1. Derivatives

2. 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

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

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

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

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

7. 7
Common Derivatives
Typically settled with net cash payments 7

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

9. 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

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 date
Futures 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 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

12. 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)

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 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)

14. 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)

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 falls
Coffee 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 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.

18. 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 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 Gain
Long Position Gain
Long Loss
Short Position Loss
Contract Price
Short Forward
Long Forward
Expiration Date Price of Underlying Security

20. 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

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

22. 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

23. Option
Represents 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 front
Purchaser enjoys upside potential with downside limited to premium paid
Seller bears downside risk with upside limited to the premium received

25. 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

26. 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.

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 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.

28. 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.

29. 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.

30. Price Changes of Optioned Items30
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. 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

32. 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

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

34. 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

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

36. Put and Call Options with Price Relations36
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

37. Multiplier Effect of Call Options37
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 = $287
Stock return = ($ $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

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 point
Floor
A contract that protects the holder from a decrease in interest rates or price decrease below a certain point

40. 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

41. Interest Rate Cap Example
5 Year Interest Rate Cap - $100mm Notional
Pay 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

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 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”

44. SFAS 130 - Nature and Use of Comprehensive Income44
SFAS 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

45. Reporting Changes in Fair Value45
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

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

47. 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

48. Accounting for Fair Value Hedges48
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

49. 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

50. 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.

51. 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

52. 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?

53. 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
6 Mo. LIBOR
Result: client effectively converts
its borrowing cost to 6.5% fixed
XYZ Bank
$100 mm 5yr.
Loan

54. 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

55. Foreign Currency Hedges55
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

56. Assessing Hedge Effectiveness56
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

57. Measuring Hedge Effectiveness57
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

58. High Effectiveness and Hedge Effectiveness Example58
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