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Financial Instruments
Chapter 5
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 1
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Financial Markets (pages 83-84)
Exchange traded Traditionally exchanges have used the open-outcry system,
but increasingly they are switching to electronic trading
Contracts are standard; there is virtually no credit risk
Over-the-counter (OTC) A computer- and telephone-linked network of dealers at
financial institutions, corporations, and fund managers Contracts can be non-standard; there is some small amount
ofcredit risk
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Short Selling (Pages 85-86)
Short selling involves sellingsecurities you do not own
Your broker borrows the securitiesfrom anotherclient and sells themin the market in the usual way
At some stage you must buy thesecurities back so they can bereplaced in the account of the client
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Short Selling (continued)
You must pay dividends and other benefitsthe owner of the securities receives
The cash flows from a short position that is
entered into at time T1 and closed out attime T2 are the opposite of those from a longposition where asset is bought at time T1and sold at time T2,except that there may be
a small fee for borrowing the asset
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Derivatives
Forwards
Futures
Swaps Options
Exotics
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 5
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GrowthofDerivatives Markets(Figure 5.1)
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 6
0
100
200
300
400
500
600
700
Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08
Size of
Market($ trillion)
OTC
Exchange
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Forward Contracts
A forward contract is an agreement to buyor sell an asset at a certain price at a
certain future time Forward contracts trade in the over-the-counter market
They are particularly popular on currenciesand interest rates
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 7
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Foreign Exchange Quotes for GBP
August 27, 2008 (See page 87)
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 8
Bid Offer
Spot 1.8356 1.8360
1-month forward 1.8314 1.8319
3-month forward
1.82
37 1.82
42
6-month forward 1.8127 1.8133
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Profit from a Long Forward Position
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 9
Profit
Price of Underlying
at Maturity, STK
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Profit from a Short Forward Position
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 10
Profit
Price of Underlying
at Maturity, STK
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Futures Contracts (pages 89-91)
Agreement to buy or sell an asset for acertain price at a certain time
Similar to forward contract Whereas a forward contract is traded
OTC, a futures contract is traded on an
exchange
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Futures Contract continued
Contracts are settled daily (e.g., if acontract is on 200 ounces of Decembergold and the December futures moves $2in my favor, I receive $400; if it moves $2
against me I pay $400) Both sides to a futures contract are
required to post margin (cash ormarketable securities) with the exchangeclearinghouse. This ensures that they willhonor theircommitments under thecontract.
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 12
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Swaps
A swap is an agreement toexchange cash flows at specifiedfuture times according to certainspecified rules
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 13
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An Exampleof
a Plain VanillaInterest Rate Swap
An agreement to receive 6-month
LIBOR & pay a fixed rate of 5% perannum every 6 months for3 years ona notional principal of $100 million
Next slide illustrates cash flows
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 14
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Cash Flows for one set ofLIBOR rates(See Table 5.4, page 93)
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 15
---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash FlowCash FlowCash Flow
Mar.5, 2010 4.2%
Sept. 5, 2010 4.8% +2.10 2.50 0.40
Mar.5, 2011 5.3% +2.40 2.50 0.10
Sept. 5, 2011 5.5% +2.65 2.50 +0.15Mar.5, 2012 5.6% +2.75 2.50 +0.25
Sept. 5, 2012 5.9% +2.80 2.50 +0.30
Mar.5, 2013 6.4% +2.95 2.50 +0.45
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Typical Uses ofan
Interest Rate Swap
Converting a liability from
fix
ed rate to floating rate floating rate to fixed rate
Converting an investment from
fixed rate to floating rate
floating rate to fixed rate
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 16
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Quotes By a Swap Market Maker(Table 5.5, page 94)
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 17
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American vs European Options
An American option can be exercised atany time during its life
A European option can be exercised onlyat maturity
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 20
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IntelOption Prices: Apr. 27, 2008;
Stock Price=23.45 (See Table 5.6; page 95)
S
trikePriceS
ept0
8Call Oc
t0
8Call
J
an0
9CallS
ept0
8Put Oc
t0
8PutJ
an0
9Put
22 1.65 2.10 n.a. 0.21 0.63 n.a.
23 0.90 1.44 n.a. 0.47 0.97 n.a.
24 0.39 0.92 1.69 0.96 1.45 2.21
25 0.12 0.54 1.27 1.68 2.06 2.78
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 21
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Options vs Futures/Forwards
A futures/forward contract gives the holderthe obligation to buy or sell at a certain
priceAn option gives the holder the right to buy
or sell at a certain price
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 22
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Hedging ExamplesA UScompany will pay 10 million for
imports from Britain in 3 months and
decides to hedge using a long positionin a forward contract
An investor owns 1,000 Microsoftshares currently worth $28 per share. A
two-month put with a strike price of$27.50costs $1. The investor decidesto hedge by buying 10contracts
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 23
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Options vs Forwards
Forward contracts lock in a price for afuture transaction
Options provide insurance. They limit thedownside risk while not giving up theupside potential
For this reason options are more attra
ctiveto many corporate treasurers than forward
contracts
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Interest Rate Options
Caps and floors
Swap options
Bond options
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009 25
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Margins (pages 97-101)
Buying on margin
Short sales
Futures Options
OTC market
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 200926
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Nontraditional Derivatives (pages101-104)
Weather derivatives
Energy derivatives Oil
Natural gas
Electricity
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 200927
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ExoticOptions (pages 104-105)
Asian options
Barrier option
Basket options Binary options
Compound options
Lookback options
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009
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Example of the Use ofExotic
Options (Business Snapshot 5.3, page 105)
If a company earns revenue month by
month in many different currencies Asianbasket put options can provide anappropriate hedge
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009
29
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Structured Products
Products created to meet the needs ofclients
A bizarre structures product is the 10/30
deal between Bankers Trust and Procterand Gamble (See Business Snapshot 5.4)
The payments by P&G were
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009
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100
priceTSYyr5.78%
%CMTyr5 305.98
,0max
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Types ofTraders
Hedgers
Speculators
Arbitrageurs
Some of the largest trading losses inderivatives have occurred becauseindividuals who had a mandate to be
hedgers or arbitrageurs switched to beingspeculators (See for example BaringsBank, Business Snapshot 5.5, page 107)
Risk Management and Financial Institutions, 2e, Chapter 5, Copyright John C. Hull 2009
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