The document discusses various methods of hedging risks with derivative securities. It covers topics like contracts (spot, forward, futures), options (calls, puts), risks associated with futures, forwards and options (contingent credit risk), and compares different hedging methods like writing vs buying options, futures vs options hedging, and swaps vs forwards/futures/options. The document is presented by various members and each member covers a specific topic related to derivative securities and hedging risks.

1. Managing Risks With
Derivative Securities
Financial Markets & Institutions
Chapter - 23

2. Introduction

3. Aim
* To accustom the students with theory and
terms related to Hedging, Contracts, Option,
Swap and Methods of Hedging

4. Members
• Major Fawad Hussain
• Rizwan Shaukat
• Hafiz Mazhar
• Ali Zeb
• Jam Waqas

5. Sequence
• Introduction : Fawad
• Contracts : Fawad
• Options : Rizwan
• Risks Associated With Future, Forward
& Options : Waqas
• Swaps : Alizeb
• Comparison of Hedging Methods : Mazhar

6. HEDGES & CONTRACTS
Fawad

7. Part – 1 Contracts
• Spot Contract . An agreement between buyer
and seller for immediate exchange of assets and
funds.
• Forward Contract . An agreement to transact
involving future exchange of a set amount of assets
at a set price.
• Futures Contracts . An agreement to transact
involving the future exchange of a set amount of
assets for a price that is settled daily .

8. Part – 1 Contracts
• Market to Market . Describes the prices on
outstanding future contracts that are adjusted each
day to reflect current futures market condition.

9. HEDGE

10. HEDGE
• A hedge is an investment position intended to offset
potential losses/gains that may be incurred by a
companion investment. In simple language, a hedge
is used to reduce any substantial losses/gains
suffered by an individual or an organization.
• A hedge can be constructed from many types of
financial instruments, including stock, exchange
traded funds, insurance, forward contracts, swaps,
options, many types of over the counter and
derivative products and future contracts.

11. HEDGING WITH FORWARD
CONTRACTS
• Off – Balance – Sheet. A form of financing in which
large capital expenditures are kept off of a company's
balance sheet through various classification methods.
Companies will often use off-balance-sheet
financing to keep their debt to equity (D/E) and
leverage ratios low, especially if the inclusion of a large
expenditure would break negative debt covenants.
• An alert FI portfolio manager expecting to incur a
capital loss on its bond can offset it and reduce the risk
of loss to zero by hedging an off balance sheet hedge
to a potential buyer with a forward time of delivery in
future .

12. HEDGING WITH FORWARD
CONTRACTS
• Immunize . To fully hedge or protect an FI
against adverse moments in interest rates ( or
asset prices).

13. HEDGING WITH FUTURE
CONTRACTS
•
Future Contracts. are one of the most common
derivatives used to hedge risk. A futures contract is as an
arrangement between two parties to buy or sell an asset at a
particular time in the future for a particular price. The main
reason that companies or corporations use future contracts is
to offset their risk exposures and limit themselves from any
fluctuations in price. The ultimate goal of an investor using
futures contracts to hedge is to perfectly offset their risk. In
real life, however, this is often impossible and, therefore,
individuals attempt to neutralize risk as much as possible
instead. For example, if a commodity to be hedged is not
available as a futures contract, an investor will buy a futures
contract in something that closely follows the movements of
that commodity.

14. HEDGING WITH FUTURE CONTRACTS
• There are two types of Hedging with future
contacts :-
– Micro hedging . An investment technique used to
eliminate the risk of a single asset. In most cases,
this means taking an offsetting position in that
single asset.
It is basically using future contract to hedge a
specific asset or liability

15. HEDGING WITH FUTURE CONTRACTS
• Macro Hedging . Hedging the entire duration gap of
an FI, it occurs when a FI manager uses future or
other derivative securities to hedge the entire
balance sheet duration gap.
• Example of a macro-hedge: an index-fund manager
believes there will be a loss in the index in the
upcoming period. To eliminate the risk of a
downward turn in the index, the manager can take a
short position in the index fund's futures market that
will lock in a price for the index.

16. Macro vs. Micro Hedging
 Most FIs hedge risk either at the micro level (called micro-hedging) or at
the macro level (called macro-hedging) using futures contracts
 An FI is Micro-hedging when it employs a derivative contract to
hedge a particular asset or liability risk (single asset or maybe a
portfolio of similar assets such as a mortgage portfolio)
 Macro-hedging occurs when an FI manager wishes to use
derivative securities to hedge the entire balance sheet duration
gap
 Micro-hedging
 In micro-hedging, the FI often tries to pick a futures or forward
contract whose underlying deliverable asset is closely matched
to the asset (or liability) position being hedged. If I'm trying to
hedge mortgages I would pick something similar like a 10 year
futures contract or government security. Both driven by the same
underlying macro-economics. Probably focused on one type of
derivative.
 Macro-hedging
 A macro-hedge takes a whole portfolio (the whole financial
institution) view and allows for individual asset and liability interest
sensitivities or durations to net each other out. It may be the
case that a mix of securities best matches for hedging. Could be many types of
derivatives

17. OPTIONS
Rizwan

18. OPTIONS
• An option is a contract which gives the owner the
right, but not the obligation, to buy or sell an
underlying asset or instrument at a specified
strike price on or before a specified date. The
seller incurs a corresponding obligation to fulfill
the transaction, that is to sell or buy, if the long
holder elects to "exercise" the option prior to
expiration. The buyer pays a premium to the
seller for this right. An option which conveys the
right to buy something at a specific price is called
a call; an option which conveys the right to sell
something at a specific price is called a put.

19. Basic Features of Options
• Buying a Call Option on Bond .
– As interest rate falls , bond prices rises, and potential
for a higher payoff for the buyer.
– As interest rates rises , bond prices fall and potential
for negative payoff for the buyer of the option
increases.
– If rate rises and prices fall below the exercise price
(EP), the call buyer is obliged to exercise the option ,
Thus the buyer losses are truncated by the amount of
up front premium payment (call premium CP)
– Buying a call option is a strategy to take when
interested rates are expected to fall.

20. Basic Features of Options
• Writing a Call Option on a Bond .
– The writing a call option is a strategy to take
when interest rates are expected to rise.
– Caution is warranted because profits are limited
and losses are unlimited. The results in writing of
a call option being unacceptable as a strategy to
use when hedging interest rate risk.

21. Basic Features of Options
• Buying a Put Option on Bond .
– When interest rate rise and bond prices fall, the
probability that the buyer of the put will make profit
from the option increases, Thus if bond prices fall the
buyer of the put option can purchase bonds in the
bond market at that price and put them back to the
writer of put at the higher exercise price, it gives
buyer unlimited profit potential
– When interest rates fall and bond prices rise, the
probability that buyer of a put will lose increses.

22. Basic Features of Options
• Writing a Put Option on a Bond .
– When interest rate falls and bond prices increase, the
writer has a enhanced probability of making profit.
The put buyer is less likely to exercise this option,
which would force the option writer to buy the
underlying bonds
– When interest rates increase and bond prices fall, the
writer of the put is exposed to potential huge losses.
The put buyer will exercise the option forcing the
writer to buy the underlying bonds at the exercise
price .

23. Basic Features of Options
• Hedging with Options .
• Hedging Stocks Using Stock Options
•
Hedging a portfolio of stocks is easy and convenient using stock options.
Here are some popular methods:
Protective Puts : Hedging against a drop in the underlying stock using put
options. If the stock drops, the gain in the put options offsets the loss in
the stock.
Covered Calls : Hedging against a small drop in the underlying stock by
selling call options. The premium received from the sale of call options
serves to buffer against a corresponding drop in the underlying stock.
Covered Call Collar : Hedging against a big drop in the underlying stock
using put options while simultaneously increasing profitability to upside
through the sale of call options.

24. Caps , Floors & Collars
• An interest rate Cap is a derivative in which the buyer
receives payments at the end of each period in which
the interest rate exceeds the agreed strike price. An
example of a cap would be an agreement to receive a
payment for each month the LIBOR rate exceeds 2.5%.
• An interest rate floor is a derivative contract in which
the buyer receives payments at the end of each period
in which the interest rate is below the agreed strike
price.
• A collar is an operation strategy that limits the range of
possible positive or negative returns on
an underlying to a specific range.

25. RISKS ASSOCIATED WITH FUTURE
FORWARD & OPTIONS
Waqas

26. Risks Associated with Future Forward & Options
• Contingent Credit Risk . When FIs expand their
positions in forward , future and option
contracts. The risk relates to the fact that the
counterparty to one of these contracts may
default on payment obligation, leaving FI
unhedged and having to replace the contract
at present day interest or price. It is more
serious risk for forward contracts.

27. Risks Associated with Future Forward & Options
• Option contracts can also be traded by an FI
over the counter (OTC),If the options are
standardized options traded on exchanges ,
such as bond options, they are virtually
default risk free. If they are specialized options
purchased OTC such as interest rate caps,
some elements of default risk exists

28. SWAPS
Alizeb

29. SWAP
• Traditionally, the exchange of one security for
another to change the maturity (bonds), quality
of issues (stocks or bonds), or because
investment objectives have changed. Recently,
swaps have grown to include currency swaps and
interest rate swaps.
• Other types of swaps are credit risk swaps,
commodity swaps and equity swaps.

30. Interest Rate Swap
• An agreement between two parties (known as
counterparties) where one stream of future interest
payments is exchanged for another based on a
specified principal amount. Interest rate swaps often
exchange a fixed payment for a floating payment that
is linked to an interest rate (most often the LIBOR). A
company will typically use interest rate swaps to limit
or manage exposure to fluctuations in interest rates, or
to obtain a marginally lower interest rate than it would
have been able to get without the swap.

31. Currency Swap
• A swap that involves the exchange of principal and interest in one
currency for the same in another currency. It is considered to be a foreign
exchange transaction and is not required by law to be shown on a
company's balance sheet.
• For example, suppose a U.S.-based company needs to acquire Swiss francs
and a Swiss-based company needs to acquire U.S. dollars. These two
companies could arrange to swap currencies by establishing an interest
rate, an agreed upon amount and a common maturity date for the
exchange. Currency swap maturities are negotiable for at least 10 years,
making them a very flexible method of foreign exchange.
•

32. Fixed –for-Fixed Currency Swap
• An arrangement between two parties (known as
counterparties) in which both parties pay a fixed
interest rate that they could not otherwise obtain
outside of a swap arrangement.

33. Credit Risk
• The risk of loss of principal or loss of a financial reward
stemming from a borrower's failure to repay a loan or
otherwise meet a contractual obligation. Credit risk
arises whenever a borrower is expecting to use future
cash flows to pay a current debt. Investors are
compensated for assuming credit risk by way of
interest payments from the borrower or issuer of a
debt obligation.

34. COMPARISON OF HEDGING
METHODS
Mazhar

35. Writing versus Buying Options
• Many FIs prefer to buy rather than write options,
one of the two reasons for this , one is economic
and other is regulatory.
• Writing options truncates upside profit potential
while downside loss potential is unlimited
• Buying option truncates downside loss potential
while upside profit potential is unlimited
• Commercial banks are prohibited by regulators
from writing options in certain areas of risk
management specially naked options

36. Naked Option
• Option which donot identifiably hedge an
underlying asset or liability position, to be
risky because of their unlimited loss potential.
Naked trading is considered very risky since
losses can be significant.

37. Future versus Options Hedging
• Future hedging produces symmetric gains and
losses when interest rates move against the on-
balance-sheet securities, as well as when interest
rates move in favor of on-balance-sheet
securities .
• Options hedging protects the FI against value
losses when interest rate move against the on-
balance-sheet securities, but unlike with future
hedging , does not fully reduce value gains when
interest rates move in favor of on-balance-sheet
securities.

38. Swaps versus Forwards, Futures and Options
• Futures and most options are standardized contracts with
fixed principle amounts. Swaps (and Forwards) are OTC
contracts negotiated directly by the counterparties to the
contract.
• Futures contracts are marked to market daily, Swaps and
Forwards require payments only at times specified in the
swap or forward agreement.
• Swaps can be written for relatively long time horizons, Futures
and option contracts do not trade for more than 2 to 3 years
into future and active trading in the contracts generally
extends to contracts with a maturity of less than 1 year.
• Swaps and forward contracts are subject to default risk, Most
future and option contracts are not subject to default risk.

39. CONCLUSION
Fawad

40. QUESTIONS
All