Derivatives pricing and valuation futres.ppt

it is about derivative contract

1. Derivative Pricing
ZuhairM Ismail

2. INTRODUCTION
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3. Type of Derivatives
FutureContracts
Forwardcontracts
Options
Swaps
Warrants
Theabovearethecommonusedderivatives.
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4. FORWARD RATE
AGREEMENTS
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5. Parties involved
Afutureborrowerwouldbeinterestedinprotecting
himselfagainstariseininterestrates.Hewillbeabuyer
ofanFRA
Borrower= BuyerofFRA
Alender,ontheotherhand,wouldwishtoguardagainst
interestratesfalling.Effectivelyhewouldbethesellerof
theFRA
Lender = SellerofFRA
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6. FRAP=((R−FRA)×NP×P)×( 1 ​)
Y 1+Rx(P/Y)
FRAP=FRApayment
FRA=Forwardrateagreementrate,orfixedinterest
ratethatwillbepaid
R=Reference,orfloatinginterestrateusedinthecontract
NP=Notionalprincipal,oramountoftheloanthat
interestisappliedto
P=Period,ornumberofdaysinthecontractperiod
Y=Numberofdaysintheyearbasedonthecorrectday-
count convention for the contract​
ForwardRateAgreementPricingor
InterestRateSwapAgreementPricing

7. Aborrowerentersintoaforwardrateagreementwiththegoal
oflockinginaninterestrateiftheborrowerbelievesrates
mightriseinthefuture.
Sothenaborrowermightwanttofixtheirborrowingcosts
todaybyenteringintoanFRA.
NoCashispaidatthetimeofenteringintothecontract.
ThecashdifferencebetweentheFRAandthereferencerate
orfloatingrateissettledonthevaluedateorsettlementdate.
Iftheamountispositivethenthesellerofthecontractpaysto
thebuyer.SoeffectivelyReferencerate>FRArate.
Iftheamountisnegativethenthebuyerpaystotheseller.So
effectivelyReferenceRate<FRArate.
Swap Agreement Pricing Explained
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8. Youbuya2x5FRAatarateof5.43.
Whatisyourviewofinterestrates?
Answer:
YouarebuyingtheFRAbecauseyouthinkthesettlement
pricewillbehigherandyouwillmakeaprofit.Therefore
youbelieveinterestrateswillrise.
Swap or FRA example
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9. AcurrencyForwardAgreementismostlyahedgingtool
Thisisabindingcontractasallforwardcontractsare.
Thepurposeistolocktheexchangerateforthepurchaseof
orsaleofacurrencyonafuturedate.
Acurrencyforwardsettlementcaneitherbeoncash
(difference)orondeliverybasis.
Howeverthesamei.e.cashordeliveryhastobespecified
beforehandsothatitismutuallyknownandacceptableto
bothparties.
Currency Forward Agreement
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10. Example
Importerwantstolockintheexchangeratefor30daysashehasto
makeaLCpayment.
AmountofLCpaymentisUSD1,000,000/-
CurrentExchangerateis PKR179/1USD
Daysare30days
Liborisbeingusedforthisexample
Soif1monthLiboris2%
Thentheratetheoreticallywouldbe
179*0.02=3.58
3.58/360daystomakeita1dayrate=0.009944
0.009944isthenmultipliedby30days=0.30approx.(taking2
decimals)
Nowtheoreticallyanyratethattheimportergetsonoraround179.30is
agoodrateasheisbasinghisdecisionontheinterestrateconvention
whichisagoodbasis.
Currency Forward Agreement
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11. Example
practicallyhoweverhewillnegotiateandtryandgetabestpossible
deal.
Nowsupposethisisadeliverycontract.
On30days,thebankwillbuytheactualdollars(supposetheyhavenot
hedgedthetransaction;otherwisetheynormallywould).
Soifrateis179.10thenthecustomerhasactuallypaidahigherrateand
looses0.20onthetransaction.HegetshispromisedUSD1Mandpays
fortheLC.
Iftherateis179.50thentheBankactuallyloosesmoneyonthedealas
theyhavetopayahigheramountonthedeal.Againtheimportergets
hispromisedUSD1MandpaysfortheLC.
IncaseofaNDcontract,onlydifferentialsarepaid;soincaseof179.10
thentheimporterhastopayPKR200KtotheBankandviceversa.
InthisexampleanNDcanonlytakeplaceifinthemiddleoftheforward
deal,theLChasbeencancelledandtheyjusthonorthecommitmentat
theendoftheforwardagreementtokeeptherelationssmoothoneither
side.
Currency Forward Agreement -2
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12. FORWARD FORWARDRATES
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13. Example
Sofarwehavetakenintoconsiderationthespotvsforwards.
Howeverattimes,thereareinstanceswhentheforward/forward
processingoftransactionneedstotakeplace.
FORWARD FORWARD INTERESTRATESAREPRICESWHICH
PERTAINTODAYTODEPOSITPERIODSCOMMENCING INTHE
FUTURE
WHATISTHERATE?
BorrowFundsfor3months
ShortFundsfor3months
0 3 6
Lendfor6months
Forward Forward Rates
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14. The need for forward forward rates
Alotoftransactionsarebasedonthefuture
Exportersreceivingfunds
Importershavetomakematuritypayments
Fundsneedtoberepatriatedforentitiesoperatingas
subsidiaries,etc.
Ratesneedtobefixedinadvancetoavoidrisk
(discussedinthecomingslides)andincaseofrolling
overcreditfacilitieswhichisagainaformofrisk
management.
Rateswouldberequiredincaseofmismatches.
Institutionslend/borrowfundsatvariousmaturitiesand
mayhavea‘maturitygap’whichisdifferentthana
‘liquiditygap’.
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15. The need for forward forward rates 2
Soadealerthanhedgeandcoverhispositions.This
wouldbepureriskmanagementtechniquesandmost
widelyusedtosupportoperationsininstitutionslike
banks.
Adealermayalsointendto‘offer’theproductasatool
toearnprofits.Notonlythenwouldthisbeagood
marketproductbutalsoutilizedtoearnprofits.Although
notwidelyusedbutincasesofarbitrageanopportunity
arisesandprofitsaremade.
Speculationcanbedoneandbasedon‘views’ofdealers
positionsmaybetaken.Anexample=ifdealerthink
ratesaregoingtofallthenshorttodayandcoverwhen
interestratesaredowntomakeprofits.
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16. Forward Forward Rates 2
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17. Forward Forward Rates example
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18. Forward Forward Rates explained
Thefirststepistoanalyzethefactthatlendingoffundsistotake
place
SupposeitisUSD1M
Sotheinterestwillbereceivedinsixmonthstime.
interestrecv=(USD1M*4%*180days=USD20,000/=)
Meanwhilesinceitneedstobesquared,wecanimmediatelyborrow
funds;thedealavailablerightnowisfor3months.
interestpay=(USD1M*3.5%*90days=USD8,750/-)
Differenceintherate=USD11,250/-
Soinordertoearnthedifferencetherateshouldnowcompensate
(fornownoloss/noprofitisbeingassumedwhichisthebasicneed
orbetterrequirementofhedging)
rate=11,250/1,008,750*360/90*100%=4.461%
Thereby4.461%wouldbetheforwardforwardrate.
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19. Forward Forward Rates Risks
Theratescanchange–interestraterisk
Therateforthegapperiodorfrom3to6monthsmaychangeatthe
3monthtimeperiod–reinvestmentrisk
IndividualriskslikeCreditRiskoftheinstitutions
Liquidityriskisalsopresentwherebytheliquiditymatrixofthe
institutioncanchangethe‘gap’mayincreaseinourexampleormay
squeezedown.
Theremaybemarketrisksincludingregulatory/policychanges.
Lastbutnottheleastasthesearetailormadeproducts(forwards)
thereisalwayscounterpartyrisk.Theotherpartymaynotprocess
oracttheoppositepositiontoyoursexposingyoutoadoubleloss.
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20. Forward Forward Rates Risks
Theratescanchange–interestraterisk
Therateforthegapperiodorfrom3to6monthsmaychangeatthe
3monthtimeperiod–reinvestmentrisk
IndividualriskslikeCreditRiskoftheinstitutions
Liquidityriskisalsopresentwherebytheliquiditymatrixofthe
institutioncanchangethe‘gap’mayincreaseinourexampleormay
squeezedown.
Theremaybemarketrisksincludingregulatory/policychanges.
Lastbutnottheleastasthesearetailormadeproducts(forwards)
thereisalwayscounterpartyrisk.Theotherpartymaynotprocess
oracttheoppositepositiontoyoursexposingyoutoadoubleloss.
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21. Forward Forward Rates Risks 2
Anyphysicalcashtransactioninflatesthebalancesheet
•Fullcapitaladequacyrequirementsapply.
•Fullcreditlineimplicationsapply.
•Cashmarketspreadimplications.
•Lossofliquidity.
Theseconsiderationscanalsohamperthedealsintheforward
forwardmarketstobeunattractive.
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22. FUTURES
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23. Future Pricing
Thepriceofafuturesistakenin3steps:
Spotpriceoftheunderlyingasset
Financingcost(whichshouldincludestorageand/orinsurance
costoftheassetincaseswhererequired)
Cashflowgeneratedbytheunderlyingasset(ifany);thisis
becauseduringthetimewherethecontractisbeingboughtthe
assetisstillintheuseofthesellerandtherebyitisacosttoyou
asabuyer.
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24. Future Pricing –an example
Thespot/readypriceofoilisUSD95
The1yearfinancingforexampleis5.5%p.a.
InsuranceandstoragecostisletssayUSD5
PriceofFutures:
USD95+(95*0.055)+5=105.225(1yearfutureprice)
Thisisthepricewherethereisnoprofitorloss.
Ofcourseinreality3possibleoutcomesasdiscussed
beforecananddotakeplace.
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