Options, Futures and Other Derivatives

September 29, 2015

Dr. Sergio S. Cao

President and Chief Academic Officer
Manila Tytana Colleges

Operational Risk: A Guide to Base II

A. Chernobai, S. Racher & F. Fabozzi
John Wiley, 2007, page 27

FINANCIAL DERIVATIVES
A financial derivative is an
instrument whose value is derived
from the value of an underlying asset
(e.g. stock, foreign currency, bond, or
another derivative)
Forward Contracts
Futures Contracts
Options
Swaps
4

WEAPONS OF MASS DESTRUCTION

The derivatives genie is now well out of
the bottle, and these instruments will
almost certainly multiply in variety and
number until some event makes their
toxicity clear ... In my view, derivatives
are
financial
weapons
of
mass
destruction, carrying dangers that,
while now latent, are potentially lethal.
Warren Buffet, 2002
5

Declaration of the G-20

Root Causes of the Current Crisis
November 15, 2008

market participants
sought higher YIELDS
without an adequate
appreciation of the
RISKS and failed to
exercise proper due
6

ewsweek, September 29, 2008

Key Words
Subprime borrowers
Securitization
Collateralized Debt
Obligations (CDO)
Mortgage-Backed
Securities (MBS)

Credit Default Swaps (CDS)

9

What are Subprime Mortgages?

Subprime mortgages are

housing loans of banks and
mortgage finance
companies to borrowers
with marginal credit
standing
Recall: What
the Cs of credit?
NINJAare
borrowers
10

Securitization
Securitization is basically the
packaging of a pool of
assets,
e.g.
mortgages, into securities that
can be sold to investors
Mortgages are thus converted
to mortgage-backed
11

Measuring and Managing Credit Risk (MMCR), A. de Servigny & O. Renault

McGraw Hill, 2004, page 15

12

RP banks caught holding

collapsed Lehman notes
[The Manila Standard Today (Online), September 17,
2008]

Metrobank, the countrys largest

bank in assets, said it had set aside
$14 million (P658 million) to cover
bonds issued by Lehman. The bank
also had a P2.4 billion loan to a
Lehman subsidiary, but said the loan
13

FORWARD CONTRACT
A forward contract is an
agreement to buy (long position)
or sell (short position) an asset in
the future at an agreed price
(delivery price) today
The asset could be a stock, a
foreign currency, another financial
instrument (e.g. bond)

14

ABS/CBN - Foreign Exchange Forward

On March 10, 1997, ABS/CBN entered into a
Loan Agreement with a local bank for
US$37.908M payable
in two
installments, on March 19, 2002 and 2004
ABS/CBN entered into a forward foreign
exchange agreement with the same bank;
ABS/CBN shall pay the local bank the
equivalent peso amount of the dollar loan

15

Interest Rate Swap: Liability Management

5% fixed

B
6-m LIBOR

6-m LIBOR + 0.1%

Suppose that Party A has arranged to borrow

$100 million at 6-month LIBOR + 0.1%
16

Currency Swap

PLDT Annual Report 200

17

Credit Default Swaps

A credit default swap is a contract where company A has the right
to sell (put option) a bond issued by company C for its face value to
company B in the event that there is a default on the bond.

For example, B = AIG

18

Table 1 - Number of quotes by type of CDS

Number of quotes
Type

1997

1998

1999

2000

2001

2002

20031

Corporate

196

1,892

11,726

22,538

55,679

102,039

88,817

Bank

394

2,715

8,021

6,854

16,844

25,490

8,615

Sovereign

771

2,283

8,169

8,133

11,535

10,124

7,844

1,361

6,890

27,916

37,525

84,058

137,653

105,276

Total

% change of number of quotes and trades from the previous year

Corporate

865.3

519.8

92.2

147.0

83.3

96.9

Bank

589.1

195.4

(14.5)

145.8

51.3

(50.5)

Sovereign

196.1

257.8

(0.4)

41.8

(12.2)

48.2

406.2

305.2

34.4

124.0

63.8

52.9

Total

First half; change over first half of 2002.

19

Source: CreditTrade

http://www.cnbc.com/id/38451750

20

Greek Default
On March 9, 2012, The ISDA EMEA Determination
Committee resolved that a Restructuring Credit
Event has occurred after Greece pulled off a massive
restructuring of debt where a vast majority of private
sector lenders agreed to swap $77 billion in Greek
debt for new bonds worth as much as 75 percent less.
The DC also announced an auction with respect to the
settlement of standard CDS for which Greece is the
reference entity.
21

Options
A call option is a
right to buy a
certain asset by a
certain date for a
certain price (the
strike price)

A put option is a
right to sell a certain
asset by a certain
date for a certain
price (the strike
price)

An American option can be exercised at

any time during its life
A European option can be exercised only
22
at maturity

Case
Study

EXAMPLE OF DEBT
RESTRUCTURING
(Using options as sweeteners)

Example[1]. Subject to satisfactory

closing of the proposed debt
restructuring
of
Piltel
pursuant
to
the
Debt
Restructuring Plan, it is
expected that PLDT will issue
three series of convertible
23
preferred shares . . .

Series V

Series VI

Par value
Dividend

Series VII

P10 per share

P18.70 annual fixed
cumulative cash dividend,
payable quarterly in arrears.

Anniversary
Date

US$0.397 annual fixed

cumulative cash dividend,
payable quarterly in
arrears.

7th Year from issue date

JPY 40.7189 annual

fixed cumulative cash
dividend, payable
quarterly in arrears
8th Year from issue
date

Voluntary and
mandatory
conversion

Convertible at the option of its holder, at anytime from the date of issue to
Anniversary Date into one PLDT Common Share. Unless previously converted into
PLDT Common Shares, shall be mandatorily converted into PLDT Common Shares
on the date immediately following the Anniversary Date (the Mandatory
Conversion). Holders may also convert such shares into PLDT Common Shares
within 10 calendar days from the date of receipt of notice from PLDT of the
occurrence of an event which would or is reasonably likely to result in PLDT
becoming insolvent (the Winding Up Conversion).

Put Option

Holders may, within 30 days after a mandatory conversion, require PLDT to

repurchase the common shares issued at Put Option Price.

Put Option Price

P1,700 per share

US$36.132 per share

JPY4,071.89 per share

24

METROPOLITAN BANK AND TRUST

COMPANY
TYPE 2 LIMITED DEALER AUTHORITY

www.bsp.gov.ph/banking/d

25

METROPOLITAN BANK AND TRUST

COMPANY
TYPE 2 LIMITED DEALER AUTHORITY

www.bsp.gov.ph/banking/d

26

METROPOLITAN BANK AND TRUST

COMPANY
TYPE 2 LIMITED DEALER AUTHORITY

www.bsp.gov.ph/banking/d

27

Thank you.