Interest Rate Risk What are Derivatives? A derivative is a financial instrument whose value is derived from the value of another asset, which is known as the underlying. When the price of the underlying changes, the value of the derivative also changes. A Derivative is not a product. It is a contract that derives its value from changes in the price of the underlying. Example : The value of a gold futures contract is derived from the value of the underlying asset i.e. Gold. OTC and Exchange Traded Derivatives. OTC Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties without going through an exchange or other intermediary. • The contract between the two parties are privately negotiated. • The contract can be tailor-made to the two parties’ liking. • Over-the-counter markets are uncontrolled, unregulated and have very few laws. OTC and Exchange Traded Derivatives Exchange-traded Derivatives Exchange traded derivatives contract (ETD) are those derivatives instruments that are traded via specialized Derivatives exchange or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange. There is a very visible and transparent market price for the derivatives What is a Forward? A forward is a contract in which one party commits to buy and the other party commits to sell a specified quantity of an agreed upon asset for a pre-determined price at a specific date in the future. It is a customised contract, in the sense that the terms of the contract are agreed upon by the individual parties. Hence, it is traded OTC. Forward Contract Example Farmer I agree to sell 500 kg wheat at Tk 40/kg after 3 months. Bread Maker 3 months Later 500kgs wheat Farmer Tk.20,000 Bread Maker Risks in Forward Contracts Credit Risk – Does the other party have the means to pay? Operational Risk – Will the other party make delivery? Will the other party accept delivery? Liquidity Risk – Incase either party wants to opt out of the contract, how to find another counter party? Terminology Long position - Buyer Short position - Seller Spot price – Price of the asset in the spot market.(market price) Delivery/forward price – Price of the asset at the delivery date. What are Futures? A future is a standardised forward contract. It is traded on an organised exchange (similar to a stock exchange) Standardisation- - quantity of underlying quality of underlying(not required in financial futures) delivery dates and procedure price quotes Types of Futures Physical Delivery Cash Settlement Physical delivery is similar to Commodity Forwards In cash settlement, no physical delivery takes place; only cash settlement Example of Cash Settled Futures A flour manufacturer buys 1 ton of wheat in futures market at Tk 1,000; settlement after three months At the time of settlement, the future price of wheat is (1) Tk 1,300 or (2) Tk 800 Under 1, seller will pay to buyer Tk 300 to settle the transaction (since he is bound to deliver at Tk 1,000 which the buyer can then sell at Tk 1,300 making Tk 300 profit) Under 2, seller will receive from buyer Tk 200 to settle the transaction (since he is bound to deliver at Tk 1,000 which the buyer can then sell at Tk 800 making Tk 200 loss) Buyer Position Buyer will buy 1 ton of wheat in spot market Gain/ (Loss) from futures Net Cost i.e. the price he bought the futures Loss/ Gain in underlying transaction: Gain/ (Loss) in future market 1 (Tk 1,300) Tk 300 (Tk 1,000) 2 (Tk 800) (Tk 200) (Tk 1,000) (Tk 300) Tk 300 Tk 200 (Tk200) Example of Cash Settled Futures .. 2 A flour manufacturer buys 1 ton of wheat in futures market at Tk 1,000; settlement after three months At the time of settlement, the market price of wheat is (1) Tk 1,300 or (2) Tk 800 Under 1, seller will pay to buyer Tk 300 to settle the transaction (since he is bound to deliver at Tk 1,000 which the buyer can then sell at Tk 1,300 making Tk 300 profit) Under 2, seller will receive from buyer Tk 200 to settle the transaction (since he is bound to deliver at Tk 1,000 which the buyer can then sell at Tk 800 making Tk 200 loss) Seller Position 1 Seller will sell 1 ton of wheat in spot market Tk 1,300 Gain/ (Loss) from futures Tk (300) Net Selling Price Tk 1,000 i.e. the price he bought the futures Loss/ Gain in underlying transaction: Tk 300 Gain/ (Loss) in future market (Tk300) 2 Tk 800 Tk 200 Tk 1,000 (Tk 200) Tk 200 Traders in Derivatives Market There are mainly two types of traders in the Derivatives Market : HEDGER A hedger is someone who faces risk associated with price movement of an asset and who uses derivatives as means of reducing risk. They provide economic balance to the market. SPECULATOR A trader who enters the futures market for pursuit of profits, accepting risk in the endeavor. They provide liquidity and depth to the market. Types of Futures Contracts Stock Futures Trading (dealing with shares) Commodity Futures Trading (dealing with gold futures, crude oil futures) Index Futures Trading (dealing with stock market indices) Interest rate futures What are Options? Contracts that give the holder the option to buy/sell specified quantity of the underlying assets at a particular price on or before a specified time period. The word “option” means that the holder has the right but not the obligation to buy/sell underlying assets. Types of Options Options are of two types – call and put. Call option give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a particular date by paying a premium. Puts give the buyer the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a particular date by paying a premium. Types of Options (cont.) The other two types are – European style options and American style options. European style options can be exercised only on the maturity date of the option, also known as the expiry date. American style options can be exercised at any time before and on the expiry date. Call Option Example Premium = Tk.25/share Amt to buy Call option = Tk.2500 Suppose after a month, Market price is Tk.400, then the option is exercised i.e. the shares are bought. Net gain = 40,000-30,0002500 = Tk.7,500 CALL OPTION Right to buy 100 Co R shares at a price of Tk.300 per share after 1 month. Current Price = Tk.250 Strike Price Expiry date Suppose after a month, market price is Tk.200, then the option is not exercised. Net Loss = Premium amt = Tk.2,500 Put Option Example Premium = Tk.25/share Amt to buy Call option = Tk.2,500 PUT OPTION Right to sell 100 Co R shares at a price of Tk.300 per share after 1 month. Suppose after a month, Market price is Tk.200, then the option is exercised i.e. the shares are sold. Net gain = 30,000-20,0002,500 = Tk.7,500 Current Price = Tk.250 Strike Price Expiry date Suppose after a month, market price is Tk.300, then the option is not exercised. Net Loss = Premium amt = Tks.2,500 Features of Options A fixed maturity date on which they expire. (Expiry date) The price at which the option is exercised is called the exercise price or strike price. The person who writes the option and is the seller is referred as the “option writer”, and who holds the option and is the buyer is called “option holder”. The premium is the price paid for the option by the buyer to the seller. A clearing house is interposed between the writer and the buyer which guarantees performance of the contract. Variable Interest Rate - LIBOR LIBOR is the average interest rate at which major global banks borrow from one another. It is based on: five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, seven different maturities—overnight/spot next, one week, and one, two, three, six, and 12 months. Each morning, just before 11 a.m. Greenwich Mean Time, the ICE Benchmark Administration (IBA) asks a panel of contributor banks (usually 11 to 16 large, international banks) to answer the following question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m. London time? Only banks that have a significant presence in the London market are considered for membership on the ICE LIBOR panel, which is determined annually. The IBA calculates the LIBOR rate using a trimmed mean, throwing out figures in the highest and lowest quartile and averaging the remaining numbers. Interest Rate Risk 2 months Loan agreement signed 3 months Loan drawdown Loan maturity 3 MONTH LIBOR ◦ If one borrows at a variable rate, the interest rate risk represents the risk that at the time of loan drawdown, the rate of interest is higher than the current rate ◦ If one deposit at a variable rate, the interest rate risk represents the risk that at the time of loan drawdown, the rate of interest is lower than the current rate Interest Rate FRA This is similar to commodity forward. Interest rate is fixed earlier with a bank to be applied when the loan drawdown takes place 3v6 FRA 3 months Loan agreement signed 3 MONTH LIBOR 3 months Loan drawdown Loan maturity Interest Rate FRA A bank has quoted the following rates for dealing in FRAs 3v6 Bid 4.59 Offer 4.56 It is 24th March and your company wants to fix an interest rate for borrowing CU 1 million for three months from 24th June. What is the payment to be made on the FRA if the company entered a 3 v 6 FRA with a bank, assuming that interest rates rise to 4.65% from their current level of 4.5%? Also, show the effective rate of interest including the supporting calculations. Interest Rate FRA Solution: Since the company will be borrowing in three months’ time and wished to hedge the interest rate risk in the underlying transaction, it can buy (Bid) an FRA. This will mean that in three months’ time, the company will pay the amount of FRA to the bank and the bank will pay the company the spot rate. 24th March Company buys FRA at 4.59% 24th June Company pays bank 4.59% Bank pays company 4.65% (spot rate) Company receives (net) 0.06% Amount 150 (0.06% x 1,000,000 x 3/12) Interest on borrowings (11,625) (4.65% x 1,000,000 x 3/12) Net Payment (11,475) Effective rate of interest 11,475 x 12 % = 4.59% 1,000,000 3 Interest Rate Futures An interest rate future is a financial derivative that allows exposure to changes in interest rates. Interest rate futures price moves inversely to interest rates. Future Price = 100 – i (If interest rate is 5%, future price will be 95) Simple Example: I will borrow at LIBOR (Current 3 month LIBOR is 3%) after 2 months 2 month futures are quoted at 97. After 2 months actual interest rate is (1) 4% and future price is 96 (2) 2% and future price is 98 After 2 months Sell 97 97 Spot 96 98 1 (1) Interest payment (4) (2) Net Cost (3) (3) Gain / (Loss) Interest Rate Futures It is 1 January, and a company has identified that it will need to borrow CU 10 million on 31st March for 6 months. The spot rate on 1 January is 8% and March 3 month interest rate futures with a contract size of CU 500,000 are trading at 91. Demonstrate how futures can be used to hedge against interest rate rises. Assume that at 31st March the spot rate of interest is 11% and the March interest rate futures price has fallen to 89. Solution 1st January Sell future at 91 No of contracts 10,000,000 x 6 = 40 contracts 500,000 3 31st March Sell 91 Spot 89 Gain 2% Amount 100,000 (2% x 500,000 x 40 x 3/12) Interest payment (550,000) (11% x 10,000,000 x 6/12) Net payment (450,000) Effective Rate 450,000 x 12 % = 9% 10,000,000 6 Interest Rate Options Panda Ltd wishes to borrow CU 4 million fixed rate in 12June for nine months and wishes to protect itself against rates rising above 6.75%. It is 11 May and the spot rate is currently 6%. The data is as follows: SHORT CU OPTIONS CU500,000 Strike price Calls Puts June Sept Dec June Sept Dec 93.25 0.16 0.19 0.21 0.14 0.92 1.62 93.50 0.05 0.06 0.07 0.28 1.15 1.85 93.75 0.01 0.02 0.03 0.49 1.39 2.10 Panda negotiates the loan with the bank on 12 June (when the CU 4m loan rate is fixed for the full nine months) and closes out the hedge. What will be the outcome of the hedge and the effective loan rate if prices on 12 June are as follows: Closing prices Case1 Case2 Spot price 7.4% 5.1% Futures price 92.31 94.75 Interest Rate Options Solution The strike rate of 93.75% appears to be most optimal considering the differential interest rate and premium. On 11 May Strike price of 93.75 No of contracts (4,000,000 / 500,000) x 9/3 = 24 contracts Premium: 0.49% x 24 x 500,000 x 3/12 = CU 14,700 On 12 June Spot rate of interest Sell at Future Spot rate Exercise Gain Amount Interest Payment Premium Net Payment Effective Rate of Interest Case 1 7.4% 93.75 92.31 Yes 1.44% 43,200 (222,000) (14,700) (193,500) 6.45% Case 2 5.1% 93.75 94.75 No - (153,000) (14,700) (167,700) 5.59% (1.44% x 24 x 500,000 x 3/12) (7.4% x 4,000,000 x 9/12) (5.1% x 4,000,000 x 9/12) (193,500 / 4,000,000 x 12/9%) (167,700 / 4,000,000 x 12/9%) What are SWAPS? In a swap, two counter parties agree to enter into a contractual agreement wherein they agree to exchange cash flows at periodic intervals. Most swaps are traded “Over The Counter”. Some are also traded on futures exchange market. Interest Rate Swap A company agrees to pay a pre-determined fixed interest rate on a notional principal for a fixed number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time. The principal is not exchanged. Hence, it is called a notional amount. What are Interest rate SWAPS? Example 1 Company A has borrowed CU 10 million at a fixed interest rate of 9% per annum. Company B has also borrowed CU 10 million but pays interest at LIBOR + !%. LIBOR is currently 8% per annum. Both companies decide to swap their obligations. • Company A thinks that interest rates will come down • Company B thinks that interest rates will go up Now Company A pays B Company B pays A Company A 9% LIBOR + 1% (9%) Company B LIBOR +1% (LIBOR +1%) 9% What are Interest rate SWAPS? Example 2 Goodcredit Ltd has been given a high credit rating. It can borrow at a fixed rate of 11% or at a variable interest rate equal to LIBOR. It would like to borrow at a variable rate. Secondtier Ltd is a company with a lower credit rating, which can borrow at a fixed rate of 12.5% or at a variable rate of LIBOR + 0.5%. It would like to borrow at a fixed rate. Solution Preferred rate Could borrow Savings Goodcredit Secondtier LIBOR 12.5% 11% LIBOR + 0.5% Total LIBOR + 12.5% LIBOR + 11.5% 1% By borrowing in their opposite preference and swapping their payments, each party can reduce their cost by 0.5%.
