Lecture Notes

Financial Products & Modeling

Topic 2
Financial Markets: Instruments and Their Relevance

Grigory Vilkov
Frankfurt School of Finance & Management
 Page 2 of Topic 2

Contents
2 Financial Markets: Instruments and Their Relevance
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.1.1 Road Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.1.2 Plan for the Day . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.1.3 Main Points for Today . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1.4 Motivating Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2 Financial Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 Case Studies: Financial Engineering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
2.4 How do YOU decide what instruments your firm needs? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
 Page 3 of Topic 2

2.1 Introduction
2.1.1 Road Map
• Financial Markets
? Functions, Participants, and Organization Topic# 1

? Instruments and Their Relevance Topic# 2

• Overview and Asset Pricing in Discrete Time

? Asset Pricing: Model-free Pricing by Replication
Forwards and Futures Topic# 3

? Asset Pricing in Discrete Time: Binomial Tree and its Limit

Options Topic# 4

• Fixed Income Securities

? Introduction to Fixed Income Securities Topic# 5

? Introduction to Swaps: Usage and Pricing Topic# 6

 Page 4 of Topic 2

2.1.2 Plan for the Day

Last Time
• Financial markets and their organization

Today
• Main question for the day: What do we want from Financial Markets?
? Instruments: what kind of and what are they good for?

For Next Time

• Please review the material covered in class.

• Please read the assigned material for the next time.

 Page 5 of Topic 2

2.1.3 Main Points for Today

1. Financial instruments: right tool for your needs.

• Tools and their “specialty” – risk/ return profile of major instruments.
• Selecting the right tool is easy, but you first have to identify your needs.
 Page 6 of Topic 2

2.1.4 Motivating Problems

Motivating Problem 2.1 (Variety of instruments and execution venues)
You are working in a large international bank in a Strategic Solutions Group
(SSG), and you design a new financing structure for a paper production plant
(PPP) in South Africa. According to the structure your bank provides a
floating-rate loan for usd 500 million for 15 years, where the rate is defined at
a complex formula so that it is minimum 5% and the add-on above depends
linearly on the lumber futures level on CME. PPP sells its products in South
Africa, and wants to be immune to zar risks. Your contract with PPP runs
under ISDA Terms, and your task is to be fully immune to any risks related to
the deal. Actions?

• SSG and PPP contract is OTC, and is not centrally cleared.

• When you sell the product to PPP, you can dissect it in terms of risks and
hedge each of them individually.

• Fixed-rate financing for your level of risk for 15 years can be arranged OTC.
 Page 7 of Topic 2

• Credit-default swaps at various country/ individual risk levels can be arranged

OTC, though some of them are centrally cleared.

• Futures/ options on lumber are traded for the next 5 years on CME; remaining
maturities can be traded OTC.

• Futures/ options on zar are traded on local SA exchange, and in USA.

• ...anything missing?

1. How is your contract with PPP executed?

Do you contact any broker or an exchange?

2. What parts of the replicating deal can you come up with?

3. Who are your counterparts on the replicating deal?

 Page 8 of Topic 2

Space for your work.

 Page 9 of Topic 2

2.2 Financial Instruments

Classification by Markets
1. Foreign exchange

2. Interest rate/ fixed income

3. Equity and stock index

4. Commodity

5. Credit
Classification by Commitment
Firm or optional commitment
Classification by trading venue
Exchange-traded or OTC
 Page 10 of Topic 2

1. Notional Value (Notional)

The notional value is the total amount of a security’s underlying asset at its
spot price. It is calculated as the units in one contract × the spot price.
Example: assume an investor wants to buy one gold futures contract. The
futures contract costs the buyer 100 troy ounces of gold. If gold futures are
trading at $1,100, then one gold futures contract has a notional value of ?

2. Market Value
Replacement value of the financial instrument at the prevailing market prices.
Example: assume you have just purchased 100 stocks at $100 each, and the
price did not change so far. The market value of your stocks is ?

3. Gross Market Values: the sum of the absolute values of all open contracts
evaluated at market prices prevailing on the reporting date.

4. Open interest is the total number of open or outstanding options and/or

futures contracts that exist at a given time.
Derivatives Statistics

http://stats.bis.org/statx/toc/DER.html
Page 12 of Topic 2
 Page 13 of Topic 2

Financial instruments in more detail

Variety of underlying instruments

? Equity
? Index
? Commodity
? Interest rate
? Credit spread . . . and plenty of others

Derivative security (derivative)

...a financial security whose value depends on (or derives from) other underlying instruments.

? Forwards/futures
? Options
? Swaps
? Your expert opinion needed: which classification is being used here?
by commitment
 Page 14 of Topic 2

1. Forward contract: an agreements for the delayed delivery of financial in-

struments or commodities in which the buyer agrees to purchase and the
seller agrees to deliver, at a specified future date, a specified instrument or
commodity at a specified price or yield.

Defining characteristic: Both parties commit to taking part in the trade or

exchange specified in the contract.

• Futures: traded at an exchange, and periodically marked-to-market

settlement of
• NDFs: non-deliverable forwards payment for liable
parties instead of
delivery
• FRA: forward rate agreement
 Page 15 of Topic 2

I Building block of most other derivatives, and thousands of years old.

I A forward contract is a bilateral agreement
• between two counterparties
? a buyer (or “long position”), and
? a seller (or “short position”)
• to trade in a specified quantity
• of a specified good (the “underlying”)
• at a specified price (the “delivery price”)
• on a specified date (the “maturity date”) in the future.
I The delivery price is related to, but not quite the same thing as, the
“forward price.” The forward price will be defined shortly.
 Page 16 of Topic 2

Important characteristics of a forward contract

I Bilateral contract: negotiated directly by seller and buyer.

I Customizable: terms of the contract can be ”tailored.”
I Credit Risk: there is possible default risk for both parties.
I Unilateral Reversal: neither party can unilaterally transfer its obligations
in the contract to a third party.

Futures & forwards differ on precisely these characteristics!

 Page 17 of Topic 2

The Forward Price and the Delivery Price

I At inception of the contract, the delivery price is set equal to the forward
price.
I As time moves on, the forward price will typically change, but the delivery
price in a contract, of course, remains fixed.
I So while a forward contract necessarily has zero value at inception, the
value of the contract could become positive or negative as time moves on.

The locked-in delivery price may look favorable or unfavorable com-

pared to the forward price on a fresh contract with the same maturity.
 Page 18 of Topic 2

Payoff Profiles for Forward Contracts

Value of Value of
long forward short forward
6 6

@
@
@
@
@
@
@
@
- @ -
@
@
Ft,T XT Ft,T @@ XT
@
@
@
@
@

? What is the payoff of the long forward? Short forward?

?
 Page 19 of Topic 2

Forwards vs. futures

I A futures contract is like a forward contract except that it is traded on

an organized exchange.
I This results in some important differences. In a futures contract:
? Buyers and sellers deal through the exchange, not directly.
? Contract terms are standardized.
? Default risk is borne by the exchange.
? Margin accounts (performance bonds) are used to manage default risk.
? Either party can reverse its position at any time by closing its contract.
• Beyond fixed maturity dates, standardization involves three components:
? Quantity (size of contract).
? Quality (standard deliverable grade).
? Delivery options (other deliverable grades + price adjustment).
 Page 20 of Topic 2

Forwards vs. futures: summary

Criterion Futures Forwards

Buyer-Seller Interaction via exchange direct

Contract Terms standardized can be tailored

Unilateral reversal possible not possible

Default risk borne by exchange individual parties

Default controlled by margin accounts collateral

 Page 21 of Topic 2

2. Option is a financial security that gives the holder the right to buy or sell
a specified quantity of a specified asset at a specified price on or before a
specified date.
I Some terminology
• Right to Buy = Call option. Right to Sell = Put option
• On/before: American. Only on: European
• Specified price = Strike or exercise price
• Specified date = Maturity or expiration date
• Specified asset = “underlying”
• Buyer = holder = long position
• Seller = writer = short position
 Page 22 of Topic 2

I Broad categories of options

• Exchange-traded options:
? Stocks (American).
? Futures (American).
? Indices (European & American)
? Currencies (European and American)
• OTC options:
? Vanilla (standard calls/puts as defined above).
? Exotic (everything else—e.g., Asians, barriers, digitals, forward-starts).
• Others (e.g., embedded options).
? Callable bonds.
? Convertible bonds.
 Page 23 of Topic 2

Gross Payoff Profiles for Plain Option Contracts

Value of Value of
buying call buying a put
predict an 6 6 predict a
upward decrease in
movement @ future price
(bearish)
@
(bullish) @
@
@
@
- @ -
K ST K ST

K ST K ST
- -
@ predict a
predict a @ stable price
decrease @ or rising
or stable @
@ (bullish)
price @
(bearish)
@

? ?
Value of Value of
selling selling
a call a put
 Page 24 of Topic 2

3. Swap is a bilateral contract between two counterparties that calls for periodic
exchanges of cash flows on specified dates and calculated using specified
rules. Similar to forwards, but instead of one exchange, there is a series of
exchanges.

I The contract specifies the dates (say, T1, T2, . . . , Tn ) on which cash flows
will be exchanged.
I The contract also specifies the rules according to which the cash flows
due from each counterparty on these dates are calculated.
• The frequency of payments for the two counterparties need not be the
same.
• For example, one counterparty could be required to make semi-annual
payments, while the other makes quarterly payments.
 Page 25 of Topic 2

I Swaps are differentiated by the underlying markets to which payments

on one or both legs are linked.
I The largest chunk of the swaps market is occupied by interest-rate swaps,
in which each leg of the swap is tied to a specific interest rate index.
I Other important categories of swaps include:
• Currency swaps, in which the two legs of the swaps are linked to
payments in different currencies.
• Equity swaps, in which one leg (or both legs) of the swap are linked to
an equity price or equity index.
• Commodity swaps, in which one leg of the swap is linked to a commodity
price.
• Credit-risk linked swaps (especially credit-default swaps) in which one
leg of the swap is linked to occurrence of a credit event (e.g., default)
on a specified reference entity.
 Page 26 of Topic 2

What do swaps achieve?

I Swaps are among the most versatile of financial instruments with new uses
being discovered (invented?) almost every day.

I One of the sources of swap utility comes from the fact that swaps enable
converting exposure to one market to exposure to another market.

I Example 1 Consider a 3-year equity swap in which

• One counterparty pays the returns on the S&P500 on a given notional
principal P .
• The other counterparty pays a fixed rate r on the same principal P .

I The first counterparty in this swap is exchanging equity-market returns for

interest-rate returns over this three-year horizon. The second counterparty is
doing the opposite exchange.
 Page 27 of Topic 2

I Example 2 Consider an interest-rate swap in which

• One counterparty pays a floating interest-rate (e.g., Libor) on a given
notional principal P .
• The other counterparty pays a fixed rate r on the same principal P .

I Such a swap enables converting floating interest-rate exposure to floating

interest-rate exposure (and vice versa).

I Example 3 Consider a currency swap in which

• One counterparty makes US dollar payments based on usd-Libor.
• The other makes Japanese yen payments based on jpy-Libor.

I The swap enables converting floating rate usd exposure to floating-rate jpy
exposure and vice versa.
 Page 28 of Topic 2

Linking Different Markets

I As a corollary, swaps provide a pricing link between different markets.

I Consider the equity swap in Example 1.

• At inception, the fixed rate r in the equity swap is set so that the swap has
zero value to both parties, i.e., so that the P V of the cash flows expected
from the equity leg is equal to the P V of the cash flows from the interest
rate leg.
• This means the interest rate r represents the market’s “fair price” for
converting equity returns into fixed-income returns.
• Thus equity swaps also provide a pricing link between the equity and
fixed-income markets: the swap not only enables transferring equity risk
into interest-rate risk, it also specifies the price at which this transfer can
be done.
 Page 29 of Topic 2

I Similarly:
• Interest-rate swaps provide a link between different interest-rate markets,
for example, the fixed-rate at which floating-rate exposure can be converted
to fixed-rate exposure.
• Currency swaps provide a link between interest-rate markets indifferent
currencies, for example, the eur fixed rate at which usd floating-rate
exposure can be converted to eur fixed-rate exposure.
 Page 30 of Topic 2

2.3 Case Studies: Financial Engineering

• Financial engineering, through the use of derivatives, can play an important
role in overall business strategy

• To see the “big picture”, please read the article Peter Tufano, “How
Financial Engineering Can Advance Corporate Strategy,” Harvard Business
Review Jan-Feb 1996, 136-146).

• Then, try and understand the problem, and the solution proposed using
financial engineering, for the following cases described in the article.
 Page 31 of Topic 2

1. Rhone-Poulenc used “options” to

• structure a plan to increase willingness of employees to buy stock,
• so that they have a stake in the success of the privatized firm.

2. Tennessee Valley Authority (TVA) decided to

• use option-purchase-agreements to add capacity to supply electricity
• as a substitute for building new power-generation plants.
 Page 32 of Topic 2

3. Enron Capital used financial engineering to convert methane from a com-

modity to a brand name
• by ensuring reliable delivery and
• by reducing volatility of prices (natural gas prices are about 4 times as
volatile as S&P 500);
• sold contracts that buyer could customize according to quantity, time
period, price index and settlement terms.

4. Cemex sold put options to investors to indicate confidence in Cemex stock,

after its drop following announcement of acquisition of two Spanish firms.
• The put options guaranteed a minimum price to the buyer of Cemex stock;
• JP Morgan then hedged the risk of the put options to Cemex via equity-
buyback-obligation rights.
 Page 33 of Topic 2

5. Amoco was successful in selling MW Petroleum Corporation to Apache

Corp. only because
• disagreement in the future commodity price was reconciled (risk-sharing)
• by using a capped price-support guarantee.

Q. How do we design such instruments with contingent cashflows?

• Need to recognize the pattern of cashflow that is needed in order to resolve
the particular situation.

Q. How do we value such instruments?

• We shall study this in the rest of the course.
 Page 34 of Topic 2

2.4 How do YOU decide what instruments your firm needs?

Risk-Management Roles

I All classes of derivatives serve important, but different, purposes.

I Futures/forwards/swaps enable to lock in cash flows from future transac-

tions.

I They are instruments for hedging risk=offsetting existing cash-flow risk.

I Example 1 A company needs to procure crude oil in one month and it can
use a one-month crude oil futures contract to lock in a price for the oil.

I Example 2 A company has borrowed at floating interest rates and wishes

to lock in fixed interest rate payments—it can enter into a swap where it
commits to exchanging fixed interest rate payments for floating ones.
 Page 35 of Topic 2

I Options provide one-sided protection.

I The option confers a right without an obligation. As a consequence:

• Call is the Protection against price increase.
• Put is the Protection against price decrease.

I In short, options provide financial insurance.

I Example Suppose a company needs to procure oil in one month.

• If the company buys a call option, it has the right to buy oil at the strike
price specified in the contract.
• If the price of oil in one month is lower than the strike price, the company
can opt out of the contract.
• Thus, the company can take advantage of price decreases but is protected
against price increases.
? Important question: is insurance for free?
 Page 36 of Topic 2

Space for your work.

Hint: . . . now let’s try to think a bit...

 Page 37 of Topic 2

Space for your work.