Derivatives

Definition Derivative --- a financial instrument or other contract deriving value from changes in the price or rate of a related asset or liability Total Value comes from: Underlying = Price, Rate or Index Notional = Quantity Requires no initial net investment (or small net investment) Requires or permits net settlement or de facto net settlement

Derivative = Contract Agree today to pay a certain price for a commodity (or other “underlying”) in the future

Derivative Market Past two decades, derivative trading has grown into a trillion dollar market

Players Professionals (Banks & Broker-Dealers) Corporations Institutional Investors

USE OF DERIVATIVES SPECULATIVE INVESTMENTS HEDGE AGAINST RISK ASSOCIATED WITH ANOTHER TRANSACTION

7 Common Derivatives Typically settled with net cash payments 7

TYPES OF DERIVATIVE CONTRACTS Symmetrical or Linear Nonlinear Forward Contracts OTC Options Futures Exchange-Traded Options Swaps Caps/Floors

Symmetrical/Linear Contracts Track the change in the underlying price, both up and down You can gain or lose, symmetrically + _ Value of contract Price of underlying

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 date Futures Contract: A forward contract traded on an exchange

Forwards and Futures LONG POSITION --- Buyer of Asset Buys the asset, for delivery and payment in the future Wins if the price rises SHORT POSITION --- Seller of Asset Sells the asset, for delivery and cash receipt in future Wins if the price falls

Uses of Forwards and Futures Sell forward/futures to hedge exposure to falling prices: Lock in profit margin on commodity inventory Lock in profit margin on future commodity sales/production with fixed cost structure Foreign currency receivables or revenue stream - sell currency forward to lock in dollar amount to be received In anticipation of a debt issuance, sell a US Treasury security forward to protect against rising interest rates (falling bond prices)

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 margins Foreign currency payables or forecasted cash outflows - buy currency forward to lock in dollar amount paid Institutional 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)

Forwards and Futures Terms Forward Price/Rate --- Specified price in the contract Forward Date --- Specified future date Spot Rate --- Current price or rate for asset Writer --- writes the contract to sell (short position) Holder --- buyer of contract(long position)

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

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 falls Coffee Co is buyer or has “long” position, and will benefit if price increases

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 date Cost to carry to maturity is the combination of Interest Rates Storage Costs Facilitator’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.

Valuing Forwards & Futures In the 2nd month the forward price of coffee increases to $1.60 BeanTrader’s loss of $.05 is discounted 2 months using an appropriate discount rate. This is the contract’s fair value, a liability Coffee Co has a fair value gain (asset) of same amount Facilitator’s Notes: Remind the audience that it will be important to understand difference between spot and forward prices under FAS 133. 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.

Forward Contract Illustration Symmetric Return Profile Contract Payoff + _ Short Gain Long Position Gain Long Loss Short Position Loss Contract Price Short Forward Long Forward Expiration Date Price of Underlying Security

FUTURES Traded on organized exchanges ---- Chicago Bd of Trade, NY Mercantile Exchange, London International Financial Futures Exchange Contracts are standardized in nature Requires an initial deposit of funds with broker called a margin account Contracts represent cash amounts settled only at delivery and must be marked to market each trading day --- no discounting required

TYPES OF DERIVATIVE CONTRACTS Symmetrical or Linear Nonlinear Forward Contracts OTC Options Futures Exchange-Traded Options Swaps Caps/Floors

Nonlinear Contracts Option contracts, or those with option-like features Upside gain with limited downside loss (or vice versa) + _ Value of contract Value of underlying

Option Represents a right, rather than obligation, to either buy or sell some quantity of a particular underlying

Option Characteristics Purchaser pays and seller receives, a premium up front Purchaser enjoys upside potential with downside limited to premium paid Seller bears downside risk with upside limited to the premium received

25 In, Out, and On the Money When it is more profitable for the holder to exercise the option than to transact directly in the optioned item In the Money When the optioned item’s current market price equals the strike price At the Money Out of the Money When it is not profitable for the holder to exercise the option compared to transacting directly in the optioned item 25

Options Valuation Dependent on: Value of underlying Strike price Volatility in price of underlying Time to expiration American vs. European Risk free interest rate Black-Scholes model or binomial pricing model Facilitator’s Note: American option can be exercised at any time during its life. European option can be exercised at expiration date.

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 Rate If option is “in the money” it has intrinsic value; if “out of the money” intrinsic value is zero Facilitator’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.

Options Valuation TIME VALUE Attributed to expected intrinsic value at expiration date Defined as: Current Value - Intrinsic Value Based on statistical measure Mathematics for measuring can get very complicated Facilitator 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.

Options Call - 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.

Price Changes of Optioned Items 30 Price Changes of Optioned Items Holder of a call ---Bets that the price of the optioned item will rise Call writer --- Bets against a price increase Takes the time value component of the premium to compensate for the risk Changes in optioned item’s price affect the option’s intrinsic value only if option is at or in the money If option is AT the money: Holder Writer Price of Optioned Item Puts Calls Increases - Gain Loss Decreases 30

31 Option Contracts One-sided contracts --- require performance only when exercised Options can be individual securities and indexes   Allows --- 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 date American Options Can be exercised any time during the agreed-upon time period European Options Can be exercised only on the expiration date 31

Call Option Example If stock price stays at or below $60: 32 Call Option Example Smith 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 buy Call will expire Jones has a loss of $120 Strike (exercise) Price If stock price rises above $60: Jones exercises the call by paying $6,000 for 100 shares worth Jones may sell the call for the difference between the $6,000 exercise price and the higher market value 32

Call Option Illustration Contract Payoff + _ Sold Call Purchased Call Expiration Date Price of Underlying Security

Put Option --- Example If stock price rises above $60: 34 Put Option --- Example Smith 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 sell Put will expire Jones loss is $120 If stock price falls to $57: Jones exercises the put by selling 100 shares worth $5,700 to Smith Barney for $6,000, or Jones may sell the put for at least $300 ($3 per share) 34

Put Option Illustration Contract Payoff + _ Sold Put Purchased Put Expiration Date Price of Underlying Security

Put and Call Options with Price Relations 36 Put and Call Options with Price Relations In, Out, or At the Money Price Relation Puts Calls Strike price > Price of optioned item In Out Strike price < Price of optioned item Strike price = Price of optioned item At Option Price = Option’s Intrinsic Value + Option’s Time Value Also called the premium Amount that the option is in the money Excess of the premium over the option’s intrinsic value 36

Multiplier Effect of Call Options 37 Multiplier Effect of Call Options Investor 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 option Option return = ($4.25 × 100) – $138 = $287 Stock return = ($54.25 - $45.50) x 100 = $875   $ Return Cost % Return Option Purchase $287 $ 138 208% Stock Purchase 875 4,550 19% Option holders can benefit from constructive ownership of large quantities of stock with a small investment through options. 37

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.)

Caps and Floors Cap Floor A contract that protects the holder from a rise in interest rates or price increase beyond a certain point Floor A contract that protects the holder from a decrease in interest rates or price decrease below a certain point

40 Interest Rate Caps Purpose --- protect against rising interest rates on a company’s variable rate loans Is a call option In the money When 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 rate 40

Interest Rate Cap Example 5 Year Interest Rate Cap - $100mm Notional Pay LIBOR @ 7% (if LIBOR > 7%) Counterparty Client $2 million premium Paid at inception Result: effectively puts a cap on borrowing cost of floating rate debt financing

Derivatives can be used to counter risk associated with unfavorable rate/price changes by using them as a hedge

FASB 133/138 Key Concepts Hedging “Best Practices” Require: Entities must have written hedging policies for hedging and risk management activities Hedging relationships must be fully documented Hedges must be matched specifically to underlying risks Hedging relationships must be monitored throughout their life - must be “highly effective”

SFAS 130 - Nature and Use of Comprehensive Income 44 SFAS 130 - Nature and Use of Comprehensive Income Comprehensive income (CI) Includes all changes in owners’ equity other than those resulting from transactions with owners CI = Net income + Other comprehensive income Other comprehensive income (OCI) Includes items that bypass net income and are carried directly to stockholders’ equity OCI = Current rate method foreign currency translation adjustments Gains and losses on derivatives used in certain hedging situations Unrealized gains and losses on available-for-sale securities + 44

Reporting Changes in Fair Value 45 Reporting Changes in Fair Value Hedge’s effectiveness guides reporting: Derivatives That Are Not Designated as Hedges Derivatives That Are Designated as Hedges Gains and losses on the hedge instrument and hedged item reported in earnings in same reporting period Gains and losses reported in current earnings 45

TYPES OF HEDGES FAIR VALUE HEDGES CASH FLOW HEDGES FOREIGN CURRENCY HEDGES

47 Fair Value Hedges Two Types: 1. Changes in the fair values of existing assets and liabilities 2. Firm Commitments ---- binding agreement with an unrelated party that: Specifies all significant terms of the transaction Includes a nontrivial disincentive for nonperformance 47

Accounting for Fair Value Hedges 48 Accounting for Fair Value Hedges Offset Gain or loss Reported in earnings concurrent with the offsetting loss or gain on the change in fair value of the hedged item attributable to the hedged risk Hedged items that are firm commitments Firm commitment recognized as an asset or liability Portion of total change in fair value of a hedge instrument due to other factors Enters earnings without offset 48

CASH FLOW HEDGES Used to establish fixed prices or rates when future cash flows could vary due to changes in prices or rates Types: Forecasted Transactions Existing assets or liabilities with variable future cash flows

Cash Flow Hedge Mechanics Fair Value of the Derivative Changes recorded in Other Comprehensive Income for effective portion Changes recorded in earnings for ineffective portion No basis adjustment to the hedged asset or liability Net effect? Amounts in OCI recognized when the hedged item impacts earnings Effective portion- recorded in OCI and recognized as a reclassification to income when the hedged transaction impacts earnings Ineffective portion- recognized currently in earnings Fair value hedges have basis adjustment for the risk being hedged for a recognized asset, liability or firm commitment. Cash flow hedge- no basis adjustment.

Swaps An agreement by two parties to exchange a series of cash flows in the future through an intermediary Typically interest rates or currencies, but may also involve commodities or equities as well Symmetrical or linear contracts

Interest Rate Swap --- Example 5 Year Interest Rate Swap - $100mm Notional 6 Mo. LIBOR Paid semi-annually Counterparty Client 6.5% Fixed Rate Paid Semi-Annually Why would a client enter into this transaction?

Interest Rate Swap Example (cont’d) 5 Year Interest Rate Swap - $100mm Notional 6 Mo. LIBOR Paid Semi-Annually Client Counterparty 6.5% Fixed Rate Paid Semi-Annually Interest @ 6 Mo. LIBOR Result: client effectively converts its borrowing cost to 6.5% fixed XYZ Bank $100 mm 5yr. Loan

FAS 133 Documentation For Cash Flow hedges, formal documentation of hedging relationship: Statement of objectives and strategy and nature of hedged risk Description of derivative hedging instrument Description of hedged item with specific identification Describe how hedge effectiveness will be assessed

Foreign Currency Hedges 55 Foreign Currency Hedges Hedging exchange rate risk in a foreign currency available-for-sale (AFS) security Gain or loss on both the hedging instrument and the hedged AFS security are reported in earnings Creates an offset to the loss or gain on the hedging derivatives 55

Assessing Hedge Effectiveness 56 Assessing Hedge Effectiveness Per SFAS 133, Management must: 1. Explicitly assess the derivative’s hedge effectiveness 2. Identify how it intends to assess hedge effectiveness 3. Conclude that a derivative will be highly effective in order to designate the derivative as a hedging instrument Ineffective portion of a gain or loss on a hedge ---reported in earnings, creating earnings volatility Gauging effectiveness Gauge initially, and, for hedge accounting to continue, when earnings are reported and at least every three months thereafter 56

Measuring Hedge Effectiveness 57 Measuring Hedge Effectiveness High effectiveness Occurs when the derivative neutralizes or offsets between 80% and 125% of the fair value or cash flow changes that represent the risk being hedged 100% offset not required Hedge Effectiveness Measure Change in fair value of hedge instrument Change in fair value of hedged item Always negative because one value change is a gain and the other is a loss 57

High Effectiveness and Hedge Effectiveness Example 58 High Effectiveness and Hedge Effectiveness Example Conagra 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 = $20,000 Loss on hedging 20,000   Commodities inventory To recognize the increase in value of the futures contract: $0.17 × 100,000 = $17,000 Investment in futures 17,000   Gain on hedging Hedge Effectiveness Measure = $17,000 ÷ ($20,000) = –85% 58