DEPARTMENT OF ACCOUNTING AND FINANCE COLLEGE OF

FINANCE, MANAGEMENT AND ACCOUNTING

MSC IN ACCOUNTING AND FINANCE
ADVANCED CORPORATE FINANCE
GROUP ASSIGNMENT ON
Derivatives and Hedging Risk

Section 2 Group 3

Name ID Number

1. Mohammed Ahmed Farah 1700817

2. Dagim Megersa 1700809

3. Roben Ochalla 1700818

4. Belaynesh Bero 1700814

5.Bachu Fanta 1700808

Submitted To: Dr. CH. Venkata Krishna Reddy (PhD)

December ,2017

Addis Ababa, Ethiopia

Introduction
Derivatives and hedging risks
Hardly a day seems to go by without a story in the popular press about some firm that has taken a
major hit to its bottom line from its activities in the derivatives markets. Perhaps the largest
losses due to derivative trading involved the U.S. firm MG Refining and Marketing (MGRM)
and its German parent Metallgesellschaft (MGAG).1 In late 1993 and early 1994, the financial
press reported more than $1 billion of losses from MGRM’s trading in oil futures. MGAG is one
of Germany’s largest industrial firms, generating more than $17 billion in sales revenue in 1993.
It has been a closely held firm with 65 percent of its ownership in the hands of seven large
institutional owners including the Deutsche Bank, one of the largest banks in the world.
MGRM’s derivatives were a central element in its marketing strategy in which it attempted to
offset customers ‘long-term price guarantees (up to 10 years) on gasoline, heating oil, and diesel
fuel purchased from MGRM with futures trading. How did MGRM hedge its resulting exposure
to spot price increases? Why did MGRM lose so much money? These are some of the questions
that we will address in this chapter. MGRM is not the only firm with reportedly large losses
because of derivatives. Procter & Gamble and Gibson Greeting Cards have allegedly lost
hundreds of millions of dollars in trading derivatives. The trading of derivatives by Nicholas
Leeson is widely credited with having brought down the venerable international merchant bank
of Barings. In addition, we have the Piper Jaffrey funds in which investors in a supposedly
secure medium-term government bond fund lost 50 percent of their value, and Orange County
(California), whose investments lost so much that there was concern about whether basic public
services would be disrupted. Whether all of these really happened because of the use or misuse
of derivatives will probably be settled years later in the courts, but in the court of public opinion,
the culprit has been named—derivatives—and regulators and politicians are deciding on the
sentence. In this chapter we take a close look at derivatives—what they are, how they work, and
the uses to which they can be put. When we are done, you will understand how financial
derivatives are designed, and you will be able to decide for yourself in an informed fashion what
is happening when the next derivatives scandal erupts. Derivatives, Hedging, and Risk The name
derivatives is self-explanatory. A derivative is a financial instrument whose payoffs and values
are derived from, or depend on, something else. Why do firms use derivatives? The answer is
that derivatives are tools for changing the firm’s risk exposure. Someone once said that
derivatives are to finance what scalpels are to surgery. By using derivatives, the firm can cut
away unwanted portions of risk exposure and even transform the exposures into quite different
forms.
A central point in finance is that risk is undesirable. would choose risky securities only if the
expected return compensated for the risk. Similarly, a firm will accept a project with high risk
only if the return on the project compensates for this risk. Not surprisingly, then, firms are
usually looking for ways to reduce their risk.
When the firm reduces its risk exposure with the use of derivatives, it is said to be hedging.
Hedging offsets the firm’s risk, such as the risk in a project, by one or more transactions in the
financial markets. Derivatives can also be used to merely change or even increase the firm’s risk
exposure. When this occurs, the firm is speculating on the movement of some economic
variables— those that underlie the derivative. For example, if a derivative is purchased that will
rise in value if interest rates rise, and if the firm has no offsetting exposure to interest rate
changes, then the firm is speculating that interest rates will rise and give it a profit on its
derivatives position. Using derivatives to translate an opinion about whether interest rates or
some other economic variable will rise or fall is the opposite of hedging—it is risk enhancing.
Speculating on your views on the economy and using derivatives to profit if that view turns out
to be correct is not necessarily wrong, but the speculator should always remember that sharp
tools cut deep, and if the opinions on which the derivatives position is based turn out to be
incorrect, then the consequences can prove costly. Efficient market theory teaches how difficult
it is to predict what markets will do. Most of the sad experiences with derivatives have occurred
not from their use as instruments for hedging and offsetting risk, but, rather, from speculation.
Derivative instruments are financial contracts whose value depends on another financial asset.
Options and futures contracts are the most common derivatives. Such contracts can be used to
hedge financial exposure. Hedging refers to the practice of reducing or fully eliminating the risk
associated with holding a volatile asset. If used properly, hedging transactions can take a lot of
worry and stress out of investing.
 Limitations of Derivatives
As mentioned above, derivative is a broad category of security, so using derivatives in making
financial decisions varies by the type of derivative in question. Generally speaking, the key to
making a sound investment is to fully understand the risks associated with the derivative, such as
the counterparty, underlying asset, price and expiration. The use of a derivative only makes sense
if the investor is fully aware of the risks and understands the impact of the investment within a
portfolio strategy.

es have a variety of functions and applications as well, based on the type of derivative. Certain
kinds of derivatives can be used for hedging, or insuring against risk on an asset. Derivatives can
also be used for speculation in betting on the future price of an asset or in circumventing
exchange rate issues. For example, a European investor purchasing shares of an American
company off of an American exchange (using U.S. dollars to do so) would be exposed to
exchange-rate risk while holding that stock. To hedge this risk, the investor could
purchase currency futures to lock in a specified exchange rate for the future stock sale and
currency conversion back into Euros. Additionally, many derivatives are characterized by
high leverage.

Hedging

Hedging risky transactions can help you avoid heavy losses in financial markets. A hedge is a
financial transaction that reduces or fully eliminates the risk associated with another transaction.
For example, an investor holding Microsoft stock may be concerned that the shares will
depreciate, but may desire to hold the stock for another six months due to tax reasons. If this
investor shakes hands with his uncle to sell him Microsoft stock in exactly six months at the
present price, he will fully eliminate the risk associated with holding Microsoft shares. Hedging
may always turn out to be a bad idea, as eliminating risk also eliminates profit potential. If
Microsoft stock appreciates significantly over the next six months, locking in the current price
for the future sale will turn out to be a bad decision.Before engaging in any hedging strategy,
management must review the savings association’s overall interest rate risk position under various
interest rate scenarios as required by Thrift Bulletin 13a. This evaluation would also include the
effect of any hedge strategies.
 Macro-hedging and Micro-hedging
The objective of a macro-hedge is to reduce the interest rate risk of a savings association based
on a complete analysis of the balance sheet and off-balance sheet items. The objective of a
micro-hedge is to reduce or eliminate the risk of a specific balance sheet or off-balance sheet
item. Section 563.172
generally requires that the hedge positions reduce the interest rate risk of the institution.
You should not evaluate the appropriateness of a micro-hedge in isolation, but rather in the
context of its effect on the overall interest rate risk of the savings association. Sometimes a
micro-hedge can increase rather than reduce a savings association’s overall interest rate risk. For
example, a savings association that is liability sensitive can establish a micro-hedge to offset the
interest rate risk of a fixed rate mortgage-servicing portfolio. This portfolio may provide
protection against an increase in interest rates, as the value of the portfolio would increase as
interest rates increase and mortgage prepayments slow. A well-constructed hedge (one developed
with the benefit of an analysis of the overall interest rate risk) should meet the requirements of
Statement of Financial Accounting Standard (SFAS) 133, Accounting for Derivative Instruments
and Hedging Activities.
In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS 133 as amended
by SFAS 137, Accounting for Derivative Instruments and Hedging Activities — Deferral of the
Effective Date of FASB Statement No. 133 (issued June 1999); and SFAS 138, Accounting for
Certain Derivative Instruments and Certain Hedging Activities (issued June 2000). SFAS 137
became effective with fiscal years ending after June 15, 2000.
Management, in coordination with an independent audit firm, should establish a policy
containing standards, parameters, and conditions to assess the required level of correlation and
hedge effectiveness. SFAS 133 requires that a gain or loss from the item hedged be highly
correlated to the gain or loss from the hedging instrument. SFAS 133 does not define high
correlation. However, in practice, the gain or loss from the future contracts should equal no less
than 80 percent to 120 percent of the change in value from the hedged instrument. SFAS 133
limits hedge accounting to those relationships in which derivative instruments and certain foreign
currency-denominated non derivative instruments are designated as hedging instruments and the
necessary qualifying criteria are met.
Derivatives subject to SFAS 133 include, but are not limited to, interest rate swaps, options,
futures ,and forwards. In developing this complex proposal, the FASB concluded that the
following five fundamental decisions should serve as cornerstones:
• Derivatives are assets or liabilities, and should be reported in the financial statements. (Prior to
SFAS 133, most derivatives, except those held for trading, were “off-balance sheet” and,
savings associations did not report them in the financial statements.)
• Fair value is the most relevant measure for financial instruments, and the only relevant measure
for derivatives.
• Savings associations should measure derivatives at fair value, and adjustments to the carrying
amount of hedged items should reflect changes in their fair value (that is, gains and losses) that
are attributable to the risk being hedged and that arise while the hedge is in effect.
• Savings associations should report only items that are assets or liabilities in the financial
statements. (Savings associations should not defer and treat realized gains and losses on certain
derivatives used for hedging as an asset or liability.)
• Savings associations should use special accounting for items designated as being hedged only
for qualifying transactions; one aspect of qualification should be an assessment of offsetting
changes in fair values or cash flows.

What are Options

Options are a type of derivative security. They are a derivative because the price of an option is
intrinsically linked to the price of something else. Specifically, options are contracts that grant
the right, but not the obligation to buy or sell an underlying asset at a set price on or before a
certain date. The right to buy is called a call option and the right to sell is a put option. People
somewhat familiar with derivatives may not see an obvious difference between this definition
and what a future or forward contract does. The answer is that futures or forwards
confer both the right and obligation to buy or sell at some point in the future. For example,
somebody short a futures contract for cattle is obliged to deliver physical cows to a buyer unless
they close out their positions before expiration. An options contract does not carry the same
obligation, which is precisely why it is called an “option.”
Why uses option?
There are a number of reasons an investor would use options. These include, speculation
hedging, spreading, and creating synthetic positions. There are other less common uses for
options that won’t be discussed here.
Speculation

Speculation is making a bet on the outcome of the future price of something. A speculator might
think the price of a stock will go up, perhaps based on a gut feeling and hopes to make a short
term profit by selling that stock at a higher price. Speculating in this way with a call option –
instead of buying the stock outright – is attractive to some traders since options provide leverage.
An out-of-the money call option may only cost a few dollars, compared the price of a $100
stock. It is this use of options that is part of the reason options have the reputation for being
risky. This is because when you buy an option, you have to be correct in determining not only
the direction of the stock's movement, but also the magnitude and the timing of this movement.
To succeed, you must correctly predict whether a stock will go up or down, and you have to be
right about how much the price will change as well as the time frame it will take for all this to
happen.

Hedging

Options were invented not for speculation, but for the purpose of hedging. Hedging is a strategy
that reduces risk at a reasonable cost. In this way, we can think of using options like an insurance
policy. Just as you insure your house or car, options can be used to insure your investments
against a downturn. Critics of options say that if you are so unsure of your stock pick that you
need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that
hedging strategies can be useful, especially for large institutions. Even the individual investor
can benefit. Imagine that you wanted to take advantage of technology stocks and their upside,
but say you also wanted to limit any losses. By using options, you would be able to restrict your
downside while enjoying the full upside in a cost-effective way. For short sellers, call options
can be used in a similar way to restrict losses during a short squeeze, or in case of an incorrect
short bet.
Spreading

Spreading is the use of two or more options positions. In effect, it combines having a market
opinion (speculation) with limiting losses (hedging). Often times, spreading also limits potential
upside as well, but these strategies can still be desirable since they are usually have a low
implementation cost. Most spreads involving selling one option to buy another. Spreading is
where the versatility of options is most apparent since a trader can construct a spread to profit
from nearly any market outcome including markets that don’t move up or down. We will talk
more about basic spreads later in this tutorial.

Synthetics

A special type of spread is known as a “synthetic.” The purpose of this strategy is to create a
position that behaves exactly like some other position without actually controlling that other
asset. For example, if you buy an at-the-money call and simultaneously sell a put with the same
expiration and strike, you will have created a synthetic long position in the underlying asset.
Why not just buy the underlying asset? Perhaps you are restricted for some legal or regulatory
reason from owning it, but are allowed to create a synthetic position, or if the underlying asset is
something like an index that is difficult to construct from its individual components.

How options work

Options contracts are essentially the price probabilities of future events. The more likely
something is to occur, the more expensive an option would be that profits from that event. This is
the key to understanding the relative value of options.

Let’s take as a generic example a call option on International Business Machines Corp. (IBM)
with a strike price of $200; IBM is currently trading at $175 and expires in 3 months. Remember,
the call option gives you the right, but not the obligation, to purchase shares of IBM at $200 at
any point in the next 3 months. If the price of IBM rises above $200, then you “win.” It doesn’t
matter that we don’t know the price of this option for the moment – what we can say for sure,
though, is that the same option that expires not in 3 months but in 1 month will cost less because
the chances of anything occurring within a shorter interval is smaller. Likewise, the same option
that expires in a year will cost more. This is also why options experience time decay: the same
option will be worth less tomorrow than today if the price of the stock doesn’t move.

A put option, on the other hand, might be thought of as an insurance policy. Our land developer
owns a large portfolio of blue chip stocks and is worried that there might be a recession within
the next two years. He wants to be sure that if a bear market hits, his portfolio won’t lose more
than 10% of its value. If the S&P 500 is currently trading at 2500, he can purchase a put option
giving him the right to sell the index at 2250 at any point in the next two years. If in six months
time the market crashes by 20%, 500 points in his portfolio, he has made 250 points by being
able to sell the index at 2250 when it is trading at 2000 – a combined loss of just 10%. In fact,
even if the market drops to zero, he will still only lose 10% given his put option. Again,
purchasing the option will carry a cost (its premium) and if the market doesn’t drop during that
period the premium is lost.

These examples demonstrate a couple of very important points. First, when you buy an option,
you have a right but not an obligation to do something with it. You can always let the expiration
date go by, at which point the option becomes worthless. If this happens, however, you lose
100% of your investment, which is the money you used to pay for the option premium. Second,
an option is merely a contract that deals with an underlying asset. For this reason, options are
derivatives. In this tutorial, the underlying asset will typically be a stock or stock index, but
options are actively traded on all sorts of financial securities such as bonds, foreign currencies,
commodities, and even other derivatives.

Some other ways of categorizing options

Some other ways of categorizing options contracts. American options can be exercised at any
time between the date of purchase and the expiration date. The example about Cory's Tequila Co.
is an example of the use of an American option. Most exchange-traded options are of this
type. European options are different from American options in that they can only be exercised at
the end of their lives on their expiration date. The distinction between American and European
options has nothing to do with geographic location, only with early-exercise. Most options on
stock indices are of the European type. Because the right to exercise early has some value, an
American option typically carries a higher premium than an otherwise identical European option.
American and European Options

Options can also be categorized by their duration until expiration. Short-term options are those
that expire generally in a year or less. Long-term options with expirations greater than a year are
classified as long-term equity anticipation securities, or LEAPs. By providing opportunities to
control and manage risk or even to speculate, LEAPS are virtually identical to regular options.
LEAPS, however, provide these opportunities for much longer periods of time. Although they
are not available on all stocks, LEAPS are available on most widely held issues.

Options can also be distinguished by when their expiration date falls. Traditionally, listed options
have expired on the third Friday of the month. However due to increased demand, sets of options
now expire weekly on each Friday, at the end of the month or even on a daily basis.

Options Exchanges

Options traded on exchanges are called listed options. In the U.S. there are a number of
exchanges, both physical and electronic, where options are traded. Options can also be traded
directly between counterparties with the use of an exchange; these are known as over-the-counter
(OTC) options. Many times, financial institutions will use OTC options to tailor specific
outcome events that are not available among listed options. In order to provide liquidity to
options markets, there exist market makers who are required to “make” a two-sided market in an
option if asked to quote. Market makers, using theoretical pricing models, can take advantage
of arbitrage and theoretical mispricing between the options’ perceived value and its market
price.

The simple calls and puts we've discussed are sometimes referred to as plain vanilla options.
Even though the subject of options can be difficult to understand at first, these plain vanilla
options are as easy as it gets. Because of the versatility of options, there are many other types and
variations of options. Non-standard options are called exotic options, which are either variations
on the payoff profiles of the plain vanilla options or are wholly different products with "option-
ality" embedded in them. For example, so-called binary options have a simple payoff structure
that is determined if the payoff event happens and doesn’t care about the degree. Other types of
exotic options include break-out, break-in, barrier options, lookback options, Asian
options and Bermudan options.

Options Risks

Because options prices can be modeled mathematically with a model such as Black-Scholes,
many of the risks associated with options can also be modeled and understood. This particular
feature of options actually makes them arguable less risky than other asset classes, or at least
allows the risks associated with options to be understood and evaluated. Individual risks have
been assigned Greek letter names, and are sometimes referred to simply as the greeks.

Meet the Greeks

price and thus represents the directional risk. Delta is interpreted as the hedge ratio, or
alternatively the equivalent position in the underlying security: a 4000 delta position is
equivalent to long 4000 shares.

The delta can represent the probability an option has at finishing in the money (a 40-delta option
has a 40% chance of finishing in the money). At-the-money options always have a 50 delta. In-
the-money options have a delta greater than 50, and out-of-the-money options less than 50.
Increasing volatility or time to expiration causes deltas to tend to 50.

Gamma is the change in delta per unit (point) change in the underlying security. The gamma
shows how fast the delta will move if the underlying security moves a point. This is an important
value to watch, since it tells you how much greater your directional risk increases as the
underlying moves. Options at the money have the largest gammas and those close to expiration
also have the largest gammas. Lowering volatility raises the gamma.

Theta is the change in option price per unit (day) change in time. Also known as time decay risk,
it represents how much value an option loses as time passes. Long-term options decay at a
slower rate than near-term options. The theta is opposite in sign to the gamma and can represent
the trade-off between time passing and the underlying security moving. Options near expiration
have the highest theta. At the money options also have the greatest theta. As volatility is
increased, the theta will also increase.

Vega is the risk to volatility risk, or the change in option price per unit (percent) change in
volatility. If an option has a 2 vega and the vol. Goes up 1%, the option value increases by $2.
Out of the money options have the largest vega as a percent of option value. Long-term options
also have the highest vegas. At the money options have fairly stable vega’s with respect to
changes in volatility.

Rho is the interest rate risk: the change in option price per unit change in interest rates. A
position with positive Rho will be helped by an increase in interest rates and a negative rho will
be helped by a decrease in interest rates.

Characteristics of Options
A savings association can purchase (long position) or sell (short position) an option. Options
differ from futures in that the holder of a option has the right to purchase or sell versus the
obligation to purchase or sell with futures. In return for the right to buy or sell securities, put and
call option buyers pay a negotiated premium to put and call option sellers. The seller of the
option must perform if the holder exercises the option. Options can provide more flexibility than
futures because the savings association can establish a wide variety of positions. Mathematical
models that represent the fair value of options use variables such as the relationship between the
market and strike price, the term remaining until option expiration, marketplace volatility, and
short-term interest rates. These models are based on the concept that the option premium has two
components: an intrinsic or in-the-money value and time value. Intrinsic value is the amount by
which the current market price of the underlying security is above the strike price for calls and
below the strike price for puts. Time value is the amount by which the premium exceeds the
intrinsic value. Because option buyers have no obligation to perform after paying the premium,
there is no additional margin required. Option writers undertake a firm commitment to assume a
long or short position in the market at the strike price if they exercise the option. Because the
seller/writer must perform, a margin deposit is required when a position is opened. Sellers can
structure OTC option transactions to meet the specific requirements of the purchaser, thereby
providing more flexibility than exchange-traded options. The trade-off is that OTC options are
not standardized and usually must be offset by the original counterparty, thereby limiting their
liquidity. OTC transactions most commonly involve options on MBSs. The buyer of an option
holds a long position, while the seller (writer) holds a short position. When the writer of the
option owns the underlying asset, the option position is covered. When the writer does not own
the underlying asset, the writer’s position is naked. An option is in the money, if exercising the
option produces a gain, while an option is out of the money if exercising the option does not
produce again.
The following five factors influence the value of an option:
• Strike price.
• Current price of the underlying instrument.
• Time to expiration of the contract.
• Expected volatility of yields (or prices) over the remaining life of the option.
• Short-term risk-free interest rate over the remaining life of the option.

Advantages and disadvantages of options

Feature Advantage Disadvantage Effect on Holder/Writer

Cost Options are an As a form of insurance, Holder may be disadvantaged due

inexpensive way to an option contract may to expiry. Writer would be
gain access to the expire worthless. This advantaged as s/he need not
underlying risk increases the make delivery once the option has
investment without greater the extent to expired.
having to buy stock which the option is out
of the money and the
shorter the time until
expiration.

Leverage Options enable Investors should realize Writers of naked calls are exposed
investors to stump that options\' leverage to unlimited risk.
up less money and can impact performance
obtain additional on the down side as
gain. well.

Marketability Option terms trade Regulatory intervention Both parties to an options

on an exchange can prevent exercise transaction benefit from
and as such are which may not be standardized and enforceable
 standardized. desirable. terms.

Hedging Options may be The investor may end Both the holder and the writer may
used to limit losses. up being incorrect as to be (dis)advantaged depending
the direction and timing upon which side of the trade they
of a stock\'s price and assume and the ultimate direction
may implement a less of the underlying security.
than perfect hedge.

Return Options may be The investor may end Both the holder and the writer may
enhancement used to enhance a up being incorrect as to be (disadvantaged depending
portfolio\'s return. the direction and timing upon which side of the trade they
of a stock\'s price, assume and the ultimate direction
rendering the attempt at of the underlying security.
enhanced portfolio
return worthless.

Diversification One can replicate Diversification cannot

an actual stock eliminate systematic
portfolio with the risk.
options on those
very stocks.

Regulation Terms of listed Restrictions upon While in some cases necessary,

options are exercise may occur by regulatory fiat can disrupt what
regulated. regulatory fiat (OCC, may be a profitable trade, affecting
SEC, court, other holder and writer alike.
regulatory agency).

Forward

A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees to
buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a
later time, but the price is determined at the time of purchase. Key features of forward contracts
are:

 Highly customized - Counterparties can determine and define the terms and features to fit
their specific needs, including when delivery will take place and the exact identity of the
underlying asset.
  All parties are exposed to counterparty default risk - This is the risk that the other party
may not make the required delivery or payment.
 Transactions take place in large, private and largely unregulated markets consisting of
banks, investment banks, government and corporations.
 Underlying assets can be a stocks, bonds, foreign currencies, commodities or some
combination thereof. The underlying asset could even be interest rates.
 They tend to be held to maturity and have little or no market liquidity.
 Any commitment between two parties to trade an asset in the future is a forward
contract.

What is a 'Forward Contract'

In finance, a forward contract or simply a forward is a non-standardized contract between
two parties to buy or to sell an asset at a specified future time at a price agreed upon today,
making it a type of derivative instrument. A forward contract is a customized contract between
two parties to buy or sell an asset at a specified price on a future date. A forward contract can be
used for hedging or speculation, although its non-standardized nature makes it particularly apt
for hedging. Unlike standard futures contracts, a forward contract can be customized to any
commodity, amount and delivery date. A forward contract settlement can occur on a cash or
delivery basis. Forward contracts do not trade on a centralized exchange and are therefore
regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to
customize terms, the lack of a centralized clearinghouse
alsogives rise to a higher degree of default risk. As a result, forward contracts are not as easily
available to the The market for forward contracts is huge, since many of the world’s biggest
corporations use it to hedge currency and interest rate risks. However, since the details of
forward contracts are restricted to the buyer and seller, and are not known to the general public,
the size of this market is difficult to estimate. The large size and unregulated nature of the
forward contracts market means that it may be susceptible to a cascading series of defaults in the
worst-case scenario. While banks and financial corporations mitigate this risk by being very
careful in their choice of counterparty, the possibility of large-scale default does exist.

Another risk that arises from the non-standard nature of forward contracts is that they are only
settled on the settlement date, and are not marked-to-market like futures. What if the forward
rate specified in the contract diverges widely from the spot rate at the time of settlement? In this
case, the financial institution that originated the forward contract is exposed to a greater degree
of risk in the event of default or non-settlement by the client than if the contract were marked-to-
market regularly.

Definition of 'Futures Contract'

A futures contract is a contract between two parties where both parties agree to buy and sell a
particular asset of specific quantity and at a predetermined price, at a specified date in future. A
futures contract is a legal agreement, generally made on the trading floor of a futures exchange,
to buy or sell a particular commodity or financial instrument at a predetermined price at a
specified time in the future. Futures contracts are standardized to facilitate trading on a futures
exchange and, depending on the underlying asset being traded, detail the quality and quantity of
the commodity.

Description: The payment and delivery of the asset is made on the future date termed as delivery
date. The buyer in the futures contract is known as to hold a long position or simply long. The
seller in the futures contracts is said to be having short position or simply short.
The underlying asset in a futures contract could be commodities, stocks, currencies, interest rates
and bond. The futures contract is held at a recognized stock exchange. The exchange acts as
mediator and facilitator between the parties. In the beginning both the parties are required by the
exchange to put beforehand a nominal account as part of contract known as the margin .Since
the futures prices are bound to change every day, the differences in prices are settled on daily
basis from the margin. If the margin is used up, the contractee has to replenish the margin back
in the account. This process is called marking to market. Thus, on the day of delivery it is only
the spot price that is used to decide the difference as all other differences had been previously
settled. Futures can be used to hedge against risk or speculate the prices.

BREAKING DOWN 'Futures Contract'

Some futures contracts may call for physical delivery of the asset, while others are settled in
cash. The terms "futures contract" and "futures" refer to essentially the same thing. For example,
you might hear somebody say he bought oil futures, which means the same thing as an oil futures
contract. To get more specific, one could say that a futures contract refers only to the specific
characteristics of the underlying asset being traded, while "futures" is more general and can also
refer to the overall market as in: "He's a futures trader."

Example of Futures Contracts

Futures contracts are used by two categories of market participants: hedgers and speculators.
Producers or purchasers of an underlying asset hedge or guarantee the price at which the
commodity is sold or purchased, while portfolio managers or traders may also make a bet on the
price movements of an underlying asset using futures.

Many different assets have futures contracts available. Futures contracts on dozens of different
major stock market indices around the world are traded, as well as futures on the major currency
pairs and major interest rates. As for commodities, a large number of contracts are available for
just about every commodity produced. For example, industrial metals, precious metals, oil,
natural gas and other energy products, oils, seeds, grains, livestock and even carbon credits all
have tradable futures contracts available.

Mechanics of a Futures Contract

Imagine an oil producer plans to produce 1 million barrels of oil ready for delivery in exactly
365 days. Assume the current price is $50 per barrel. The producer could take a gamble, produce
the oil, and then sell it at the current market prices one year from today. Given the volatility of
oil prices, the market price at that time could be at any level. Instead of taking chances, the oil
producer could lock-in a guaranteed sale price by entering into a futures contract. A
mathematical model is used to price futures, which takes into account the current spot price, the
risk-free rate of return, time to maturity, storage costs, dividends, dividend yields and
convenience yields. Assume that the one-year oil futures contracts are priced at $53 per barrel.
By entering into this contract, in one year, the producer is obligated to deliver 1 million barrels
of oil and is guaranteed to receive $53 million. The $53 price per barrel is received regardless of
where spot market prices are at the time.

What happens when a futures contract expires?

Each of the futures contracts is active (can be traded) for a specific amount of time. The contract
then expires, and cannot be traded any more. The date upon which a futures contract expires is
known as its expiration date.
What does it mean to sell a futures contract?
The seller of the futures contract (the party with a short position) agrees to sell the underlying
commodity to the buyer at expiration at the fixed sales price. As time passes, the contract's price
changes relative to the fixed price at which the trade was initiated. This creates profits or losses
for the trader.

Difference between a Futures Contract and a Forward Contract

Futures and forwards are financial contracts which are very Similar in nature but there
exist a few important differences:

 Futures contracts are highly standardized whereas the terms of each forward contract can
be privately negotiated.
 Futures are traded on an exchange whereas forwards are traded over-the-counter.

Counterparty risk

In any agreement between two parties, there is always a risk that one side will renege on the
terms of the agreement. Participants may be unwilling or unable to follow through the
transaction at the time of settlement. This risk is known as counterparty risk.

In a futures contract, the exchange clearing house itself acts as the counterparty to both parties in
the contract. To further reduce credit risk, all futures positions are marked-to-market daily,
with margins required to be posted and maintained by all participants at all times. All this
measures ensures virtually zero counterparty risk in a futures trade.

Forward contracts, on the other hand, do not have such mechanisms in place. Since forwards are
only settled at the time of delivery, the profit or loss on a forward contract is only realized at the
time of settlement, so the credit exposure can keep increasing. Hence, a loss resulting from a
default is much greater for participants in a forward contract.
Secondary Market

The highly standardized nature of futures contracts makes it possible for them to be traded in a
secondary market.

The existence of an active secondary market means that if at any time a participant in a futures
contract wishes to transfer his obligation to another party, he can do so by selling it to another
willing party in the futures market.In contrast, there is essentially no secondary market for
forward contracts.

1.6. Swaps, caps and floors

Swaps
Swaps are another common type of derivative. A swap is most often a contract between two
parties agreeing to trade loan terms. One might use an interest rate swap in order to switch from
a variable interest rate loan to a fixed interest rate loan, or vice versa. If someone with a variable
interest rate loan were trying to secure additional financing, a lender might deny him or her a
loan because of the uncertain future bearing of the variable interest rates upon the individual’s
ability to repay debts, perhaps fearing that the individual will default. For this reason, he or she
might seek to switch their variable interest rate loan with someone else, who has a loan with a
fixed interest rate that is otherwise similar. Although the loans will remain in the original
holders’ names, the contract mandates that each party will make payments toward the other’s
loan at a mutually agreed upon rate. Yet, this can be risky, because if one party defaults or
goes bankrupt, the other will be forced back into their original loan. Swaps can be made using
interest rates, currencies or commodities.

Interest Rate Swaps

Interest rate swaps are the most common type of financial derivative used by savings
associations. An interest rate swap is an agreement between two parties to exchange a series of
cash flows (based on notional principal amounts) at specified intervals known as payment or
settlement dates. The parties do not exchange actual principal amounts. Instead, the parties
usually net interim payments, with the net amount being paid to one party or the other.
Savings associations use interest rate swaps primarily to manage interest rate exposure and to
reduce debt-financing costs. Swaps transform an existing cash flow stream into a more desirable
one from the point of view of a financial institution. For example, a savings association can use a
swap to transform floating-rate liabilities into fixed-rate liabilities. Because the parties negotiate
swap contracts, they can swap virtually any kind of payment stream. The most common type of
swap is the fixed-for-floating interest rate swap. With a fixed-for-floating interest rate swap, one
party exchanges a fixed-rate interest payment stream for a floating-rate payment stream. The
party that agrees to make fixed-rate payments is the fixed-rate payer, and the party that makes
the floating-rate payments is the floating-rate payer. In this instance, a fixed-for-floating swap
enables the fixed-rate payer to transform floating-rate liabilities into fixed-rate liabilities. A party
could also transform fixed-rate assets into floating-rate assets.
Figure 1 shows an example of a fixed-for-floating interest rate swap. In this example,
Counterparty A has $10 million of fixed-rate borrowings that it wants to convert into floating-
rate borrowings. Counterparty B has $10 million of floating-rate borrowings that it wants to
convert into fixed-rate borrowings. Both parties agree to enter into an interest rate swap with a
notional amount of $10 million. The agreement requires Counterparty B to make semi annual
payments to Counterparty A at a fixed rate of five percent for three years. In exchange,
Counterparty A agrees to make floating-rate payments based on the six-month London Interbank
Offered Rate (LIBOR) with an initial rate of four percent. In the example, B (the fixed-rate
payer) will make a net payment of $50,000 to A (the floating-rate payer) on the first semi annual
payment date. On that date, the floating rate for the next six months resets based on the
prevailing six-month LIBOR. If six-month LIBOR increases after the swap is initiated, A’s cost
of funds will rise because it is obligated to make floating-rate payments to B. On the other hand,
B, will benefit if rates rise, since it will receive higher floating-rate payments, while its payments
remain fixed at five percent of the notional amount. Savings associations exposed to rising rates
(for example, the typical savings association holding interest-bearing deposits) can reduce their
exposure by entering into fixed-for-floating swaps as the fixed-rate payer.

Basis Swaps
Basis swaps involve the exchange of payments based on two different floating-rate indices, such
as one month LIBOR against the Eleventh District Cost of Funds Index (COFI). For example, a
pay-COFI, receive-LIBOR swap effectively converts a COFI ARM into a LIBOR ARM,
allowing the savings association to match LIBOR-indexed borrowings more closely. The market
also calls basis swaps floating-for-floating swaps.

Swap Termination
A savings association may wish to reverse or terminate (unwind) a swap before maturity. There
are two ways to unwind a swap position. One way is to negotiate a termination settlement with
the original counterparty. The other is to enter into a new swap that is a mirror image of the
existing swap to offset the existing position.

Swap Variations
Most swaps have a specified maturity date and a fixed notional amount. Some swaps, however,
have notional amounts that amortize over time. Swaps can also be callable, where one of the
counterparties has an option to terminate the swap if interest rates increase or decrease beyond
the strike rate. A forward swap is a firm commitment to enter into a swap at a specified future
date.
Uses and Evaluation of Swaps
Swaps can synthetically extend the term of a matched liability over the term of the swap in much
the same way as futures contracts are used to fix financing costs. However, swaps do not require
the same active management that futures or options positions require. Swaps are not as liquid as
futures
contracts. A savings association can offset a swap position and, in effect, cancel it if they
negotiate an offset with the counterparty or enter into a reverse swap with terms that are similar
to the original swap agreement.
To evaluate the appropriateness of a swap agreement, management should monitor the
correlation of the effective spread from the assets and liabilities being hedged by using a swap
with a fixed-rate payable and a variable-rate receivable. For example, if a savings association
enters into a five-year swap where the fixed interest rate is nine percent and the variable rate on
the first payment date is seven percent, the savings associations must pay 200 basis points.
However, if the savings association matches the swap, you should compare the variable rate with
the rate paid on the matched short-term liability to determine how closely the variable rate
received from the swap correlates. If these rates correlate well and the assets funded by the
matched liability have a duration of approximately five years, the association may achieve a
“locked-in” spread.

Swaptions
A swaption (or swap option) is an option on a swap. It gives the buyer the right, but not the
obligation, to enter into a specified swap at a future date.

CAPS AND CAPLETS

An interest rate cap is designed to provide insurance against the floating interest rate rising
above a certain level. This level is known as the “cap rate”. It protects a borrower against the
risk of paying very high interest rate. The borrower, who buys the caps, receives payments at
the end of each period in which the interest rate exceeds the agreed strike price. More
specifically, it is a collection of caplets, each of which is a call option on the LIBOR rate at a
specified date in the future.
Bank and institutions will use caps to limit their risk exposure to upward movements in short
term floating rate debt. Caps are equally attractive to speculators as considerable profits can
be achieved on volatility plays in uncertain interest rate environments.
An interest rate cap can also be characterized as a portfolio of put options on zero-coupon
bonds with payoffs on the puts occurring at the time they are calculate

The parameters affecting the cap price

The parameters affecting the cap price Since the cap is a tool to guarantee of a future rate, so the price of
the cap will therefore depend on the likelihood that the market will change its view. This likelihood of
change is measured by volatility. An instrument expected to be volatile between entry and maturity will
have a higher price than a low volatility instrument. The volatility used in calculating the price should be
the expected future volatility. This is based on the historic volatility. As time goes by, the volatility will
have less and less impact on the price, as there is less time for the market to change its view. Therefore, in
a stable market, the passing of time will lead to the cap falling in value
 Advantage and disadvantage of caps
Advantages/benefits
Major advantages of caps are that the buyer limits his potential loss to the premium paid, but
retains the right to benefit from favorable rate movements. The other one is
• Caps provide investor with protection against unfavorable interest rate moves over the
strike rate, while allowing investor unlimited participation in favorable moves down.
• Caps are flexible. The strike rate can be positioned to reflect the level of protection
investor seeks. However, the amount of premium payable is also affected by the
choice the investor makes.
• The term of the cap is flexible and does not have to match the term of the underlying
investment. A cap may be used as a form of short term interest rate protection in times
of uncertainty.
• Caps can be cancelled (however there may be a cost to the investor in doing).
• As a cap does not form part of the underlying investment, the protection afforded can
apply to any investment with similar commercial terms.
• Purchasers can make considerable profits because interest rate option products are
highly geared instruments and, for a relatively small outlay of capital. At the same
time, a seller with a decay strategy in mind, where he would like the option's value to
decay over time so that it can be bought back cheaper at a later stage or even expire
worthless, can make a profit amounting to the option premium, without having to
make a capital outlay.
• The cost is limited to the premium paid.

Disadvantages/risks

The premium is not refundable in any circumstances. This includes situations where the reference rate
always exceeds the strike rate and no payments are made. · Investor will be exposed to interest rate
movements if the term of the cap is shorter than that of the underlying investment.

FLOORS AND FLOORLETS

(Interest Rate Floor, Westpac Banking Corporation) Definition An Interest Rate Floor (Floor) is an
interest rate management tool for an investor who has an investment with returns linked to a Floating rate
note. A Floor helps an investor to protect himself against a fall in interest rates and maintain the ability to
participate in a rise in interest rates. It is an interest management tool that is used with an investment that
has returns linked to a market bank bill reference rate such as LIBOR, plus a fixed spread. The underlying
investment continues to be governed by the terms and conditions applying to that investment. A Floor
works in conjunction with a variable rate investment. It protects investor against decreasing interest rates
by setting a minimum interest rate payable on the investment. This minimum interest rate is known as the
strike rate. In exchange for the protection of a Floor, investor pays a premium. The reference rate to be
used is also set at the beginning of the transaction. It provides a benchmark interest rate. It is usually the
same as the base rate applying to the underlying investment. The reference rate applies for set periods,
called calculation periods. If the strike rate is more than the reference rate for a calculation period, then
the investor will receive an amount based on the difference between these rates. When this amount is used
to offset the lower base interest rate applying to the underlying investment, the effective base interest rate
for the calculation period becomes the strike rate. If the strike rate is less than the reference rate for a
calculation period, then the investor will get or pay nothing for that calculation period and the base
interest rate applicable to the underlying investment will be the rate applying under the agreed terms of
the investment. In the real world, the investor can decide to buy Floor with notional less than the size of
the underlying investment. Hence, sometime buying the large number of Floor contract may cost than the
loss from the change in reference rate.

Conclusion

An option is a contract giving the buyer the right but not the obligation to buy or sell an
underlying asset at a specific price on or before a certain date.
Options are derivatives because they derive their value from an underlying asset.
A call gives the holder the right to buy an asset at a certain price within a specific period of
time.
A put gives the holder the right to sell an asset at a certain price within a specific period of
time.
There are four types of participants in options markets: buyers of calls, sellers of calls, buyers
of puts, and sellers of puts.
Buyers are often referred to as holders and sellers are also referred to as writers.
The price at which an underlying stock can be purchased or sold is called the strike price.
 The total cost of an option is called the premium, which is determined by factors including
the stock price, strike price and time remaining until expiration.
The premium of an option increases as the chances of the event of the option finishing in-the-
money increases.
A stock option contract typically represents 100 shares of the underlying stock.
Investors use options both to speculate and hedge risk.
Spreads and synthetic positions highlight the versatility of options contracts
Employee stock options are different from listed options because they are a contract between
the company and the holder. (Employee stock options do not involve any third parties.)
The two main classifications of options are American and European. Options can also be
distinguished as listed/OTC, or vanilla/exotic, among other classification schemes.
Long term options are known as LEAPS.
Options risks are defined by the greeks and allows options risks to be understood and
evaluated.
REFERENCES
Code of Federal Regulations (12 CFR)
Part 562 Regulatory Reporting Standards
§ 563.170 Examinations and audits
§ 563.172 Financial Derivatives
§ 563.176 Interest Rate Risk Management Procedures
Financial Accounting Standards Board, Statement of Financial
Accounting Standards (SFAS)
SFAS No. 52 Foreign Currency Translation (amended and certain paragraphs superseded by
No. 133 as amended)
SFAS No. 80 Accounting for Futures Contracts (superseded)
SFAS No. 105 Disclosure of Information about Financial Instruments with Off-Balance Sheet
Risk and Financial Instruments with Concentrations of Credit Risk (superseded)
SFAS No. 107 Disclosures about Fair Value of Financial Instruments (as amended by No. 133)
SFAS No. 115 Accounting for Certain Investments in Debt and Equity Securities (as amended
by No. 133)
SFAS No. 119 Disclosure about Financial Instruments and Fair Value of Financial Instruments
(superseded)
SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities (supersedes
SFAS Nos. 52, 80, 105, and 119)
SFAS No. l37 Accounting for Derivative Instruments and Hedging Activities – Deferral of the

Ross− Westerfield− Jaffe: Corporate Finance, Sixth Edition

Futures Contracts
A futures contract is a legally binding agreement to trade an asset at a future
date and a predetermined price. A futures contract can be over the counter or
exchange-traded. An over-the-counter futures contract is an agreement to
trade assets for a fixed price on a specific future date. An exchange-traded
contract, on the other hand, is entered into under the supervision of a
regulatory body. The two parties agreeing to trade an asset on a future date
must deposit collateral, which eliminates the risk of either party not keeping
her promise.

Options
Options are similar to futures contracts in that they lock in a future
transaction price. However, executing the trade at that price is mandatory for
only one of the parties, while it's optional for the other party -- hence the
name. Options come in two flavors: A call option allows the option-holder to
buy an instrument if she so desires, while a put option allows her to sell. The
option holder can decide whether to engage in the transaction, and could
simply ignore the option if she wants to. However, to attain this privileged
position, the option holder must pay the option seller an upfront sum. In
futures contracts, on the other hand, no money changes hands at the time the
agreement is entered into.

Interest Rate Swaps

Interest rate swaps are another hedging instrument. Such agreements stipulate
exchanging, or swapping, one type of interest rate payment for another. A
corporation may have an obligation to pay floating interest rates to a bank,
for example. The company may have borrowed $100,000 and has to make
annual interest payments for the next five years, which are determined by the
average rates banks are charging on newly initiated loans for that year. To
eliminate the risk of having to pay a higher sum as a result of interest rates
climbing, the company may sign a swap agreement. The agreement would
allow the company to pay another corporation a fixed annual sum and receive
in return the floating rate on $100,000, which would exactly equal its
obligation to the bank and thus eliminate risk.