Futures and Options

1
Futures and Options
Tools for Managing Financial Risk
2
Risk Profile

• The value of the firm depends on some price
• There is a negative relationship
• How can this risk be managed?
• Should this risk be managed?

3
The Building Block Approach

• Forwards
• Futures
• Options
• Swaps
• Protected Equity Notes

4
Forward Contracts

• To buy (go long) a forward contract means to
  agree to buy a product at a pre-specified price
  in the future.
• To sell (go short) a forward contract means to
  agree to sell a product at a pre-specified price
  in the future.

Buy
Sell
5
Hedging with a Forward Contract

• Firm has a positively sloped risk profile.
• How can this risk be hedged?
• When hedged, price changes in this asset will
  have no effect on the value of the firm.

Risk Profile
Sell Forward
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Hedging with a Forward Contract

• Now the firm has a negatively sloped risk profile
• How can this risk be hedged?

Buy Forward
Risk Profile
7
Futures Contracts

• Same payoff profile as a forward contract
• Exchange traded
• Marked to market daily
• A futures contract is a series of daily forwards
• Less credit risk

8
Interest Rate Swaps

• A swap is an agreement to trade interest payments
• A common swap will trade fixed for floating rate
  interest payments
• Notice that this is a series of forward contracts
  on interest rates

R
R
R
R
R
Get Floating
Pay Fixed
R
R
R
R
R
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Risk Profile of a Swap
Pay Fixed/ Get Float

• The value of the swap varies with the floating
  interest rate
• A swap can be used to hedge interest rate
  movements

DSwap
DR
Pay Float/ Get Fixed
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Hedging Interest Rate Risk

• Swap pay fixed for get float
• Buy interest rate forward
• Sell bond forward

DV
DR
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Hedging Interest Rate Risk

• Swap pay float for get fixed
• Sell interest rate forward
• Buy bond forward

DV
DR
12
Options

• An option is the right to buy or sell at a
  pre-determined price
• An option contract includes
• A strike price
• An expiration date
• A premium

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Option Payoff Profiles
Buy a Call
Sell a Call
Buy a Put
Sell a Put
14
Hedging with Options
Risk Exposure

Strategy Payoff
Result

Buy a Call
15
The Option Premium
Risk Exposure

Strategy
Net Result

Buy a Call
16
Hedging Examples
Risk Exposure

Strategy
Remove Risk

Sell Forward
17
Hedging Examples
Risk Exposure

Strategy
Insurance

Buy a Put
18
Hedging Examples
Risk Exposure

Strategy
Cheaper Insurance

Buy an Out-of-the-Money Put
19
Put-Call Parity orSnap Together a Forward
Buy a Call

Sell a Put
Buy a Forward

20
Protected Equity Notes

• Invest 1 million today
• At maturity, receive 1 million plus 100 of the
  upside return on the SP index
• How do you construct this security?

21
PEN Construction
Buy a Bond

Buy a Call
PEN Payoff

PEN
DSP