1. Risk Management with Financial Derivatives
Mishkin/Serletis
The Economics of Money, Banking, and Financial Markets Sixth Canadian Edition
Chapter 13
Risk Management with Financial Derivatives

2. Learning Objectives
Define a hedge, a long position, and a short position
Define a forward contract and summarize its advantages and disadvantages
Summarize the differences between a forward contract and a financial futures contract
Identify different options contracts, and summarize the three conclusions regarding call and put options
Define a swap – and summarize advantages and disadvantages of interest-rate swaps.
Summarize the three types of credit derivatives

3. Hedging
To hedge is to engage in a financial transaction that reduces or eliminates risk
When a financial institution has bought an asset, it is said to have taken a long position
When a financial institution has sold an asset that it has agreed to deliver an asset to another party at a future date, it is said to have taken a short position
To “hedge risk” means to offset a long position by taking a additional short position, or to offset a short position by taking an additional long position

4. Forward Contracts and Markets
A forward contract is an agreement between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now
Forward contracts are traded over-the-counter (OTC)
Two types discussed:
Interest-rate forward contracts
Forward contracts for foreign currencies

5. Interest Rate Forward Contracts
An interest rate forward contract involves the future sale (purchase) of a debt instrument
Contract specifies
Specification of the debt instrument
Amount of the instrument to be delivered
The price (interest rate) on the instrument when it is delivered
The date when delivery takes place

6. Interest-Rate Forward Markets
Long position = agree to buy securities at future date
Hedges by locking in future interest rate if funds coming in future
Short position = agree to sell securities at future date
Hedges by reducing price risk from change in interest rates if holding bonds

7. Pros and Cons of Forward Contracts
Flexible (can be used to hedge interest rate risk)
Cons
Lack of liquidity: hard to find a counterparty to make a contract with
Subject to default risk: requires information to screen good risk from bad risk

8. Financial Futures Markets
Financial futures are classified as
Interest-rate futures
Stock index futures
Currency futures

9. Interest-Rate Futures Contracts
Specifies delivery of type of security at future date
Arbitrage  at expiration date, price of contract = price of the underlying asset delivered
If i , long contract has loss, short contract has profit
Hedging similar to forwards

10. Interest-Rate Futures Contracts (cont’d)
At the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered
The elimination of riskless profit opportunities in the futures market is referred to as arbitrage
A micro hedge occurs when the institution is hedging the interest rate for a specific asset it is holding
A macro hedge is when the hedge is for the entire portfolio

11. Financial Futures Markets
Organization and Trading
CBOT, Chicago Mercantile Exchange, Montreal Exchange, London International Financial Futures Exchange, Marché à Terme International de France
Open interest: number of contracts outstanding
Globalization of financial futures markets
contracts traded in other countries virtually identical to those traded in the United States
movement to 24-hour-a-day trading in financial futures
Globex electronic trading platform

12. Widely Traded Financial Futures Contracts in the United States

13. Explaining the Success of Futures Markets
liquid
standardized
can be traded again
delivery of range of securities
Margin requirement
Marked to market: avoids default risk
Do not have to deliver: netting

14. Q1
A contract that requires the investor to buy securities on a future date is called a ________.
A) short position
B) long position
C) hedge
D) Cross
Answer B

15. Q2
A contract that requires the investor to sell securities on a future date is called a ________.
A) short position
B) long position
C) hedge
D) micro hedge
Answer A

16. Q3
If you sell in March a bond future contract for 125 that matures on June 30 of the same year, and at the maturity date the same future sells for 135, you have a ________ of $________.
A) loss; 10000
B) loss; 10
C) profit; 10000
D) profit; 10
Answer A

17. Q4
If you buy in March a bond future contract for 125 that matures on June 30 of the same year, and at the maturity date the same future sells for 135, you have a ________ of $________.
A) loss; 10000
B) loss; 10
C) profit; 10000
D) profit; 10
Answer C

18. Q5
If you sell in March a bond future contract for 115 that matures on June 30 of the same year, and at the maturity date the same future sells for 110, you have a ________ of $________.
A) loss; 5000
B) loss; 5
C) profit; 5000
D) profit; 5
Answer C

19. Q6
If you bought a long contract on financial futures, you hope that interest rates ________.
A) rise
B) fall
C) are stable
D) fluctuate
Answer B

20. Q7
If you sold a short futures contract, you will hope that bond prices ________.
A) rise
B) fall
C) are stable
D) fluctuate
Answer B

21. Stock Index Futures Contracts
Stock index futures were designed to manage stock market risk and are now among the most widely traded of all futures contracts
The S&P Index measures the value of 500 of the most widely traded stocks in the United States
Price quotes for this contract are also quoted in terms of index points
Change of 1 point represents a change of $250 in the contract’s value

22. Stock Index Futures Contracts (cont’d)
Stock index future contracts differ from most other types of financial futures contracts in that they are settled in cash delivery rather than delivery of a security
Cash settlement gives a high degree of liquidity
For the S&P 500 Index contract, at the final settlement date, the cash delivery due is
$250 x the index

23. Q8
If you buy in April a stock index future contract on the S&P 500 index at the price of 800 points that matures on June 30 of the same year and on the maturity date the S&P 500 Index is at 795, you have a ________ of $________.
A) loss; 1250
B) loss; 5
C) profit; 1250
D) profit; 5

24. Q9
If you sell in April a stock index future contract on the S&P 500 index at the price of 1000 points that matures on June 30 of the same year and on the maturity date the S&P 500 Index is at 900, you have a ________ of $________.
A) loss; 25000
B) loss; 100
C) profit; 25000
D) profit; 100

25. Q10
If you sell in April a stock index future contract on the S&P 500 index at the price of 1050 points that matures on June 30 of the same year and on the maturity date the S&P 500 Index is at 1047, you have a ________ of $________.
A) loss; 750
B) loss; 3
C) profit; 750
D) profit; 3

26. Q11
If you buy a futures contract on the S&P 500 Index at a price of 450 and the index rises to 500, you will ________.
A) lose $12500
B) gain $12500
C) lose $50
D) gain $50

27. Q12
Who would be most likely to buy a long stock index future?
A) A mutual fund manager who believes the market will rise
B) A mutual fund manager who believes the market will fall
C) A mutual fund manager who believes the market will be stable
D) A mutual fund manager who does not believe in hedging

28. Q13
If you sell in April a stock index future contract on the S&P 500 index at the price of 1200 points that matures on June 30 of the same year and on the maturity date the S&P 500 Index is at 1000, you have a ________ of $________.
A) loss; 50000
B) loss; 200
C) profit; 50000
D) profit; 200

29. Options
A call option is an option that gives the owner the right (but not the obligation) to buy an asset at a pre-specified exercise (or strike) price within a specified period of time
A call represents an option to buy, so sensible if the price of the underlying asset is expected to go up
The buyer is long in a call and the writer is short in a call
The buyer of a call has to pay a premium in order to get the writer to sign the contract and assume the risk

30. Options (cont’d) There are two types of option contracts:
American options that can be exercised any time up to the expiration date
European options that can be exercised only on the expiration date
Stock options
Financial futures options (futures options)

31. The Payoff from Buying a Call
Assume that you hold a European call on an asset with an exercise price of X and a call premium of α
If at the expiration date, the price of the underlying asset, S, is less than X, the call will not be exercised, resulting in a loss of the premium
At a price above X, the call will be exercised
At a price between X and X + α, the gain would be insufficient to cover the cost of the premium
At a price above X + α, the call will yield a net profit
At a price above X + α, each $1 rise in the price of the asset will cause the profit of the call option to increase by $1

32. The Payoff from Writing a Call
The payoff function from writing the call option is the mirror image of the payoff function from buying the call
The writer of the call receives the call premium, α, and must stand ready to sell the underlying asset to the buyer of the call at the exercise price, X, if the buyer exercises the option to buy

33. Profits from Buying and Writing a Call Option

34. Summary
The value of a call option, C, at expiration with asset price S (at that time) and exercise price X is
C = max (0, S - X)
The value of a call option (intrinsic value) at maturity is S - X, or zero, whichever is greater
If S > X, the call is said to be in the money, and the owner will exercise it for a net profit of C - α
If S < X, the call is said to be out of the money and will expire worthless
A call with S = X is said to be at the money (or at par)

35. Buying and Writing Puts
A put option gives the owner the right (but not the obligation) to sell an asset to the option writer at a pre-specified exercise price
A put is an option to sell, it is worth buying a put when the price of the underlying asset is expected to fall
The owner of a put is said to be long in a put and the writer of a put is said to be short in a put
The buyer of a put option will have to pay a premium (called the put premium) in order to get the writer to sign the contract and assume the risk

36. The Payoff from Buying a Put
Consider a put with an exercise price of X and a premium of β
At a price of X or higher, the put will not be exercised, resulting in a loss of the premium
At a price below X - β, the put will yield a net profit
Between X - β and X, the put will be exercised, but the gain is insufficient to cover the cost of the premium

37. The Payoff from Writing a Put
The payoff function from writing a put is the mirror image of that from buying a put
The writer of a put receives the put premium, β, up front and must sell the asset underlying the option if the buyer of the put exercises the option to sell

38. Profits From Buying and Writing a Put Option

39. Summary
The value of a put option, P, at the expiration date with exercise price X and asset price S (at that time) is
P = max (X - S, 0)
The value of a put at maturity is the difference between the exercise price of the option and the price of the asset underlying the option, X - S, or zero, whichever is greater
If S > X, the put is said to be out of the money and will expire worthless
If S < X, the put is said to be in the money and the owner will exercise it for a net profit of P - β.
If S = X, the put is said to be at the money

40. Futures Options An example:
Option on a June Canada Bond futures contract
Buy the futures contract at 115 (costs $115,000)
Purchaser has to pay $ for $ face value of long-term Canada bonds on delivery at the end of June
Sold contract means you will deliver the $ of bonds at the end of June and will be paid $

41. Profits and Losses on Options Versus Futures Contracts

42. Factors Affecting Option Premium
Higher strike price
Lower premium on call options
Higher premium on put options
Greater term to expiration
Higher premiums for both call and put options
Greater price volatility of underlying instrument

43. Q14
The seller of an option has the ________.
A) right to buy or sell the underlying asset
B) the obligation to buy or sell the underlying asset
C) ability to reduce transaction risk
D) right to exchange one payment stream for another

44. Q15
If a bank manager wants to protect the bank against losses that would be incurred on its portfolio of treasury securities should interest rates rise, he could ________.
A) buy put options on financial futures
B) buy call options on financial futures
C) sell put options on financial futures
D) sell call options on financial futures

45. Q16
If you buy a European call option on Canada bonds with a strike price of 115 assuming that the premium is $0, and on the maturity date the market price of Canada bonds is 120, you will ________ the option in order to make a profit of $________.
A) not exercise; 5000
B) not exercise; 5
C) exercise; 5000
D) exercise; 5

46. Q17
If you buy an option to buy Canada futures at 115, and at expiration the market price is 110, ________. (more than one selection may be correct)
A) the call will be exercised
B) the put will be exercised
C) the call will not be exercised
D) the put will not be exercised

47. Q18
An option that gives the owner the right to sell a financial instrument at the exercise price within a specified period of time is a(n) ________.
A) call option
B) put option
C) American option
D) European option

48. Q19
Suppose that you buy a call option on a $100,000 Canada bond futures contract with an exercise price of 110 for a premium of $ If on expiration, the futures contract has a price of 111, what is your profit or loss on the contract?

49. Q20
Suppose the pension you are managing is expecting an inflow of funds of $100 million next year and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?
Would you buy/sell futures contracts?
How many contracts would you buy/sell?
How will this ensure you receive the desired 8% interest rate?

50. Q21
How would you use the options market to accomplish the same thing as in previous problem?
Would you buy call or put options?
How many options on futures contracts?
What are the advantages and disadvantages of using an option contract rather than a futures contract?

51. Interest Rate Swaps
Swaps are financial contracts obligating each party to exchange (swap) a set of payments it owns for another set of payments owned by another party
Two kinds of swaps:
Currency swaps
Interest-rate swaps
The exchange of one set of interest payments for another set of interest payments, all denominated in the same currency

52. Interest-Rate Swap Payments

53. Advantages of Interest Rate Swaps
Reduce risk, no change in balance-sheet
Longer term than futures or options
Disadvantages of interest rate swaps
Lack of liquidity
Subject to default risk

54. Q22
If Second Bank has more rate-sensitive assets than rate sensitive liabilities, it can reduce interest rate risk with a swap which requires Second Bank to ________.
A) pay a fixed rate while receiving a floating rate
B) receive a fixed rate while paying a floating rate
C) both receive and pay a fixed rate
D) both receive and pay a floating rate

55. Q23
If a bank has a gap of -$10 million, it can reduce its interest rate risk by ________.
A) paying a fixed rate on $10 million and receiving a floating rate on $10 million
B) paying a floating rate on $10 million and receiving a fixed rate on $10 million
C) selling $20 million fixed rate assets
D) buying $20 million fixed rate assets