Derivatives Usage: The Basic InstrumentsDerivativesFuturesBasic Picture of FuturesExchange-traded Interest Rate FuturesTypical Bank FuturesSimulationSlide 8OptionsCall OptionPut OptionInterest Rate OptionsInterest Rate Cap (Cap/Floor Handout)Interest Rate FloorInterest Rate CollarSwapsSwaps contractsSwaps ParticipantsDerivatives Usage:Derivatives Usage:The Basic InstrumentsThe Basic InstrumentsDerivativesDerivativesG & K Chps. 6 and 14Basic Terms and DefinitionsFuturesOptionsSwapsFuturesFuturesBuy (Sell) a futures contract = commitment to buy (sell) later.Need to buy X in the future; Buy a futures contract today at an known price and you will “net” pay that price later.No monies exchanged now;Bilateral – Money exchanged laterExchange Traded – Daily settleBasic Picture of FuturesBasic Picture of FuturesProfitCurrentPricePurchase Price of ContractGainLossSoldFuturesGain/Loss = Sale Price – Purch PriceProfitCurrentPricePurchase Price of ContractGain/Loss = Purch Price - Sale PriceBoughtFuturesGainLossExchange-traded Exchange-traded Interest Rate FuturesInterest Rate FuturesMost Trade Price, not interest rate.Most at least $1 million face valueTreasuries, EuroDeposits, Fed Funds, Munis, Foreign Floating Rates (LIBOR, PIBOR, etc.)WSJ, Reuters, BloombergCBOT (Treasuries, Munis, FF); CME (T-Bill, Euro$, Floating Rate)Typical Bank FuturesTypical Bank FuturesInvmt Portfolio T-Secs and MunisInterest Rates rise and not only do you hold poor coupons, but MV fell.Sell Futures (at current price), rates rise, spot (futures) prices fall. You settle (or buy back) position at a lower price, hopefully offsetting portfolio MV drop.Unrealized vs. Realized  Tax IssueSimulationSimulation$10m Face of 8%, 1yr. USTs10, $1m bondsMature 6 days before end of each quarterMargin 15% of position value, marked against pledge, but held off-balance sheet.Futures changes run thru I/SSimulationSimulationDW: Duration Weighted Market Value of Securities portfolio..68: adjustment for quarterly coupons/compounding vs. actual semi-annual of futures.N/M: Percent of year annual futures contract held (3mo of 1yr = .25)Number of Contracts = (Total DW Value of Securities x .68) x (N/M)OptionsOptionsRight to buy (Call) or sell (Put) in futureCan Sell (Write) Call or Put, or Buy Call or PutWhen Buying, pay cost (Premium) immediately. When Writing, receive premium immediately, but usually locked up until position repurch’dCall OptionCall OptionCall OptionCall OptionPayoffPriceCurrent StockPriceStock PayoffsPayoffPriceOptionExercisePriceCall Option PayoffsOut ofthe MoneyInthe MoneyCall Option Payoff = Max[ 0 , S - X ]Put OptionPut OptionPut OptionPut OptionPayoffPriceCurrent StockPriceStock PayoffsPayoffPriceOptionExercisePricePut Option PayoffsInthe MoneyOut ofthe MoneyPut Option Payoff = Max[ 0 , X - S ]Interest Rate OptionsInterest Rate OptionsMost of the trading done off the exchange floorsThe interest rate options market isVery largeHighly efficientHighly liquidEasy to useInterest Rate CapInterest Rate Cap(Cap/Floor Handout)(Cap/Floor Handout)An interest rate capIs like a portfolio of European call options (caplets) on an interest rateOn each interest payment date over the life of the cap, one option in the portfolio expiresIs useful to firms with floating rate liabilitiesCaps the periodic interest payments at the caplet’s exercise priceInterest Rate FloorInterest Rate FloorAn interest rate floorIs related to a cap in the same way that a put is related to a calllike a portfolio of European put options (floorlets) on an interest rateOn each interest payment date over the life of the cap, one option in the portfolio expiresIs useful to firms with floating rate assetsPuts a lower limit on the periodic interest payments at the floorlet’s exercise priceInterest Rate CollarInterest Rate CollarAn interest rate collar is simultaneously long an interest rate cap and short an interest rate floorSacrifices some upside potential in exchange for a lower position costPremium from writing the floorlets reduces position costsSwapsSwapsThe most common type of interest rate swap is the fixed for floating rate swapOne party makes a fixed interest rate payment to another party making a floating interest rate paymentOnly the net payment is made (difference check)The firm paying the floating rate is the swap sellerThe firm paying the fixed rate is the swap buyerSwaps contractsSwaps contractsTypically, the floating interest rate is linked to a market rate such asLIBOR orT-bill ratesThe swap market is standardized partly by the International Swaps and Derivatives Association (ISDA)ISDA provisions are master agreementsSwaps ParticipantsSwaps ParticipantsThe swap facilitator will find a counterparty to a desired swap for a fee or take the other sideA facilitator acting as an agent is a swap brokerA swap facilitator taking the other side is a swap dealer (swap bank)A plain vanilla swap refers to a standard contract with no unusual features or bells and