FINANCIAL DERIVATIVES

Futures Forwards Options Swaps

Shares Bonds

Derivatives are an insurance policy A Contract representing a Security Price is dependent upon an underlying asset Value is determined by fluctuations in the underlying asset Common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes Derivatives cover everything from shares market index moves, consumer price index changes, and even weather conditions Derivatives exist due to risk Investors use derivatives to reduce / hedge against risk when they make a trade

BOB GREENWOOD

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OPTION BASED DERIVATIVES Represent the right but not the obligation to exercise a transaction within a set period of time CALL (BUY) or PUT (SELL) OPTION Option Type Premium Call Security ABC Apr Expiry 55 Strike Price 2.50

STRIKE PRICE of $55 is what the OPTION HOLDER can purchase the shares of ABC for anytime up until the 3rd Friday of April This would cost the OPTION HOLDER $2.50 per contract per share Purchasing the CALL OPTION CONTRACT will have three different outcomes: 1. Share price goes up 2. Share price does not change 3. Share price goes down In-the-money ABC trading at $60 before Expiry Date Sell the OPTION Bought OPTION CONTRACT of $55 + premium of $2.50 ($57.50) Sell OPTION CONTRACT for $60 = $2.50 gain At-the-money Break Even Out-of-the-money ABC drops to $50 by the Expiry Date OPTION CONTRACT HOLDER only loses $2.50 FORWARD-BASED CONTRACTS
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Forwards represent the obligation to make a transaction at a set point in time in the future No up-front cost to entering into a FORWARD-BASED CONTRACT FORWARD CONTRACTS traded on a recognised exchange called FUTURES

Forward Rate Agreements ABC needs to borrow $30 million for eight months, starting in three months' time but wants to hedge against interest rate changes which are likely to fluctuate between 2 4% A 311 FRA at 2.75 2.60 is available ABC will lock into an interest rate of 2.75% 4% 2% FRA on $30m @ 2.75% 550,000 550,000 Interest payable $30m x 0.04 x 8/12 (800,000) Interest payable $30m x 0.02 x 8/12 (400,000) Gain 250,000 Loss 150,000 SWAPS Swaps are contractual agreements to exchange or swap a series of cash flows Interest Rate swaps Plain vanilla swaps are agreements between two parties to exchange fixed rate for floating-rate financial obligations This type of swap forms the largest single financial derivative market in the world Bank Rates Available to Company A Borrow fixed at 10% Borrow floating at LIBOR + 1% 2%
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Company B Borrow fixed at 13% Borrow floating at LIBOR +

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Prefers Floating

Prefers Fixed

Outcome of Swap Company A swaps Fixed Interest for Company B Libor so that both Companies would be in a better position than had they sought financing on its own
A 10% (10%) LIBOR LIBOR LIBOR + 1% 1% B LIBOR + 2% 10% (LIBOR) EXCLUDING + 2% 12% 13% 1%

CURRENT INTEREST A SWAPS FIXED WITH B B SWAPS LIBOR WITH A INTEREST AFTER SWAP OPEN MARKET COST SAVING

LIBOR stands for 'London Inter Bank Offered Rate'. It is a benchmark used by banks, securities houses and investors to gauge the cost of unsecured borrowing in the London interbank market It is calculated each day by Thomson Reuters which acts on behalf of the British Bankers Association from information submitted by 16 major banks of their cost of borrowing unsecured funds from other banks in up to 10 currencies across 15 different time frames by 11 am daily. Banks submitting
HSBC SANTAN DER RABOBA NK BARCLAY S ROYAL BANK OF CANADA LLOYDS BANKING GROUP BNP PARIBAS ROYAL BANK OF SCOTLAN D SOCIETE GENERAL E CITIBANK DEUTSCH E BANK BANK OF TOKYO MITSUBI SHI UFJ UBS

JP MORGAN CHASE

CREDIT AGRICOL E

MIZUHO

Average Calculated 1.001%................................................................................................ ................1.016% The Top Four Rates and the Bottom Four Rates are excluded from the calculation LIBOR RATE = 1.0085% Libor used by Lenders and Deposit Takers to price a whole range of loans and savings and investment products Interest rate on some loans and investment products is directly
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pegged to the Libor rate Fixed rate Mortgages and Investment Bonds Libor also used by bankers as an indicator of the future availability of credit and therefore enters into the calculation of the pricing of virtually all savings and loan products such as Mortgages Credit Card Interest Rates Car Loans Instant Access Savings Accounts

BOB GREENWOOD

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CURRENCY SWAPS

BOB GREENWOOD

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