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Fundamentals of Derivative Contracts No Slide Title Currency Risk

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					                                      Brussels
                                      17 September 2002




European Parliament Financial Services Forum
Fundamentals of Derivative Contracts




David Mengle
International Swaps and Derivatives Association and
Fordham University Graduate School of Business
Three forms of derivatives activity

 Futures are customized, exchange-traded derivatives contracts
    – Futures contracts
    – Exchange-traded options

 Over-the-counter (OTC) are customized, privately-negotiated derivatives
    – Forwards
       • Contracts to exchange something at an agreed time in the future at a
         price agreed upon today
    – Swaps
       • Contracts between two counterparties to exchange cash flows on a
         notional principal amount at regular intervals during a stated period
    – OTC options
       • Contracts that give the buyer, in exchange for the payment of a premium,
         the right but not the obligation to buy or sell a specified amount of the
         underlying asset at a predetermined price at or until a stated time.

 Structured securities combine securities with derivatives contracts
Situation 1: Interest rate risk
Situation
 Client is a European bank that has made a 5-year
  €100 million loan at a fixed rate to a domestic
  corporation
 Loan funded with one-year euro deposits
 Client is concerned that euro interest rates will rise
             Assets                 Liabilities

       Loan                    Deposit
       (5-year fixed rate)     (1-year Euribor)
       €100 MM                 €100 MM
 Interest rate risk
Situation

                  1-year                            5-year
                  Euribor                         fixed rate
Deposit                          Bank                            Loan




  There is a mismatch between the term of the asset and that of the liability
    that funds the asset
  The client here faces refinancing risk that the cost of rolling over
    (reborrowing) funds will rise relative to the returns on assets
  Mismatches often occur because the investment and funding decisions
    are made by different parts of the firm
 Solution: Interest rate swap
       Swap: A contractual agreement between two counterparties to
       exchange cash flows on a notional principal amount at regular
       intervals during a stated period
                                                   5-year
                1-year                             Fixed
                Euribor                             Rate
                               Bank                               Loan
Deposit

                                               Notional amount = €100 million
The most common                           Swap
type of interest rate   Euribor            Rate
swap involves the                        (4.12%)      In an interest rate
exchange of a fixed                                   swap, the notional
rate cash flow for a                                  amount is never
floating rate cash flow         Dealer                exchanged



          Net Funding Cost: 5-Year Swap Rate = 4.12%
Swap cash flows
€ millions

Time         Deposit                 Swap        Net
0             100               --          --    100
1            (EURIBOR)         EURIBOR (4.12)     (4.12)
2            (EURIBOR)         EURIBOR (4.12)     (4.12)
3            (EURIBOR)         EURIBOR (4.12)     (4.12)
4            (EURIBOR)         EURIBOR (4.12)     (4.12)
5            (100 + EURIBOR)   EURIBOR (4.12)    (104.12)
Result of hedging with interest rate swap

 Client has given up interest rate risk by locking in
  fixed swap rate (replaced risk with certainty)
    – Client will be protected from rising deposit rates,
    – But will not benefit if rates fall

 Client assumes credit exposure to Dealer (and vice
  versa) over next five years
 The Dealer does not charge the client a fee to
  enter the swap
Situation 2: Interest rate risk

 A European corporation plans to borrow €100 million to fund its domestic
   expansion plans, but is not well known enough to issue fixed-rate bonds to the
   public
 The corporation is able to borrow from its bank at a floating rate of 1-year Euro
   Libor plus 1.5 percent
 The corporation can obtain synthetic fixed-rate financing by paying a fixed rate on
   an interest rate swap with its bank


                 Euriibor + 1.50%                     Libor

      Bank                        Corporation                       Dealer
                    €100 MM                          4.12%
                                                     (fixed)

   5-year Euro swap rate = 4.12%
   Total annual funding cost to corporation = 4.12% + 1.50% = 5.62%


                                                                                        8
Situation 3: Currency risk

 A European electrical company has contracted to sell
  US$100 million of power generating equipment to a U.S.
  electrical power producer, with delivery and payment
  occurring six months from today
 Deal is profitable at current spot exchange rate (€1 = $0.97),
  but is concerned that the deal will become unprofitable if the
  euro falls relative to the U.S. dollar
 Company is not willing to lock in an exchange rate today,
  however, because it want to profit if the U.S. dollar
  depreciates relative to the euro
 Solution: Currency option
Options: Definitions

 An option is a legal contract that gives the buyer, in exchange
  for the payment of a premium, the right but not the
  obligation to buy or sell a specified amount of the underlying
  asset at a predetermined price (strike price) at or until a stated
  time (maturity date).
 Types of option
    – Call option is an option to buy
    – Put option is an option to sell
 Maturity date is the time after which the option is no longer
  valid; also called expiration date
    – European option can only be exercised at maturity date
    – American option can be exercised any time up to expiry Option
      buyer or holder (long)
        Currency option
       The corporation bought a put option on the dollar with a strike price
          of 1.05 $/€ by paying a premium today
       At the maturity of the option six months from today:
           – If the exchange rate is below 1.05 $/€, there will be no payment on the
             option
           – If the exchange rate is above 1.05 $/€, the Dealer will compensate the
             company in euros for the depreciation of the value of the receivable



                                                     Up-front premium
                                                      (on Trade Date)
                US$100 MM
 Receivable                         Electrical
                                                                             Dealer
(in 6 months)                       company

                                                    Payment if $/€ > 1.05
                                                     (on Maturity Date)
Result of hedging with currency option


 Client will be protected if dollar depreciates
  below 1.05 euro per dollar
 Client will benefit from any appreciation of
  euro (net of premium)
 Client assumes credit risk of default by Dealer
Situation 4: Credit risk


 A European bank enjoys profitable lending relationships with
  manufacturing corporations
 The bank would like to diversify its exposure, however, and is
  particularly concerned that it has become more exposed to one
  borrower than it would like
 The bank is reluctant, however, to reduce its exposure by selling
  the loans to other banks or by demanding immediate repayment
  of some of its outstanding loans
 Solution: Credit derivative



                                                                      13
Credit (default) swaps are the most basic
form of credit derivative
                                   X bp per annum

   Protection buyer              Contingent payment             Protection seller



 Buyer pays premium for protection against default by reference
   credit
 If reference credit(s) default (or other credit event occurs), buyer
   receives payout equal to one of the following:
    – Physical settlement: Par value in return for delivery of reference obligation; or
    – Cash settlement: Post-event fall in price of reference obligation below par; or
    – Binary settlement: Fixed sum or percentage of notional

 Results:
    – Credit swap hedges both default risk and credit concentration risk
    – Buyer trades credit risk of reference credit for counterparty credit risk of seller
Results of hedging with credit default swap

 Protection buyer
   – Gives up exposure to default of reference credit without
     removing reference asset from balance sheet
   – Takes on counterparty credit exposure to protection seller
      • More precisely, protection buyer takes on risk of
        simultaneous default by reference credit and protection
        seller

 Protection seller
   – Takes on exposure to reference credit without need for funding
     underlying position
Managing risks with OTC derivatives

 End-users encounter financial risks in connection with their core business
  activities
    – Corporations
    – Financial institutions
    – Governments and agencies

 Dealers must manage the risks they take on from users by hedging
    – Other dealers
    – Inventories of the underlying risk
    – Futures and securities exchanges

 Types of market participants
    – Hedgers seek to pass their risks on to others
    – Speculators seek to take on risks

 Liquid markets are essential to the ability to manage risks effectively



                                                                               16
     How dealers hedge the directional risk of swaps
     Dealer pays fixed and receives floating


                  Euribor

                                                                 Hedge
Counterparty                         Dealer
                                                                Strategy
                 Fixed rate



    Hedge strategy can consist of:
     Offsetting swap
     Buy treasury securities, financed with repurchase agreement
     Buy Euribor futures
     Leave position open

                                                                           17
       How risks are passed on by dealers


                                                              Futures                     Other
                                                                                          users


                                                               Other                      Other
      User                       Dealer
                                                              dealers                     users


                                                               Other                      Other
                                                              markets                     users

 Dealers manage many of their risks though offsetting transactions with other dealers
    – The other dealers often have user clients with offsetting risks

 Dealers can pass their risks on to organized futures exchanges
 Dealers can offset their risks through offsetting transactions in money, currency, and
   capital markets
    – Liquid markets are those in which participants can easily pass on their risks with little of no
      effect on the market
    – The existence of both hedgers and speculators in markets is necessary to ensure liquidity

                                                                                                        18
Profile of derivatives participants


        11%
                                       16%
                                               27%
              46%
      43%
                                         57%


   Interest rate swaps           Credit derivatives


                                   Dealers
        27%       31%
                                   Other financial institutions

            42%                    Non-financial institutions



   Currency options      Source: Bank for International Settlements

                                                                      19
Derivatives growth, 1987-2001
                                                                                                                   69,207

                                                                                                          63,009
Notional principal outstanding, interest
                                                                                                 58,265
rate swaps and options and cross-
currency swaps                                                                          50,997




                                                                               29,037
                                                                      25,455


                                                             17,715

                                                    11,305
                                            8,477
                              4,452 5,348
                2,477 3,452
 868    1,656

 1987           1989          1991          1993             1995              1997              1999              2001


                                     Source: International Swaps and Derivatives Association
                                                                                                                            20
                                      Brussels
                                      17 September 2002




European Parliament Financial Services Forum
Fundamentals of Derivative Contracts




David Mengle
International Swaps and Derivatives Association and
Fordham University Graduate School of Business

				
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