options futures and other derivatives

Options, Futures and Other Derivatives

Dr. Sergio S. CaoPresident and Chief Academic OfficerManila Tytana Colleges

September 29, 2015

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Operational Risk: A Guide to Base IIA. Chernobai, S. Racher & F. FabozziJohn Wiley, 2007, page 27

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FINANCIAL DERIVATIVESA 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

“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.”

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Warren Buffet, 2002

WEAPONS OF MASS DESTRUCTION

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

Declaration of the G-20 Root Causes of the Current Crisis

November 15, 2008

7Newsweek, September 29, 2008

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Key Words Subprime borrowers Securitization

Collateralized Debt Obligations (CDO) Mortgage-Backed Securities (MBS)

Credit Default Swaps (CDS)

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What are Subprime Mortgages? Subprime mortgages are housing

loans of banks and mortgage finance companies to borrowers with marginal credit standing

“NINJA” borrowers

Recall: What are the C’s of credit?

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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 securities (MBS)

12Measuring and Managing Credit Risk (MMCR), A. de Servigny & O. RenaultMcGraw Hill, 2004, page 15

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

“Metrobank, the country’s 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 was current.”

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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)

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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 based on its original spot exchange rate of P26.38

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Interest Rate Swap: Liability Management

A B5% fixed

6-m LIBOR

Suppose that Party A has arranged to borrow$100 million at 6-month LIBOR + 0.1%

6-m LIBOR + 0.1%

PLDT

Japanese Term Loan

Facility

Existing US$ Loan

Swap Dealer

$ interest payments (fixed)

¥ interest payments (floating)

$ interest payments (fixed)

¥ floating rate loan

¥ interest payments

Yen loan proceeds to pay

off US$ loan

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PLDT Annual Report 2000

Currency Swap

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Credit Default SwapsA 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

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Table 1 - Number of quotes by type of CDS

Type

Number of quotes

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

Total 1,361 6,890 27,916 37,525 84,058 137,653 105,276

% 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

Total - 406.2 305.2 34.4 124.0 63.8 52.9

1First half; change over first half of 2002.

Source: CreditTrade

http://www.cnbc.com/id/3845175020

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.

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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 at maturity

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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 preferred shares . . .

[1] PLDT Annual Report 2000

Case Study

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Series V Series VI Series VIIPar value P10 per share

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

US$0.397 annual fixed cumulative cash dividend, payable quarterly in arrears.

JPY 40.7189 annual fixed cumulative cash dividend, payable quarterly in arrears

Anniversary Date

7th Year from issue date 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

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METROPOLITAN BANK AND TRUST COMPANYTYPE 2 – LIMITED DEALER AUTHORITY

www.bsp.gov.ph/banking/derivatives

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METROPOLITAN BANK AND TRUST COMPANYTYPE 2 – LIMITED DEALER AUTHORITY

www.bsp.gov.ph/banking/derivatives

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METROPOLITAN BANK AND TRUST COMPANYTYPE 2 – LIMITED DEALER AUTHORITY

www.bsp.gov.ph/banking/derivatives

Thank you.