Derivative asset markets have developed vertiginously on an international scale over the last three decades, decisively influencing the rise of computer and communication systems, the high volatility of interest rates and the processes of financial deregulation and liberalization.
The derivatives market deals with the negotiation of contracts for hedging instruments, in the event of possible market risks, either due to variations in interest rates, exchange rates or other types of asset prices. Example of them: futures, financial options and swaps.
This work is precisely an approach to this important market.
Financial futures market
Financial future
A futures contract is a corporate legal agreement between a buyer and a seller in which:
- Buyer agrees to accept delivery of something at a specified price at the end of a designated period. Seller agrees to deliver something at a specified price at the end of a designated period.
When you say the buyer or the seller of a contract, you are adopting the jargon of the futures markets, which refers to the parties to the contract based on the future obligation, to which they are committing themselves.
Since the value of the futures contract is derived from the value of the supporting asset, futures contracts are commonly called derivative assets.
Of course, nobody buys or sells anything when you sign up for a futures contract. Instead, the parties to the contract agree to buy or sell at a specific amount, of something specific, on an agreed futures date.
Elements involved in a futures contract:
Sustaining: is the something that the parties agree to exchange.
Future price: is the price at which the parties agree to negotiate in the future.
Established or delivery date: is the designated date on which the parties agree to negotiate.
Futures contracts are products created by brokerage houses. For this, these houses must obtain government approval, provided that it shows that there is an economic purpose of the contract.
Before 1972 only futures contracts involved traditional agricultural commodities (grain and livestock) and industrial products. That is why they were called commodity futures.
Futures contracts based on financial assets are called financial futures.
The basic economic function of financial futures markets is to provide an opportunity for participants in this market to hedge against the risk of adverse price movements.
When an investor takes a position in the market by buying a futures contract (or agreeing to buy at a future date), they are said to be long, or futures long.
When an investor takes a position in the market to sell a futures contract (or agree to sell at a future date), they are said to be short, or to have short futures.
Examples of futures contracts:
If you take a position to buy a financial asset within a month at $ 100 and when the expiration date arrives that asset has a value of $ 120, then you could sell the contract for $ 120, pay the $ 100 of the purchase contract and stay with a profit of $ 20.
The one who assumes the opposite position to sell the financial asset of the previous example, when the expiration date arrives that asset has a value of $ 80, then you could buy the contract for $ 80 and sell it for $ 100 to the expected buyer for $ 100 and keep a profit of $ 20.
Generalizations
The buyer of a futures contract will make a profit if the futures price increases.
The seller of a futures contract will make a profit if the futures price decreases.
Most futures contracts have a settlement date in the months of March, June, September or December. This means that at a certain period in the month of settlement of the contract, it stops trading and the brokerage firm determines a price for settlement. The contract with the closest settlement date is the close futures contract. The next futures contract is the one that is settled just after the close contract. The furthest contract in time from settlement is the furthest futures contract.
A party to a futures contract has two choices in liquidating the position. First, the position can be liquidated before the cancellation date. For this purpose, the party must take a cancellation position in the same contract. For the buyer of a futures contract, it means selling the same number of identical futures contracts, for the seller of a futures contract, it means buying the same number of identical futures contracts.
The alternative is to wait until the settlement date. In that period, the buying party of the futures contract accepts the delivery of the holder, the party that sells a futures contract liquidates the position by delivering the holder at the agreed price.
Example of a financial futures contract.
Suppose that there is a futures contract on financial asset “ABC” between Entity “X” that buys it and Entity “Y” that sells it. Both parties agree on a delivery date of three months from now and a futures price of $ 100.
Contract analysis:
Elements of the contract:
Sustaining: the financial asset "ABC".
Future Price: $ 100
Set or Delivery Date: Three months from now.
On the established date, Entity “Y” will send asset ABC to Entity “X”.
Additional Information:
Suppose that after both investors took positions, one of the following occurred:
a) One month later, the price of the financial asset ABC increased by $ 120.
b) A month later the price of the financial asset ABC fell to $ 40.
In the case of the first subsection:
The buyer can make a profit of $ 20 ($ 120- $ 100), since he could sell the contract for $ 120 and exercise the purchase for $ 100.
The seller of the contract may have a loss of $ 20 ($ 100-120), since he has to deliver it at $ 100 and his market price is $ 120.
In the second subsection:
The seller can make a profit of $ 60 ($ 100- $ 40), since he could buy the contract for $ 40 and make the sale at $ 100.
The buyer can realize a loss of $ 60 ($ 40- $ 100), since he has the obligation to buy the contract for $ 100 when the market is worth $ 40.
Role of the clearing house in futures contracts
A clearinghouse is related to all futures brokerages, which performs various functions. One of these is ensuring that the parties to the transaction act. To see the importance of this function, consider the potential problems in the futures transaction described earlier, from the perspective of both parties.
Assume that on the stated date, the price of the financial asset ABC in the cash market is $ 70.
Company “Y” can sell asset ABC for $ 70 and deliver it to Company “X”, who in turn must pay it $ 100. However, if Company "X" is unable to pay $ 100 or refuses to pay, Entity "Y" loses the opportunity to realize a profit of $ 30 ($ 100- $ 70).
Suppose another case. The price of asset ABC in the cash market is $ 150 on the established date.
In this case, Company “X” is ready and willing to accept delivery of asset ABC and pay the agreed price of $ 100. If Entity “Y” cannot deliver or refuses to deliver asset ABC, Entity “X” has lost the opportunity to realize a profit of $ 50 ($ 150- $ 100).
The clearinghouse exists to address this problem. When someone takes a position in the futures market, the clearing house takes the opposite position and faces the problem of meeting the terms set out in the contract.
Due to the clearing house the parties need not worry about the integrity and financial strength of the party taking the opposite side of the contract.
After the initial execution of an order, the relationship between the two parties ends. The clearinghouse stands as the buyer for each sale and as the seller for each purchase. Therefore, the two parties are free to liquidate their positions without involving the other party in the original contract, and without concern that the other party may fail. In addition to its function of guarantee, the Clearing House facilitates for both parties to the futures contract, the development of their positions before the settlement date.
Margin requirements
When taking a position in a futures contract, the investor must deposit a minimum amount of money per contract, as specified by the brokerage house. This amount, called the initial margin, is required as a contract deposit. Individual brokerage corporations are free to set margin requirements above the minimum set by the brokerage house. The initial margin can be in the form of a security of other people's means (example a Treasury note). As the price of futures contracts fluctuates for each day traded, the value of the investor's shares in the position changes. The shares in a futures account is the sum of all margins placed and all daily profits, less all daily losses in the account.
At the end of each trading day, the brokerage firm determines the “settlement price” of the futures contracts.
The closing price is the price of the financial asset at the end of the trading day (wherever trading occurred during the day).
The brokerage house uses the liquidation price to mark the investor's position in the market, in such a way that any gain or loss from the position is quickly reflected in the investor's share account.
The maintenance margin is the minimum level (specified by the brokerage firm), at which the investor's share position may fall r as a result of an unfavorable price movement, before the investor is required to deposit a additional margin.
The additional margin deposited is called variation margin and is an amount necessary to bring shares into the account to bring it to its initial level. The variation margin must be in cash, rather than in foreign media instruments. Any excess margin in the amount can be withdrawn by the investor.
If a party to a futures contract that is required to deposit a variation margin fails, by doing so within a 24 hour period, the brokerage house closes the futures position.
Example of a market value adjustment procedure:
Assume the following margin requirements for asset ABC, described above:
Initial margin $ 7 per contract.
Maintenance margin $ 4 per contract.
Assume that Entity "X" buys 500 contracts at a futures price of $ 100, and that Entity "Y" sells the same number of contracts at the same future price.
The initial margin for both companies is $ 3,500 ($ 7X500 contracts), which must be deposited in cash, or in Treasury notes or other acceptable external means.
The maintenance margin for both positions is $ 2000 (4X500 contracts), so the shares in the account should not fall below $ 2000. If this happens, the party whose shares fall below the maintenance margin must pay an additional margin, which is called variation margin.
The variation margin must be paid in cash, and represents the amount to bring the shares into account at the initial margin and not at the maintenance margin.
Assume that at the end of several days, after the transaction is established, the following prices are observed:
| Days marketed. | Established price of the future contract. |
| one | $ 99 |
| two | $ 97 |
| 3 | $ 98 |
| 4 | $ 95 |
At the end of the first day:
Company "X" as buyer of the futures contract realizes a loss of $ 1 ($ 99- $ 100) per contract, resulting in a decrease in the stock position of $ 500 ($ 1X500 contracts). The initial margin is reduced to $ 3000 ($ 3500- $ 500), but the clearing house does not take any action because the shares in the account are above the maintenance margin of $ 2000.
Company “Y” as seller of the futures contract realizes a profit of $ 1 ($ 99- $ 100) per contract, resulting in an increase in the stock position of $ 500 ($ 1X500 contracts). The initial margin increases to $ 4000 ($ 3500 + $ 500). This gives you the right to take the profit of $ 500 and use those funds elsewhere. Suppose you do so whereby your initial margin remains at $ 3,500 at the end of the first trading day.
At the end of the second day:
Company "X" as buyer of the futures contract realizes a loss of $ 2 ($ 97- $ 99) per contract, resulting in a further decrease in the stock position of $ 1000 ($ 2X500 contracts). The initial margin is reduced to $ 2000 ($ 3000- $ 1000), but the clearing house does not take any action because the stocks in account are at the level of the maintenance margin which is $ 2000.
Company “Y” as seller of the futures contract realizes a profit of $ 1 ($ 97- $ 99) per contract, resulting in an increase in the stock position of $ 1000 ($ 2X500 contracts). The initial margin increases to $ 4,500 ($ 3,500 + $ 1,000).
This gives you the right to take the profit of $ 1000 and use those funds elsewhere. Suppose you do so whereby your initial margin remains at $ 3,500 at the end of the second trading day.
At the end of the third day:
Company “X” as buyer of the futures contract realizes a profit of $ 1 ($ 98- $ 97) per contract, resulting in a further decrease in the stock position of $ 500 ($ 1X500 contracts). The initial margin is increased to $ 2,500 ($ 2,000 + $ 500), so the clearing house does not take any action because the shares in account are over the maintenance margin of $ 2,000.
Company “Y” as seller of the futures contract realizes a loss of $ 1 ($ 97- $ 98) per contract, resulting in a decrease in the stock position of $ 500 ($ 1X500 contracts). The initial margin decreases to $ 3000 ($ 3500- $ 500). The clearinghouse does not take any action because the shares in the account are above the maintenance margin of $ 2000.
At the end of the fourth day:
Company “X” as buyer of the futures contract realizes a loss of $ 3 ($ 98- $ 95) per contract, resulting in a decrease in the stock position of $ 1500 ($ 3X500 contracts). The initial margin is reduced to $ 1000 ($ 2500- $ 1500), for which the clearing house forces it to put an additional or variation margin of $ 2500, to place the shares into account at the initial margin level.
Company “Y” as seller of the futures contract realizes a profit of $ 3 ($ 98- $ 95) per contract, resulting in an increase in the stock position of $ 1500 ($ 3X500 contracts). The initial margin increases to $ 4,500 ($ 3,000 + $ 1,500). This gives you the right to take the $ 1,500 profit and use those funds elsewhere. Suppose you do so whereby your initial margin remains at $ 3,500 at the end of the fourth trading day.
Option contracts
Previously, the first derivative instrument, a futures contract, was introduced. Now it corresponds to the second, an options contract and the differences between the two.
Parties involved in an options contract
The buyer.
The writer (also called the salesperson).
Options contract:
The writer grants the option buyer the right but not the obligation to buy or sell something from him on a specified date in a specified period.
The price at which the holder (that is, the asset or commodity) can be sold or bought is called the exercise price or the strike price.
The writer grants this right to the buyer in exchange for a certain amount of money, which is called the option price or the option premium.
The date after which an option is invalid is called the expiration date or expiration date.
Options types
Purchase option or a purchase
When an option gives the buyer the right to buy the holder from the writer (seller).
Put option or a sale
When the option buyer has the right to sell the holder to the writer.
American options
When the option can be exercised at any time and include the expiration date.
European options
When the option can be exercised only on the expiration date.
Example of an options contract
Suppose that Entity "X" buys a put option on financial asset "ABC" at a price of $ 3 with an expiration date of three months from now. The option can be purchased at any time throughout the period including the expiration date. Each unit of asset "ABC" is priced at $ 100.
Analysis of the financial operation
- It is a put option. The supporting asset is an “ABC” asset unit. The option price is $ 3. The exercised price is $ 100. The expiration date is three months from now, and how it can be exercised in any time during the period, including the expiration date, is an American option.
If it is not profitable for Entity "X" to exercise the option, it will not do so.
Whether Entity "X" exercises the option or not, the $ 3 he paid for the option will remain at the writer's option.
If Entity “X” buys a put option instead of a call option, then it will be able to sell Asset “ABC” to the option writer at a price of $ 100.
There are no margin requirements for the buyer of an option once the option price has been fully paid. Because the option price is the maximum amount the investor can lose, no matter how adverse the price movement of the holding asset is, no margin is needed.
Because the writer (seller) of an option has agreed to accept all risk (and no reward) of the holding asset position, the writer is generally required to put the received option price as margin. In addition to this, as the price change occurs in such a way that it affects the position of the writer, it is necessary for the writer to deposit an additional margin (with some exceptions) when the position is adjusted to market value.
Options like any other financial instrument can be traded in an organized brokerage house or on the counter market.
Advantages of options traded in brokerage houses.
The standardization of the price exercised, the amount of the holder, and the expiration date of the contract.
As in the case of futures contracts, the direct link between the buyer and the seller is broken after the order is executed, due to the interchangeability of the options traded on the brokerage house. The clearing house, associated with the brokerage house where option operations perform the same function in the options market, does the futures market.
Transaction costs are lower for options traded on brokerages than for options on the counter market.
Differences between options and futures contracts
One difference between futures and options contracts is that a party to an option contract is not required to trade at a later date. More specifically, the option buyer has the right but not the obligation to exercise the option. The writer of choice. (seller), has the obligation to perform, if the buyer of the option insists on exercising it. In the case of a futures contract, both the buyer and the seller are obligated to perform. Of course, a futures buyer does not pay the seller to accept the obligation, while an option buyer pays the seller an option price. Consequently, the risk / reward characteristics of the two contracts are also different. In the case of a futures contract, the buyer of the contract makes a dollar-for-dollar profit,when the price of the futures contract rises and you suffer a dollar-for-dollar loss when the price of the futures contract falls. The opposite is true for the seller of a futures contract.
Options do not provide this symmetric risk / reward ratio. The most an option buyer can lose is the option price. Although the buyer of an option retains all potential profits, the profit is always reduced by the amount of the option price. The maximum profit that the writer (seller) can make is the option price, this is offset by the substantially lower risk. This difference between options and futures is extremely important, because as we will see in the following chapters, investors can use futures to hedge against symmetric risk and options to hedge against asymmetric risk. We will return to the difference between options and futures later in this chapter,when we present the application of these derivative contracts for protection purposes.
Buying call options
Example.
Suppose that Entity "X" buys a call option on financial asset "ABC" at a price of $ 3 with an expiration date of three months from now. The option can be purchased at any time throughout the period including the expiration date. Each unit of asset “ABC” is priced at $ 100. What is the gain or loss for the investor who buys this call option and holds it until the expiration date?
On the expiration date the asset "ABC" can have the following prices: $ 97, $ 100, $ 101, $ 102, $ 103, $ 104, $ 113.
The profit and loss of the strategy will depend on the price of the ABC Asset at the expiration date. A number of outcomes are possible.
1. If the price of Asset ABC at the expiration date is less than $ 100, the investor will not exercise the option. It would be foolish to pay the option writer $ 100, when Asset ABC can be bought on the market at a lower price. In this case, the option buyer loses the right to the original option price of $ 3. However, note that this is the maximum loss that the option buyer will make regardless of how low the price of Asset ABC has fallen.
2. If the price of Asset ABC is equal to $ 100 at the expiration date, there is no economic value again in the exercise of the option. As in the case where the price is less than $ 100, the buyer of a call option will lose the total price of the option of $ 3.
3. If the price of Asset ABC is greater than $ 100, but less than $ 103 at the expiration date, the option buyer will exercise the option. By exercising it, the option buyer can buy Asset ABC for $ 100 (the strike price) and sell it on the market at a higher price. Suppose for example that the price of Asset ABC is $ 102 at the expiration date, the buyer of the call option will make a profit of $ 2 when exercising the option. Of course, the cost of buying the call option was $ 3 therefore a $ 1 is lost on this position. By failing to exercise the option, the investor loses $ 3 instead of just $ 1.
4. If the price of Asset ABC is equal to $ 103 at the expiration date, the investor will exercise the option. In this case, the investor has no profit or loss, making a profit of $ 3 that cancels the cost of the $ 3 option. If the price of Asset ABC is greater than $ 103 at the expiration date, the investor will exercise the option and realize a profit. For example, if the price is $ 113, exercising the option will generate a gain on Asset ABC of $ 13. By reducing this option cost gain ($ 3), the investor will realize a net gain of $ 10 on this position.
The profit and loss profile of the short call position (the position of the writer of the call option) is the spitting image of the profit and loss profile of the long call position (the position of the buyer of the call option). purchase). Consequently, the gain on the short buy position for any given price of Asset ABC at the expiration date is the same as the loss on the long buy position. In addition to this, the maximum profit that the short buy position can produce is the option price. The maximum loss is not limited, because it is the highest price reached by an ABC Asset on or before the expiration date, minus the option price, which can be indefinitely high.
Selling a call option
This option is exercised by the seller of a call option.
Example.
With the same conditions of the previous year.
What is the gain or loss to the investor who sells this call option, at the expiration date?
Purchase of put options.
Example.
Suppose that Entity "X" buys a put option on financial asset "ABC" at a price of $ 2 with an expiration date of one month from now. The option can be purchased at any time throughout the period including the expiration date. Each unit of asset "ABC" is priced at $ 100.
What is the gain or loss for the investor who buys this put option and holds it until the expiration date?
On the expiration date the asset "ABC" can have the following prices: $ 97, $ 100, $ 101, $ 102, $ 103, $ 104, $ 113.
Sale of put options.
This option is exercised by the seller of a put option.
Example.
With the same conditions of the previous year.
What is the gain or loss for the investor who sells this put option, at the expiration date?
Summary of option positions
There are four basic option positions: buying a call option, selling a call option, buying a put option, and selling a put option.
An option can be used to alter the risk / reward ratio of the holder's position.
The buyer of a call option benefits if the price of the holder rises, the writer (seller) of a call option benefits if the price of the holder is unchangeable or falls.
The buyer of a put option benefits if the price of the holder falls, the writer (seller) of a put option benefits if the price of the holder is unchangeable or rises.
T he economic role of options markets
Futures contracts allow investors to protect themselves from the risks associated with adverse price movements. Hedging with futures allows a market participant to close on a price, and therefore eliminates price risk. However, in the process the investor gives up the opportunity to benefit from a favorable price movement. In other words, hedging futures involves canceling the benefits of a favorable price movement, for protection against an adverse price movement.
A good way to show the use of option protection is to return to the initial illustration, where the holder of the option is Asset “ABC”.
Consider first an investor of Asset "ABC" described above which is expected to sell within a month for $ 100. The concern of the same is that during that period the price may drop to less than $ 100. An available alternative is to sell it now for $ 100, but you don't want to, because there are restrictions that prohibit this or because you think the price may rise. Suppose also that an insurance company offers to sell an insurance policy to the investor promising that, if at the end of the month the price of Asset “ABC” is less than $ 100, the insurance company will pay the difference between the $ 100 and the market price.
The insurance company naturally charges the investor a premium for writing this policy, suppose the premium is $ 2. Putting aside the cost of the insurance policy, the payment that that investor faces is then as follows:
The minimum price of Asset “ABC” that the investor can receive is $ 100, because if it is less, the insurance company will pay the difference.
If the price of Asset “ABC” is higher than $ 100, the investor will receive the higher price. The $ 2 premium that is required to buy this insurance policy effectively insures the investor at a minimum price of $ 98 ($ 100 - $ 2), although if the price behaves above $ 100, the investor will enjoy the benefits of a higher price (always reduced by the $ 2 of the insurance policy).
In purchasing this policy, the investor has purchased protection against adverse price movement, while thus maintaining the opportunity to benefit from a favorable price movement.
Insurance companies do not offer such policies, but an option strategy has been described that provides the same protection.
Consider the “ABC” Asset put option with a one-month expiration, a strike price of $ 100, and an option price of $ 2 that was presented earlier in this section. The payment of a long position in this sale is identical to the insurance policy. The option price is similar to the hypothetical insurance premium, this is the reason why, the option price is mentioned as the option premium.
Therefore, a put option can be used to hedge against a decline in the price of the supporting instrument.
The payment of the long sale is very different than that of a futures contract Suppose that a futures contract of Asset “ABC” as the supporting instrument, has a futures price equal to $ 100 and a settlement date of one month at from now on. By selling this futures contract, the investor would be agreeing to sell Asset "ABC" at $ 100 a month from now. If the price of Asset "ABC" falls below $ 100, the investor is protected, because he will receive $ 100 upon delivery of the asset to satisfy the futures contract. If the price of Asset “ABC” rises above $ 100, however, the investor will not realize the price appreciation, because he must deliver the asset for an agreed amount of $ 100. By selling the futures contract, the investor has closed at a price of $ 100,and you fail to make a profit if the price rises, even if you avoid a loss if the price falls.
Purchase options are also useful as protection. A call option can be used to protect against a rise in the price of the supporting instrument, while maintaining the opportunity to benefit from a fall in the price of the instrument. Suppose an investor expects to receive $ 100 in a month from now, and plans to use that money to buy Asset “ABC”, which is currently sold for $ 100. The risk that the investor faces is that Asset “ABC” will rise above $ 100 in a month from now. Suppose even further, that there is a call option as described above: the option costs $ 3 and has a strike price of $ 100 and one month to expire. By purchasing this call option, the investor has protected himself from the risk of an increase in the price of Asset “ABC”.
The result of the protection is as follows. If the price rises above $ 100, a month from now, the investor will exercise the purchase option and realize the difference between the market price of Asset “ABC” and the $ 100. Therefore, if the cost of the option is abstracted for a moment, it can be seen that the investor is ensuring that the maximum price that he will have to pay for Asset “ABC” is $ 100. If the price falls below $ 100, the put option expires worthless, but the investor benefits from being able to buy Asset “ABC” at a price less than $ 100. Once the cost of the $ 3 option is considered, the payment is as follows. The estimation of the eventual price of the asset, the maximum price that the investor will have to pay for the Asset “ABC”,it is $ 103 (the strike price plus the option price). If the price of the asset falls below $ 100, the investor will benefit when the amount of the price falls below $ 3.
Compare this situation with that of a futures contract where Asset “ABC” is the supporting instrument, the settlement is in one month and the futures price is $ 100. Suppose the investor buys this futures contract. If in a month from now, the price of Asset “ABC” rises to more than $ 100, the investor has contracted to buy the asset for $ 100, therefore eliminating the risk of price increases, if the price falls below of $ 100. However, the investor cannot benefit because she has contracted to pay $ 100 for the asset.
It should be clear now how option protection differs from futures protection. This difference cannot be too pronounced, options and futures are not interchangeable instruments.
Although this focus has been on protecting price risk, options also allow investors an efficient way to expand the range of available performance characteristics, as they can use options to 'model' a performance distribution of a company. portfolio, to adapt particular investment objectives.
Swap markets
Interest rate swaps
It is an agreement where two parties agree to exchange periodic interest payments.
Characteristics of interest rate swaps
Interest payments are based on a predetermined principal, called the notional principal.
Only the interest payments are exchanged, not the notional principal.
One party agrees to pay the other party fixed interest payments on set dates in the life of the contract. It is known as a fixed rate payer.
The other party agrees to make interest rate payments that vary according to a benchmark rate. It is known as a floating rate payer.
Example:
Suppose that for the next five years, party X agrees to pay party Y 10% per year, while party Y agrees to pay party X six-month LIBOR, on the notional principal amount of $ 50 million. If the payments are exchanged every six months for the next five years, how much is the value of interest that both parties will pay and receive?
If interest rates rise to 11%, the price of the commodity (six-month LIBOR) will be higher, resulting in a gain for the fixed-rate payer, who is extending a six-month advance contract on LIBOR also at six months.
The floating rate payer is cutting a six-month advance contract on LIBOR to six months as well. Accordingly, each planned change over the life of a swap constitutes an anticipated contract, which is settled on the change date.
| Risk / return profile of the counterparties of an interest rate swap. | ||
| Concepts. | Decrease in interest rates. | Increase in interest rates |
| Floating rate payer. | Gain | Lost |
| Fixed rate payer. | Lost | Gain |
Application of swaps to asset / liability management.
Suppose a bank has a portfolio of five-year fixed-rate loans. The principal value of the portfolio is $ 50 million and the interest rate on all loans in the portfolio is 10%. The interest is paid every six months and the principal is paid at the end of the five years.
To fund your loan portfolio, suppose the bank has the issuance of six-month certificates of deposit. The interest rate that the bank plans to pay on its six-month certificates of deposit is the six-month Treasury note rate plus 40 basis points. What if the rate on the six-month Treasury notes is 9.6% per year or higher?
The cash flow in this negotiation can be represented in the following table:
Secondary market for swaps
There are three general types of secondary market swap transactions that include: 1) a swap reversal, 2) a swap sale (or assignment), and 3) a full swap payment (closing or cancellation).
In a swap reversal, the party that wants to exit the trade will arrange an additional swap in which 1) the maturity of the new swap is equal to the remaining time of the original swap, 2) the reference rate is the same and 3) the amount notional principal is the same.
Selling the swap or assigning the swap solves this difficulty. In this secondary market transaction, the party that wishes to close the original swap finds the other party willing to accept its obligations under the swap.
To achieve a swap sale, the original counterparty must agree to the sale, The full payment or closing (or cancellation) sale involves the swap sale to the original counterparty. As in the case of the swap sale, one party could have been offset by the other, depending on how interest rates and credit spreads have changed since the swap began.
These exit or entry methods leave much to be desired for market participants. It is this illiquidity in the secondary market that will impede the growth of the swap market. There have been proposals to create a swap offsetting corporation similar to futures and options offsetting, in which case the swaps would be adjusted to market value and the credit exposure of a swap could be reduced. However, these proposals have not been implemented.
Earlier, basic swaps were described as generic interest rate swaps. Non-generic or individualized swaps have been developed as a result of the asset / liability needs of borrowers and lenders.
In a generic swap, the notional principal amount does not change over the life of the swap. In contrast, due to the amortization, accretion and free renewal of swaps, the notional amount varies over the life of the swap.
An amortized swap is one where the notional principal amount falls by default over the life of the swap.
A growing bond is where the notional principal amount increases in a predetermined way over time.
In a free rollover swap the notional Principal amount may rise or fall from one period to another.
The terms of a typical interest rate swap ask the brokerage house for fixed and floating rate payments. In a base rate swap, both parties exchange floating rate payments based on a different money market benchmark rate.
Identify and explain the main characteristics of an option contract.
What is the difference between a put option and a call option?
What is the difference between an American option and a European option?
Why does a writer of an option need to place a margin?
Identify two important ways in which an option traded on a brokerage house differs from a typical over-the-counter option.
What are the main ways that an option differs from a futures contract?
Why are options and futures labeled "derivative values"?
Explain why this statement may be true: "A long buy position offers potentially unlimited profit if the price of the supporting asset rises, but a fixed maximum loss if the price of the supporting asset falls to zero."
Suppose that a call option on a stock has a strike price of $ 70 and a cost of $ 2, and suppose you can buy the call. Identify the return on your investment at purchase maturity for each of these supporting stock values: $ 25, $ 70, $ 100, and $ 400.
Consider once again the situation in question 8. Suppose you have sold the call option. What would your profit be at the expiration date for each of the stock prices?
Explain why you agree or disagree with this statement: “Buying a sale is just like shorting the supporting asset. You earn the same from either position if the price of the supporting asset falls. If the price goes down, you have the same losses.
Consider a swap with these characteristics: five-year maturity, notional principal is $ 100 million, payments occur every six months, the fixed-rate payer pays at a rate of 9.05% and receives LIBOR, while the payer floating rate pays LIBOR and receives 9%. Suppose that on a payment date LIBOR is at 6.5%. What is the payment of each part and the income on this date?
A bank borrows funds by issuing certificates of deposits that carry a variable rate equal to the yield on the six-month treasury note plus 50 basis points. The bank gets the opportunity to invest in a seven-year loan that will pay a fixed rate of 7%. Therefore, the bank wants to commit to a designated interest rate swap to close at an interest margin of 75 basis points. From the results of the two possible swaps: one designated to change the cash flow of the asset within a variable rate, and the other designated to change the cash flow of the liability within a fixed rate.
Suppose an agent trades these terms in a five-year swap: the fixed-rate payer pays 9.5% for fixed LIBOR and the floating-rate payer pays fixed LIBOR for 9.2%.
a) What is the agent's bid - ask margin?
b) How the agent would price the terms of reference for the yield on five-year Treasury notes assuming that this yield is 9%.
Bibliography
Suárez SA "Optimal investment and financing decisions in the company", 15th. Ed., Editorial Pirámide, SA, Madrid, 1993.
Fabozzi FJ, F. Modigliani, M G. Ferri. “Markets and Financial Institutions”, Prentice Hall, 1996.
Various INTERNET articles dealing with derivative instruments.
