Re: Derivatives Questions
Ratan Gupta, FRM
Q2 - Like a call option gives you the right to buy shares in the
future, Swaption gives you the right to enter into a swap contract in
the future. Companies tend to enter into swaption mainly for the
following reason:-
- They estimate some floating rate income/payment in the future and
would like to have an option to get into a contract which will allow
them to mitigate the impact of floating payment. This is a straight
forward case.
- To enable the firm to close out any existing swap position in case
there is unfavorable interest rate movement. I will explain this with
an example. Suppose firm A is fixed rate payer and floating rate
receiver in a swap of maturity 7 years. After 2 years, the interest
rate started falling, firm A will lose as the receivables are less and
payables are more, a good option is to close the contract, by getting
into an opposite contract. If the firm had bought a swaption which
allowed it to enter into a swap contract as a fixed rate receiver and
floating rate payer, it could easily exercise this option and enter
into the contract. however if the interest rate did not fall but
increase , firm A will not exercise the option. The cost of this
arrangement would be the option premium.
Q3 - Equity swaps are financial innovation which has come because of
the restrictions of investing in some country or security. This type
of instruments emerged when US domiciled firms were not allowed to
take exposure in Japanese stocks. If you see, basically equity swaps
are one way of taking exposure in the stock or index of your choice. I
will explain this with the following scenario.
Suppose you want to take exposure in Apple Stock (priced at $100) and
u dont have money. You have taken $1000 loan from a bank at 6%
interest rate per annum, and from this money you bought 10 shares of
Apple on 1st Jan 2010. Lets take 3 prices for the apple share and see
what is your profit and loss
A> Apple price : $90 => You have lost $10 * 10 = $100, also you have
to pay interest to the bank which is $60.So your total cash outflow is
$160.
B> Apple price : $120 => You have gained $20 * 10 = $200, also you
have to pay interest to the bank which is $60.So your total cash
inflow is $140.
C> Apple price : $100 => You have lost $0 * 10 = $0, also you have to
pay interest to the bank which is $60.So your total cash outflow is
$60.
Now take an instance where you are not allowed to invest in USA, but
you desperately want Apple shares as u think ipod and iphone will be
the next big thing. Here comes a bank, which offers an equity swap to
you, with the following terms.
- bank will pay you the return of Apple
- You pay the bank 6% fixed rate of return.
- Notioanl amount is $1000
Again, i can apply the same 3 prices of apple and see what is your
profit and loss
A> Apple price : $90 => Return is -10%, therefore bank will pay you
-10% or in other words, you have to pay bank an additional 10% (over
the 6% already committed). So you pay 6% - (-10%) = 16% to the bank or
$160.
B> Apple price : $120 => Return is 20%, therefore bank will pay you
20%. So you pay 6% - (20%) = -14% to the bank or you will receive $140
from the bank.
C> Apple price : $100 => Return is 0%, therefore bank will pay you 0%.
So you pay 6% - (0%) = 6% to the bank or $60.
Now compare the first case with the second case, in both the cases the
cash flow is the same. So you had to undertake Equity swap which is
just like taking exposure on stocks without your own money. Another
type of Swap is Total return swap where you are entitled for the
dividends also.
Thanks
Ratan
On Feb 9, 9:32 am, Geetha Vramani <vramani.gee...@gmail.com> wrote:
> Hi Ratan,
>
> I have the following questions. Please advise -
>
> Q1) (Schweser pg 195) - In options on futures, please explain how does
> a bond future underlying an option work? I could not understand the
> illustration on page 196.
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>
> Q2) (Schweser pg 221) - Please explain with an example how swapation
> will work.
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>
> Q3) I find equity swaps confusing. Please explain with example in
> Schweser pg 227.
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>
> Thanks,
> Geetha