Derivatives and Alternative Investments - Coursework Example

? Derivatives and alternative investments Question Number of future bonds to be shorted = 50,000,000/ (122*100,000)= 409.8 = 410 bond futures Question 2 The interest rate swap market is one of the most important fixed-income markets in the trading and hedging of interest rate risk. It is used by non-financial firms in the management of the interest rate risk of their corporate debt. Financial firms use the swaps market intensively in hedging the mismatch in the interest rate risk of their assets and liabilities. The liquidity of the swaps market also underpins the residential mortgage market in the United States, providing real benefits to the household sector. If the swaps market were less liquid than it is, market mortgage lenders would find it more difficult and expensive to manage the interest rate risk of the prepayment option in fixed rate mortgages (Greenspan 2004). The extensive use of interest rate swaps means that volatility of the swap spread can affect a large range of market participants, as they rely on a stable relationship between the interest rate swap rate and other interest rates in using swaps for their hedging objectives. For this reason, trading activity that would stabilize the swap spread performs a useful role in ensuring that market participants can rely on the market for their trading and hedging needs. By market convention, the fixed-rate payer that has a long swap position in a fixed/floating interest rate swap is called the taker or buyer of the swap, while the floating-rate payer that has a short swap position in the fixed/floating interest rate swap is called the provider or seller of the swap. The fixed-rate payer and the floating-rate payer of an interest rate swap are called the counterparties of the swap. At the date of contract initiation of a fixed/floating interest rate swap, the swap contract is usually executed at-the-money and the counterparties are said to have positions in a par value swap because there is no initial cash exchange between the two counterparties. Thus, at the date of contract initiation, an interest rate swap contract is neither an asset nor a liability to either counterparty. However, subsequent to its initial date of agreement, any market interest rate movements can cause the market value of a swap contract to become positive to one counterparty and negative to other counterparty. For instance, a fall in the market prices of the fixed/floating interest rate swaps will make the existing swap contract a liability to the counterparty with a long swap position and an asset to the counterparty with a short swap position. Conversely, a rise in the market prices of the fixed/floating interest rate swaps will bring a gain to the counterparty with a long swap position and a loss to the counterparty with a short swap position. Financial managers should be able to determine at any time the market values of the individual swap contracts held by their firms, if they want to manage the swap positions of their firms in a prudent fashion. In the following, we shall develop and discuss models for determining the market values of existing long and short swap positions. Credit risk and interest rate or market risk are the two major types of risk inherent in an interest rate swap position. In this section, some brief comments on the credit risk are followed by a more detailed examination of the interest rate risk. Since interest rate swaps are private contractual agreements between two counterparties, they are of course subject to a credit or default risk: the counterparty might not meet its interest payment obligation. However, it should be pointed out that the credit risks in interest rate swaps are relatively unimportant for two reasons. First, because entering into an interest rate swap agreement is a voluntary market transaction performed by two counterparties, a counterparty’s credit standing must be acceptable to the other counterparty If one counterparty’s credit standing has not reached the par, then a letter of credit from a guarantor is usually required before the signing of the swap contract. Secondly, an interest rate swap contract calls for a periodic payment of the net amount of the difference between the fixed and the floating interests on the notional principal. Thus, the amount that might be defaulted is relatively small in relation to the notional amount of the interest-rate swap (Gorton and Souleles 2006). An interest rate swap has a zero market value to its counterparties when the swap originates. However, a subsequent change in market interest rates can cause a change in the market value of the swap contract, making the swap position an asset with positive market value to one counterparty and a liability with negative market value to the other counterparty To the extent market interest rates change in a predictable fashion, it does not pose a risk to the holder of a swap position since the induced changes in the market value of the swap position are foreseen. It is the unanticipated or stochastic variations in the market interest rates leading to variations in the value of a swap position that are at the source of the interest rate or market risk of a swap position. Question 3 =((3.2*115)+(3*250))/365=3.06% Question 4- alternative hedging choices Financing Choices Firms can affect their overall risk exposure through their financing choices. A firm that expects to have significant cash inflows in yen on a Japanese investment can mitigate some of that risk by borrowing in yen to fund the investment. A drop in the value of the yen will reduce the expected cash inflows (in dollar terms) but there will be at least a partially offsetting impact that will reduce the expected cash outflows in dollar terms. Insurance One of the oldest and most established ways of protecting against risk is to buy insurance to cover specific event risk. Just as a home owner buys insurance on his or her house to protect against the eventuality of fire or storm damage, companies can buy insurance to protect their assets against possible loss. In fact, it can be argued that, in spite of the attention given to the use of derivatives in risk management, traditional insurance remains the primary vehicle for managing risk. Insurance does not eliminate risk. Rather, it shifts the risk from the firm buying the insurance to the insurance firm selling it. Smith and Mayers (2005) argued that this risk shifting may provide a benefit to both sides, for a number of reasons. First, the insurance company may be able to create a portfolio of risks, thereby gaining diversification benefits that the self-insured firm itself cannot obtain. Second, the insurance company might acquire the expertise to evaluate risk and process claims more efficiently as a consequence of its repeated exposure to that risk. Third, insurance companies might provide other services, such as inspection and safety services that benefit both sides. While a third party could arguably provide the same service, the insurance company has an incentive to ensure the quality of the service. From ancient ship owners who purchased insurance against losses created by storms and pirates to modern businesses that buy insurance against terrorist acts, the insurance principle has remained unchanged. From the standpoint of the insured, the rationale for insurance is simple. In return for paying a premium, they are protected against risks that have a low probability of occurrence but have a large impact if they do. The cost of buying insurance becomes part of the operating expenses of the business,reducing the earnings of the company. The benefit is implicit and shows up as more stable earnings over time. Derivatives Derivatives have been used to manage risk for a very long time, but they were available only to a few firms and at high cost, since they had to be customized for each user. The development of options and futures markets in the 1970s and 1980s allowed for the standardization of derivative products, thus allowing access to even individuals who wanted to hedge against specific risk. The range of risks that are covered by derivatives grows each year, and there are very few market-wide risks that you cannot hedge today using options or futures. Futures and Forwards The most widely used products in risk management are futures, forwards, options and swaps. These are generally categorized as derivative products, since they derive their value from an underlying asset that is traded. While there are fundamental differences among these products, the basic building blocks for all of them are similar. In a forward contract, the buyer of the contract agrees to buy a product (which can be a commodity or a currency) at a fixed price at a specified period in the future; the seller of the contract agrees to deliver the product in return for the fixed price. Options Options differ from futures and forward contracts in their payoff profiles, which limit losses to the buyers to the prices paid for the options. Call options give buyers the rights to buy a specified asset at a fixed price anytime before expiration, whereas put options gives buyers the right to sell a specified asset at a fixed price.The buyer of a call option makes as a gross profit the difference between the value of the asset and the strike price, if the value exceeds the strike price; the net payoff is the difference between this and the price paid for the call option. If the value is less than the strike price, the buyer loses what he or she paid for the call option. The process is reversed for a put option. The buyer profits if the value of the asset is less than the strike price and loses the price paid for the put if it is greater. There are two key differences between options and futures. The first is that options provide protection against downside risk, while allowing you to partake in upside potential. Futures and forwards, on the other hand, protect you against downside risk while eliminating upside potential. A gold mining company that sells gold futures contracts to hedge against movements in gold prices will find itself protected if gold prices go down but will also have to forego profits if gold prices go up. The same company will get protection against lower gold prices by buying put options on gold but will still be able to gain if gold prices increase. The second is that options contracts have explicit costs, whereas the cost with futures contracts is implicit; other than transactions and settlement costs associated with day-to-day gold price movements, the gold mining company will face little in costs from selling gold futures but it will have to pay to buy put options on gold. Swaps In its simplest form, titled a plain vanilla swap, you offer to swap a set of cash flows for another set of cash flows of equivalent market value at the time of the swap. Thus, a U.S, company that expects cash inflows in Euros from a European contract can swaps thee for cash flows in dollars, thus mitigating currency risk. To provide a more concrete illustration of the use of swaps to manage exchange rate risk, consider an airline that wants to hedge against fuel price risk. The airline can enter into a swap to pay a fixed price for oil and receive a floating price, with both indexed to fuel usage during a period. During the period, the airline will continue to buy oil in the cash market, but the swap market makes up the difference when prices rise. Thus, if the floating price is $1.00 per gallon and the fixed price is $0.85 per gallon, the floating rate payer makes a $0.15 per gallon payment to the fixed rate payer. Broken down to basics, a plain vanilla swap is a portfolio of forward contracts and can therefore be analyzed as such. In recent years, swaps have become increasingly more complex and many of these more complicated swaps can be written as combinations of options and forward contracts. Question 5- How credit risk can be hedged Credit derivatives can be said to be financial contracts that are bilateral with payoffs that may be linked to an event that is credit related such as bankruptcy filling , credit downgrade, or non-payment of interest.. A bank can use a credit derivative to transfer some or all of the credit risk of a loan to another party or to take on additional risks. In principle, credit derivatives are tools that enable banks to manage their portfolio of credit risks more efficiently. The sector that largely uses the credit derivatives market is the credit default swap market where the most liquid individual names on which credit derivatives are written are large US investment grade firms, large multinational firms and foreign banks, but much of the most recent growth of the market has been in index derivatives (Fitch, 2006). The use of derivatives for credit is not widespread among banks, but the amount of credit derivatives held by the banks that use credit derivatives is extremely large. Banks also can manage the risk of credit for their loans by selling loans directly or through loan securitization. We find that banks that securitize loans or sell loans can easily become net buyers for the protection of credit. Consequently, the various tools banks can use to reduce their credit risk appear to be complements rather than substitutes. Our results provide an explanation for the limited use of credit derivatives. Larger bank holding companies are more likely to have exposures to larger investment grade US firms, foreign banks and foreign multinational firms and are more likely to be net buyers of credit protection than are small bank holding companies. A bank choosing to manage credit risk exposures with credit derivatives must consider liquidity costs, transactions costs, and basis risk. Banks are delegated monitors with comparative advantage in assessing and monitoring the credit risk of obligors. The resulting equilibrium ensures that banks monitor credits efficiently and avoid costly liquidations. We would therefore expect banks to hedge all their interest rate risk as well as other risks in which they do not have a comparative advantage such as foreign currency risk. Through hedging, banks also can take on more risks for which they have a comparative advantage for a given probability of financial distress. We would expect banks with less capital, banks with more non-performing loans, with weaker liquidity, and with smaller interest margins to be more likely to hedge since such banks are more likely to face financial distress. Liquidity is measured as cash and liquid assets as a percentage of total assets. Banks have a comparative advantage in monitoring credits and hence in bearing credit risks. This suggests that the reasoning for why banks use credit derivatives has to be more subtle than the reasoning that leads the literature to conclude that banks should hedge interest rate risks. Morrison (2005) argues that the availability of credit derivatives could adversely affect banks by reducing their incentives to monitor and to screen borrowers. Further, the use of credit derivatives could make bank loans less valuable to borrowers because the loans would entail less of a certification effect. Marsh (2006) provides some evidence supportive of this view, showing that loan announcement returns are less for borrowers when a bank issues collateralized loan obligations (CLOs). A clean loan sale or securitization removes the risk of a loan completely from the bank’s balance sheet. Hence, if a bank does not want to bear the risk associated with all or part of a loan, such transactions can achieve that purpose leaving no residual risk or capital requirements. In practice, however, the lemons problem in loan sales and securitizations forces banks to take steps to reduce that problem. By using credit derivatives, banks keep the loan on their balance sheets. Transferring credit risks with credit derivatives therefore has risks that credit risk transfers with loan sales or securitizations do not have. Banks using these derivatives have to bear associated counterparty, operational, and legal risks. Consequently, credit derivatives are most likely to be used when the costs of selling or securitizing loans are too high. Loans could be expensive to sell for a number of reasons. Kiff, Michaud, and Mitchell (2002) review the issues that arise with various instruments for credit risk transfer. These problems are reduced if banks want to reduce their exposure for a period that terminates before maturity of the loan. A credit derivative would achieve that purpose if it matures before the maturity of the loan. Since the bank would have exposure at maturity of the loan, it would have greater incentives to screen and monitor the borrower. Most importantly, the existence of a relationship between the lender and the borrower will make it less likely that the loan will be sold. First, the borrower may not want the loan to be sold since it would be harder to negotiate with a lender who has no experience with the borrower. Second, the lender may want to protect the relationship with the borrower. Third, relationship-based lending can involve implicit commitments on both parties that would become worthless if the loan is sold. In all these cases, the bank may not be in a position to sell the loan either by itself or through a securitization. In general, these issues do not arise with small loans that meet recognizable criteria, such as mortgages, retail loans, and credit card loans because these loans can be packaged in pools and relationships do not play much of a role in how borrowers are treated in the event of default when the bank is large. We expect banks to be more likely to sell or securitize loans secured by real estate and retail loans. When banks want to reduce their credit exposure by buying credit protection, they create a lemons problem. The protection seller has to be concerned that the bank wants credit protection because it has adverse information about the name on which it wants to buy protection. Acharya and Johnson (2007) show that adverse information about a company can be incorporated in credit default swap prices before it gets incorporated in the stock price. The lemons problem is sharply reduced when a bank buys credit protection on a name with a credit rating since the rating provides a public evaluation of credit quality for the name. The problem also is much smaller when credit derivatives and public debt are actively traded for the name since adverse private information is likely to make its way into prices. We would therefore expect banks to find it more advantageous to use credit derivatives to hedge credit exposures to rated names and to names for which there is a market for credit instruments. However, if that is the case, banks are most likely to use credit derivatives on those loans where their comparative advantage is smallest and be unable to use them where their comparative advantage is largest. An additional difficulty with the use of credit derivatives to hedge loans is that the credit derivatives hedges usually do not qualify for hedge accounting treatment. When derivatives used for hedging do not qualify for hedge accounting, the derivative hedge can make accounting earnings more volatile than if the hedge had not been put on because earnings are directly affected by the mark-to-market losses of the derivative even when the balance sheet value of the exposure being hedged does not change. To the extent that banks are concerned about earnings volatility, they may use credit derivatives less because of the accounting treatment of credit derivatives. Credit derivatives also can be used by banks in their intermediary roles. In particular, banks can offer credit support in transactions they underwrite using credit derivatives. They can also make a market in credit derivatives. For example, banks can sell credit protection to clients who wish to hedge their credit exposures and buy credit protection (i.e., sell credit risk) from other clients who want to be long the same credit exposures. If banks use credit derivatives in an intermediary capacity, then we would expect banks, which are dealers in the derivatives market, or have clients with which they trade or for which they provide hedging products to be more likely to use credit derivatives. If credit derivatives are used as credit enhancement for commercial paper conduit facilities or asset securitization facilities, then we expect the use of credit derivatives to be positively related to asset securitization. If larger banks and banks which use other derivatives are more likely to have trading departments for bank and client accounts, we expect to observe positive associations between the likelihood of using credit derivatives and bank size, and the use of foreign exchange, equity and commodity derivatives. Bibliograpghy FitchRatings. (2006). Global credit derivatives survey: Indices dominate growth as banks' risk position shift. Gorton, G. and N. Souleles (2006). Special purpose vehicles and securitization, in The Risks of Financial Institutions. University of Chicago Press, 549-597. Greenspan, A., (2004). Economic flexibility, speech to HM Treasury Enterprise Conference, London, U.K. Johnson, C. (2007). The use of loan sales and standby letters of credit by commercial banks, Journal of Monetary Economics. 22, 399-422. Kiff, J., F.-L. Michaud, and J. Mitchell (2002). Instruments of credit risk transfer: Effects on financial contracting and financial stability, working paper, Bank of Canada. Marsh, I. W. (2006). The effect of lenders’ credit risk transfer activities on borrowing firms’ equity returns, working paper, Bank of Finland. Morrison, A. D. (2005). Credit derivatives, disintermediation, and investment decisions, Journal of Business. 78, 621-647. Smith, C.W. and D. Mayers (2005). On the Corporate Demand for Insurance. Journal of Business, v55, 281-296. Read More