Topic 11 - Options, Interest Rate And Currency Swaps

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This article is a topic within the subject Capital Markets and Institutions.

Contents

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 670-722.

The Nature Of Options

[1] Options differ from futures as they provide an asymmetric cover against price movements (futures have symmetric payoffs). They limit effects of adverse price movements without reducing profit from favourable moves. An Option gives the buyer the right, but not the obligation to buy or sell a specified commodity or financial instrument at a predetermined price (strike price), on or before an expiration date[2]. The buyer pays the seller a premium.

  • Call Options - gives the option buyer the right to buy the commodity/instrument at the exercise price
    • Exercise if the market price > strike price
  • Put Options - gives the option buyer the right to sell the commodity/instrument at the exercise price
    • Exercise if the market price < strike price

The buyer of the right takes a 'long position' giving him/her the right to buy (call option) or sell (put option). The seller of the right takes a 'short position'. This means that he/she has the obligation to sell (call option) or buy (put option) the if the buyer exercises the option.

American options can be exercised any time up to expiration date & buyers pay a premium for this flexibility (greater chance of being in the money). European type options can only be exercised on the contract expiration date.

Call Options

[3] FINS16121101.jpg[4]

Put Options

[5] FINS16121102.jpg[6]

Covered And Naked Options

[7] Unlike the case with futures, the risk of loss for a buyer is limited to the premium. The seller has the potential for unlimited losses (risk) & may be subject to margin requirements (cash covering) unless a covered option is written. An option is covered when there is a guarantee that the writer of the option can complete the contract if the option holder chooses to exercise the option. The writer of a call option has written a covered option if the writer:

  • Owns a sufficient amount of the underlying asset to satisfy the option if exercised
  • Is the holder of a call option on the same asset with a lower exercise price

The writer of a put option has written a covered option if the writer is also the holder of a put option on the same asset at a higher strike price

Factors Affecting An Option Contract Premium

[8] The option price (premium – is the price paid by the buyer) is influenced by 4 key factors:

  1. Intrinsic Valuedifference between the spot price & the strike price, the greater the value the greater the premium
    • Positive Relationship e.g. the higher the market price compared to the spot, the higher the value of the call option
  2. Time Valuethe longer the time to expiry, the greater the possibility that the option will be able to be exercised profitably
    • Positive Relationship
  3. Price Volatilitythe greater the spot price volatility, the greater the option premium (greater chance of exercising for a large profit & large losses can be ignored)
    • Positive Relationship
  4. Interest Ratesopposite impacts on call & put options
    • Call - Positive Relationship – the higher the IR, the higher the premium, benefit – PV of deferred payment > lower PV of profit if exercised
      • The investor is able to conserve capital & invest it into the money market (instead of purchasing the asset)
    • Put - Negative Relationship - the higher the IR, the lower the premium, opportunity cost of holding asset (could rather invest into money markets at a high IR) & lower PV of the profit if exercised

FINS16121103.jpg[9]

Option Risk Management Strategies

[10]

Single Option Strategies

Long Asset And Bearish About Future Asset Price

To protect against the prospects of lower future prices, the investor can buy a put option or write a call option to limit his or her downside.

The payoff profile of being long an asset as well as writing a call is shown below.[11]

FINS16121104.jpg

Short Asset And Bullish About Future Asset Price

To protect against a rising price, an investor may buy a call option or write a put option to limit losses or make gains from a rising asset price.

Other Strategies

A Cap Option Contract places an upper limit on an interest rate. A Floor Option Contract places a lower limit on an interest rate. A Collar Option Contract is a combination & places an upper & lower limit on an interest rate.

A manager may pay a premium & buy an options contract that places a maximum limit (cap) on the interest rate whilst selling an option contract (to receive a premium) that places a minimum limit (floor) on the interest rate. This is a collar strategy that minimises the cost of the interest rate risk cover required.

Interest Rate Swaps

[12] An interest rate swap is an organised agreement between 2 borrowing parties who swap their interest payment obligations based on a notional principal amount. There is no exchange of principal (reduce settlement risk – only the net cash flow requirement) & both parties should benefit from the swap.

A firm should borrow from the market for which it has comparative advantage & swap the interest payments obligations in the market in which does not have a comparative advantage. This allows both parties to achieve a cost of funds lower than without the swap.

The Interest Rate Swap Market

The interest rate swap market is significant (36,013 billion in Australia & 381,829 billion worldwide). Swaps may be used to hedge interest rate risk & enable investors & borrowers to obtain a lower cost of funds or higher yield.

Example

[13]

FINS16121105.jpg

Firm A has absolute advantage in both debt markets & comparative advantage in the fixed rate market. There is a 0.80% differential that can be used to give benefits to both parties. We assume this is split 50/50. The benefit (0.4% each) lowers borrowing rate of market for which the firm does not have comparative advantage

  1. Firm A borrows at 12% & Firm B borrows at BBSW + 1.70%
    • Firm B swaps its BBSW + 1.70% with Firm A, While Firm A in return receives 13.6%
      • Firm A can now borrow at BBSW + 0.1% (0.4% lower) & Firm B can borrow at 13.6% (0.4% lower)

We can use algebra to work out specific value as we know the 'net amount'.

[14]

FINS16121106.jpg

Intermediated Swaps

The majority of swaps require the involvements of an intermediary that seeks an offsetting ‘matched swap’. The intermediary enters into opposite swap transactions to offset its net swap exposure & makes a profit on the spread. Firm A & B can now only reduce their net costs of funds by 0.7% (in total) as the intermediary takes a 0.1% spread. (This is what must be understood).

Theadvantage of this structure is that credit & settlement risk for both parties is lowered.

There are numerous ways to structure this swap - 2 ways are shown below. [15]

FINS16121107.jpg

Rationale For The Existence Of Interest Rate Swaps

[16]

  • Lowering the Net Cost of Funds (via comparative advantage)
    • For comparative advantage to exist, the advantage in the fixed market must be different from that in the floating market i.e. a different risk premium – occurs due to segmentation in the floating & fixed debt markets
      • Some institutions lend more heavily in floating markets (commercial banks) & some more heavily in fixed markets (life insurance & superannuation – rely on credit rating agencies)
    • Achieve a lower cost of funds than what would be achieved without the swap
  • Access to Otherwise Inaccessible Debt Markets (Get Fixed Rate Funding)
    • Banks prefer lending at floating rates (allowing them to maximise spread on loans when rates are changing)
      • May provide some fixed funding with the balance at floating rates
    • Corporate borrowers with good credit rating can issue fixed interest bonds
      • Other borrowers can only access banks & use swaps to obtain a net fixed rate cost of funds
  • Hedge Interest Rate Risk Exposures (Risk Management)
    • If the firm has an existing floating rate loan & is worried about rate rises it can synthesis (create)/ lock in a fixed cost loan;
      • Pay a fixed rate to the swap counterparty
      • Receive a floating payment from the swap counterparty
      • Rate Rise Effect - payments to floating rate lender increase but matched by increases in receipts from swap counter party, whilst the fixed rate payment to the counterparty remains unchanged
    • If a firm has a fixed rate loan & wanted to synthesise a variable rate cost of funds due to predictions of lower rates
      • Pay a variable rate to swap counterparty & receive fixed rate in return (mitigates existing fixed rate loan)
      • If rates fall, the interest payments to the lender remain unchanged, payments from the counterparty are unchanged but payments to the counterparty fall

[17]

FINS16121108.jpg

  • Lock in Profit Margins on Economic Transactions
    • A manufacturer of fixed priced goods or services is exposed to any movements in variable costs (including floating rate funds)
      • Has incentive to enter into a swap to lock in costs (sells a fixed price good – fixed costs allow price setting)
    • Locking in a net fixed funds cost fund locks in a fixed profit margin.

End

This is the end of this topic. Click here to go back to the main subject page for Capital Markets and Institutions.

References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 672-673
  2. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  3. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 673-677
  4. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  5. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 677-679
  6. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  7. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 679-680
  8. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 686-691
  9. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  10. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 690-695
  11. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  12. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 713-718
  13. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  14. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  15. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  16. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 718-722
  17. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
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