Asset Pricing

ECONM2035

Futures, Swaps and IR

Derivatives
CHAPTERS 22-23
 Futures and Forwards

l Forward - an agreement calling for a future

delivery of an asset at an agreed-upon price
l Futures - similar to forward but feature formalized
and standardized characteristics
l Key difference in futures
l Secondary trading - liquidity
l Marked to market

l Standardized contract units

l Clearinghouse warrants performance

 Key Terms for Futures Contracts

l Futures price - agreed-upon price at maturity

l Long position - agree to purchase
l Short position - agree to sell
l Profits on positions at maturity
Long = spot minus original futures price
Short = original futures price minus spot
Figure 22.2 Profits to Buyers and Sellers of
Futures and Option Contracts
 Trading Mechanics
l Clearinghouse - acts as a party to all buyers and
sellers
l Obligated to deliver or supply delivery
l Closing out positions
l Reversing the trade
l Take or make delivery
l Most trades are reversed and do not involve actual
delivery
l Open Interest
Figure 22.3 Panel A, Trading without a Clearinghouse.
Panel B, Trading with a Clearinghouse
 Trading Strategies
l Speculation -
l short - believe price will fall
l long - believe price will rise
l Hedging -
l long hedge - protecting against a rise in price
l short hedge - protecting against a fall in price
 Basis and Basis Risk

l Basis - the difference between the futures price

and the spot price
l over time the basis will likely change and will
eventually converge
l Basis Risk - the variability in the basis that will
affect profits and/or hedging performance
 Futures Pricing

Spot-futures parity theorem - two ways to acquire an

asset for some date in the future
l Purchase it now and store it

l Take a long position in futures

l These two strategies must have the same market

determined costs
 Spot-Futures Parity Theorem

l With a perfect hedge the futures payoff is certain -

- there is no risk
l A perfect hedge should return the riskless rate of
return
l This relationship can be used to develop futures
pricing relationship
General Spot-Futures Parity

( F0 + D ) - S 0
= rf
S0
Rearranging terms

F0 = S 0 (1 + rf ) - D = S 0 (1 + rf - d )
d=D
S0
Spread Pricing: Parity for Spreads

F (T1 ) = S0 (1 + r f - d ) T1

F (T2 ) = S0 (1 + rf - d ) 2
T

(T 2 -T 1)
F (T2 ) = F (T1 )(1 + rf - d )
Figure 22.6 Gold Futures Prices
 Example: the Hedge

l Investor holds $1000 in a mutual fund indexed to

the S&P 500. Assume dividends of $20 will be paid
on the index fund at the end of the year.
l A futures contract with delivery in one year is
available for $1,010. The investor hedges by selling
or shorting one contract.

What is the rate of return to this hedge?

 Example: the Hedge

Value of ST 990 1,010 1,030

Payoff on Short
(1,010 - ST) 20 0 -20
Dividend Income 20 20 20

Total 1,030 1,030 1,030

 Example: the Hedge

( F0 + D ) - S 0 (1,010 + 20) - 1,000

= = 3%
S0 1,000
Definitions
l In a swap, two counterparties agree to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
l There are two types of interest rate swaps:
l Single currency interest rate swap
l “Plain vanilla” fixed-for-floating swaps are often just called
interest rate swaps.
l Cross-Currency interest rate swap
l This is often called a currency swap; fixed for fixed rate debt
service in two (or more) currencies.
The Swap Bank
l A swap bank is a generic term to describe
a financial institution that facilitates
swaps between counterparties.
l The swap bank can serve as either a
broker or a dealer.
l As a broker, the swap bank matches counterparties but
does not assume any of the risks of the swap.
l As a dealer, the swap bank stands ready to accept either
side of a currency swap, and then later lay off their risk,
or match it with a counterparty.
 The convention is to quote against U.S. dollar LIBOR.

Interest Rate Swap Quotations

Euro-€ £ Sterling Swiss franc U.S. $
Bid Ask Bid Ask Bid Ask Bid Ask
1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57
2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94
3 year 2.86 2.89 3.82–3.85
5.13 means:1.50
5.17 1.58 4.11 4.13
4 year 3.06 3.09 the5.12
swap bank
5.17 will
1.73pay fixed-rate
1.81 4.25€ 4.28
5 year 3.23 3.26 payments
5.11 at 3.82%
5.16 1.93against
2.01 receiving
4.37 €4.39
6 year 3.38 3.41 LIBOR
5.11 and 2.10 2.18
5.16 4.46 4.50
7 year 3.52 3.55 it will
5.10 receive
5.15 fixed-rate
2.25 € payments
2.33 4.55 at4.58
8 year 3.63 3.66 3.85%
5.10 against
5.15 paying
2.37 € 2.45
LIBOR4.62 4.66
9 year 3.74 3.77 5.09 5.14 4.48 2.56 4.70 4.72
10 year 3.82 3.85 5.08 5.13 2.56 2.64 4.75 4.79
 Swap Quotations
3.82–3.85 means the swap bank will pay fixed-rate
euro payments at 3.82% against receiving dollar
LIBOR or it will receive fixed-rate euro payments at
3.85% against paying dollar LIBOR
Firm €3.85% Swap €3.82% Firm
B $LIBOR Bank $LIBOR A
While most swaps are quoted against “flat” dollar
LIBOR, “off-market” swaps are available where
one party pays LIBOR plus or minus some number.
Example of an Interest Rate Swap
Consider firms A and B; Fixed Floating
each firm wants to borrow A 5% LIBOR
$40 million for 3 years.
B 5.50% LIBOR + .20%
Firm A wants finance an interest-rate-sensitive asset and
therefore wants to borrow at a floating rate.
A has good credit and can borrow at LIBOR
Firm B wants finance an interest-rate-insensitive asset and
therefore wants to borrow at a fixed rate.
B has less-than-perfect credit and can borrow at 5.5%
The swap bank quotes 5.1—5.2 against dollar LIBOR for a
3-year swap.
 Example of an Interest Rate Swap

Firm 5.10% Swap

A LIBOR Bank

If Firm A borrows from their bank at 5.0% fixed

%
5.0

and takes up the swap bank on their offer of

5.1—5.2 they can convert their fixed rate 5%
debt into a floating rate debt at LIBOR – 0.10%
Bank A’s all-in-cost:
X = 5.0% + LIBOR – 5.10% = LIBOR – 0.10%
 Example of an Interest Rate Swap

Swap 5.20% Firm

Bank LIBOR B

LI
If Firm B borrows floating from their bank at

BO
LIBOR + 0.20% and takes up the swap bank on

R
+
their offer of 5.1—5.2 they can convert their

.2%
floating rate debt into a fixed rate debt at 5.40%
B’s all-in-cost: Bank
= –LIBOR + LIBOR + 0.20% + 5.20% = 5.40% Y
 Example of an Interest Rate Swap

Firm 5.10% Swap 5.20% Firm

A LIBOR Bank LIBOR B

The Swap Bank makes 10 basis points on the deal:

The Swap Bank’s all-in-cost:

= –LIBOR + LIBOR – 5.20% + 5.10% = –0.10%
 Example of an Interest Rate Swap

Firm 5.10% Swap 5.20% Firm

A LIBOR Bank LIBOR B

LI
The notional size is $40 million.
%

BO
5.0

R
The tenor is for 3 years.

+
.2%
A earns $40,000 per year on the swap.
B earns $40,000 per year on the swap. Bank
Bank
Swap Bank earns $40,000 per year. Y
X
Using a Swap to Transform a Liability
l Firm A has transformed a fixed rate liability
into a floater.
l A is borrowing at LIBOR – .10%
l A savings of 10 bp
l Firm B has transformed a floating rate liability
into a fixed rate liability.
l B is borrowing at 5.40%
l A savings of 10 bp
Example of a Currency Swap
Firm A is a U.S. MNC and wants to $ €
borrow €40 million for 3 years. A $7% €6%
Firm B is a French MNC and wants to B $8% €5%
borrow $60 million for 3 years
Firm A wants to finance euro denominated asset in Italy and
therefore wants to borrow euro.
A can borrow euro at 6%
Firm B wants to finance a dollar denominated asset and
therefore wants to borrow dollars.
B can borrow dollars at 8%
The current exchange rate is $1.50 = €1.00
Example of a Currency Swap

How would a currency swap work?

 Example of a Currency Swap
l Supposethat the Swap Bank publishes these quotes.
The convention is to quote against U.S. dollar LIBOR.
Euro-€ U.S. $
Bid Ask Bid Ask
3 year 5.00 5.20 7.00 7.20

Firm A wants finance euro-denominated

asset in Italy and wants to borrow euro. $ €
A can borrow euro at 6% or they can A $7% €6%
borrow euro at 5.2% by using a
currency swap. B $8% €5%
 Example of a Currency Swap
(The convention is to quote against U.S. dollar LIBOR.)
Euro-€ U.S. $ $ €
Bid Ask Bid Ask A $7% €6%
5.00 5.20 7.00 7.20 B $8% €5%
LIBOR
Bank $7.0% Firm $7.0% Swap
X $60m A €5.2% Bank
LIBOR

€40m
$60m
Suppose that Firm A borrows
$60m at $7%; trades for € at spot.
Firm A then enters in to 2 FOREX Market
fixed for floating swaps.
 Example of a Currency Swap
(The convention is to quote against U.S. dollar LIBOR.)
Euro-€ U.S. $ $ €
Bid Ask Bid Ask A $7% €6%
5.00 5.20 7.00 7.20 B $8% €5%
LIBOR
Swap $7.2% Firm €40m Bank
Bank €5.0% B €5%
Y
LIBOR
$60m
€40m

Suppose that Firm B borrows

€40m at €5%, trades for $.
FOREX Market Firm B then enters in to 2
fixed for floating swaps.
 Example of a Currency Swap
Swap Bank earns 40 bp per year (20bp in $ and 20bp in €).

Firm $7.0% Swap $7.2% Firm

A €5.2% Bank €5.0% B
.0%

The notional size is $60m.

€5
$7

The tenor is for 3 years.

.0%
Firm A earns 80 bp per year on the swap and
hedges exchange rate risk.
Bank Bank
Firm B earns 80 bp per year on the swap Y
X and hedges exchange rate risk.
The QSD
l The Quality Spread Differential represents the
potential gains from the swap that can be shared
between the counterparties and the swap bank.
l There is no reason to presume that the gains will
be shared equally.
$ € The QSD is calculated
A $7% €6% as the difference
B $8% €5% between the differences.
QSD 1% – –1% = 2%
Comparative Advantage
as the Basis for Swaps
l A has a comparative advantage in borrowing in
dollars.
l B has a comparative advantage in borrowing in
euro. $ €
A $7% €6%
B $8% €5%
Concluding Remarks
l The growth of the swap market has been
astounding.
l Swaps are off-the-books transactions.
l Swaps have become an important source of
revenue and risk for banks