2 DefinitionDerivative --- a financial instrument or other contract deriving value from changes in the price or rate of a related asset or liabilityTotal Value comes from:Underlying = Price, Rate or IndexNotional = QuantityRequires no initial net investment (or small net investment)Requires or permits net settlement or de facto net settlement
3 Derivative = ContractAgree today to pay a certain price for a commodity (or other “underlying”) in the future
4 Derivative MarketPast two decades, derivative trading has grown into a trillion dollar market
6 USE OF DERIVATIVES SPECULATIVE INVESTMENTS HEDGE AGAINST RISK ASSOCIATED WITH ANOTHER TRANSACTION
7 7Common DerivativesTypically settled with net cash payments7
8 TYPES OF DERIVATIVE CONTRACTS Symmetrical or LinearNonlinearForward ContractsOTC OptionsFuturesExchange-TradedOptionsSwapsCaps/Floors
9 Symmetrical/Linear Contracts Track the change in the underlying price, both up and downYou can gain or lose, symmetrically+_Value ofcontractPrice of underlying
10 Forwards and Futures Forward Contract: Futures Contract: Executory contract obligating one party to buy, and the other party to sell, a specific asset for a fixed price at a future dateFutures Contract:A forward contract traded on an exchange
11 Forwards and Futures LONG POSITION --- Buyer of Asset Buys the asset, for delivery and payment in the futureWins if the price risesSHORT POSITION --- Seller of AssetSells the asset, for delivery and cash receipt in futureWins if the price falls
12 Uses of Forwards and Futures Sell forward/futures to hedge exposure to falling prices:Lock in profit margin on commodity inventoryLock in profit margin on future commodity sales/production with fixed cost structureForeign currency receivables or revenue stream - sell currency forward to lock in dollar amount to be receivedIn anticipation of a debt issuance, sell a US Treasury security forward to protect against rising interest rates (falling bond prices)
13 Uses of Forwards and Futures Buy forward/futures to hedge exposure to rising prices:Raw materials used in manufacturing - lock in purchase price to protect marginsForeign currency payables or forecasted cash outflows - buy currency forward to lock in dollar amount paidInstitutional investor that anticipates buying a bond or other debt instrument – buy US Treasury security forward as a hedge against falling interest rates (rising bond prices)
14 Forwards and Futures Terms Forward Price/Rate --- Specified price in the contractForward Date --- Specified future dateSpot Rate --- Current price or rate for assetWriter --- writes the contract to sell (short position)Holder --- buyer of contract(long position)
15 Change in Value of Forward and Future Contracts Measured by:Difference between the Original Forward Rate and the Remaining Forward Rate Discounted to Present Value
16 Forward Contract Example Bean Trader agrees to sell 100,000 lbs of coffee beans for $1.55 per pound (forward price) to Coffee Co for delivery three months from now.Bean Trader is seller or has “short” position and will benefit if the price of coffee beans fallsCoffee Co is buyer or has “long” position, and will benefit if price increases
17 Forward Contract Pricing Forward price of $1.55 is based on:Current spot price of coffee (assumed to be $1.50)+Cost to carry to the maturity dateCost to carry to maturity is the combination ofInterest RatesStorage CostsFacilitator’s Notes:Similar to interest rates, forward rates on commodities are not predictions of the future. They are the current market price for a transaction committed for the future. They are based on an arbitrage free, efficient market theory:I should be indifferent to buying coffee forward 30 days, versus buying spot and incurring the costs of carry.
18 Valuing Forwards & Futures In the 2nd month the forward price of coffee increases to $1.60BeanTrader’s loss of $.05 is discounted 2 months using an appropriate discount rate. This is the contract’s fair value, a liabilityCoffee Co has a fair value gain (asset) of same amountFacilitator’s Notes:Remind the audience that it will be important to understand difference between spot and forward prices under FAS The standard presents a choice in terms of how those components of fair value are accounted for. The spot forward difference can be included or excluded from the evaluation of hedge effectiveness.
19 Forward Contract Illustration Symmetric Return Profile Contract Payoff+_Short GainLong Position GainLong LossShort Position LossContract PriceShort ForwardLong ForwardExpiration Date Price of Underlying Security
20 FUTURESTraded on organized exchanges ---- Chicago Bd of Trade, NY Mercantile Exchange, London International Financial Futures ExchangeContracts are standardized in natureRequires an initial deposit of funds with broker called a margin accountContracts represent cash amounts settled only at delivery and must be marked to market each trading day --- no discounting required
21 TYPES OF DERIVATIVE CONTRACTS Symmetrical or LinearNonlinearForward ContractsOTC OptionsFuturesExchange-TradedOptionsSwapsCaps/Floors
22 Nonlinear ContractsOption contracts, or those with option-like featuresUpside gain with limited downside loss (or vice versa)+_Value ofcontractValue of underlying
23 OptionRepresents a right, rather than obligation, to either buy or sell some quantity of a particular underlying
24 Option Characteristics Purchaser pays and seller receives, a premium up frontPurchaser enjoys upside potential with downside limited to premium paidSeller bears downside risk with upside limited to the premium received
25 25In, Out, and On the MoneyWhen it is more profitable for the holder to exercise the option than to transact directly in the optioned itemIn the MoneyWhen the optioned item’s current market price equals the strike priceAt the MoneyOut of the MoneyWhen it is not profitable for the holder to exercise the option compared to transacting directly in the optioned item25
26 Options Valuation Dependent on: Value of underlyingStrike priceVolatility in price of underlyingTime to expirationAmerican vs. EuropeanRisk free interest rateBlack-Scholes model or binomial pricing modelFacilitator’s Note: American option can be exercised at any time during its life. European option can be exercised at expiration date.
27 Options Valuation Intrinsic Value Intrinsic value represents the value based solely on the current price of the underlying compared to the option strike price.Defined as: Strike Price - Spot RateIf option is “in the money” it has intrinsic value; if “out of the money” intrinsic value is zeroFacilitator’s Note: Remind audience that option strike price is the fixed exercise price. An option only has intrinsic value when the option is “in the money.” If out of the money intrinsic value is zero. Can never go below zero (for holder). Again “one sided” not symmetrical like forwards.
28 Options Valuation TIME VALUE Attributed to expected intrinsic value at expiration dateDefined as: Current Value - Intrinsic ValueBased on statistical measureMathematics for measuring can get very complicatedFacilitator Notes:Time value is HOPE. The more hope that the you have that the option will be in the money prior to the exercise date, the more time value an option has.Time until expiry, volatility, and current stock price/exercise price relationship could all be measures of hope and therefore measure time value.Time Value Decay - discuss concept (i.e., as option reaches expiration).When an option is purchased (out of the money or at the money) the premium paid entirely represents time value.
29 OptionsCall - A contract giving the holder the right, but not the obligation, to buy a specific asset for a fixed price during a specific period.Put - A contract giving the holder the right, but not the obligation, to sell a specific asset for a fixed price during a specific period.
30 Price Changes of Optioned Items 30Price Changes of Optioned ItemsHolder of a call ---Bets that the price of the optioned item will riseCall writer --- Bets against a price increaseTakes the time value component of the premium to compensate for the riskChanges in optioned item’s price affect the option’s intrinsic value only if option is at or in the moneyIf option is AT the money:HolderWriterPrice of Optioned ItemPutsCallsIncreases-GainLossDecreases30
31 31Option ContractsOne-sided contracts --- require performance only when exercisedOptions can be individual securities and indexesAllows --- not require, the holder to buy (call) or sell (put) at an agreed-upon price during an agreed-upon time period or on a specified dateAmerican OptionsCan be exercised any time during the agreed-upon time periodEuropean OptionsCan be exercised only on the expiration date31
32 Call Option Example If stock price stays at or below $60: 32Call Option ExampleSmith writes and sells to Jones a $120 a call option for 100 shares of Merck stock, exercisable at the stock’s current market price of $60 per share and expiring in 90 days.If stock price stays at or below $60:Jones will not exercise the right to buyCall will expireJones has a loss of $120Strike(exercise) PriceIf stock price rises above $60:Jones exercises the call by paying $6,000 for 100 shares worthJones may sell the call for the difference between the $6,000 exercise price and the higher market value32
33 Call Option Illustration Contract Payoff+_Sold CallPurchased CallExpiration Date Price of Underlying Security
34 Put Option --- Example If stock price rises above $60: 34Put Option --- ExampleSmith writes and sells to Jones for $120 a put option for 100 shares of Merck stock, exercisable at the stock’s current market price of $60 per share and expiring in 90 days.If stock price rises above $60:Jones will not exercise the right to sellPut will expireJones loss is $120If stock price falls to $57:Jones exercises the put by selling 100 shares worth $5,700 to Smith Barney for $6,000, orJones may sell the put for at least $300 ($3 per share)34
35 Put Option Illustration Contract Payoff+_Sold PutPurchased PutExpiration Date Price of Underlying Security
36 Put and Call Options with Price Relations 36Put and Call Options with Price RelationsIn, Out, or At the MoneyPrice RelationPutsCallsStrike price > Price of optioned itemInOutStrike price < Price of optioned itemStrike price = Price of optioned itemAtOption Price = Option’s Intrinsic Value + Option’s Time ValueAlso called the premiumAmount that the option is in the moneyExcess of the premium over the option’s intrinsic value36
37 Multiplier Effect of Call Options 37Multiplier Effect of Call OptionsInvestor purchases a call contract for 100 shares of Apple Computer stock with a $50 exercise price that expires in 90 days for $138. The investor also purchases 100 shares of Apple stock at $45.50 per share.If Apple stock rises to $54.25 before expiration:Option is in the money:$54.25 – $50.00 = $4.25 per optionOption return = ($4.25 × 100) – $138 = $287Stock return = ($ $45.50) x 100 = $875$ ReturnCost% ReturnOption Purchase$287$ 138208%Stock Purchase8754,55019%Option holders can benefit from constructive ownership of large quantities of stock with a small investment through options.37
38 Other Types of Options Swaptions (option on swap) Captions/Floortions (option on a cap or floor)Futures Options (option on futures)Split-fee Options (options on options)Exotic Options (look-back, Asian, etc.)Embedded Options -- options embedded in other instruments (e.g., prepayment, ARM caps, etc.)
39 Caps and Floors Cap Floor A contract that protects the holder from a rise in interest rates or price increase beyond a certain pointFloorA contract that protects the holder from a decrease in interest rates or price decrease below a certain point
40 40Interest Rate CapsPurpose --- protect against rising interest rates on a company’s variable rate loansIs a call optionIn the moneyWhen the variable rate rises above the cap’s strike price, writer of the cap pays the holder the difference in interest between the holder’s variable rate and the cap rate40
41 Interest Rate Cap Example 5 Year Interest Rate Cap - $100mm NotionalPay 7%(if LIBOR > 7%)CounterpartyClient$2 million premiumPaid at inceptionResult: effectively puts a cap on borrowing cost offloating rate debt financing
42 Derivatives can be used to counter risk associated with unfavorable rate/price changes by using them as a hedge
43 FASB 133/138 Key Concepts Hedging “Best Practices” Require: Entities must have written hedging policies for hedging and risk management activitiesHedging relationships must be fully documentedHedges must be matched specifically to underlying risksHedging relationships must be monitored throughout their life - must be “highly effective”
44 SFAS 130 - Nature and Use of Comprehensive Income 44SFAS Nature and Use of Comprehensive IncomeComprehensive income (CI)Includes all changes in owners’ equity other than those resulting from transactions with ownersCI = Net income + Other comprehensive incomeOther comprehensive income (OCI)Includes items that bypass net income and are carried directly to stockholders’ equityOCI =Current rate method foreign currency translation adjustmentsGains and losses on derivatives used in certain hedging situationsUnrealized gains and losses on available-for-sale securities+44
45 Reporting Changes in Fair Value 45Reporting Changes in Fair ValueHedge’s effectiveness guides reporting:Derivatives That Are Not Designated as HedgesDerivatives That Are Designated as HedgesGains and losses on the hedge instrument and hedged item reported in earnings in same reporting periodGains and losses reported in current earnings45
46 TYPES OF HEDGES FAIR VALUE HEDGES CASH FLOW HEDGES FOREIGN CURRENCY HEDGES
47 47Fair Value HedgesTwo Types:1. Changes in the fair values of existing assets and liabilities2. Firm Commitments ---- binding agreement with an unrelated party that:Specifies all significant terms of the transactionIncludes a nontrivial disincentive for nonperformance47
48 Accounting for Fair Value Hedges 48Accounting for Fair Value HedgesOffsetGain or lossReported in earnings concurrent with the offsetting loss or gain on the change in fair value of the hedged item attributable to the hedged riskHedged items that are firm commitmentsFirm commitment recognized as an asset or liabilityPortion of total change in fair value of a hedge instrument due to other factorsEnters earnings without offset48
49 CASH FLOW HEDGESUsed to establish fixed prices or rates when future cash flows could vary due to changes in prices or ratesTypes:Forecasted TransactionsExisting assets or liabilities with variablefuture cash flows
50 Cash Flow Hedge Mechanics Fair Value of the DerivativeChanges recorded in Other Comprehensive Income for effective portionChanges recorded in earnings for ineffective portionNo basis adjustment to the hedged asset or liabilityNet effect?Amounts in OCI recognized when the hedged item impacts earningsEffective portion- recorded in OCI and recognized as a reclassification to income when the hedged transaction impacts earningsIneffective portion- recognized currently in earningsFair value hedges have basis adjustment for the risk being hedged for a recognized asset, liability or firm commitment. Cash flow hedge- no basis adjustment.
51 SwapsAn agreement by two parties to exchange a series of cash flows in the future through an intermediaryTypically interest rates or currencies, but may also involve commodities or equities as wellSymmetrical or linear contracts
52 Interest Rate Swap --- Example 5 Year Interest Rate Swap - $100mm Notional6 Mo. LIBORPaid semi-annuallyCounterpartyClient6.5% Fixed RatePaid Semi-AnnuallyWhy would a client enter into this transaction?
53 Interest Rate Swap Example (cont’d) 5 Year Interest Rate Swap - $100mm Notional6 Mo. LIBORPaid Semi-AnnuallyClientCounterparty6.5% Fixed RatePaid Semi-Annually6 Mo. LIBORResult: client effectively convertsits borrowing cost to 6.5% fixedXYZ Bank$100 mm 5yr.Loan
54 FAS 133 DocumentationFor Cash Flow hedges, formal documentation of hedging relationship:Statement of objectives and strategy and nature of hedged riskDescription of derivative hedging instrumentDescription of hedged item with specific identificationDescribe how hedge effectiveness will be assessed
55 Foreign Currency Hedges 55Foreign Currency HedgesHedging exchange rate risk in a foreign currency available-for-sale (AFS) securityGain or loss on both the hedging instrument and the hedged AFS security are reported in earningsCreates an offset to the loss or gain on the hedging derivatives55
56 Assessing Hedge Effectiveness 56Assessing Hedge EffectivenessPer SFAS 133, Management must:1. Explicitly assess the derivative’s hedge effectiveness2. Identify how it intends to assess hedge effectiveness3. Conclude that a derivative will be highly effective in order to designate the derivative as a hedging instrumentIneffective portion of a gain or loss on a hedge ---reported in earnings, creating earnings volatilityGauging effectivenessGauge initially, and, for hedge accounting to continue, when earnings are reported and at least every three months thereafter56
57 Measuring Hedge Effectiveness 57Measuring Hedge EffectivenessHigh effectivenessOccurs when the derivative neutralizes or offsets between 80% and 125% of the fair value or cash flow changes that represent the risk being hedged100% offset not requiredHedge Effectiveness MeasureChange in fair value of hedge instrumentChange in fair value of hedged itemAlways negative because one value change is a gain and the other is a loss57
58 High Effectiveness and Hedge Effectiveness Example 58High Effectiveness and Hedge Effectiveness ExampleConagra carries at cost 100,000 bushels of soybeans to be sold in 3 months on a local market. The current local market price is $5.50 a bushel. Conagra enters a futures contract to sell 100,000 bushels in 3 months at $5.60 per bushel, a fair value hedge. The local market price fell by $.20 to $5.30 and the futures price fell by $0.17 to $5.43.To report the decline in soybean inventory:$0.20 × 100,000 = $20,000Loss on hedging20,000Commodities inventoryTo recognize the increase in value of the futures contract: $0.17 × 100,000 = $17,000Investment in futures17,000Gain on hedgingHedge Effectiveness Measure = $17,000 ÷ ($20,000) = –85%58