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Derivatives
Derivative = obligation to accomplish a transaction in the future
Forward Contract = basic derivative from which all others have evolved
• Repurchase Agreements – Reverse Repurchase Agreements
• Futures Contracts
Derivatives
• Swaps – Futures and Forward Contracts On
Swaps
• Options • Currency Options
– Swaptions – Options On Futures – Futures On Options
Floating-Fixed Swaps
Fixed
If net is positive, underwriter pays party. If net is negative, party pays underwriter.
Illustration of a Floating/Fixed Swap
Party Underwriter CounterpartyVariable
Fixed
Variable
Floating to Floating Swaps
LIBOR
If net is positive, underwriter pays party. If net is negative, party pays underwriter.
Illustration of a Floating/Floating Swap
Party Underwriter CounterpartyT-Bill
LIBOR
T-Bill
Parallel Loan
United States Germany
Loan guarantees
Debt service in $
Illustration of a parallel loan
German Parent
U.S. subsidiary of German
Firm
U.S. Parent
German subsidiary of
U.S. Firm
Principal in $
Debt service in Euro
Principal in Euro
Currency Swap
German rate x €1,000,000
€ 1,000,000
2 2
U.S. rate x $1,500,000
German rate x €1,000,000
U.S. rate x $1,500,000
1 1
€ 1,000,000
$1,500,000$1,500,000
€ 1,000,000
3 3
$1,500,000
€ 1,000,000
$1,500,000
Illustration of a straight currency swap
Step 1 is notionalSteps 2 & 3 are net
Borrow in US, invest in Europe
Borrow in Europe, invest in US
Swaps
Investor UnderwriterLibor ± Spread
Equity Index Return*
*Equity index return includes dividends, paid quarterly or reinvested
Illustration of an Equity Return Swap
Swaps
Investor Underwriter
Foreign Equity Index Return* A
Illustration of an Equity Asset Allocation Swap
*Equity index return includes dividends, paid quarterly or reinvested
Foreign Equity Index Return* B
Equity Call Swap
Investor Underwriter
Illustration of an Equity Call Swap
Equity Index Price Appreciation*
* No depreciation—settlement at maturity
Libor ± Spread
Equity Asset Swap
Underwriter
Equity Index Return*
* Equity index return includes dividends, paid quarterly or reinvested
Income Stream
Investor
Income
Stream
Asset
Caps
PremiumClient UnderwriterToday
*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year
Illustration of a 7% Interest Rate Cap on LIBOR
Max[(LIBOR – 7%), 0]
UnderwriterLater* Client
Floors
PremiumClient UnderwriterToday
*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year
Illustration of a 3% Interest Rate Floor on LIBOR
Max[(3% – LIBOR), 0]
UnderwriterLater* Client
Collars
PremiumClient UnderwriterToday
*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year
Illustration of a 3,7 Collar on LIBOR
Max[(LIBOR – 7%), 0]+ Max[(3% – LIBOR), 0]
UnderwriterLater* Client
Long Straddle
S
$
0
- CX
X+CX
S
$
0X+CC
Lon
g P
utL
ong
Cal
l
Sho
rt C
all
S
$
0
P
XX-P
S
$
0X
- P
X-P
Sho
rt P
ut
S
$
0X
-(P+C)
X-P-C
X+P+C
Short Straddle
S
$
0
- CX
X+CX
S
$
0X+CC
Lon
g P
utL
ong
Cal
l
Sho
rt C
all
S
$
0
P
XX-P
S
$
0X
- P
X-P
Sho
rt P
ut
S
$
0X
-(P+C)
X-P-C
X+P+C
Lon
gS
trad
dle $
0X
P+C
X-P-C
X+P+C
S