Financial Innovation
Derivative Markets
Lecture Preview
Starting in the 1970s, the world became a
riskier place for financial institutions.
Interest rate volatility increased, as did the
stock and bond markets. Financial
innovation helped with the development of
derivatives. But if improperly used,
derivatives can dramatically increase the
risk institutions face.
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Lecture Preview
• In this chapter, we look at the most important
derivatives that managers of financial institution
use to manage risk. We examine how the
markets for these derivatives work and how the
products are used by financial managers to
reduce risk. Topics include:
– Hedging
– Forward Markets
– Financial Futures Markets
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Lecture Preview (cont.)
– Stock Index Futures
– Options
– Interest-Rate Swaps
– Credit Derivatives
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Hedging
• Hedging involves engaging in a financial
transaction that reduces or eliminates risk.
• Definitions
– long position: an asset which is purchased
or owned
– short position: an asset which must be
delivered to a third party as a future date, or an
asset which is borrowed and sold, but must be
replaced in the future
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Hedging
• Hedging risk involves engaging in a
financial transaction that offsets a long
position by taking an additional short
position, or offsets a short position by
taking an additional long position.
• We will examine how this is specifically
accomplished in different financial markets.
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Forward Markets
• Forward contracts are agreements by two
parties to engage in a financial transaction at a
future point in time. Although the contract can be
written however the parties want, the contact
usually includes:
– The exact assets to be delivered by one party,
including the location of delivery
– The price paid for the assets by the other party
– The date when the assets and cash will be exchanged
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Forward Markets
• An Example of an Interest-Rate Contract
– First National Bank agrees to deliver $5 million
in face value of 6% Treasury bonds maturing
in 2023
– Rock Solid Insurance Company agrees to pay
$5 million for the bonds
– FNB and Rock Solid agree to complete the
transaction one year from today at the FNB
headquarters in town
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Forward Markets
• Long Position
– Agree to buy securities at future date
– Hedges by locking in future interest rate of funds
coming in future, avoiding rate decreases
• Short Position
– Agree to sell securities at future date
– Hedges by reducing price risk from increases in
interest rates if holding bonds
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Forward Markets
• Pros
1. Flexible
• Cons
1. Lack of liquidity: hard to find a counter-party
and thin or non-existent secondary market
2. Subject to default risk—requires information
to screen good from bad risk
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Financial Futures Markets
• Financial futures contracts are similar to
forward contracts in that they are an
agreement by two parties to engage in a
financial transaction at a future point in
time. However, they differ from forward
contracts in several significant ways.
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Financial Futures Markets
• Financial Futures Contract
1. Specifies delivery of type of security at future date
2. Arbitrage: at expiration date, price of contract = price
of the underlying asset delivered
3. i , long contract has loss, short contract has profit
4. Hedging similar to forwards: micro versus macro
hedge
• Traded on Exchanges
– Global competition regulated by CFTC
Commodity Futures Options Trading,
Inc. home page 25-12
[Link]
Example: Hedging Interest Rate Risk
• A manager has a long position in Treasury
bonds. She wishes to hedge again interest
rate increases, and uses T-bond futures to
do this:
– Her portfolio is worth $5,000,000
– Futures contracts have an underlying value of
$100,000, so she must short 50 contracts.
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Example: Hedging Interest Rate Risk
– As interest rates increase over the next 12
months, the value of the bond portfolio drops
by almost $1,000,000.
– However, the T-bond contract also dropped
almost $1,000,000 in value, and the short
position means the contract pays off that
amount.
– Losses in the spot T-bond market are offset by
gains in the T-bond futures market.
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Financial Futures Markets
• The previous example is a micro hedge –
hedging the value of a specific asset.
Macro hedges involve hedging, for
example, the entire value of a portfolio, or
general prices for production inputs.
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Financial Futures Markets
• In the U.S., futures are traded on the
CBOT and the CME in Chicago, the NY
Futures Exchange, and others.
• They are regulated by the Commodity
Futures Trading Commission. The most
widely traded are listed in the Wall Street
Journal, as we see on the next slide.
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Following the News
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Financial Futures Markets
• The U.S. exchanges dominated the market
for years. However, this isn’t true
anymore.
• The London Int’l Financial Futures
Exchange trades Eurodollar futures
• The Tokyo Stock Exchange trades Euroyen
and gov’t bond futures
• Several others as well, as seen next.
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Widely Traded Financial
Futures Contracts
Financial Futures Markets
• Success of Futures Over Forwards
1. Futures are more liquid: standardized
contracts that can be traded
2. Delivery of range of securities reduces the
chance that a trader can corner the market
3. Mark to market daily: avoids default risk
4. Don't have to deliver: cash netting
of positions
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Hedging FX Risk
• Example: A manufacturer expects to be
paid 10 million euros in two months for the
sale of equipment in Europe. Currently, 1
euro = $1, and the manufacturer would like
to lock-in that exchange rate.
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Hedging FX Risk
• The manufacturer can use the FX futures
market to accomplish this:
1. The manufacturer sells 10 million euros of futures
contracts. Assuming that 1 contract is for $125,000
in euros, the manufacturer takes as short position in
80 contracts.
2. The exchange will require the manufacturer to
deposit cash into a margin account. For example,
the exchange may require $6,250 per contract, or
$500,000.
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Hedging FX Risk
3. As the exchange rate fluctuates during the
two months, the value of the margin account
will fluctuate. If the value in the margin
account falls too low, additional funds may
be required. This is how the market is
marked to market. If additional funds are
not deposited when required, the position will
be closed by the exchange.
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Hedging FX Risk
4. Assume that actual exchange rate is 1 euro = $0.96
at the end of the two months. The manufacturer
receives the 10 million euros and exchanges them in
the spot market for $9,600,000.
5. The manufacturer also closes the margin account,
which has $900,000 in it—$400,000 for the changes
in exchange rates plus the original $500,000
required by the exchange (assumes no margin
calls).
6. In the end, the manufacturer has the $10,000,000
desired from the sale.
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Stock Index Futures
• Financial institution managers, particularly
those that manage mutual funds, pension
funds, and insurance companies, also need
to assess their stock market risk, the risk
that occurs due to fluctuations in equity
market prices.
• One instrument to hedge this risk is stock
index futures.
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Stock Index Futures
• Stock index futures are a contract to buy or sell
a particular stock index, starting at a given level.
Contacts exist for most major indexes, including
the S&P 500, Dow Jones Industrials, Russell
2000, etc.
• The “best” stock futures contract to use is
generally determined by the highest correlation
between returns to a portfolio and returns to a
particular index.
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Hedging with Stock Index Futures
• Example: Rock Solid has a stock portfolio
worth $100 million, which tracks closely
with the S&P 500. The portfolio manager
fears that a decline is coming and what to
completely hedge the value of the portfolio
over the next year. If the S&P is currently
at 1,000, how is this accomplished?
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Hedging with Stock Index Futures
• Value of the S&P 500 Futures Contract =
250 index
– currently 250 x 1,000 = $250,000
• To hedge $100 million of stocks that move
1 for 1 (perfect correlation) with S&P
currently selling at 1000, you would:
– sell $100 million of index futures =
400 contracts
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Hedging with Stock Index Futures
• Suppose after the year, the S&P 500 is at 900
and the portfolio is worth $90 million.
– futures position is up $10 million
• If instead, the S&P 500 is at 1100 and the
portfolio is worth $110 million.
– futures position is down $10 million
• Either way, net position is $100 million
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Hedging with Stock Index Futures
• Note that the portfolio is protected from
downside risk, the risk that the value in the
portfolio will fall. However, to accomplish this,
the manager has also eliminated any
upside potential.
• Now we will examine a hedging strategy that
protects again downside risk, but does not
sacrifice the upside. Of course, this comes at
a price!
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Options
• Options Contract
– Right to buy (call option) or sell (put option) an
instrument at the exercise (strike) price up until
expiration date (American) or on expiration
date (European).
• Options are available on a number of
financial instruments, including individual
stocks, stock indexes, etc.
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Options
Factors Affecting Premium
1. Higher strike price, lower premium
on call options and higher premium on
put options.
2. Greater term to expiration, higher
premiums for both call and put options.
3. Greater price volatility of underlying
instrument, higher premiums for both call
and put options.
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Hedging with Options
• Example: Rock Solid has a stock portfolio
worth $100 million, which tracks closely
with the S&P 500. The portfolio manager
fears that a decline is coming and what to
completely hedge the value of the portfolio
against any downside risk. If the S&P is
currently at 1,000, how is this
accomplished?
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Hedging with Options
• Value of the S&P 500 Option Contract =
100 index
– currently 100 x 1,000 = $100,000
• To hedge $100 million of stocks that move
1 for 1 (perfect correlation) with S&P
currently selling at 1000, you would:
– buy $100 million of S&P put options =
1,000 contracts
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Hedging with Options
• The premium would depend on the strike price.
For example, a strike price of 950 might have a
premium of $200 / contract, while a strike price of
900 might have a strike price of only $100.
• Let’s assume Rock Solid chooses a strike price of
950. Then Rock Solid must pay $200,000 for the
position. This is non-refundable and comes out
of the portfolio value (now only $99.8 million).
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Hedging with Options
• Suppose after the year, the S&P 500 is at 900
and the portfolio is worth $89.8 million.
– options position is up $5 million (since 950 strike price)
– in net, portfolio is worth $94.8 million
• If instead, the S&P 500 is at 1100 and the
portfolio is worth $109.8 million.
– options position expires worthless, and portfolio is
worth $109.8 million
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Hedging with Options
• Note that the portfolio is protected from any
downside risk (the risk that the value in the
portfolio will fall ) in excess of $5 million.
However, to accomplish this, the manager
has to pay a premium upfront of $200,000.
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Interest-Rate Swaps
• Interest-rate swaps involve the exchange
of one set of interest payments for another
set of interest payments, all denominated in
the same currency.
• Simplest type, called a plain vanilla swap,
specifies (1) the rates being exchanged,
(2) type of payments, and
(3) notional amount.
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Interest-Rate Swap Contract Example
• Midwest Savings Bank wishes to hedge rate
changes by entering into variable-rate contracts.
• Friendly Finance Company wishes to hedge
some of its variable-rate debt with some fixed-
rate debt.
• Notional principle of $1 million
• Term of 10 years
• Midwest SB swaps 5% payment for T-bill + 1%
from Friendly Finance Company.
Interest-Rate Swap Contract Example
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Hedging with Interest-Rate Swaps
• Reduce interest-rate risk for both parties
1. Midwest converts $1m of fixed rate assets to
rate-sensitive assets, RSA, lowers GAP
2. Friendly Finance converts $1m of RSA to
fixed rate assets, lowers GAP
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Hedging with Interest-Rate Swaps
• Advantages of swaps
1. Reduce risk, no change in balance-sheet
2. Longer term than futures or options
• Disadvantages of swaps
1. Lack of liquidity
2. Subject to default risk
• Financial intermediaries help reduce
disadvantages of swaps (but at a cost!)
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Credit Derivatives
• Credit derivatives are a relatively new
derivative offering payoffs based on
changes in credit conditions along a variety
of dimensions. Almost nonexistent twenty
years ago, the notional amount of credit
derivatives today is in the trillions.
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Credit Derivatives
• Credit derivatives can be generally
categorized as credit options, credit swaps,
and credit-linked notes. We will look at
each of these in turn.
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Credit Derivatives
• Credit options are like other options, but
payoffs are tied to changes in credit
conditions.
– Credit options on debt are tied to changes in
credit ratings.
– Credit options can also be tied to credit
spreads. For example, the strike price can be
a predetermined spread between AAA-rated
and BBB-rated corporate debt.
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Credit Derivatives
• For example, suppose you wanted to issue
$100,000,000 in debt in six months, and
your debt is expected to be rated single-A.
Currently, A-rated debt is trading at 100
basis points above the Treasury. You could
enter into a credit option on the spread,
with a strike price of 100 basis points.
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Credit Derivatives
• If the spread widens, you will, of course,
have to issue the debt at a higher-than-
expected interest rate. But the additional
cost will be offset by the payoff from the
option. Like any option, you will have to
pay a premium upfront for this protection.
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Credit Derivatives
• Credit swaps involve, for example,
swapping actual payments on similar-sized
loan portfolios. This allows financial
institutions to diversify portfolios while still
allowing the lenders to specialize in local
markets or particular industries.
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Credit Derivatives
• Another form of a credit swap, called a
credit default swap, involves option-like
payoffs when a basket of loans defaults.
For example, the swap may payoff only
after the 5th bond in a bond portfolio
defaults (or has some other bad credit
event).
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Credit Derivatives
• Credit-linked notes combine a bond and a
credit option. Like any bond, it makes
regular interest payments and a final
payment including the face value. But the
issuer has an option tied to a key variable.
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Credit Derivatives
• For example, GM might issue a bond with a
5% coupon rate. However, the covenants
would stipulate that if an index of SUV
sales falls by more than 10%, the coupon
rate drops to 3%. This would be especially
useful if GM was using the bond proceeds
to build a new SUV plant.
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Are derivatives a time bomb?
• In the 2002 annual report for Berkshire
Hathaway, Warren Buffett referred to
derivatives (bought for speculation) as “…
weapons of mass destruction.” (although
also noting that Berkshire uses
derivatives). Is he right?
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Are derivatives a time bomb?
• There are three major concerns with the
use of financial derivatives:
– Derivatives allow financial institutions to
increase their leverage (effectively changing
their capital), possibly to take on more risk
– Derivatives are too complicated
– The derivative positions of some banks exceed
their capital – the probability of failure has
greatly increased
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Are derivatives a time bomb?
• As usual, the blanket comments are usually
not accurate. For example, although the
notional amount of derivatives exceeds
capital, often these are offsetting positions
on behalf of clients – the bank has no
exposure. In other words, you have to look
at each situation individually. Further,
actual derivative losses by banks is small,
despite a few news-worthy exceptions.
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Are derivatives a time bomb?
• In the end, derivatives do have their
dangers. But so does hiring crooks to run
a bank (Lincoln S&L ring a bell). But
derivatives have changed the
sophistication needed by both managers
and regulators to understand the whole
picture.
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Chapter Summary
• Hedging: the basic idea of entering into an
offsetting contract to reduce or eliminate
some type of risk was presented.
• Forward Markets: the basic idea of
contracts in this highly specialized market,
as well as a simple example of eliminating
risk was presented.
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Chapter Summary (cont.)
• Financial Futures Markets: these exchange
traded markets were presented, as well as
their advantages over forward contacts.
• Stock Index Futures: the specific
application of stock index futures was
presented, exploring their ability to reduce
or eliminate risk for equity portfolios.
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Chapter Summary (cont.)
• Options: these contracts, which give the
buyer the right but not the obligation to act,
were presented, as well as an example
showing their costs.
• Interest-Rate Swaps: the idea of trading
fixed-rate interest payments for floating-
rate payments was presented, as well as
the pros and cons of such contracts.
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Chapter Summary (cont.)
• Credit Derivatives: we examine this
relatively new market for hedging the credit
risk of portfolios and the dangers involved.
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