HullRMFI2ndEdCh05

8/4/2019 HullRMFI2ndEdCh05

1/31

Financial Instruments

Chapter 5

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 1


2/31

Financial Markets (pages 83-84)

Exchange traded Traditionally exchanges have used the open-outcry system,

but increasingly they are switching to electronic trading

Contracts are standard; there is virtually no credit risk

Over-the-counter (OTC) A computer- and telephone-linked network of dealers at

financial institutions, corporations, and fund managers Contracts can be non-standard; there is some small amount

ofcredit risk



3/31

Short Selling (Pages 85-86)

Short selling involves sellingsecurities you do not own

Your broker borrows the securitiesfrom anotherclient and sells themin the market in the usual way

At some stage you must buy thesecurities back so they can bereplaced in the account of the client



4/31

Short Selling (continued)

You must pay dividends and other benefitsthe owner of the securities receives

The cash flows from a short position that is

entered into at time T1 and closed out attime T2 are the opposite of those from a longposition where asset is bought at time T1and sold at time T2,except that there may be

a small fee for borrowing the asset



5/31

Derivatives

Forwards

Futures

Swaps Options

Exotics



6/31

GrowthofDerivatives Markets(Figure 5.1)


0

100

200

300

400

500

600

700

Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08

Size of

Market($ trillion)

OTC

Exchange


7/31

Forward Contracts

A forward contract is an agreement to buyor sell an asset at a certain price at a

certain future time Forward contracts trade in the over-the-counter market

They are particularly popular on currenciesand interest rates



8/31

Foreign Exchange Quotes for GBP

August 27, 2008 (See page 87)


Bid Offer

Spot 1.8356 1.8360

1-month forward 1.8314 1.8319

3-month forward

1.82

37 1.82

42

6-month forward 1.8127 1.8133


9/31

Profit from a Long Forward Position


Profit

Price of Underlying

at Maturity, STK


10/31

Profit from a Short Forward Position


Profit

Price of Underlying

at Maturity, STK


11/31

Futures Contracts (pages 89-91)

Agreement to buy or sell an asset for acertain price at a certain time

Similar to forward contract Whereas a forward contract is traded

OTC, a futures contract is traded on an

exchange



12/31

Futures Contract continued

Contracts are settled daily (e.g., if acontract is on 200 ounces of Decembergold and the December futures moves $2in my favor, I receive $400; if it moves $2

against me I pay $400) Both sides to a futures contract are

required to post margin (cash ormarketable securities) with the exchangeclearinghouse. This ensures that they willhonor theircommitments under thecontract.



13/31

Swaps

A swap is an agreement toexchange cash flows at specifiedfuture times according to certainspecified rules



14/31

An Exampleof

a Plain VanillaInterest Rate Swap

An agreement to receive 6-month

LIBOR & pay a fixed rate of 5% perannum every 6 months for3 years ona notional principal of $100 million

Next slide illustrates cash flows



15/31

Cash Flows for one set ofLIBOR rates(See Table 5.4, page 93)


---------Millions of Dollars---------

LIBOR FLOATING FIXED Net

Date Rate Cash FlowCash FlowCash Flow

Mar.5, 2010 4.2%

Sept. 5, 2010 4.8% +2.10 2.50 0.40

Mar.5, 2011 5.3% +2.40 2.50 0.10

Sept. 5, 2011 5.5% +2.65 2.50 +0.15Mar.5, 2012 5.6% +2.75 2.50 +0.25

Sept. 5, 2012 5.9% +2.80 2.50 +0.30

Mar.5, 2013 6.4% +2.95 2.50 +0.45


16/31

Typical Uses ofan

Interest Rate Swap

Converting a liability from

fix

ed rate to floating rate floating rate to fixed rate

Converting an investment from

fixed rate to floating rate

floating rate to fixed rate



17/31

Quotes By a Swap Market Maker(Table 5.5, page 94)

Maturity Bid (%) Offer (%) Swap Rate (%)

2 years 6.03 6.06 6.045

3 years 6.21 6.24 6.225

4 years 6.35 6.39 6.370

5 years 6.47 6.51 6.490

7 years 6.65 6.68 6.665

10 years 6.83 6.87 6.850



18/31


19/31


20/31

American vs European Options

An American option can be exercised atany time during its life

A European option can be exercised onlyat maturity



21/31

IntelOption Prices: Apr. 27, 2008;

Stock Price=23.45 (See Table 5.6; page 95)

S

trikePriceS

ept0

8Call Oc

t0

8Call

J

an0

9CallS

ept0

8Put Oc

t0

8PutJ

an0

9Put

22 1.65 2.10 n.a. 0.21 0.63 n.a.

23 0.90 1.44 n.a. 0.47 0.97 n.a.

24 0.39 0.92 1.69 0.96 1.45 2.21

25 0.12 0.54 1.27 1.68 2.06 2.78



22/31

Options vs Futures/Forwards

A futures/forward contract gives the holderthe obligation to buy or sell at a certain

priceAn option gives the holder the right to buy

or sell at a certain price



23/31

Hedging ExamplesA UScompany will pay 10 million for

imports from Britain in 3 months and

decides to hedge using a long positionin a forward contract

An investor owns 1,000 Microsoftshares currently worth $28 per share. A

two-month put with a strike price of$27.50costs $1. The investor decidesto hedge by buying 10contracts



24/31

Options vs Forwards

Forward contracts lock in a price for afuture transaction

Options provide insurance. They limit thedownside risk while not giving up theupside potential

For this reason options are more attra

ctiveto many corporate treasurers than forward

contracts



25/31

Interest Rate Options

Caps and floors

Swap options

Bond options



26/31

Margins (pages 97-101)

Buying on margin

Short sales

Futures Options

OTC market

Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 200926


27/31

Nontraditional Derivatives (pages101-104)

Weather derivatives

Energy derivatives Oil

Natural gas

Electricity



28/31

ExoticOptions (pages 104-105)

Asian options

Barrier option

Basket options Binary options

Compound options

Lookback options


28


29/31

Example of the Use ofExotic

Options (Business Snapshot 5.3, page 105)

If a company earns revenue month by

month in many different currencies Asianbasket put options can provide anappropriate hedge


29


30/31

Structured Products

Products created to meet the needs ofclients

A bizarre structures product is the 10/30

deal between Bankers Trust and Procterand Gamble (See Business Snapshot 5.4)

The payments by P&G were


30

100

priceTSYyr5.78%

%CMTyr5 305.98

,0max


31/31

Types ofTraders

Hedgers

Speculators

Arbitrageurs

Some of the largest trading losses inderivatives have occurred becauseindividuals who had a mandate to be

hedgers or arbitrageurs switched to beingspeculators (See for example BaringsBank, Business Snapshot 5.5, page 107)


31

HullRMFI2ndEdCh05

Documents