1. PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 8 Derivative Securities

2. Copyright © 2004 South-Western. All rights reserved.8–2 Fundamental Issues 1.What are interest rate risk, financial instrument duration, and derivative securities? 2.What are forward and futures contracts,and how can they be used to limit risks? 3.What are options, and how can they be used to reduce foreign exchange risk exposure? 4.What are swaps, and how are they used to hedge against risks? 5.What are the key risks of derivative securities, and what regulations govern derivatives trading?

3. Copyright © 2004 South-Western. All rights reserved.8–3 Interest Rate Risk Interest rate risk:  The possibility that the market value of a financial instrument will change as interest rates vary.  Factors influencing interest rate risk:  Term to maturity  Frequency of coupon returns  Duration is a measure of the average time required to receive all payments of principal and interest.

4. Copyright © 2004 South-Western. All rights reserved.8–4 Selected Interest Rates Figure 8–1 SOURCES: Economic Report of the President,2002; and Economic Indicator.

5. Copyright © 2004 South-Western. All rights reserved.8–5 Interest Rate Risk (cont’d) Capital loss:  A decline in the market value of a financial instrument at the time it is sold as compared with its market value at the time it was purchased. Reinvestment risk:  The possibility that available yields on short-term financial instruments may decline, so that holdings of longer-term instruments might be preferable. Zero-coupon bonds:  Bonds that pay lump-sum amounts at maturity.

6. Copyright © 2004 South-Western. All rights reserved.8–6 One-Year $10,000Two-Year $10,000 Zero-Coupon BondZero-Coupon Bond Bond Price at 8% Rate$10,000/(1.08) = $9,259.26$10,000/(1.08) 2 = $8,573.39 Bond Price at 7% Rate$10,000/(1.07) = $9,345.79$10,000/(1.07) 2 = $8,734.39 Dollar Price Change–$86.53–$161.00 Percentage Price Change(-$86.53/$9,345.79) X 100(-$161.00/$8,734.39) X100 = –0.9%= –1.8% One-Year $10,000Two-Year $10,000 Zero-Coupon BondZero-Coupon Bond Bond Price at 8% Rate$10,000/(1.08) = $9,259.26$10,000/(1.08) 2 = $8,573.39 Bond Price at 7% Rate$10,000/(1.07) = $9,345.79$10,000/(1.07) 2 = $8,734.39 Dollar Price Change–$86.53–$161.00 Percentage Price Change(-$86.53/$9,345.79) X 100(-$161.00/$8,734.39) X100 = –0.9%= –1.8% Effects of an Interest Rate Increase on the Market Prices of Two Zero-Coupon Bonds Table 8–1

7. Copyright © 2004 South-Western. All rights reserved.8–7 Hedging and Derivative Securities Hedge:  A financial strategy that reduces the risk of capital losses arising from interest rate or currency risks.  Engaging in a countervailing financial trading strategy that reduces interest rate risk in the underlying portfolio.  A perfect hedge fully eliminates these risks and can also help reduce, or even fully offset, foreign exchange risks. Derivative securities:  Financial instruments whose returns depend on the returns of other financial instruments.

8. Copyright © 2004 South-Western. All rights reserved.8–8 Major Derivatives Losses since 1990 Table 8–2 Estimate of LossCompany/MunicipalityPrimary Derivatives $50 millionFirst BostonOptions $260 millionVolkswagenCurrency futures $100 millionCargill FundMortgage derivatives $157 millionProcter & GambleCurrency futures $100 millionFlorida State TreasuryMortgage derivatives $20 millionGibson Greeting CardsSwaps $35 millionDell ComputerSwaps and options $20 millionParamount CommunicationsSwaps $150 millionGlaxo,Inc.Mortgage derivatives $1,500 millionOrange County,CaliforniaMortgage derivatives $50 millionCapital Corp.Credit UnionMortgage derivatives $195 millionWisconsin Investment FundsSwaps $25 millionEscambia County,FloridaMortgage derivatives $1,400 millionBarings Bank,UKStock index futures $65 millionPacifiCorpCurrency options $83 millionBank of Tokyo-MitsubishiSwaps and options $689 millionUnited Bank of SwitzerlandStock index futures $720 millionDeutsche BankSwaps and options $149 millionNatWest BankSwaps and options $3,500 millionLong-Term Capital ManagementSwaps $691 millionAllied Irish BanksCurrency options

9. Copyright © 2004 South-Western. All rights reserved.8–9 Forward and Futures Contracts Forward contract:  A contract requiring delivery of a financial instrument at a specified price on a certain date. Interest-rate forward contract:  A contract committing the issuer to sell a financial instrument at a given interest rate as of a specific date.

10. Copyright © 2004 South-Western. All rights reserved.8–10 Short And Long Positions In Forward Contracts Long position:  An obligation to purchase a financial instrument at a given price and at a specific time. Short position:  An obligation to sell a financial instrument at a given price and at a specific time. Forward currency contract:  A contract for delivery of foreign currency, or financial instruments in a foreign currency, at a specific exchange rate on a certain date.

11. Copyright © 2004 South-Western. All rights reserved.8–11 Futures Contracts Futures contract:  An agreement to deliver to another a given amount of a standardized commodity or financial instrument at a designated future date. Interest rate future:  A contract to buy or sell a standardized denomination of a specific financial instrument at a given price at a certain date in the future. Stock index future:  An agreement to deliver, on a specified date, a portfolio of stocks represented by a stock price index.

12. Copyright © 2004 South-Western. All rights reserved.8–12 Futures Contracts (cont’d) Stock index future:  An agreement to deliver, on a specified date, a portfolio of stocks represented by a stock price index. Currency future:  An agreement to deliver to another a standardized quantity of a specific nation’s currency at a designated future date.

13. Copyright © 2004 South-Western. All rights reserved.8–13 Hedging with Currency Futures Margin account (bond performance requirement):  Payment of a portion of the value of the futures that a broker purchases on a firm’s behalf. Maintenance margin (minimum bond performance requirement):  A minimum balance that must remain in a firm’s account with a futures broker. Mark-to-market procedure:  Applying the futures contract gains and losses to the firm’s account at the close of each trading day.

14. Copyright © 2004 South-Western. All rights reserved.8–14 Mth/Strike:Maturing month. Open:Price of futures contract at the opening of business. On this day, a contract for 62,500 pounds for September 2002 began trading at $1.5260 per pound. High:Highest price of the futures contract reached during the day; $1.5266 per pound on this day. Low:Lowest price of the futures contract reached during the day; $1.5176 per pound on this day. Last:Price of the last futures contract at the close of business on this day; $1.5264 per pound. Pt. Chge:Change in price during the day. Est.Vol.:Approximate number of pound futures transactions during the day. Prior Day Sett.:Price of the contract at market close the previous day. Prior Day Vol.:Volume of futures contracts traded the previous day. Prior Day Int.:Number of contracts outstanding on the previous trading day. Currency Futures Prices for the British Pound Figure 8–2

15. Copyright © 2004 South-Western. All rights reserved.8–15 Options Option:  A financial contract giving the owner the right to buy or sell an underlying financial instrument at a certain price within a specific period of time. Exercise price:  The price at which the holder of an option has the right to buy or sell a financial instrument; also known as the strike price.

16. Copyright © 2004 South-Western. All rights reserved.8–16 Types of Options Contracts Call option:  An option contract giving the owner the right to purchase a financial instrument at a specific price. Put option:  An option contract giving the owner the right to sell a financial instrument at a specific price.

17. Copyright © 2004 South-Western. All rights reserved.8–17 Types of Option Contracts (cont’d) American option:  An option that allows the holder to buy or sell a security any time before or including the date at which the contract expires. European option:  An option that allows the holder to buy or sell a financial instrument only on the day that the contract expires.

18. Copyright © 2004 South-Western. All rights reserved.8–18 Types of Option Contracts (cont’d) Futures options:  Options to buy or sell futures contracts. Stock options:  Options to buy or sell firm equity shares. Currency option:  A contract granting the holder the right to buy or sell a given amount of a nation’s currency at a certain price within a specific period of time.

19. Copyright © 2004 South-Western. All rights reserved.8–19 Mth/Strike:Month of maturity and various exercise (or strike) exchange rates of option contracts on 62,500 euros. Open:Price of options contract at the opening of business.On this day,a call option contract of 62,500 euros for December 2002 with an exercise exchange rate of 1.070 began trading at $0.0020 per option. High:Highest price of option contracts reached during the day. Low:Lowest price of option contracts reached during the day. Last:Price of the last option contract at the close of business. Pt. Chge:Change in price during the day. Est.Vol.:Approximate number of euro options transactions during the day. Prior Day Sett.:Price of the contract at market close the previous day. Prior Day Vol.:Volume of options contracts traded the previous day. Prior Day Int.:Number of contracts outstanding on the previous trading day. Currency Options Prices for the Euro Figure 8–3

20. Copyright © 2004 South-Western. All rights reserved.8–20 Potential Profit and Limited Loss from a Call Option Figure 8–4

21. Copyright © 2004 South-Western. All rights reserved.8–21 Swaps Swap:  A contract entailing an exchange of payment flows between two parties. Interest rate swap:  A contractual exchange of one set of interest payments for another. Currency swap:  An exchange of payment flows denominated in different currencies.

22. Copyright © 2004 South-Western. All rights reserved.8–22 Swaps (cont’d) Plain vanilla swap (bullet swap):  An agreement between two parties to simply trade streams of payments to which each party is entitled. Forward swap:  Agreement to delay the actual swap transaction for a period ranging from a few days to a few years. Swap option (swaption)  The option owner has the right to enter into a swap when the swap’s market price reaches an exercise or strike price.

23. Copyright © 2004 South-Western. All rights reserved.8–23 A Sample Currency Swap Figure 8–5 Ford Motor Company receives yen- denominated earnings from selling automobiles in Japan, and Honda receives dollar-denominated earnings from selling autos in the United States. The two companies could use a currency swap contract to trade their yen- and dollar-denominated earnings to make payments to holders of their stocks and bonds.

24. Copyright © 2004 South-Western. All rights reserved.8–24 Types Of Derivatives Risks Derivative credit risk:  Risk stemming from the potential default by a party in a derivative contract or from unexpected changes in credit exposure because of changes in the market yields of instruments on which derivative yields depend. Derivative market risk:  Risk arising from unanticipated changes in derivatives market liquidity or from failures in payments systems.

25. Copyright © 2004 South-Western. All rights reserved.8–25 Derivatives Risk (cont’d) Derivative operating risk:  Risk owing to a lack of adequate management controls or from managerial inexperience with derivative securities.

26. Copyright © 2004 South-Western. All rights reserved.8–26 Measuring Derivatives Risk Notional value of derivatives:  A measure of aggregate derivatives volume  The amount of principal that serves as a basis for computing streams of payments. Replacement cost exposure  The cost that a party to a derivatives contract faces at current market prices if the other party in the derivative contract defaults before contract settlement.

27. Copyright © 2004 South-Western. All rights reserved.8–27 Values of Derivatives Traded in Organized Exchanges and Over-the-Counter Figure 8–6 SOURCES: Donald Mathieson and Garry Schinasi, et al., International Capital Markets: Developments, Prospects and Policy Issues, August 2001,International Monetary Fund; BIS Global OTC Derivatives Market Semi-Annual Reports; BIS International Banking and Financial Market Developments.

28. Copyright © 2004 South-Western. All rights reserved.8–28 The Value of Interest Rate Swaps Relative to the Value of OTC Derivatives Figure 8–7 SOURCES: Donald Mathieson and Garry Schinasi, et al., International Capital Markets: Developments, Prospects and Policy Issues, August 2001,International Monetary Fund; BIS Global OTC Derivatives Market Semi-Annual Reports; BIS International Banking and Financial Market Developments.

29. Copyright © 2004 South-Western. All rights reserved.8–29 The Global Distribution of Holdings of Derivative Securities Figure 8–8 SOURCES: BIS Global OTC Derivatives Market Semi-Annual Reports; BIS International Banking and Financial Market Developments.