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Physical Market
Change in i/r
Risk Market
Derivatives
• Investor risk management
Change in firm value
Risk Market
Change in i/r
Physical Market
Futures
• Standardized Contract
Futures Contract
90-Day Bank Bills
• Contract Face Value $1 Million
• Price = Yield to two decimal places
• Quoted as an index of 100 minus yield
(i.e.) yield 5.63 % quoted as 94.37
- Formula
- Price = $ 1,000,000 * 365
365 + (Yield/100*90)
Futures Contract
90-Day Bank Bills
• Example: a company Physical Futures
has to borrow in three
months and is
concerned that Today 10% Sell 88
interest rates may rise
Buy 86
before it obtains the
loan: 3M 14%
- 2 % Profit 2%
Net Cost 12%
Futures Example (1) –
Buying Hedge
• A funds manager is to reinvest $2 Million in 3
months. Current investment rates are 12.6% p.a.
but the manager is concerned that the rates are
going to fall prior to the reinvestment date
• The manager decides to hedge the position
using 90 days bills futures contract
• The steps are: December is buying two march
contract at 88.11and sell two march contract at
89.49 (Action Now)
• On march will invest in commercial paper at
current market rates of 10.5 % (Future Action)
Physical (Cash) Market Derivatives (Futures) Market
December
Expect to reinvest $2 Million in Buy 2 march Contracts at 11.89%
3 months – current market Value $ 1,943,034.49
rates 12.6% Pay Deposit; Meet future margin
calls
March
Invest in CP at 10.5% Prior to expiry date sell 2 march
Cost $ 1,949,525.97 contracts at 10.51 %
Interest 50,474.03 Value $ 1,949,479.12
Profit 6,444.63 Profit = $ 6,444.63
Total Return $ 56,918.66
Effective Yield = $ 56,918.66 * 365 * 100 = 11.88 %
$ 1,943,081.34 * 90 * 1
Futures Example (2) –
Selling Hedge
• A company has an existing bank bill loan facility
of $ 1 Million which it will roll-over in 3 months.
The company is concerned that interest may rise
and decides to hedge its exposure using 90 day
bank accepted bills futures contract
• On March, current rates is 11.50 %
• The steps are: March is selling one June
contract at 88.12 and Buy one June contract at
87.00 (Action Now)
• On June will roll over loan at current market
rates of 12.95 % (Future Action)
Physical (Cash) Market Derivatives (Futures) Market
March
Roll over $ 1 Million loan in 3 Sell one June contract at 11.88 %
months time – current rates - Value $ 971,540.52
are 11.50 % Pay deposit; meet future margin
calls
June
Roll Over bank bills Prior to expiry date buy one
@12.95% June contract at 13.00 %
Cost $ 969,056.56 Value $ 968,940.80
Interest 30,943.44 Profit = $ 2,599.72
Profit 2,599.72
Net Cost $ 28,343.72
Effective Yield = $ 28,343.72 * 365 * 100 = 11.83 %
$ 971,656.28 * 90 * 1
Forward Rate Agreement
• An agreement between a borrower or an
investor and a FRA Dealer on an interest rate
level that will apply at a specified future date
• No underlying transaction necessary
• The FRA relates to future interest rates, there is
no exchange of principal
• Settlement is the value of the difference between
the FRA agreed rate and current rates on the
future settlement date
Forward Rate Agreement
• Contract Prices are quoted as two way
Buy Sell
• 2Mv5M 10.50 % 10.00 %
• 3Mv6M 11.20 % 10.70 %
• 3Mv9M 12.00 % 11.75 %
• 365 * P - 365 * P
365 + (is * d) 365 + (ic * d)
Settlement Rate Contract Rate
• 365 * P - 365 * P
365 + (is * d) 365 + (ic * d)
Settlement Rate Contract Rate
365* 500,000 - 365 * 500,000
365 + (0.0875*182) 365 + (0.0830 *182)
= $ 479,096.94 - 480,129.23 = ($1,032.29)
Loan
Physical Market
Settlement Rules
Mega Bank
ABC Ltd XYZ Ltd
Fee 0.10 %
12 %
Fixed Rate
12 %
Debentures
Construction of SWAP
Libor + 1.7 %
Mega Bank
XYZ Ltd
Fee 0.10 %
13.80 %
Libor + 1.7 %
Floating Rate
Libor + 1.7 %
Bank Loan
Construction of SWAP
LIBOR LIBOR + 1.7 %
Mega Bank
ABC Ltd XYZ Ltd
Fee 0.10 %
12 % 13.80 %
12 % Libor + 1.7 %