Chapter 13

FinancialDerivatives

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Hedging
ForwardandFuturecontracts
Options
Interestrateswap

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Hedging
Hedge:engageinafinancialtransactionthat
reducesoreliminatesrisk
Basichedgingprinciple:
Hedgingriskinvolvesengaginginafinancial
transactionthatoffsetsalongpositionbytakingashort
position,oroffsetsashortpositionbytakinga
additionallongposition

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Spot, Forward, and Futures

Contracts
A spot contract is an agreement (at time 0) when the seller
agrees to deliver an asset and the buyer agrees to pay for the
asset immediately (now)
A forward contract is an agreement (at time 0) between a
buyer and a seller that an asset will be exchanged for cash at
some later date at a price agreed upon now
A futures contract is similar to a forward contract and is
normally arranged through an organized exchange (i.e., ME,
CBT)
The main difference between a futures and a forward contract
is that the price of a forward contract is fixed over the life of
the contract, whereas futures contracts are marked-to-market
daily.
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Interest-Rate Forward Markets

Longposition=agreetobuysecuritiesatfuturedate
Hedgesbylockinginfutureinterestrateiffundscomingin
future
Shortposition=agreetosellsecuritiesatfuturedate
Hedgesbyreducingpriceriskfromchangeininterestratesif
holdingbonds
Pros
1. Flexible(canbeusedtohedgecompletelytheinterestrate
risk)
Cons
1. Lackofliquidity:hardtofindacounterpartytomakea
contractwith
2. Subjecttodefaultrisk:requiresinformationtoscreengood
frombadrisk
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Example
FNBtosell$5millionfacevalueof6sof2023
Treasurybondatparoneyearfromnow.
Useofforwardcontracts:lockprofitfromholding
bond
Counterparty:tolockpriceforfutureinvestment

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Financial Futures Markets

Financialfuturesareclassifiedas
Interestratefutures
Stockindexfutures,and
Currencyfutures
FinancialfuturesaretradedintheExchange
(seeTable1)

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Application
Hedgingwithfinancialfuturesp.338

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Profits and Losses: Options vs. Futures

$100,000Canadabondcontract,
1.Exercisepriceof115,
$115,000.
2.Premium=$2,000

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Payoff Function from Buying an

Interest Rate Futures (see Fig. 13-1)
ConsidertheJuneCanadabondfuturescontracttradedonthe
ME.Ifyoubuythiscontractfor115,youagreetopay$115,000
for$100,000facevalueoflongtermCanadawhentheyare
deliveredtoyouattheendofJune.Ifattheexpirationdatethe
underlyingCanadabondforthefuturescontracthasapriceof
110,meaningthatthepriceofthefuturescontractalsofallsto110,you
sufferalossof5points,or$5,000(pointA')
115,youwouldhaveazeroprofit(pointB')
120,youwouldhaveaprofitonthecontractof5points,or$5,000
(pointC')
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Payoff Function from Selling an

Interest Rate Futures (see Fig. 13-1)
Ifyousellthiscontractfor115,youagreetodeliver$100,000
facevalueoflongtermCanadabondsfor$115,000attheend
ofJune.IfattheexpirationdatetheunderlyingCanadabondfor
thefuturescontracthasapriceof
110,meaningthatthepriceofthefuturescontractalsofallsto
110,yougain5points,or$5,000(pointA')
115,youwouldhaveazeroprofit(pointB')
120,youwouldhavealossonthecontractof5points,or
$5,000(pointC')
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Option - Buying and Writing Calls

A call option is an option that gives the owner the right (but not
the obligation) to buy an asset at a pre specified exercise (or
striking) price within a specified period of time.
Since a call represents an option to buy, the purchase of a call
is undertaken if the price of the underlying asset is expected to
go up.
The buyer of a call is said to be long in a call and the writer is
said to be short in a call.
The buyer of a call will have to pay a premium (called call
premium) in order to get the writer to sign the contract and
assume the risk.
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Option terms p.344

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Figure 13-1.
Interest Rate Futures Options

AnoptioncontractontheME'sJuneCanadabondfutures
contracthasthefollowingkeyfeatures:
ithasthesameexpirationdateastheunderlyingfutures
contract
itisanAmericanoptionandsocanbeexercisedatanytime
beforetheexpirationdate,and
thepremiumoftheoptionisquotedinpointsthatarethesame
asinthefuturescontract,soeachpointcorrespondsto$1,000.
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How Interest Rate Futures Options

Work (see Fig. 13-1)

Supposethattodayyoubuy,fora$2,000premium,aEuropean
callonthe$100,000JuneCanadabondfuturescontractwitha
strikepriceof115.Ifattheexpirationdatetheunderlying
Canadabondforthefuturescontracthasapriceof
110,thefuturescallwillbeoutofthemoney,sinceS<X.Itwill
expireworthlessforalossof$2,000(pointA)
115,thefuturescallwillbeatthemoney,butproducesnogain
orloss(pointB)
120,thefuturescallwillbeinthemoneyandwillbeexercised.
Youwouldbuythefuturescontractattheexercisepriceof115
andthensellitfor120,therebyearninga5pointgain($5,000
profit)onthe$100,000Canadabondcontract.Becauseyou
paida$2,000premium,however,thenetprofitis$3,000(point
C)
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Figure 13-1. The Difference between

Interest Rate Futures and Interest Rate

Futures
Options

thefuturescontracthasalinearprofitfunctionthereisaone
toonerelationshipbetweenprofitsandthepriceofthe
underlyingfinancialinstrument
thekinkedprofitcurvefortheoptioncontractisnonlinear,
meaningthatprofitsdon'talwaysgrowbythesameamountfor
agivenchangeinthepriceoftheunderlyingfinancial
instrument
thereasonforthisnonlinearityisthatthecalloptionprotects
youfromhavinglossesthataregreaterthantheamountofthe
$2,000premium
oncethepriceoftheunderlyingfinancialinstrumentrises
aboveX,however,yourprofitsonthecalloptiongrowlinearly.
Theyare,however,alwayslessthantheprofitsonthefutures
contractbyexactlythe$2,000premiumpaid.
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Interest Rate Swaps

In an interest-rate swap, two unrelated parties take out
loans. Then they agree to make each others periodic
interest payments.
The two parties do not exchange their debts or lend each
other money, but simply agree to make each others
periodic interest payments as if they had swapped debts.
This kind of swap is illustrated by the hypothetical
example in the next slide.
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Interest-Rate Swap Contract

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Hedging with Interest Rate Swaps

Reduceinterestrateriskforbothparties
1. Midwestconverts$1moffixedrateassetstoratesensitive
assets,RSA,lowersGAP
2. FriendlyFinanceRSA,lowersGAP
Advantagesofswaps
1. Reducerisk,nochangeinbalancesheet
2. Longertermthanfuturesoroptions
Disadvantagesofswaps
1. Lackofliquidity
2. Subjecttodefaultrisk
Financialintermediarieshelpreducedisadvantagesofswaps
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