
Module 11 4/67
Module 12 4/74

References R/1

Index I/1

Derivatives Edinburgh Business School ix


Introduction
This elective course covers one of the core areas of market finance, namely deriva-
tives. The major classes of derivatives forwards, futures, options, and swaps are
key instruments for allowing market participants to transfer and mitigate risks and to
speculate on future asset values. The growth in the size and diversity of derivatives
markets testifies to their importance within the financial system. Furthermore, the
theory of option pricing is one of the key ideas in finance for which Myron Scholes
and Robert Merton were awarded their Nobel Prize in 1997.* The BlackScholes
option pricing model has been described as the workhorse of the financial services
industry. Understanding derivative pricing is an important element for financial
engineers when seeking to address problems in finance.
Financial futures are one of the most heavily traded markets in the world, with
futures exchanges existing in all major countries. Since the mid-1970s over seventy
futures (and options) exchanges have been established. They are organised markets
for exchanging a wide variety of financial and business risks, ranging from interest
rates across to insurance and, latterly, weather. The volume of transactions and the
types of instruments available to speculate on and manage risk continues to increase
as new uses are found for futures.
The development of a theory to price contingent securities has had major ramifi-
cations for the financial services industry. Option markets, both formal markets (as
with futures) and over-the-counter trading between principals, have expanded
dramatically following the introduction of a working model for their pricing. Option
pricing is complex with a number of factors determining their value. Many financial
transactions include option-like elements. In addition, some problems in corporate
finance can also be best understood in terms of option theory. This course provides
a conceptual understanding of how options are priced and how they can be used for
a wide range of risk management and other uses by financial practitioners.
Swaps are one of the newest developments in the derivatives product set and
have become an important component of derivatives markets. The pricing of swaps
illustrates how financial securities are valued in a competitive market. Swaps are a
key tool for asset-liability managers for all types of firms and complement the
derivative instruments available in futures and options markets.
A large part of the role of finance, the actions of the financial specialist and the
operations of the financial department within firms, are devoted to handling,
controlling, and profiting from risk. Hence this course emphasises how market
participants manage and exploit financial risks using derivatives. Of course, such
instruments can also be used for speculation or arbitrage. But it is the ability of

* Nobel Prize in Economic Science, 1997, for a new method to determine the value of derivatives
We only need to look at the activities of Nick Leeson of Barings Bank fame to see how an arbitrage
strategy can be easily turned into a speculative one! He fraudulently undertook highly speculative
transactions when he was supposed to be involved in low-risk arbitrage activity. As a result, Barings
Bank collapsed in 1995.

Derivatives Edinburgh Business School xi


Introduction

derivatives to modify risks that has helped place these instruments at the centre of
current activity in the global financial markets.
Before starting this course, the student is expected to have some prior knowledge
of the fundamentals of finance and, in particular, time value of money methods and
an understanding of statistical concepts. The level of knowledge required is that
which it is necessary to have in order to successfully complete a course in finance. It
is also strongly recommended that students have taken Financial Risk Management
which covers the sources of financial risk and methods of risk assessment.

Arrangement of the Course


The Modules that go to make up Derivatives fall into the following topic areas:

Topic area Modules


One Introduction to the Derivatives Product Set: 1 and 2
Introduces the fundamentals of derivatives and their
pricing, the different types, and their uses
Two Terminal Instruments 3 to 5
The different types of terminal derivatives: forwards,
futures and swaps
Three Options 6 to 10
The nature, types, pricing and uses of options
Four Using Derivatives and Hedging: 11, 12
Risk management using derivatives

The initial modules (Part One) introduce the different types of derivatives, name-
ly forwards, futures, swaps and options, how they are used, and explains the way in
which they can be valued.
The discussion then proceeds to cover in detail the mechanics and use of the
different terminal instruments, that is, forwards, futures and swaps (Part Two), and
options (Part Three) principally as risk management tools since this is a prime
justification for the growth in derivatives markets and shows how they can be
incorporated into the process as a means to transfer and control risk. The applica-
tion of these tools then follows (in Part Four), together with some of the inevitable
complexities that result from this process.
In presenting the text in this way, the aim is it provides a comprehensive and
logical approach to what is a complex subject.

Approach and Key Concepts


Derivative pricing is a complex subject. The text presents the different derivatives
product set elements in rising order of complexity. Whilst this is useful in develop-
ing a good understanding of how the derivatives product set works, it does have
some disadvantages in that material on one subject (for instance, the cost of carry

xii Edinburgh Business School Derivatives


Introduction

model used to price forwards and futures) is presented in different parts of the
elective. As a result, we would encourage students to look at alternative ways to
approach the text.
A basic premise of the material is that it is orientated towards the needs of a
market user, with a strong emphasis on using derivatives for risk management
purposes. Of course, as is explained at different points, these instruments can be
used for other objectives for instance, speculating and spreading.
As a course, it concentrates on the methodological and operational issues in-
volved in using derivatives. That is, it is technique based and emphasises the
mathematical, financial, or engineering approach to these instruments. Market users
can and do use these instruments without such knowledge. But seasoned
practitioners will agree that gaining the understanding of derivatives that this course
provides will assist you in using these instruments wisely.
As a subject derivatives introduces ideas that are central to modern financial
theory and practice. Daily, and all over the world, practitioners are putting to use the
models described in this course to manage the ongoing financial risks in the
organisations for which they work. For instance, the ideas behind option theory and
arbitrage pricing are central to managing the risks of contingent cash flows. It is a
prerequisite for anyone wishing to pursue a career in financial services or become a
financial specialist to gain an understanding of derivatives markets and pricing.

Assessment
As is customary with this programme, you will find self-test questions and cases at
the end of each Module. The answers are given at the end of the text. Also, there are
two pro-forma exams of the type it is necessary to pass in order to gain credit from
this course. The exam assessment is based on the following criteria:

Section Number of Marks Total marks


questions obtainable for the
per question section
Multiple choice questions 30 2 60
Cases 3 40 120
180

Derivatives Edinburgh Business School xiii


Acknowledgements
I would like to thank the Financial Times Ltd and the Scotsman for permission to
reproduce items from their publications as background material to this course.
Thanks are also in order to the production team at Edinburgh Business School
and an anonymous reviewer of an early draft of some of the text who provided
valuable comment on the evolving material. As is usual in these matters, all errors
remain the authors responsibility.

Derivatives Edinburgh Business School xiv


PART 1

Introduction to the Derivatives


Product Set
Module 1 Introduction
Module 2 The Derivatives Building Blocks

Derivatives Edinburgh Business School


Module 1

Introduction
Contents
1.1 Introduction.............................................................................................1/2
1.2 Arbitrage Relationships..........................................................................1/8
1.3 Derivative Markets .............................................................................. 1/17
1.4 Uses of Derivatives .............................................................................. 1/19
1.5 Learning Summary .............................................................................. 1/24
Review Questions ........................................................................................... 1/25
Case Study 1.1: Terms and Conditions of a Futures Contract ................. 1/29
Case Study 1.2: Constructing a Derivative Security using Fundamental
Financial Instruments .......................................................................... 1/29

Learning Objectives
Derivatives have become an important component of financial markets. The
derivative product set consists of forward contracts, futures contracts, swaps and
options. A key issue is how prices for such derivatives are determined. The ability of
market participants to set up replicating portfolios ensures that derivative prices
conform to no-arbitrage conditions. That is, the prices cannot be exploited without
taking a risk. Replication also explains how derivative claims can be manufactured to
order.
The principal justification for the existence of derivatives is that they provide an
efficient means for market participants to manage risks. But derivatives also have
other uses such as speculation and the implementation of investment strategies.
After completing this module, you should:
know the history of the development of derivatives, namely that:
there is early historical evidence for forward and option contracts
futures contracts were developed in the 19th Century and that financial fu-
tures were introduced in 1973
swaps were first traded as recently as 1981
new derivative products continue to be developed to meet specific needs of
market participants
know that derivatives are designed to manage risk, usually the price or market
risk of the underlier that arises from uncertainty about the underliers value in
the future. In particular, that:
market participants who need to buy in the future are exposed to the risk that
prices may rise before they can buy. This exposure to price risk is known as
buyers risk

Derivatives Edinburgh Business School 1/1


Module 1 / Introduction

market participants who need to sell in the future are exposed to the risk that
prices may fall before they can sell. This exposure to price risk is known as
sellers risk
be able to differentiate between the different elements of the risk management
product set, namely forward contracts, futures, swaps, and options;
understand how prices in financial markets are maintained in proper relationship
to each other through arbitrage;
be aware that arbitrage relationships rely on the Law of One Price and how
imperfections in the way real markets operate can limit the applicability of the
law;
understand that the payoff of derivative instruments can be replicated using
combinations of fundamental financial instruments;
understand how in an efficient market the prices of derivatives, which can be
replicated using fundamental financial instruments, are determined through arbi-
trage-free relationships;
know the main uses for derivatives, namely:
risk modification
hedging
speculation
spreading
arbitrage
lowering borrowing costs
tax and regulatory arbitrage
completing the market
be aware that the main justification for derivatives is that they enable market
participants to efficiently transfer risks.

1.1 Introduction
In 1995, Nick Leeson a trader at Barings Bank made the headlines when it became
public knowledge that, unknown to his bosses, he had run up losses of US$1.3bn
through dealing in derivatives. Prior to this, many people had been unawares of the
importance of derivatives in the financial system and their capacity to generate profits
or (in Leesons case) disastrous losses. Derivative is the generic name for a set of
financial contracts that include, forward contracts, futures, swaps and options. The
term derivative comes from the fact that the instruments obtain their value (derive it)
from the behaviour of more basic underlying variables. Hence derivatives are also often
referred to as contingent claims. The underlying variables can be a specific asset or
security, index, commodity, or even the relationship between different assets. The main
classes of instruments are forward contracts, futures, swaps and options. Later modules
of this course will examine each of these instruments in detail.
The number, type and variety of derivative contracts has expanded greatly since
the introduction of the first exchange-traded instruments in the early 1970s. Since
then, instruments have been introduced to manage the risks in interest rates,

1/2 Edinburgh Business School Derivatives


Module 1 / Introduction

currencies, commodities, equities and equity indices, credit and default risks, and
other financial risks. This increased variety, coupled to a wider use of derivatives by
market practitioners to address a variety of problems, has meant an explosion in the
volume of outstanding contracts.
While the current interest in the use and abuse of derivatives has been a
recent phenomenon, the commercial world has employed derivative contracts since
the dawn of trade. The increased use of financial derivatives, that is instruments
used to manage or speculate on financial risks, can be traced back to the introduc-
tion of financial futures in 1972 by the Chicago Mercantile Exchange (CME) and by the
Chicago Board of Trade (CBOT) and options on company shares by the Chicago Board
Options Exchange (CBOE) the following year. The CBOE is a subsidiary of the
CBOT, an exchange established in the 19th century to trade derivatives on agricul-
tural products. By introducing financial futures, the CME was responding to a
demand by financial markets for better ways to manage risks. By offering exchange-
traded options, the CBOE made available contracts that provided insurance against
future uncertainty.
Since 1973 the use of financial derivatives has snowballed and many new finan-
cial derivatives exchanges have been established. Not only has the volume of
transactions increased but the type and complexity of the instruments themselves
has increased dramatically. For instance, the original types of options traded at the
CBOE are now referred to as standard options to distinguish them from the exotic
options that have since been introduced.
Derivatives were introduced into commerce as a necessary tool for merchants to
handle risks. The principal risk that they are designed to manage is the price risk or
market risk of the underlier (the asset, security or variable that is the basis of the
derivative contract). The earliest form of derivative is the forward contract, which is
simply a purchase/sale agreement where the implementation or settlement of the
contract is deferred to some mutually agreed date in the future. In a normal contract
the purchase/sale leads to an immediate transfer of the contracted element from the
seller to the buyer, that is on the spot and hence are called spot contracts or cash
market contracts. With the forward contract, the transfer of the underlier is deferred
to a mutually agreed date although the price (and other features such as quality and
quantity) is agreed today. The attractions for both buyer and seller are obvious: by
trading now the buyer is guaranteed the price at which he can purchase. In the same
way, the seller is guaranteed the price at which he can sell in the future. This
arrangement makes a lot of commercial sense and evidence from earliest history
suggests that fixing a price for future delivery was an important element in commer-
cial activity. Early evidence of the prevalence of such contracts comes from the
ancient Assyrian commercial code, which included laws governing the writing and
enforcement of such contracts. There is also evidence from as early as 2000BC of
forward dealing in India. Historians have uncovered evidence that ancient Rome
had a market in such forward contracts for wheat, the staple commodity food for
the city.
In the 15th century, historians have documented that Antwerp was the centre of
a sophisticated forward currency market linked to the Flanders cloth trade. Mer-

Derivatives Edinburgh Business School 1/3


Module 1 / Introduction

chants due to receive or make payments in one of the many different currencies that
circulated in Europe at the time were able to fix in advance the exchange rate for
conversion (for example from florins to marks) so as to eliminate the risk. In fact
Thomas Gresham, the English businessman, established a bourse (or exchange) in
London in direct imitation of those that existed in Antwerp. This later became the
Royal Exchange. Greshams initiative was an early example of the commercial
competition for the management of risks. In the 18th century, terminal markets at
dockyards and other transit points were the focal points for dealing in forward
contracts. Merchants with goods being shipped to the port would be concerned that
their cargoes would temporarily upset the demand and supply balance. To counter
this, they would sell forward part or all of their products for delivery when the ship
docked.
In the mid-19th century, Chicago, Illinois, had become a centre for the mid-West.
Its proximity to the Great Lakes and the grain growing plains meant that farmers
shipped their produce to the city. The seasonal nature of production meant that
prices for grain rocketed in the spring but collapsed after the harvest. In 1848,
merchants in the city gathered together to find a better way of organising the grain
trade. As a result, the Chicago Board of Trade was created. Over the next few years, the
technology of forward contracts was refined. The result was the development of
futures contracts. While economically the same, these differed from forward
contracts by the fact that they not only managed the price risk in the underlier but
that they eliminated the credit risk that exists in forward contracts. The benefit of a
forward contract depends entirely on the willingness of both parties to honour the
agreement. If the market price changes substantially, there is a strong incentive for
the buyer (seller) to renege on the agreement and buy (sell) in the spot market. The
development of futures solved the performance risk problem by requiring each
party to collateralise their position. Futures have allowed a tremendous expansion of
the market in forward transactions since there is no longer a requirement to check
the soundness of the party with whom one is dealing.
Unlike forwards or futures contracts, options allow the buyer, known as the option
holder, the right to terminate the agreement and hence are more flexible. Like forward
contracts the first use of option contracts pre-dates written records. There is an
account by Aristotle of Thales, a philosopher in ancient Athens, about the use of
options. While the account is meant to show the benefits of an understanding of
philosophical ideas, the story itself shows that the use of options for commercial
purposes was well established. The story is that, stung by critics as to why he was poor,
Thales used the insights he had developed through philosophy to make himself a
considerable fortune. Observing that the forthcoming olive harvest was likely to be a
good one, he travelled around Attica making contracts with olive press owners to hire
their facilities in the autumn. As he had little money, the contracts involved his being
given the right of first use for the press at a given price. He paid a small amount of
money for this option. In the event as he had anticipated the harvest was abundant and
Thales was able to exercise his option and hire out the presses at a profit to growers,
making him rich in the process. While Aristotles account may be exceptional, there is
good historical evidence elsewhere. For instance during the Shogun era, the Japanese
silk trade made frequent use of option contracts. Options also are often written into

1/4 Edinburgh Business School Derivatives


Module 1 / Introduction

commercial contracts. For instance, many contracts allow the buyer to cancel delivery
in exchange for a fee.
Prior to the initiative taken by the Chicago Board of Trade in 1973, options on fi-
nancial instruments had been traded in financial markets, but were considered
esoteric and of little significance. The existence of traded options plus the happy
coincidence of the publication of the BlackScholes option-pricing model (BSOPM)
greatly accelerated the expansion of the market in financial options. BSOPM
provided a mathematical solution to the pricing of options based on two important
premises. First, that the value of an option can be modelled by looking at a replicat-
ing portfolio which has the same payoffs as the option, and second, the importance
of arbitrage forces in an efficient market. In the 1970s, financial institutions intro-
duced options on an ever-wider range of financial assets and sectors: currency
options, options on stock and other indices, options on interest rates and debt
securities to name but a few. In the 1980s financial engineers, that is mathematically
adept modellers of such contingent claims, were able to develop a range of options
with non-standard terms and conditions. These exotic options offered features
such as average prices (known as average rate options), or fixed payoffs (binary
options), or under certain conditions ceased to have a value (that is, they were
knocked out), and many more. More recently, a second generation of exotic
options has been created with names such as perfect trader that greatly expand the
opportunities available. Today, financial market users can find options to manage all
sorts of different risk characteristics. And if they cannot, they can ask a financial
institution to create one that exactly meets their needs.
Swiss Re and Mitsui Sumitomo Insurance Swap Catastrophic
Risks ______________________________________________________
In August 2003, Swiss Re, the reinsurance company, and Mitsui Sumitomo Insur-
ance of Japan entered into one of the worlds first catastrophe risk swaps. The
US$100 million transaction between the two insurance companies allows each
company to reduce its exposure to natural disasters, known in the insurance
industry as catastrophic risk, in its core market by passing on this risk to the
other party.
Under the agreement announced by the two firms, Swiss Re swapped US$50
million of potential insurance losses from North Atlantic hurricanes with the
same amount of protection given by Mitsui Sumitomo Insurance for a Japanese
typhoon.
According to a spokesperson at Swiss Re the key attraction was to swap future
potential insurance payouts on rare but devastating events. The likelihood that
the event would occur is about 2 per cent; that is, there is an expectation that
there will be one such event every 50 to 100 years. However, if such an event
happened, both insurers would be exposed to very large losses. Such events are
known as peak risks, insurance market jargon for the natural disasters that cost
insurance companies hundreds of millions in payouts.
The rationale from both sides is to provide an element of protection against the
very large exposures that the insurers have to such infrequent but costly

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catastrophes and to diversify their risk. It leaves both insurers core business
unaffected.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Swaps in contrast to the other derivatives are a relatively recent innovation. The
first cross-currency swap was unveiled only in 1981 although there were instruments
with similar characteristics traded prior to this. The first interest rate swap to be
publicly traded followed in 1982. The market in swaps grew very rapidly throughout
the 1980s and the instrument became established as a class of derivative. The
difference between a forward contract and a swap is that, with the swap, there is a
multiplicity of cash flows. The two parties to a swap agree to exchange a set of
predetermined cash flows rather than the single cash flow from a forward contract
(this singularity also applies to futures and options). The development of an
agreement that exchanged a series of cash flows helped financial market users to
manage the risks of a given cash stream. As a result, market users can now swap
cash flows from equities and commodities as well as manage interest rates and
currencies. Additional non-standard features have been introduced to meet special
circumstances, such as swaps which have option elements and are callable or
putable.
The Risk Management Product Set __________________________
The different derivative instruments that are traded in financial markets are
often called the risk management product set because their main function is to
transfer risks. The market for derivatives deals principally with market risk (or
the risk that the price of the underlying variables will change over time) but
other risks, such as credit risks and catastrophic risks, are also traded. The
market in derivatives can be seen as a market in risk. By appropriately trading
the instruments, market participants can exchange risks and reduce their
exposure to undesirable economic factors. Instruments exist to manage interest
rate risks, currency risks, equity risks, and commodity risks as well as some
other specialised risks. The instruments used to manage these risks are:
Forward contract: A commercial contract between two parties to buy and
sell at a price agreed today which has the delivery or settlement of the contract
deferred until some mutually agreed date in the future (when the exchange then
takes place). Quantity and quality are specified when the forward contract is
initiated. Any contract where the delivery or settlement is later in time than
that which is normal for the market in the physical commodity, known as the
spot market, is a forward contract.
Futures contract: Functionally this is the same as the forward contract.
However, it differs because the contract is traded on an exchange, the contracts
are standardised for all users to facilitate trading, the contract will be between
the buyer and the exchanges clearing house and the seller and the exchanges
clearinghouse. The result is that the credit risk will be intermediated. In addi-
tion, both buyer and seller will be required to post a performance bond to
ensure that the can fulfil their obligation under the contract.

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Option contract: This gives the holder (or buyer) of the option the right but
not the obligation to buy or sell the underlier at a specific price at or before a
specific date. While the option buyer (or holder) has the right to complete the
contract or not, the option seller (or writer) is obliged to complete the con-
tract if the holder requests it.
Swap contract: An agreement between two parties to exchange (or in
financial parlance, to swap) two different sets of future periodic cash flows
based on a predetermined formula.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

1.1.1 Fundamental Financial Instruments


Fundamental financial instruments exist in order to allow individuals to invest for
the future, to allow individuals and firms to raise capital and to borrow. In doing so,
these instruments or securities have a number of risks. For example, investors in a
firms shares are hoping that the management will be able to realise a profit. The
managers may be spectacularly successful or woefully unsuccessful in this regard. In
addition, the legal and economic structure of fundamental financial instruments is
designed to allow investors to modify and transfer risks as well as to address
contractual problems. An investor who holds all his wealth in just one company is
exposed to the risk that the business might underperform or even fail. By creating
a company where ownership is split into shares, investors can spread the risk across
a great many companies. At the same time, firms can raise money from a large
number of individuals. By spreading their investment across a wide range of firms
investors can diversify and hence reduce the impact on their wealth of one particular
business failing. As a consequence, they can take more risk in their portfolios. The
legal contract also protects shareholders so that in the event of failure the most they
can lose is the money they invested. These contractual arrangements help savers and
borrowers to contract together and undertake economic activity.
On the other hand, derivatives are securities that obtain their existence from the
value of fundamental financial instruments. They mimic the performance of the
underlier. But unlike fundamental financial instruments, which are a necessary part
of the economic system, derivatives are redundant securities. For a firm to raise
capital, it will have to issue shares or borrow money. In theory all the benefits of
derivatives can be achieved through the use of fundamental financial instruments.
The reasons derivatives exist is that they provide an efficient solution to the
problems of risk transfer. Take the situation where a merchant wants to lock-in the
price of grain. The fundamental financial instrument solution would be to buy the
grain today and store it. For most businesses this is both costly and inefficient. Far
better to be able to buy in the forward market and lock in both delivery and price
today in anticipation of future need. Similarly with a seller: a farmer may wish to
take advantage of current high prices to lock in the selling price. Without the
existence of a forward market in his produce, this is impossible. So although
derivatives are technically redundant, they exist because they allow economic agents
needs to manage their risks in an efficient manner. They are the least-cost solution
to the risk management process.

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They also exist because there is a two-way market in risks. A buyer is exposed to
potential price increases, a seller to possible price declines. We can show their
positions in terms of risk profiles, as shown in Figure 1.1. The buyer and seller are
both exposed to the risk that the market price will change. For the buyer the main
concern is that the price will rise and future purchases will cost more. For the seller,
the main concern is that the price will fall and a future sale will generate less
revenue. The solution is for buyers and sellers to exchange their risks. This is what
derivatives are largely designed to do. That said, as with fundamental financial
instruments, derivatives can also be used and are used for other purposes: for
investment and speculation.

Position of buyer

+ Buyer gains if market price declines

Market price
M
Current price
Buyer loses if market price rises

Position of seller
Seller loses if market price declines
+
Seller gains if market price rises

Market price
M
Current price

Figure 1.1 Risk profiles of buyers and sellers


Buyers will gain if market price falls, but lose if price rises. Sellers will gain if market price rises,
but will lose if price falls
In the jargon of financial markets, the buyer would be considered to be short the risk, or having a
short position in the risk (or the market for the risk); the seller would be considered to be long
the risk, or having a long position in the risk (or the market for the risk).

1.2 Arbitrage Relationships


A key issue is how to determine the value of derivative instruments. By value one
means the price at which the agreement is reached (for instance the forward price
for delivery) and/or any payment required by one party to the other (this applies to
options). Prices of such instruments are set by arbitrage conditions. As discussed in
the previous section, derivatives are functionally redundant since they can be
replicated through the use of fundamental financial instruments. Consequently, the
value relationships that apply between fundamental financial instruments have a

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critical role in determining the value of derivatives. Of equal importance is the


ability of market participants to create replicating portfolios using combinations of
instruments to mimic the value of derivatives. This ability to replicate allows market
participants to arbitrage between fundamental financial instruments (that is items
traded in the spot markets) and derivatives.
In an economically efficient market, assets or combinations of assets that have
the same payoffs should trade at the same price. In economics, classic deterministic
arbitrage involves market participants buying an asset at one price in one market and
simultaneously selling it at a higher price in another market thus enabling the
arbitrageur to realise an immediate risk-free profit.1 The rule of thumb is to buy low
and sell high. For instance, if the exchange rate for sterling against the US dollar in
London was $1.75/and in New York it was $1.74/, in the absence of any market
imperfections which prevented it, an arbitrageur could sell pounds in London and
obtain $1.75 and buy pounds in New York at $1.74 netting a profit of 1 per pound
with little or no risk.2 In an efficient market such, as that which characterises foreign
exchange, opportunities to arbitrage should be rare to non-existent. Economists
refer to the relationship where assets, or combinations of assets, which have the
same payoffs and hence should trade at the same price as the Law of One Price.
Arbitrage ensures that prices between different assets (and combinations of assets)
remain in the correct value relationship to each other.
It may take some thought and analysis to determine whether the price of two
assets or combinations of assets are in the correct arbitrage-free relationship to each
other. To be sure that the prices offer an arbitrage opportunity we need to know
what the prices should be. Hence, we need a pricing or valuation model. In finance
most models are valuation models since we want to know whether the asset, security
or portfolio is being valued correctly. That is, we want to measure our should be (or
theoretical) price against the actual market price.
For instance, if the current or spot market gold price is $400 per ounce, the for-
ward market price with one year delivery is $450 per ounce and the one-year interest
rate in US dollars is 4 per cent is there the possibility for arbitrage or are prices in the
correct relationship to each other? Or what if the spot gold price is $400/oz, the one-
year forward price is $400/oz and the one-year US dollar interest rate is 4 per cent,
does this present an arbitrage opportunity? In order to answer this, we need to be able
to set up a replicating portfolio to take advantage of any mispricing. The arbitrageur
would need to know if any element was mispriced. In order to know whether the
forward price was correct or not he would need a pricing model with which to
compare the actual price. For forward contracts the theoretical price (as determined
by the pricing model) is called the cost of carry. This is discussed in detail in Module 3.
1 Note that in practice there may be some small residual risks involved. Also, the terms arbitrage and
arbitrageur have been much abused. Many speculative activities, such as betting on the outcome of
mergers and acquisitions, are termed arbitrage. Risk arbitrage as such activities are known has little in
common with the classic definition of deterministic arbitrage.
2 Moving money from London to New York and back is virtually costless. The counterparties to the
transactions might worry about the arbitrageurs credit standing but otherwise without the presence of
government regulations there is little to stop a market participant from exploiting the opportunity.
Hence in a competitive market it is unlikely to be present for long.

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Suffice at this point to explain that with the forward price of gold at $450/oz, the
arbitrageur would want to buy the gold in the spot market, finance this by borrowing
dollars at 4 per cent and simultaneously agreeing to sell gold in one years time. The
payoff from this strategy, which is known as a cash-and-carry arbitrage, is shown in
the upper half of Table 1.1. On the other hand, with the forward price of gold in one
year at $400/oz the arbitrageur would want to undertake the opposite strategy:
borrow gold for a year and sell it, investing the proceeds at 4 per cent and agreeing to
buy gold in the forward market. This is known as a reverse cash and carry and is
shown in the lower half of Table 1.1.

Table 1.1 Arbitrage operations in gold


Cash-and-carry in gold $
At initiation
Sell gold in forward contract @ $450/oz
Buy gold spot at $400/oz (400.00)
Finance purchase by borrowing for 1 year 400.00
Net investment 0.00
At maturity
Sale of gold through forward contract 450.00
Repayment of borrowed funds (400.00)
Interest on funds at 4% (16.00)
Net profit 34.00

Reverse cash-and-carry in gold $


At initiation
Buy gold in forward contract @ $400/oz
Sell gold spot at $400/oz 400.00
Invest by lending for 1 year (400.00)
Net position 0.00
At maturity
Purchase gold through forward contract (400.00)
Loan 400.00
Interest on loan 16.00
Net profit 16.00

Note: it is possible to configure the transaction so as to extract the profit at initiation.

Note that the cash-and-carry and reverse-cash-and-carry strategies require us to


set up replicating portfolios using fundamental financial instruments. These portfo-
lios involve buying or selling in the spot market, borrowing or lending, and taking
the opposite position in the derivative.
If the price is above this replicating price we can expect many market participants
to set up cash-and-carry transactions and seek to buy gold in the spot market and

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sell it in the forward market. Supply and demand will push down the price at which
buyers are prepared to transact in the forward market. In the same way, with the
price of the forward contract at $400/oz, market participants will seek to sell gold in
the spot market and buy it back in the forward market. The only price that would
prevent arbitrage is one where the forward price exactly equalled the replicating
portfolio price, namely $416/oz.
To summarise: in order to determine whether arbitrage is possible we need a
pricing model for the derivative that explains what the price should be. Equally, we
can consider that the only appropriate price for the forward contract is the price that
prevents arbitrage. Another way to look at it is to see that that the correct (or
theoretical) price is the reproduction cost of taking the opposite side of the transac-
tion. Knowing this provides a way of valuing such contracts. Another example will
help to make this latter point clear. In Table 1.2, we have the exchange rate and
relevant interest rates between sterling and the US dollar. At what rate would a bank
agree to undertake a forward foreign exchange transaction with a customer who
wished to buy 1 million and sell US dollars in 12 months time?

Table 1.2 Currency and interest rates for the US dollar and sterling
Market conditions
Spot exchange rate US$1.4500 = 1
Interest rates
1 year US dollar 4.00%
1 year sterling 5.00%

The reproduction approach requires us to create a replicating portfolio that is


risk-free to the bank. The agreement involves the bank paying (a) 1 million and (b)
receiving US dollars in exchange. We can do this by the bank (1) borrowing US
dollars in the money markets for one year, (2) buying the present value of 1 million
and selling dollars at the spot exchange rate and (3) depositing the sterling in the
money market for one year. At maturity, the deposited sterling (3) is repaid and is
used to pay (a) 1 million to the customer in exchange for which the customer gives
(b) US dollars which are then used to pay off (1) the dollars borrowed by the bank.
By correctly pricing the forward foreign exchange contract and trading through the
replicating portfolio, the liability is exactly matched. The bank needs to quote a
forward exchange rate of US$1.43619 to the pound. The replicating transactions are
shown in Table 1.3.

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Table 1.3 Replicating transactions required to price a forward foreign


exchange contract
At initiation
US dollars Exchange Sterling
rate
Borrow $ 1380952.38 $1.4500 (952 380.95) Invest
[1] [2] [3]
At maturity
Customer (1436190.48) $1.4362 1 000 000 Customer
pays receives
(b) (a)
Notes:
(a) customer buys sterling and (b) sells US dollars
[1] bank borrows US dollars at 4 per cent per annum which will be offset at the maturity of the
forward contract by the customer delivering US dollars (b)
[2] bank converts US dollars into sterling at the spot exchange rate of $1.4500
[3] bank invests the sterling at the one-year sterling rate of 5 per cent. At maturity, sterling will be
used to pay the customer (a)

In practice, the bank can simply price the forward foreign exchange contract
using the interest rate parity relationship for the forward foreign exchange rate:

1 1.1
1
where is the forward rate at time t, and are foreign (quoted currency) and
domestic (base currency) interest rates respectively for the currency pair for the time
period t. Equation 1.1 gives the same result as the replicating portfolio calculations
in Table 1.3 and can be considered an arbitrage-free pricing model for the forward
foreign exchange rate. In fact, the interest rate parity model is a variant of the cost
of carry model discussed earlier in the context of the gold price, which is also, as we
have seen, an arbitrage-free pricing model.

1.2.1 Dynamic Arbitrage


Not all arbitrage operations can be undertaken simultaneously. Consider the
following situation. Take a contingent claim (an option to purchase a share) which
has an agreed purchase price of $90 after two years. The current share price is $100.
We dont know what the price of the shares will be in two years time. We do know
that if the share price is less than $90, the holder of the contingent claim will not
exercise their right of purchase and instead will buy at the then prevailing lower
market price. Given this uncertainty, we cannot simply buy the shares now and sell
them to the contingent claim holder at maturity. Let us now assume that an investor
is willing to pay $25 for this contingent claim. Is there an arbitrage opportunity?
We need to know something about how the share price might behave between
now and two years time. Keeping things simple, we know that at t=1 the share

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price might rise to $120 or it might fall to $80. If it rises to $120 at 1, at 2 it


might subsequently rise again to $140 or fall back to $100. If on the other hand it
falls to $80 at 1, at 2 the price might recover to $100 or continue its fall to
$60. The possible price paths for the share are given in Figure 1.2.

Value of contingent
t=0 t=1 t=2 claim (S K)

140 50

120

100 100 10

80
60 0

Figure 1.2 Possible price paths for the share


The value of our contingent claim will therefore depend on the possible price
paths between now and year 2. Its current value is the difference between the
market price for the shares and the price at which the claim can be exercised. The
current price is $100 for the shares and the price at which the shares can be pur-
chased is $90, so the claim must be worth at least $10. That is the claim must be
worth a minimum of (S K) where S is the share price and K is the price at which
the share can be purchased. Since the contingent claim is an option, if the share
price is below K, the investor will not exercise the right of purchase and abandon
the claim. So the payoff (S K) is bounded on the downside at zero. The payoff
will be the maximum of (S K), or zero. Depending on the future price behaviour
the value of the contingent claim will be:

Share price at t=2 140 100 60


Contingent claim value 50 10 0

As with the earlier examples, the arbitrageur will want to sell the overpriced ele-
ment and hold the correctly priced one. In this case it involves selling the contingent
claim and holding the arbitrage or replicating portfolio. At initiation, the arbitrageur
will have sold one contingent claim and will take a fractional investment of 0.6985
shares plus borrowing 48.32.3 Interest rates are 4 per cent per annum. The position
at t=0 is given in Table 1.4.

3 The fractional investment, known as delta (), is determined by the ratio of price change in the
derivative if the share price rises or falls to that of the underlier, namely:


1.1

The share price range is 120 80 and the value of is .6985 so the value ( ) is 27.94. To
solve for we need to know the value of the contingent claim at t=1 for both the up move (U) and

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Table 1.4 Arbitrage position at t=0


Component Value
Buy 0.6985 of a share (69.85)
Borrow 48.32
Sell contingent claim 25.00
Net position/gain 3.47
Arbitrageur has sold one contingent claim and set up a replicating portfolio to deliver the
commitment to sell, if required, under the claim

What happens at the end of year one? The arbitrageur does not know whether
the share price will go up or down. However, the portfolio will need to be re-
balanced at t=1. After one year, if the share price has risen, the required fractional
holding needs to be increased (in this case to one, or one share). If the share price
has fallen, then the fractional holding needs to be reduced (in this case to 0.25 or a
quarter of a share). The net value of the position at t=1 when the share price has
either risen or fallen and after rebalancing is shown in Table 1.5.

Table 1.5 Arbitrage position at t=1


Component Share price
120 80
Value of fractional holding in share from 83.82 55.88
t=0
Required fractional holding in shares 1.000 0.2500
Required additional holding .3015 (.4485)
Adjustment to share position 36.18 (35.88)
[A] Total position in shares 120.00 20.00

Original borrowing (48.32) plus interest 50.29 50.29


at 4%
Additional borrowing/(repayment) 36.18 (35.88)
[B] Net borrowed funds 86.47 14.41

[A B] Value of position (contingent 33.53 5.58


claim)

Arbitrageur rebalances the replication portfolio established at t=1. If the value of the shares has
risen, the arbitrageur increases the fractional holding in the shares; if the share price has fallen, the
arbitrageur reduces the fractional holding in the shares.

the down move (D). We can only find this by solving first the value of the claim at t=2 and working
backwards to find the theoretical (or arbitrage free) price of the claim at t=1, knowing its value at t=2.
The value of the position in Table 1.5 in the upper node is 33.53 and the lower node is 5.58. So for
t=0, the appropriate fractional investment to take in the share is:
33.53 5.58
.6985
120 80

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At maturity, the contingent claims value will depend on how the share price has
performed between the first and second year. As Figure 1.2 shows there are three
possible outcomes. The result of the replicating portfolio is given in Table 1.6.
As Table 1.6 shows by following the replicating strategy, regardless of the out-
come at maturity, the arbitrageur has exactly the required amount of money to pay
off the value of the contingent claim. With the share price at $140 and the exercise
price of $90 the contingent claim seller has to deliver a security worth $140 for $90.
Buying the security in the market at $140 but selling at $90 means a loss of $50. The
replicating strategy has delivered a profit of $50 so the arbitrageur walks away
without loss.

Table 1.6 Arbitrage position at t=2


Component Share price
140 1001 60
[A] Portfolio from t=1 140 100
when share = $120
[B] Borrowing (86.47) 90 90
plus interest at 4%
[A B] Net value of position 50 10(a)

[A] Portfolio from t=1 25 25


when share = $80
[B] Borrowing (14.41) 15 15
plus interest at 4%
[A B] Net value of position 10(b) 0

Payout on contingent claim 50 10 0


Net position of arbitrageur 0 0 0

Possible outcomes depending on the share price at t=1


1 Note that either outcome (a) or (b) occurs depending on what happens at t=1

As with the earlier examples for gold and the forward foreign exchange transac-
tion, the theoretical or arbitrage free price thrown up by the model for the
contingent claim is the price that exactly compensates the contingent claim seller for
replicating the payoff of the claim. This means the correct theoretical price for the
contingent claim should have been $21.53. Market forces will lead arbitrageurs to
sell contingent claims if the market price is above the theoretical price and buy them
if it is below thus forcing convergence to the theoretical price.4
The model for valuing a contingent claim is known as a conditional arbitrage
model and requires the arbitrageur to rebalance the replicating portfolio as the value
of the underlier changes. This conditional arbitrage model is the basis of all standard

4 As with the cost-of-carry example, if the price of the contingent claim is below that of the replicating
portfolio, the arbitrageur will buy the contingent claim and sell the replicating portfolio (going short
the shares and lending) and rebalancing at t=1.

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option pricing models where the value of the option is determined by reference to
its replicating portfolio. For this reason such pricing models are often called
arbitrage pricing models.
An important corollary of the replicating portfolio approach is that the contin-
gent claim seller, who has the obligation to deliver under the contract, is indifferent
to the price behaviour of the underlier. Hence risk preferences do not affect the
pricing of these claims. As the position is risk-free, it will earn the risk-free rate of
interest and this means that complications about risk-adjusted discount rates can be
ignored when working out the present value of the portfolio.
Note another outcome of the modelling process: even without an arbitrage op-
portunity, the dynamic replication strategy allows the contingent claim seller to
manage the risk from selling the contract. In the example above, once the vendor
has received $21.53 for the contingent claim, by following the dynamic replication
strategy, the writer has eliminated all risk.5

1.2.2 Impediments to the Law of One Price


In an efficient market there are no impediments to prevent smart market partici-
pants exploiting the fact that if there are two assets or packages of assets that have
the same payoff and which have different prices then arbitrage can be undertaken.
In order to determine whether there is a profitable arbitrage opportunity, the market
participant may have to undertake sophisticated modelling to determine whether he
can construct a replicating portfolio synthetically via a combination of fundamental
financial instruments. Given the potential rewards from arbitrage, market partici-
pants will devote time and effort to constructing replicating portfolios in order to
exploit incorrect prices.
How realistic is it for market participants to undertake such arbitrages? The repli-
cating portfolio is almost the same as the asset or contingent claim being replicated.
To the extent that the model has non-realistic assumptions when applied in practice
then the values of the two may differ. Arbitrageurs and contingent claim vendors
are always seeking to improve the accuracy of their models. However, the real world
departs from that of the models. In particular, transaction costs affect the result and
are not a feature of most theoretical models. In the case of our dynamic replication
example, the arbitrageur does not know in advance whether at t=1 more shares will
be purchased or sold and how many. Hence transaction costs will affect the
exactness of the result.
Other real world market imperfections or frictions can also affect the result. One
possible problem is contractual uncertainties. For instance, when a market partici-
pant sells shares he does not own, these have to be borrowed. Generally shares can
only be borrowed for a short period (days or weeks). Hence the maturity of the

5 In practice of course the model is only a representation of reality and to the extent that actual market
behaviour differs from that assumed in the model the writer will have an element of residual risk.
Hence a prudent writer will charge more for the option to cover himself. But to the extent that actual
and model behaviour converge, competition for business in financial markets will drive down the
prices of contingent claims towards their theoretical values.

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contingent claim being replicated may differ from the transactions that underpin the
replicating portfolio. There are other complications from stock borrowing. The
stock lender may require a haircut (or prudential deposit) so that the short seller
does not receive the totality of the value of the short sale. Also, it is the case that
borrowing and lending rates differ.
Another issue is taxes. The assumption of most models is that there are no taxes.
In practice, the tax treatment of the gains and losses from the written leg of the
position (the contingent claim sold to the investor) might be treated differently from
that of the components of the replicating portfolio. So one may not be able to offset
the other leading to unanticipated losses. Another factor is the periodic apparent
irrationality of financial markets. For instance, in periods of disturbance or stress,
pricing relationships can break down leading to unanticipated losses.6 Yet another
factor that can make arbitrage hazardous are differences in information between
market participants. Prices at which transactions are made may not reflect the true
intrinsic value of the instruments being traded.
The result is that while the pricing models that are used to compute the theoreti-
cal or fair value of a derivative have been shown to be good representations of the
actual market prices of such instruments, the models are not quite the same thing as
the derivatives themselves. This always needs to be kept in mind when considering
the analysis of such models. Nevertheless, the arbitrage principle is a powerful tool
for both analysing derivatives and explaining the observed prices of such instru-
ments in financial markets.

1.3 Derivative Markets


Derivatives are traded in financial markets. We can distinguish two types of markets
and instruments: exchange-traded and over-the-counter (OTC) markets. Exchange-
traded instruments are bought and sold through an organised exchange. For
example, in the UK, the major exchange for financial derivatives is Euronext-LIFFE.
On this exchange, interest rate, equity and commodity derivatives are traded. In
order to facilitate trading products are standardised. For instance, all the options
traded on a particular underlier will have the same terms. The exchange will fix the
number of units in the underlier, the maturity dates and the exercise prices for the
options, where and when the underlier is to be delivered. These are laid out in the
contract specifications. The only factor that will vary will be the price at which the
options trade. Transactions either are executed on the trading floor or as with
Euronext-LIFFE through screen-based trading systems. The exchange controls
how trading is organised and regulates the activities of traders, who have to be
registered with the exchange. The way trading and other elements of the settlement
process are organised means that market participants have virtually no credit risk.
In contrast OTC markets involve bilateral transactions between market partici-
pants. Since these are negotiated directly between the parties involved, it is possible

6 A good example is the collapse of Long-Term Capital Management (LTCM). See Roger Lowenstein
(2001), When Genius Failed, New York: HarperCollins Publishers.

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to offer non-standard products. Unlike exchange-traded products that have to be


standardised to ensure liquidity, OTC markets can offer great flexibility to users. All
terms can be negotiated and customised to meet the needs of the parties involved.
However, since contracts are negotiated directly between the two parties, OTC
transactions are subject to credit risk. This means that only counterparties with a
good credit reputation are acceptable as counterparties although mechanisms similar
to those used for exchange-traded products can be used to alleviate this problem.
Plus since the contracts are customised, it is not easy to unwind or cancel such a
contract after it has been agreed.
Derivatives Markets Terminology ____________________________
Derivatives markets are replete with their own, sometimes esoteric, terminolo-
gy. Some of the more common terms are given below.
Cash market: The market in fundamental financial instruments or physical
goods. Also called the spot market.
Derivative or derivative instrument or security: A contract whose payoff
and hence value is determined by the price of another underlying asset. Also
referred to as a contingent claim.
Contract specifications or characteristics: The terms detailing the quality,
size, price and delivery terms of a derivatives contract. For over-the-counter
markets these might differ between transactions, for exchange-traded contracts
only some elements are negotiable.
Underlier: the fundamental financial instrument, portfolio, or physical asset,
from which the derivatives contract obtains its value.
Delivery: Procedures for settling the payment and receipt of the underlier at
maturity or upon exercise. Some contracts do not involve a transfer of the
underlier from seller to buyer and settle by paying the difference between the
contracted price and the delivery price.
Clearinghouse: The institution which, as it names suggests, organises the
settlement of transactions and, for exchange-traded derivatives, acts as the
counterparty to all transactions.
Long or long position: A situation where a market participant either currently
holds the underlier or will need to purchase the underlier in the future. Hence a
purchaser of a forward or futures contract who is contracted to receive the
underlier at the maturity of the contract is deemed to have a long position in
the contract.
Short or short position: A situation where a market participant either
currently has sold the underlier short or will need to sell the underlier in the
future. Hence a seller of a forward contract who is contracted to deliver the
underlier at the maturity of the contract is deemed to have a short position in
the contract.

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Holder. The buyer of an option. The buyer has the right to exercise the option
and complete the transaction if it is advantageous to do so. That is, the buyer
holds the rights from the option.
Writer: The seller of an option. With a call option the writer has to sell at the
strike price, with a put the writer has to buy at the strike price. Hence the
seller has written the right of exercise.
Exercise: To activate the right to purchase or sell given by an option.
Exercise price or strike price: The contracted price (or rate) at which an
option holder can execute or complete the transaction.
Expiration: The point at which a derivatives contract ceases to exist, that is it
expires. Also called maturity.
Life: The length of time a derivatives contract is in force. Also called the tenor.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

1.4 Uses of Derivatives


As discussed above in Section 1.2.2, market participants need fundamental financial
instruments to borrow and lend. As we have seen, derivatives can be replicated
using combinations of fundamental financial instruments. That said, derivative
instruments provide an efficient or least-cost means of undertaking many financial
activities. Their ability to meet the many different needs of market users reinforces
their importance in the financial system. This section examines the different uses to
which market participants put derivatives.7

1.4.1 Risk Modification


The fundamental justification for the existence of derivatives is their ability to
modify risks. Consider the following situation. An investor can either buy a share
with a current value of $100 or purchase an option to buy the share for $4. With the
option the investor has the right to buy the share in six months time at $100. What
are the possible outcomes? Let us assume that the share can be worth either $120 or
$80 in six months time. With the immediate share purchase, the investor can either
gain or lose $20 depending on the outcome. With the option, however, the inves-
tors maximum loss is $4, the cost of the option. Only if the share price is at $120 in
six months time will the investor exercise his right to buy at $100. Then his gain will
be $120 $100 $4, or $16. By buying the option rather than the share the
investor has modified his risk. The maximum loss is now limited. In like fashion all
derivatives allow users to modify their risks. This ability to modify risk is a key
characteristic of derivatives and justifies their position within the financial pantheon.

7 Of course the total market activity recorded for particular types of derivative will represent the sum of
the different uses that market participants have for the particular instruments.

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Note that risk modification can involve taking more risk rather than reducing risk.8
If the investor had wanted to take more risk then he could have written the option!

1.4.2 Hedging
Hedging is a special case of risk modification that has as objective the elimination of
all risk. While risk modification changes the nature of a risk but may not eliminate it
completely, with hedging the intention is to remove the source of risk. For instance,
a company is selling its product abroad. The currency in which the buyer negotiates
is not the operating currency of the seller. Once the contract is struck, the seller is
faced with the fact that due to the time lag between agreeing terms and receiving
payment there is a risk that the exchange rate will have changed. Derivatives provide
a simple solution to this problem. In this case the seller can agree a forward foreign
exchange contract with a bank to sell the foreign currency and buy the domestic
currency. In this way the company has hedged its exchange rate risk on the sale. The
intention when entering the forward contract is to reduce the unwanted exchange
rate risk to as little as possible. This will be zero in this case as the forward foreign
exchange contract exactly matches and offsets the foreign currency position. In
other cases, the fit might not be so exact and the hedge will be imperfect. Neverthe-
less, the intention when using derivatives for hedging is to obtain the maximum
protection from the source of risk even if there is some residual risk. With an
imperfect hedge, some protection is better than none at all.

1.4.3 Speculation
Speculation is risk modification designed to benefit from exposure to a particular
risk. Take the situation where a market participant has a view that as a result of
tensions in the Gulf region, the oil price will increase. Strategy one is to buy crude
oil in the spot market. There are significant disadvantages to this strategy if the only
reason for buying oil is to profit from an anticipated increase in price. Oil is a bulky
commodity and will have to be stored, and this can be costly. It is also necessary to
find a buyer for the oil when the anticipated price increase has taken place. Far
simpler from the speculators perspective is to buy crude oil futures. That is,
exchange-traded contracts that fix the price at which crude oil can be bought and
sold at a specific date in the future. These have the same economic exposure to
changes in the spot price for crude oil but none of the disadvantages of physical
ownership. In fact by using futures, which are highly liquid instruments, the
speculator can immediately take a position in the crude oil market (the underlying
risk factor) and sell it again without worrying about finding a seller, storage or an
eventual buyer. The costs of setting up a position to take advantage of a rise in the
crude oil price in the futures market will be far less than the costs of setting up a
similar trade in the spot market. That means that even a relatively small increase in
the crude oil price will make money for the speculator. So while derivative markets

8 The emphasis of this course will be on how derivatives can modify risk and, in particular, how they are
used for risk management. This focus builds on the principles and processes of the eMBA elective
Financial Risk Management.

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are designed to manage risks, they do allow the more adventurous to benefit from
assuming risk. In this case, the speculator is taking the risk that oil prices do not rise
as anticipated! The existence of speculative activity in derivative markets acts to
increase the pool of capital available for the market and to increase the supply of
counterparties thus increasing the market size for market participants who are
natural hedgers.

1.4.4 Arbitrage
Arbitrage operations aim to exploit price anomalies. The basic mechanisms have
been described in Section 1.2. The existence of derivatives provides arbitrageurs
with more pricing relationships that can be exploited if the prices move away from
their correct relationships. For instance, if the prices at which options are traded
differ from their theoretical value, arbitrageurs will step in to exploit this fact. Take
the situation where a call option on a share with an exercise price of $100 is trading
at $4.5 and the corresponding put (with the same exercise price) is trading at $2.7.
The current share price is $102. The options have 3 months to maturity (expiration)
after which they are void. The three months interest rate is 4 per cent per annum. A
trader can arbitrage the mispricing of the call and the put. The trader buys the call
for $4.5, sells the put at $2.7 and sells the share for $102 and invests the present
value of the $100 exercise price (this is $99.02). The net gain from this is $1.18. At
maturity one of two situations arises. If the share price is above $100, the arbitrageur
exercises the call by using the invested funds and receives the share. This share is
then returned to the stock lender. If the share price is below $100, the call is
abandoned. Having written the put the arbitrageur is now contractually committed
to purchasing the share for $100 when its market price is less than this. The holder
exercises the put and the arbitrageur pays for the share he is obliged to receive using
the invested funds. Again the share is returned to the stock lender. Whatever the
outcome, the arbitrageur nets a $1.18 from the transaction without having to invest
any of his own money.

1.4.5 Spreading
Spreading involves taking advantage of or limiting the impact of price changes
between two assets. Hence it can be either for speculative purposes or for risk
management. Extending the oil speculator example in Section 1.4.3, now the
speculator has a view that the margin between unrefined crude oil and its refined
products (unleaded gasoline and heating oil) is likely to increase due to refining
capacity shortages. He wants to take advantage of this fact. One possibility, as with
the simple directional crude oil transaction, is for him to sell crude oil and buy
unleaded gasoline and heating oil in the spot market. But this is even more compli-
cated than the simple strategy of buying crude oil on the expectation that its price
will rise. It is far simpler for the speculator to deal in energy futures contracts.
Contracts exist for crude oil and its refined elements, unleaded gasoline and heating
oil. By buying futures in the refined products and selling the crude oil futures, the

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speculator is anticipating a widening their price relationship.9 If he is correct,


regardless of whether the crude oil price goes up or down, the speculator will make
money. This is an important feature of spread trading. The profit (or loss) from the
spread transaction is not dependent on absolute price levels but on changes in the
price relationship between the two assets. Using derivatives for spreading reduces
the cost and complexity of setting up transactions designed to exploit or hedge
changes in this relationship. Hence derivatives are the instruments of choice for this
type of transaction. In fact, to use the spot or physical markets to exploit these
spread relationships, speculators would have to anticipate very significant changes in
their relative prices to compensate for transaction and other costs.

1.4.6 Decreasing Financing Costs


Derivatives allow users to modify their risks. They can help firms decrease their
financing costs. Take the situation where a company can either borrow in its own
country and lend the money to its foreign subsidiary or the subsidiary can borrow in
the local currency. In the case where the subsidiary borrows locally, the local income
will service the debt. In the case where the parent supplies the funds, the local
income has to be exchanged for the currency of the parent company. The company
is likely to be able to borrow in its own country on much finer terms because it is
better known and respected than in the foreign country where it is less well known.
By borrowing locally it is paying more (but eliminating the exchange rate risk on the
borrowing). The company would benefit if it could borrow in its home country and
yet lend in the local currency of its subsidiary. This is precisely what cross-currency
swaps allow firms to do. They can raise finance in the cheapest market and currency
without having to worry about the exchange rate risk. The cross-currency swap
converts the borrowed currency into the desired currency while at the same time
eliminating the exchange rate risk. Firms can reduce their financing costs because
derivatives are available to manage undesirable financial risks.

1.4.7 Tax and Regulatory Arbitrage


Under UK laws, individuals and firms have the right to organise their affairs to
minimise the amount of taxes they pay. Derivatives allow firms to manage their tax
liabilities. For instance, a firm that borrows money from a bank may not know what
its future interest rate cost will be. Interest expense is normally tax deductible, but
only if there is sufficient profit. The firm therefore may be exposed to unanticipated
increases in borrowing costs that it cannot offset against its profits if these are not
large enough. It may therefore want to fix the total interest charge it pays so as to
ensure that it can take advantage of the interest rate tax shield. The firm can do this
using derivatives. By entering into a forward rate agreement the firm can fix the
amount of interest it will pay for a given period without having to renegotiate its

9 This margin is known as the crack spread. That is, the difference in price between the unrefined and
refined products which represent the refiners costs and margin from cracking the crude into its
constituents. A refiner might be interested in protecting this margin and hence would undertake a
crack spread designed to lock-in a fixed margin if it was of the view that excess refining capacity was
likely to depress margins.

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borrowing from the bank. The contract converts an uncertain future interest
expense into a fixed or certain expense.
In a similar manner to the firms management of its tax deductibles, banks and
other regulated financial institutions can manage the amount of regulatory capital
required to support their business. One way of doing this is to use derivatives.
Banks have to allocate more capital against loans to commercial enterprises than for
loans to governments and state entities to cover against the potential default risk.
This means banks are limited in the amount of lending they can make to commercial
firms without raising more capital. Banks can use derivatives to reduce the amount
of capital required to lend to commercial enterprises. By using a credit derivative,
the bank buys insurance against default. As a result financial regulators are prepared
to allow banks which have lent to commercial enterprises and used credit derivatives
to transfer the default risk to allocate less capital to such loans.

1.4.8 Completing the Market


Finance theory suggests that it should be possible to construct unique payoffs for
every future possible state of the world. Take the simple example given in Table 1.7
that assumes there are only two possible outcomes and two available securities.

Table 1.7 Complete market


Security Price State of nature
1 2
B 9 10 10
M 13 10 20

By holding judicious combinations of security B and M, a financial engineer can


create portfolios which have a positive payoff in one state and zero payoff in the
other. The cost of setting up a security with a payoff of 1 in state two will be 0.4 and
that for state one will be 0.5.10
In that sense, the two available securities B and M span the market and the
market can be considered complete. If, on the other hand, as given in Table 1.8,

10 The replicating portfolio will be created by finding the appropriate value for such that the portfolio is
risk-free with in state one a net value of zero and in state two a net value of one. This is obtained by:
1 0
.1
20 10
And setting up the replicating portfolio, such that:
20 1 1

10 1 0
Where B is the amount of borrowing at the risk-free rate (which is 11.11 per cent). The cost now of
setting up such a portfolio will be:
13 / 1 .4
In like fashion, the cost of setting up a replicating portfolio with a payoff of 1 in state one and zero in
state two is 0.5.

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there are three states of nature and only two securities, then the market is incom-
plete.

Table 1.8 Incomplete market


Security Price State of nature
1 2 3
B 9 10 10 10
M 13 9 11 13

The market could be completed by adding a third security, such as a derivative that
had a positive payoff in one of the states but a value of zero in the others. Then the
available securities would span the market and it would be complete and it would be
possible to construct a replicating portfolio that generated a positive value in one state
and zero in the others.
While this analysis is largely theoretical and based on a simple example, the ability
of derivatives to help complete the market provides an important justification for
their existence.

1.5 Learning Summary


Derivatives are contracts specifically designed to manage risks. Although technically
redundant securities since they can be replicated using fundamental financial
instruments, they provide an efficient means for market participants to manage and
transfer risks. Their importance in this role continues to increase and they have
become an important element in modern financial markets. While some, such as
futures and swaps, are relatively new classes of instruments others such as forward
contracts and options have always been a feature of commercial life. The great
expansion over the last 30 years or so in derivatives on fundamental financial
instruments is due to changes in the financial system and theoretical developments
in our understanding of how these instruments can be valued.
A key principle of valuation in an efficient market is the ability of replicating
portfolios made up of fundamental financial instruments to provide the same
payoffs as derivatives. Under the Law of One Price, two assets or combinations of
assets with the same payoffs should have the same price. This identity between the
derivative contract and a replicating portfolio with the same payoffs as the derivative
is enforced by arbitrage. While this theoretical understanding provides the ability to
price derivatives, frictions in real world financial markets may lead to divergences
between theoretical arbitrage-free prices and actual market prices for derivatives.
Derivatives are traded either on organised exchanges with specific rules and a
significant degree of investor protection or directly between market participants in
the over-the-counter markets. In the later case, market participants have to take into
consideration the credit risk of the counterparty to the transaction. Exchange-traded
contracts have standardised terms and conditions, OTC derivatives can be custom-
ised as required.

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Derivatives provide market participants with not just the opportunity to modify
risks, but also to engage in speculation and to undertake transactions that would
otherwise be problematical when undertaken using fundamental financial instru-
ments. These include such benefits as reducing financing costs and taking advantage
of tax benefits and regulations.

Review Questions

Multiple Choice Questions

1.1 Which of the following is correct? The forward market that existed in the Netherlands
at Antwerp in the 14th century was a market for:
A. Grain and other agricultural produce.
B. Tulip bulbs.
C. Currencies.
D. Wool and cloth.

1.2 Which of the following best describes the nature of a forward contract? With a forward
contract, the two parties agree to:
A. exchange an item of a specific quality for cash at a future predetermined date.
B. exchange an item for an agreed amount of cash at a future predetermined date.
C. exchange a given amount of an item for an agreed amount of cash at a future
predetermined date.
D. exchange a given amount of an item of a specific quality for an agreed amount
of cash at a future predetermined date.

1.3 If you have a ____ sensitivity to changes in market prices, you would be said to be
____ and would benefit from an ____ in the market price. Which is correct?
A. positive long the risk increase
B. positive short the risk decrease
C. negative long the risk decrease
D. negative short the risk increase

1.4 Which of the following correctly describes a futures contract?


A. A futures is an instrument whose value depends on the values of other more
basic underlying variables.
B. An exchange-traded contract to buy or sell a specific amount of an asset or
security for a specific price or rate on a specific future date.
C. An agreement to buy or sell an asset at a certain time in the future for a certain
price (the delivery price).
D. All of A, B, and C.

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1.5 What is the economic difference between forward contracts and futures?
A. There is no economic difference between forward contracts and futures.
B. Futures are only available on some underlying assets, whereas it is possible to
trade any asset with forward contracts.
C. Futures contracts are traded on an exchange and have standardised terms and
conditions whereas forward contracts are traded over-the-counter and have
negotiated terms.
D. Both B and C explain the economic difference between forward and futures
contracts.

1.6 Which of the following is correct? A swap is:


A. An agreement between two counterparties to exchange two different sets of
future periodic cash flows.
B. The spot purchase or sale of a commodity combined with the simultaneous
sale or purchase of the same commodity in the forward market.
C. The sale of one security to purchase another.
D. None of A, B, or C, correctly defines a swap.

1.7 Which of the following is correct? An exotic option is:


A. an option to exchange currencies where one of the currency pair is an
emerging market country.
B. an option which has non-standard terms and conditions.
C. an option-like feature that has been incorporated into a security.
D. an option that is not traded on a derivatives exchange.

1.8 Which of the following is correct? The major impediment to market participants using
forward contracts is:
A. The reputation and credit standing of the counterparty on the other side.
B. The lack of counterparties willing to enter the other side of the transaction.
C. There are no transactions available with the right maturity.
D. All of A, B and C.

1.9 Which of the following is correct? Fundamental financial instruments are:


A. a set of redundant securities issued by firms to investors.
B. required by firms in order to raise capital and borrow money.
C. those replicating transactions used to model the payoff of contingent claims.
D. another name for the risk management product set.

1.10 Which of the following is not deterministic arbitrage?


A. You borrow in euros and lend in dollars and buy dollars in the forward market
to exploit a mispricing opportunity in the market.
B. In a takeover situation, you buy the target companys shares and sell the
bidders company shares to exploit a mispricing opportunity in the market.
C. You sell gold in London and simultaneously buy gold in Los Angeles to exploit a
mispricing opportunity in the market.
D. You sell crude oil futures and buy crude oil in the spot market to exploit a
mispricing opportunity in the market.

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1.11 Which of the following is correct? Dynamic arbitrage requires that:


A. the derivative that is sold and the offsetting arbitrage transactions have the
same value at maturity.
B. the payoffs at maturity of the element that has been sold is less than that of the
purchased element.
C. the composition of the replicating portfolio be adjusted over time in response
to changes in the derivative price.
D. the replicating portfolio is rebalanced over time to maintain the correct
relationship to the derivative being arbitraged.

1.12 Which of the following is the correct definition of a replicating portfolio?


A. A package of securities and borrowing or lending designed to give the same
payoff as another financial security.
B. A portfolio of securities designed to meet a specific investment objective or
target.
C. A package of fundamental financial instruments and derivative securities
designed to meet a specific investment objective or target.
D. A portfolio of fundamental financial instruments and derivative securities
designed to eliminate risk.

1.13 Which of the following is not a fundamental financial instrument?


A. A share.
B. A call option on a share.
C. A bond.
D. A bank loan.

1.14 The spot price of a commodity is $1200 and its forward price in one year is $1255. The
one-year interest rate is 4 per cent per annum. Which of the following is correct? An
arbitrageur can create a replicating portfolio by:
A. borrowing and buying the commodity in the cash market and buying the
forward contract to give a profit of $55.
B. selling the commodity in the cash market and investing and buying the forward
contract to give a profit of $7.
C. borrowing and buying the commodity in the cash market and selling the
forward contract to give a profit of $7.
D. selling the commodity in the cash market and investing and selling the forward
contract to give a profit of $55.

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1.15 The spot exchange rate between sterling and the US dollar is $1.7425/. The six-month
interest rate is sterling is 3.75 per cent per annum and that in US dollars is 2.5 per cent
per annum. The six-month forward foreign exchange rate is $1.7385. Which of the
following is correct? An arbitrageur can create a replicating portfolio by:
A. borrowing US$1.7425 million for six months, exchanging it at the spot
exchange rate into sterling, investing the sterling, and selling sterling at the
forward exchange rate to make a net profit of $6650.
B. borrowing 1 million for six months, exchanging it at the spot exchange rate
into US dollars, investing the dollars, and selling the dollars at the forward
exchange rate to make a net profit of $6650.
C. borrowing US$1.7425 million for six months, exchanging it at the spot rate into
dollars, investing the dollars, and buying the dollars at the forward exchange
rate to make a net profit of $6650.
D. borrowing 1 million for six months, exchanging it at the spot exchange rate
into sterling, investing the sterling, and buying the sterling at the forward
exchange rate to make a net profit of $6650.

1.16 Which of the following is correct? In the context of derivatives markets, hedging can be
considered to be a special case of:
A. arbitrage that involves taking no risk on delivery.
B. risk reduction where the intention is to eliminate all risks.
C. speculation where the intention is to take on as much risk as possible.
D. financial engineering that involves taking no model risk.

1.17 The general rule for undertaking arbitrage is this: ____ and ____ which means, in terms
of derivatives, ____ a derivative instrument when its price is ____ its theoretical or fair
value price. Which of the following is correct?
A. buy low sell high selling above
B. sell low buy high buying below
C. buy low sell high buying below
D. sell low buy high selling above

1.18 Why might you not wish to undertake an arbitrage transaction despite the fact there
appeared to be a profitable opportunity available?
A. There are uncertainties surrounding the model used to evaluate the arbitrage
opportunity which might lead to a loss rather than a gain.
B. There are timing differences in the nature of the two sides of the arbitrage
opportunity which might lead to a loss rather than a gain.
C. The tax treatment of the gains and losses may differ and one may fail to offset
the other which might lead to a loss rather than a gain.
D. All of A, B and C might lead to a decision not to arbitrage an apparently
profitable opportunity.

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Case Study 1.1: Terms and Conditions of a Futures Contract


1 You have been asked to research and propose a new futures contract on pepper.
Pepper is a consumption commodity and is a major additive to food both during
preparation and at the table and, by weight, is an expensive commodity. Lay out the
specifications of the contract giving all the important elements you would need to
include in the contract so that potential users would know exactly what is being traded.

Case Study 1.2: Constructing a Derivative Security using Fundamental


Financial Instruments
There is an economy which has only two possible futures states or conditions. Either
economic conditions will be good, or they will be poor. Two fundamental financial instruments
or securities exist in this economy which are used to finance operations; we can consider
these to be debt and equity.
The current or market prices of the two securities or fundamental financial instruments
available in the market are given below and the values that they may have in one years time,
depending on the state of the economy:

Time t=0 t=1


Security Under good Under poor
conditions conditions
Security 1 (debt) 100 105 105
Security 2 (equity) 60 120 30

1 Create two derivative securities from these fundamental financial instruments.


1. A derivative security that will provide a positive return under good market condi-
tions, but no losses if the market at t=1 turns out to be poor.
2. A derivative security that will provide a positive return under poor market condi-
tions, but no losses if the market at t=1 turns out to be good.
Hint: you must think of a suitable combination or portfolio of the two securities which provides a
payoff in the two states, such that in the desired state it has a positive value and zero value in the
undesired state.

References
1. Chicago Board of Trade: www.cbot.com
2. Chicago Mercantile Exchange: www.cme.com
3. Roger Lowenstein (2001), When Genius Failed, New York: HarperCollins Publishers.
4. Peter Moles & Nicholas Terry (1997) The Handbook of International Financial Terms,
Oxford: Oxford University Press

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Module 2

The Derivatives Building Blocks


Contents
2.1 Introduction.............................................................................................2/2
2.2 Forward Contracts .................................................................................2/4
2.3 Futures Contracts ...................................................................................2/6
2.4 Swap Contracts .......................................................................................2/7
2.5 Option Contracts ....................................................................................2/9
2.6 Learning Summary .............................................................................. 2/12
Review Questions ........................................................................................... 2/13
Case Study 2.1................................................................................................. 2/16

Learning Objectives
This module introduces the derivatives product set and shows how the individual
products are related. It discusses the two principal kinds of products used to manage
financial risk: terminal instruments and options. It follows a building-block ap-
proach to show how the different instruments, forward contracts, futures contracts,
swap contracts and options, have common fundamentals.
The key differences for terminal products relate not so much to their economic
effects, which are remarkably similar in that their gains or losses are directly related
to the underlying asset price, but to the way the different instruments handle
performance risk. With a forward and a swap contract, each party is directly taking
the counterparty risk of the other. This is not the case with futures where contracts
are collateralised and an intermediary institution, the clearing house, acts as guaran-
tor.
Options have a non-linear function in relation to the underlying asset price and
the position of the two sides to the option transaction is very different. The option
buyer has performance risk with the option seller, but the seller has no risk in regard
to the buyer since the buyer will only exercise his right to perform if it is to his
advantage to do so.
Although options appear to be radically different instruments from the terminal
products, it is shown that this is not the case and that options can be seen as being
made up of a package consisting of a forward contract and a loan.
After completing this module, you will understand:
how terminal contracts are put together;
how options modify the underlying risk profile of a position; and
how to apply a building-block approach to derivatives.

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2.1 Introduction
Increasing awareness of uncertainty in the economic environment has changed the
way that financial markets operate. Firms operating in various product markets have
realised that successful strategies require that the risks inherent in changes in interest
rates, currencies and commodities be successfully managed. Firms have turned to a
number of different instruments to manage these risks. This module looks at the
building blocks that form the derivative product set used to manage price risk (and
other risks) in the financial markets.
As previously discussed, firms have a number of ways in which they can seek to
control the financial risks they face. The most commonly adopted approach is to
hedge; in order to hedge, firms turn to a number of different approaches. For
instance, if a firm is exposed to foreign exchange-rate risk on its exports, it might
resort to borrowing in a foreign currency. The intended effect is that the income
stream would be directly correlated with or would offset the foreign currency
exposure from the loan. That is, the firm applies the matching principle to reduce its
risk. However, such an on-balance-sheet approach is generally costly and
perhaps more important somewhat inflexible in the face of changing circumstanc-
es. The alternative is to use what are known as off-balance-sheet instruments, or
derivatives: that is, forwards, futures, swaps and options, or combinations thereof.
It is easy to assume that a forward lending/borrowing transaction is somehow
different to a foreign exchange forward transaction, or that an option to buy a
particular commodity differs from an option on a particular share. In fact, these
instruments, forwards and options, are the fundamental building blocks that allow
market participants to manage a variety of market-related risks. At their most basic,
these building blocks come in only two guises: terminal instruments and options.
These latter can even be considered as a special case of the former, in which the
good and bad elements of the payoffs of the terminal instrument have been snapped
apart.

2.1.1 Risks and the Building-Block Approach


The basic approach to risk management involves initially identifying the exposure
that the firm faces. For instance, a copper producer would have an exposure to the
copper price that is positively correlated to price movements: the producer gains if
prices rise, but loses if prices fall. The producers risk profile is illustrated in Fig-
ure 2.1.
The producers area of concern is the effect of a fall in the market price. In order
to protect the firm against such an eventuality, the producer wants to enter into a
hedging transaction that has the opposite price behaviour to the existing exposure,
namely that the value of the hedge will increase as the copper price falls. The risk
profile of such a position is shown in Figure 2.2.

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+
Value

Risk profile
of the firm

Producer gains if
market price increases

+
Market price
Producer loses if of copper
market price falls

Area of
concern

Figure 2.1 Risk profile for copper producer

+
Payoff of hedging Value
instrument

+
Market price
of copper

Figure 2.2 Payoff of a hedging instrument that is inversely correlated to


the copper price
Through combining the original existing exposure with the hedging instrument,
the firm ensures that its exposure to the copper price is matched and eliminated.
This is shown in Figure 2.3.

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+ Firm's risk profile


Payoff of hedging Value
instrument

(a') (b)

+
Market price
Result is that of copper
exposure (a) (b')
to changes
in copper
price is
eliminated

Figure 2.3 The firms original exposure to movements in the copper


price is eliminated when combined with the appropriate
hedge
If the market price falls to the point represented by line (a), the company is com-
pensated for by the gain on the hedging instrument (a). Since the hedging
instrument has the opposite profile to the exposed position, the gain in price at line
(b) is offset by a loss on the hedging position (b). The net effect, however, is for the
producer to have eliminated its exposure to changes in the market price of copper
over the hedging horizon.

2.2 Forward Contracts


Of the building blocks, the forward contract is the earliest in origin and also the
simplest. The forward contract binds the buyer, or long position holder, to buy a
given asset on a set date in the future at a price agreed at the time the contract is
entered into. If at the time the contract matures, the market price is above the
contracted price, the buyer gains. If, however, the market price is below the con-
tracted price, the buyer loses. The opposite applies to the seller, or short position
holder. These are illustrated in Figure 2.4.
The position to adopt in a forward contract to hedge a given exposure depends
on the underlying risk position or sensitivity, as shown in Table 2.1.
There is a major problem with forward contracts, namely the concern by both
parties that the other party will honour its obligation on the contract at maturity.
This default risk or credit risk means that only creditworthy counterparties are
acceptable.

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Long underlying position + Short hedge = Producer's hedge


+ + +


+ + +

Short underlying position + Long hedge = Buyer's hedge

+ + +


+ + +


Underlying risk profile Hedge risk profile

Figure 2.4 Underlying risk positions and forward contracts

Table 2.1 The effect of hedging long and short positions in an


underlying asset
Effect of Effect of
Underlying adverse Hedging adverse Hedging
risk change in position change in transaction
position price in to adopt price in known as
underlying underlying
Long Fall in the Short Gain in the Producers
position market price hedge value of the hedge, since
hedging producers are
instrument concerned
offsets loss on about the price
the long at which they
position can sell assets
Short Rise in the Long Gain in the Buyers
position market price hedge value of the hedge, since
hedging consumers are
instrument concerned
offsets loss on about the price
the short at which they
position can buy assets
Note: The risk positions are illustrated in Figure 2.4.

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2.3 Futures Contracts


Futures contracts developed in the 1860s on agricultural commodities as a direct
result of the problems arising from actual or potential non-performance by the
counterparty that are inherent features of the forward contract. This took place in
Chicago with the founding of what has become the Chicago Board of Trade
(CBOT). Financial futures, that is, futures contracts on financial instruments, were
not introduced until 1972 when trading in currency futures contracts started. Note
that, not coincidentally, the introduction of financial futures took place at the same
time as the Bretton Woods system was collapsing.
The futures contract, whether on commodities or exchange rates, as a means of
handling risk has the same characteristics as a forward. Thus the use of futures for
risk management purposes is identical to that illustrated in Figure 2.4 and Table 2.1.
However, it differs in several major respects to the forward in that the performance
or credit risk that is inherent in entering a forward contract is virtually eliminated.
Futures were originally conceived as a means of eliminating the credit risk from
forward contracts. This is achieved in two ways, by marking to market the
contract every day and through the use of a clearing house which stands between
the buyer and seller and undertakes to honour all transactions.
The marking to market process reduces credit risk by requiring that the losses
and gains on a contract relative to the underlying cash instrument are paid for or
credited to the parties concerned. Since the time over which the contract is out-
standing is reduced to one day or trading session, the performance risk is reduced
correspondingly. One can envisage a futures contract as being a series of one-day
forward contracts where the contract is settled each day and a new contract entered
into for the next day at the new price.
The clearing house also acts to protect market participants from default risk. It
does this in two ways. First it requires each contract to be collateralised or paid for
in advance by requiring buyers and sellers to post margin (also known as a perfor-
mance bond) with the exchange. This margin is set above the maximum anticipated
daily price movement. In effect, the potential losses are paid by users in advance, the
clearing house having received the performance bond which it can use to meet any
non-payment. For administrative purposes, the margin required when setting up a
position in futures, known as the initial margin, is made up of two components. It
consists of a minimum or maintenance margin below which the account held by the
participant at the exchange is not allowed to fall, and the difference between this
maintenance margin and the initial margin required when establishing the position.
The reason for this is to avoid having to call for additional margin whenever the
futures settlement price changes slightly, as it is likely to do.
If the minimum margin point is reached and the call for more margin to top up
the account back to its original collateralised level is not met, the clearing house will
close out the position by doing the opposing transaction on the exchange. The
amount in the margin account is used to cover any losses. However, just in case a
loss is realised, the exchange will also have an insurance fund and be able to call on
its members to make good the loss. As a result of the margin mechanism and the

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availability of funds from its members, there is very little credit risk for futures
users.
The other function of the clearing house is to act as the counterparty to all trans-
actions that are effected on the exchange. The forward transaction involves both
parties taking each others credit risk. With futures, the exchange is the counterparty
to both buyers and sellers. This is shown in Figure 2.5.

Forward contract

Party A Party B

Futures contract

Party A Party B

Clearing
House

Figure 2.5 The role of the clearing house as intermediary in the futures
contract
The clearing houses function is to reduce transaction costs in futures contracts.
Each party enters into a transaction, not with a specific counterparty whose credit
standing needs to be evaluated, but with a single entity which, due to the collateralis-
ing mechanism and the surety of its membership, has a rock solid credit standing.
Performance risk is all but eliminated through this arrangement.
Because they standardise transactions as to amounts and delivery dates, futures
are also highly liquid instruments. Since the clearing house is the counterparty to all
transactions, it is relatively easy for a futures position to be closed. The holder of the
long position simply sells the contract; and the purchase followed by a sale, once the
difference in price has been accounted for, extinguishes the obligation with the
clearing house. Similarly, the holder of the short position buys back the contract and
the sale followed by a repurchase likewise eliminates the outstanding obligation to
the clearing house. This feature of futures makes them very attractive instruments
for setting up short-term, off-balance-sheet positions since complex negotiations
with the other party are not required. Participants need only to buy and sell the
contracts on the exchange.

2.4 Swap Contracts


Swaps are the newest form of terminal product building blocks. The introduction of
swaps into the financial markets is generally credited with the cross-currency swap
transaction between the World Bank and International Business Machines (IBM) in

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1981, although there is some evidence to suggest that the approach may have been
used privately in the 1970s. Although a single contractual obligation, a swap is
merely a package of forward contracts that are bundled together. However, unlike a
series of forward contracts or futures, the swap is a single contractual obligation and
the pricing is structured so as to achieve a level series of fixed payments over the life
of the swap.
The swap, or exchange contract as it is sometimes called, obliges the two parties
to exchange or swap a series of cash flows at specified intervals over a particular
time period. The commonest type of swap relates to an exchange of payments
determined by two different interest rates, and hence called an interest-rate swap,
where one party typically agrees to pay a fixed rate of interest and the other party a
rate based on an index or reference rate. Figure 2.6 shows the cash flows from a
fixed-for-floating interest-rate swap. Financial markets were particularly volatile at
this point. Such a swap can be decomposed into a series of simple forward agree-
ments where one party agrees to pay a fixed rate and the other party agrees to make
a payment determined at the maturity of the contract based on a reference or index
rate. A forward contract based on interest rates is available and is known as a
forward-rate agreement (FRA), although the exact mechanics of the contract are
slightly different from those of forward contracts, as discussed.

Swap contract
Rfixed Rfixed Rfixed

m
1 2
Rfloating Rfloating Rfloating

equals a bundle of forward contracts


Rfixed

1
Rfixed
+ Rfloating
2
Rfixed
+ .... + Rfloating
m
Rfloating

Figure 2.6 Cash flows on a fixed-for-floating interest-rate swap


Note: The swap is equal to a package of forward contracts on interest rates where one party pays
a fixed rate and the other party pays a floating rate related to an index or reference rate.
There is nothing to prevent such an arrangement being made for other cash flows,
as long as they can be contractually defined, and swap contracts exist on currencies (as
mentioned earlier the cross-currency swap contract preceded the interest-rate swap),
commodities, equities or any other definable asset. The basic approach once under-
stood can be and has been used in a wide variety of applications.
At this point it should be clear that the major differences between the terminal
product building-block product set relate not to their characteristic, which in all cases

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is a linear payoff (or symmetric profile) between the value of the underlying asset
and the position in the instrument, but to the amount of credit or default risk that is
being assumed by market participants. Forward and swap contracts are direct obliga-
tions between market participants whereas futures use credit-enhancement methods
to eliminate virtually all performance risk. The use of the different instruments in a
particular context will be driven by the balance between credit concerns, the degree of
tailoring required on the contract that is, how perfectly the contract acts as a hedge
and the ability to be able to trade out of the position at minimal cost.

2.5 Option Contracts


The terminal product, whether forward, future or swap, creates a two-sided obliga-
tion which the parties are required to perform. Options are different: they confer on
the holder or owner the right, but not the obligation, to make a particular future
transaction. In the case of a call option, the holder has the right to buy at a set
price; with a put option, the holder has the right to sell at the agreed price. In both
cases, since the holder has a right, this right need not be exercised if it suits the
holder not to do so. The holder will only exercise the option if it leads to a gain. On
the other hand, the option seller (known as the option writer) is required to perform
under the terms of the contract if called upon to do so. As a result, the holder is
taking credit risk on the writer, but not vice versa.
With an option, the holder will only exercise if it is beneficial to do so. The pay-
off profiles for calls and puts are given in Figure 2.7 and show that there is an
asymmetric or non-linear payoff between the option and the underlying asset.

Payoff for call option holder Payoff for put option holder
+ +


+ +

Payoff for call option writer Payoff for put option writer

+ +


+ +

Figure 2.7 Payoffs from holding (taking a long position in) call options
and put options and the corresponding written (or short)
positions

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The payoffs in Figure 2.7 beg the question why anyone should be willing to take
a short or written position in an option given that it appears that the only outcome
is the loss of money. A detailed explanation of how pricing on options reconciles
the advantages of being the holder with the disadvantage of being the seller is given
later. Suffice to say at this point that the option value is that which ensures that, ex
ante, the transaction is a fair one, that is, it has a zero net present value.
What is apparent from the option payoffs is that these are similar to those given
in Figure 2.4 for forward contracts, minus the undesirable bits which lead to losses.
Note that this characteristic of options in providing payoffs or protection against
only undesirable movements in the value of the underlying asset has led them to be
characterised as a form of insurance. As one of the derivatives product set, options
provide a very useful capacity to insure against undesirable consequences and these
are shown in Figure 2.8. The combination of holding a put and having a long
underlying exposure provides a hedge against price falls but allows gains to be made
if the price rises. The combination of holding a call and having a short underlying
exposure provides a hedge against price rises, but allows gains to be made if the
price falls.

Long underlying exposure + Put option = Downside hedge


+ + +


+ + +

Short underlying exposure + Call option = Upside hedge

+ + +


+ + +

Underlying risk profile Option risk profile Combined risk profile

Figure 2.8 Hedging exposures using options


Note: A long position is hedged by holding a put option which gives the right to sell if the price
change is undesirable; a short position is hedged by holding a call option which gives the right to
buy if the price change is undesirable.
In terms of the building blocks of financial risk management, the asymmetrical
profile of options would appear to make them very different from the terminal
products previously described. However, options are not as different as they would
at first appear. The originators of modern option theory, Fisher Black and Myron
Scholes, showed that an option is in fact a portfolio consisting of two elements: a
forward contract on the underlying asset and a loan. They demonstrated mathemati-

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cally that a call option can be replicated dynamically by continually adjusting these
two elements. As the value of the underlying asset rises, the portfolio consists of
more of the underlying asset and less of the loan; the opposite happens as the price
falls.1 Since the payoffs from this replicating portfolio and the option are the same,
under the law of one price they should have the same value.
The important point in terms of the building blocks is that options are packages
consisting of a forward contract and a loan. This is even clearer if the ways in which
options can be combined are examined. By combining a long position in a call
option with a short position in a put option with the same exercise price, or a long
position in a put with a short position in a call, we can re-create the two possible
positions available in forward contracts, as shown in Figure 2.9.

Long call + Short put = Long forward position


+ + +


+ + +

Long put + Short call = Short forward position

+ + +


+ + +

Figure 2.9 Synthetic forward positions created from long and short
positions in options (putcall parity)
The identity between combinations of calls and puts and a forward contract is
known technically as putcall parity. In terms of the building blocks, a package of
a long position and a short position in calls and puts with the same exercise price is
equivalent to a forward contract. Options can be seen as a special case of the
forward contract where the undesirable element has been cut off, leaving just the
desired payoff.
The relationships between the derivatives product set basic building blocks can
be summarised as: Terminal products, forwards, futures and swaps have the same
linear payoff profiles and differ significantly only in terms of the degree of default

1 Note that the original BlackScholes option-pricing model only derived the value for call option on
non-dividend paying shares with European-style exercise (that is, exercise may only take place at the
expiry of the option contract). The model has been significantly developed to allow the pricing of
options on a much wider range of asset types.

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risk in the instrument.2 Options have, however, a non-linear payoff profile and
provide a one-way bet on the future value of the underlying asset, and these in turn
are packages of forward contracts and loans.

2.6 Learning Summary


This module introduces the basic elements of the derivatives product set and
illustrates how the building blocks relate to each other. The financial markets are
replete with different products which are baffling to an outsider. Does an exchange
of differences differ from a forward outright transaction, or a currency option from
the call provision in a bond? These are just some of the complexities that must be
dealt with if one is to understand financial markets. Examination reveals, however,
that seemingly complicated instruments are similar if not the same in terms of what
they do.
The product set can be broken down into two parts. First, there are the terminal
products. These are made up of various kinds of forward contracts, which are
bilateral agreements between market participants and which are subject to counter-
party risks. Next are futures, which differ from forwards in that the contract is
effectively renegotiated each day at the new prevailing market rate. When this
approach is used, futures virtually eliminate credit risk or performance risk, which is
the major disadvantage of forward contracts. Finally, there are swaps, which involve
intermediate payments over the life of the contract and which are equivalent to a
bundle of forward contracts.
The other building block of the financial derivatives product set consists of op-
tions. These come in two basic kinds, an option giving the right to buy, known as a
call, and an option giving the right to sell, known as a put. Although options offer a
one-way bet on the future outcome, they can be characterised as being a package
made up of a forward contract and a loan.

2 Note that this is a generalisation and that specific forward instruments differ slightly as a result of the
way in which the contract has been defined.

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Review Questions

Multiple Choice Questions

2.1 The following diagram shows a risk profile.

Gains

Underlier

Losses

This is the risk profile of:


I. a commodity consumer.
II. a commodity producer.
III. a short position in an underlier.
IV. a long position in an underlier.
V. a short hedge.
VI. a long hedge.
The correct answer is:
A. I, III and V.
B. II, IV and V.
C. V.
D. VI.

2.2 For a hedged long position holder, a fall in the market price will:
A. reduce the price of the hedge and increase the value of the asset position.
B. increase the price of the hedge and reduce the value of the asset position.
C. reduce the price of the hedge and reduce the value of the asset position.
D. increase the price of the hedge and increase the value of the asset position.

2.3 Performance risk is the risk that:


A. the asset return will be less than expected.
B. the hedges counteracting behaviour in relation to the asset is less than
expected.
C. a counterparty to a transaction will not honour the bargain.
D. arises from mismatches between the maturity of the assets and the liabilities.

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2.4 Marking to market involves:


A. establishing the difference between the purchase price and the current market
price for reporting purposes.
B. revaluing an asset to the current price at which it can be realised in the market.
C. the calculation of the margin requirement on a position.
D. none of A, B and C.

2.5 The following diagram shows a risk profile.

Gains

Underlier

Losses

This is the payoff profile for:


A. a written call.
B. a purchased put.
C. an upside hedge.
D. none of the above.

2.6 A forward contract has the following characteristics:


I. It is a bilateral agreement between the buyer and seller to be executed in the future.
II. The contract terms are set by the exchange on which forwards are traded.
III. The contract terms are agreed between the two sides at the initiation of the
transaction.
IV. There is performance risk between the two sides.
V. The final transaction price is varied in accordance with market conditions at
maturity.
The correct answer is:
A. I, II and IV.
B. I, II and V.
C. I, III and IV.
D. II, IV and V.

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2.7 In establishing an underlying ____ position, the effect of a positive movement in the
underlier is a ____ in the market price. To hedge the position requires a ____ position
in the hedging instrument. The correct set of terms is:
A. long rise short
B. long fall long
C. short fall long
D. short rise short

2.8 The role of a clearing house in futures markets is:


A. to settle all the different transactions that take place on the exchange.
B. to interpose itself between buyers and sellers.
C. to guarantee transactions.
D. all of A, B and C.

2.9 The main difference between a forward contract and a swap contract is:
A. there are no differences between these two forms of contract.
B. the forward contract is concerned with interest-rate risks whereas the swap
contract handles currency risk.
C. the forward contract has one cash flow whereas the swap has a multiple set of
cash flows.
D. the buyer of a forward contract can only make gains whereas the buyer of a
swap may make gains or losses.

2.10 The structure of forward transactions and swap transactions is such that:
A. forward transactions can be applied to all financial instruments, whereas swaps
can only be applied to currencies and interest rates.
B. forward transactions can only be applied to currencies and interest rates,
whereas swaps can be applied to all financial instruments.
C. forward transactions can only address problems of market risk whereas swaps
can be applied to different kinds of financial risks.
D. both forward transactions and swaps can be applied to the same types of
financial instruments.

2.11 The main difference between options and the other derivative products is:
A. there is no difference between options and other derivative products.
B. there is less credit risk in options that in the other derivative products.
C. there is more credit risk in options than in the other derivative products.
D. options provide a non-linear payoff profile, whereas the other derivative
products have a linear payoff profile.

2.12 A put option requires the option seller to:


A. buy the underlying asset from the option holder at a fixed price.
B. sell the underlying asset to the option holder at a fixed price.
C. pay the purchase price for the option at initiation.
D. reimburse the option holder for all losses on the put.

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2.13 In establishing an underlying ____ position, the effect of a positive movement in the
underlier is a ____ in the market price. To hedge the position requires a ____ position
in the hedging instrument. The correct set of terms is:
A. long rise long
B. long fall short
C. short rise long
D. short fall short

2.14 In the case of an option:


A. both the buyer and the seller will have unlimited market risk.
B. the buyer will have unlimited market risk but the seller will have no market
risk.
C. the buyer will have no market risk but the seller will have unlimited market
risk.
D. neither the buyer nor the seller will have market risk.

2.15 In the case of an option:


A. both the buyer and the seller will have credit risk.
B. the buyer will have credit risk but the seller will have no credit risk.
C. the buyer will have no credit risk but the seller will have credit risk.
D. neither the buyer nor the seller will have credit risk.

Case Study 2.1


We have seen that an option has an asymmetrical payoff when compared to the terminal
product set. Use payoff diagrams (such as that of Figure 2.1) to show how different combina-
tions of options can be used to engineer different payoffs. In this exercise you may ignore the
cost or premium from buying and selling options.

1 How would you create a position that benefited from both a rise and a fall in the value
of the underlying asset using options?

2 How would you create a position that provided a gain over a given expected price range
if the underlying was (a) expected to increase; and (b) expected to decrease? Note that
the logic of such an approach is that options are valuable and it costs money to buy an
option. One way of reducing the cost of setting up the desired exposure to the
underlying is to sell an option against the desired position. (This is known in the market
as a spread.)

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PART 2

Terminal Instruments
Module 3 The Product Set:
Terminal Instruments I Forward Contracts
Module 4 The Product Set:
Terminal Instruments II Futures
Module 5 The Product Set:
Terminal Instruments III Swaps

Derivatives Edinburgh Business School


Module 3

The Product Set:


Terminal Instruments I Forward
Contracts
Contents
3.1 Introduction.............................................................................................3/2
3.2 The Nature of the Forward Contract ..................................................3/2
3.3 Using Forwards as a Risk-Management Instrument ........................ 3/11
3.4 Boundary Conditions for Forward Contracts................................... 3/12
3.5 Modifying Default Risk on Forward Contracts ................................. 3/13
3.6 Learning Summary .............................................................................. 3/27
Review Questions ........................................................................................... 3/28
Case Study 3.1: Interest-Rate Risk Protection ............................................ 3/34
Case Study 3.2: Exchange-Rate Protection ................................................. 3/35

Learning Objectives
Terminal contracts are of three kinds: forwards, futures and swaps. The least
complicated is the forward contract, which is a bilateral agreement between two
parties. The key determinant of the pricing of terminal instruments is through
hedging. This module and Module 4 on futures examine the nature, structure and
risks of simple terminal contracts. Module 5 looks at swaps, which can also be seen
as packages of forward contracts. The other member of the derivatives product set
consists of options (which are discussed in Modules 610).
This module examines the nature and use of forward contracts to hedge risks.
Forward contracts are the simplest of the terminal instruments used to manage
various kinds of risk and, because they can be tailored to specific user needs, they
provide a perfect hedge.
The forward contract form has been adapted to address the problem of credit
risk (or default) on such deferred-performance contracts and two examples are
shown: the forward-rate agreement, for interest rates, and the synthetic agreement
for forward exchange, for currencies.
After completing this module you should:
be able to price a forward contract;
know how specific forward contracts work in currencies and interest rates;
understand the credit risk implications of the forward contract;
understand how modifying the contractual cash flows reduces credit exposure.

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3.1 Introduction
One of the risks facing any holder or potential buyer of an asset is that the market
price will change at some point in the future. Business activities are already compli-
cated enough without the added risk that the final delivery price is different from
the one expected. As most economic activity involves a number of factor costs,
land, labour and capital, uncertainty about the payoff from engaging in a given
enterprise is an added problem. One can well envisage the merchants of the ancient
world seeking to reduce this uncertainty by agreeing today a price for selling or
buying a given item at some mutually agreed date in the future. Assuring a given
outlet for a particular course of activity mitigates the risks inherent in the enterprise.
This works both for the seller, who may earn less than anticipated, and the buyer,
who may have to pay more than expected. Both have an incentive to deal today for
implementation in the future.
Thus the forward contract was developed. Its origin is probably as old as com-
merce itself. Ancient texts, such as clay tablets from the Assyrian empire, record
commercial transactions which relate to agreements that have the deferred execu-
tion characteristics of the forward contract. Today, forward contracts exist on a
wide range of financial instruments, commodities, indices and assets. The most
frequently used contracts are foreign-exchange forwards which are used by banks,
companies, investment institutions, governments and other entities, to manage their
currency exposures.
The subject of this module is the first type of terminal product, known generical-
ly as a forward contract or simply a forward. These instruments allow parties to
lock in a value for an agreed future execution or maturity date. A forward contract is
simply a bilateral commercial agreement negotiated today but with its execution or
settlement deferred to some agreed date in the future. To anticipate the later
discussion, it is worth mentioning at this point that a futures contract is essentially
an exchange-traded version of a forward contract, although as a result, there are
some important differences between the two instruments. Futures contracts are
discussed in the next module.
Underlying the development of terminal contracts has been a desire by market
participants (producers and users) to lock in future transaction costs. This ability to
fix a price for future delivery means that terminal markets are a valuable way of
reducing or transforming price risk for both buyers and sellers. That said,
forward contracts since they involve no investment can be and are used for
speculation on asset values. The original development of such markets reflected the
economic requirements of the time. The earliest markets were in agricultural
produce, but more recently the needs of financial markets have led to the introduc-
tion of terminal products to trade risks in a variety of financial instruments.

3.2 The Nature of the Forward Contract


A forward contract is a very simple commercial agreement. It involves two parties, a
buyer and a seller, agreeing a price at which a quantity of a product, commodity or
other item will be exchanged for a given amount of money. The price specified in

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the contract is known as the contract price or exercise price. Thus, John Doe Inc.
of the USA might have a currency exposure in relation to sterling where Jock
Distillers plc of the UK has agreed to sell a given quantity of whisky to the other
company in six months time and the contract is priced in sterling. In order to
protect itself, John Doe can enter into a contract with a financial intermediary (for
foreign exchange, this is likely to be a bank) where the intermediary agrees to buy
dollars from the company and sell it sterling at a price determined today for delivery
at an agreed future date. This contract is shown schematically in Figure 3.1. As a
result of this transaction, John Doe has managed to eliminate the exchange-rate
risk by entering into the forward contract with the intermediary rather than waiting
until the goods have to be paid for. Undertaking the forward contract transfers the
currency risk to the intermediary, who may be better placed to take on this risk.
Assuming that the whisky is duly delivered, then John Doe has completely eliminat-
ed currency risk from the transaction.

Sterling ()
Intermediary John Doe
US dollars ($)

Figure 3.1 Forward transaction between John Doe Inc. and the financial
intermediary (e.g. a bank)
Note: John Doe provides US dollars to the intermediary in exchange for sterling at an agreed date
in the future.
Participants in forward markets are those entities which wish to fix their future
transaction costs. As the above example demonstrates, the ability of John Doe to
buy whisky for sale in the US market would be much reduced if it could not hedge
its currency exposure. The company would not know its costs until the moment it
came to pay for the whisky in six months time. This might greatly reduce the
attraction of buying and marketing the whisky.1 The existence of a forward market
in currencies reduces the importers risks and makes the business commercially
attractive. Alternatively, it can be seen as increasing the whisky producers oppor-
tunity to sell abroad. The economic rationale for forward markets is that they add
value by eliminating or reducing uncertainty. The demand for forward contracts will
be determined by the number of firms facing uncertainty about future prices.

3.2.1 Pricing the Forward Contract


The above example raises the question of the price at which the financial intermedi-
ary should agree to buy the dollars and sell the customer sterling. The answer is
based on the intermediarys ability to hedge its exposure, a theory of forward pricing
often referred to as the cost-of-carry model. The simplest explanation of the cost-
of-carry pricing model is with an illustration. Continuing our foreign exchange
forward transaction example, let us assume that at the time the contract was to be

1 Of course, the dollar price of the sterling amount might have fallen, thereby providing a gain. But it is
the potential for losses which most exercises the mind!

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negotiated, the market conditions described in Table 3.1 existed in the two curren-
cies.

Table 3.1 Market conditions when the forward contract in Figure 3.1
was negotiated
Sterling Market conditions US dollars
1.000 Spot exchange rate 1.5000
10% 6 months euro-deposit rate in the currency 6%

Let us also assume that the intermediary has no other outstanding transactions.
The pricing through hedging approach requires the intermediary to create a
situation where it is in a position to fulfil the forward contract obligation and, at the
same time, to eliminate the risk of the transaction.2 This is important because the
financial intermediary, by entering into the forward transaction with John Doe, has
assumed the currency risk. In order to eliminate its risk, the intermediary will need
to undertake each of the following transactions:
(i) borrow US dollars today;
(ii) exchange these into sterling at the current spot rate;
(iii) deposit these for six months in sterling.
At the maturity of the forward contract the following will happen: the customer
will (a) pay the bank US dollars, which can be used to repay the initial dollar loan (i);
the maturing sterling deposit (iii) is used to pay the customer the contracted sterling
amount (b). The various steps of the transaction are shown schematically in
Figure 3.2.
Thus the various elements of the contract will net out at maturity. The borrowing
in dollars will be matched off against the dollars paid to the intermediary at the
forward date ((i) against (a)). The deposit in sterling will mature and is used to pay
out the sterling received against the dollars ((ii) against (b)).
Given the market information in Table 3.1 and the steps in Figure 3.2, we can
work out the price at which the bank can create the transaction in such a way that it
is fully hedged and has no market risk. For foreign exchange forward contracts, this
will be a function of the interest-rate differential between the two currencies. This is
also known as covered arbitrage. The formula used to calculate the forward price
based on the difference between the two interest rates is given by Equation 3.1:
1 Foreign currency rate 3.1
Spot rate
1 Domestic currency rate

2 As we will see in Section 3.2.2, the financial intermediary is still left with a credit risk on the contract.

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Lend (iii) (b)

Sterling

Spot Forward Customer


FX bank: (ii) bank sells ; buys ;
sells $; buys $ sells $
buys

US dollars

Borrow $ (i) (a)


$
t=0 t=m

Figure 3.2 Schematic representation of the pricing by hedging (cost-of-


carry) model for a foreign exchange forward contract
Substituting the market rates from Table 3.1 gives:
.
1.5000
.
1.4725 3.2
. .

We can see that this is the correct forward rate if we break down the calculation
as shown in Table 3.2.

Table 3.2 Calculation of the forward foreign-exchange rate from the


deposit rates of the two currencies
Sterling Exchange rate US dollars
t=0 66.67 1.5000 $100.00
Deposited at 10% for 6 months = Borrowed at 6% for 6 months =
t=m 69.92 1.4725 $102.96
Note that $102.96 69.92 = 1.4725

The interest-rate markets (via the eurocurrency markets) and the forward foreign-
exchange market are closely integrated. For a given maturity, the difference between
the interest rates in the two currencies is directly related to the difference between
the spot and the forward exchange rate for the currencies for the same period.
Note that we can also conceive, in the foreign exchange case, that the forward
contract can be priced as if it were a pair of zero-coupon loans (which is typically
the case for short-term borrowings and lendings). Since both sides are equal, at
inception the forward has a zero net present value. Neither party pays the other to
enter into the contract if we ignore the bid-offer spread charged by a market
maker. It is this feature where no payments are made until maturity that sometimes
leads to the idea that forward contracts are free. Although there is no upfront
payment, they are only free in the sense that the contracted terms are fair to each
side. The cost-of-carry model is therefore also a model that provides a fair valuation
of the contracts worth. Of course, once the contract becomes seasoned, it will have

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a positive value to one or other party depending on what has happened to the cash
or spot price of the contracted item and to interest rates in the two currencies.
The cost-of-carry approach works with other forward contracts. If a customer
has agreed to buy a given quantity of crude oil, the contract price at which the seller
will agree to enter into the agreement will be based on the funding cost of buying
crude oil and the costs associated with holding and storing the commodity (includ-
ing any anticipated wastage while in storage) until the delivery date. If the contract is
for a year and the interest rate is 8 per cent per annum and the annual storage cost 4
per cent, the forward price in one years time will be set 12 per cent above the
current spot, or cash market, price. The vendor, or short position in the forward
contract, can cover his position in the same way as the financial intermediary in the
foreign exchange example, by buying the crude oil in the market for current
delivery, storing it for 12 months and then delivering it to the customer. Note that
the price of the contract is independent of either partys views on what the future
price will be. As long as the seller can hold the deliverable item and can borrow to
fund the position, the obligation is hedged out.
This model has led economists to characterise terminal markets into two catego-
ries. The first are carry markets, where the commodity, asset or financial
instrument can be held for delivery and the second are markets, such as those for
soft commodities like wheat, maize, soy bean and so forth, where the delivery is
conditional on future events. These are called discovery markets in that the futures
price uncovers facts about future availability.
The Cost-of-Carry Model ___________________________________
The generic cost-of-carry model for the forward price
Forward price cash price financing cost per unit storage cost per unit
(Note that this model also applies to the futures price.)
The basic equation is given as:
t 3.3
, R , G,
365
where:
t,T : forward price at time t, for a forward (futures) contract requiring de-
livery at time T
t : cash price at time t
Rt,T : riskless interest rate at which funds can be borrowed at time t, for the
period (T t)
Gt,T : storage costs and other related costs for the physical asset per unit of
time from holding the asset for the period (T t)

Note that different forward contracts will have different elements in their
pricing. The cost of storing financial instruments is virtually nil, so the storage
costs in this case will be zero. In addition, with most financial instruments, the
short position (the party required to make the delivery in the future) will
receive any income on the asset prior to the contracts maturity date. This is a

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loss to the buyer, so the storage cost in this case can be seen as foregone
income, that is, dividends or interest paid before the contract matures. This is
true, for instance, of forward contracts on equities or an equity index. The
buyer gains by deferring the purchase of the shares; the seller, however,
receives the dividends before maturity. In this situation, the financing cost raises
the forward price, but the value leakage from dividend (or interest payments for
debt instruments) reduces the forward price. As with the currency forward, the
price is the balance between these two effects.
Note also that the above model is an operational model in the sense that the
forward price is that which an intermediary or market maker might quote. It
therefore follows common money market usage and computes the interest cost
based on simple interest. Sometimes the cost-of-carry model is expressed in
textbooks as:
1 3.4
or:
e
where the terms are as previously defined. In this case 1 is the
compounded rate of return for the period, or in the continuously compounded
model is the continuously compounded rate of return. Correctly con-
verting between the various methods should give the same value to the forward
price.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

All the Colours of Cost-of-Carry Models ______________________


Standard Cost of Carry Model
The standard cost of carry model assumes the underlying asset in the contract
pays no interest and suffers no value loss. In such a condition, the only factor
influencing the forward price will be interest rates. The standard model for the
cost of carry model is therefore:
3.5
where 0 is the current spot price, (T t) is the time to expiration, r is the
interest rate, and is the current forward or futures price for delivery at time
T.
Cost of Carry with a Dividend Payment
When the asset pays a dividend or other value leakage, then the value of the
forward or futures contract becomes:
3.6
where D is the dividend or value leakage and (k t) is the time to the dividend
payment. Note that in this case, the forward price can be below the current
spot price.
If there is more than one dividend due, then the model becomes:

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3.7

where is the ith dividend payment at time .


Cost of Carry with Continuous Dividends
When the asset pays a continuous dividend (for instance, if the underlying asset
is an index of securities which pay dividends) or the underlier is a currency with
a foreign interest rate, the model becomes:
3.8
where q is the dividend yield or foreign currency interest rate. Note for
currencies, the cost of carry formula given above is simply a continuous time
version of the interest rate parity equation that underlies the pricing of foreign
exchange forward contracts.
Cost of Carry with Storage Costs
Storage costs can either be considered as a lump sum and as such act as a
negative dividend, that is they will raise the forward price, or as a continuous
cost, like an add-on to the interest rate. The lump sum cost of carry model with
storage costs (W) will be:

3.9

where is the ith storage cost monetary payment over the life of the forward
contract payable at time .
For the continuous cost version of the model we have:
3.10
where w is the add-on to the interest cost to reflect the storage costs of the
underlier over the forward period (T t).
Note that for commodities, there may be an additional element in storage costs,
namely wastage which also needs to be included.
Cost of Carry with a Convenience Yield
The convenience yield is the price (expressed as an interest yield) a consumer
of a commodity is willing to pay to ensure security of supply of the physical
product. As such it is equivalent to value leakage or a dividend yield in that it
reduces the forward price. The model is therefore:
3.11
where y is the convenience yield.
Convenience yields are not observable in the market and can only be computed
by reference to the cost of carry valuation of the forward price without the
convenience yield. That is, they are backed out using the appropriate cost of
carry model for the underlier in question. For instance, if the underlier was
priced using the cost of carry model where the only pricing factor was the
interest rate, then we can determine the implied convenience yield as:

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ln / 3.12
For instance, if a commodity without value leakage or storage costs was trading
at 100 in the spot market ( 0 ), the six month continuously compounded interest
rate was 5 per cent per annum and the futures price ( ) was 101, then the
implied convenience yield would be 2 per cent per annum:

ln .05 .5 /.5 .02 3.13


To obtain the present value of the convenience yield, we use the following
formula:
3.14
So if the time to expiration is 9 months and the continuously compounded
interest rate is 5 per cent, there is no wastage of storage cost (u), the futures
value is 102 and the spot value of the commodity is 100, we have:
. .
100 102 1.75 3.15
while its future value at the expiration of the contract is 1.82.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

3.2.2 Forward Contracts and Default


Although forward contracts are an efficient way of transferring different price or
rate risks to another party, they have a major disadvantage from the viewpoint of
each party. There is a cost involved in entering into the transaction, namely the cost
of default. Let us return to the currency example analysed earlier. If the company,
for whatever reason, fails to honour the bargain struck with the financial intermedi-
ary, the latter may suffer a loss. This loss will be the shortfall that arises when it sells
the sterling to repay the dollar borrowing. This shortfall is the contracts replace-
ment cost. In fact, because the companys position is the mirror of the
intermediarys, we can confidently say that the company will only default on its
promise if it is to its advantage to do so, that is, when the contract is a loss from the
companys point of view. Naturally, the opposite condition pertains to the credit
risk the company is taking with the financial intermediary. Table 3.3 shows the
situation under different market scenarios.
The credit risks involved in entering forward contracts act as a deterrent to their
use. Only those counterparties who will honour their obligations with a high degree
of certainty are likely to be acceptable participants in such a market. In addition,
whereas the demand for price protection is likely to increase as the price volatility of
the contracted asset increases, the replacement costs associated with default likewise
increase. It is deviations from the expected path between the current or spot price
and the forward price that lead to this performance risk. The greater the deviation
or volatility, the greater the risk. It is, however, this same undesirable volatility in the
price that makes the contract valuable to both parties!

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Table 3.3 Effect of changes in the exchange rate on the value of the
forward contract at maturity
Currency at Profit and loss from the position
maturity Contract value of the company
1.5000 1.5000 1.4725 = 0.0275 Gain: company can buy sterling for
1.4725, and sell in the market at
1.5000

1.4725 1.4725 1.4725 = 0 No effect

1.4500 1.4500 1.4725 = Loss: company has to buy sterling for


0.0225 1.4725 rather than in the market at
1.4500

3.2.3 Forward Contracts, Asset Prices and Time


We have already said that the agreed price at which a forward is negotiated, ignoring
any intermediarys bid-offer spread and other incidental transaction costs, is based
on the cost-of-carry model. By implication, the forward will have a net present value
of zero at origination. There is no gain to either the buyer or the seller at this point
(ignoring transaction costs). Note that although from a pricing point of view the
contract has no special value (and, as we have said, that is why it is sometimes
confusingly considered to be free), there may be strong economic incentives to
enter into the contract as a way of reducing risk. Another point that is also worth
repeating at this juncture is that the forward price will be largely a function of the
net cost of financing the hedging position for delivery into the contract.3 The
forward rate will be determined by the shape of the term structure of interest rates.
Let us illustrate this on the basis of a commodity and the following interest rates to
one year. As you will see in Table 3.4, the short-term interest rate structure is
humped, with a maximum interest rate of 6 per cent per annum in nine months,
which then falls to 4 per cent for one year. This is somewhat unrealistic but serves
to make the point. If we use the cost-of-carry model, we see that the forward price
will be the funding cost for holding the asset to delivery.

Table 3.4 Spot, or cash, price and forward prices for a hypothetical
commodity
Period Interest rate (p.a.) (%) Commodity price
Spot (today) n/a 200.00
Three months 3 201.50
Six months 5 205.00
Nine months 6 209.00
Twelve months 4 208.00

3 See Module 4 for a discussion of the implied financing rate or implied repo rate.

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As the forward price is determined by interest rates, as long as the party which is
obliged to make delivery has the asset in question, it is in a position to transform the
nature of the risks being assumed into ones where it has superior expertise. Let us
use the above example to illustrate this process. A consumer of the commodity
seeks to acquire the commodity in six months time and approaches an intermediary
which specialises in providing forward contracts. This intermediary has a strong
view that the six-month interest rate overprices the expected change in interest rates
in the second (forward) three-month period. As a result, it enters into the contract
and decides to fund its position by borrowing for three months at 3 per cent. In
three months time, it so happens that it has correctly forecast the course of interest
rates and that the three-month rate is unchanged. Its total cost of funds on an
annual basis is 3 per cent, netting the firm a gain of just less than 3.00 on delivery at
the end of the second three-month period. Note that the nature of the risk being
assumed here is interest-rate risk, not price risk on the commodity.
At the time the contract is entered into, an at-market forward will have a net
present value of zero. This will not be the case as time passes. Two factors will
change over time. The time delay before the contract is executed will shorten. The
value difference between the cash price and the forward price should, therefore,
converge. This will only happen if the cash price remains unchanged. If, however,
the cash price changes, then the forward price will also change. Any forward
contract hitherto entered into will gain or lose value from this change. If the price of
the commodity in Table 3.4 has, after three months changed from 200 to 180 and
the interest rate for three months is 3.5 per cent, then the forward price for three
months will be 181.54, some way from the 205.00 on the existing forward contract.

3.3 Using Forwards as a Risk-Management Instrument


From the users perspective, forward contracts provide a convenient means of
hedging an exposure. As our earlier example based on the currency requirements of
John Doe showed, the use of a forward foreign exchange contract served to
eliminate that firms exchange-rate risk. It allows the user to separate the price risk
from the underlying position and to transfer this to another party better able to
assume the risk. Note that at the macro level, risk is not extinguished by this
process: it is merely passed on. If, however, two entities have the opposite expo-
sures (as the commodity producer and consumer do), then there is a benefit of
reduced risk to both sides from entering into such an agreement.
In using a forward as a risk-management instrument, if the underlying asset in the
forward transaction is an exact match for the exposure, and if the amount and maturity
of the contract also exactly match, the forward will provide a perfect hedge against the
risk. Such perfectly tailored solutions are generally possible with forward contracts since
they are bilateral agreements entered into in the over-the-counter (OTC) markets with
a specific counterparty, with the intention of being held to maturity. For this reason,
they are not usually unwound before maturity since there is a significant cost from doing
so. They also require that each party be willing to accept the credit risk (the performance
or default risk) of the other. The amount of credit risk that is being assumed is the
replacement cost if the counterparty should not be in a position to meet its obligation at

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the maturity of the contract. Note that if the underlying asset spot or cash market price
behaves as might be expected and moves towards the forward price, there is negligible
credit risk. It is the volatility in the potential outcome that creates a credit exposure.
There is a degree of paradox here since the more volatility or uncertainty there is about
the market price in the future, the greater the demand for hedging; but the greater the
credit risk of entering into the transaction. What is happening is that the forward
contract is exchanging a high probability about changes in market prices into a low(ish)
probability of default.
Because significant transaction costs preclude trading (with the exception of the
market in currency forwards, where the breadth of the market means transaction costs
are low) and concerns over credit, futures provide an alternative method of achieving
nearly the same degree of protection without assuming significant counterparty risk.4

3.4 Boundary Conditions for Forward Contracts


The discussion so far shows that in an efficient market, the forward price must be close
to the price of the cost-of-carry model. If it is not, then riskless arbitrage can be undertak-
en, known as a cash and carry arbitrage. If the forward price is higher than the cost of
carry (that is, the contract is expensive), the arbitrageur will sell the forward and hold the
underlying cash commodity or instrument for delivery into the contract. Since the cash
instrument is pre-sold via the forward, there is no price risk. The difference between the
buying price and the selling price, less any interest and storage costs, is the net gain from
the arbitrage. The opposite is done if the forward contract is lower than the price of the
cost-of-carry model, that is, the contract is cheap. (This arbitrage transaction is known as a
reverse cash and carry.) The underlying position is sold and the proceeds are invested.
The price risk is eliminated by receiving the cash commodity or instrument at the maturity
of the contract. The two relationships are shown in Table 3.5. Because of the existence of
such a money-making machine, the market prices of both elements, forwards and cash,
rapidly adjust, with the result that the opportunity disappears. In fact, such opportunities
are generally very rare in a smoothly functioning market.

Table 3.5 Cash market forward market arbitrage opportunities (cash


and carry arbitrage)
If forward con-
tracts are: (in Action to be taken in Action to be taken in the cash
relation to their the forward market market
fair or theoretical
value)
Expensive (higher) Sell the forward contract Buy and hold cash commodity or
(agree to make delivery) instrument (deliver into forward
contract)
Cheap (lower) Buy the forward contract Sell (short) cash commodity or
(agree to accept delivery) instrument (receive from the
forward contract)

4 Typically there will be some degree of basis risk left to the user of futures contracts.

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The arbitrage-free channel that will exist between the forward price and the
ability of market participants to engage in riskless arbitrage will be determined by
the boundary conditions shown in Table 3.5 and given by Equation 3.16.
1 1 3.16
The arbitrageur can buy the underlying cash asset and sell the forward contract
when 1 . That is, the cost of carry, at the borrowing rate
including transaction costs ( ), is less than the value of the forward contract. The
opposite applies when 1 , the arbitrageur sells the forward
and invests at the lending rate less any transaction costs. The greater the uncer-
tainty about , , and transaction costs ( ), the wider the channel before arbitrage
can take place. Different markets will show variations in the boundary before
arbitrage becomes feasible. There may also be differences in the various costs for
individual market participants which may provide different boundaries to the
viability of such strategies.
There is another reason why arbitrage situations will not arise very frequently: the
bid-ask spread in the forward market is likely to be narrower than the arbitrage
range spread. This is because the credit risk inherent in the forward contract is less
than that implied in the actual borrowing and lending of funds that would be
necessary to perform the arbitrage. With a forward contract, as previously discussed,
the actual amount at risk is the difference between the original value and the current
replacement cost (the replacement transaction in the market). In most circumstanc-
es, this will usually be less than the full value of the contract. Hence the implied
price of credit will be less than that which operates in the cash markets where the
full value is at risk.

3.5 Modifying Default Risk on Forward Contracts


The default risk problem of the forward contract has led financial intermediaries to
develop instruments where the credit risk can be greatly reduced. Futures are one
solution and these are discussed in the next module. This section will look at two
credit-efficient forward instruments which address the problem of default risk, one
on interest rates, known as a forward-rate agreement (FRA) and the other on
currencies. Currency forward contracts based on the FRA model are known by the
generic name of synthetic agreements for forward exchange or SAFEs.

3.5.1 Forward-Rate Agreements


If you knew you had the opportunity to deposit some money for six months in
three months time and were concerned about the rate at which the deposit could be
made, you might approach a deposit-taking institution now with a view to arranging
a forward-start deposit. The question is, how might the bank determine the interest
rate at which it would be willing to borrow money? The implied forward rate is the
forward-start interest rate for period other than the present. For instance, the
interest rate for a fixed rate investment which was due to start in six months time

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and last for six months would have an interest rate based on the interest rate that is
expected to prevail for the half year in six months time.5
Let us reconsider the issue in the light of our understanding of this relationship.
For a given period , the interest rate will be made up of the spot rates prevailing
for periods 0, 0, where . That is:

1 1 1 3.17
Note that, for short-term maturities, interest rates are quoted as simple rates, with
the result that Equation 3.17 becomes:

1 1 1
3.18
12 12 12
If the bank lends for the period to a customer, and borrows for a period in
the market , the new deposit that we would make at time will replace the
maturing borrowing by the bank. The maximum rate that the bank would be
prepared to accept on our deposit will thus be the current implied forward rate .
Let us calculate this result but, in addition, also include the markets bid-offer spread
for borrowing and lending. In fact we will calculate the rate at which the bank will
theoretically quote both to receive a deposit and to make a forward-start loan
for the same period. The relevant figures are given in Table 3.6.

Table 3.6 Short-term interest rates showing the bid and offer spreads
Period Bid rate Offer rate
Three months 5.75% 5.875%
Nine months 6.125% 6.25%
Note: For currencies quoted on the London market, the bid and offer spreads (London interbank
offered rate (LIBOR) and London interbank bid rate (LIBID)) for short maturities are usually one-
eighth of a percentage point apart.

We can visualise the banks situation as that shown in Figure 3.3. In the case of a
forward-start deposit, the bank conceptually lends for the nine months and borrows
for the intervening three months. In the opposite case, the bank borrows for nine
months, and lends for three months.6 In both cases, the bank needs to price up the
interest rate at which it will agree to lend or borrow for a forward start.

5 For a discussion of how these are obtained, see Financial Risk Management, section 10.4.
6 Short-term interest rates are often quoted on the basis of a notional year of 360 days (as with the US
dollar and the Deutschemark and a range of other Continental currencies) or a year of 365 days (as
with sterling).

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

Time 0 Time t Time T


(Present) (3 months) (9 months)
Bank lends for 9 months at offer rate

Forward start deposit


A
Bank borrows for
3 months at bid rate

Bank borrows for 9 months at bid rate

Bank lends for


3 months at offer rate Forward start loan

Figure 3.3 Forward-forward contracts from the banks perspective


Note: The banks customers cash flows would be reversed. A involves the bank agreeing to take a
deposit in three months for six months; B is the case where the bank agrees to make a loan for
six months in three months time.
The two rates will be (using the simple interest rates from Equation 3.18):
1 0.0625 0.75
1
1 0.05875 0.25
1 0.06125 0.75 3.19
1
1 0.0575 0.25
This comes to 6.34 per cent for the loan and 6.22 per cent for the deposit. We
can quote the above as being a three-month borrowing (lending) versus a nine-
month lending (borrowing) contract (that is, a 3 v. 9). The forward-start deposit
period is therefore six months.
Forward-Rate Agreement Terminology ______________________
The terminology of the FRA market evolved from the interbank market. The
following terms are commonly used.
the buyer has buy the FRA; take the FRA: to pay the fixed rate on the
notionally agreed to FRA; to be long funded, that is, to agree to pay interest at
borrow: the contractual rate on the FRA (see Table A1.1);
the seller has sell the FRA; place the FRA: to receive the fixed rate on
notionally agreed to the FRA; to be short funded; that is, to agree to pay interest
make a loan: at the floating rate on the FRA at settlement (see Table A1.1);

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

Table A1.1 Comparison of buying and selling the FRA


Buy the FRA, Take the Sell the FRA, Place the
Settlement rate FRA (to be long funded) FRA (to be short funded)
R R Receive PV of difference: Pay PV of difference:
R R R R
R R Pay PV of difference: Receive PV of difference:
R R R R

contract amount: the principal sum that notionally underlies the contract
and is used for computing the payments;
contract currency: the currency in which the contract is denominated;
transaction, dealing or trade date: the date at which the FRA transac-
tion is agreed;
settlement or value date: the date on which the notional loan/deposit
commences;
maturity date: the date on which the notional loan/deposit terminates;
fixing date: the date at which the market interest rate for reference
purposes is determined;
reference rate: the market interest rate used to determine the settlement
amount;
contract period: the number of days between the settlement and maturity
dates;
settlement amount: the amount paid by one party to the other in settle-
ment of the contract; it is the present value of the difference between the
contracted rate and the settlement rate at the settlement date;
FRABBA terms: British Bankers Association terms and conditions for
forward-rate agreement contracts. These have become the industry stand-
ard.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

The difference between a forward-start deposit and the forward-rate agreement is


that there is no lending by the counterparties involved in the latter case. All that is paid
is a compensating payment for the difference between the contracted rate and the
actual settlement rate at the start of the deposit period. The settlement formula for the
FRA contract is:

| | 3.20
Settlement amount 100 Basis
1
Basis 100
where is the reference interest rate at settlement, is the contracted rate, is
the number of days between the settlement date and the maturity date, that is, the
period ( ), is the notional amount of the contract, and the basis will be either
360 days or 365 days, depending on the currency.
There are two possible outcomes: one is when is higher than and the other
is the opposite. In the first, the floating rate payer (the FRA seller) makes a payment

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

to the fixed payer; when the settlement rate is below the contracted rate, the
opposite occurs. For example, if the rate on a US$10 million three-month US dollar
FRA had been 6 per cent and the settlement rate 4.5 per cent, with a 90-day period
for , then we would have had:
4.5 6 90
| | US$10000000
Settlement amount 100 360
90
1 4.5
36000
US$37083
If it had been the opposite situation, where the settlement rate had been, say, 9
per cent, as the customer making the deposit we would have paid the difference of 3
per cent to the bank (9 per cent 6 per cent). In this case, we pay the bank
US$73349.63.
You may have realised that the denominator of the above equation is a present
value formula. This is included because the settlement amount is paid at the start of
the notional deposit period, not at the end as with most interest payments. You will
further recall that forward contracts are credit instruments. Present valuing the
payment to the start is designed further to reduce the credit risk element of the FRA
contract, which is already a payment of an interest-rate difference rather than an
actual cash deposit or loan. In the above, the FRA transaction is completed with all
payments being made on the settlement date, thus eliminating a further three
months of counterparty credit exposure with the customer.
The above present value adjustment does not alter the economics of the transac-
tion. Let us assume that the customer wanted to lock in a rate of 5.875 per cent (the
bid side of the 6 per cent on the FRA). If the settlement rate is 4.5 per cent, then the
bid side will be 4.375 per cent. The deposit then pays US$109375 at maturity.
However, at the start of the deposit period, there is an additional US$37083 being
provided by the FRA. The total, FRA value plus the interest, now becomes
US$146863.60. This is equal to an interest rate of 5.875 per cent for the 90-day
period. The FRA has successfully acted to lock in the expected forward interest
rate.
Note that these results are not very sensitive to the addition of a lenders spread
over the reference rate when actual funds are being borrowed, or a margin below
the reference rate on deposited funds (as we have shown).
British Bankers Association Formulae for Forward-Rate
Agreements _______________________________________________
The British Bankers Association uses slightly different computational formulae
to calculate the value of the payment to be made at settlement, but they provide
the same result.
When the market reference rate at settlement is above the contracted rate the
formula is R R :
R R D A

basis 100 R

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When the contracted rate is higher than the settlement rate, the formula is
R R :
R R D A

basis 100 R
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

3.5.2 Synthetic Agreements for Forward Exchange


The preceding section has shown how an off-balance sheet instrument can be used
to replicate a forward-start deposit or loan. This section looks at a similar instru-
ment used for managing credit exposure in foreign exchange which can be thought
of as a cross-currency forward rate agreement.
The structure is known by the generic name of synthetic agreement for for-
ward exchange or SAFE. However, unlike FRAs, there are a number of different
types in use which differ in the nature of their payoffs. Within this category of
credit-risk reducing forward contract, there are, for instance, exchange-rate
agreements (ERAs) and forward-exchange agreements (FXAs), these being the
most common structures. The development of SAFEs (as an alternative to the
standard currency forward contract already discussed at the start of this module)
came in response to the capital adequacy guidelines imposed by the Bank for
International Settlements (BIS). SAFEs are notional principal contracts and are
treated as interest rate products, rather than currency products, and hence need a
lower level of regulatory capital in support.7 Barclays Bank and Midland Montagu are
both credited with a role in developing the instruments for the international
financial markets.
To understand how the structure works, it is necessary to understand the idea of
the forward-forward foreign exchange swap transaction. The foreign exchange swap
is a purchase (sale) of one currency and a repurchase (resale) of the currency at a
later date.8 The forward-forward element is when the initial currency exchange is
deferred into the future. This is different from the standard foreign-exchange swap
which has a spot or cash market initial cash flow. The cash flows for a spot foreign
exchange swap are shown in Figure 3.4. At the initial exchange, currency A is
received and currency B is paid away; at the re-exchange, the opposite occurs. The
effect is to have lent currency B and borrowed currency A over the period. We can
therefore either think of the swap as the interest rate differential between currencies
A and B, or the forward foreign exchange rate at time m between A and B. For a
delayed start or forward-forward swap, the rate at which the transaction will be
made will be the forward interest rates in the two currencies over the swap period.

7 The weights attached to currency exposures by the capital adequacy regulations imposed significantly
higher regulatory capital requirements than for similar maturity interest rate products. Thus, given the
additional cost of capital to currency business, intermediaries have a strong incentive to convert such
exposures to interest rate equivalents.
8 This transaction should not be confused with the cross-currency swap (currency swap) discussed in the
upcoming swaps module. We will use the term foreign exchange swap for the short-term exchange
discussed here and cross-currency swap for long-dated, multiple cash flow swaps discussed in Module
5.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

In fact, the foreign exchange swap is the sister to that required by a bank seeking to
price the forward foreign exchange rate.

Foreign exchange swap period


t0 tm

Initial exchange Re-exchange

Currency A B

Currency B A
Figure 3.4 Schematic representation of a foreign-exchange swap
Quoting Foreign Exchange __________________________________
The quotation of currency pairs in the foreign exchange market involves one
currency being the base currency and the other the quoted currency. So, for
instance, when quoting sterling against the US dollar, sterling is the base curren-
cy and the dollar is the quoted currency. The quotation seen in the newspaper
or from an information provider will thus be one unit of sterling (that is, one
pound) against a variable amount of US dollars. A typical quote will thus be
$1.5425 to the pound. This is often written as /$ for convenience.
This quotation applies even if the transaction is a forward contract. The only
difference will be that the rate will reflect the interest rate parity (IRP) condi-
tions between the two currencies. Taking our example above, if the one-year
interest rates are 3.25 per cent in dollars (quoted currency) and 4.125 per cent
in sterling (base currency), then the IRP values for the two currencies will be:
$1.5425 1.0325
$1.5295
1.04125
This rate is known as the forward outright.
In many instances, since the spot currency value changes as transactions take
place, it is easier to quote the forward rate not as an outright rate but in terms
of the interest rate differentials. In the above case, the interest rate differential
is 1.0325 / 1.04125 0.9916. But it is awkward to use this in practice. What
the currency markets do, is quote this differential in terms of the premium or
discount of the exchange rate relative to the spot rate. In the above case, this
differential is $1.5425 $1.5295 0.0130.
The currency markets make two further adjustments. Quoting fractions can
lead to mistakes, so the differentials are expressed in terms of points by
multiplying the differential by 10000.9 So the one-year would be quoted as 130.
Actually, the fact that the points need to be subtracted from the spot quotation

9 This might differ in some currencies where the quotation is a multiple of a single unit, such as the
Japanese yen.

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is often ignored as market participants would know the interest rates in the two
currency pairs and since there is a bid-offer (bid-asked) spread, there will be
two quotations. Whether the swap points are added or subtracted will be
obvious from the quotation. (This information is given to you so you will
understand how quotations operate in the market. For the purposes of this
module, there will be no market makers spread and you will be given the
forward outright rates.)
Lets see what happens if interest rates remain unchanged but the spot changes.
(Note short-term interest rate changes are far less frequent than changes in the
exchange rate.) Let us assume the dollar rate goes from $1.5425 to $1.5420.
The outright forward rate based on the equation will be:
$1.5420 1.0325
$1.5290
1.04125
The forward swap points will be $1.5420 $1.5290 0.0130. There is no
change in the swap points (which represent the interest rate differentials) for
small changes in the spot rate. Hence it is much easier to quote the forward
rate in terms of swap points rather than in terms of a constantly changing spot
rate. Just remember that the swap points represent the interest rate differential
between the currency pair.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Let us look at an example. If the market conditions for sterling () and the euro
() are as given in Table 3.7. Note that sterling is the quoted currency and the euro
is the base currency. The transaction therefore relates to the number of pounds (or
fractions thereof) that are required to purchase one euro.

Table 3.7 Interest rate and currency conditions for sterling and the
euro
Time Sterling Euro Exchange Swap
rate points
Spot 0.6500 = 1
1 month 4.00% 3.25% 0.6504 4
6 months 4.125% 3.375% 0.6524 24

If 100 million is exchanged for one month at 0.6500 at the re-exchange, you
need 100 million 0.6504 to receive back the same amount of euros.10 If the
transaction had been for 6 months, then we would have had to pay back
100 million 0.6524. In fact, we could use the spot less the forward value,
known as the forward points, as an indication of the effect: 1 month = 4 points; 6
months = 24 points.11 These swap points are effectively the interest-rate differential

10 By convention, the interest rate differential is all taken in terms of changes in the quoted currency.
11 These are positive, i.e. the swap points are added to the spot rate to get the forward outright exchange
rate.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

expressed in terms of the exchange rate between the pair of currencies. The
differential for six months between the two currencies is:
1.04125 0.5
1.003688
1.03375 0.5
Multiplying by the value of the spot currency unit gives: 0.6500 1.003688 =
0.6524. Subtracting the spot rate gives the interest rate differential in terms of
currency units. For convenience in quoting, the currency differential is quoted in
pips such that the swap points at one and six months are 4 and 24 respectively.
(That is, the differential is multiplied by 10000.)
If we had wanted to create a foreign exchange swap that started in one months
time for five months, then we could have (1) entered into the long-dated swap to
obtain the currency of choice (e.g. the euro dollars) and (2) entered into an opposing
one month swap so as to eliminate the requirement to deliver sterling for the initial
one-month period (and actually receive the euros). This is an inconvenience since it
requires the user to borrow sterling and then invest the euros. By entering into the
short one-month reversing swap, the result is a forward-start swap for 5 months in 1
months time. The cash flows required to generate such a forward-start foreign
exchange swap are shown in Figure 3.5.

Foreign exchange swap period


t0 tm
t1

Initial Re-exchange Re-exchange


exchange No.1 No.2
Spot
A to B
for tm
+
Spot
B to A
for t1
=
Deferred start
A to B for t1 to tm

Figure 3.5 Schematics of the cash flows required for creating a forward-
start foreign-exchange swap
The level of demand for forward-start foreign exchange swaps is such that mar-
ket makers are willing to quote the above foreign exchange swap as a package. This
package is priced in exactly the same way as Figure 3.5 but removes the necessity for
the extra reversing transaction (and also increased credit exposure). The market
maker would quote the forward-start swap differential in terms of FX points as 20
(24 4) points. The two cash flows would then be as set out in Table 3.8.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

Table 3.8 Cash flows from the forward-start foreign-exchange swap


Time Sterling Exchange Euro
rate
1 month (6504 000) 0.6504 10 000 000
6 months 6524 000 0.6524 (10 000 000)

If after the one month delay, the interest rate differential between the two cur-
rencies had decreased by one per cent, then (and for convenience assuming that the
spot rate is now 0.6504), the market would be quoting a forward rate of 0.6547 to
the euro. Closing out the swap at this new (5-month) rate would lead to a profit or
loss on the position as calculated in Table 3.9.

Table 3.9 Cash flows from closing out the forward-start foreign-exchange swap
Initial transactions Transactions taking place after one month
Time Sterling Euro FX rate Sterling Euro Net gain

Foreign-exchange swap 1 Foreign-exchange swap 2


1 m (a) (6504000.00) 10 000 000.00 0.6504
Spot (i) 0.6504 6 504 000.00 (10 000 000.00)
6 m (b) 6524000.00 (10 000 000.00) 0.6524

5 m (ii) 0.6547 (6 547 000.00) 10 000 000.00


20000.00 0 (43 000.00) 0
(23000.00)
(14959.20)
Note: the initial transaction has a start date at 1 month and a completion date in 6 months (transactions a and b). The
reversing swaps with the opposite signs take place after 1 month and include a spot transaction and a 5-month
forward transaction (transactions i and ii). The resultant losses and gains from the four transactions indicate a net loss
of 23000.

The cash flows computed in Table 3.9 show that the package of forward transac-
tions involve actual cash flows between the two parties, as would also be the case in
a single currency forward-forward deposit. If the requirement is to exploit or hedge
against changes in interest rate differentials between the two currencies, the logical
step is to remove these cash flows and pay only the difference at maturity (or as
with the FRA, the present value of the gain).
The SAFE is therefore an agreement between two parties which either want to
hedge against or speculate on a change in the interest rate differentials between two
currencies. Or equivalently, a change in the forward swap points of the currency
pair.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

Synthetic Agreement for Forward Exchange (SAFE) Definitions


___________________________________________________________
primary currency: the base currency for the SAFE;
secondary currency: the foreign currency;
settlement date: the date at which the currencies are initially exchanged;
maturity date: the date at which the currencies are re-exchanged;
buyer: the party which notionally obtains the primary currency at the
settlement date and repays the primary currency at the maturity date;
seller: the party which has the opposite position to the buyer, sells the
primary currency at the settlement date and repurchases the primary cur-
rency at the maturity date.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

As we said at the start, there are two major variants of SAFEs. We will discuss
the exchange rate agreement (ERA) first, as it is the simpler instrument and similar
to an FRA. The difference is that the contract is not on an interest rate, but on the
interest-rate differential between the pair of currencies. The second type of SAFE,
the forward exchange agreement (FXA), is a contract for differences on the foreign
exchange swap we have just looked at. In practice, the actual choice of contract
(ERA or FXA) will depend on the type of exposure or protection required.

3.5.3 Exchange-Rate Agreement (ERA)


The exchange rate agreement (ERA) offers a payoff that is conditional on the
change in the forward swap points over the contract period. That is, it has a value
that depends on the change in the interest rate differential between the two con-
tracted currencies.
The payoff of an ERA is calculated as follows:

3.21
Settlement amount Notional principal
1
100 basis
where is the forward points at the settlement date, the forward points as
originally contracted, is the interest rate over the period between the settlement
date and the maturity date , and the notional principal is the contracted
amount in the primary or base currency.
Take the example as per Table 3.9. If we had contracted using an ERA for 10
million against sterling with a one-month deferred swap over 6 months, with the
forward points contracted at 20, at the settlement date the points have moved to 43.
Note that in FRA terminology this would be a 1 v. 6 type contract. Given the 5-
month interest rate in sterling is now 5.00 per cent (we have assumed that all the
interest change has occurred on the sterling side), the settlement amount would be:
0.0020 0.0043 3.22
22 531 10000000
5.00% 150
1
100 365

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The payment here is the same (but present valued to the settlement date) as that
shown in Table 3.9 because all the gain (loss) arises from a change in the forward
points. However in practice in most cases, there will also been some movement in
the spot rate which can either increase or decrease the profit or loss from the
forward-start foreign exchange swap. This does not form part of the ERA calcula-
tion. It does, however, feature in the calculation for the forward exchange
agreement (FXA) contract.
Note too that, as with the FRA contract, the payment is present valued to the
settlement date. As a result, the credit exposure period is the one month between
the transaction date and the settlement date, rather the full swap period to the
maturity date of the re-exchange period. As with the FRA, the result is to further
reduce the capital requirements on the contract relative to the conventional foreign
exchange swap since all obligations by both parties are extinguished at the settle-
ment date.
British Bankers Association Settlement Terms for SAFEs ______
The British Bankers Association formula for calculating the settlement amount is as
follows:

/ / / 3.23

OEX / BBASSR /

where:
C1: primary currency
C2: secondary currency
A1: first amount in the SAFE contract
A2: second amount in the SAFE contract; for ERAs, 1 2
BBASFSc1/c2: British Bankers Association settlement rate for the forward
spread
BBASSRc1/c2: British Bankers Association spot settlement rate (for ERAs this
is zero)
BBAIRc2: British Bankers Association interest rate for the second curren-
cy for the period T
FS: forward spread contracted in the SAFE
OEXc1/c2 outright exchange rate to the settlement date (this is nil for
ERAs)
Tsm: time from settlement to maturity (for the ERA this is the swap
period)
Basis: number of notional days in the year, either 365, for sterling, or
360, for most other currencies

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An example of the settlement price on such an agreement would be a transac-


tion between sterling and the US dollar FXA for 10 million at the start date
and 12 million at the maturity date:

C1: sterling (first currency [base currency in the currency pair])


C2: US dollars (second currency [quoted currency in the currency
pair])
A1: 10000000 (first amount in the SAFE contract)
A2: 12000000 (second amount in the SAFE contract)
BBASFSc1/c2: 50
BBASSRc1/c2: $1.4650
BBAIRc2: 8.5%
FS: 75
OEXc1/c2: $1.5240
Tsm: 90 days
Basis: 360 for the US dollar

This gives:
. . . .
US$73892.29 12000000 . %

10000000 1.5240 1.4650


Note that the FXA provides the user with the flexibility of different notional
amounts at the theoretical initial and re-exchange of the two currencies.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

3.5.4 Forward-Exchange Agreements (FXA)


In the case of the exchange rate agreement (ERA) only the changes in the forward
swap points are used in the contract. In the case of the forward exchange agreement
(FXA), the contract covers both a change in the swap points and a change in the
spot rate between the transaction date and the settlement date. The FXA is there-
fore equivalent to a forward foreign exchange swap, but without the need to
exchange principal. Since the principal element is removed, the credit exposure is
significantly reduced allowing a greater variety of users to use these synthetic
forward swap agreements.
The computational formula for an FXA is:

3.24
Settlement amount
1
100 basis
where is the notional amount of currency exchanged at the maturity date, the
notional amount of currency at the start date, is the outright exchange rate at the

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settlement date, the contract outright exchange rate and the other terms are as per
the ERA. The equation can be divided into two parts. The elements within the
brackets relates to the changes in the maturity leg of the swap will the other compo-
nent relates to the changes in value at the settlement leg of the swap.
Note there are several terms that need to be carefully identified. The rate is the
contracted forward rate. In our example this is the one month outright rate
(0.6504). The forward points will be the swap points for the 1 v. 6 transaction,
namely 20 points. The outright exchange rate for the maturity leg at initiation will be
0.6504 as per the then market. The settlement values will be the value of the
spot rate at the settlement date (that is, in one months time from initiation) and
will be the then forward points for the 5 months to the swaps maturity date.
Using the same example, the settlement amount on the FXA will be:
0.6504 0.0024 0.6504 0.0043
10000000 10000000
5.00% 150
1
100 365
0.6500 0.6504
The payoff on the FXA is equivalent to the value obtained in Table 3.9 when we
calculated the gain from the forward-start swap, except that it has been present
valued to the start of the swap period. The equivalent future value is (23000), if
the discounting part of Equation 3.23 is ignored, which is the same as that obtained
in Table 3.9. Since by calculation there has been no movement in the contracted
spot rate, the term is zero and the payment is the same as for the
ERA.
Note that the calculation here has been slightly changed from the layout in Equa-
tion 3.23 to show where the value change has arisen. The initial forward rate on the
forward-start swap was the difference between the initial spot of 0.6500 and the
one month swap points which were 4 and the six month swap points of 24, giving a
forward differential of 20 points over the 5 months. At settlement this differential
has changed to 43 points, giving a gain of 23 points, as per the ERA. However, the
exchange rate has also changed, moving from 0.6500 at the onset to .6504 after
one month. Because we have assumed the spot rate after one month is the same as
the one month forward, there is no value adjustment required from changes in the
spot rate (this is the right hand element of Equation 3.23: . Typically,
the spot rate at settlement will differ from the settlement forward outright rate in
the FXA contract.
If the spot rate had moved not the contracted rate of 0.6504 but to 0.6510 and
had remained unchanged at 0.6500, then the settlement value of the FXA would
have been (18531) and (28531) respectively.
Quoting SAFEs _____________________________________________
The market will quote SAFEs in the same way as other financial instruments. As
with the FRA, the quote will be for a 1 v. 4, 2 v. 5, 3 v. 6, and so on. A market
maker will quote the offered side as the lower of the two swap points (for
instance 110/114). The trader is offering to sell the SAFE at 110 and buy at 114.

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At first sight this defies the normal logic of buying low and selling high. Howev-
er, as we have demonstrated, the payoff from the SAFE depends on a change in
the swap points over the contract period in the secondary currency. Looking at
the ERA, for simplicity, we can see that the payments to be made/received will
decrease if the contracted rate is increased. The original ERA settlement
amount was (22531) when the swap points were 20. If the swap points had
been 15, then the payment would have been:
0.0015 0.0043
27429 10000000
5.00% 150
1
100 365
This means that, with the points at 20, we have (22531) and at 15 it is
(27429). A positive number means a payment has to be made to the buyer;
the first term is the contracted rate, the second the settlement rate .
The SAFE buyer is anticipating that swap point rates will fall, so that, at settle-
ment, the value of is positive.
This is due to the nature of the settlement formula used. Buying a SAFE is
equivalent in swap terms to buying the primary currency (selling the secondary
currency, in this case selling dollars and buying sterling) at the settlement date
and selling the primary currency (buying the secondary currency, that is buying
dollars and selling sterling) at the maturity date. This means in order to make
money, the trader acts in a counterintuitive manner and must sell high and buy
low to make his spread. The SAFE user is equally following a buy high/sell low
approach in aiming to get the greatest difference between the contracted rate
and the settlement rate .
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

To summarise the attraction of the SAFE family of contracts. They provide


currency protection, but only pay the difference in the rates rather than requiring a
full transfer between the two parties as with the conventional forward-start foreign
exchange swap. As we have shown, there are significant differences between the
way the exchange rate agreement (ERA) and the forward exchange agreement
(FXA) work. The instruments are designed to achieve different objectives. The ERA
allows interest rate differentials to be covered, whereas the FXA acts like a contract
for differences on the foreign exchange swap. By reducing the credit exposure of
forward contracts, these instrument provide an opportunity for currency protection
to less creditworthy firms or require less capital to be set aside against potential
credit losses.

3.6 Learning Summary


Forward contracts exist on a great range of different financial instruments and
commodities. They are transacted between firms in the over-the-counter markets,
are bilateral agreements and can be modified to meet both parties needs. This
inherent flexibility in relation to terms and conditions makes them very useful
instruments.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

The basic model for valuing a forward contract is the cost-of-carry model. This
might equally be called the pricing through hedging model since it is based on the
net cost of eliminating the price risk by the seller of the contract. For most forward
contracts this will be the net funding costs associated with holding the underlying
asset, plus some storage, and other ancillary costs. In situations where storage and
other costs are virtually zero, as with financial instruments, the cost-of-carry model
is simply the net interest-rate cost over the contract period to the future delivery.
The attraction of the forward contract as a risk-management instrument is that it
provides a simple way of eliminating future uncertainty on the price or rate at which
a transaction can be made at some point in the future. Whereas the tailored nature
of the forward is very advantageous, the fact that it is a bilateral agreement means
that both parties to the contract have counterparty risk on the other. This makes
forward contracts credit instruments with all the disadvantages that these entail.
Variations on the basic forward have been developed to reduce the credit ele-
ment on such contracts. Two examples, the forward-rate agreement (FRA) and the
synthetic agreement for forward exchange (SAFE), show how an instrument can be
developed which mitigates credit risk. The FRA is a useful instrument for eliminat-
ing interest-rate risk. The SAFE group of instruments provide an equal structure
between two currencies, the ERA being an instrument that protects against move-
ments in the forward points, or interest-rate differential; while the EXA has the
same exposure as a forward-start foreign-exchange swap. The latter instrument
makes it more useful in hedging currency risk, but without the same degree of
counterparty exposure that is inherent in a conventional swap contract.
Of course, intermediaries have other ways of controlling credit risk, for instance,
by requiring the other party to post a surety or performance bond (collateral). Such
an approach will be looked at in the context of the futures contract, which forms
the basis of the next module.

Review Questions

Multiple Choice Questions

3.1 The interest rate in US dollars is 5 per cent per annum and that in French francs is 6.5
per cent per annum. The spot exchange rate is FFr6.50/US$.
What is the forward rate in five months time between the two currencies?
A. FFr6.4085
B. FFr6.4598
C. FFr6.4617
D. FFr6.5385

3.2 In a forward contract, the buyer agrees to:


A. provide delivery of the product.
B. accept delivery of the product.
C. fix the price at which the transaction will take place.
D. none of A, B and C.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

3.3 The principal purpose of a forward transaction is to allow market participants:


A. to speculate on current values.
B. to hedge the current spot value.
C. to fix transaction prices.
D. none of A, B and C.

3.4 The cost-of-carry model is:


A. the price paid by the buyer to the seller for agreeing to enter into a forward
transaction.
B. the costs associated with holding assets for future delivery.
C. the cost of hedging a forward transaction.
D. all of A, B and C.

3.5 A forward contract which involves no storage or wastage cost has a forward price for
three months delivery of 335.25. The cash commodity price is 325.75.
What is the implied interest rate?
A. 2.9 per cent.
B. 9.5 per cent.
C. 11.7 per cent.
D. 12.2 per cent.

3.6 A commodity has a dollar storage cost per month of $5 per ton. The one-month
interest rate is 9 per cent and the spot price for the commodity is $723.50/ton.
What would we expect the forward price to be?
A. $728.7
B. $733.8
C. $788.6
D. $793.6

3.7 A forward contract has been entered into to purchase an asset. It has an original
maturity of six months and a contract price of 950.25 when originated. The contract
now has three months to maturity and the spot price of the asset is 875.80, the three-
month interest rate is 6.5 per cent (there are no holding costs).
What is the replacement cost of the contract?
A. Nil.
B. 59.6
C. 60.6
D. 74.5

3.8 A financial instrument which pays no interest is trading in the market at 450.25. The
term structure of interest rates is flat at 8.5 per cent. The prices of two forward
contracts on the financial instrument (which has no storage costs), with three and six
months maturity, will be:
A. 459.5 and 469.0.
B. both contracts will be priced at 450.3.
C. both contracts will be priced at 464.3.
D. 469.4 and 488.52.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

3.9 As a rule, forward contracts have the following features:


I. Forwards are traded between participants on an organised exchange.
II. Forwards are traded directly between participants.
III. The contract is based on mutually agreed terms.
IV. The contract is based on standardised terms and conditions.
V. A forward contract will only roughly hedge an exposure.
VI. A forward contract will perfectly hedge an exposure.
The correct answer is:
A. I, IV and V.
B. I, III and VI.
C. II, III and V.
D. II, III and VI.

3.10 The major cause of credit problems in forward contracts is:


A. the lack of suitable counterparties to take the opposite position.
B. the risk that a counterparty will not honour the agreement.
C. the lack of liquidity in such contracts.
D. All of A, B and C.

3.11 In undertaking a forward contract to hedge a position, a participant is:


A. exchanging a liquid instrument for an illiquid one.
B. exchanging a current obligation for a future-dated one.
C. exchanging a high probability of price changes for a low probability of non-
performance.
D. all of A, B and C.

3.12 In the forward markets an arbitrageur will ____ the cash instrument and ____ the
forward if the forward is trading ____ to the cash.
Which of the following is correct?
A. buy sell cheap
B. sell sell expensive
C. buy buy expensive
D. sell buy cheap

3.13 When comparing forward transactions with similar cash market transactions we expect
that:
A. cash and forward markets have the same bid-offer spread.
B. cash market bid-offer spreads are smaller than forward market ones.
C. cash market bid-offer spreads are larger than forward market ones.
D. some cash market bid-offer spreads are smaller and some larger than forward
market ones.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

This table is used for Questions 3.14 to 3.16.

Time t=1 t=2 t=3 t=6 t=12 t=18


Rate % 8.25 8.3125 8.4375 8.625 8.75 8.9375

3.14 What is the forward-start deposit rate for three months starting in three months time?
A. 8.4375 per cent.
B. 8.5313 per cent.
C. 8.625 per cent.
D. 8.8128 per cent.

3.15 The market would refer to a forward-start arrangement as an versus agreement.


For Question 3.14, and are:
A. 1 and 3.
B. 3 and 3.
C. 3 and 6.
D. 1 and 6.

3.16 The market in short-term interest rates uses simple interest to calculate values.
Assuming that months are one-twelfth of a year, what is the six months deposit rate
starting in one year?
A. 8.5632 per cent.
B. 8.75 per cent.
C. 8.8438 per cent.
D. 8.9375 per cent.

3.17 A forward-rate agreement (FRA) for 100000000 has a contracted rate of 8.25 per
cent and the actual rate for the six months deposit on the contract at settlement is
7.875 per cent.
What will be the amount paid by the buyer of the contract?
A. No money is exchanged between the parties.
B. The buyer receives 180 397.
C. The buyer pays 180397.
D. The buyer pays 187500.

3.18 A forward-rate agreement (FRA) for US$20000000 has a contracted rate of 6.15 per
cent and the actual rate for the three months (91 days) deposit at expiry is 6.375 per
cent.
What will be the amount paid or received by the seller of the contract?
A. The seller receives US$310 917.
B. The seller receives US$11 375.
C. The seller pays US$11 375.
D. The seller pays US$11 194.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

The following information is used for Questions 3.19 to 3.23.

Initial exchange rate (US$/)


Spot 1m 2m 3m 4m 5m 6m
1.6385 1.6377 1.6360 1.6351 1.6303 1.6238 1.6190

Exchange rate after one month (US$/)


Spot 1m 2m 3m 4m 5m 6m
1.5450 1.5451 1.5450 1.5449 1.5447 1.5444 1.5441

3.19 You enter into a spot-start foreign-exchange swap for 5 million for three months
involving an initial sale of US dollars. At the maturity date:
A. you pay 5 million and receive US$8 175 500.
B. you receive 5 million and pay US$8 192 500.
C. you receive 5 million and pay US$7 724 500.
D. you pay 5 million and receive US$7 725 000.

3.20 In the swap entered into in Question 3.19 above, after one month you decide to
reverse the swap (that is, trade on the other side) to eliminate the position.
What transaction do you undertake?
A. You sell sterling and buy US dollars spot and buy US dollars and sell sterling
forward.
B. You buy sterling and sell US dollars spot and sell US dollars and buy sterling
forward.
C. You buy sterling and sell US dollars spot and there is no further liability at the
forward date.
D. You sell sterling and buy US dollars spot and there is no further liability at the
forward date.

3.21 In the transaction in Question 3.20, what is the net book gain or loss from entering into
the transaction (ignore discounting and the timing of the cash flows)?
A. (US$17 000).
B. (US$450 500).
C. (US$467 500).
D. US$450 500.

3.22 You enter into a forward-start foreign-exchange swap in three months time for three
months for 8 million in which you agree to pay sterling and receive US dollars at the
start date.
How many US dollars will you receive at the start of the swap?
A. US$12 359 200.
B. US$12 952 000.
C. US$13 080 800.
D. US$13 108 000.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

3.23 In the forward-start swap given in Question 3.22 above, after one month you decide to
close out the position. What are the net payments remaining on the transaction?
A. A receipt of US$720800 in two months and a payment of US$596800 in five
months.
B. A receipt of US$128800 in two months and a payment of US$4800 in two
months.
C. A receipt of 80259 in two months with no further obligation.
D. A payment of US$720800 in two months with no further obligation.

3.24 In a synthetic agreement for forward exchange (SAFE), the buyer of the contract will
notionally:
A. sell the base currency at the settlement date and repurchase it at maturity.
B. sell the foreign currency at the settlement date and repurchase it at maturity.
C. sell the base currency at the transaction date and repurchase it at the settle-
ment date.
D. sell the foreign currency at the transaction date and repurchase it at the
maturity date.

3.25 In the forwards markets an arbitrageur will buy the cash instrument and ____ the
forward if the forward is ____ relative to the cash.
Which of the following is correct?
A. sell cheap
B. sell expensive
C. buy expensive
D. buy cheap

3.26 The initial and current exchange rates after one month between the US dollar and the
Deutschemark (DM) are given as follows:

Initial conditions
Time Spot 1m 2m 3m 6m
DM/$ 1.56 1.559 1.557 1.553 1.54

Conditions after one month


Time Spot 1m 2m 3m 5m
DM/$ 1.57 1.568 1.564 1.561 1.553

If a US$10 million forward foreign-exchange swap for the 3 v. 6 months maturity had
been undertaken in which at the near date dollars had been sold, what would be the
marked-to-market value of the foreign-exchange swap after one month (ignore present
valuing and the effect of interest rates)?
A. (DM110000).
B. DM0.
C. DM20 000.
D. DM130000.

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

3.27 If the spot exchange rate between sterling and the euro is 0.6575 per euro and the
three months interest rates in sterling is 5.125 per cent and that for the euro is 3.75 per
cent, what will be the swap points for the three-months forward exchange rate? Is it?
A. 87.
B. 33.
C. 22.
D. 82.

3.28 If the spot exchange rate between the US dollar and the euro is $0.9823 and the
forward points at one-year are 124, which of the following is correct?
A. The swap points are negative because the one-year US dollar interest rate is
above the one-year interest rate in euros.
B. The swap points are negative because the one-year US dollar interest rate is
below the one-year interest rate in euros.
C. The swap points are negative because the two interest rates are the same.
D. It is not possible to tell from the information provided which interest rate is
the higher.

Case Study 3.1: Interest-Rate Risk Protection


The current date is 1 January and Dreadnought plc has a future borrowing requirement for
DM15 million in three months time for three months. The finance director of the company is
concerned that interest rates will rise in coming months and wants to protect the firms
borrowing requirement. The decision is reached that a forward-rate agreement (FRA) would
best hedge the exposure. The current yield curve, DM yield curve and FRA rates are as below:

1 Jan 1 Feb 1 Mar 1 Apr 1 May 1 June 1 July


1m 2m 3m 4m 5m 6m
No days 31 28 31 30 31 30
Offered 6.50 7.125 7.125 7.1875 7.25 7.25
Bid 6.375 7.00 7.00 7.0625 7.125 7.125

A market maker quotes the 3 v. 3 DM-LIBOR FRA rate as: 7.28 18.

1 Which element of the FRA quote is relevant from the companys perspective?

2 After three months, the three-month LIBOR rate has risen to 7.85 per cent. What are
the payments that have to be made or received on the FRA and what is Dreadnoughts
actual cost of funds on its borrowing? Use the exact day count. What would the cost of
funds have been had the LIBOR rate fallen to 6.50 per cent? (The year basis for DM is
360 days).

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Module 3 / The Product Set: Terminal Instruments I Forward Contracts

Case Study 3.2: Exchange-Rate Protection


Initial market conditions
Interest rates Exchange rate
in US dollars Interest rates (dollars per
Time Days (per cent) in Euros (per euro)
cent)
Spot 1.1500
1 month 30 4.25 3.25 1.1510
2 months 60 4.3125 3.375 1.1518
3 months 90 4.375 3.375 1.1529
The basis is 360 for both US dollars ($) and euro ()

Conditions at settlement
Interest rates Interest rates Exchange rate
in US dollars in Euros (per (dollars per
Time Days (per cent) cent) euro)
Spot 1.1900
1 month 30 4.125 3.125 1.1910
2 months 60 4.25 3.25 1.1920
3 months 90 4.3125 3.25 1.1931
The basis is 360 for both US dollars ($) and euro ()

1 If we enter into an exchange rate agreement (ERA) with a settlement date in one month
and a maturity date of 3 months (as of initiation) (90 days) for an amount of 100
million, what is the settlement amount that is paid on the contract? (use the exact day
count/basis)

2 If we had sold the ERA would we have made or lost the amount determined in
Question 1?

3 If, however, the contract had been a forward-exchange agreement (FXA) and the two
amounts were 100 million at the near date and 120 million at the far date, what
would have been the payment?

4 Explain the difference in the settlement values of the two contracts.

Derivatives Edinburgh Business School 3/35


Module 4

The Product Set:


Terminal Instruments II Futures
Contents
4.1 Introduction.............................................................................................4/2
4.2 Futures Contracts ...................................................................................4/2
4.3 Types of Futures Transactions ........................................................... 4/13
4.4 Convergence ........................................................................................ 4/18
4.5 The Basis and Basis Risk...................................................................... 4/21
4.6 Backwardation and Contango ............................................................ 4/35
4.7 Timing Effects ...................................................................................... 4/37
4.8 CashFutures Arbitrage ...................................................................... 4/40
4.9 Special Features of Individual Contracts .......................................... 4/42
4.10 Summary of the Risks of Using Futures ............................................ 4/46
4.11 Learning Summary .............................................................................. 4/47
Review Questions ........................................................................................... 4/48

Learning Objectives
This module continues the examination of the nature and use of terminal products
by looking at the second type of basic derivative, namely futures. Terminal contracts
are of three kinds: the simplest is the forward contract, already discussed in Module
3, which is a bilateral agreement between two parties; the futures contract is an
exchange-traded contract which has many of the features of a forward contract but
is designed to eliminate, to a large extent, the credit-risk element that exists in
forwards.
The key determinant of the pricing of all the terminal instruments is through
hedging or the cost-of-carry model.
After completing this module you should:
be able to price a futures contract;
understand the technical differences between a forward contract and a futures
contract;
know how specific futures contracts work in currencies and interest rates;
understand the effects of the basis on a futures price;
know what is meant by backwardation and contango in futures prices;
know what convergence means and how it affects the futures price over time;
know the limitations involved with futures contracts for hedging purposes.

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Module 4 / The Product Set: Terminal Instruments II Futures

4.1 Introduction
In the nineteenth century, Chicago, Illinois, emerged as a market centre for farm
products in the mid-west United States. In the fall, farmers would take their produce
to Chicago in order to sell it. However, there was such a glut of grain at this period
that some farmers, for want of buyers, ended up dumping the unwanted produce in
Lake Michigan. This was in stark contrast to the situation that existed in the spring
when there was a shortage and grain prices rose significantly. Grain prices thus
followed a rollercoaster pattern, plunging in the fall when deliveries took place from
the agricultural hinterland and soaring in the spring when weather conditions meant
that transport to market was extremely difficult. Grain merchants realised that there
had to be a better way of organising the business. To ensure supply, merchants
entered into forward contracts with farmers and also with consumers. However, as
we saw in Module 3, the forward contract involved taking counterparty risk. In
periods of shortage, farmers have a strong incentive to sell elsewhere; in times of
plenty, consumers want to renege on contracts. As a result, two developments
occurred. One involved merchants developing standardised contracts in order to
minimise contractual disputes. The second was the setting up of a central organisa-
tion to trade agricultural produce and the Chicago Board of Trade (CBOT) was
established in 1848. This formalisation of the arrangements in agricultural produce
allowed merchants to invest in silos to store grain for the periods of scarcity. Over a
number of years, the contractual arrangements used by the CBOT were refined,
contracts became largely standardised and, finally, the concept of margin or perfor-
mance bonding was introduced. These features, an organised exchange, standardised
contracts and margining (with a daily marking to market or revaluation of the gains
and losses on contracts), are the principal distinguishing characteristics between
futures and forward contracts. These institutional arrangements largely eliminate
performance risk for both the buyer and the seller. The formula has proved an
enduring one, with the basic approach being used around the world in a variety of
futures exchanges on commodities, metals, financial instruments and currencies.

4.2 Futures Contracts


There are many different futures contracts and markets. The principal distinguishing
features between the over-the-counter (OTC) forward market and the exchange-
traded futures market in the same asset relate not to fundamental differences in their
economic effect, but to institutional arrangements for handling counterparty risk
and providing liquidity. The first problem is addressed by requiring all participants
to post a performance bond and revaluing the position each day, at which point
the losers pay up on their losses. Equally winners have their gains credited to their
account every day. Liquidity is provided by restricting the number of maturity dates
and standardising the nature of the contracted instruments. The key differences
between forwards and futures are summarised in Table 4.1.

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Module 4 / The Product Set: Terminal Instruments II Futures

Table 4.1 Differences between forward and futures contracts


Forward contracts Futures contracts
All terms negotiable; private transaction Standardised terms; exchange-traded
Default risk (participants must have good credit Virtually no default risk
standing or post a deposit)
No intermediate cash flows Daily cash flows from margin changes as price
changes (to ensure performance of the con-
tract)
Creating contract often costly due to Low cost
intermediarys profit margin
Cannot (usually) be traded before delivery; Can trade contract on an exchange which has
requires either (a) counter-trade; or (b) liquidity
cancellation by mutual agreement
Contract can be for any amount/ specification Specified contract amount or multiples thereof
Any expiry, settlement or maturity date Specific expiry date(s) (there can be as few as 4
in a year)
Terms and conditions as negotiated Standard terms as laid down by the exchange
Counterparty can be anyone Exchange clearing house
No price variability or quality risk from Risk related to differences between standard-
negotiated contract ised contract and security (position)
Cancellation by mutual consent (usually with Has to be offset; i.e. sold if owned; bought back
compensating payment) if sold short
No margin requirements Initial and variation margin required

The major types of futures contracts are listed in Table 4.2. An examination of
the table will show two things. The first is that there is a wide range of contracts to
cover different economic risks. The second is that each contract covers a major
asset class or risk type. For instance, despite the market size of corporate bonds,
there is currently no corporate bond futures contract in existence.1
Corporate bonds are very heterogeneous as far as credit quality, terms and condi-
tions are concerned, and maturity and hence standardisation is difficult. A generic
contract on such instruments would be hard to engineer. Similarly, more specific
contracts on a particular corporate type would suffer from lack of interest since any
single sub-category of corporate bond would appeal to relatively few investors. As a
result, a futures contract will be successful only if it provides a hedging mechanism
for a large number of market participants. The types of contracts in existence can be
seen as locus points in a continuum of instruments and/or exposures.2 Futures
contracts require liquidity (that is, the participation of a large enough group of active

1 Note that in the USA, there are municipal bond futures contracts.
2 The government bond futures contract allows the hedging of interest-rate risk in corporate bonds. It
will not be a perfect hedge since there will be changes in the default spread over time. However, for
most users the attractions of a liquid contract outweigh the disadvantages of what are known as cross-
asset positions.

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Module 4 / The Product Set: Terminal Instruments II Futures

users) to reduce transaction costs and ensure sufficient trading volumes. Thus
futures contracts provide general cover at the expense of asset specificity. A trade-
off between transaction costs and liquidity and asset specificity is a feature of
futures. This is not a consideration with forward contracts since their bilateral nature
means that all the necessary specific features can be included in the agreement.

Table 4.2 Major categories of futures contracts


Usual deliv-
Type of futures contract Nature of underlying ery/Settlement at
expiry**
Currency futures Exchange of two currencies Give the right to buy and sell
a particular currency
Currency index futures Currency index Cash-settled exposure into a
basket of currencies
Short-term interest-rate futures Treasury bills; bank deposits Deliverable into a money
market instrument or a cash-
settled bank deposit equiva-
lent
Medium-term interest-rate Usually bonds or notes with Deliverable into an interme-
futures (a.k.a. bond futures) maturities of around 5 to 7 diate-term bond or note
years
Long-term interest rate futures Usually bonds with maturi- Deliverable into a long-term
(a.k.a. bond futures) ties around 10 years, or bond
longest available in the
market

Futures on an index of interest- Index of swap rates from Cash settled


rate swaps leading interest-rate swap
intermediaries
Spread futures Difference between two Cash settled
market reference points or
indices

Stock futures (on individual Single common stock issue Deliverable stock or cash
stocks) settled
Stock index futures (a.k.a Provide exposure to Cash settled
index futures*) performance of a stock
index

Commodity index futures Index of commodities Cash settled


Agricultural futures or softs Perishable commodities Deliverable into underlying
physical commodity
Industrial metal futures Base metals used in produc- Deliverable into underlying
tive process physical commodity
Precious metals futures Rare and precious metals Deliverable into underlying
physical commodity

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Module 4 / The Product Set: Terminal Instruments II Futures

Energy futures Oil and other energy Deliverable or cash settled,


products depending on contract

Freight futures Index of freight costs Cash settled

Insurance futures Index of catastrophic Cash settled


insurance losses

Weather futures Temperature index Cash settled


* This term is misleading since it is possible to have indices on other underliers than a portfolio or index of stocks
(e.g. commodities).
** Deliverable means that the underlying cash market instrument or commodity is provided by the short position
holder; cash settled means that the gains and losses are paid up in cash. Participants who desire the underlying
physical commodities buy them in the market directly. In some cases, with cash-settled contracts, the buyer can elect
to receive the underlier at expiry.

The structure of futures markets where there is a central, often physical, market-
place means that the trading and pricing of futures is transparent. The trading
arrangements, which involve brokers executing orders via open outcry and rapid
reporting and settlement of positions, ensure that pricing information is widely
available. Such transparency helps in providing information on the current and
future cash price based on known information. Although the value of a futures
contract is largely dictated by the term structure of interest rates, trading activity, the
demand for and the supply of futures (the open interest and volume of a particu-
lar contract) provide a forecast of the future price based not just on current
information but also on the consensus of market participants expectations.3
Another important function is the ability of futures markets to provide risk ad-
justment to cash or physical market positions. This is probably the most important
function of futures in that they provide a market for the trading of risk. Futures
markets are wholesale markets in risk management. In the futures markets risks are
transferred from the cautious to the more intrepid, the reckless or those better able
to absorb the risk. The key economic advantages and disadvantages of futures
markets are summarised in Table 4.3.

Table 4.3 Advantages and disadvantages of futures markets


Economic advantages of futures markets
Increased (economic) A central marketplace integrates the various segments of a
efficiency market; the availability of standardised contracts increases the
liquidity of the market
Increased availability of Futures markets provide price, volume and open-interest
information (outstanding contracts) information; they also act to discover the
market clearing price (price discovery/expectations of the
market)

3 Open interest is the sum of all the bought (or sold) contracts that are in existence. Volume is the
number of contracts traded on the exchange in a given period, usually a session (day). The greater the
open interest and volume, the more hedging and speculating activity there is taking place. Market
participants monitor these variables to try to discern changes in market behaviour.

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Module 4 / The Product Set: Terminal Instruments II Futures

User-specific advantages of futures markets


Reduced transaction costs Commissions, bid-offered spreads and costs of effecting a short
sale are smaller than those for cash markets
Reduced credit-risk expo- The clearing house acts as counterparty to all transactions; the
sures requirement to provide margin largely eliminates performance
risk (counterparty risk)
Ability to create synthetic Allow the creation of cash and futures positions that would be
securities prohibitively expensive in the cash markets alone
Allow for hedging and Leverage or gearing on futures contracts allows hedging or
speculation speculative activity to take place with minimal (additional)
investment
Price disclosure Centralised marketplace provides transparency of pricing
Disadvantages of futures markets
Possibility of price squeezes The risk that a few individuals take control of available supply,
thus driving prices above fundamental value
Require a cash deposit to Affect the cash flow of the transaction since margin requirements
collateralise the position are unpredictable
Require the position holder Create timing mismatches between losses and gains on hedging
to pay out on losses on a transactions
daily, mark-to-market basis
Imperfect hedging Behaviour of cash and futures markets do not fully correspond
over the short term

An important function of futures markets is to provide price discovery. This


arises in those futures markets where the underlying asset has yet to come into
existence. For instance, it is April and the contract for September delivery of wheat
reflects two factors: expected demand for wheat at that period and expected supply.
Thus observers of the futures price are provided with information about the likely
market for the coming harvest. The price of the futures contract tells us something
of the markets views on supply/demand factors in a product it is impossible to buy
in the physical markets. One can read about and observe commodities futures
markets reacting to events that change the future supply of and demand for those
products which are greatly susceptible to price discovery. Note that, on the whole,
financial futures markets are dominated by the cost-of-carry principle since the
supply of underlying financial instruments is generally infinite and any shortage is
likely to create its own supply.

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Trading Futures Contracts __________________________________


Futures exchanges which have a physical floor locate futures activity in areas
known as pits.4 Each pit normally trades one type of future. A large exchange
may have quite a number of different contracts, each with its own pit. The pit is
octagonal and it is sunk into the floor in a series of steps. This shape allows
traders to see each other across the pit so as to be able to carry out transactions.
These are done through a direct auction process known as open outcry where
buy and sell orders are shouted (cried out) between all traders in the pit until a
match is made. The match is then recorded by an official of the exchange for
entry into the price dissemination and settlement system. Each broker will also
confirm the transaction with his/her own firm at the booth on the floor of the
exchange. This information is then fed into the exchange clearing houses settle-
ment system. Confirmation is also passed back to the client. The basic sequence
of events is shown in Figure 4.1.
Futures exchanges pride themselves on both the speed at which transactions
can be carried out and the openness of the pricing involved. Open outcry
provides a visible two-sided auction process in which each trader seeks the
lowest buy (highest sell) price at which to execute the transaction. This is
immediately communicated to all traders wanting to take the opposite position.
Only the best bid and offer are allowed to appear in the marketplace. If the
trader is willing to pay the highest price, this is announced and all lesser bids are,
as a result, silenced. In this case, the best buying price will prevail at the expense
of the others. Similarly, giving the lowest selling price will ensure that the
transaction gets priority of execution. Market forces therefore determine the
result, with increased buying pushing up the price and increased selling pushing
down the price.
Behind the market, the exchange has a key role in promoting an orderly market,
ensuring that all transactions entered into are correctly recorded for settle-
ment, disseminating price and other information to all market participants, and
providing a set of rules that all members are required to follow. The exchange
may also have a regulatory role. In addition, its members act as guarantors of
the integrity of the clearing house system, ready to make good any default by
market participants.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

4 Unlike many other financial markets, some futures exchanges still have a physical trading floor and
brokers working in the pits. However, new electronic exchanges which use screen-based trading that
provides the same orderly market as traditional floor exchanges have come to dominate the industry.
Some of the new electronic exchanges have been extensions of the existing physical exchanges and the
two systems work side-by-side whereas others are new challengers.

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Module 4 / The Product Set: Terminal Instruments II Futures

Buying Selling
client client

Confirmation Telephoned Confirmation


of the Telephoned of the
order order
transaction transaction

Account Account
broker broker
at futures firm A at futures firm B

Confirmation Transmission Transmission Confirmation


of the of the order of the order of the
transaction to the exchange to the exchange transaction

Broker A's Broker B's


booth booth
on the exchange on the exchange
floor floor

Trading pit

Broker Broker
A B
Floor runner Buying Selling Floor runner
or hand signals or hand signals
to assistant at to assistant at
edge of the pit edge of the pit
Transactions made by 'open outcry'
between brokers in the pit

Figure 4.1 Trading procedures on a futures exchange


The key factors of futures markets are standardisation, only a limited number of
expiry dates, there not being a futures contract that exactly matches the asset to be
hedged and various institutional arrangements designed to promote liquidity and
ensure an orderly market. The nature of futures contracts is such that, although they
do address problems of liquidity and credit risk, unfortunately, they do create other
problems when in use.

4.2.1 Market Mechanisms to Increase Liquidity and Eliminate Credit Risk


Futures are readily tradeable instruments. Transaction costs are typically very low
relative to those in the cash markets or of equivalent forward contracts. These low
costs are achieved by making the contracts fungible by interposing a clearing
house as the counterparty to all transactions. The role of the clearing house is
shown in Figure 4.2. At time T, party A buys a futures contract. The (unknown)
other party is a seller, party B. This deal is carried out on the floor of the exchange
in the appropriate trading pit (see Figure 4.1). Both sides have their transaction
recorded by the exchange clearing house, which then interposes itself between A
and B. As a result, A and B have both entered into contracts with the exchanges
clearing house. Note that from the exchanges perspective, it is not at risk from
changes in the contracts price since it holds offsetting positions with A and B.
Where it does have risk is in ensuring performance by both parties.

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Time T

Party A Party B

Exchange clearing house

Time T+n

Party A Party C

Exchange clearing house

Party A can buy and sell futures contract, exchange


acts as counterparty to all transactions. A is initially
matched to B; when selling, a new party, C, is the buyer.

Figure 4.2 Role of the exchange clearing house in a futures market


The mechanics of the transaction are shown in Table 4.4. At time T, the clearing
house records party A as having a long outstanding position; this is offset in the
market by party B having established a short position. From the clearing houses
perspective, the two positions cancel each other out although contractually the
clearing house is separately the counterparty to both A and B and if either defaults is
still liable to the remaining party. Thus to protect itself, the exchange will require
both A and B to post margin (a performance bond). The role of margining is
discussed in the Section 4.2.2.

Table 4.4 The role of the exchange clearing house


Exchange Total open
Time Party A clearing Party B Party C interest
house
T +1 +1
1 1 1
+1 0 1 1

T+n 1 1 / +1
1 1
+1 +1 1
0 0 1 +1 1
Note that, as futures positions are created or cancelled, the open interest (last column) increases
or decreases. Open interest is therefore a measure of the demand for hedging/speculation in the
market. Volume data measure the rate of change in demand.

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Module 4 / The Product Set: Terminal Instruments II Futures

When A decides to close out the position, A sells its contract in the market. Be-
cause the clearing house is the other party to the future, it does not matter who the
buyer is. In this case, it is another party, C, which wishes to establish a long position.
At the same time, party Bs short or sold position remains unaffected. This would
not have been the case in a forward contract if A had approached B to cancel the
transaction. Party B would have been forced to search out C, or A would somehow
have had to pass on the position to C. This would have led to delay and additional
cost. With the futures contract, it is a quick and simple matter for A to instruct a
broker to execute the transaction.5
The Terminology of the Futures Markets _____________________
basis: the difference between the cash asset or instrument and the futures
contract. Changes in the basis lead to basis risk;
cash, cash asset, cash instrument, cash market: the market in the
physical or spot market value date in contrast to the futures contract or
futures market. Also called the underlying or underlier, or alternatively the
spot or physical market;
contracted asset or underlying instrument: the exact instrument,
commodity or other item that the futures contract can be exchanged for or
the price against which the contract is cash settled. For commodity futures,
for instance, it includes the degree of purity or type(s) that may be delivered
into the contract. For notes and bonds it will include a list of deliverable
issues;
contract size or trading unit: number of units, value, weight and so on of
the asset or underlying instrument;
convergence: the gradual reduction of the basis to zero as the futures
contract moves towards expiry. At expiration, the price of the cash and the
futures contract will be the same;
delivery options: the process of settlement at the expiry of the contract
when the short position holder sends the appropriate cash instrument or
makes over the requisite physical quantity of the commodity, instrument and
so forth to the futures buyer;
expiration and expiry: the date at which the futures contract is settled.
Typically, most financial futures contracts have only four expiry dates per
year, at three-month intervals, known as the expiry cycle. The most com-
mon cycle is March, June, September, December. Commodity futures may
have a more complex cycle reflecting seasonal variations in demand, etc.;
last trading day: the last day it is possible to trade a particular contract
prior to expiry;
delivery: how and where delivery will be made; what options are available
to the short position holder;

5 In fact, exchanges such as the Euronext-LIFFE take pride in the fact that a typical transaction can be
executed within half a minute of the instruction being given.

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notice day: the day on which the short position holder gives notice of the
intention to deliver;
implied repo rate: the rate of return that can be earned, before financing
costs, that is implied by selling a futures contract and buying a cash instru-
ment, such as a bond;
margin: the cash deposit required by futures buyers and sellers and used to
collateralise their positions and maintain the creditworthiness of the futures
clearing house. Margin is made up of an initial margin deposit (which can
be in the form of high-grade income-generating securities, such as Treasury
bills) and variation margin, which is required to be added to maintain the
account above the minimum margin level;
price quotation: how the price is quoted on the exchange. For commodity
futures, for instance, it is in units per ounce (precious metals) or tonnes
(base metals), or barrels of oil (crude oil futures). With financial futures a
variety of price quotations are used: for stock index futures, it is in index
points; for short-term interest-rate futures, it is an index equal to 100 less
the interest rate; for bond futures, it is the price of the notional bond in the
contract. The contract size is carefully designed both to provide a meaningful
tick size (typically in the region of US$10$25) and to balance transaction
costs versus contract size;
price limit: a maximum price change within a trading session. This is set by
the exchange. If reached, it halts trading in the contract. Limit up is the
maximum increase, limit down, the maximum price decrease allowed;
serial months: expiry and settlement months outside the normal expiration
cycle. If the normal cycle is March, June, September and December, then
expiry months in January and February would be serial months.
tick: the minimum price fluctuation permitted in a contract. The tick size of
the contract is determined so as to balance price sensitivity and the change
in the value of the futures contract. For instance, energy futures contracts
for crude oil are for 1000 barrels and the tick size is 1 cent. The tick value is
therefore:

Tick size Number of barrels: 1000 US$0.01 US$10


1
The tick size (being 0.01 or of 1 per cent) is called an oh-one;
100th
position limits: the maximum number of contracts it is permitted for one
account to hold on the exchange on one side of the market;
alternative procedures: whether alternative procedures are available in
relation to the location of delivery, quality, grade and so on. Such variation is
more typical of commodities than financial futures;
invoice amount: how the price to be paid or received is determined.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

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Module 4 / The Product Set: Terminal Instruments II Futures

4.2.2 Margin
We have seen in the previous section that the clearing house assumes the counter-
party risk of each futures contract. Recall that the major problem with forward
contracts is that they are credit instruments. The two parties need to be assured that
the other party will honour the obligation even though there is an incentive to
default if the cash market price has moved against the position. The same risk of
default on futures now arises between the clearing house and users of futures
contracts. It is addressed by requiring all buyers and sellers to post margin. Margin
is a form of collateral, in either cash or eligible high-grade securities such as
Treasury bills. This acts as a performance bond.
Margin is generally set so as to cover the largest daily price change that can be
anticipated, plus a safety factor. The other element of the margining system is the
daily marking to market of the contract and the crediting and debiting of gains and
losses to market participants as they occur at the end of the day.
The margining process works as follows. Every contract specifies the amount of
margin required to be deposited when initiating a transaction, known as the initial
margin and the minimum margin that has to be in the account, the maintenance
margin. This is provided by both buyers and sellers. At the end of each trading day,
the exchange will revalue each position in a process known as marking to market.
Positions that stand at a loss have their margin account debited by that days loss,
while positions making a profit are credited with that days gain, the debits and
credits being known as the variation margin. Those positions where the balance in
the account falls below the maintenance margin requirement are informed and are
required to provide additional margin to top up the account, a process known as a
margin call.6 Note that a margin call can arise even if profits have been earned,
since the exchange has the right to vary the margin requirements at will. This might
happen, for instance, if there was a significant sudden increase in the volatility in the
underlying cash market.
The margin account is under the control of the clearing house. Failure to respond
to the margin call gives the clearing house the automatic right to close out the position
by undertaking the appropriate reversing transaction. The funds in the margin account
are used to meet any resultant losses, the balance if any being subsequently
returned to the account holder.
The daily revaluation of gains and losses ensures that margin accounts are replen-
ished and all market participants essentially collateralise their own position by paying
for losses and being credited for any gains as they occur. Any surplus above the
initial margin can then be withdrawn as profit.

6 So as to avoid the need for continual margin calls that might arise from small changes in the futures
price, the exchange normally sets the initial margin somewhat higher than the maintenance margin
level.

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Effect of Margin on the Cost of a Futures Contract7 ___________


Although margin is a cost, its effect, as we show below, is not very significant.
Let the interest rate be 10 per cent and the initial margin be US$750 per
contract for a short-term interest-rate futures contract. Holding one futures
contract for six months incurs US$37.50 in interest cost. This is equal to 1.5
basis points (bp) per annum on the underlying principal of US$1m for three
months; or the variation cost on one-and-a-half ticks (US$25).
Since both the buyer and the seller have this opportunity cost, this cost has the
effect of increasing the bid-offer spread on the future by 3 bp per annum. Note
that this is the highest extent of the loss. Since most exchanges allow margin to
be posted in high-grade negotiable securities such as Treasury bills (T-bills), the
actual cost is the difference between the firms borrowing cost and the rate
earned on the T-bills.
Note too that, first, this cost will vary directly with interest rates, rising as
interest rates rise; and second, the cost of the variation margin will depend on
the course of interest rates over the period. Let us assume a 1 per cent change
over the first three months (first rates initially fall by 1 per cent and then rise by
1 per cent; if you have a long position in the contract, you receive margin and
then reinvest it at a lower rate. Subsequently you pay when rates have risen.)
The cost will therefore be:
US$25 100 11 0.25 US$25 100 9 0.25 4.1
US$12.50
100 100
Under this scenario, the cost equals half an 01 per contract.
Note that this analysis is not to be confused with the exposition of the tailing of
the position given in Section 4.7.1.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

4.3 Types of Futures Transactions


Futures markets allow firms and individuals to take long or short positions in a
range of underlying assets. The markets themselves are markets in risk. The liquidity
of futures markets, the ability to trade on margin and the ease with which short
positions can be established mean that they are used for a range of activities in
addition to transferring risks. That the markets are used by a wide variety of
participants for different purposes leads to increased turnover and in consequence
liquidity. The principal uses for futures are given in Table 4.5.

7 This is based on an example given by Manson, Bernard (1992) The Practitioners Guide to Interest Rate Risk
Management. London: Graham & Trotman Ltd.

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Table 4.5 Illustrative uses for futures


User Activity or Application or transaction
strategy*
Market makers Hedging the trading Long cash market position: sell futures; short
book cash market position: buy futures
Traders Directional view on Buy or sell futures
the market
Intra-commodity Sell (buy) early expiry contract; buy (sell) later
spread expiry contract
Inter-commodity Buy (sell) contract on one underlier and sell (buy)
spread another contract on different underlier
Volatility trade Combinations using options and futures
Basis trading View on cash-futures Buy (sell) underlying and sell (buy) futures
relationship (the basis)
Long positions in the Hedging Long underlying: sell futures
underlying
Investing future cash Buy futures and close position on purchase of the
flows underlying in the cash market
Asset allocation Sell futures on one underlier; buy futures on a
different underlier
Duration adjustment** Buy (sell) futures to lengthen (shorten) duration
Short positions in the Hedging Short underlying: buy futures
underlying
Future borrowing Sell futures and close position when borrowing is
undertaken
* Not all futures will be used for all these different strategies.
** Used with interest-rate sensitive assets

Market participants are therefore often characterised as given in Table 4.6.

Table 4.6 Types of futures activity


Type Activity
Hedger Someone seeking to reduce or offset risk
Speculator A risk taker seeking (large) profits
Backing a view Pursuing a specific investment strategy or market outcome
Arbitrage Exploiting market imperfections and anomalies
Spreading Exploiting changes in the relationship between two asset
classes

In fact, some exchanges (such as the London Metal Exchange) make a distinction
in the nature of the contract being undertaken for reporting and monitoring
purposes as to whether it is speculative or for hedging purposes.

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Module 4 / The Product Set: Terminal Instruments II Futures

4.3.1 Outright Purchases and Sales


The following types of naked transactions are carried out using futures:
outright purchase: the purchase of a futures contract in its own right. The
buyer has the obligation to receive the underlying at expiry. A naked purchase is
undertaken in anticipation of a rise in the price of the futures. An offsetting
transaction is designed to hedge a short position in the underlying asset, or an
asset with similar characteristics (a cross-hedge).
outright sale: the sale of a futures contract. The seller has the obligation to
make delivery of the underlying at expiry. A naked sale is undertaken in anticipa-
tion of a fall in the price of the futures. An offsetting transaction is designed to
hedge a long position in the underlying asset, or an asset with similar characteris-
tics (cross-hedge).

4.3.2 Spread Transactions


A spread position is taken by simultaneously buying and selling futures contracts as
a package. There are two basic variants: the calendar spread and the cross-spread.
Examples of both types are given in Table 4.7.

Table 4.7 Types of spread transaction using futures


Type Activity
Calendar spread
Buy (sell) nearest to expiry future Sell (buy) back contract

Cross spread
Buy (sell) stock index future Sell (buy) government bond future
Buy (sell) FT-SE 100 future* Sell (buy) MidCap future*
* These are contracts traded on LIFFE. The FT-SE 100 contract is on the largest 100 companies
traded on the London Stock Exchange. The MidCap is the next largest group of 250 companies.

To make a profit the spreader needs to determine whether the spread between
the two contracts will increase or decrease and put on the appropriate trade. Note
that the expectation of profit does not depend on getting the direction of movement
in the assets right. The basic variants and rationale for a spread transaction are:
intra-commodity spread (also known as a calendar or intra-market spread).
In this transaction the long and short positions are in the same contract but for
different expiry dates. It is a non-directional transaction which aims to make a
profit when the spread changes to the advantage of the position, when the price
difference either widens or narrows between the two contracts.
inter-commodity spread (cross-asset, inter-market spread): where the long
and short positions are in contracts on different underlying assets. This can be
set up either with the same expiry date, or with different expiry dates. Thus a
long position in gold and a short position in silver could be set up to anticipate a
change in the relative value of the two metals over the transaction period.

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Module 4 / The Product Set: Terminal Instruments II Futures

crush or refining spread. In some commodity markets, notably groundnuts and


crude oil, there are contracts on both the raw product and its processed product.
A spread can be established that hedges or speculates on the processing cost.
For instance, a spread between crude oil and unleaded gasoline futures is effec-
tively a play on refiners margins.

Note that all the transactions detailed above can be duplicated using the cash or
physical markets. However, in all cases, the cost of these strategies is significantly
greater than the equivalent result achieved by using futures. In some cases, setting
up such strategies in the physical markets would render the strategy null and void
since transaction costs would eat up all the anticipated benefits. Short selling, for
instance, is often difficult in the physical markets. The seller has to borrow the asset
to be sold and pays accordingly. In addition, short sales are often closely regulated
since they have traditionally been seen as highly speculative.

4.3.3 Leverage Effects


The final advantage of futures is the leverage provided by the instrument. In the
futures market, unlike the cash market, the buyer and seller need only provide a
fraction of the total value of the contract at the onset. A small change in the futures
price represents a large change in the value of the invested amount. The effect of
leverage (gearing) is shown in Table 4.8.

Table 4.8 Effect of futures leverage


Return on
Asset Investment Return on Future Margin investment
value in the asset investment in value on the in the
the asset future future
100 100 110 100 100 100 10 20 10 10
110 = 10% 110 = 100%

Taking a View on the Oil Price ______________________________


In late April, a speculator in the oil market has a view on the unfolding events in
the Gulf and thinks that these will affect the price of oil as there is a strong
potential for an outbreak of hostilities. If fighting breaks out, the threat of or
actual interruptions to oil supplies will significantly drive up its price. To back
this analysis of events, the speculator therefore buys 10 July crude oil futures
which are trading at US$20.50/barrel. At the same time the current cash or spot
delivery price is US$19.00/barrel.
Subsequently (in May), fighting does break out in the Middle East and oil prices
jump. The cash price or spot delivery price rises, in fact, to US$35.00 per barrel,
the crude oil futures contract for July delivery is now trading at US$30.00 and
the speculator closes out the transaction by selling the futures.

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Speculators Profit
To get the profit from the speculators view on an increased oil price, we must
calculate the number of ticks the July oil futures contract has moved. The initial
purchase price was US$20.50; the closing-out price US$30.00, so the difference
is US$9.50 or 950 ticks (as each tick is equal to US$0.01 on the oil price). The
tick value is determined from the contract size. The crude oil futures contracts
are for 1000 barrels with a tick size of 1 cent. The tick value for the contract is
therefore US$10 (tick size number of barrels = 1000 US$0.01 = US$10).
As the speculator bought 10 contracts, the gain is computed as:
Ticks Tick value Number of contracts

950 US$10 10 US$95000 gain
This figure ignores margin and other transaction costs.
Note that, as is expected, the cash and futures markets have both moved in the
same direction as a result of the shock to oil supplies. This is shown in Ta-
ble 4.9.

Table 4.9
Cash Futures
market price
Original (April) price US$19.00 US$20.50
Later (May) price US$35.00 US$30.00
Change in price US$16.00 US$9.50

However, the change in prices in the two markets has not been the same, as the
cash market has increased more than the futures price. The value differential
between the cash and futures markets, what is known as the basis, has changed.
There are a number of reasons for this. Although cash and futures prices are
related they form separate markets and are subject to their own particular
demand and supply factors. In the case of a key commodity like oil, the lack of
any ready substitutes leads to users being willing to accept a cost, known as a
convenience yield, to insure themselves against any shortfall. The greater the
chance of a shortage, the greater the convenience yield. A shock, like an
outbreak of hostilities in the Gulf, a key oil-producing region, is likely to drive up
considerably the markets convenience yield in the short term and hence change
the basis.8
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

8 We can say that the basis went from $1.50 to $5 over this period. If interest rates remained largely
unchanged then the big swing in the basis was almost entirely due to changes in the convenience yield,
with users, anxious about the availability of supply, bidding up the cash market price.

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4.4 Convergence
As the future moves towards expiry, the cost of carry will decline to the point
where, at expiry, the two prices should be the same. This coming together of the
cash and futures prices is known as convergence and it is the only time when the
futures price and the cash price must necessarily be the same.
Fair or Theoretical Value of a Futures Contract _______________
In conditions where there is an adequate supply of assets for delivery (that is,
where there is no market squeeze on the physical asset), it is possible to
calculate the theoretical or fair value of a futures contract.
The difference between the cash and futures price is influenced by supply and
demand factors, but interest rates are normally the most important factor.

Calculating a Fair Value


If the cash price of gold = $355/oz, the US dollar interest rate is 5 per cent p.a.,
storage costs (warehousing and insurance, etc.) are 0.5 per cent p.a., then we
can calculate the fair value of the gold future.
Method:
Calculate the cost of carry by working out the cost of finance and other
charges for a three-month period (90 days):
Cash (Interest rate + Other charges) days/3609
US$355 5.5% 90/360 US$4.88 cost of carry
To obtain the fair value add the cost of carry to the cash price:
US$355 US$4.88 US$359.88
The fair value of all futures contracts can be calculated by the above method. It
is slightly more complicated for bonds, currencies and equities; but the underly-
ing principle is the same.
Note that, when there are restrictions to the availability of supply of the
underlying asset and the market is in backwardation it is impossible to
calculate fair values. Note also that the existence of a convenience yield acts
to reduce the futures price relative to the cash price.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Recall the cost-of-carry model that we said underlies the valuation of forwards
and futures. Given that the price differential between the two was largely a function
of interest rates, the longer the time to expiry of the futures contract, the greater the
value of delay, and hence the greater the difference in value of the two. However,
we can expect the value of the futures price to change gradually as the contract
moves towards expiry, with the differential becoming smaller with time. In an
efficient market, we would anticipate that the two converged items would have the
same value on the last day the contract was extant.
Convergence is an important property of futures prices. Depending on the shape
of the term structure, we can anticipate that convergence will happen in one of two

9 This is following the market convention for such valuations which use simple interest.

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basic ways: either the cash and futures prices converge from above, or they con-
verge from below. Both are shown in Figure 4.3.

Convergence from above


Backwardation

Contract
expiry
Contango

Convergence from below

Time to expiry

Figure 4.3 Cashfutures convergence


Note: This shows the convergence of the cash price to the futures price as the contract moves to
expiry. The contract can either converge from above (known as backwardation), when the cash
price is above the futures price, or converge from below (known as contango), when the cash
price is below the futures price.
If we were to plot the cash price and the futures price over time, we might see a
relationship like that of Figure 4.4.

Futures price

Cash price

Time to expiry Expiry

Figure 4.4 Behaviour of the cash or spot price and the futures price as
the futures contract moves towards expiry
Note: The narrowing of the price gap or basis is due to the price convergence that occurs as the
time to expiry on the futures price diminishes. In order to prevent riskless arbitrage, at expiry the
cash and futures prices should be equal, that is, the basis goes to zero.
Understanding Convergence ________________________________
If we assume that the interest rate is flat for all maturities at 10 per cent and is
unchanged over time and the spot price of oil is US$20 per barrel, then we
would, in the absence of any market frictions, expect the oil futures prices to be
as given in Table 4.10.

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Module 4 / The Product Set: Terminal Instruments II Futures

Table 4.10
Time to expiry (days) Futures price Basis
0 20.00 0
30 20.17 0.17
60 20.33 0.33
90 20.50 0.50
180 21.00 1.00
365 22.00 2.00

That is, the further away the contract is from expiry, the greater all other
things being equal should be the basis. The basis reflects the interest cost,
storage and other factors between the spot market price and the price for
future delivery. Obviously, as this period gets shorter, these factors become
smaller until, at expiry, to prevent arbitrage, the two converge to zero. Changes
in any of the cost-of-carry factors will change the basis, a problem known as
basis risk.
Note that in the above situation, the basis is negative (that is, the market is in
contango).
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

The difference between the cash and futures price is known as the basis. The
basis is the cash market price (often referred to as the spot price) less the futures
price:
Basis , , 4.2
The basis for Figure 4.4 is shown in Figure 4.5.

Contract expiry
Time to expiry

Basis

Figure 4.5 Behaviour of the basis in Figure 4.4

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Module 4 / The Product Set: Terminal Instruments II Futures

4.5 The Basis and Basis Risk


Basis is the price difference between the cash market and the futures price:
Basis Cash price Futures price 4.3
If the cash price of wheat is 120/tonne and the July futures price is currently
125/tonne, then the basis is:
Basis 120 125 5
In this case, the basis is negative. This is sometimes referred to as 5 under
futures. If the result had been positive, the basis would have been described as
over futures.

4.5.1 Actual, Theoretical and Value Basis


Futures users often talk of basis relationships. These are the price relationships
between the actual futures price ( ) in the market, the theoretical futures price ( ),
and the value basis.
Given the cost-of-carry model, it is possible to calculate the theoretical basis of
a futures contract and compare this to the actual basis in the market. This theoreti-
cal price ( ) is computed using the cost-of-carry formula. The difference between
the cash price ( ) and the theoretical futures price is known as the carry basis, in
that the actual market basis (also known as the raw or simple basis) needs to be
adjusted by subtracting the carry basis to see if the futures contract is trading cheap
or dear in relation to its break-even value, known as the value basis. These
relationships are shown in Equation 4.4.
Raw basis 4.4
Carry basis
Value basis
In working out the implied futures break-even yield, that is, the rate at which we
are indifferent as to whether we hold cash and invest it until the futures expiry date
or buy the physical asset today, there are three distinct elements to be borne in mind
when calculating value:
the cash or physical asset we could buy today and whether it offers any income,
its storage, insurance and depreciation;
the rate at which we would earn interest until the delivery date;
the price of the futures contract.
If we start with any two of the above, it is possible to calculate the third. The
resultant relationship may show that the futures contract may be trading cheap or
dear in relation to the calculated price. This is known as the value basis.
A simple example will show why the value basis is considered by market partici-
pants to be the important element. Let us consider a short-term interest rate
contract which is on three-month eurodollar deposits. We have three months to go
before the expiry of the contract. The current eurocurrency interbank yield curve
out to six months is shown in Table 4.11.

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Module 4 / The Product Set: Terminal Instruments II Futures

Table 4.11 Short-term interest-rates yield curve


Maturity Eurodollar Eurodollar
offered rate bid rate
3 months 5.75 5.625
6 5.875 5.75
9 5.9375 5.8125

The eurodollar futures contract is trading at 94.08, giving an implied three-month


yield of 5.92 per cent. One could suppose that one might invest now at 5.625 per
cent, the bid side of the curve, and then obtain a deposit of 5.92 per cent in three
months time. This looks better than placing directly for the whole six-month
period. But think again, the implied bid side yield for three months is actually 5.79
per cent, so both strategies have an equal payoff.10 The value basis on the futures
contract (against the forward rate) is in fact only 0.01 per cent, in cash terms a mere
US$25 per contract, a gain likely to be eaten up in transaction costs.
There is another consideration to take into account here. Let us look at the next
contract. It would have a price of 94.11 on the current yield curve. Now we deposit
for six months and hold the future. If we then allow the yield curve to change both
in a parallel shift and via a rotation, let us look at the resultant impact on prices, as
shown in Table 4.12.

Table 4.12 Short-term-interest rates yield curve


Original Parallel
Maturity deposit shift Futures Rotational Futures
rate (+0.25%) price shift price
3 5.75 6.00 6.00
6 5.875 6.125 93.84 6.00 94.09
(6.16%) (5.91%)
9 5.9375 6.1875 93.87 5.9375 94.36
(6.13%) (5.64%)

For the three months contract, the futures price has moved from 94.08 to 93.84,
a drop of 0.24 per cent for an upward parallel shift in the curve of 0.25 per cent.
For the deferred contract with six months to go, the change has been from 94.11 to
93.87 or, again, 0.24 per cent. That is, with a parallel shift, the futures and cash
prices have moved in tandem. If the yield curve had rotated, however, the change in
the contract with the three-month expiry is to 94.09, a change of +0.01 per cent.
For the contract with six months to expiry, the price change has been to 94.36, or
+0.25 per cent. The change in the shape of the yield curve has produced unexpected
behaviour between the cash and futures prices when the yield curve twisted. That is
because the contracts are being priced off the forward interest rate. Whether the

10 This is because the eurodollar contract is on the offered rate. The difference between the bid and offer
is 0.125 per cent, therefore the payoff will be: offered rate spread, or 5.79 per cent.

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Module 4 / The Product Set: Terminal Instruments II Futures

result is desirable or undesirable will depend on the nature of the underlying


transaction.11
We can summarise the response of the carry basis to the three factors which will
affect the carry basis as per Figure 4.6.

Rotational
Parallel shift shift in the yield Time
in the yield curve curve

Carry Shorter period


spread for pre-delivery

Carry
basis Convergence

Yield on Yield on
cash asset futures

Futures price

Figure 4.6 Factors affecting the carry basis

4.5.2 Factors which Affect the Basis


The cost of carry provides a model for determining futures prices, but a number of
factors can affect the basis and push it away from its theoretical or carry basis. Since
futures are margined and gains and losses are credited and debited every day, futures
will be subject to interim cash flows. When this process is allied to differences in
borrowing and lending rates and other transaction costs, deviations from fair value
can occur. In addition, with some types of futures, there may be a problem in short
selling the underlying. In a number of cases, the proceeds from short selling are not
100 per cent of the market value of the asset. For instance, short-sellers of shares
have to deposit a fraction of the sales proceeds as collateral and are required to
reimburse the lender for dividends. Equally, some transactional arrangements
involving expiry and settlement can lead to uncertainty about the deliverable asset or
as with stock index futures, where the asset is a basket of securities the behav-
iour of the basket before expiry. Furthermore, some contracts allow the short seller
to time the exact delivery date and thus the settlement date is not known precisely.

11 This problem is taken up in the discussion of hedging techniques in Module 11 on hedging.

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Module 4 / The Product Set: Terminal Instruments II Futures

For these reasons the basis will deviate from its theoretical value and, as we have
discussed, we need to separate the carry basis component from the actual basis to
show the value basis. We can expect the carry basis to erode at a fairly predictable
rate. If we return to the oil example discussed earlier, we can see that if the contract
has 90 days to expiry, it will have a value of 20.50. We can expect the carry basis to
decline by about 0.005 per day, giving a price of 20.49 after one or two days have
elapsed.12 The behaviour of the carry basis will thus be largely predictable (in the
absence of a significant change in interest rates), whereas that for the other factors
will be unpredictable. This is shown in Figure 4.7.

Basis

Contract expiry

Time to expiry

Actual basis

Theoretical basis

Basis = Cash price Future price

Figure 4.7 The basis over time


Consequently, as market prices change, the cash and futures prices will normally
move in the same direction, but the basis will not be constant. Sometimes the cash
price will move more than the futures price; at other times, the futures price will
move more than the cash price. This is referred to as a change in the basis. This
movement arises from the factors already discussed. It might also be partly caused
by changes in the supply and demand for hedging and/or speculating in the
underlying assets. Equally, it will arise from changes in interest rates.
We can summarise the factors that lead to basis instability as being due to:
changes in the convergence path of the cash and the futures price;
changes affecting the cost of carry;
mismatches between the hedging instrument and the cash position;
random deviations from the cost-of-carry model (noise).
Whatever the cause, basis instability leads to potential problems in the use of
futures. If the basis alters then the equivalency of the cash and the futures position
will not match. This is a problem for the hedger, the effects of which are summa-
rised in Table 4.13. Remember that the problem of basis risk only applies when the
futures contract is to be sold/bought before expiry. If the contract is held to expiry,
the position pays the absolute difference between and , where is the price at

12 Of course the fact that crude oil futures are quoted to two decimal places requires the price either to
stay unchanged or to jump by one cent, not move by the straight line simple average of half a cent.

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Module 4 / The Product Set: Terminal Instruments II Futures

expiry time and is the price when the contract was originated. Note that, as
discussed later, while the payoff of the future is assured in this later case, there is still
an uncertainty over the timing of the cash flows since profits are credited (and losses
met) on a daily basis.

Table 4.13 Basis risk and hedge performance


Hedge position and return
Type of hedge Basis weakens Basis strengthens
Short Returns < 0 Returns > 0
Long Returns > 0 Returns < 0
Weaker basis: Cash price increases less or falls more than futures price
Stronger basis: Cash price increases more or falls less than futures price

The result of a change in the basis on the performance of a hedge is given in


Table 4.14.

Table 4.14 Basis change effects and resultant hedge performance


Basis movement
Direction
Price Type of Type of Effect of basis Return
movements hedge basis
Unchanged changes Short 0 nil unchanged nil
directly with

increases Long 0 nil unchanged nil


less or falls
more than
Weakens or 0 positive narrows negative
widens
Short 0 negative widens negative
Long 0 positive narrows positive
0 negative widens negative
Strengthens or 0 positive narrows positive
narrows
Short 0 negative widens negative
Long 0 positive narrows positive
0 negative widens negative

4.5.3 Effects of a Change in the Basis


Table 4.15Table 4.19 illustrate how a strengthening or a weakening of the basis
affects a hedging transaction. The example is based on hedging using copper futures
to hedge a copper position and a cross-asset position to bronze. A hedge is designed

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Module 4 / The Product Set: Terminal Instruments II Futures

to balance potential losses from a change in the market price on the underlying
position against gains in the corresponding futures position entered into as a hedge.
In Table 4.15, there is no change in the basis and the two sides match exactly.
In the next case, Table 4.16, the hedged position of Table 4.15 is subject to a
widening of the basis while prices decrease. In this case, the hedge has not worked
properly and there is a net loss of US$82174 from the combined portfolio. Note
that if the hedge had been put on the other way round, that is, a short hedge to
hedge a future purchase, the loss shown would have been a profit.

Table 4.15 Hedging a long position with a price decrease; no change in


the basis
Market conditions
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1520
Futures price at time hedge is removed $1543
Hedging amount in tonnes 10000
Number of tonnes per futures contract 1000
Number of futures contracts used to hedge position 10
Long hedge by copper producer: transactions
Cash Futures Basis
market
At
inception
$16000000 $16 234 782 23
At time hedge is removed
$15200000 $15 434 782 23
Cash position Futures position Overall gain/(loss)
$800000 $800 000 $0

Table 4.16 Price decrease; widening of the basis


Market conditions
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1520
Futures price at time hedge is removed $1552
Hedging amount in tonnes 10000
Number of tonnes per futures contract 1000
Number of futures contracts used to hedge position 10

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Module 4 / The Product Set: Terminal Instruments II Futures

Long hedge by copper producer: transactions


Cash Futures Basis
market
At
inception
$16 000 000 $16 234 782 23
At time hedge is removed
$15 200 000 $15 516 955 32
Cash position Futures position Overall gain/(loss)
$800 000 $717 826 ($82174)

Table 4.17 shows the same basis change but with a price increase. It has the same
result as Table 4.16. As with the price decrease, if the hedge had been established
against a future purchase, the position would have turned in a profit, not a loss.
If the basis had moved the other way, that is, had narrowed instead of widened,
the outcome would have been that shown in Table 4.18 for a price decrease and in
Table 4.19 for a price increase.

Table 4.17 Price increase; widening of the basis


Market conditions
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1684
Futures price at time hedge is removed $1716
Hedging amount in tonnes 10000
Number of tonnes per futures contract 1000
Number of futures contracts used to hedge position 10
Long hedge by copper producer:
transactions
Cash Futures Basis
market
At
inception
$16 000 000 $16 234 782 23
At time hedge is removed
$16 842 105 $17 159 060 32
Cash position Futures position Overall gain/(loss)
$842 105 $924 279 ($82174)

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Module 4 / The Product Set: Terminal Instruments II Futures

Table 4.18 Price decrease; narrowing of the basis


Market conditions
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1520
Futures price at time hedge is removed $1537
Hedging amount in tonnes 10000
Number of tonnes per futures contract 1000
Number of futures contracts used to hedge position 10
Long hedge by copper producer: transactions
Cash Futures Basis
market
At
inception
$16000000 $16 234 782 23
At time hedge is removed
$15200000 $15 373 912 17
Cash position Futures position Overall gain/(loss)
$800000 $860 869 $60869

Note that in this case, the narrowing of the basis has worked in favour of the
hedger, providing a net gain of US$60869. As with the widening of the basis, the
opposite transaction setting up a short hedge would have turned in the opposite
result: a loss. The general conclusion for the hedger is that a widening of the basis
disadvantages the long position but benefits the short position and a narrowing of
the basis benefits the long position but disadvantages the short.
These results should be set against the outcomes that would have resulted if no
hedging had taken place. In this case, the full cash price change would have been
either a loss or a gain depending on the direction of the price movements.
Although changes in the basis affect the result of the hedge, they are less than the
losses that would have occurred if the position had remained unhedged.

Table 4.19 Price increase; Narrowing of the basis


Market conditions
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1684
Futures price at time hedge is removed $1702
Hedging amount in tonnes 10000
Number of tonnes per futures contract 1000
Number of futures contracts used to hedge position 10

4/28 Edinburgh Business School Derivatives


Module 4 / The Product Set: Terminal Instruments II Futures

Long hedge by copper producer: transactions


Cash Futures Basis
market
At inception
$16 000 000 $16 234 782 23
At time hedge is removed
$16 842 105 $17 016 018 17
Cash position Futures position Overall gain/(loss)
$842 105 $781 236 $60869

As there are a limited number of futures contracts in existence and a potentially


much wider range of assets to be hedged, many situations require the use of a cross-
hedge, where the asset to be hedged is not that of the underlying futures contract.
For example, as previously mentioned, there is no corporate bond contract, so
hedgers wishing to protect themselves have to resort to a cross-hedge between
government bond futures and corporate bond positions. There are other instances,
as illustrated by our example, where a bronze producer wishes to hedge and has
decided that copper futures provide the best (but by no means perfect) match for
this purpose.
In these situations, we have an additional problem, namely the behaviour or
relationship between the asset to be hedged and the asset underlying the futures
contract, as well as the basis risk between the latter two. A full discussion of
methods to address this problem is held over to Module 11 on hedging. At this
stage, we simply highlight the problem that we are dealing with two sources of risk:
(1) the price correlation behaviour between the asset to be hedged and the asset
underlying the futures contract and (2) the basis risk from using futures. Table 4.20
to Table 4.25, therefore, illustrate the potential difficulties of hedging the bronze
price which, although correlated to the copper price, has idiosyncratic factors that
dictate its price independently of copper.
Another issue is that the value of bronze is greater than the value of copper so
the hedge position has to be adjusted to take account of this fact. Such a dollar
equivalency is a prerequisite to balancing the hedge, thus ensuring that the change
in value on both sides is the same.
In Table 4.20, when the two prices move in tandem and there is no basis shift,
the hedge is exact. However, given the nature of the hedge being used, this is
unlikely to be the case. A more likely scenario is given in Table 4.21 where the price
behaviours of copper and bronze do not move together.

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Module 4 / The Product Set: Terminal Instruments II Futures

Table 4.20 Cross-hedge, copper to bronze: price increase; copper and


bronze price changes move together
Market conditions
Bronze
Cash price at time hedge is established $1760
Cash price at time hedge is removed $1853
Number of tonnes of bronze to be hedged 10000
Price ratio of bronze to copper 1.1

Copper
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1684
Futures price at time hedge is removed $1708
Hedging amount in tonnes 11000
Number of tonnes of copper per futures contract 1000
Number of futures contracts used to hedge position 11
Long cross-hedge by bronze producer: cash bronze; transactions in
copper futures
Cash Futures Basis
market
At inception
$17600000 $17 858 260 23
At time hedge is removed
$18526316 $18 784 575 23
Cash position Futures position Overall gain/(loss)
$926316 $926 316 $0
Net value change for bronze position $0

In Table 4.21, the increased price of bronze has outstripped the loss on the fu-
tures position, leading to a hedging gain of US$378088 on the combined position.
This is a happy result for the hedger. However, if the opposite short asset/long
futures position had been set up, the hedge would have underperformed, with the
gain being a loss.
If the basis had also changed, as in Table 4.22, the unanticipated divergence
between the two sides would have been even greater, leading to an unexpected
windfall of US$624631 on the position! Note that some of this mismatch in these
examples arises from the fact that the futures position is slightly above that actually
required due to the need to deal in a (complete) round number of contracts.13

13 You may wish to re-evaluate these results using a nave hedge ratio of 1:1 rather than the 12:10 given in
the tables. Module 11 provides an in-depth discussion of how to set the appropriate hedge ratio.

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Module 4 / The Product Set: Terminal Instruments II Futures

Table 4.23 shows the effect of a price increase and, at the same time, the basis
decreases. The result is a very significant hedging gain of just under US$1 million.
Table 4.24 shows another possible set of outcomes. In this case bronze prices fall
more dramatically than copper prices, while at the same time the basis increases.
The loss in this situation is US$297884. The situation would have been worse if the
position had not been slightly overhedged to give an 11-contract protection rather
than ten. If only ten contracts had been used, then the loss would have been
US$429363.

Table 4.21 Cross-hedge, copper to bronze: price increase; copper and


bronze price changes do not correlate
Market conditions
Bronze
Cash price at time hedge is established $1760
Cash price at time hedge is removed $1890
Number of tonnes of bronze to be hedged 10000
Price ratio of bronze to copper 1.1

Copper
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1684
Futures price at time hedge is removed $1708
Hedging amount in tonnes 11000
Number of tonnes of copper per futures contract 1000
Number of futures contracts used to hedge position 11
Long cross-hedge by bronze producer: cash bronze; transactions in
copper futures
Cash Futures Basis
market
At inception
$17 600 000 $17 858 260 23
At time hedge is removed
$18 904 404 $18 784 575 23
Cash position Futures position Overall gain/(loss)
$1 304 404 $926 316 $378088
Net value change for bronze position $378088

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Module 4 / The Product Set: Terminal Instruments II Futures

Table 4.22 Cross-hedge: copper to bronze: price increase; copper and


bronze price changes do not correlate
Market conditions
Bronze
Cash price at time hedge is established $1760
Cash price at time hedge is removed $1910
Number of tonnes of bronze to be hedged 10000
Price ratio of bronze to copper 1.1

Copper
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1684
Futures price at time hedge is removed $1703
Hedging amount in tonnes 11000
Number of tonnes of copper per futures contract 1000
Number of futures contracts used to hedge position 11
Long cross-asset hedge by bronze producer: cash bronze; transactions in
copper futures
Cash Futures Basis
market
At inception
$17600000 $17 858 260 23
At time hedge is removed
$19099295 $18 732 924 19
Cash position Futures position Overall gain/(loss)
$1499295 $874 664 $624631
Net value change for bronze position $624631

Table 4.23 Cross-hedge, copper to bronze: price increase; copper and


bronze price changes do not correlate and the basis
decreases
Market conditions
Bronze
Cash price at time hedge is established $1760
Cash price at time hedge is removed $1890
Number of tonnes of bronze to be hedged 10000
Price ratio of bronze to copper 1.1

Copper
Cash price at time hedge is established $1600

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Module 4 / The Product Set: Terminal Instruments II Futures

Futures price at time hedge is established $1623


Cash price at time hedge is removed $1684
Futures price at time hedge is removed $1654
Hedging amount in tonnes 11000
Number of tonnes of copper per futures contract 1000
Number of futures contracts used to hedge position 11
Long cross-asset hedge by bronze producer: cash bronze; transactions in
copper futures
Cash Futures Basis
market
At inception
$17 600 000 $17 858 260 23
At time hedge is removed
$18 904 404 $18 196 316 30
Cash position Futures position Overall gain/(loss)
$1 304 404 $338 056 $966348
Net value change for bronze position $966348

Table 4.24 Cross-hedge, copper to bronze: price decrease; copper and


bronze price changes do not correlate and the basis increases
Market conditions
Bronze
Cash price at time hedge is established $1760
Cash price at time hedge is removed $1586
Number of tonnes of bronze to be hedged 10000
Price ratio of bronze to copper 1.1

Copper
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1520
Futures price at time hedge is removed $1492
Hedging amount in tonnes 11000
Number of tonnes of copper per futures contract 1000
Number of futures contracts used to hedge position 11

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Module 4 / The Product Set: Terminal Instruments II Futures

Long cross-asset hedge by bronze producer: cash bronze; transactions in


copper futures
Cash Futures Basis
market
At inception
$17600000 $17 858 260 23
At time hedge is removed
$15855856 $16 412 000 28
Cash position Futures position Overall gain/(loss)
$1744144 $1446 260 $297884
Net value change for bronze position $297884

Finally, in Table 4.25, we show the effect of a price decrease coupled to a nar-
rowing of the basis.
As with the earlier example of the price rise, the decision to round to 11 rather
than ten contracts has meant that the loss is US$396884, instead of $519363, as it
would have been if only ten contracts (a naive hedge) had been used.
To summarise, the effectiveness of the hedge will depend on the degree to which
the cross-asset positions correlate and the extent of basis risk.

Table 4.25 Cross-hedge, copper to bronze: price decrease; copper and


bronze price changes do not correlate and the basis
decreases
Market conditions
Bronze
Cash price at time hedge is established $1760
Cash price at time hedge is removed $1586
Number of tonnes of bronze to be hedged 10000
Price ratio of bronze to copper 1.1

Copper
Cash price at time hedge is established $1600
Futures price at time hedge is established $1623
Cash price at time hedge is removed $1520
Futures price at time hedge is removed $1501
Hedging amount in tonnes 11000
Number of tonnes of copper per futures contract 1000
Number of futures contracts used to hedge position 11

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Module 4 / The Product Set: Terminal Instruments II Futures

Long cross-asset hedge by bronze producer: cash bronze; transactions in


copper futures
Cash Futures Basis
market
At inception
$17 600 000 $17 858 260 23
At time hedge is removed
$15 855 856 $16 511 000 19
Cash position Futures position Overall gain/(loss)
$1 744 144 $1 347 260 $396884
Net value change for bronze position $396884

4.6 Backwardation and Contango


The pricing model that we have presumed to be applicable so far to the futures
market is the cost of carry. This still begs the question of how the current futures
price relates to the spot price that is expected to prevail at expiry. The expectations
model states that the current futures price is equal to the markets expected value
for the spot price at expiry . That is,
4.5
where is the spot price at time .
If the expectation correctly specifies the futures pricing model, the return from
speculating in futures should be the riskless rate, as in the cost-of-carry model. This
would imply that in a normal state, the price of futures should be higher than spot
prices. Equally, the basis should be negative . That is, we have an
upward-sloping term structure, or a premium market (traditionally known as
contango). This is illustrated in Figure 4.8.

Value

Time to delivery
or expiry

Figure 4.8 Premium market; basis will be negative (contango)


However, for certain types of futures contracts we may expect the futures price
to be lower than the spot price. That is, we have an inverted term structure or a

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Module 4 / The Product Set: Terminal Instruments II Futures

discount market (traditionally known as backwardation). Such a discount market


is illustrated in Figure 4.9.

Value

Time to delivery
or expiry

Figure 4.9 Discount market; basis will be positive (backwardation)


Normal backwardation, as it is called, arises because of the interrelationship between
two factors: the gain from holding the asset (that is, its running yield) as against the
cost of funding the position, the interest cost. This is best illustrated with a simple
example.
Let us assume that the term structure of interest rates is upward sloping. The
three-month rate, applicable to the expiry of the bond futures contract, is 5 per cent
p.a., while the notional bond underlying the contract is trading at par and has an
annual coupon rate of 8 per cent. (Note that the par assumption is simply for
expositional convenience.) The question is therefore: what is the fair value of the
futures contract? Under the cost of carry model, we would expect the future value
of the contract, without value leakage to be:

4.6

100
We have already said that prices are set by the short position holder who has the
obligation to deliver the underlying. If the short borrows 100, then the cost will be
100 over the period, or a terminal repayment of 101.26. However, over the
same period, the income earned by holding the bond will be at the rate of 8 per
cent, giving a terminal value of 102.02. If the futures contract was so priced as to
ignore the income advantage gained from the asset, there would be a strong
incentive to short the futures and hold the bonds. The equilibrium price of the
futures contract must therefore be 99.25, at a discount to the spot price, so as to
preclude such cost-of-carry arbitrage.
This bond example enables us to observe the process by which we obtain a
backwardated market. With other types of futures this process is not so obvious.
For stock index futures, we have the dividend yield ( ) on the index constituents.
The generic pricing model in such circumstances will be:

4.7

100

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where is the current futures price with expiry at time , is the riskless interest
rate and is the dividend yield. Equally, this yield could be the bond yield or the
foreign currency rate applicable to the security.14 The balance between the earning
yield on the asset for delivery and the short-term interest rate will dictate
whether the contract is in contango or backwardation.
With commodities, we have mentioned that a number of other factors can also
affect the market:
short-term lack of supply in the cash market. For instance, zinc available for
immediate delivery might be in short supply (a condition known as a supply
squeeze);
seasonal influences (such as oil demand; wheat supply in the later sum-
mer/autumn etc.). It is possible to see some contract months in contango and
others in backwardation as a result. In addition, some commodities deteriorate
rapidly and cannot be stored for long (for instance, eggs);
convenience yield. Since with commodities substitution is difficult, the value of
holding the physical commodity itself can lead to the existence of a convenience
yield, if supplies are expected to be interrupted or squeezed. In effect, it is the
value to the user of having an assured supply.
In such cases, the price of a commodity futures contract will be:
4.8
where is the current futures price with expiry at time , is the riskless rate, is
the cost of holding the commodity and is the (unobservable) convenience yield
applicable.
When , we can expect commodities futures to be in contango and when
, in backwardation.

4.7 Timing Effects


Since futures have only limited expiry dates, there will be more times when unwind-
ing a hedge requires the closing of a futures position than running the position to
expiry. This gives rise to the delivery basis risk problem. There is also another
problem, illustrated in Figure 4.10, when the exposure to be hedged does not match
the contract period. In the top half of the figure (A), we have the situation where
the underlying exposure period, in terms of the two start dates, and the contract
period match exactly. A more typical situation occurs in the bottom half (B) where
the exposure period and the contract period do not match.
The second case presents a problem. We could hedge with the first contract, but
this contract expires before the start of the underlying exposure period and would
require us to roll over the expiring contract into the next contract. An alternative
approach is to use the second contract to hedge the exposure. However, as we have

14 We can think of a bond as having a dividend yield. In the same way, a currency future has a foreign
currency yield. The pricing model for such forward contracts is the same as Equation 4.7.

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Module 4 / The Product Set: Terminal Instruments II Futures

seen earlier, there is considerable basis risk in doing so from a rotation in the term
structure of interest rates. These matters are discussed further in Module 11 on
hedging.
By using futures, the hedger has exchanged the unacceptable price risk for the
lesser problem of basis risk. In general, basis risk will be much less of a problem
than price risk and the trade-off is worth while. It is only in forward contracts that
all price risks are eliminated, but at the expense of assuming counterparty risk. By
using futures the hedger has gained liquidity, largely eliminated counterparty risk and
reduced transaction costs. The advantages derived from an exchange-traded
instrument with contract standardisation, fixed expiry dates, a central clearing
organisation and counterparty have to be counterbalanced by the residual basis risk
that results.

Perfect hedge
Contract period

Exposure period

Underlying
exposure period

Imperfect hedge
Contract period 1
Exposure period Contract period 2

Underlying
exposure period

Figure 4.10 Problem of timing with futures and underlying cash flows

4.7.1 Tailing the Hedge


Margining, where gains and losses are credited and debited each day, leads to
intermediate cash flows. Given that they occur, and as the futures price converges to
the cash price, the position holder in futures will be either paying out on losses or
receiving the gains. If these are reinvested, to assume that the notional amount on
the futures contract is equal to the underlying position is potentially to overhedge.
The timing effects that arise from the margining system require the hedger to tail
the hedge, that is, reduce the exposure on the futures contract by the expected
reinvested income from the margin position. The adjustment is shown in Equation
4.9:
Tailed hedge 4.9
The easiest way to explain the concept is to use an example. Global Corporation
Inc. expects to require US$100 million in 11 months time and anticipates raising a

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Module 4 / The Product Set: Terminal Instruments II Futures

three-month borrowing as a result. The Chief Financial Officer has decided to


hedge the interest-rate risk on the future borrowing and considers futures the most
appropriate instrument. Following an analysis of the alternatives, it is decided that
the three-month eurodollar futures contract is the appropriate hedge. Given that
each contract has a value of US$1 million, a simple hedge would involve the selling
of 100 contracts. However, given the daily margin cash flows into and out of the
account, the number of contracts required to hedge the position is in fact:
100 4.10
where, in our example, is 11 months. If the current interest rate is 10 per cent, the
appropriately tailed hedge is:
.
100 91.24
Rounded to the nearest whole number, this becomes 91 contracts to be shorted.
This tailing requirement arises from the timing of cash flows from a futures
hedge. In order for the hedge to operate effectively, the position needs to be
monitored and adjusted as required as cash flows into and out of the margin
account. The rate at which the futures and cash converge may change. In Fig-
ure 4.11 a number of alternative scenarios for convergence are shown. If the
convergence, and hence the margin flow, is different from that which is anticipated,
it may be necessary to rebalance the hedge. Futures positions therefore need to be
monitored over their life and adjusted accordingly. If the hedge had been via a
forward contract (that is, a forward rate agreement (FRA)), this would not be a
requirement.

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Module 4 / The Product Set: Terminal Instruments II Futures

Futures price

Ft

Panel
A
FT

Time
E

Ft

Panel
B
FT

Time
E

Ft

Panel
C
FT

Time
E

Figure 4.11 The timing of cash flows into the margin account

4.8 CashFutures Arbitrage


Market participants are always looking for ways to earn riskless profits. Arbitrage is
that trading activity in which traders (arbitrageurs) seek to make risk-free profits by
exploiting mispricings between instruments and markets. Generic arbitrage involves
selling the expensive asset and buying the cheap one with a view to making a profit
when the price anomaly unwinds. One such opportunity is provided by the relation-
ship between the cash market price and its concomitant futures contract. For
futures markets, the generic arbitrage strategies are given in Table 4.26.

Table 4.26 Cashfutures arbitrage


If futures are (in relation
to their fair or theoretical Futures market Cash market action
value): action
Expensive Sell futures Buy cash
Cheap Buy futures Sell cash

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Module 4 / The Product Set: Terminal Instruments II Futures

What Table 4.26 means is that, if the relationship derived from the cash-and-
carry model moves out of line, there is an opportunity for a riskless arbitrage. If, as
shown in Table 4.27, the futures price is expensive in relation to its fair or theoreti-
cal value, including known or estimated transaction costs, then the best course is to
short the futures contract and hold the asset for delivery into the contract or more
typically until the anomaly reverses itself. If the opposite condition applies and
futures are cheap, a reverse cash and carry, involving buying the futures and selling
the cash asset, is undertaken.
While the approach in Table 4.26 is certainly valid, a number of factors will mean
that there are costs associated with cash-futures arbitrage strategies:
Transaction costs. There are two sets of transaction costs to be overcome.
Short-selling restrictions. Many markets impose restrictions on the ability to
short-sell cash assets and there are costs associated with borrowing assets for
short-selling purposes. For instance, many stock or bond lending situations not
only involve a fee to the lender but also require a partial deposit of the asset
value and reimbursement for interest or dividend payments.
Borrowing funds may be problematical or be subject to other restrictions.
Also the borrowing rate may not be the same as that implied by the basis.
Unequal borrowing and lending rates are involved, the bid-offer spread
widens the range before which arbitrage becomes profitable.
There will be intervening cash flows in the form of interest received or paid in
marking-to-market the futures contracts.
The mechanics of the market. These include the wild card option on delivery,
expiry conditions for setting the price. These and other market mechanisms
increase the uncertainty over the ultimate gain to be made from arbitrage trans-
actions.

Table 4.27 Cashfutures arbitrage strategies


Arbitrage Futures price Cash market Futures market
Cash and carry =
Short futures Buy asset (long) Sell futures

Reverse cash and carry =


Long futures Sell asset (short) Buy futures

is the theoretical or fair value of the futures based on the cash and carry model
and is the transaction costs. is the market price of the futures contract.

4.8.1 Arbitrage Channel for Futures


Given the above we can posit an arbitrage channel for futures prices between the
opportunities provided by cash-and-carry arbitrage and its opposite, a reverse cash-
and-carry operation. This arbitrage has to take into account the market imperfec-
tions detailed above before a turn can be made. This will lead to a channel within
which the futures price can move, based on expectations and supply and demand

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Module 4 / The Product Set: Terminal Instruments II Futures

factors, before arbitrage can operate to bring the two markets back into line. This
will also affect the amount of value basis to be expected on a particular contract.
This channel will be:

4.11
where is the transaction costs per unit of the cash asset. Equation 4.11 can be
expressed more simply as:
4.12
Since there is such a channel, futures prices are likely to deviate somewhat from
their theoretical value and trade cheap or dear to the theoretical price. Such noise
effects can affect the outcome of the hedge, and the width of the channel is an
influence on the degree of basis risk being assumed in any transaction.

4.9 Special Features of Individual Contracts


The discussion so far has avoided any particular reference to the specific features of
different types of contract. Although futures can be considered a generic class, there
are some special features of individual types of contract that warrant a mention.
Note that the discussion that follows is not a full analysis of individual futures
contracts but aims to highlight those special characteristics which influence their use
as a risk-management instrument.

4.9.1 Short-Term Interest-Rate Futures


The price quotation for short-term interest-rate futures based on interbank deposits
and government Treasury bills is based on an index (100 less the interest rate on the
futures contract). If interest rates were 10 per cent, the futures price would be 90
(100 10).

Table 4.28 Index pricing mechanism for short-term interest-rate futures


Implied interest Futures price
rate quote
7 93.00
8 92.00
9 91.00
9.50 90.50
10 90.00
10.50 89.50
11 89.00
12 88.00
13 87.00
14 86.00
15 85.00

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Module 4 / The Product Set: Terminal Instruments II Futures

This method of quoting the price of a futures contract means that as interest
rates rise, futures prices fall; and vice versa. This gives interest-rate futures the same
relationship as is found with bond futures (when interest rates rise, prices fall).
When investors buy or sell short-term interest-rate futures, they are trading an
index. The index measures the impact of interest-rate changes on a notional
borrowing or lending amount. For Euronext-LIFFEs short-sterling interest-rate
contract, the notional amount is 500000 over a specific three-month period: for
example, a June future measures the period between mid-June and mid-September.
The tick size of all short-term interest rates is an 0.01. This equals 1/100 of 1 per
cent (one basis point (1bp)); it is pronounced oh-one. As the notional amount of
money underlying the contract and the period of time on the deposit are known, it
is possible to attribute a monetary value to each tick:
For Euronext-LIFFEs short sterling this equals:
Contract size Time period Tick
500 000 3/12 0.01% 12.50
Note that virtually all short-term interest-rate products have a tick size of 1 bp
and it is also conventional for the period of the notional investment to equal three
months.
Hedging a Borrowing Requirement __________________________

3 January: A corporate treasurer has a borrowing requirement of 1.5m for


the next three months from 3 February; the treasurer fears a rise
in rates from the current 13 per cent, so he wishes to hedge his
exposure.
Action: Sell 3 March short sterling futures at 86.75 (13.25 per cent).
Contract size = 0.5m
1.5m
Number of contracts required = 3 contracts
0.5m

The position on 3 February.


Action: Borrow 1.5m at an interest rate of 13.5 per cent fixed for 3
months.
Close futures position by making a closing purchase.
Buy 3 March short sterling futures at 86.25 (13.75 per cent).

Cost of borrowing = 0.5 per cent increase


1.5m 0.5% 3/12 1875
Profit from futures is therefore:
86.75 86.25
50 ticks
0.01
Ticks Tick value Number of contracts Profit/ Loss

50 12.50 3 1875

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Module 4 / The Product Set: Terminal Instruments II Futures

The profit from the futures market exactly compensated for the loss arising
from the rise in interest rates. The hedge was perfect because the basis re-
mained unchanged; in practice, such perfection is unlikely.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

4.9.2 Long-Term Interest-Rate Futures


The use of long-term interest-rate futures or bond futures is identical to other
futures hedges, if a little more complicated. The basic actions are shown in Ta-
ble 4.29.

Table 4.29 Cash-futures arbitrage


Position to be hedged Action
A current bond holding Sell future
Anticipate a purchase Buy future

Bond futures allow the holder to receive delivery of debt securities, usually gov-
ernment securities or similar. To facilitate trading a number of mechanisms are used,
both to increase the supply of eligible securities and to ensure equivalence of value.

4.9.2.1 Notional Bonds


The long-term interest-rate futures contract is based on a notional bond of a given,
constant maturity and a set coupon. For the short position holder, if the contract is
held to expiry, delivery can be made from a range of eligible bonds with the
appropriate characteristics of the notional bond. Some of these bonds will have
more or less accrued interest in their price than others.
If bond futures contracts were based on actual bond issues, it is possible that
activity in the futures markets would be so great as to cause problems of delivery of
the underlying bond at expiry. To avoid the danger of lack of supply resulting in a
squeeze, the futures exchange allows a number of eligible bonds with different
coupons and redemption dates to be delivered to satisfy the obligations of short
position holders in the contract. To equate the two, the exchange uses a conversion
factor between the notional bond and the bonds eligible for delivery.
As a result, when you look at a bond future you are looking at an index price
reflecting the prices of all deliverable bonds.

4.9.2.2 Price Factors in Bond Futures


When under the obligation to make delivery, short position holders in the bond
contract may deliver bonds with a variety of coupons and redemption dates.
Different bonds have different market prices because of coupon and maturity. As a
result, it is necessary for the exchange to introduce into the calculation of the price
(or invoice amount) a method of fairly (or equitably) treating these differences when
sellers deliver high-coupon and (as a result) high-value bonds.

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Module 4 / The Product Set: Terminal Instruments II Futures

The exchange, as a result, adjusts the delivery price or amount by a price factor to
reflect differences in the value of the actual deliverable bonds relative to the
notional bond.

4.9.2.3 Cheapest-to-Deliver
Price or conversion factors seek to bring all bonds to the same value for delivery.
For a number of technical reasons, they are not entirely accurate. As a result, the
short position holder (or bond seller) needs to calculate which bond is best for him
to deliver (that is, is the least-cost bond). This is known as the cheapest-to-deliver
(CTD).
Correctly identifying the CTD is obviously important for the seller (and for the
buyer!). It is important in the pricing of the future and in the creation of correct
hedges. The complexities of this process are outside the remit of this module.

4.9.2.4 Delivery Options


In addition to the above, a number of other special features are of note. These are
summarised in Table 4.30.

Table 4.30 Summary of delivery options for bond futures


Option Privilege Effect
Accrued interest The right of the short position holder This will be determined by the cost
option to decide when within the delivery of carry; a positive carry on the bond
month to make delivery of the tending to delay delivery to the last
underlying moment; negative carry tending to
ensure early delivery*
End-of-the-month The ability to make use of the delay It allows in making delivery for the
option in settlement allowed between the short holder either to substitute a
exchanges final delivery settlement cheapest-to-deliver bond or to close
price set at the expiry of the futures out an arbitrage position at a profit
contract and the settlement date by buying more cheaply in the cash
market
Quality option The right of the short position holder The existence of a quality option
to deliver any of the cash bonds in makes a cash-and-carry arbitrage
the basket that meet the specifica- position difficult since in setting up
tions of the contract the position the arbitrageur does not
know which bond will be delivered if
the position is held to expiry
Wild card option Involves making use of the differences Differences in the two prices lead
between the cut-off time on giving either to an arbitrage that allows the
notice of the intention to deliver on substitution of an alternative cheap-
any given delivery day within the est-to-deliver bond, or to the closing
delivery month and the exchange out of an arbitrage position at a profit
delivery settlement price (EDSP) set by buying more cheaply in the cash
at the closing market
* Positive carry occurs when the yield on the bond (its internal rate of return) is higher than the short-term interest
rate involved in pricing the futures contract. With negative carry, the opposite applies.

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Module 4 / The Product Set: Terminal Instruments II Futures

4.9.3 Commodity Futures


Commodity futures have their own special features. Some contracts allow for an
extended delivery period so that the short position holder can elect the exact day for
delivery. They may also allow for the substitution of a lesser quality or grade of
product from that specified in the contract against a price adjustment. The contract
will also specify those locations at which delivery is allowed.
A particular arrangement allowed in commodities markets is the ability to enter
into an off-exchange transaction involving futures known variously as an exchange
for physical (EFP), against actuals (AA) or exchange of futures for physical
(EFFP).15 An exchange for physical transaction allows market participants to agree a
closing-out transaction between the physical and the futures market at the same
time as they enter into a cash market transaction. The EFP is then confirmed
through the exchange at a later stage. The rationale is to allow adjustment to the
cash, or physical, position at minimum cost, by eliminating any pricing mismatches
between the position and the futures contract acting as a hedge. Thus two parties
with a buyers hedge and a sellers hedge can agree to extinguish their obligations to
the exchange at the same time as they agree the price of the cash transaction.
One final aspect worth noting, although not of a contractual nature, is that, on
the whole, commodity futures suffer from greater basis risk than financial futures.
This arises from commodities being consumption assets and not investment assets.

4.10 Summary of the Risks of Using Futures


The attractive features of futures such as standardisation, liquidity, the low transac-
tion cost, open pricing and low credit risk make them useful instruments for
managing risks. There are however, as we have seen, a number of disadvantages to
using futures which stem from the mechanisms used to create the attractive
features. The key risks from using futures are summarised in Table 4.31.

Table 4.31 The risks of using futures


Source of risk Nature of the risk
Basis risk Problem of variable convergence leading to an uncertain
match between cash and futures position performance
Cross-asset positions Underlying position and futures contract are not the same,
leading to potential differences in performance
Rounding error Requirement to transact in whole contract amounts leads to
slight over- (under-) hedging
Variation margin Margin flows on futures position can cause uncertainty in hedging
Timing mismatches Gains and losses on the two sides may not match
Maturity Maturity of the underlying position does not match that of the
mismatches contracts

15 This is also possible with some financial futures contracts, when it is known as a basis trade facility.
The rationale is the same as that for commodities: to minimise the price risk from the two sides of the
transaction taking place at different times.

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4.11 Learning Summary


This module has examined the institutional and market arrangements used for futures.
The great advantages of futures over forward contracts are their liquidity, low transac-
tion costs and the role of the exchange in addressing specific counterparty risk
problems. Liquidity is achieved through standardisation of contract specifications.
While the advantages of futures derive from their institutional arrangements,
these same structures also lead to their disadvantages. Futures contracts are inflexi-
ble, leading to hedge inexactness, a problem known as basis risk. The margining
systems lead to intervening cash flows which require the hedger to monitor the
position and, possibly, to make adjustments to the hedge.
Consequently, there are trade-offs between the benefits of a traded market and
contract specificity, between virtually eliminating counterparty risk and assuming
credit risk and between cost and continual monitoring of positions. Functionally,
forwards and futures achieve the same result. The judgement as to which to use is as
much part of the risk-management task as is the decision to hedge or live with the
exposure.

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Module 4 / The Product Set: Terminal Instruments II Futures

Review Questions

Multiple Choice Questions

4.1 Counterparty risk is handled in futures markets by:


A. requiring all participants to post a deposit on their transactions.
B. revaluing transactions at the end of each trading day.
C. having a central clearing house act as counterparty to all transactions.
D. all of A, B and C.

4.2 Futures markets provide liquidity for traded contracts by:


A. restricting the number of market makers in the contracts.
B. restricting the number of maturity dates for delivery.
C. increasing the number of underlying assets in a particular contract.
D. all of A, B and C.

4.3 Marking to market is the process by which a futures exchange:


A. ensures that traded prices are correctly reported.
B. reconciles the purchase and selling prices of market participants.
C. revalues market participants positions at the futures clearing house.
D. ensures an orderly opening price on the exchange at the start of the trading
session.

4.4 Margin is required to be posted to the futures exchange clearing house:


A. to ensure that the buyer or seller acts in good faith.
B. to pay for losses incurred by changes in market prices during the trading
session.
C. to protect the clearing house against possible default by futures users.
D. all of A, B and C.

4.5 Price discovery as a process observable in futures markets is the result of transactions
with forward maturity dates providing information on:
A. the likely price at maturity.
B. the likely future balance of supply and demand.
C. the price behaviour of the underlying instrument in the futures contract till the
maturity date.
D. all of A, B and C.

4.6 The mechanism for determining transaction prices in futures markets involves:
A. an auctioneer acting for the exchange calling out bid and offered prices until a
match is made in the market.
B. a specialist offering to buy and sell at the highest and lowest prices in the
market.
C. brokers seeking the highest sell and lowest buy prices available in the market.
D. all of A, B and C.

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4.7 The exchanges clearing house has the following outstanding positions on day 1 and day
2, as given in the table below:

Types of transactions Day 1 Day 2


Long positions at close 11 150 13 725
Short positions at close 11 150 13 725
Daily trading volume 23 750 35 550

What will be the open interest position reported at the close of business at the end of
day 2?
A. 2 575.
B. 11 800.
C. 13 725.
D. 35 550.

4.8 Using the information from Question 4.7, an analysts report on the market at the end
of day 2 would indicate that there has been:
A. an increase in the demand for hedging or speculation.
B. a decrease in the demand for hedging or speculation.
C. no change in the demand for hedging or speculation.
D. Cannot answer the question from the information provided.

4.9 You purchase 20 sterling short-term interest rate (STIR) futures contracts at a price of
83.25 and the market improves so that the contracts can be sold for 86.23. The notional
value of the sterling STIR contract is 500000 and the minimum price fluctuation is one
basis point. Each basis point price change is worth 12.50. How much profit has been
made from the transaction?
A. 3725.
B. 5580.
C. 74 500.
D. 149 000.

4.10 In setting up a futures position, the margin required to be deposited on the short-term
eurodollar contract with a notional value of US$1 million is US$500 per contract. Each
tick is worth US$25 per tick. If five contracts are entered into at 92.34 and the contract
closes at the end of the day at 92.28, how much margin will be debited from the
account at the futures clearing house?
A. US$150.
B. US$500.
C. US$750.
D. US$2500.

4.11 If we sell a futures contract we have:


A. committed to purchase the underlying asset at expiry.
B. committed to sell the underlying asset at expiry.
C. received the premium on the sale.
D. done none of A, B and C.

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Module 4 / The Product Set: Terminal Instruments II Futures

4.12 An inter-commodity spread involves:


A. buying a nearby date expiry futures contract and selling a later-dated futures
contract.
B. selling a nearby date expiry futures contract and buying a later-dated futures
contract.
C. buying a futures contract on one underlier and selling a futures contract on
another underlier.
D. all of A, B and C.
The following information is used for Questions 4.13 to 4.15.
Bill Wildman is a speculator who takes risks in order to have a chance of obtaining high
returns. Bill believes that gold is overpriced and will drop substantially in response to a change
in market sentiment. On 9 July, he sells five gold futures contracts at US$375.60 per troy
ounce (one futures contract is worth 100 troy ounces). On 9 September, Bill buys back the
gold contracts at US$350.20 and closes out his position. When dealing with its customers, the
brokerage house has a margin requirement of US$2500 per contract with customers on gold
futures. The tick size for gold futures is US$0.10 and its value is US$10.

4.13 What is Bills profit or loss in US dollars?


A. (US$12 700).
B. (US$200).
C. US$12 700.
D. US$200.

4.14 How much variation margin would have been credited to his account?
A. US$25.4
B. US$127.0
C. US$254.0
D. US$12 700

4.15 What is Bills return on his investment?


A. 101.6 per cent.
B. 1.6 per cent.
C. 1.6 per cent.
D. 101.6 per cent.
The following information is used for Questions 4.16 to 4.18.
Arnold Schwartz is an aspiring futures trader. His first assignment by his boss is to monitor
the fair value of copper futures on the London Metal Exchange. On 21 October, the spot price
of copper is US$1346.70. The December futures price is US$1361.80. (This futures contract
expires on the twenty-first day of the expiration month, that is, in 61 days.) The financing rate
is 5 per cent (assume actual days/360). Determine the following:

4.16 What is the basis on the futures contract?


A. (US$3.69)
B. (US$15.1)
C. US$11.41
D. US$15.1

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4.17 Given the current relationship of spot to the futures price, a trader would define the
basis as:
A. long the basis.
B. short the basis.
C. over futures.
D. under futures.

4.18 What is the fair value of the futures contract?


A. US$1358.11
B. US$1361.80
C. US$11.41
D. US$0.00

4.19 You would have a short futures position if you have:


A. bought and then sold futures.
B. sold and then bought futures.
C. sold futures.
D. bought futures.

4.20 You are a hedger if you have:


A. a long position in the cash market and a short position in futures.
B. a short position in the cash market and a short position in futures.
C. a long position in the cash market and a long position in futures.
D. a long and a short position in futures.

4.21 You are a speculator if you have:


A. a long position in the cash market and a short position in futures.
B. a short position in the cash market and a short position in futures.
C. a long and a short position in futures.
D. None of A, B and C applies.

4.22 For interest-rate futures on bonds, the term cheapest-to-deliver means:


A. the bond which is in greatest supply.
B. the bond which is most easily borrowed.
C. the bond which generates either the greatest profit or least loss to the seller.
D. the bond which has the highest cost of carry.

4.23 The current price of a commodity is 245.25 and the term structure of interest rates is
flat at 6.25 per cent. Storage costs are 5 per month paid in arrears. What is the fair
value of the futures contract with three months expiration on the commodity?
A. 249.00
B. 260.58
C. 264.00
D. 264.07

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Module 4 / The Product Set: Terminal Instruments II Futures

4.24 In Question 4.23, the cash price has not changed but the three months interest rate has
now instantaneously changed to 7.50 per cent. In this case, the futures price will:
A. rise in value.
B. fall in value.
C. remain unchanged.
D. There is insufficient information to determine an answer.

4.25 In Question 4.23, if the interest rate and storage costs are unchanged at 6.25 per cent
and 5 per month but the cash commodity price has changed to 238.70 and the
futures contract now has two months to maturity, the new fair value of the futures will
be:
A. 241.12
B. 250.14
C. 251.15
D. 253.62

4.26 The cash market price of an asset is 718.35 and the three months futures price is
729.10. The three-month interest rate is 6.15 per cent and the storage, insurance and
depreciation is 2.5 per cent p.a. The value basis on the futures is:
A. (10.75)
B. (4.3)
C. 0
D. 10.75

4.27 The one-month futures price is 450.75 and the cash price is 448.60. The one-month
interest rate is 6 per cent and the storage costs are 0.5 per cent per annum. Is the value
basis:
A. nil?
B. positive?
C. negative?
D. Cannot be determined from the information.

4.28 A futures contract on a commodity is initially trading at 1118.25 versus a cash price of
1050.75. After a few days, the futures price rises to 1245.75 and the cash price is
1160.25. In this case, the basis:
A. remains unchanged.
B. has strengthened.
C. has weakened.
D. The answer cannot be determined from the information provided.

4.29 A short-term interest-rates futures position is sold at 87.53 against an implied forward
rate of 12.4375 per cent. The contract subsequently moves to 88.12 and the implied
cash position moves to 11.875 per cent. In this case, the basis:
A. remains unchanged.
B. has strengthened.
C. has weakened.
D. The answer cannot be determined from the information provided.

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4.30 An equity index futures contract with a three months maturity is trading at 6101.25 and
there is a dividend yield on the index of 4 per cent per annum. The current short-term
interest rate is 5 per cent per annum. The current level of the index is 6080.00. What is
the carry basis?
A. (21.25)
B. (15.14)
C. 6.11
D. 15.14

4.31 A six months hedging transaction is to be undertaken against a future borrowing of 65


million using the sterling short-term interest-rate contract which has a notional amount
of 500000. If the current six months rate is 4.5 per cent, and we want to tail the
hedge, how many contracts are required?
A. 64 contracts.
B. 65 contracts.
C. 127 contracts.
D. 130 contracts.

4.32 In the futures markets an arbitrageur wanting to take advantage of price discrepancies
will ____ the cash instrument and ____ the futures contract if the future is ____
relative to the cash. Which of the following is correct?
A. buy sell expensive
B. buy buy cheap
C. sell sell expensive
D. sell buy cheap

4.33 The current index value in mid-January is 3733 and the June futures price is at 3805
(there are 152 days left on the futures contract), the risk-free rate is 8 per cent (using a
year of 365 days), and the dividend yield is 3 per cent and transaction costs are 0.5 per
cent. (Note that stock index futures values are calculated using simple interest.) Which
of the following applies?
A. A profitable cash and carry exists between the two markets after transaction
costs.
B. A profitable reverse cash and carry exists between the two markets after
transaction costs.
C. A cash and carry exists between the two markets, but it is unprofitable after
transaction costs.
D. A reverse cash and carry exists between the two markets, but it is unprofitable
after transaction costs.

4.34 The fundamental differences between financial forward contracts and financial futures
contracts are:
I. forwards are bilateral contracts between two counterparties.
II. futures are traded on an organised exchange whereas forwards are not.
III. the cost-of-carry model applies to forward contracts only.
IV. futures contracts are standardised whereas forward contracts are not.
V. forward contracts are not tradable.
VI. for a forward, the underlying asset in the contract is restricted by law.

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Module 4 / The Product Set: Terminal Instruments II Futures

The correct answer is:


A. I, III and VI.
B. II, IV and V.
C. I, III and V.
D. I, II and VI.

4.35 When referring to futures contracts, the margin is:


A. the current difference between the cash or spot price and the futures price.
B. the price difference between the nearest contract to expiry and the longest-
dated contract being traded.
C. the collateral placed with the exchanges clearing house to ensure performance.
D. the difference between the total value of the contract and the cash market
price at expiry.

4.36 Cash-settled when applied to futures contracts on commodities means that:


A. payments are due when the contract is settled.
B. payment is made between the buyer and the commodity clearing house which
then settles with the seller.
C. the value of the contract is paid in cash and no physical commodity is ex-
changed at maturity.
D. payment is made when the contract is first negotiated.

4.37 A long-term interest-rate futures contract has three months until expiry and is based on
a notional bond rate of 9 per cent. A deliverable bond with a 9 per cent coupon is
trading at 100 in the cash market. The short-term interest rate is 12 per cent. What will
be the futures price?
A. 99.25
B. 100
C. 100.75
D. 100.95

4.38 Scotvalue Investment Managers have decided that the price relationship between the
FT-SE 100 and the FT-SE MidCap Index is due for a readjustment in that the MidCap is
undervalued compared to the FT-SE 100 index. They decide to use futures to set up a
cross-asset spread between the two indices. Which of the following transactions should
they put on to back their view?
A. A long position in the MidCap contract and a short position in the FT-SE 100
contract.
B. A short position in the MidCap nearest-to-expire contract and a short position
in the longest-to-expire FT-SE 100 contract.
C. A short position in the MidCap contract and a long position in the FT-SE 100
contract.
D. A long position in the MidCap nearest-to-expire contract and a long position in
the longest-to-expire FT-SE 100 contract.

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4.39 If we bought a short-term interest-rate futures contract at 88.79 and sold it again at
89.85, what has happened to interest rates and would we have made money?
A. Interest rates have risen and we have made money.
B. Interest rates have fallen and we have lost money.
C. Interest rates have risen and we have lost money.
D. Interest rates have fallen and we have made money.

4.40 A stock index has a current value of 830.00. The risk-free interest rate is 6 per cent per
annum and the dividend yield on the index is 4 per cent per annum. (Note that stock
index futures values are calculated using simple interest.) What would you expect the
futures price of a stock index future with an expiry date in four months time to be?
A. 846.60
B. 835.53
C. 841.07
D. 856.95

4.41 Today is 15 October and the spot price of crude oil quoted on the New York
Mercantile Exchange (NYMEX) is US$70.40 and the price for mid-January expiration is
US$68.75, a period of 91 days. The US dollar continuously compounded interest rate
for the three months is 3.00 per cent per annum. What is the implied convenience yield
(as an annualised rate) on the contract if crude oil storage costs (continuously com-
pounded) are 1 per cent per annum?
A. 3.37 per cent.
B. 5.51 per cent.
C. 11.17 per cent.
D. 13.51 per cent.

Case Study 4.1: The Use of Short-Term Interest-Rate Futures for


Hedging
The current date is 2 April, and the treasurer of GH Inc. is expecting to receive the proceeds
of an asset sale on 15 May (that is, in 41 days). These funds will be invested for three months
(a period of 92 days). The amount due on 15 May is US$50 million.
When the treasurer looks at the situation, the cash three month rate = 9.50% 9.625%. At
the same time, the June eurodollar futures price = 90.18 (this is the nearby contract with a
delivery (maturity) date on the contract for 20 June, that is, 77 days away).
Remember that short-term interest rates in US dollars are quoted on an Actual/360-day
basis and use simple interest.

1 What is the impact of a 50 bp adverse movement in the interest-rate position on the


return from the asset sales proceeds when invested?

2 How many eurodollars futures contracts should the treasurer use to hedge out his
interest-rate risk? The tick value of the short-term interest-rate future in eurodollars =
$25 per contract which has a nominal value of US$1 million. The hedge ratio ( ) used to
determine the appropriate number of contracts is found by:

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Module 4 / The Product Set: Terminal Instruments II Futures

Price sensitivity of the cash position



Price sensitivity of the hedge position

3 What is the interest rate on the investment as a result of the transaction in eurodollar
futures? (You will have to use straight-line interpolation between the cash and futures
rates to find this value.)

4 What are the basis effects and convergence on the futures contract between 2 April and
15 May?

5 On 15 May, the cash market rates have in fact fallen as the treasurer feared and the
three month eurodollar is trading at 9% 9.125% and the June futures at 90.70 (scenar-
io 1). What is the treasurers investment rate on the US$50 million in this case?
(Express the result as an annualised rate.)

6 As in Question 5 above, cash market rates have in fact fallen and the three month
eurodollar is trading at 9 per cent 9.125 per cent, but the June futures are now at
90.79 (scenario 2). What effect has the change in the futures price had on the return in
this case?

7 Explain why the predicted return when setting up the hedge has either performed as
expected or led to an unexpected result.

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Module 5

The Product Set:


Terminal Instruments III Swaps
Contents
5.1 Introduction.............................................................................................5/2
5.2 Interest-Rate Swaps................................................................................5/5
5.3 Cross-Currency Swaps ...........................................................................5/9
5.4 AssetLiability Management with Swaps .......................................... 5/11
5.5 The Basics of Swap Pricing ................................................................. 5/17
5.6 Complex Swaps .................................................................................... 5/29
5.7 The Credit Risk in Swaps .................................................................... 5/34
5.8 Learning Summary .............................................................................. 5/41
Appendix 5.1: Calculating Zero-Coupon Rates or Yields .......................... 5/41
Review Questions ........................................................................................... 5/43
Case Study 5.1................................................................................................. 5/49

Learning Objectives
This module looks at the third category of derivative terminal instrument: the swap.
Such an instrument is more complex than the single-date structures of forwards and
futures. Following their invention, a large number of different swap types have been
developed in response to market needs, although the two principal kinds relate to
cross-currency and interest-rate swaps. A swap contract has many of the features of
a term instrument, such as a bond, but equally it can be unbundled into a portfolio
of simple forward contracts for pricing and risk-management purposes. The credit
risks of interest-rate swaps are far less than the equivalent risks of holding a bond.
This is not true of a cross-currency swap, where credit risk increases with the time
to maturity.
As a liability-management instrument, swaps provide an effective means for
borrowers to exploit their comparative advantage in particular markets while at the
same time maintaining their desired exposure profile to interest rates and currencies.
Swaps therefore enable borrowers to manage position risk rapidly and at minimum
cost.
As an asset-management instrument, they offer the same attractions as for liabil-
ity management, namely, exploiting anomalies and rapidly managing position risk at
minimum cost.
Swaps allow assetliability managers to alter their overall exposure to a particular
currency or interest rate without having to undertake the early repayment of

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Module 5 / The Product Set: Terminal Instruments III Swaps

outstanding borrowings or to realise investments. Swaps also facilitate cash-flow


management.
After completing this module, you should know:
the nature of the different types of swaps;
how swaps are used for risk modification, assetliability management and
arbitrage across markets;
how to price a new, or at-market, swaps contract;
how to value or unwind an existing, or seasoned, swaps contract;
the credit exposure on swaps.

5.1 Introduction
Swaps are the third and newest member of the terminal instruments in the deriva-
tive product set. They only came to public knowledge in the early 1980s. Shortly
after the market became aware of these latest instruments, I can distinctly remember
my then manager saying to me that I should find out how these newfangled
transactions worked. At the time, there were only a handful in existence and
information about their structure and function was scarce. Yet by the end of the
decade, swaps were being traded by financial institutions in the same way as forward
contracts on currencies. Swaps have rapidly established themselves as an important
class within the derivative product set. This is because they are extremely useful in
managing interest-rate and currency risks and swaps now form a key part of the
various methods used by firms in managing their risks. If forwards and futures
contracts are designed to hedge a single cash flow, a swap can be seen as the
equivalent instrument for hedging a series of cash flows. Their popularity and rapid
expansion were due to two factors: they helped complete financial markets by
allowing participants to undertake new types of transactions and they acted as a
mechanism for linking the bond markets of major countries.
Swaps have the same symmetric or linear payoff profile as forwards and futures.
However, they differ from forwards and futures in that there is a multiplicity of cash
flows between the two counterparties over the life of the swap. Another reason for
the extensive use of swaps is their adaptability. Any set of cash flows which can be
contractually predetermined can form one side of a swap.
Before looking at the uses of swaps, it is worth pausing at this point to resolve
the terminological confusion that arises between what the market understands as a
swap and the similarly named short-term foreign exchange swap. The latter is a
short-dated exchange of one currency into another with the corresponding re-
exchange at a later date (that is, a purchase (sale) and subsequent sale (repurchase)).1
The difference between the foreign exchange swap and the capital markets swap is
that, in the second case, there is a series of periodic payments to be made by both
parties. This module looks at capital markets swaps. The foreign exchange swap is
really a specific use of foreign exchange forward contracts.

1 See Module 3 for the details of such transactions.

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.1.1 Uses of Swaps


Swaps, like the other financial instruments of the derivative product set, have to fulfil
an economic purpose in a more efficient way than other instruments or methods in
order to have a place in the financial markets. All derivatives can be replicated using
other fundamental instruments and in that sense they are superfluous. However
their economic rationale is that they allow market participants to manage risks at a
lower cost than via cash instruments.
Swaps permit market participants to modify sets of connected cash flows in
attractive ways and thus have become an important tool for assetliability manage-
ment. They allow the risk manager to modify the nature of these cash flows, either
changing their currency of denomination to a more favourable one, or altering the
nature of their interest-rate risk. They have therefore become important liability
management tools for the treasury manager. However, they also provide the asset
manager with ways to take advantage of investment opportunities. They allow
attractive assets or securities which have undesirable risk characteristics to be
modified by adding the relevant swap structure. Because they transform risk, swaps
have also been extensively used in structured finance to create new riskreward
characteristics that address the specific needs of different categories of investor.
Finally, as with all off-balance-sheet instruments, swaps provide an opportunity for
speculation.
A New Derivative is Created ________________________________
The first publicly reported swap occurred in August 1981 between the Interna-
tional Bank for Reconstruction and Development (IBRD, or World Bank) and
International Business Machines (IBM). The World Bank wanted to raise low-
interest currencies for onlending and, in order to do so, had been issuing bonds
in the Swiss market. However, the World Bank had over-issued in this market
and was seen as an unattractive credit by investors in the Swiss Franc sector.
On the other side, IBM wanted to raise funds in US dollars at least cost. A
cross-currency swap would meet both their needs. In response to this shared
objective, IBM issued a Swiss Franc denominated bond and the IBRD a US dollar
bond and both parties swapped the proceeds. In addition to the Swiss Francs,
there was a Deutschemark tranche as well, raising a total of US$290 million.
As always in these matters, the swap did not emerge out of thin air. Prior to the
milestone 1981 transaction, which is generally given as the starting point for
swaps, a large number of what are known as back-to-back loans had been
made to get around currency controls and other market frictions. The key
technological innovation in the World BankIBM swap that made it attractive
and allowed the market to develop subsequently was that it did not involve the
inconvenient topping-up arrangements on both sides that was a feature of the
back-to-back loan. This simple change to the contractual arrangements via an
enforceable single contract on both sides made swaps far easier to negotiate
and use. The rest, as they say, is history.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.1.2 The Basics of Swaps


Swaps are simply a bilateral contractual agreement by two parties to exchange a
series of cash flows. Many different types of swap have been developed out of the
original swap transactions that initiated this derivative category. The basic swap
types are shown in Table 5.1, together with some of the more common variations.

Table 5.1 Basic swap characteristics and types


Interest-rate swaps Cross-currency swaps
One currency More than one currency
No exchange of principal Exchange of principal is made
Fixed/floating interest rates Fixed/floating interest rates
Floating/floating interest rates (cross-currency coupon swap)
(basis-rate swap or basis swap) Fixed/fixed interest rates
Floating/floating interest rates
(cross-currency basis swap)

Variations
Amortising swaps Zero-coupon swaps
Accreting swaps Forward rate (start) swaps
Rollercoaster swaps Indexed-amortising principal swaps

A swap involves an agreement between two parties, party (A) and party (B)
(known as the counterparties), to make a series of payments. Party (A) makes
payments to party (B) in return for and contingent upon receipt of payments
from party (B); and vice versa. Payments may be in the same currency (known as an
interest-rate swap) or in different currencies (known as a cross-currency swap), or
an index or product (known variously as a commodity swap, basis swap or index
swap). The payments by both parties are predetermined amounts, or calculated by
applying a pre-agreed index, such as a fixed or variable interest rate, a commodity
price, an equity index value or other calculable reference rate, to an actual or
notional amount of monetary or commodity principal (known as the notional
principal amount).
For an interest-rate swap, the positions of the two parties are as follows:
Fixed-rate payer
pays the fixed interest rate on the swap;
receives the floating interest rate on the swap;
has purchased a swap;
has a long position in the swap;
is short the bond market;
has the price sensitivities of a longer-dated fixed-rate liability and a floating-
rate asset.
Floating-rate payer
pays the floating interest rate on the swap;
receives the fixed interest rate on the swap;

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Module 5 / The Product Set: Terminal Instruments III Swaps

has sold a swap;


has a short position in the swap;
is long the bond market;
has the price sensitivities of a longer-dated fixed-rate asset and a floating-rate
liability.
Other swaps market terms are as follows:
swap counterparty: the other party to the swap;
notional amount or notional principal amount: the amount of principal that
underlies the swap and is used to determine the value of the two payment
streams;
fixed rate: the interest rate on the fixed side of the swap;
floating rate: the interest rate on the floating side of the swap;
maturity date: the date the contract terminates (the date that the last set of cash
flows is exchanged by the parties);
start date: the date from which interest is calculated and accrues;
value date: the date at which the two sides of the swap are deemed to have the
same value after any initial upfront payments or other adjustments.

5.2 Interest-Rate Swaps


Interest-rate swaps are a package which consists of a long (short) position in one
(notional) asset and a short (long) position in another. That is, the standard or plain
vanilla interest-rate swap can be seen as:
a long (short) position in a fixed-rate bond
a short (long) position in a floating-rate note (loan)
This identity is illustrated in Table 5.2.

Table 5.2 Interest-rate swap mechanics


Bond FRN Swap
Date (Fixed rate) (Floating (Fixed rate) (Floating
rate) rate)
6/11 (i) (100) 100
6/5 (a) (3.5625) (3.5625)
6/11 8 (6m LIBOR) 8 (6m LIBOR)
6/5 (6m LIBOR) (6m LIBOR)
6/11 8 (6m LIBOR) 8 (6m LIBOR)
6/5 (6m LIBOR) (6m LIBOR)
6/11 (1) 8 (6m LIBOR) 8 (6m LIBOR)
6/11 (2) 100 (100)
Note: (a) For the standard swap contract, the first floating payment is known since the swap is
traded for spot (cash) settlement with the first six-month floating rate being set on a spot basis in
November at (i).

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Module 5 / The Product Set: Terminal Instruments III Swaps

We can interpret Table 5.2 as follows. The swap is equivalent to buying a fixed-
rate bond at the start date and issuing or selling a floating-rate note (FRN) to
finance the purchase. The package or swap shows the residual contractual arrange-
ments that result from such a combination. In the case presented in Table 5.2, the
payment flows represent the right to receive the fixed side of the swap and pay the
floating side, which is exactly the case if the bond had been purchased and the FRN
sold. (Obviously the counterparty to the swap will have the same cash flows but
with the opposite signs.)
An alternative way to view an interest-rate swap is as a series of forward-rate
agreements (FRAs) with end-period payments.2 Such an end-period FRA involves
the counterparties agreeing to pay or receive the difference between the fixed rate of
8 per cent and the six-month floating rate for a six-month period commencing on 6
May and with payment taking place on 6 November. The exchange in November is:
Payment in November 8% 6 month floating rate 0.5
Such an arrangement is the same as an interest-rate swap with only one payment
period. A series of end-period FRAs would look the same as a series of swap
payments. This is shown in Figure 5.1.

A swap contract
Rfixed Rfixed Rfixed

m
1 2
Rfloating Rfloating Rfloating

equals a bundle of forward contracts (FRAs)

Rfixed
1
Rfloating Rfixed
+
2
Rfloating Rfixed
+ .... +
m
Rfloating

Figure 5.1 Relationship of interest-rate swap to forward contracts


(forward-rate agreements)
It should be noted that in practice such a series of FRAs, known in market par-
lance as a strip, would not be identical to the swap in terms of the fixed rate. As we

2 The standard FRA contract present values the interest-rate differential to the start of the protection
period. The advantage of this arrangement is that it reduces the period of credit exposure for both
sides. Such an arrangement does not alter the economics of the transaction. Present valuing to the
settlement date significantly reduces the performance period for FRAs, but hardly alters the credit
exposure on a swap. Since the underlying cash instruments that underpin the swap have end-period
payment, this feature of swaps avoids additional cash transactions that the present valuing approach
would entail.

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have seen with forwards and futures, the pricing is based on the cost of carry, and
each FRA fixed rate would be determined separately from the implied forward rate
in the term structure. For swaps, the fixed side (as in Table 5.2) is a flat rate, as with
a bond. Thus the value of the fixed side is made up of a blended rate, as is the case
with a bullet fixed-rate bond. We will look at how such a package is valued a bit
later.

5.2.1 Origins of the Interest-Rate Swap


The argument for the early development of the interest-rate swap is based on the
concept of comparative advantage. We have two firms, BBB which has a low
investment grade rating and wants to raise fixed-rate funding, and AAA which has
the highest investment grade rating and which wants to raise floating rate at the
lowest cost. Their respective cost of funding in the floating-rate and fixed-rate
markets is shown in Table 5.3.

Table 5.3 Cost of funding in two markets for firms of different credit
quality
Firm Cost of finance
BBB Pays LIBOR + 0.5% for a seven-year loan from a bank
BBB Pays 12% for a seven-year bond issue
AAA Pays LIBOR + 0.125% for seven-year money from a bank
AAA Pays 11% for a seven-year bond issue
Note: LIBOR is the London interbank offered rate, the benchmark index for floating-rate funds
used for most international financial transactions.

Both sides can improve their positions (that is, lower their costs) if they swap the
payment flows. In the above transaction, AAA issues a bond and swaps the cash
flows with BBB which has raised money via a bank loan. The basic flows of the
transaction are shown in Figure 5.2.

Fixed rate

1/4
11 %
11% AAA BBB LIBOR + 0.5%
LIBOR
(floating rate index)

Interest service Interest service


to bondholders to bank loan

Figure 5.2 Origins of the interest-rate swap

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Module 5 / The Product Set: Terminal Instruments III Swaps

Both parties are better off as a result of the swap transaction. The economic
benefits of the transaction are detailed in Table 5.4 and show the gains each can
make by swapping the interest basis of the two types of borrowing.
It should be noted that although the above explanation might have applied when
the swaps market first started, it hardly explains the continued use of swaps since
in a reasonably efficient market such arbitrage opportunities soon disappear.
Although the above condition is less likely to produce opportunities for the two
sides consistently to reduce costs, there are a number of other reasons for the
persistence of swaps:
interest-rate swaps provide an economical and flexible means for firms to
manage their asset and liability positions, in particular to limit the interest-rate
mismatch between the types and maturities of assets and liabilities;
swaps provide a link between distinct markets and/or types of firms which have
differing degrees of access to various markets;
swaps provide a lower overall cost of funding;
swaps can minimise the cost of regulation and taxes.

Table 5.4 Economics of interest-rate swap transaction


Net cost to AAA
Payments Receipts Net position
Fixed payments 11.00% 11.25% +0.25%
Floating payments LIBOR LIBOR
LIBOR
0.25%
Direct funding alternative LIBOR +
0.125%

Gain to AAA via swap + 0.375%

Net cost to BBB


Payments Receipts Net position
Fixed payments 11.25% 11.25%
Floating payments LIBOR + 0.50% LIBOR 0.50%
11.75%
Direct funding alternative 12.00%

Gain to BBB via swap +0.25%


Note: AAA gains difference between floating-rate borrowing from the bank at L+0.125% and all-in
cost of funds from the swap at L0.25%. BBB gains difference between fixed-rate bond at 12% and
swapped loan at 11.75%. Who obtains the benefits depends on the relative scarcity of high-grade
credits versus demand to pay the fixed side on a swap.

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.3 Cross-Currency Swaps


The cross-currency coupon swap is similar to the interest-rate swap discussed in
Section 5.2 except that it involves exchanges between two different currencies. The
generic model can therefore be seen as:
a long position (fixed-rate bond or floating-rate note (FRN)) in one currency; or
a short position (bond or FRN) in another currency.
Note that it can also be a long position in a floating-rate note in one currency and
a short position in a floating-rate note in another currency (that is, a cross-currency
basis swap) or a fixed-for-fixed (or cross-currency coupon swap) where the two sides
involve predetermined fixed payments.
An example of a generic fixed-for-floating cross-currency swap is given in Ta-
ble 5.5 for a cross-currency coupon swap between sterling and the US dollar
showing the payments for the fixed-rate receiver (the floating-rate payer) on the
swap.

Table 5.5 Cross-currency swap mechanics


Sterling () US dollar
bond FRN Swap
Date (Fixed rate) (Floating (Fixed in ) (Floating in US$)
rate)
6/11 (i) (100) 150 (100) 150
6/5 (a) (3.75) (3.75)
6/11 8 (6m LIBOR) 8 (6m LIBOR)
6/5 (6m LIBOR) (6m LIBOR)
6/11 8 (6m LIBOR) 8 (6m LIBOR)
6/5 (6m LIBOR) (6m LIBOR)
6/11 (1) 8 (6m LIBOR) 8 (6m LIBOR)
6/11 (2) 100 (150) 100 (150)
Note: (a) For the standard swap contract, the first floating payment is known since the swap is
traded for spot settlement with the first six-month floating rate being set on a spot basis in
November at (i).

In the case of the cross-currency swap, both sides need to exchange the underly-
ing principal at the onset and re-exchange it at maturity.3 In Table 5.5, the sterling
amount is exchanged at the onset for a given US dollar amount. Interest payments
are then calculated on these two and, at maturity, the initial principal amounts are
re-exchanged (shown in Table 5.5 by the last row, 6/11 (2)).

3 Although this helps explain the mechanics of the cross-currency swap, this statement is not strictly true
since it is possible to have a swap where the principal is re-exchanged only at maturity. The parties can
arrange for the initial exchange via the foreign exchange markets. This structure is useful for the party
which has already exchanged the principal.

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Module 5 / The Product Set: Terminal Instruments III Swaps

There is an alternative way of explaining a cross-currency swap. It is also a pack-


age made up of an interest-rate swap in currency A, a cross-currency basis swap to
currency B and an interest-rate swap in currency B.

5.3.1 Simple Cross-Currency Swap Example


DuPont, the US chemicals company, needs to raise sterling for its UK operations.
At the same time ICI, the British chemicals company, needs US dollars for its North
American operations. They agree to swap (that is, exchange) sterling for dollars for,
say, five years. The terms are that ICI pays the five-year US$ rate of 5 per cent on
the US dollar amount of US$15 million and DuPont the five-year sterling rate at 6
per cent on 10 million. Payments are usually made on a net basis (that is, the
differences). The effective exchange rate is therefore US$1.50 = 1. At the end of
the transaction, the principal amounts are re-exchanged by both parties (at the
contracted rate). The three components of this cross-currency swap are shown in
Figure 5.3.

Panel A US$15 million


Initiation
Dupont ICI
Original
exchange of 10 million
principal

Panel B 0.6 million


Each party Dupont ICI
services their
respective sides US$0.75 million
of the transaction

Panel C 10 million
Maturity Dupont ICI
Re-exchange
of principal US$15 million

Figure 5.3 Components of the DuPontICI cross-currency swap


The three stages of the cross-currency swap that are illustrated in Figure 5.3 and
that of Table 5.6 show how the desired positions of both parties are created via the
swap mechanism. In Panel A, the two parties originally exchange the principal
amounts, giving them the desired currencies. Throughout the life of the swap (Panel
B), the two parties service each others interest-rate payments. DuPont pays ICI in
sterling at the agreed interest rate of 6 per cent on the initial principal and, in
exchange, ICI pays the US dollar rate of 5 per cent.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Table 5.6 Cross-currency swap cash flows from ICIs perspective


Swap cash flows Original funding Net
position
Time US$(m) (m) (m) (in US
dollars)
0 15.00 (10.00) 10.00 15.00
1 (0.75) 0.60 (0.60) (0.75)
2 (0.75) 0.60 (0.60) (0.75)
3 (0.75) 0.60 (0.60) (0.75)
4 (0.75) 0.60 (0.60) (0.75)
5 (15.75) 10.60 (10.60) (15.75)
Note: DuPonts cash flows are the same, with the opposite signs.

At maturity, the end of Year 5, both parties pay the last interest payment and re-
exchange their respective principal amounts at the original exchange rate (Panel C).

5.4 AssetLiability Management with Swaps


The development of swaps has provided assetliability managers with new ways of
managing their exposures. Although forwards and futures provide hedges against
various risks, they are not without their problems. Swaps, since they are over-the-
counter forward-style contracts, can be tailored to the specific needs of customers.
They provide useful ways of modifying the interest-rate risk on assets and liabilities
and converting one type of exposure to another, for instance, changing the currency
or price risk on a commodity or asset (via index or commodity swaps).

5.4.1 Arbitrage Transactions


There are four principal ways in which assetliability managers use swaps.
1. The repackaging of liabilities to create a synthetic floating-rate note. This is
achieved by issuing a bond and (simultaneously) entering into a swap to receive
the fixed rate and pay the floating rate. The economic result is a synthetic loan or
floating-rate note since the interest payments on the liability are now at a floating
or variable rate.
Market participants will prefer this route if they seek to raise floating-rate funds
and the package of bond issue plus a swap to floating is cheaper than borrowing
floating direct (see Figure 5.4, column 1).
2. The repackaging of liabilities to create a synthetic bond. This is achieved by
reversing the set of transactions in 1 above: that is, borrowing at a floating rate
and entering into a swap to pay the fixed rate and receive the floating rate. The
economic result is a fixed-rate loan or a synthetic fixed-rate bond.
As with 1, market participants will prefer this route if they wish to raise fixed-
rate finance and issuing a bond is either inappropriate (for instance, if the
amount to be fixed is below the size that is appropriate for the market), or una-
vailable (as can happen if the market considers the credit risk of the issuer to be

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Module 5 / The Product Set: Terminal Instruments III Swaps

too high), or if the cash flow structure does not lend itself to a security transac-
tion, or direct issuance has a higher cost.
3. The repackaging of assets to create a synthetic floating-rate note, or
synthetic loan. This is achieved by buying a bond (often in the secondary mar-
ket) and entering into a swap to pay the fixed rate and receive the floating rate.
The result is to create an asset with a floating-rate income stream, that is, a syn-
thetic floating-rate note or loan.
The attractions of such an arrangement from an investors point of view are that
it might provide an investment that was otherwise unavailable or it might pro-
vide an increased return. For instance, most highly rated borrowers do not raise
long-term loans, but issue bonds. However many investors, such as banks, have
access to floating-rate funding and have under-utilised credit lines to high-grade
borrowers. Buying fixed-rate bonds in such a circumstance might be unaccepta-
bly risky. However, if the asset can be transformed into a loan equivalent, then it
meets the asset managers interest-rate risk requirements and credit criteria. Such
investors can also take advantage of temporary anomalies in the market when,
for instance, for various reasons fixed-rate bonds might be cheap (for instance
due to temporary oversupply), without assuming unwanted interest-rate risk.
4. The repackaging of assets to create a synthetic straight bond. This is
achieved by buying the floating-rate note and entering into a swap to pay the
floating rate and receive the fixed rate. The result is to create synthetically the
cash flows of a fixed-rate security or straight bond.
The attractions of such a package are the same as with the synthetic floating-rate
note. In this case, it is fixed-interest investors who find the synthetic attractive as
it allows them to diversify their credit risk and to enhance the yield on their port-
folios by broadening the set of securities available.

Decision
Fixed Floating Arbitrage

Bb + mb
L
Fixed Bb + mb + Bs + ms
(bond market)
L + (mb ms) Bb + mb
Market

+ Bs + ms
L + ml L<
Floating
L + ml
(loan market) +L
Bs + ms L + ml

Bs + (ml + ms)

+Bb + mb
Arbitrage
Bs + ms
+L>
+L + ml

Figure 5.4 Interest-rate swap decision matrix for assetliability


managers

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Module 5 / The Product Set: Terminal Instruments III Swaps

Note: Bb is the benchmark for bond issuance; mb the issuers margin over (possibly under) the
benchmark; Bs is the swaps rate benchmark; ms is the margin over (possibly under) the swaps
rate; L is the floating-rate reference rate; ml is the margin over the floating-rate reference rate.
Note that in most cases the swaps and issuing benchmarks will be the same (that is, Bb Bs .
The available arbitrage opportunities for assetliability managers are shown in
Figure 5.4. For instance, the decision to raise fixed-rate finance will involve either
the direct issue in the bond market, where the all-in cost or yield (benchmark rate
plus margin and other issuing costs) is less than the synthetic alternative
(margin on the loan and the benchmark rate plus margin on the swap
). An investment arbitrage opportunity exists when the synthetic alternative
provides a positive net gain over the floating-rate loan equivalent .
The alternative floating-rate structure provides similar arbitrage opportunities
between the direct and synthetic routes. We can visualise the two conditions as in
Figure 5.5, where the swap bid rates (at which swap traders are fixed payers or
floating receivers) are such that it is possible for borrowers to issue fixed-rate bonds
and swap them into floating rate at more attractive rates than borrowing directly.
This arbitrage will continue until either bond prices fall or swap rates decline (or
both). This provides the arbitrage boundary shown as .
If, on the other hand, the bond yield is greater than the swap offered rate plus
spread (A), the rate at which an investor can create a synthetic FRN rather than
holding loans or floating-rate notes directly, then bonds will be purchased until this
yield-enhancing arbitrage opportunity disappears due to an increase in the price of
bonds or a decrease in the swap offered rate.

Arbitrages

Yield Investors
+B + mb
B + ms + L
ld
et yie > L + mFRN
Mark
B + mb
A + B + ms L
rate
rate p bid < L + mFRN
Swa
ered
p off
Swa
L

yield
ing
ssu
All -in i

Maturity

Figure 5.5 Arbitrage boundaries for bonds and swaps in a single


currency

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.4.2 Cross-Currency AssetLiability Management


As we have seen, the original swap between the World Bank and IBM involved
cross-currency positions on both sides. Such transactions provide useful ways to
manage multi-currency flows. Given that there are costs in raising funds, firms find
it advantageous at times to fund in currencies which have little or limited appeal.
For example, a purchaser of a Japanese-built ship might be offered preferential
export-financing terms in yen spread over a number of years. Given the currency
risks involved, it may be preferable for firms to source elsewhere rather than have a
naked exposure to a potential appreciation of the yen. However, the cross-currency
swap market allows the firm to enter into a competitive sourcing decision and to
eliminate the currency risk of such a transaction, while at the same time capturing
most of the benefits of the subsidised yen financing rate.
For instance, the subsidised yen financing is offered for ten years, to be repaid in
equal annual instalments. Such a repayment scheme can be hedged via an amortising
cross-currency swap (say to US dollars, which is the working currency for the
shipping industry). If the market rate of interest for such a fixed-rate loan is 6 per
cent and the export finance rate 4.5 per cent, there is a 1.5 per cent interest-rate
subsidy being offered. The buyer, however, wants to pay in US dollars to match the
income from the ship. If the swap rate for a yenUS dollar ten-year amortising swap
is 6.85 per cent, then other things being equal the buyer should be able to
capture about 1.5 per cent of the gain in US dollars, depending on US dollar interest
rates for the relevant period.
The arithmetic goes as follows. The contract is worth US$50 million which, at the
prevailing exchange rate of Japanese yen 120 = US$1, is worth 6 billion. The loan is
amortised in equal instalments over ten years, so the repayment at the market rate of 6
per cent is 815.21 million per annum. The same cash flow at the subsidised rate of 4.5
per cent is worth 6.45 billion. The present value of the subsidy element is therefore
450.51 million. At the current exchange rate (120/$) this is worth US$3.75 million.
The amortising cash flow on a US$50 million swap is US$7.07 million. The amortising
value of the subsidy in US dollars is US$0.53 million per annum. Therefore the US
dollar equivalent to the interest reduction means a payment of US$6.54 million p.a. This
is equivalent to an interest cost of 5.2 per cent, a saving of 1.65 per cent, if the reduced
interest charge on the yen side is fully reflected in the dollar payments. In practice, since
the swap counterparty has to invest the interest-rate differential for ten years and take
some additional credit risk, there may be some transaction costs involved and the actual
rate may not be as low as the 5.2 per cent calculated above.
In order to service the off-market swap, the swaps intermediary will be receiving
a lower dollar flow from the company. In order to avoid a cash flow mismatch, the
intermediary will have to ensure that the difference between the at-market rate, at
which it can deal in the market, and the rate it receives is covered by borrowing.
Figure 5.6 shows the necessary cash-matching transactions it needs to make.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Liability Asset

Yen US dollar
Principal Excess Excess
PV PV

Yen 6bn US$50m

Annuity stream

Reduction
in Invested
1.5% 1.65%
interest cash

Payment
6% Payment from 6.85%
4.5% to Shipping 5.2%
Ship Company
builder at
reduced rate

Market rate Subsidised rate Market rate

Figure 5.6 Schematics of subsidised cross-currency swap from interme-


diarys perspective

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Module 5 / The Product Set: Terminal Instruments III Swaps

Case Study: Swedish ExportKredits Treasury Management


Using Swaps _______________________________________________
Swedish ExportKredit (SEK) is the official export-financing agency for Sweden and,
in the mid-1980s, was one of the first firms to make extensive use of swaps as part
of its treasury management. The agency was a regular and highly rated borrower
on the international markets, in particular, via fixed-rate eurobond issues which
could be issued on fine terms. To eliminate any interest-rate risk before the
disbursement of funds, these were swapped to provide a floating-rate liability. The
target rate of funding (expressed in relation to the floating-rate side) was an all-in
cost of around LIBOR less 50 basis points. LIBOR is short for the London inter-
bank offered rate and is the benchmark rate for international short-term
borrowing by leading financial institutions in the international market or eurocur-
rencies. The bid rate (LIBID) at which short-term deposits can be placed is
normally 0.125 per cent below LIBOR. Thus, SEK could re-deposit or warehouse
excess funds in the market and earn a positive carry or interest-rate differential of
0.375 per cent on the principal. These liability-side funding transactions are shown
on the left side of Figure 5.7.

Fixed payments Importers of Swedish


to bondholders products pay fixed

Liability-side Export credit Asset-side


Management SEK issues package at Management
Fixed payments bonds a fixed rate
from swaps Partial use of
service coupon gain to
payments subsidise
swap rate
Swaps SEK pays Swaps SEK pays
floating rate fixed rate

All in LIBOR 0.5% Net gain SEK


~ 3/8% receives
LIBOR
Excess funds Money Money
deposited to market market
earn LIBID deposits advance

Figure 5.7 SEKs treasury-management process


SEKs use of swaps did not stop with controlling interest-rate risk on its
liabilities. When quoting for export finance (which was offered in a range of
major currencies), the agency was able to offer clients fixed-rate financing. It
was able to do this by again using swaps to eliminate the mismatch that now
existed between the variable-rate liabilities (achieved by swapping bond issues
for floating) and receiving a fixed rate on the export finance. By agreeing with a
swap counterparty to pay fixed and receive the floating rate (LIBOR), SEK could
ensure that the asset could be booked at a fixed rate but without incurring any
interest-rate risk since the payment was swapped for a floating rate. The net
result of these asset-side and liability-side transactions was that SEK assumed

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Module 5 / The Product Set: Terminal Instruments III Swaps

virtually no interest-rate or currency risk in its operations. Swaps were a


perfect solution to its requirements.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

5.5 The Basics of Swap Pricing


As with all financial instruments, the price is determined by supply and demand.
The willingness of a counterparty to assume the opposite side to a transaction will,
ultimately, dictate the value at which both parties will transact. Given the derivative
nature of swaps, it is obvious that either side of the swap can be hedged in other
markets and hence the pricing by hedging approach will apply. In normal circum-
stances, it is therefore possible for a counterparty to construct a riskless position on
either side of the swap so that they assume virtually no interest-rate risk. Given this,
swap pricing is not materially affected by supply and demand factors other than
when increased demand/supply causes other asset values to adjust accordingly. We
have seen this in the previous section in our examination of liability swaps. Given a
change in swaps demand, bond prices and/or swap spreads will adjust to the
imbalance between supply and demand until equilibrium is restored.
Early swap pricing adopted the traditional approach used in bond valuation and
used the yield to maturity (the internal rate of return) to calculate the value of the
payments. This was possible since the value of the floating rate payments must be
equal to the fixed rate payments. However, the floating rate is set at each rollover
date and is not known in advance, so hence the value of future floating payments is
not known. Given this, as we shall see below, they can be largely ignored in deter-
mining the price of the swap. That is not to say that the expected floating rate
payments are irrelevant for pricing, but simply to value the swap in relation to its
known fixed payments as these must equal the unknown floating rate ones. This
allowed the swap to be treated as an annuity stream valued using the current swap
yield. Modern practitioners have turned to a term structure approach based on
spot or zero-coupon interest rates in order to price the swap.
As we have seen, a swap is a bundle of forward contracts. Therefore the value to
both sides of an at-market swap based on the current market terms is such that
neither side is required to compensate the other when entering into the transaction.
As a result, swaps, like forwards and futures, are free in that, at inception, they do
not involve an initial cash flow. Given this fact, an at-market swap must have a zero
net present value. If that is so, the two sides of the swap, the present value of the
receipts and that of the payments, must be equal. This must be so even in an
interest-rate swap where the floating-rate side is not known. In this case, as shown
in Equation 5.1, the expected value of the future floating-rate payments must be
equal to the known contractual fixed-rate payments.

5.1
0 NPV
1 1
where is the swaps respective fixed and floating cash flows, . is the expected
value and 1 is the appropriate zero-coupon discount factor for time .

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Module 5 / The Product Set: Terminal Instruments III Swaps

We can equally visualise a swap as a series of single cash flows (in similar fashion
to an unbundled bond). This is shown conceptually in Figure 5.8.

CF1 CF2 CF3 CF4 CFm1 CFm

S PV of
= t1 t2 t3 t4 m1 m
CF1
PV1 CF2
+ t1
PV2 CF3
+ t2
PV3 CF4
+ t3
PV4
+ t4
CFm1
...
+
PVm1 CFm
m1
+
PVm m

Figure 5.8 The fixed-side cash flows on a swap


The identity illustrated in Figure 5.8 shows us how we can price up the swap
when using Equation 5.1. The swap will be priced on the basis of the individual cash
flows that underlie the swap. Any set of fixed cash flows can be seen as the sum of a
series of zero-coupon bonds with matching cash flows.
Given an appropriate set of term instruments (or in the case of swaps, at-market
swap rates) we can generally bootstrap a set of spot or zero-coupon rates. The
payment flows on the swap are then discounted using the term structure implied by
the spot-rate term structure. The fair value so derived corresponds (as we shall see)
to the risk position which can be hedged by entering into appropriate (new) par (at-
market) swaps. Such a pricing via hedging approach will be perfect if (1) the cash
flows on the instrument and hedges all occur at the same time and (2) the marginal
cost or return to the entity is the floating-rate index.
The advantages of adopting term structure methods are that:
(a) it is a generally used method for calculating the fair value of a set of cash flows;
and
(b) it provides a robust pricing and risk-management framework within which swaps
can be valued and traded.

5.5.1 Pricing a Swap


Contrary to what one might imagine, the starting point for valuing an interest-rate
swap (ignoring bid-offer spreads) is to value the (unknown) floating-rate side. The
pricing process proceeds in three steps:

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Module 5 / The Product Set: Terminal Instruments III Swaps

1. Establish a best guess of the floating rate applicable to each future settlement
date on the swap. This is done by using the implied forward rates from the term
structure for the relevant floating-rate period.
2. Use the zero-coupon yield curve to calculate the present value of the expected
future payments under the swap.
3. Calculate the annuity rate that has the same present value as determined in 2 to
give the fixed-rate side.

5.5.2 The Best Guess of the Floating-Rate Payments


The starting point is to use the markets estimate of the forward rates that will prevail at
each settlement date on the floating-rate side. The first requirement is to calculate the
zero-coupon rate that relates to the relevant period by selecting an appropriate
yield curve from which to construct the zero rate, for instance, the corporate yield
curve, government bond curve, swaps curve and so forth. (We show a quick method
for bootstrapping the zero-coupon curve from par yields in Section 5.5.4 when we look
at how to value a seasoned swap.)
The floating-rate payment for the period will be the periodic interest rate for that
part of the swap. This, under the expectations hypothesis of the yield curve, will be
equal to the implied forward rate for the period times the nominal amount. To
illustrate how this is calculated, we will calculate the rate for the second payment
(the period 0.5 to 1.0) given in Table 5.7. The two zero-coupon rates correspond to
six months and one year. Therefore, the implied six-month rate in six months is
the unknown rate in Equation 5.2:
. . . 5.2
1 . 1 . . 1 .

All that is required to determine the implied six-month rate in six months is to
rearrange the terms in Equation 5.2. This gives the (annualised) floating-rate
payment as 5.33 per cent. Since the cash value of this payment is for six months
only, the actual payment is 2.66 (per 100 notional principal), as in column 4 of
Table 5.7. The other rates are calculated in similar fashion. The last step is to present
value these cash flows using the formula in Equation 5.1 for the floating-rate cash
flows.
The above analysis shows that the present value of the expected floating-rate
payments comes to 28.70. Since this is an at-market swap, the present value of the
fixed rate must also come to the same amount (as per Equation 5.3):

5.3
28.70
. 1

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Module 5 / The Product Set: Terminal Instruments III Swaps

Table 5.7 Calculating the net present value of the expected floating-
rate payments on an interest-rate swap
Zero-
Time coupon Floating Floating Present
rate ( % rate (%) payment value
0.5 5.00 4.94 2.47 2.41
1.0 5.20 5.33 2.66 2.53
1.5 5.40 5.72 2.86 2.64
2.0 5.80 6.89 3.45 3.08
2.5 6.00 6.69 3.35 2.89
3.0 6.25 7.37 3.69 3.07
3.5 6.30 6.50 3.25 2.62
4.0 6.50 7.76 3.88 3.02
4.5 6.75 8.59 4.29 3.20
5.0 7.00 9.07 4.54 3.23
Total present value: 28.70

Given the above results, all that is now left for us to calculate is the interest rate that
prevails on the fixed-rate side. Again making use of the zero-coupon rates, we can
calculate the annuity factor that pertains for the ten half-yearly periods, as the example
involves the use of the same frequency for both sides of the transaction. This is shown
in Equation 5.4. It is worth noting that this is a special form of annuity where the
discount rate is not constant across time.
1 5.4
8.4852
. 1
Note also that having different payment frequencies (semi-annual on the floating-
rate side versus annual on the fixed-rate side) does not alter the basic approach. Our
last step is to value the fixed-rate payments and express these as an interest rate.

5.5.3 Valuing the Fixed-Rate Side


The last requirement is to back out the fixed-rate payments that correspond to the
expected floating-rate payments on the swap as an interest rate. This is done using
the following approach. The present value of the cash flows is discounted by the
annuity factor to determine the payments, which are expressed as an interest rate.
This is 6.77 per cent, as shown in Equation 5.5:
28.70 2 5.5
6.7647%
8.4852 100
Note that for the swap to have a zero net present value, there will be periods
when the value of the fixed is above that of the floating side payments. At onset the
degree to which each side is initially subsidising the other depends on the shape of
the term structure. Figure 5.9 shows the relationship from the perspective of the
fixed-rate payer.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Forward
rate Forward rate curve
(% p.a.)
Fixed rate on swap

ve +ve value
value of net cash
of net flow
cash flow elements
elements

Positive or upward sloping term structure


Forward
rate
(% p.a.)

Fixed rate on swap


+ve value
of net cash ve value
flow of net cash Forward rate curve
elements flow elements

Negative or downward sloping term structure

Figure 5.9 Shape of the term structure and its effects on net payments
on a swap (from the fixed-rate payers standpoint)
Note: The position is reversed for the floating-rate payer.
This element of cross-subsidy is a result of the flat or packaged element of pay-
ments on the swap. This, of course, is one of the reasons swaps are useful since the
fixed payments on one side can be matched to corresponding extant liabilities (or
assets) such as the coupon payments on bond issues.
In the example above, the party paying the fixed side in period 1 will pay 3.38
and receive 2.47, a net payment of 0.91. However, according to the shape of the
term structure at initiation future short-term interest rates will rise and the net
payment position on the fixed side will become positive on later payment dates. For
instance, the last payment has an implied floating-rate payment of 4.54, giving a net
receipt of 1.16. In the same way, if the term structure had been downward sloping,
the fixed side would only be willing to pay a lower coupon rate than the current
short-term interest rate. In general, therefore, an upward-sloping term structure
means that the fixed payer has a net payable position in the early periods versus a
net receivable position in later ones. For a downward-sloping curve, the situation
(for the fixed payer) is the opposite.

5.5.4 The Value of a Seasoned Interest-Rate Swap


As interest rates change, the value of an interest-rate swap will change as the
discount factors used to value the swap change. The value of a seasoned interest-
rate swap is the price that is required to hedge or replace the swap with current, at-
market (or par) swaps. This section shows how the valuation process is carried out.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Creating a Zero-Coupon Yield Curve from a Par Yield Curve __


When the instruments used to create a zero-coupon yield curve trade at par, a
shorthand method for calculating the zero-coupon rates can be used. The basic
formula is:
100 5.6
1 100
100 Annuity factor
Equation 5.6 essentially uses an annuity to present value the intermediate
interest to remove the intermediate cash flows in order to leave a single
present value and future value which are, consequently, linked by the zero-
coupon rate. Alternatively, we can see the equation as deriving the present
value of the zero-coupon bond that makes up the last cash flow on the par
instrument, having subtracted the coupon annuity from the par value.
This rapid bootstrapping method is shown below. The starting point is the
longest maturity zero-coupon instrument (a bank deposit or money market
instrument). The yield on this par instrument is by definition the zero-coupon
rate for that maturity. Using this rate, the reciprocal value or discount rate is
added to the next maturity period (period t + 1) in the column marked in
Table 5.8. This value is used to present value the interest rate for the two-
period par instrument. This is then subtracted from 100 (the par value) to give
the price relative for the second period . The calculation for deriving 2 in
Table 5.8 is shown in Equation 5.7:
8.98% 100 5.7
100 8.98% 0.913690
In Equation 5.7, the rate is 8.98 per cent, the par yield for the second maturity
in Table 5.8. The process is repeated until all the desired maturities have been
covered. In Table 5.8, is equal to ( 1 ) and where 2 to is
[ 100 100 ] and the discount factor is 1 1 .

Table 5.8 Calculating the zero-coupon yield and associated discount


factors for par instruments
ZC
Maturity Par yield At st ZC yield discount
factor
1 9.4469 1.094469 9.4469 0.913685
2 8.9800 0.913685 1.187209 8.9591 0.842312
3 8.6000 1.755997 1.279176 8.5534 0.781753

You may wish to check the accuracy of the zero-coupon rate given for period 3
using the above method.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

The starting point for the valuation of the seasoned swap is to determine the
value of the swap from Equation 5.1. We can ignore the floating side since, by

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Module 5 / The Product Set: Terminal Instruments III Swaps

replacing the seasoned and off-market swap with a new at-market swap with the
opposite payment flows, the two floating-rate payments will cancel each other out.
We start by determining the zero-coupon rates that are used to present value the
cash flows. This is shown as Step 1 in Table 5.9. The method used to create the
zero-coupon rates is shown above.4

Table 5.9 Valuation of a seasoned (off-market) interest rate swap


Step 1: Determine discount factors for PV from ZC yield curve
Maturity Par yield ZC yield Discount factor
1 9.4469 9.4469 0.913685
2 8.9800 8.9591 0.842312
3 8.6000 8.5534 0.781753

Step 2: Present value future cash flows


Maturity Cash flow Discount factor Present value
0 (100.00) 1.000000 (100.00)
1 3.00 0.913685 2.741
2 3.00 0.842312 2.527
3 103.00 0.781753 80.521
(14.211)
PV using par yield: (14.277)

The second step is to present value the cash flows on the swap using the dis-
count factors derived from the zero-coupon rates. Note that to obtain a sensible
result using this approach we have to treat the swap cash flows as if they were a
bond (that is, we include the notional principal on the swap). Note that this result
provides a net present value loss of (14.211). If we had used the par yield for the
three-year maturity to value the cash flows, we would have obtained a loss of
(14.277), that is:

14.277
5.8
1.086
This single rate method provides a slightly different result to the value derived
from the zero-coupon rates. That is the yield-to-maturity or internal rate of return
valuation approach overestimates the loss. As we shall see, a payment of 14.211 on
this swap is all the subsidy that is required to replace it with at-market swaps and,
hence, is the swaps fair value. An understanding of this outcome was one reason
why practitioners abandoned the yield-to-maturity method in favour of term-
structure methods. The attractions of the zero-coupon pricing method are summa-
rised in Table 5.10.

4 The method is further discussed in Appendix 5.1 to this Module.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Table 5.10 Comparison of yield-to-maturity (YTM) and zero-coupon


pricing methodologies
Methodology
Characteristics Yield-to- Zero-
maturity coupon
Accurately prices at-market swaps Yes Yes
Accurately prices off-market swaps No Yes
Consistently values all cash flows regardless of the No Yes
structure of the instrument
Identifies opportunities for arbitrage between No Yes
instruments

We can now proceed to show how a series of at-market swaps can be used to
unwind the swap position using an investment of 14.211 per 100. The required
transactions are shown in Table 5.11.

Table 5.11 Zero-coupon pricing model for a swap


Notional 100 4.323 4.732 (94.843)
maturity Original 1 year 2 years 3 years Total
0 (100.00) (4.323) (4.732) 94.843 (14.211)
1 3.00 4.732 0.425 (8.157) nil
2 3.00 5.517 (8.157) nil
3 103.00 (103.00) nil

We start with the furthest maturity payment, the 103.00 in Year 3. To hedge this
position requires an at-market swap that provides for a payment of this amount to
be made at the end of Year 3. The current at-market swap rate is 8.60 per cent, so
that we need a principal amount (P) which gives P + 0.0860(P) = 103.00, which
exactly cancels our Year 3 payment, leaving no cash flow. To do this, we enter a
swap with a notional principal of 94.843 103/1.086 . As we are receiving fixed
on the original swap, we want to pay on the new cancelling swap. We therefore have
two payments in Years 1 and 2 where we pay out 8.157 94.843 8.6% . The three
cash flows on this swap are therefore as follows:

t=0 t=1 t=2 t=3


94.843 (8.157) (8.157) (103)

The next step is to eliminate all cash flows at Year 2. We are receiving 3.00 on the
existing swap and paying out 8.157 on the new swap to eliminate cash flows in Year
3, so we now need a further receipt of 5.157 (8.157 3.00) to eliminate cash flows
at this point. We proceed as before, but this time use the two-year swap rate of 8.98
per cent and we require to enter into a swap to receive fixed so that at the end of
Year 2, the notional principal amount (P) and 0.0898 5.157. To do this
requires an initial outlay of (4.732) but since we contract to receive, we also have an
intervening interest payment in Year 1 of 0.425. The payments are therefore:

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Module 5 / The Product Set: Terminal Instruments III Swaps

t=0 t=1 t=2 t=3


(4.732) 0.425 5.157

We must now eliminate the cash flow for Year 1. We have the outgoing cash
flow from the three-year reversing swap in Year 1 of 8.517, the inflow on the
original swap of 3.00 and the receipt from the two-year swap of 0.425. This means
we must hedge a net cash outflow of 4.732 (8.157 3 0.425) for one year. Again
we need to find the principal (P) for this cash flow. This is equal to 1.094469
4.732. Therefore P is an outflow of 4.323. The two payments are therefore:

t=0 t=1 t=2 t=3


(4.323) 4.732

The above explanations of the combination of the original swap cash flows and
the new, at-market swap, hedging cash flows are shown in tabular form in Ta-
ble 5.12 which should be studied in conjunction with Table 5.11.

Table 5.12 Summary of the swaps required to hedge the off-market


swap in Table 5.11
Year 0 Year 1 Year 2 Year 3
Step 1
Year 3 swap 8.60% P + 0.086(P) (103.00)
= =
P= 94.843
CF (3) 94.843 (8.157) (8.157) (103.00)

Step 2
Year 2 swap 8.98% P + 0.0898(P) 5.157
= =
P= (4.732)
CF (2) (4.732) (0.425) 5.157

Step 3
P 4.732
(1.094469) =
P= (4.323)
CF (1) (4.323) 4.732

We now need to put all these receive and pay swaps together. The net result is
shown in the headings of Table 5.11. The original investment is worth a notional
100, but we need to add 4.323 for the one-year swap, 4.732 for the two-year swap,
but we notionally deposit 94.843 for the three-year swap. To make the transaction
balance, we need to receive/pay in an extra 14.211. This is the same amount as that
at which we valued the swap earlier, using term-structure methods. An alternative
way to consider the valuation arrived at earlier is to think of this sum as the payment

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Module 5 / The Product Set: Terminal Instruments III Swaps

that the fixed payer requires to surrender his right to receive the floating-rate
payment and be no worse off as a result under the new market conditions.5
The above calculations (which incidentally assume that the floating-rate indices
cancel out) show that the term-structure approach correctly values the contractual
set of cash flows in an off-market swap (or equally, in any other set of fixed cash
flows). We now turn to a similar analysis for cross-currency swaps.

5.5.5 The Value of a Seasoned Cross-Currency Swap


The valuation of an off-market or seasoned cross-currency swap uses the same
approach as that used in Section 5.5.4, but as an added complexity has to factor
in the possible change in value of the currency rate as well. Again, the principle of
valuation is the cost required to replace or hedge out the swap. As with a simple
interest-rate swap, the value of the at-market swap at the outset will be zero
(ignoring transaction costs):

5.9
0
1 1

where superscript A is the cash flow in currency A at time , and superscript B


is the cash flow in currency B at time . At origination, the present value of the two
sides when converted into a common currency will be the same.
In order to illustrate the valuation process for a seasoned swap, we will use the
DuPontICI swap described in Section 5.3. The terms of the original swap and
current market conditions, which have changed somewhat since the transaction was
entered into, are given in Table 5.13.

Table 5.13 Original terms and market conditions for the DuPontICI
cross-currency swap
Terms on the swap Original swap (Time Current market
0) (Time 0 + 2)
Exchange rate $1.50/ $1.45/
Sterling interest rate 6% 7%
US dollar interest rate 5% 4.5%

From Table 5.13 it can be seen that the interest rate on the US dollar cash flows
has fallen from 5 per cent to 4.5 per cent (0.50 per cent) for the remaining three
years of the swap transaction, whereas for sterling it has risen from 6 per cent to 7
per cent (+1 per cent). Also, the exchange rate has now moved from US$1.50 to
US$1.45 (that is, the US dollar has strengthened against sterling).
The first step is to revalue the cash flows at the new interest rates. This revalua-
tion is shown in the last two columns of Table 5.14.

5 In this case, the fixed payer is obtaining the benefit of net receipts over the remaining life of the swap.
Alternatively, we could think of it as the value required to compensate the floating-rate payer for
entering into an off-market swap with a below-market coupon at 3 per cent.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Table 5.14 Valuation of the DuPontICI cross-currency swap


Swap cash flows Remaining cash Present value
flows
Time US$(m) (m) US$(m) (m) $4.5% 7%
0 15.00 (10.00)
1 (0.75) 0.60
2 (0.75) 0.60 0
3 (0.75) 0.60 (0.75) 0.60 (0.7177) 0.5608
4 (0.75) 0.60 (0.75) 0.60 (0.6868) 0.5241
5 (15.75) 10.60 (15.75) 10.60 (13.8017) 8.6528
PV: ($15.2062) 9.7376

The analysis shows that the present value of the US dollar side is now
US$15.2062 million. The valuation of the sterling side reveals it is worth 9.7376
million. The overall value of the swap will be the sum of these two parts expressed
in a common currency. We now apply our valuation model to the cash flows and, to
work out the value, convert the US dollar value into sterling. (Alternatively, we
could have converted the sterling flows value into US dollars.)
$15.2062
9.7376 0.74945
1.45
From ICIs perspective, the valuation of the swap shows it is now a liability, from
DuPonts, an asset.
An alternative method of valuing the swap, which gives an equivalent result, is to
consider the swap as a function of par swaps and to add or subtract an annuity for
the cash-flow differences between the off-market swap and par swaps over the
remaining term. On the US dollar side, interest rates have fallen by 50 basis points.
The three-year annuity factor at the new interest rate of 4.5 per cent is 2.7490. The
present value of 50 bp per unit of nominal comes to 0.0138, which is then added to
the 1 unit nominal. We can consider this amount to be the additional payment a
holder of a 5 per cent income stream requires at the current interest rate to substi-
tute a 4.5 per cent income stream and be no worse off. The total current value is
therefore 1.0138 times the principal amount on the dollar side of the swap. The
same calculation is carried out on the sterling side, but in this case there has been a
rise in interest rates, so the annuity has a negative value of 0.0262. The value per 1
nominal is therefore 0.9738. We now convert the US dollar side to sterling by
dividing the US$15 million by the current exchange rate of $1.45/ and multiplying
by the new market value of 1.0138 to give a sterling value of 10487015. The
sterling side is now worth only 0.9738 10 million, or 9737568. The difference
between these two is the swap value of 749447.6

6 Rounding means this differs slightly from the earlier result.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Using this method, we can work out how the change in value came about. There
are three elements to consider:
1. the change in the US dollar interest rate;
2. the change in the sterling interest rate; and
3. the change in the exchange rate.
Using the above methodology, we can calculate the value change for the two
interest-rate elements separately. For the sterling side, the loss in value is simply the
value change at the new interest rate:
1 0.9738 10 million 262432
On the US dollar side, the same calculation needs to be converted to sterling:
1 1.0138 US$15 million US$206 172
US$206172 1.45 142188
Finally, the exchange rate effect is calculated as:
US$15 million 1.45 10 million 344828
The contribution of each of the components to the overall change in value is
shown in Table 5.15.

Table 5.15 Market prices affecting the value of the DuPontICI cross-
currency swap
Value element of the swap Gain/(loss)
US dollar interest-rate effect ( 0.5%) (142 188)
Sterling interest-rate effect (+1%) (262 432)
Exchange-rate effect ($1.45/) (344 828)

Total value change (749 448)

The payment of 749448 represents the present value of the cost to ICI of re-
versing out the existing swaps with current, at-market swaps with a residual term of
three years. This value, a liability to ICI and a gain to DuPont, is the cost of hedging
out the existing position and matching all the future cash flows. Both sides should
agree on this termination or cancellation value, since they can independently achieve
the equivalent outcome by arranging swaps with back-to-back matching cash flows
that provide the same result. Cancellation, with a countervailing payment, is a
preferred option since it eliminates any credit risk on the existing swap and reduces
servicing costs. The credit risk in the swap is, as we will discuss a bit later, equivalent
to the replacement cost we have just calculated.
To conclude, we can see with a fixed-to-fixed cross-currency swap that there are
three factors which will influence its value. The first two are the changes in the interest
rates used to value the cash flows in the two currencies and the third is any change in
the exchange rate. This illustrates that the change in value to be expected in a currency
swap, unless some of the effects are offsetting, is likely to be greater than the change
in value of an interest-rate swap. Consequently, cross-currency swaps have more credit
risk than interest-rate swaps since their replacement cost is likely to be greater.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Swap Valuation Summarised ________________________________


Since a swap can be replicated via a combination of cash market instruments,
this provides a model for valuing swaps.
For an interest rate swap (IRS), the value off the swap is the difference between
a fixed rate bond (B) and a floating rate note (FRN), namely:

5.10
The valuation of the bond element is:


5.11
1 1
where C is the coupon value of the swap (that is the fixed interest payment),
is the zero-coupon interest rate for time period t, and P is the notional principal
of the swap.
The valuation of the floating rate note (between interest reset dates) will be:

5.12
1 1
where 1 is the zero-coupon interest rate to the next reset date. Since the
floating interest payment will be reset at the next rollover date the floating rate
note will trade at par, so there is no requirement to value the future, unknown
floating rate payments. If the swap is at the rollover date, then obviously
.
The valuation of the cross-currency swap (CCS) is the same as that for the
interest rate swap, except that we have to take into account the exchange rate
between the two currencies. The value of the CCS will therefore be:

5.13 /
That is, to obtain a value, we need to convert the present value of one of the
currency elements into the other one. Note that in the case of the CCS, there
are two sets of zero coupon rates, those in currency A and those for currency
B. In addition, as discussed elsewhere in this Module, there is more variety with
currencies: we could have one leg of the CCS being fixed and the other floating,
and so forth.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

5.6 Complex Swaps


The swaps so far discussed are generic or standard in their construction. They are
bullet-type with uniform features. In some cases, swap users require a more compli-
cated structure to reflect the principal and interest payments on the underlying asset
or liability stream. The more common types of complex swaps are the amortising
swap, the deferred-start swap (and the more elaborate version known as the
accreting swap), and the rollercoaster swap which combines features of the
accreting swap and the amortising swap.

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.6.1 Amortising Swaps


The amortising swap has a structure in which the amount of principal in the swap is
reduced over time. An example of a profile of a reducing principal structure is
shown graphically in Figure 5.10, Panel A. To create such a swap principal profile
requires that a number of plain vanilla swaps of different maturities be put together
as shown in Panel B of Figure 5.10.

Principal Panel A
amount Amortising swap

Time

Principal Panel B
amount Swap 1 Amortising swap
from Panel A
Swap 2 created from plain
vanilla swaps with
Swap 3 different maturities

Swap 4

Time

Figure 5.10 Principal profile and structure of an amortising swap


In most cases the swap rates on the different swaps that make up the amortising
swap will not be the same. This is acceptable if the swap user is happy to have a
different interest rate for different maturities. However, if the underlying position to
be modified using swaps has a constant interest rate, as might be the case with an
amortising bond, for example, then the swap user would want to have a flat interest
rate regardless of the maturity and underlying amount on the swap.
In this case, the swaps market maker can arrange that the swap rate is a blended
rate created from the different maturity swaps used to make up the amortising
profile. Let us assume that the profile and interest rates in Table 5.16 exist.

Table 5.16 Present value of 1 per cent of the four swaps used to create
the amortising swap
Principal Effective PV of 1% PV of 1%
Year amount swap rate (Annuity) Swap rate
1 100 7.50% 0.9302 6.9767
2 100 7.60% 1.7940 13.6341
3 100 7.75% 2.5933 20.0983
4 100 7.80% 3.3338 26.0039
400 66.7130

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Module 5 / The Product Set: Terminal Instruments III Swaps

By calculating the value of 1 per cent (that is, an annuity on the principal
amount), we obtain the results in column 4 of Table 5.16. Next, this present value of
an annuity is multiplied by the interest on each swap (columns 3 and 4) to give the
results in column 5. The total is the present value of the interest that would be paid
on the different swaps. Next, as shown in Table 5.17, we find the present value of 1
per cent on the blended swap based on the par swap rates for each of the maturities.
This is given in column 4 of the table. This comes to 8.6514.

Table 5.17 Present value of 1 per cent of the amortising swap


Discount factor PV of 1%
Year Swap principal used to present Blended swap
value
1 400 0.9302 3.7209
2 300 0.8637 2.5912
3 200 0.7994 1.5987
4 100 0.7405 0.7405
8.6514

We can now find the interest rate that pertains to the blended swap rate. The
effective interest rate that the swaps market maker would quote on the amortising
swap is 7.7113 per cent (66.7130 8.6514). This is the weighted-average interest rate
on the swaps package. Note that in offering such a quote, the swaps market maker
is potentially exposed to some interest-rate risk since there is a cash flow mismatch
between the simple swaps underlying the amortising package and the four swaps
used to hedge (or create) the position.

5.6.2 Deferred-Start Swaps


A deferred-start or forward swap is any swap which has the start date of the
contract delayed beyond the normal market terms for settlement. Swaps have a
normal start date from which interest is accrued that is the same as the cash
settlement period (between one and five working days after the contract is negotiat-
ed). It is possible, however, to agree to a swap in which the start date is deferred to
some mutually agreed future date. Thus the swap is priced today but only comes
into effect at the future date. Because the swap is priced off the term structure, the
fixed rate payable has to be adjusted to reflect this delay.
Let us look at the example of a swap which is deferred for one year and has a
maturity of four years. We could create this by using two simple swaps:
a five-year spot swap with the desired fixed payment stream (paying or receiv-
ing);
a one-year swap with the opposite characteristics to the five-year swap.
The creation of the deferred-start structure is shown graphically in Figure 5.11.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Five-year spot swap

Less one-year swap

= Four-year deferred-start swap

Spot Maturity

Figure 5.11 Mechanics of the deferred-start swap


Pricing such a swap is equivalent to pricing the implied forward rate. We start
with the two simple swaps which are based on the five-year and one-year annuity
rates. Taking the one-year rate from the five-year rate gives the four-year forward
annuity rate, as shown in Table 5.18.

Table 5.18 Calculating the deferred-start four-year annuity rate


Year Swap rate Annuity factor
5 9.25 3.86455
1 8.50 (0.92166)
Four-year swap: 2.94289

The fixed side of the swap rate can now be determined as:
9.25 3.86455 8.50 0.92166 5.14
9.4849%
2.94289
The forward-start swap rate is higher (as we would expect from the shape of the
term structure implied by Table 5.17) than the rate on the five-year spot start swap.

5.6.3 Accreting and Rollercoaster Swaps


We now have all the elements required to price up accreting swaps. As shown in
Figure 5.12, the accreting swap is a package made up of an initial spot swap and a
series of deferred-start swaps. Flat pricing is achieved in exactly the same manner as
for the amortising swap. Again from a risk-management perspective, for the market
maker quoting such a swap, there may be some residual interest-rate risk from the
cash flow mismatches between the underlying spot swaps and the payments on the
accreting package. If this was significant, the swaps market maker would need to
hedge out these residual cash flows.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Panel A
Principal Accreting swap
amount

Maturity

Principal Panel B
amount Swap 4 The four swaps,
three of which
Swap 3 are deferred start,
which make up
Swap 2 the Accreting swap

Swap 1

Maturity
Figure 5.12 Mechanics of the deferred-start swap
The final structure is a combination of the accreting swap and the amortising
swap, generally known as a rollercoaster swap. The principal profile of an example
of such a swap is shown in Panel A of Figure 5.13. The principal profile is made up
of four swaps, three of which are deferred start, as shown in Panel B of Figure 5.13.

Principal Panel A
amount Rollercoaster swap

Maturity

Principal Panel B
amount Swap 4 The rollercoaster
swap is made up
Swap 3 of a number of
deferred start
swaps with
Swap 2 different maturity
dates
Swap 1

Maturity

Figure 5.13 Mechanics of a rollercoaster swap

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Module 5 / The Product Set: Terminal Instruments III Swaps

Other Product Extensions of the Swaps Method ______________


The swaps mechanism, involving as it does a series of payments based on one
reference rate being exchanged against another series of payments based on
another reference rate, has allowed financial engineers to develop swaps based
on other products and instruments. The two most common swaps developed
using interest-rate and cross-currency swaps financial technology are commod-
ity swaps and equity swaps.

Commodity Swaps
There are many different types and mechanisms used for commodity swaps. The
fixed-for-floating commodity swap is a bilateral agreement in which one
party agrees to pay a fixed amount for a commodity in exchange for receiving a
variable rate. As with the interest-rate swap, the two parties do not exchange
the physical commodity at each payment period and settle the difference in cash
based on a notional amount of commodity.
Another variant is a basis commodity swap where the two pricing indices are
different. For instance, a producer might wish to exchange the price of crude oil
based on the North Seas Brent Oil price for that for the USAs benchmark
grade West Texas Intermediate.
Equity Swaps
As with commodity swaps, a number of different variants of equity swaps have
been developed. The simplest type is similar to an interest-rate swap where one
side of the swap is the performance of an equity index or a basket of stocks,
normally the total return (that is, capital appreciation plus dividends) whereas
the other side is pegged to a floating rate such as LIBOR. Occasionally, both
sides are stock indices and a cross-currency variant, known as a quantity-
adjusting index-linked swap, has also been developed.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

5.7 The Credit Risk in Swaps


Swaps, as with other derivatives, create a counterparty exposure or credit risk on the
other party to the contract. Two methodologies have been used to estimate the
amount of credit risk in a swap:
original exposure method. This assumes the maximum credit exposure can be
predetermined at the start. Many banks use a simple formula for calculating the
credit risk of a swap:
swap risk 5.15 3% notional principal amount years to maturity
This heuristic approach was based on the view that a 3 per cent p.a. change in
interest rates is a fairly cautious guess as to how far interest rates might quickly
move in an adverse direction.
current exposure method. This revalues the exposure in terms of the cost to
replace or hedge out the exposure at any time before the contracts maturity.

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.7.1 How Credit Risk Arises


A bank enters into a swap with a company as counterparty. At the onset, the swap is
at-market and has (excluding the dealers turn) a zero net present value. It is only
after the swap has moved off-market that the counterpartys side of the swap, if
marked to market or revalued, entails a loss if unwound. In this case we mean the
new value of the payments is greater than the corresponding receipts. At this point,
from the banks perspective, the swap is now an asset; equally from the counterpar-
tys (the companys) perspective, the swap is a liability. Also typically, the bank may
have fully or partially offset the interest-rate exposure by entering into other
swaps in the opposite direction with other counterparties.
An example of the situation is shown in Figure 5.14, Panel A, where PDQ Bank
has entered into a swap with XYZ Company to receive fixed and pay the floating
rate (the floating rate is based on LIBOR the London interbank offered rate).
After 12 months, XYZ goes bankrupt as shown in Panel B, and PDQ ceases to
receive the fixed-rate payments from XYZ. Meanwhile swaps rates have fallen and
PDQ Bank is exposed to ABC Bank, with which it had entered into an opposing
swap to hedge out its interest-rate risk on the swap with XYZ.7 In order to prevent
any further losses on the now defaulted swap, PDQ Bank enters into a new at-
market swap with another swaps market maker, DEF, at the new interest rate of 5.5
per cent, locking in a loss of 2.4 per cent per annum for the remaining four-year
term of the outstanding swap with ABC Bank.

Panel A PDQ Bank enters into a swap with XYZ Co. for 5 years on US$50 million
where PDQ covers its exposure at 7.9% with ABC Bank.
8% 7.9%
XYZ Co. PDQ Bank ABC Bank
LIBOR LIBOR
Panel B After 12 months, XYZ goes bankrupt
8% 7.9%
PDQ Bank ABC Bank
LIBOR LIBOR

Panel C PDQ Bank is now exposed, so enters a new at-the-market swap with
DEF Bank at 5.5% = 2.4% p.a. loss for 4 years
5.5% 7.9%
DEF Co. PDQ Bank ABC Bank
LIBOR LIBOR

Figure 5.14 The credit risk in swaps


Note that an alternative (and probably preferable) solution would have been for
PDQ Bank to cancel the swap with ABC Bank and pay out the present value of the
swap as compensation to ABC Bank. At the new rate of 5.5 per cent, the present

7 A fall in interest rates is the required condition for the swap to be an asset, from the banks
perspective.

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Module 5 / The Product Set: Terminal Instruments III Swaps

value of 2.4 per cent on US$50 million would have come to US$4.2 million.8 Note
that in terms of the loss suffered by PDQ Bank this represents 8.41 per cent of the
notional principal of the swap.
The loss that has occurred is a function of a directional change in interest rates.
The default only occurs in cases where the swap has a positive value to the
exposed counterparty. It is also a function of the remaining term on the swap. If
the default had occurred with only one year to maturity, the exposed value would
have been only US$1.14 million. Thus for an interest-rate swap, the amount at risk
rises from inception as the rate on the swap moves away from the current market
rate but also as the time to maturity declines the credit exposure also declines. The
at-risk profile of an interest-rate swap is shown in Figure 5.15. For comparison
purposes, the exposure on a cross-currency swap is also shown. Unlike the interest-
rate swap, the cross-currency swaps exposure continues to grow towards maturity
since the exchange rate is unlikely to revert towards the contracted rate.9 As a result,
cross-currency swaps have more credit risk than interest-rate swaps.

Cross-currency swap
Expected exposure

Interest rate swap

Time

Figure 5.15 Exposures on swaps

5.7.2 Calculating Expected Loss Rates


Section 5.7.1 showed how credit risk arises on a swap. In order to establish a proper
estimate of the actual credit risk in swaps we need to understand that two factors
must be present simultaneously for a default to take place:

8 We should perhaps distinguish the loss from the lost profit. The bank anticipated making a spread of
0.1 per cent on the swap, which is lost profit. The unanticipated loss, as calculated here, is 2.4 per cent
on the interest rate based on the replacement. We will consider, for evaluation purposes, that the loss is
on the difference between the swap and its replacement value.
9 In fact, a currency is likely either to appreciate or to depreciate in a fairly predictable trend based
around purchasing power parity. The credit risk will thus grow with time as the principal to be re-
exchanged depreciates or appreciates. In fact, the party holding the appreciating currency has less risk
than the holder of the depreciating currency, since this is always likely to mean the swap is a liability.

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Module 5 / The Product Set: Terminal Instruments III Swaps

the counterparty (the company XYZ in our example) must experience financial
distress, or become insolvent (that is, file for protection against its creditors in
legal bankruptcy proceedings);
the value of the swap to the company must be such that it would have to pay out
to the other party if the transaction was terminated voluntarily. For the firm in
financial difficulties or in bankruptcy proceedings, the swap must represent a
liability. Conversely, it is an asset to the other party to the transaction (PDQ
Bank, in Figure 5.14). We can safely assume that, in the case where the swap is
an asset to the company (and a liability to the bank), the company would seek to
arrange its affairs in such a way as to realise the value of the swap, before or even
during bankruptcy proceedings.10
The expected loss rate from a swap is therefore the product of two factors:
Expected loss from default of default expected loss if default occurs
We can also think of the expected loss if default occurs as being (1 recovery
rate) from defaults.
To understand how much credit risk is being taken in a swap, we need to under-
stand how far, from the original market rate, interest rates can move. As we saw
with the original exposure method discussed at the start of this section, a conserva-
tive estimate was 3 per cent p.a.
In order to be able to model the value change, we need some information on the
change that can be expected over the life of the swap. A binomial tree of interest
rate changes is shown in Figure 5.16 that, for simplicity, assumes rates can either rise
or fall by a fixed amount per annum and follow a continuing diffusion pattern.
Note, however, that there is strong empirical evidence that interest rates revert to
the mean over time and we might expect interest rates to return to some central
tendency over time.
To help explain the analysis, we show the time remaining on the swap exposures
at the bottom of the lattice, with 5 being the inception date and 0 , maturity.
Therefore 1 is one year from maturity, when interest rates can have risen to 10 per
cent or fallen to 6 per cent. This inversion of time is used to show how the exposure
declines over time as the swap moves towards maturity.
The next stage is to revalue the swap at each node on the lattice to determine the
amount required to replace the swap if it is terminated. At each node, the replace-
ment value of the swap is calculated as shown in Figure 5.16. Since the swap is a
liability to the bank at rates at or above 8 per cent, the values of the nodes are zero.
For the nodes below 8 per cent, there will be a loss, which is calculated by discount-
ing the interest rate differential that is implicit at each point, times the principal for
the number of remaining interest rate periods, and present valuing this to the
appropriate nodal point; the valuation is simply an application of DCF methods.

10 In fact swap intermediaries have had to find ways to protect themselves from the cherry picking
activities of liquidators who have sought to terminate (and hence realise the positive value of) swaps
which are assets to the bankrupt firm, while disputing those which are liabilities.

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Module 5 / The Product Set: Terminal Instruments III Swaps

0.0625 10.0%
Lattice with price change of 2 0.125 9.5%
with no value leakage
9.0% 0.25
0.25 9.0%

0.5
8.5% 0.375 8.5%

8.0% 0.5 8.0% 0.375 8.0%


0.5 7.5% 7.5%
0.375
0.25
7.0% 0.25 7.0%
0.125
6.5%

0.0625 6.0%
t5 t4

t3

t2

t1

Figure 5.16 Lattice of interest rates


The swap has a notional principal of $50 million. The difference in interest rates
is 8% 7.5% on the notional amount over 2 years that is 0.5 per cent of 100 for 2
years, that is 0.5 per 100 per year (i.e. 0.5 per cent of $50 million = US$250000). We
need to discount this at the 7.5 per cent rate for two years. The two year annuity
factor at 7.5 per cent is 1.7956. The value per 100 = 0.89778, rounded give 0.90. For
the cash amount this is $448891 which, with generous rounding, gives the $450000
figure in the text.
Thus for the 7.5 per cent rate in 2 , the interest rate differential is 0.50 per cent
(8.00 7.5%) on 100 over two years, discounted at 7.5 per cent. This comes to 0.90
per hundred, or for the swap with XYZ, this is US$450000. The same calculation is
carried out for the lower rate of 7 per cent applicable at time 2 , which gives a value
of 2.73. The final stage is to work out the probability-weighted average (or expected
value) at time 2 and this is shown in the lower part of Figure 5.17. The same
calculations are made for each of the nodes and time periods. The results of the
analysis are shown in Table 5.19. The final step is to present value these to the start
of the swap. Our analysis shows that the swap has a present value exposure of
2.13445 per 100. (For the XYZ swap on a notional principal of US$50 million, that
translates to US$1.067 million.)

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Module 5 / The Product Set: Terminal Instruments III Swaps

0
If rate is above 8%,
no default takes place 0
0
0
0 0

0 0 0
1.68 0.90

2.62 0.94
If rate is below 8%,
there is a risk of default 2.73

1.89

i% swap Value r E(V)

7.4% 0.90 0.374 0.34


6.9% 2.73 0.125 0.34
0.68

Figure 5.17 Expected loss calculation for a swap


Although the expected loss is 2.13445 per hundred if the swap party defaults, as
discussed earlier, we also need to factor in the probability of default from the
counterparty. This requires us to evaluate the likelihood of a given credits becoming
unable to service its agreement. Default is likely to be a function of the creditwor-
thiness of the counterparty. In Table 5.20, we show the results of such an analysis
for two different credits, the best rated triple-A credit and the lowest investment
grade credit, the triple-B rated credit. These probabilities of default would be
established from examining the historical experience of default by a given credit
class. We will not discuss how this can be achieved at this point or whether the
historical record is an appropriate guide to the future. Suffice to say, the example
given here should be taken as illustrative of the required approach to establishing
the credit-risk exposure on a swap position.

Table 5.19 Establishing the expected loss on a swap


Expected loss of value
Swap period Value at time Present
t value
5 years (at inception ) 0 0
4 years (+ 1 year ) 0.83733 0.77531
3 years (+ 2 years ) 0.65608 0.56248
2 years (+ 3 years ) 0.67804 0.53825
1 year (+ 4 years ) 0.35157 0.25841
0 years (+ 5 years ) 0 0
2.13445

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Module 5 / The Product Set: Terminal Instruments III Swaps

Table 5.20 Expected losses from swap default for a AAA (best investment grade) and
BBB (worst investment grade) credit*
Expected Contribution Contribution
positive of default to credit of default to credit
value of for losses for losses
Year swap in PV AAA/Aaa (per 100 BBB/Baa (per 100
(mid-point) terms credits nominal) credits nominal)
1 0.4029 0.01 0.0040 0.08 0.0322
2 0.6653 0.02 0.0133 0.109 0.0725
3 0.5503 0.027 0.0149 0.125 0.0688
4 0.3932 0.033 0.0130 0.137 0.0539
5 0.1243 0.04 0.0050 0.156 0.0194
0.0502 0.2468
Annual cost over 5 years 1.26 bp 6.18 bp
* Details of the credit rating criteria appear in Module 12.

Table 5.20 needs some explanation to reconcile the result with that given in Ta-
ble 5.19. The expected positive value of the swap in present value terms in each year
used in Table 5.20 differs in that the default rates represent the mid-point between
years, as we have no indication of when such an event may take place. Thus, the
value of 0.4029 arrived at in Year 1 is a linear average of the probabilistically
weighted outcome of future interest rates as shown in Table 5.21, combined with
the exposure in the previous period, which is zero for 5 , and the result then present
valued.
The final result is to allocate the expected loss across the life of the swap as a
credit premium. For the best quality credit (triple-A), this is 1.26 basis points per
annum, whereas for the lowest investment grade (triple-B credit), this is 6.18 basis
points. Based on the above, if the swap rate was 6 per cent, the swaps market maker
would quote 6.01 to the triple-A credit and 6.06 (or higher) to the triple-B credit.
We may now summarise this discussion of the credit element of a swap. The
exposure on a swap is far less than the corresponding exposure on a cash instru-
ment for the same maturity. The amount at risk will be a function of:
1. the probability that a counterparty will default over the life of the swap; and
2. whether the swap is an asset or a liability.
The degree to which the swap is off-market and the cost of replacement at any
time is a measure of the asset risk equivalence of the swap.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Table 5.21
Interest rate Expected
Probability (r) Exposure positive value
8.5% 0.5 0 0
7.5% 0.5 1.67466 0.83733

8.00 1.0 0 0
Period E(V) Discount factor Present Value
0
0.83733
. 0.41867 0.96225 0.40286

5.8 Learning Summary


Swaps are the newest instrument in the derivatives product set. Whereas forwards
and futures hedge a single cash flow, swaps hedge a series of periodic cash flows.
From an initial start in the early 1980s they have established themselves as a very
important building block in managing various kinds of market risks. The swap
mechanism provides a very flexible way of altering the nature of a set of cash flows,
either in terms of their interest-rate exposure or currency, or both. The development
of swaps has provided linkages between different markets, thus allowing participants
to exploit advantages and arbitrage opportunities.
Swaps are extensively used by asset and liability managers to control risks and to
exploit anomalies in the capital markets. By combining simple swaps, it is now
possible to create complex packages which provide tailored solutions to many risk-
management problems.
Swaps need to be carefully valued using a term-structure approach. At inception,
an at-market swap (ignoring transaction costs) will have a zero net present value,
after any adjustments. As the swap moves towards maturity it will become off-
market and may become an asset or a liability. Depending on the path of interest
rates, it may be subject to credit risk. Calculating the potential loss from a swap
default requires two things to happen simultaneously: the swap must be an asset and
the counterparty must also default.

Appendix 5.1: Calculating Zero-Coupon Rates or Yields


We can convert a par yield curve into a set of zero-coupon rates. Assume for
simplicity that a par yield curve is given and that these rates are 1 , 2 and 3 for the
first three years. We need to find the corresponding one-, two- and three-year, zero-
coupon rates 1 , 2 and 3 that underlie the par yields.
Rather than find these rates directly, it is easier to find the value of a correspond-
ing zero-coupon bond for the required maturities. To further simplify the
arithmetic, we will take 100 to be 1, a percentage such as 6 per cent to equal 0.06. So

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Module 5 / The Product Set: Terminal Instruments III Swaps

a zero-coupon bond with a three-year maturity trading at a yield of 6 per cent will
have a price of 0.8396. You will realise that this is equivalent to the discount factor
used to present value a payment at 6 per cent for three years. Alternatively, to solve
for the zero-coupon rate, given the zero-coupon bond price, we use the price
relative (FV/PV):

5.16
1

If we can calculate the prices of zero-coupon bonds with a value of 1, we know


that:
1 1
1 1
1 1
and so on, until the desired maturities have been covered.
Since coupon-paying bonds are portfolios of zero-coupon bonds, we can express
their value as:
One year 1 1
Two years 1 1
Three years 1 1
and so on. is the zero coupon discount factor for the relevant period.
We can set up a model (or computerised model) for solving the above. Let us
define:

These are simply the annuity factors for 1, 2, and 3 years respectively derived
from the three zero-coupon prices. As an alternative, we can solve directly from the
par yield curve by substituting the annuity into the bond equation:
1

1
and so forth.
We now have the means to calculate zero-coupon rates from the par curve. To
facilitate computation, we use the following formula:

5.17
1
1
1
1
1

where is the nth period zero-coupon interest rate, is the nth year par bond (or
swap) rate. The annuity factor allows for a simple means to compute the present
value of the coupon stream from t=1 to t=n1 periods, namely:

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Module 5 / The Product Set: Terminal Instruments III Swaps

1

1
The series is equivalent to an annuity factor. As Equation 5.17 shows, this
simplifies the stripping out the coupon payments paid on the par bonds (or par
yield securities) in order to determine the zero coupon rate for the bonds maturity.
In order to do so, we need to know the 1 zero coupon rates. Hence it is
necessary to proceed in an iterative process from the earliest zero-coupon maturity
date to the last, a process known as bootstrapping.
The following example shows how the method works:

Table 5.22 Bootstrapping zero-coupon rates from the par yield curve
Time Par yield Zero
period coupon
rate (%)
1 6.00 1.06 0 0.9434 6.00
2 6.25 1.0625 0.9434 1.8291 0.94104 6.2578
3 6.375 1.06375 1.8291 2.6596 0.88340 6.3885
4 6.4375 1.064375 2.6596 3.4383 0.82879 6.4542

Review Questions

Multiple Choice Questions

5.1 A cross-currency swap is a transaction that involves:


A. an initial exchange of one currency at one time period with the subsequent re-
exchange of the currency at a future time period.
B. an exchange of two sets of cash flows in different currencies.
C. modification of the interest rate on a set of cash flows.
D. the exchange of bonds denominated in different currencies.

5.2 Interest-rate and cross-currency swaps allow financial managers to:


A. transform assets and liabilities in one currency into another.
B. transform the nature of the interest-rate risk.
C. take advantage of funding and investment opportunities.
D. all of A, B and C.

5.3 With a cross-currency swap it is possible to:


A. exchange cash flows in one currency for cash flows in another currency.
B. change fixed-rate cash flows into floating-rate cash flows or the opposite.
C. exchange floating-rate cash flows based on one reference rate into floating-rate
cash flows based on another reference rate.
D. all of A, B and C.

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.4 We may regard the fixed-rate payer on a swap as:


A. having purchased a floating-rate asset.
B. being long the bond market.
C. having sold the swap.
D. all of A, B and C.

5.5 There are two firms, X and Y, with the following cost of funds.

Transaction Firm X Firm Y


Bank loan LIBOR + 0.25% LIBOR + 0.5%
Bond issue 7.25% 8.125%

If they enter into an interest rate swap where Y pays Xs fixed rate plus a margin equal
to a quarter of the difference between Xs and Ys cost of fixed funds and X pays Y a
floating rate (LIBOR), what will be the total interest cost to each side following the swap
transaction? (Answer to 2 decimal places)
A. For X, floating funds cost LIBOR 0.13 per cent and for Y, fixed funds are 7.69
per cent.
B. For X, floating funds cost LIBOR 0.03 per cent and for Y, fixed funds are 7.97
per cent.
C. For X, floating funds cost LIBOR 0.13 per cent and for Y, fixed funds are 7.21
per cent.
D. For X, floating funds cost LIBOR 0.03 per cent and for Y, fixed funds are 7.69
per cent.

5.6 ABC plc of the UK and DEF SA of France agree to enter into a ten-year fixed-for-fixed
cross-currency swap between the French franc and sterling where ABC plc borrows
French francs and DEF SA sterling. The current exchange rate is FFr8.75/. The amount
involved is 10 million. The interest rate, to be paid annually in both cases, is in FFr4.55
per cent and in sterling 6.50 per cent. What will be the amount of the first payment on
the swap?
A. FFr3.98 million/0.52 million.
B. FFr83.52 million/9.39 million.
C. FFr87.5 million/10 million.
D. FFr91.48 million/10.52 million.

5.7 In the swap described in Question 5.6, what is the present value of the French franc side
of the swap?
A. Zero.
B. FFr83.52 million.
C. FFr87.50 million.
D. FFr91.48 million.

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.8 In Question 5.6, what will be the amount exchanged between the two parties in French
francs at maturity?
A. Zero.
B. FFr83.52 million.
C. FFr87.50 million.
D. FFr91.48 million.

5.9 To create a synthetic fixed-rate bond, we need to:


A. borrow at a fixed rate and enter into a swap to pay fixed and receive floating.
B. borrow at a floating rate and enter into a swap to pay fixed and receive
floating.
C. borrow at a fixed rate and enter into a swap to pay floating and receive fixed.
D. borrow at a floating rate and enter into a swap to pay floating and receive
fixed.

5.10 An investor will have a return-enhancing opportunity using the capital markets and
swaps if:
A. the rate on a fixed-rate bond less that on a swap to receive the floating rate is
positive.
B. the rate on a fixed-rate bond less that on a swap to pay the floating rate is
negative.
C. the rate on a fixed-rate bond less that on a swap to receive the floating rate is
negative.
D. the rate on a floating-rate note less that on a swap to pay the floating rate is
positive.
The following information is used for Questions 5.11 and 5.12.
Amex Shipping Lines have agreed to buy a new container ship from Kaiwo Shipyards of
South Korea. Because the Korean Export Bank is willing to assist Kaiwo win the order, the
Bank is willing to quote an attractive financing package in Swiss Francs (SFr). This involves a
ten-year fully amortising loan with a subsidised rate of 3.5 per cent. The current interest rate
in Swiss Francs for a ten-year maturity is 4.75 per cent. The total amount of the loan is SFr75
million. The exchange rate between the Swiss Franc and the US dollar is SFr1.5/$. Amexs
operating currency is the US dollar and in order to eliminate its currency risk it wants to swap
the proceeds into US dollars. (NB: assume annual payments and round to 2 decimal places.)

5.11 What is the present value of the cash subsidy element in Swiss Francs?
A. SFr0.80 million.
B. SFr4.80 million.
C. SFr9.00 million.
D. SFr9.60 million.

5.12 If the ten-year swaps rate in US dollars is 5.50 per cent, what will be Amexs annual
payments in dollars if the subsidy is repaid over the life of the swap?
A. US$5.79 million.
B. US$6.21 million.
C. US$6.63 million.
D. US$7.05 million.

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Module 5 / The Product Set: Terminal Instruments III Swaps

The following information is used for Questions 5.13 to 5.16.

Term 1y 2y 3y 4y
Par swaps 7.10% 7.20% 7.30% 7.35%

5.13 Based on the swaps rates given in the table above what is the three-year zero coupon
discount rate?
A. 7.2072 per cent.
B. 7.3000 per cent.
C. 7.3099 per cent.
D. 7.3633 per cent.

5.14 What will be the true value of a four-year off-market interest-rate swap which has a
coupon rate of 6.5 per cent and on which you are the fixed-rate payer?
A. (0.028608)
B. (0.028565)
C. 0.028565
D. 0.028608

5.15 How much would we have overvalued the swap per 100 nominal if we had used the
internal rate of return or yield to maturity to price the swap?
A. 0 (the two valuation methods give the same value).
B. 0.0043
C. 0.0043
D. 0.0051

5.16 What is the implied one-year floating rate in two years time?
A. 7.25 per cent.
B. 7.30 per cent.
C. 7.52 per cent.
D. 7.72 per cent.
The following information is used for Questions 5.17 to 5.19.

Time (years) 0.5 1 1.5 2 2.5


Zero-coupon 4.50% 4.55% 4.60% 4.70% 4.75%

5.17 Given the zero-coupon rates in the table, what is the present value of the expected
floating-rate payments on a two-year swap per 100 of nominal principal? (Assume equal
values for each half-year and ignore day-count conventions.)
A. 8.67
B. 8.78
C. 9.18
D. 9.29

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5.18 A two-and-a-half-year semi-annual pay swap has a present value for the floating-rate side
of 10.95 per 100 nominal. What will be the swaps fixed rate?
A. 4.62 per cent.
B. 4.66 per cent.
C. 4.69 per cent.
D. 4.75 per cent.

5.19 What will be the fair value of an off-market swap with a two-year remaining maturity
per 100 nominal that has a semi-annual fixed rate of 6.50 per cent to the fixed-rate
payer?
A. (3.51)
B. 0
C. 3.51
D. 103.51

5.20 If, when an at-market swap is initially entered into, the term structure of interest rates
is upward sloping, the fixed-rate payers first payment will:
A. be higher than that paid by the floating-rate payer.
B. be lower than that paid by the floating-rate payer.
C. be the same as that paid by the floating-rate payer.
D. depend on the slope of the yield curve.

5.21 With the yield-to-maturity approach, which of the following provides an incorrect value
for the swap?
A. A swap with an off-market fixed rate.
B. An amortising swap.
C. A deferred-start swap.
D. All of A, B and C.

5.22 On the ABC plc of the UK and DEF SA of France fixed-for-fixed cross-currency swap
between the French franc and sterling (see Question 5.6), six years have passed and the
two companies have decided that they would like to terminate the agreement. The
contractual amount was 10 million and interest was paid annually. The original market
and current conditions are given in the following table:

Condition Original terms Current market


Exchange rate FFr8.75/ FFr7.25/
Fixed French interest rate 4.55% 5.65%
Fixed UK interest rate 6.50% 5.75%
Tenor 10 years 4 years

Who pays whom and how much to terminate the swap?


A. ABC plc pays DEF SA FFr9.74 million.
B. ABC plc pays DEF SA 0.26 million.
C. DEF SA pays ABC plc FFr3.36 million.
D. DEF SA pays ABC plc 2.07 million.

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Module 5 / The Product Set: Terminal Instruments III Swaps

5.23 In Question 5.22, which of the following elements that contribute to the change in value
of a cross-currency swap were positive and which were negative when looking at the
swap from the point of view of DEF SA (the French company)?
A. The change in the FFr interest rate was positive, the change in the sterling
interest rate was positive and the change in the exchange rate was positive.
B. The change in the FFr interest rate was positive, the change in the sterling
interest rate was negative and the change in the exchange rate was positive.
C. The change in the FFr interest rate was negative, the change in the sterling
interest rate was positive and the change in the exchange rate was positive.
D. The change in the FFr interest rate was negative, the change in the sterling
interest rate was negative and the change in the exchange rate was positive.
The following information is used for Questions 5.24 to 5.26.

Time 1 year 2 years 3 years 4 years


Par swaps rate 8.25% 8.10% 8.00% 7.80%

5.24 A customer wants to enter into a four-year amortising swap where the notional
principal amount of 400 is reduced by 100 at the end of each year. What should be the
uniform fixed swaps rate quoted by the swaps market-maker on the swap?
A. 7.80 per cent.
B. 7.94 per cent.
C. 7.97 per cent.
D. 8.08 per cent.

5.25 What rate will the swaps market maker quote for a two-year swap with a one-year
deferred start?
A. 7.86 per cent.
B. 8.00 per cent.
C. 8.05 per cent.
D. 8.12 per cent.

5.26 For credit risk to arise on a swap, which of the following has to take place?
I. The floating rate on the swap has to change.
II. The fixed rate on the swap has to be off-market.
III. The other party to the swap must cease to honour the agreement.
The correct answer is:
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.

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Module 5 / The Product Set: Terminal Instruments III Swaps

Case Study 5.1


You observe the following zero-coupon yield curve.

Period Rate (%)


.
5.5
.
5.7
.
6.0
.
6.2
.
6.4

1 You are considering a two-and-a-half-year LIBOR interest-rate swap with semi-annual


settlement. Estimate the present value of the floating-rate side of the swap per 1
million of notional principal.

2 What is the fixed rate on the swap?

3 In the above swap, you estimate that there is a 1% chance that the counterparty to the
swap will experience financial distress/default over the next year. You also estimate that
interest rates could decline by the following amounts over the year:

1% 25% chance
2% 10% chance
3% 5% chance

What is the potential loss on the swap in such a situation per 1 million?

4 You want to enter into an amortising swap where the total payment of 1500 is
amortised in two instalments: 1000 in 1 year and the balance at the end of 2 years.
Draw a profile of the swap for evaluation. What will be the blended rate quoted on the
swap?

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PART 3

Options
Module 6 The Product Set II: The Basics of Options
Module 7 The Product Set II: Option Pricing
Module 8 The Product Set II: The BlackScholes
Option-Pricing Model
Module 9 The Product Set II: The Greeks of Option
Pricing
Module 10 The Product Set II: Extensions to the Basic
Option-Pricing Model

Derivatives Edinburgh Business School


Module 6

The Product Set II:The Basics of


Options
Contents
6.1 Introduction.............................................................................................6/1
6.2 Types of Options .....................................................................................6/6
6.3 Option-Pricing Boundary Conditions ................................................ 6/18
6.4 Risk Modification with Options .......................................................... 6/21
6.5 Learning Summary .............................................................................. 6/25
Review Questions ........................................................................................... 6/26
Case Study 6.1................................................................................................. 6/31

Learning Objectives
This module introduces options, the terminology used in describing options and
how they are used to modify the risk profile of a given position. One of the com-
plexities with options is the specialist language used to describe them. The basic
factors which affect option values are shown with a simple example and the
boundaries to the value of options are then explained. The module finishes with a
discussion of how options can be used to modify the risk profile of a given expo-
sure.
After studying this module, you should understand:
the options terminology;
the basic option-pricing variables;
how options are used to modify risks;
the boundary conditions for the values of options.

6.1 Introduction
This module begins the examination of the second category of financial risk-
management products, namely options. As we have seen in earlier modules, which
looked at those derivative products that have a linear or symmetrical payoff, price
certainty (or the elimination of the market risks) is not always desirable. In the case of
forward contracts, for instance, entering into a forward foreign exchange contract
converts the future uncertain outcome to a fixed, predetermined rate. Sometimes this
is beneficial, but if subsequently the exchange rate moved in your favour, then the
forward contract represents an opportunity loss. The problem, of course, is that we
only have a rough idea whether the currency is likely to move in our favour. What we

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Module 6 / The Product Set II: The Basics of Options

really want is a situation where we can have the forward cover provided by the
derivative product and the opportunity to make the gain if the outcome is to our
advantage. That is, as the saying goes, we want to have our cake and eat it.
In this sense, options are the cake-and-eat-it product, because they allow the
holder (but not the option writer or seller) to avoid the undesirable outcomes and
retain the benefit of the favourable developments. It is this ability for gain if
developments are favourable that makes options so attractive. Options, and the
more exotic products derived from them, seem to provide the best possible risk-
management tool. Unfortunately for the option holder they, unlike terminal
products, cost money upfront and a payment is required to compensate the writer
or seller of the option for taking on the other side of the transaction. For, if the
option holder gains if the outcome is favourable, the option seller or writer must
lose. We will look at how the fair value of this transaction is established in Section
6.2.3.
Options in one form or other have been a feature of business activity since time
immemorial. However, financial options (that is, options on financial instruments)
are a relatively new phenomenon. The development of a market in stock options in
the early 1970s was followed by the widespread expansion of options into all
spheres of financial activity throughout the 1980s and 1990s as more and more
markets and increasingly exotic product areas have added options or option-like
products. This is because, in modern financial practice, options are one of the most
versatile and exciting of the fundamental derivative building blocks. Their inherent
flexibility, coupled to sophisticated methods to establish their value, has created
opportunities for intermediaries to provide tailored solutions to many, previously
insurmountable, risk-management problems and investment problems.
From the holders perspective, the buying of options provides a non-linear or
asymmetrical payoff which has some of the characteristics of insurance.

6.1.1 Why Options Are Special


The terminal products examined in previous modules have the virtue of eliminating
price or value uncertainty at some point in the future. The payoff on the terminal
product will depend on the market rate at the maturity of the contract as it relates to
the rate agreed in the contract. The price at which the contract was entered into
reflected, not so much either sides view on the future value, but the cost of
replicating the position, known as the cost-of-carry. The payoff to either side at the
maturity of the contract will depend on whether the market price is above or below
the contract price. If a future purchase is anticipated, then by entering into the
contract, the holder gains if the market price is higher at maturity than when the
original contract was negotiated, but loses if the market price is lower. This payoff
profile is shown in Figure 6.1.

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Module 6 / The Product Set II: The Basics of Options

Gains (+)

Value at maturity
Market price

Contracted price

Losses ()

Figure 6.1 Payoff of a forward contract involving a future purchase


Note: The holder of the position expects to buy the product or instrument in the future, hence is
exposed to price rises. By entering into the forward contract, the holder gains if the market price
is above the contract price. Conversely, the holder loses if the market price is below the contract
price since the holder could have bought more cheaply in the market.
With respect to the seller of the forward contract, the opposite condition applies.
This is shown in Figure 6.2 where the payoffs for the two sides of the contract are
shown. The gains from the buyer are matched by losses from the seller. Under these
conditions, the buyer and seller have the same chance of gaining or losing. Thus,
when the transaction is negotiated, the expected value of the contract is zero.
Because the value of the contract is zero, there is no need for the buyer to compen-
sate the seller and in that sense such contracts are free, that is, they have a zero net
present value ex ante.

Gains (+)
Value at maturity

Market price

Contracted price

Losses ()

Figure 6.2 Payoff at maturity for the buyer and seller of a forward
contract
This situation is different when it comes to options. The holder or buyer of the
option has the right, but not the obligation, to purchase at the expiry of the con-
tract. If the current market price is above the contracted price, the holder gains and
will therefore take advantage of the right to purchase. If, however, the market price
is below the contracted price, the holder is not obliged to purchase under the terms
of the option contract and can buy more cheaply in the market. As a result, the

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Module 6 / The Product Set II: The Basics of Options

buyer stands to gain from favourable price movements, but not to lose from
movements in the other direction. The symmetrical payoff between buyer and seller
no longer applies. Gains from favourable movements are losses to the writer (or
seller) but these are no longer compensated for by gains in the opposite direction.
This is shown in Figure 6.3.

Gains (+)
Holder or option buyers payoff

Value at maturity

Market price

Contracted price

Writer or option sellers payoff


Losses ()

Figure 6.3 Payoff at expiry of the positions on a call option for the buyer
or option holder and the writer or option seller
It is important to distinguish the gains and losses made by both the buyer and the
seller in Figure 6.3. The buyer (solid line) always gains from changes in the market
price. These gains are mirrored by losses made by the option writer or seller. There
is no symmetry between the opportunity for gain that is evident in Figure 6.2, where
the potential losses by the seller if prices rise are matched by gains if prices fall. With
options, the writer does not gain from this. Hence the payoff is asymmetric or non-
linear.
The question is why anyone should be willing to sell or write options. The writer
always loses. The simple answer is that in order to be willing to enter into the
contract, the writer receives an upfront payment, known as a premium, for taking
on the risk that the option will be exercised. The adjusted payoffs for both sides,
allowing for the payment of the premium on entering the contract, are shown in
Figure 6.4.

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Module 6 / The Product Set II: The Basics of Options

Gains (+)
Holder or option buyers payoff

Value at maturity
Premium received by
option writer

Market price
Premium paid by
option buyer Contracted price

Writer or option sellers payoff


Losses ()

Figure 6.4 Payoff for option holder and writer at expiry, including the
premium paid and received on the contract
Figure 6.4 shows that if the option is not exercised, the writer has made a gain,
which is the premium received against the risk that a future loss might be incurred.
Similarly, the holder has suffered a cost, the premium that is not recoverable, if the
option is abandoned.

6.1.2 A Simple Illustration of the Value of Options


We have said that options are valuable, but what are they worth? The following
illustration shows the key ingredients for the value inherent in options.
Let us suppose that a shipping company has been offered the chance to purchase
a standard bulk cargo freighter for 9.4 million that is being built in a shipyard and
will be available in one years time. A virtually identical ship could be purchased for
9 million today in the secondary market. The current interest rate is 10 per cent. If
the company buys the ship now, it can be leased out for a year to earn net 0.4
million in rental charges (less expenses), paid in advance.
In order to have the ownership of the bulk freighter in one years time, the ship-
ping company can adopt one of two alternatives:
(a) buy the second-hand vessel now1 and rent it out for one year ;
(b) pay the premium on the call option to acquire the new ship and invest the
present value of the future purchase price in order to be sure of having
the right amount of money in one years time to make the purchase, if it should
so choose.
The payoff of the second action (b) must be at least as valuable as the first action,
such that the following holds:
6.1
Thus, the package of the call plus the present value of the exercise price must be
at least equal to the direct purchase alternative since it offers the same benefits, but
probably will be more valuable. The inequality exists because the option allows the

1 The notation used here is that which is commonly used for options.

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Module 6 / The Product Set II: The Basics of Options

shipping company to walk away from the purchase in one years time if market
conditions are such as to make it unattractive to exercise the right to purchase the
ship. Rewriting the equation, we can now solve for the unknown minimum value
that the call must have:
6.2
9m 0.400 8.545m
This gives a minimum value of 55000. The option must be worth at least this
amount. In fact, the value of being able to break the contract (or walk away) will
also depend on the volatility or range of ship prices anticipated in the future. If there
is a high degree of volatility in ship prices then the option is likely to be much more
valuable since the holder will either (a) make a profit by being able to buy a ship
with a market price well above the purchase price, with the possibility of being able
to re-sell it for an immediate profit in the market; or (b) be able to walk away from
the transaction and buy a similar ship in the second-hand market in one years time
at a lower price.
Note that if the option had two years to run and the terms remained largely un-
changed, it would have had much more value:
6.3
9m 0.800 7.769m
which gives a value of 431000.
The above simple illustration shows why options are valuable. It also shows the
factors that go into option pricing:
1. The exercise or strike price for the option .
2. The interest rate over the life of the option .
3. The current asset price (less any income it might generate over the life of the
option) .
4. The length of time provided by the option .
5. The potential volatility in price .
We will look at these again in more detail (see Section 6.3) to explain why they are
important. Before that, we will explain the different types of options that are
available.

6.2 Types of Options


Definition
An option gives the holder the right but not the obligation to buy/sell a fixed
quantity of an underlying asset at a fixed price at or before a specific future date
(maturity).
The terms of the option contract will specify: the time over which the option is
valid, known as the life of the option, the price, or sometimes rate, at which the
underlying asset can be purchased or sold, variously known as the exercise price or
the strike price, the amount involved, and under what conditions the option may

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Module 6 / The Product Set II: The Basics of Options

be exercised, whether during the life of the option or only at the moment the
contract terminates, known as the expiry date, or expiry of the option (also called,
perhaps erroneously, the maturity date or maturity of the option). In exchange for
the right to exercise, the buyer pays the seller a payment, known as the premium.
The old terms call money and put money are sometimes still used, but premium
or price of the option are the common terms in usage today. How this premium is
determined is discussed in Section 6.2.3.
Definition
The premium is the payment made by the option buyer (or holder) to the
option seller (or writer) for acquiring the option.
There are two types of transaction that a party may wish to undertake using op-
tions: either to buy or to sell an asset or underlying instrument. The two basic types
of options which exist cater for these transactions. The call option allows the
holder the right to purchase and the put option allows the holder the right to sell at
the pre-agreed price (or rate). Conversely, the option writer or seller is obliged to
sell, in the case of the call, and to purchase, in the case of the put. The nature of the
rights and obligations is summarised in Figure 6.5. With the call, the holder has the
right to receive the asset from the writer at the predetermined price upon the
payment of a premium. With the put, the holder has the right to sell (hence put) the
asset or underlying instrument to the writer at the predetermined price.

Asset

Call
Buyer Premium Seller
Holder Writer
Put

Asset

Figure 6.5 Relationship of option holders, writers, premium and the


underlying asset
Puts and calls can generally be of two types based on when the holder has the
right to buy or to sell the underlying asset. With the American-style option, the
holder has the right to exercise throughout the life of the option up to and including
expiry, whereas the European-style option may only be exercised at the point of
expiry. In addition to these basic types, some hybrid American-style/European-style
options exist, variously known as Atlantic-style or Bermudan options, which
incorporate features from both types.
Definitions
American-style option: an option which can be exercised at any time up to,
and including, the expiry date.
European-style option: an option which can be exercised only at the expiry
date.

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Module 6 / The Product Set II: The Basics of Options

6.2.1 The Call Option


Call options allow the holder the right but not the obligation to purchase the
underlying, but require the option seller or writer to sell the underlying at the strike
price.
Definition
A call option gives the right, but not the obligation, to buy a given quantity of
the underlying asset or instrument at the strike price on (or before) the expiry
day.
The call option allows the holder to benefit from a rise in the market price. The
payoff of such an option has already been given in Figure 6.4. The purchase of a call
option with a strike price of 100, for a premium of 3, would have the payoffs given
in Table 6.1, depending on the value of the underlying asset at expiry.
The values in Table 6.1 show the market price in column (i), the cost of the asset
together with the premium paid on the option in column (ii) and the profit/loss in
column (iii). When the market price is below the exercise or strike price of 100, the
holder does not exercise, but buys in the market instead. When the price is above
the strike price, the holder exercises the option and caps the purchase price at the
strike price plus the premium paid for acquiring the option. The payoff diagram
from this transaction is shown in Figure 6.6.

Table 6.1 Value of a call option at different market prices at expiry


Market price of
underlying asset at Cost of asset to Value of option
expiry option holder
(i) (ii) (iii)
90 93 3

93 96 3

95 98 3
96 99 3
97 100 3
98 101 3
99 102 3
100 (strike price) 103 3
101 103 2
102 103 1
103 103 0
104 103 1
105 103 2

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Module 6 / The Product Set II: The Basics of Options

Market price of
underlying asset at Cost of asset to Value of option
expiry option holder
107 103 4

110 103 7
Note: The strike price equals 100, the premium paid is 3. The break-even price is 103.

+
Payoff from long position in the asset (+U)

Payoff from long


Exercise or strike price call option (+C)
(K)
Gain/Loss

Market price
Breakeven
K+ PC

K PC

Figure 6.6 Payoff of a long position in the underlying and a purchased


call option
Table 6.1 and Figure 6.6 show the gain and loss from holding a call on an asset.
In Figure 6.6, a long position in the underlying is shown for comparison
purposes. At the exercise or strike price , the holder of the option would lose the
total value of the premium. As the price improves, the break-even point on the
option is the strike price plus the premium , that is , given in the
table as 103 (the exercise price of 100, plus the premium of 3). The maximum gain
will be the difference between the price of the underlying and the strike price
less the cost of the option .
The holder is better off if the price has fallen below the long position in the asset
, if the price falls below the strike price less the premium . The
maximum loss that can be incurred is 3, the value of the premium. Between the
break-even point and the stop-loss point on the option, the value of holding the
option or having a long position will depend on the market value at expiry.
Market parlance defines the condition of a call option in relation to the underly-
ing depending on whether the strike price is above, at or below the price of the
underlying:

If the strike price of the call is: The option is said to be:
above the market price of the underlying (K > U) out-of-the-money (OTM)
the same as the market price of the underlying (K=U) at-the-money (ATM)
below the market price of the underlying (K < U) in-the-money (ITM)

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Module 6 / The Product Set II: The Basics of Options

These relationships are shown in Figure 6.7 for call options.

Option
value
At-the-money

Out-of-the-money In-the-money

Strike price Intrinsic value

Asset value

Figure 6.7 In-the-money, at-the-money and out-of-the-money conditions


for call options
Note: The difference between the asset value and the option strike price , if positive, is a
call options intrinsic value.
Definitions
In-the-money: an option which has intrinsic value. That is, for calls, the strike
price of the option is below the underlying price; for puts, the opposite holds
and the strike price is above the underlying price.
At-the-money: an option where the underlying price and the strike price are
equal.
Out-of-the-money: an option which has no intrinsic value. That is, for calls,
the strike price of the option is above the underlying price; for puts, the
opposite holds and the strike price is below the underlying price.

6.2.2 The Put Option


The put option gives the holder the right but not the obligation to sell, or put, the
underlying to the option writer at the contracted strike (exercise) price.
Definition
A put option gives the right, but not the obligation, to sell a given quantity of
the underlying asset or instrument at the strike price on (or before) the expiry
day.
The put option allows the holder to benefit from a fall in the market price. The
purchase of a put option, with a strike price of 100 for a premium of 3, would have
the payoffs given in Table 6.2, depending on the value of the underlying asset at
expiry.

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Module 6 / The Product Set II: The Basics of Options

Table 6.2 Value of a put option at different market prices at expiry


Market price of under- Cost of asset to
lying asset at expiry option holder Value of option
(i) (ii) (iii)
90 97 7

93 97 4

95 97 2
96 97 1
97 97 0
98 97 1
99 97 2
100 (strike price) 97 3
101 98 3
102 99 3
103 100 3
104 101 3
105 102 3

107 104 3

110 107 3
Note: The strike price equals 100, the premium paid is 3. The break-even price on the option is 97.
The values in Table 6.2 show the market price in column (i), the selling price of
the asset together with the premium paid on the option in column (ii), and the
difference between the two in column (iii). When the market price is above the
exercise or strike price of 100, the holder does not exercise, but sells at the higher
price in the market instead. When the price is below the strike price, the holder
exercises the option and thereby is assured of a minimum selling price or floor,
which is the strike price less the premium paid for acquiring the option. The payoff
diagram from this transaction is shown in Figure 6.8.
+

Payoff from short position in the asset (U)

Exercise or strike price


Gain/Loss

(K)

Market price
Breakeven
K PP

K + PP Payoff from
long put option
(+P)

Figure 6.8 Payoff of a short position in the underlying and a purchased


put option

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Module 6 / The Product Set II: The Basics of Options

Table 6.2 and Figure 6.8, together, show the gain and loss from owning a put
option on an asset. In Figure 6.8, a short position in the underlying is shown
for comparison purposes. At the strike price , the holder of the option would
lose the total value of the premium. As the price falls, the break-even point on the
option is the strike price less the premium ( ), that is ( ), given in the
table as 97 (the exercise price of 100, less the premium of 3). The maximum gain
will be the difference between the strike price and the price of the underlying asset
less the cost of buying the option .
The put holder is better off in the situation where the price has risen when com-
pared to the short position in the asset if the price goes above the strike price
plus the premium . For the put holder, the maximum loss that can be
incurred is 3, the value of the premium. Between the break-even point and the stop-
loss point on the option, the value of holding the option or having a short position
will depend on the market value at expiry.
Market parlance defines the condition of a put option, in relation to the underly-
ing, depending on whether the strike price is above, at or below the price of the
underlying:
If the strike price of the put is: The option is said to be:
below the market price of the underlying out-of-the-money (OTM)
the same as the market price of the underlying at-the-money (ATM)
above the market price of the underlying in-the-money (ITM)
These relationships are shown in Figure 6.9 for put options. Note that the situa-
tions for calls and puts are mirror images of each other. Calls become more
valuable, the more the underlying asset price rises above the strike price; for puts,
the opposite is true. Puts become more valuable the more the asset price falls below
the strike price, and would have their highest value if the asset value falls to zero.

Option
value
At-the-money

In-the-money Out-of-the-money

Intrinsic Strike price


value

Asset value

Figure 6.9 In-the-money, at-the-money and out-of-the-money for put


options
Note: The difference between the strike price and the asset price , if positive, is a put
options intrinsic value.

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Module 6 / The Product Set II: The Basics of Options

6.2.3 The Intrinsic Value and Time Value of Options


The value at which an option is traded in the market is its premium or price.
Conventionally, this premium is made up of two elements: an intrinsic value (IV)
element and a time value (TV) element.
Definitions
Intrinsic value of an option: the positive value if an option is immediately
exercised. For calls, it is the difference between the underlying price and the
strike price when this is positive, or zero. For puts, it is the difference between
the strike price and the underlying price when this is positive, or zero.
Time value of an option: the difference between the option price and the
intrinsic value of the option, if any. The time value will depend on the remaining
life of the option, the difference between the underlying price and the strike
price and the volatility of the underlying.
The intrinsic value (IV) is simply the difference in the value between the under-
lying asset and the option strike price, as long as this is positive. For a call option,
this occurs when the strike price is below the current market price . That is,
there would be an immediate gain to the holder if the option were exercised and the
underlying purchased . The opposite condition applies to puts, where the
put has intrinsic value if there is an immediate gain from selling the asset .
Thus, in our earlier example, the call at 100 would have an intrinsic value of 4, if the
underlying was trading at 104. Conversely, the put would have zero intrinsic value at
this point, since it would be better to sell in the market rather than exercise. Howev-
er, if the underlying was trading at 96, the call would have zero intrinsic value but
now the put would have an intrinsic value of 4.

For Intrinsic value will be positive if:


Calls underlying is above the strike price IV = U K, min 0
Puts underlying is below the strike price IV = K U, min 0

We can consider intrinsic value as a measure of the gain accruing on exercise. If


the option is out-of-the-money, there is no gain. In addition, we can calculate the
intrinsic value of an option without having to know its price as long as we have the
strike price and the market value of the underlying.
The other element in the option price (or premium) is known as time value
(TV). We can consider time value in a number of ways: as the compensation option
writers require for taking on the risk that the option will be exercised and as the
value implied by being able to defer a purchase or a sale. The combination of the
options intrinsic value and the options time value gives the option price or
premium:
Premium 6.4
Thus, returning to our earlier examples, if the price of the call option (with a
strike of 100) is 5 when the underlying is trading at 104, the price consists of 4 of
intrinsic value (104 100), plus 1 of time value (5 4).

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Module 6 / The Product Set II: The Basics of Options

Time value gets its name from the fact that the time to expiry, or maturity, is a
significant factor in the value of an option. First, it allows the holder to defer having
to make the transaction. The longer the period, the more valuable this must be.
Second, for options which currently are not worth exercising since they are out-of-
the-money, the longer the time to expiry, the greater the chance (and the risk to the
writer), that the underlying price may move in such a way as to make the option
worth exercising. This latter point will depend not just on time but also on the
behaviour of the underlying asset or instrument, as we will see in Section 6.3 when
we look at how options are priced. The greater the likelihood of large price move-
ments (known as volatility), the greater the chance that the underlying price will
change in a favourable direction to the holder, thus making the option worth
exercising.
Before expiry, options will be made up of a combination of time value and intrin-
sic value. Figure 6.10 shows the relationship of the option price, time value and
intrinsic value.

Option Option price


value prior to expiry

At-the-money
point of greatest
time value
In-the-money

Out-of-the-money
Intrinsic value

KS Asset value

Figure 6.10 Relationship of time value and intrinsic value of a call option
prior to expiry in relation to the price of the underlying asset
The characteristic of the option changes depending on whether it is in- or out-of-
the-money. An out-of-the-money option will be all time value. This is highest in
relation to the option value when the option is at-the-money. As the option moves
more into-the-money, the option value is increasingly made up of intrinsic value.
That is, it becomes more like a terminal contract. These sensitivities will be exam-
ined in Module 9 once a formal method for establishing the option value has been
described.
Table 6.3 shows put and call option prices on the same underlying asset with
different maturities and strike prices.

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Table 6.3 Call and put prices for a range of strike prices
Calls Puts
Strike 1 2 3 1 2 3
month months months month months months
90 10.8 11.8 12.8 0.4 1.1 1.7
95 6.7 8.2 9.4 1.3 2.4 3.2
100 3.6 5.2 6.5 3.2 4.4 5.3
105 1.7 3.2 4.4 6.3 7.3 8.1
110 0.7 1.8 2.8 10.2 10.9 11.5

Table 6.3 shows that the three month calls at 95 (that is, with a 95 strike price)
are trading at 9.4. They have an intrinsic value of 5 (100 95), therefore the time
value element is 4.4. There are two things to note with the table. First, the calls are
more valuable than the puts. This is typical of most asset prices, which are bounded
by a price of zero on the downside, but have a potentially infinite upside gain. As a
result, puts have less time value than calls. The second point is that, as mentioned
earlier, the time value of an option increases with maturity. If we take the 110 calls
which are out of the money and therefore have no intrinsic value, we see the time
value increases with the maturity or time to expiry of the option, the one month call
having a value of 0.7, the three month call a value of 2.8. The same applies for the
puts. Note that this reduction in value to the option price as the time to expiry
approaches is known as time decay. For options of the same type and with the
same strike price, the longer the time to expiry, the greater the value. If the underly-
ing market price remains unchanged, the time value will fall to zero as the option
approaches its expiry date. In Table 6.4 we have a range of option prices for in the
money, at the money and out of the money options on the same asset.

Table 6.4 Value of an option prior to and at expiry


Asset price 6 months 3 months 1 month At expiry
K = 100
80 1.049 0.215 0.020 0
90 3.568 1.585 0.252 0
100 8.367 5.652 3.103 0
110 15.315 12.723 10.738 10
120 23.777 21.687 20.063 20
Note: The strike price is 100.

If we remove the intrinsic value from the option values given in Table 6.4, we are
left with the time value of the options as in Table 6.5.

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Module 6 / The Product Set II: The Basics of Options

Table 6.5 Effect of time decay on the time value of an option


Asset price 6 months 3 months 1 month At expiry
K = 100
80 1.049 0.215 0.020 0
90 3.568 1.585 0.252 0
100 8.367 5.652 3.103 0
110 5.315 2.723 0.738 0
120 3.777 1.687 0.063 0
Note: The time value is highest for the at-the-money options.

We can also show the same relationship graphically as per Figure 6.11 which
shows the value curve for options with different remaining time to expiry. As the
time shortens, the option value is pulled towards its expiry value, which will be all
intrinsic value.
To summarise, the value of an option will depend on whether it has a positive
intrinsic value (that is, whether it is in-the-money), the time to expiry and the
likelihood that the option may be worth exercising up to or upon expiry.

Option value
Option
value
6 months

3 months
Time decay
as option moves 1 month
At expiry
towards expiry

Intrinsic value

KS Asset value

Figure 6.11 The effect of time decay on the value of an option


Note: The closer the option gets to expiry, the less the time value. At expiry, the option value is
all intrinsic value.

6.2.4 Factors which Affect Option Values


We saw in our earlier simple illustration of option value that there are a number of
factors which have a bearing on the value of a call option. These are the length of
time for which the option is granted, the prevailing interest rate, the strike price, the
assets current price and its volatility. In addition, any value leakage from interest or
dividend payments, and so on, over the period of the option, will also affect the
options value.

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Module 6 / The Product Set II: The Basics of Options

The effect of time on option value. To have the opportunity to do something advanta-
geous for a week is not as attractive as having the same opportunity for a month or
a year or longer. Therefore the longer the life of an option or time-span over which
the option is valid, the more attractive it is. This is due to the fact that the longer the
time over which the option is extant, the greater the chance that conditions will
move in a favourable way so as to increase the value of the option to the holder.
The effect of interest rates on option value. The possibility to defer a purchase means
we do not have to provide funds today: this saves on borrowing or allows the
money to be invested and earn a return. Therefore any contract (such as a terminal
contract) which postpones a purchase has a value. Hence, the interest rate will affect
option value in a similar way. Note that this works against puts, since a put defers
the sale of the underlying asset.
The effect of the strike price on option value. If we have the right to buy an asset which
has a current market value of 100 at a price of 10, this has an immediate opportunity
to provide a gain of 90 on the transaction. Similarly, if a call option can be exercised
at 100 and the asset is trading at 120, there is a gain of 20 from exercise. However, if
the asset price is 90, there is no value to the option. Thus the underlying asset price
or asset rate (if based on interest rates) will have a bearing on the options value. All
things being equal, a lower strike price will raise the value of a call but lower the
value of a put.
Loss of asset value from leakages due to dividends or interest payments also affects
option values since we can expect the asset price to decline by the amount of the
dividend or interest payment. If we have a situation where an option has a strike
price of 100 and the asset price is 105, but it pays out an interest payment of 8 just
before the option can be exercised, we would expect the asset price to fall by the
amount of interest paid, to 97, thus making the option less valuable. The opposite
applies to puts, where value leakages reduce the asset price, making the put more
valuable.
Finally, the assets volatility (that is, the degree of potential price movement in the
future) will have a bearing on the options value. If we have a situation where a call
option is out-of-the-money with a strike price of 100 when the asset price is 95,
such an option will only become valuable if the asset price should rise above the
strike price before expiry. The more volatile the asset, the greater the chance of such
an occurrence. Thus, all things being equal, a more volatile asset will have a higher
option value.
Note that the effect of the pricing variables on the value of puts is not all the
same as it is for calls. The behaviour of put and call prices in relation to an increase
in the pricing variables is given in Table 6.6.

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Module 6 / The Product Set II: The Basics of Options

Table 6.6 Effects of increase in option-pricing variables on value of calls


and puts
Change in value of:
Increase in Call Put
Asset (stock) price plus (+) minus ()
Strike (or exercise) price minus () plus (+)
Time to expiry* plus (+) plus (+)
Risk-free interest rate plus (+) minus ()
Volatility plus (+) plus (+)
Leakages (dividends) minus () plus (+)
* Strictly speaking, for European-style options, the time to expiry is indeterminate. This is true for
calls if there is the potential for a large value leakage: the earlier-expiring option might then be
more valuable. It also applies to puts since the opportunity to reinvest at a higher interest rate
might make the earlier-expiring put more attractive as a result.

6.3 Option-Pricing Boundary Conditions


An option is the right to buy (if a call) or the right to sell (if a put) an underlying
asset. This might be a share, a bond, an interest rate, a currency exchange, a stock
index or some other kind of financial or real asset. Since it has some of the character
of a deferred purchase (or sale), there will be a set of boundary conditions that
relate the value of the asset to the value of the option. For example, it will be
irrational of the purchaser of an option to pay more for the option than the value of
the underlying asset itself. Following this logic, it is possible to establish a set of
boundary conditions within which the price or value of the option should fall. These
are shown in Figure 6.12.

Option
value C
Max C
A
Min C
Out-of-the-money

o C Intrinsic value
45

PV(K) K Asset value (U)

Figure 6.12 Minimum and maximum value boundary conditions for an


option
Note: is an American-style option, is the strike price, is the present value of the
strike price, is the current market value of a call option.

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The minimum value of calls: An American-style call should be either worthless or


the difference between the underlying asset price and the strike price ,
whichever is the greater. It cannot have a negative value. The European-style call
should either be worthless or sell for the difference between the underlying asset
price and the present value of the strike price , whichever is the greater. It
cannot have a negative value. If the underlying asset has value leakage, that is, it pays
one or more dividends or interest payments before the options expiry, the Europe-
an-style call price should be at least zero, or the difference between the underlying
asset price, adjusted for the present value of the loss of value and the present value
of the strike price, whichever is greater.
The maximum value of calls is the value of the underlying .
The time to expiry. The value of a longer-dated American-style call must be at
least the same as that of a corresponding shorter-dated American-style call. The
value of a longer-dated European-style call must be at least the same as that of a
corresponding shorter-dated European-style call as long as the underlying asset has
no value leakage (that is, there is no loss of value through interest or dividend
payments). In the case of value leakage, this condition for European-style calls does
not apply, since it may be preferable to have the shorter-dated option which can be
exercised ahead of the value distribution rather than the longer-dated one.
The strike price of calls. The difference in price between two calls that differ only in
their strike or exercise price must be less than or equal to the present value of the
difference in the exercise price. For American-style calls the difference cannot
exceed the difference in their strike prices.
The value of American-style and European-style calls. An American-style call should
sell for at least the same price as a European-style call.
The minimum value of puts. An American-style put should be either worthless or
the difference between the strike price and the underlying price , whichever
is the greater. It cannot have a negative value. In the case of a zero-leakage asset, a
European-style put should be either worthless or the difference between the
present value of the exercise price and the underlying, whichever is the greater. It
cannot have a negative value. If the underlying asset has value leakage before expiry,
the European-style put price should be at least zero, or the difference between the
present value of the strike price and the underlying asset, adjusted for the present
value of the value leakage, whichever is the greater.
The maximum value of puts. The value of an American-style put should not ex-
ceed its exercise price; the value of a European-style put cannot exceed the present
value of its exercise price.
The time to expiry. The value of a longer-expiry American-style put must be at
least as great as that of a corresponding shorter-dated American-style put; for
European-style puts no such condition applies (that is, there is uncertainty as to
whether a longer-dated put is always more valuable than a shorter-dated one).
The strike price of puts. The value of a higher strike price put must be at least the
same as the value of a corresponding put but with a lower strike price. The differ-
ence in price between two European-style puts with different strike prices must

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Module 6 / The Product Set II: The Basics of Options

not exceed the present value of the difference in their strike prices. For American-
style puts this difference must not exceed the difference between the two strike
prices.
The value of American-style and European-style puts. An American-style put should sell
for at least the same price as a European-style put. However, with an American-style
put it may be best to exercise early. A situation when this might be the case could
arise when the gain from reinvesting the proceeds at the current interest rate
outweighs the loss of time value surrendered from the early exercise.
The putcall parity condition. This condition holds that the price of a European-
style call is equal to the price of its corresponding put plus the current price of the
underlying, less the present value of the strike price. That is:
Call
Put Underlying Present value of strike price 6.5

6.3.1 Optimal Early Exercise of American-Style Options


While, in most cases, early exercise leads to the loss of time value, there are a
number of conditions for American-style options where early exercise may be the
optimal investment strategy. Because, in certain circumstances, it may be advanta-
geous to exercise an option early, American-style options are likely to trade at a
higher price than the corresponding European-style options. This price differential
reflects the increased flexibility accorded to holders of such options. The factors
which may lead to a decision to exercise early are as follows.
1. A put being deeply in-the-money. By not exercising early, the holder forgoes
the possible interest on the realisable value of the underlying . Since the
underlyings value is not likely to recover, the loss of time value is small. (Re-
member, we have said that a deeply in-the-money option is akin to a forward
transaction.) The advantages of early exercise might apply even in cases where
there was a small intervening cash flow on the underlying (such as a dividend
due), the loss of which would have to be balanced against the gain in interest
income. The critical asset price or break-even point from early exercise can be
worked out approximately as the ratio of the underlying asset price to the strike
price, the remaining time to expiry and the prevailing interest rate available for
the released funds.
2. A call being deeply in-the-money and where (a) there may be one or more
cash flows due on the underlying asset which may or may not have been known
with certainty when the option was written or bought; or (b) the known cash
flow may be higher than was earlier predicted. An example is a call on a stock
which was going to pay a dividend before expiry or which might announce a
special dividend to holders. In this case the options time value is small and it
may prove best to exercise early and lose this. As is usual in such a situation, the
holder should exercise at the last possible moment that would allow him/her to
take advantage of the situation (that is, just before the stock went ex-dividend).
3. Where the risk of default by the option writer is high or rising. Holders may
exercise in such a situation if the position is near to, at- or just in-the-money, so

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Module 6 / The Product Set II: The Basics of Options

as to preserve value. Early exercise effectively accelerates the transaction and


pre-empts a potential default by the counterparty. If recovery of value is uncer-
tain, it may be preferable to forgo some time value than to hold on to expiry.

6.4 Risk Modification with Options


We have already said that options are useful as a way of changing the risk profile of
a given situation. This section looks at some of the ways in which this can be
achieved by combining options and the asset being optioned in different ways.
There are a great many different strategies that can be adopted. The Euronext-
LIFFE recognises 17 complex option strategies, in addition to the basic fundamen-
tal strategies. These go by exotic names such as butterfly, guts, ladder, strangle,
combo, condor, box and so forth. There is no theoretical limit to the complexity
that can be created using options, although in practice positions using more than
four options are rare.

6.4.1 Fundamental Strategies


There are six fundamental strategies for options. These are:
1. Purchased call
2. Purchased put
3. Written (sold or short) call
4. Written put
5. Written call plus a long position in the underlying asset
6. Written put position plus a short position in the underlying asset

Table 6.7 The fundamental option strategies and their effects


Strategy Payoff Effect
(1) Long call Gain if asset price rises Loss limited to premium paid potential
infinite gain from asset price rise
(2) Long put Gain if asset price falls Loss limited to premium paid , potential
large gain from asset price fall
(3) Short call Premium received Gain limited to premium received, potential risk
of loss if asset price rises
(4) Short put Premium received Gain limited to premium received, potential risk
of loss if asset price falls
(5) Short call, plus Premium received , Gain limited to premium received; potential
long position in plus any income from opportunity loss from surrendering the underly-
underlying asset asset (+i) ing asset if the asset price rises above strike
, price
(6) Short put, plus Premium received , Gain limited to premium received; potential
short position in less any income from opportunity loss from having to purchase asset
underlying asset asset (i) at the strike price if the asset price falls below
, the strike price
These strategies are summarised in Table 6.7. Complex strategies can be created
by combining the different fundamental strategies into more elaborate packages.

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Module 6 / The Product Set II: The Basics of Options

The strategies from Table 6.7 are shown as a set of payoff diagrams in Fig-
ure 6.13 to Figure 6.16.
+ Long call

Strike price Area of gain


Premium
Area of loss

+
Short call

Area of gain
Premium
Area of loss

Figure 6.13 The payoff from a long call (fundamental strategy (1)) and a
short call (fundamental strategy (3))
Note: For details, see Table 6.7.

+ Long put

Area of gain Strike price


Asset
Gain/Loss
price
Area of loss

Premium

+ Short put
Premium

Area of gain Asset


Gain/Loss
price
Area of loss

Figure 6.14 The payoff from a long put (fundamental strategy (2)) and a
short put (fundamental strategy (4))
Note: For details, see Table 6.7.

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Gain/Loss
+
Value of long position
in the underlying asset

Combined position

Premium Asset
price

Strike price
(K) Written call

Figure 6.15 A covered call write (fundamental strategy (5))


Note: The combined position is made up of a long position in the underlying asset (+U) and a short
or written position in a call option (C). The combined position is equivalent to a written put
(P). For details see Table 6.7.

Gain/Loss
+ Value of short position
in the underlying asset

Written put

Premium Asset
price

Strike price Combined position

Figure 6.16 A covered put write (fundamental strategy (6))


Note: The combined position is made up of a short position in the underlying asset (U) and a
short or written position in a put option (P). The combined position is equivalent to a written
call (C). For details see Table 6.7.

6.4.2 Strategies Using Options


As mentioned at the start of Section 6.4, options can be used to manipulate the risk
profile or sensitivities of the position in relation to the underlying asset, interest rate,
currency, index or other optioned instrument. It is beyond the scope of this module
to expand on all the different option strategies that can be adopted, but this section
looks at a few of the more common methods used in the markets. The two most
important relationships are spreads and straddles.
The vertical spread is designed to reduce the cost of a given exposure profile
based on a directional view of the asset being optioned. It is essentially a package
made up of two of the first four fundamental strategies, (1) and (3), a purchased call

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Module 6 / The Product Set II: The Basics of Options

and a written call, or (2) and (4), a purchased put and a written put, where the strike
prices between the purchased and the written options differ. Thus a degree of
protection is provided over a given range by the purchased option whereas the
written option (which provides an immediate inflow of premium) reduces the cost
of the overall position. The payoff of a vertical call spread is shown in Figure 6.17.

Gain/Loss
+ Purchased call

Premium received
Combined
position

K1 K2 Asset
price
Premium paid

Written call
Net premium

Figure 6.17 Payoff of a vertical call spread (bull spread) based on buying a
call at strike price and selling another call with strike price

Variations on the spread structure include having options with different expiry
dates (called a horizontal or time spread), using puts instead of calls (known as a
credit spread), having different quantities of options on the purchased and sold legs
(ratio spreads), adding a further purchased deeply out-of-the-money option ( ladder)
and combining two spreads to create butterflies, iron butterflies, condors and so on.
The other derived strategy is a straddle. This has no directional view on the
movement in the underlying asset. It is a combination based on fundamental
strategi