Managing Risks With Derivative Securities

Financial Markets & InstitutionsChapter - 23

Introduction

Aim

* To accustom the students with theory and terms related to Hedging, Contracts, Option, Swap and Methods of Hedging

Members

• Major Fawad Hussain• Rizwan Shaukat• Hafiz Mazhar• Ali Zeb• Jam Waqas

Sequence

• Introduction : Fawad• Contracts : Fawad• Options : Rizwan• Risks Associated With Future, Forward

& Options : Waqas• Swaps : Alizeb• Comparison of Hedging Methods : Mazhar

HEDGES & CONTRACTS

Fawad

Part – 1 Contracts

• Spot Contract . An agreement between buyer and seller for immediate exchange of assets and funds.

• Forward Contract . An agreement to transact involving future exchange of a set amount of assets at a set price.

• Futures Contracts . An agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily .

Part – 1 Contracts

• Market to Market . Describes the prices on outstanding future contracts that are adjusted each day to reflect current futures market condition.

HEDGE

HEDGE

• A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization.

• A hedge can be constructed from many types of financial instruments, including stock, exchange traded funds, insurance, forward contracts, swaps, options, many types of over the counter and derivative products and future contracts.

HEDGING WITH FORWARD CONTRACTS

• Off – Balance – Sheet. A form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants.

• An alert FI portfolio manager expecting to incur a capital loss on its bond can offset it and reduce the risk of loss to zero by hedging an off balance sheet hedge to a potential buyer with a forward time of delivery in future .

HEDGING WITH FORWARD CONTRACTS

• Immunize . To fully hedge or protect an FI against adverse moments in interest rates ( or asset prices).

HEDGING WITH FUTURE CONTRACTS

• Future Contracts. are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price. The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this is often impossible and, therefore, individuals attempt to neutralize risk as much as possible instead. For example, if a commodity to be hedged is not available as a futures contract, an investor will buy a futures contract in something that closely follows the movements of that commodity.

HEDGING WITH FUTURE CONTRACTS

• There are two types of Hedging with future contacts :-– Micro hedging . An investment technique used to

eliminate the risk of a single asset. In most cases, this means taking an offsetting position in that single asset.It is basically using future contract to hedge a specific asset or liability

HEDGING WITH FUTURE CONTRACTS

• Macro Hedging . Hedging the entire duration gap of an FI, it occurs when a FI manager uses future or other derivative securities to hedge the entire balance sheet duration gap.

• Example of a macro-hedge: an index-fund manager believes there will be a loss in the index in the upcoming period. To eliminate the risk of a downward turn in the index, the manager can take a short position in the index fund's futures market that will lock in a price for the index.

Macro vs. Micro Hedging Most FIs hedge risk either at the micro level (called micro-hedging) or at the macro level (called macro-hedging) using futures contracts An FI is Micro-hedging when it employs a derivative contract to hedge a particular asset or liability risk (single asset or maybe a portfolio of similar assets such as a mortgage portfolio) Macro-hedging occurs when an FI manager wishes to use derivative securities to hedge the entire balance sheet duration gap Micro-hedging In micro-hedging, the FI often tries to pick a futures or forward contract whose underlying deliverable asset is closely matchedto the asset (or liability) position being hedged. If I'm trying to hedge mortgages I would pick something similar like a 10 year futures contract or government security. Both driven by the same underlying macro-economics. Probably focused on one type of derivative. Macro-hedging A macro-hedge takes a whole portfolio (the whole financial institution) view and allows for individual asset and liability interest sensitivities or durations to net each other out. It may be the case that a mix of securities best matches for hedging. Could be many types of derivatives

OPTIONS

Rizwan

OPTIONS

• An option is a contract which gives the owner the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller incurs a corresponding obligation to fulfill the transaction, that is to sell or buy, if the long holder elects to "exercise" the option prior to expiration. The buyer pays a premium to the seller for this right. An option which conveys the right to buy something at a specific price is called a call; an option which conveys the right to sell something at a specific price is called a put.

Basic Features of Options

• Buying a Call Option on Bond . – As interest rate falls , bond prices rises, and potential for a

higher payoff for the buyer.– As interest rates rises , bond prices fall and potential for

negative payoff for the buyer of the option increases.– If rate rises and prices fall below the exercise price (EP),

the call buyer is obliged to exercise the option , Thus the buyer losses are truncated by the amount of up front premium payment (call premium CP)

– Buying a call option is a strategy to take when interested rates are expected to fall.

Basic Features of Options

• Writing a Call Option on a Bond . – The writing a call option is a strategy to take when

interest rates are expected to rise. – Caution is warranted because profits are limited

and losses are unlimited. The results in writing of a call option being unacceptable as a strategy to use when hedging interest rate risk.

Basic Features of Options

• Buying a Put Option on Bond . – When interest rate rise and bond prices fall, the

probability that the buyer of the put will make profit from the option increases, Thus if bond prices fall the buyer of the put option can purchase bonds in the bond market at that price and put them back to the writer of put at the higher exercise price, it gives buyer unlimited profit potential

– When interest rates fall and bond prices rise, the probability that buyer of a put will lose increses.

Basic Features of Options

• Writing a Put Option on a Bond . – When interest rate falls and bond prices increase, the

writer has a enhanced probability of making profit. The put buyer is less likely to exercise this option, which would force the option writer to buy the underlying bonds

– When interest rates increase and bond prices fall, the writer of the put is exposed to potential huge losses. The put buyer will exercise the option forcing the writer to buy the underlying bonds at the exercise price .

Basic Features of Options

• Hedging with Options . • Hedging Stocks Using Stock Options•

Hedging a portfolio of stocks is easy and convenient using stock options. Here are some popular methods:

Protective Puts : Hedging against a drop in the underlying stock using put options. If the stock drops, the gain in the put options offsets the loss in the stock.

Covered Calls : Hedging against a small drop in the underlying stock by selling call options. The premium received from the sale of call options serves to buffer against a corresponding drop in the underlying stock.

Covered Call Collar : Hedging against a big drop in the underlying stock using put options while simultaneously increasing profitability to upside through the sale of call options.

Caps , Floors & Collars

• An interest rate Cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.

• An interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.

• A collar is an operation strategy that limits the range of possible positive or negative returns on an underlying to a specific range.

RISKS ASSOCIATED WITH FUTURE FORWARD & OPTIONS

Waqas

Risks Associated with Future Forward & Options

• Contingent Credit Risk . When FIs expand their positions in forward , future and option contracts. The risk relates to the fact that the counterparty to one of these contracts may default on payment obligation, leaving FI unhedged and having to replace the contract at present day interest or price. It is more serious risk for forward contracts.

Risks Associated with Future Forward & Options

• Option contracts can also be traded by an FI over the counter (OTC),If the options are standardized options traded on exchanges , such as bond options, they are virtually default risk free. If they are specialized options purchased OTC such as interest rate caps, some elements of default risk exists

SWAPS

Alizeb

SWAP

• Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps.

• Other types of swaps are credit risk swaps, commodity swaps and equity swaps.

Interest Rate Swap

• An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.

Currency Swap• A swap that involves the exchange of principal and interest in one currency

for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet.

• For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange.

•

Fixed –for-Fixed Currency Swap

• An arrangement between two parties (known as counterparties) in which both parties pay a fixed interest rate that they could not otherwise obtain outside of a swap arrangement.

Credit Risk

• The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

COMPARISON OF HEDGING METHODS

Mazhar

Writing versus Buying Options

• Many FIs prefer to buy rather than write options, one of the two reasons for this , one is economic and other is regulatory.

• Writing options truncates upside profit potential while downside loss potential is unlimited

• Buying option truncates downside loss potential while upside profit potential is unlimited

• Commercial banks are prohibited by regulators from writing options in certain areas of risk management specially naked options

Naked Option

• Option which donot identifiably hedge an underlying asset or liability position, to be risky because of their unlimited loss potential. Naked trading is considered very risky since losses can be significant.

Future versus Options Hedging

• Future hedging produces symmetric gains and losses when interest rates move against the on-balance-sheet securities, as well as when interest rates move in favor of on-balance-sheet securities .

• Options hedging protects the FI against value losses when interest rate move against the on-balance-sheet securities, but unlike with future hedging , does not fully reduce value gains when interest rates move in favor of on-balance-sheet securities.

Swaps versus Forwards, Futures and Options

• Futures and most options are standardized contracts with fixed principle amounts. Swaps (and Forwards) are OTC contracts negotiated directly by the counterparties to the contract.

• Futures contracts are marked to market daily, Swaps and Forwards require payments only at times specified in the swap or forward agreement.

• Swaps can be written for relatively long time horizons, Futures and option contracts do not trade for more than 2 to 3 years into future and active trading in the contracts generally extends to contracts with a maturity of less than 1 year.

• Swaps and forward contracts are subject to default risk, Most future and option contracts are not subject to default risk.

CONCLUSION

Fawad

QUESTIONS

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