Professional Documents
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A- HE22- FRM- 1
Hedging
Using futures contract -equity risk FKLI -interest rates risk KLIBOR
Using option contract - equity risk FKLI -foreign exchange rate risk
Using credit derivatives -credit risk
Using swaps -foreign exchange rates risk -credit risk
As a credit office of a large Malaysia bank you have agreed to provide an important institutional customer
with a fixed rate, 3-month, RM20 million loan 90 days from today. You had price the loan at 12% annual
interest rate. Assuming your cost of funds is the KLIBOR rate and the following quotes are now available.
3-month KLIBOR = 9%
3-month KLIBOR futures = 90.0 (matures in 90 days)
Note that the KLIBOR futures priced at 90.0 is yielding 10%, since your priced the loan at 12%, you have
essentially priced in a 2% profit margin.
How would you protect yourself from a rise in interest rates? Once again, since a rise in interest rates will
hurt by squeezing the profit margin, the appropriate hedge strategy would be short the KLIBOR futures.
Hedge strategy: Short, 20, 3-month KLIBOR futures contracts.
To see if the above hedge strategy would indeed enable you to lock-in the 2% interest spread, let us
assume that interest rates rise 2% over the next 90 days. Would your interest spread be protected?
Without hedging, with spot rate at 11%, your profit spread would have reduced from 2% to 1% (12%-
11%).
Example:
Your company has just signed an agreement, with a foreign supplier. The agreement calls for your
company to pay RM10 million in 3 months for goods from the supplier. As you do not have the needed
finds, you have arranged with you banker for a 3-month RM10 million loan. Your banker has agreed to
provide the loan at an interest rate of KLIBOR +2%. You now fear that an increase in interest rates
between now and the loan is taken might increase your cost of funds and thereby erode your profits. Is
there any way by which you could use KLIBOR futures to lock-in the interest rate on your forthcoming
loan?
Assume it is now 25 June. Loan will be taken in September (exactly 90 day from 25 June). The following
quotations are available on 25 June.
Given the above quotes, the target interest cost you would want to ’lock-in’ is the yield (25 June0 on the
KLIBOR futures +the 2% premium, i.e. 10% since the KLIBOR futures is yielding 8%; (8%+2%) =10%.
What should the right strategy be? Should we go long or short the KLIBOR futures contract? One could
arrive at the right hedge strategy by thinking in terms of the directional movement in interest rates that
would hurt you. Clearly, a rise in interest rates would hurt, since you are borrowing. Thus, you need to
create a futures position that will profit if rates rise. We know in earlier section that interest rates and
futures prices are inversely related. This means that a rise in interest rates will cause KLIBOT futures
prices to fall. To profit from falling futures prices, the right strategy is to go short. Since you need to hedge
RM10 million od borrowings, you need 10 contracts.
To see if the hedge strategy does indeed ‘lock-in’ the cost, we examine two interest rate scenarios.
Result of hedge
Profit from futures = (92.00 − 91.50) × (RM25 × 100) × 10 contracts = RM12,500.00
90
Interest on loan = (8.5% + 2%) × × RM10 million = RM262,500.
360
Net interest cost = RM262,500 − RM12,500 = RM250,000.
Effective interest rate with hedge = RM250,000 for 3 months, which is 2.5% of RM10 million
Annualised interest rate = 2.5% × 4 = 10%
This equals exactly 8% + 2%. (KLIBOR futures was 8% in June). As a result of the hedge, you were able to
borrow at the futures rate in June of 8.00 + 2% instead of 8.5% + 2% which you would have had to pay in
September if you had not hedged. Thus you saved 0.5%.
N.A- HE22- FRM- 3
Note:
1. The saving came from the profit of RM12,500 from futures.
2. The price at maturity of the KLIBOR September futures must be 91.50 because of convergence.
3. In determining profit from futures, we multiply the net of the entry minus exit prices by RM25
since that is the value per tick, which is in turn multiply by 100 since each tick is one basis point
1
which is 100 of 1%.
With the fall in interest rates, the quotes on 25 September would be:
3-month KLIBOR = 5.50% (lower by 1.5%)
September KLIBOR futures = 94.50 (same as spot since it is maturity day for futures;
convergence).
Result of hedge
Profit from futures = (92.00 − 94.50) × (RM25 × 100) × 10 contracts = RM62,500.00
90
Interest on loan = (5.5% + 2%) × × RM10 million = RM187,500.
360
Net interest cost = RM187,500 + RM62,500 = RM250,000.
RM250,000
Effective interest rate with hedge = ( ) × 10 = 2.5% for 3 months
RM10,000,000
Annualised interest rate = 2.5% × 4 = 10%
Once again, the effective interest rate has been locked-in at 8% + 2%. Notice that regardless of whether
interest rates go up or down, you have locked-in the 10% cost of borrowing.
N.A- HE22- FRM- 4
1. INTRODUCTION
The foreign exchange (FX) market is the market for trading currencies against each other.
- The FX market is the world’s largest market.
- The FX market facilitates world trade.
- The FX participants buy and sell currencies needed for trade, but also transact to reduce risk
(hedge) and speculate on currency exchange rates.
An exchange rate is the price of a country’s currency in terms of another country’s currency.
This means that one US dollar will buy 66.91 Indian rupees.
If this exchange rate falls to 65, the dollar will buy fewer Indian rupees. In other words,
- The US dollar is depreciating relative to the rupee or
- The rupee is appreciating relative to the US dollar.
Important note: There are many different conventions that are used around the world, but this
presentation is using the conventions displayed by the authors in the chapters’ examples.
THE FX MARKET
Participants and Purposes Types of FX Products
Companies and individuals transact for the Currencies for immediate delivery (spot
purpose of the international trade of goods market).
and services. Forward contracts, which are agreements
Capital market participants transact for the for a future exchange at a specified exchange
purpose of moving funds into or out of rate.
foreign assets. FX swaps, which are a combination of a spot
Hedgers, who have an exposure to exchange contract and a forward contract, used to roll
rate risk, enter into positions to reduce thus forward contract a position in a forward
risk. contract.
Speculators participate to profit from future FX options, which are options to enter into
movements in foreign exchange. an FX contract some time in the future at a
specified exchange rate.
FX PARTICIPANTS
BUY SIDE Retails accounts
Corporations Governments
Real money accounts Central banks
Leverage accounts Sovereign wealth funds
N.A- HE22- FRM- 6
SELL SIDE
Large dealing banks
Others financial institutions
Dealers will quote a bid (at which the dealer will buy) and an offer price (at which the dealer will
sell). [Note: bid < offer]
APPRECIATING OR DEPRECIATING
Appreciating or depreciating is with respect to the base currency relative to the price currency.
Appreciation is a gain in value of one currency relative to another currency.
Depreciation is the loss in value of on currency relative to another currency.
N.A- HE22- FRM- 7
The percentage change is the ratio of the exchange rates minus one:
(A⁄B)
New
% change = −1
A
( ⁄B)
Old
CURRENCY CROSS-RATES
Given three currencies, a currency cross-rate is the implied exchange rate of a third country pair
given the exchange rates of two pairs of three currencies that have a common currency.
- If arbitrage is possible, cross-rates will be consistent.
Example:
Suppose that the AUD/USD spot rate is 1.3012 and that the one-month forward rate 1.2985.
Therefore,
𝐹𝑓/𝑑 = 1.2985,
𝑆𝑓/𝑑 = 1.3012,
𝜏 = 30/360
There is a forward discount of 1.2985 − 1.3012 = −0.0027 or 27 pips, so 𝑖𝑓 < 𝑖𝑑 .
Example:
Suppose we have the spot exchange rate of the CAD/USD of 1.2923. If the one-year T-bill interest
rate in the United States is 0.55% and the Canadian one-year Treasury rate is 0.95%, what is the one-
year forward rate?
𝑖𝑓 − 𝑖𝑑 0.0095 − 0.0055
𝐹𝑓/𝑑 = 𝑆𝑓/𝑑 + 𝑆𝑓/𝑑 ( ) 𝜏 = 1.2923 + [1.2923 ( ) 1]
1 + 𝑖𝑑 𝜏 1 + 0.0055 × 1
= 1.2923 + 0.0051 = 1.2974
The estimated forward rate is 1.2974, representing a forward rate premium of 1.2974 –
1.2923=51 pips.
N.A- HE22- FRM- 9
Exports less imports Saving less investment Taxes less government spending
The potential flow of financial capital in or out of a country is mitigated by changes in asset prices
and exchange rates.
Forward rates are typically quoted in terms of forward points. The points are added to (or
subtracted from) the spot exchange rate to calculate the forward rate.
The base currency is said to be trading at a forward premium if the forward rate is higher than
the spot rate (that is, forward points are positive). Conversely, the base currency is said to be
trading at a forward discount if the forward rate is less than the spot rate (that is, forward points
are negative).
The currency with the higher interest rate will trade at a forward discount.
Points are proportional to the spot exchange rate and to the interest rate differential and
approximately proportional to the term of the forward contract.
Empirical studies suggest that forward exchange rates may be unbiased predictors of future spot
rates, but the margin of error on such forecasts is too large for them to be used in practice.
Virtually every exchange rate is managed to some degree by central banks. The policy framework
that each central bank adopts is called an “exchange rate regime.”
An ideal currency regime would have three properties:
1. The exchange rate between any two currencies would be credibly fixed;
2. All currencies would be fully convertible; and
3. Each country would be able to undertake fully independent monetary policy in pursuit of
domestic objectives, such as growth and inflation targets.
The IMF identifies the following types of regimes: dollarization, monetary union, currency board,
fixed parity, target zone, crawling peg, crawling band, managed float, and independent float.
- Most major currencies traded in FX markets are freely floating, albeit subject to occasional
central bank intervention.
Any factor that affects the trade balance must have an equal and opposite impact on the capital
account, and vice versa.
The impact of the exchange rate on trade and capital flows can be analyzed from two perspectives.
1. The elasticities approach focuses on the effect of changing the relative price of domestic and
foreign goods. This approach highlights changes in the composition of spending.
2. The absorption approach focuses on the impact of exchange rates on aggregate
expenditure/saving decisions.
The elasticities approach leads to the Marshall–Lerner condition, which describes combinations
of export and import demand elasticities such that depreciation of the domestic currency will
move the trade balance toward surplus and appreciation will lead toward a trade deficit.
The idea underlying the Marshall–Lerner condition is that demand for imports and exports must
be sufficiently price sensitive so that an increase in the relative price of imports increases the
difference between export receipts and import expenditures.
- If there is excess capacity in the economy, then currency depreciation can increase
output/income by switching demand toward domestically produced goods and services.
- If the economy is at full employment, then currency depreciation must reduce domestic
expenditure to improve the trade balance.
2. A credit default swap is the most common form of credit derivative and may involve municipal
bonds, emerging market bonds, mortgage-backed securities or corporate bonds.
Both provide insurance against a particular company defaulting during a period of time. In a credit default
swaps, the payoff is the notional principal amount multiplied by one minus the recovery rate. In a binary
swap the payoff is the notional principal.
Example:
Principal = RM300 million
CDS cash-settled
Default occurs after four years and two months 2/12 = 0.1667
Cheapest deliverable bond is 40% of its face value
List cashflows & timings for the seller of the CDS
Receive/Pay Pay/Receive
0
0.5 300,000,000*0.006*0.5 = RM900,000
1 300,000,000*0.006*0.5 = RM900,000
1.5 300,000,000*0.006*0.5 = RM900,000
2 300,000,000*0.006*0.5 = RM900,000
2.5 300,000,000*0.006*0.5 = RM900,000
3 300,000,000*0.006*0.5 = RM900,000
3.5 300,000,000*0.006*0.5 = RM900,000
4 300,000,000*0.006*0.5 = RM900,000
4.1667 300,000,000*0.006*0.1667 = RM300,000 300,000,000*(1 - 0.4) = 180,000,000.00
N.A- HE22- FRM- 14
A Credit Default Swap (CDS) is a contract in which a buyer pays a payment to a seller to take on the
credit risk of a third party.
In exchange, the buyer receives the right to a payoff from the seller if the third party goes into default
or on the occurrence of a specific credit event named in the contract (such as bankruptcy or
restructuring).
EXAMPLE:
Say there is a person A who lends Rs. 1000 to person B on Monday. Person B promises to pay him
back on Friday. But there is a possibility that person B may default in paying back person A in the
event of a bankruptcy etc.
• Therefore, person A gets into a contract with a person C to take over the credit risk of this
transaction, in case person B defaults.
• According to the contract, person A pays a onetime premium of Rs. 100 to person C.
SITUATION:
Situation A: Person B pays back Rs. 1000 to person A. Since person B has not defaulted, the
transaction ends between persons A & B, and also between persons A & C.
Situation B: Person B defaults in his payment to person A. Now, according to the contract
between persons A & C, It becomes the obligation of person C to pay back Rs. 1000 to person A.
Person B
(borrows money from A)
Person C Person A
(takes on the credit risk of B) (lends money to B & enters into a
contract with C)
~ One party of the CDS contract is called the protection buyer while the other party is called the protection
seller.
~ Protection Buyers are mostly banks and financial institutions, but Protection Sellers could be
anybody with an appetite for risk, such as hedge funds and insurers in the US.
~ In all CDS contracts, a protection buyer transfers his Credit Risk of a third-party transaction to a
protection seller.
So, what is credit risk?
~ Credit risk is the risk involved in all transactions of borrowing and lending. If you lend money, what are
the chances that the borrower will make the repayment?
~ In case the borrower is likely to promptly return the money, then you have a low credit risk, and in case
there is a high probability of default then you have a high credit risk.
~ So, each borrowing and lending has its own element of risk involved.
N.A- HE22- FRM- 15
So,
~ A credit default swap resembles an insurance policy. You pay the premium and the insurance company
undertakes to make good your loss.
~ So, everything depends on the happening of the credit event. If no default occurs then the protection
seller would not make any payment.
Does not usually own Payment only occur if Tends to own underlying
underlying credit credit event occurs credit asset
Also,
~ Like any other Over The Counter (OTC) derivatives contract, CDS contracts are negotiated directly
between the two parties.
~ But most of these contracts follow the standard terms and conditions of the International Swaps and
Derivatives Association (Isda), which makes them look like a standardized product.
To sum up:
~ A Credit Default Swap (CDS) is a credit derivative contract between two counterparties, whereby the
"buyer" pays periodic payments to the "seller" in exchange for the right to a payoff if there is a default
or credit event in respect of a third party.
~ They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks,
hedge funds and others.
~ Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit
risk, or to speculate on changes in credit spreads.
EXERCISE 1:
What is the credit default swap spread in Problem 24.8 if it is a binary CDS?
If the swap is a binary CDS, the present value of expected payoffs is calculated as follows:
EXERCISE 2:
Show that the spread for a new plain vanilla CDS should be 1 – R times the spread for a similar new binary
CDS where R is the recovery rate.
The payoff from a plain vanilla CDS is 1 R times the payoff from a binary CDS with the same principal.
The payoff always occurs at the same time on the two instruments. It follows that the regular payments
on a new plain vanilla CDS must be 1 R times the payments on a new binary CDS. Otherwise there
would be an arbitrage opportunity.
What is Derivatives Market? Value that can be derive from equity, so, that we can have option, futures,
forward and swaps.
Derivatives: Financial instruments whose payoffs derive from other, more primitive financial variables
such as a stock price, a commodity price, an index level, an interest rate, or an exchange rate.
How can derivatives be used?
~ Forwards and futures: to hedge an existing market exposure.
~ Options: to obtain downside protection to an exposure even while retaining upside potential.
~ Swaps: to transform the nature of an exposure.
~ Credit derivative: to obtain insurance against events such as default.
What’s a credit derivative? Derivatives written on the credit risk of an underlying reference entity.
Isolate credit risk from other risks present in an asset. Are off-balance-sheet instruments.
Types of credit derivatives: Secured loan Credit Default Swap
Credit Default Swap (CDS) Credit Default Swap on Asset Backed
Total Return Swap Securities
Constant Maturity Credit Default Swap Credit Default Swaption
(CMCDS) Recovery lock transaction
First to Default Credit Default Swap Credit Spread Option
Portfolio Credit Default Swap CDS index products
CDS: definition: A Credit Default Swap (CDS) is a kind of insurance against credit risk.
How does a CDS work?
Bp per annum
Protection buyer Protection seller
(short position) (long position)
Contingent
Buy municipal bond payment
($900)
Credit event
RISK MANAGEMENT
Delta
~ Delta of a portfolio is the partial derivative of a portfolio with respect to the price of the
underlying asset (gold in this case)
~ Suppose that a $0.1 increase in the price of gold leads to the gold portfolio decreasing in value by
$100
~ The delta of the portfolio is −1000
~ The portfolio could be hedged against short-term changes in the price of gold by buying 1000
ounces of gold. This is known as making the portfolio delta neutral
Delta Hedging
~ Initially the delta of the option is 0.522
~ The delta of the position is -52,200
~ This means that 52,200 shares must purchased to create a delta neutral position
~ But, if a week later delta falls to 0.458, 6,400 shares must be sold to maintain delta neutrality
Tables 7.2 and 7.3 (pages 142 and 143) provide examples of how delta hedging might work for
the option.
Gamma
Gamma () is the rate of change of delta () with respect to the price of the underlying asset
Gamma is greatest for options that are close to the money
Gamma measures the delta hedging errors caused by curvature
Interpretation of Gamma
- For a delta neutral portfolio, P t ½ S
Theta
Theta () of a derivative (or portfolio of derivatives) is the rate of change of the value with
respect to the passage of time
The theta of a call or put is usually negative. This means that, if time passes with the price of the
underlying asset and its volatility remaining the same, the value of the option declines
Rho: the partial derivative with respect to a parallel shift in all interest rates in a particular country
Hedging in Practice
~ Traders usually ensure that their portfolios are delta-neutral at least once a day
~ Whenever the opportunity arises, they improve gamma and vega
~ As portfolio becomes larger hedging becomes less expensive
With the notation of the text, the increase in the value of the portfolio is
A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
(a) What position in the traded option and in sterling would make the portfolio both gamma
neutral and delta neutral?
(b) What position in the traded option and in sterling would make the portfolio both vega neutral
and delta neutral?
N.A- HE22- FRM- 21
The delta of the portfolio is −1, 000 × 0.50 − 500 × 0.80 − 2,000 × (−0.40) − 500 × 0.70 = −450
The gamma of the portfolio is −1, 000 × 2.2 − 500 × 0.6 − 2,000 × 1.3 − 500 × 1.8 = −6,000
The vega of the portfolio is −1, 000 × 1.8 − 500 × 0.2 − 2,000 × 0.7 − 500 × 1.4 = −4,000
(a) A long position in 4,000 traded options will give a gamma-neutral portfolio since the long
position has a gamma of 4, 000 × 1.5 = +6,000. The delta of the whole portfolio (including traded
options) is then:
Hence, in addition to the 4,000 traded options, a short position in £1,950 is necessary so that the
portfolio is both gamma and delta neutral.
(b) A long position in 5,000 traded options will give a vega-neutral portfolio since the long position
has a vega of 5, 000 × 0.8 = +4,000. The delta of the whole portfolio (including traded options) is
then
Hence, in addition to the 5,000 traded options, a short position in £2,550 is necessary so that the
portfolio is both vega and delta neutral.
N.A- HE22- FRM- 22
VaR: It is the loss level: RM1,000,0000 over N=10days days that we are X%=99% certain will not be
exceeded.
How bad can things get bad?
ES: Whereas VaR asks how bad can thing get, expected shortfall asks: "If things do get bad, what is the
expected loss?"
ADVANTAGES OF VaR
~ It captures an important aspect of risk in a single number
~ It is easy to understand
~ It asks the simple question: “How bad can things get?”
(a) What is the VaR for one of the investments when the confidence level is 95%?
(b) What is the expected shortfall when the confidence level is 95%?
(c) What is the VaR for a portfolio consisting of the two investments when the confidence level is 95%?
(d) What is the expected shortfall for a portfolio consisting of the two investments when the
confidence level is 95%?
(e) Show that, in this example, VaR does not satisfy the subadditivity condition whereas expected
shortfall does.
ANSWER:
(a) A loss of $1 million extends from the 94 percentile point of the loss distribution to the 96 percentile
point. The 95% VaR is therefore $1 million.
(b) The expected shortfall for one of the investments is the expected loss conditional that the loss is in
the 5 percent tail. Given that we are in the tail there is a 20% chance than the loss is $1 million and
an 80% chance that the loss is $10 million. The expected loss is therefore $8.2 million. This is the
expected shortfall.
N.A- HE22- FRM- 23
(c) For a portfolio consisting of the two investments there is a 0.04 × 0.04 = 0.0016 chance that the loss
is $20 million; there is a 2 × 0.04 × 0.02 = 0.0016 chance that the loss is $11 million; there is a 2 ×
0.04 × 0.94 = 0.0752 chance that the loss is $9 million; there is a 0.02 × 0.02 = 0.0004 chance that the
loss is $2 million; there is a 2 × 0.2 × 0.94 = 0.0376 chance that the loss is zero; there is a 0.94 × 0.94
= 0.8836 chance that the profit is $2 million. It follows that the 95% VaR is $9 million.
(d) The expected shortfall for the portfolio consisting of the two investments is the expected loss
conditional that the loss is in the 5% tail. Given that we are in the tail, there is a 0.0016/0.05 = 0.032
chance of a loss of $20 million, a 0.0016/0.05 = 0.032 chance of a loss of $11 million; and a 0.936
chance of a loss of $9 million. The expected loss is therefore $9.416.
(e) VaR does not satisfy the subadditivity condition because 9 > 1 + 1. However, expected shortfall does
because 9.416 < 8.2 + 8.2.