Forward and Futures Contracts
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Section 1256 and Foreign Currency Derivatives
Section 1256 and Foreign Currency Derivatives Viva Hammer1 Mark-to-market taxation was considered “a fundamental departure from the concept of income realization in the U.S. tax law”2 when it was introduced in 1981. Congress was only game to propose the concept because of rampant “straddle” shelters that were undermining the U.S. tax system and commodities derivatives markets. Early in tax history, the Supreme Court articulated the realization principle as a Constitutional limitation on Congress’ taxing power. But in 1981, lawmakers makers felt confident imposing mark-to-market on exchange traded futures contracts because of the exchanges’ system of variation margin. However, when in 1982 non-exchange foreign currency traders asked to come within the ambit of mark-to-market taxation, Congress acceded to their demands even though this market had no equivalent to variation margin. This opportunistic rather than policy-driven history has spawned a great debate amongst tax practitioners as to the scope of the mark-to-market rule governing foreign currency contracts. Several recent cases have added fuel to the debate. The Straddle Shelters of the 1970s Straddle shelters were developed to exploit several structural flaws in the U.S. tax system: (1) the vast gulf between ordinary income tax rate (maximum 70%) and long term capital gain rate (28%), (2) the arbitrary distinction between capital gain and ordinary income, making it relatively easy to convert one to the other, and (3) the non- economic tax treatment of derivative contracts. Straddle shelters were so pervasive that in 1978 it was estimated that more than 75% of the open interest in silver futures were entered into to accommodate tax straddles and demand for U.S. -
How Much Do Banks Use Credit Derivatives to Reduce Risk?
How much do banks use credit derivatives to reduce risk? Bernadette A. Minton, René Stulz, and Rohan Williamson* June 2006 This paper examines the use of credit derivatives by US bank holding companies from 1999 to 2003 with assets in excess of one billion dollars. Using the Federal Reserve Bank of Chicago Bank Holding Company Database, we find that in 2003 only 19 large banks out of 345 use credit derivatives. Though few banks use credit derivatives, the assets of these banks represent on average two thirds of the assets of bank holding companies with assets in excess of $1 billion. To the extent that banks have positions in credit derivatives, they tend to be used more for dealer activities than for hedging activities. Nevertheless, a majority of the banks that use credit derivative are net buyers of credit protection. Banks are more likely to be net protection buyers if they engage in asset securitization, originate foreign loans, and have lower capital ratios. The likelihood of a bank being a net protection buyer is positively related to the percentage of commercial and industrial loans in a bank’s loan portfolio and negatively or not related to other types of bank loans. The use of credit derivatives by banks is limited because adverse selection and moral hazard problems make the market for credit derivatives illiquid for the typical credit exposures of banks. *Respectively, Associate Professor, The Ohio State University; Everett D. Reese Chair of Banking and Monetary Economics, The Ohio State University and NBER; and Associate Professor, Georgetown University. We are grateful to Jim O’Brien and Mark Carey for discussions. -
Implied Volatility Modeling
Implied Volatility Modeling Sarves Verma, Gunhan Mehmet Ertosun, Wei Wang, Benjamin Ambruster, Kay Giesecke I Introduction Although Black-Scholes formula is very popular among market practitioners, when applied to call and put options, it often reduces to a means of quoting options in terms of another parameter, the implied volatility. Further, the function σ BS TK ),(: ⎯⎯→ σ BS TK ),( t t ………………………………(1) is called the implied volatility surface. Two significant features of the surface is worth mentioning”: a) the non-flat profile of the surface which is often called the ‘smile’or the ‘skew’ suggests that the Black-Scholes formula is inefficient to price options b) the level of implied volatilities changes with time thus deforming it continuously. Since, the black- scholes model fails to model volatility, modeling implied volatility has become an active area of research. At present, volatility is modeled in primarily four different ways which are : a) The stochastic volatility model which assumes a stochastic nature of volatility [1]. The problem with this approach often lies in finding the market price of volatility risk which can’t be observed in the market. b) The deterministic volatility function (DVF) which assumes that volatility is a function of time alone and is completely deterministic [2,3]. This fails because as mentioned before the implied volatility surface changes with time continuously and is unpredictable at a given point of time. Ergo, the lattice model [2] & the Dupire approach [3] often fail[4] c) a factor based approach which assumes that implied volatility can be constructed by forming basis vectors. Further, one can use implied volatility as a mean reverting Ornstein-Ulhenbeck process for estimating implied volatility[5]. -
Tax Treatment of Derivatives
United States Viva Hammer* Tax Treatment of Derivatives 1. Introduction instruments, as well as principles of general applicability. Often, the nature of the derivative instrument will dictate The US federal income taxation of derivative instruments whether it is taxed as a capital asset or an ordinary asset is determined under numerous tax rules set forth in the US (see discussion of section 1256 contracts, below). In other tax code, the regulations thereunder (and supplemented instances, the nature of the taxpayer will dictate whether it by various forms of published and unpublished guidance is taxed as a capital asset or an ordinary asset (see discus- from the US tax authorities and by the case law).1 These tax sion of dealers versus traders, below). rules dictate the US federal income taxation of derivative instruments without regard to applicable accounting rules. Generally, the starting point will be to determine whether the instrument is a “capital asset” or an “ordinary asset” The tax rules applicable to derivative instruments have in the hands of the taxpayer. Section 1221 defines “capital developed over time in piecemeal fashion. There are no assets” by exclusion – unless an asset falls within one of general principles governing the taxation of derivatives eight enumerated exceptions, it is viewed as a capital asset. in the United States. Every transaction must be examined Exceptions to capital asset treatment relevant to taxpayers in light of these piecemeal rules. Key considerations for transacting in derivative instruments include the excep- issuers and holders of derivative instruments under US tions for (1) hedging transactions3 and (2) “commodities tax principles will include the character of income, gain, derivative financial instruments” held by a “commodities loss and deduction related to the instrument (ordinary derivatives dealer”.4 vs. -
Derivative Securities
2. DERIVATIVE SECURITIES Objectives: After reading this chapter, you will 1. Understand the reason for trading options. 2. Know the basic terminology of options. 2.1 Derivative Securities A derivative security is a financial instrument whose value depends upon the value of another asset. The main types of derivatives are futures, forwards, options, and swaps. An example of a derivative security is a convertible bond. Such a bond, at the discretion of the bondholder, may be converted into a fixed number of shares of the stock of the issuing corporation. The value of a convertible bond depends upon the value of the underlying stock, and thus, it is a derivative security. An investor would like to buy such a bond because he can make money if the stock market rises. The stock price, and hence the bond value, will rise. If the stock market falls, he can still make money by earning interest on the convertible bond. Another derivative security is a forward contract. Suppose you have decided to buy an ounce of gold for investment purposes. The price of gold for immediate delivery is, say, $345 an ounce. You would like to hold this gold for a year and then sell it at the prevailing rates. One possibility is to pay $345 to a seller and get immediate physical possession of the gold, hold it for a year, and then sell it. If the price of gold a year from now is $370 an ounce, you have clearly made a profit of $25. That is not the only way to invest in gold. -
Derivative Securities, Fall 2012 – Homework 3. Distributed 10/10
Derivative Securities, Fall 2012 { Homework 3. Distributed 10/10. This HW set is long, so I'm allowing 3 weeks: it is due by classtime on 10/31. Typos in pbm 3 (ambiguity in the payoff of a squared call) and pbm 6 (inconsistent notation for the dividend rate) have been corrected here. Problem 1 provides practice with lognormal statistics. Problems 2-6 explore the conse- quences of our formula for the value of an option as the discounted risk-neutral expected payoff. Problem 7 makes sure you have access to a numerical tool for playing with the Black-Scholes formula and the associated \Greeks." Problem 8 reinforces the notion of \implied volatility." Convention: when we say a process Xt is \lognormal with drift µ and volatility σ" we mean 2 ln Xt − ln Xs is Gaussian with mean µ(t − s) and variance σ (t − s) for all s < t; here µ and σ are constant. In this problem set, Xt will be either a stock price or a forward price. The interest rate is always r, assumed constant. (1) Suppose a stock price st is lognormal with drift µ and volatility σ, and the stock price now is s0. (a) Give a 95% confidence interval for sT , using the fact that with 95% confidence, a Gaussian random variable lies within 1:96 standard deviations of its mean. (b) Give the mean and variance of sT . (c) Give a formula for the likelihood that a call with strike K and maturity T will be in-the-money at maturity. -
Value at Risk for Linear and Non-Linear Derivatives
Value at Risk for Linear and Non-Linear Derivatives by Clemens U. Frei (Under the direction of John T. Scruggs) Abstract This paper examines the question whether standard parametric Value at Risk approaches, such as the delta-normal and the delta-gamma approach and their assumptions are appropriate for derivative positions such as forward and option contracts. The delta-normal and delta-gamma approaches are both methods based on a first-order or on a second-order Taylor series expansion. We will see that the delta-normal method is reliable for linear derivatives although it can lead to signif- icant approximation errors in the case of non-linearity. The delta-gamma method provides a better approximation because this method includes second order-effects. The main problem with delta-gamma methods is the estimation of the quantile of the profit and loss distribution. Empiric results by other authors suggest the use of a Cornish-Fisher expansion. The delta-gamma method when using a Cornish-Fisher expansion provides an approximation which is close to the results calculated by Monte Carlo Simulation methods but is computationally more efficient. Index words: Value at Risk, Variance-Covariance approach, Delta-Normal approach, Delta-Gamma approach, Market Risk, Derivatives, Taylor series expansion. Value at Risk for Linear and Non-Linear Derivatives by Clemens U. Frei Vordiplom, University of Bielefeld, Germany, 2000 A Thesis Submitted to the Graduate Faculty of The University of Georgia in Partial Fulfillment of the Requirements for the Degree Master of Arts Athens, Georgia 2003 °c 2003 Clemens U. Frei All Rights Reserved Value at Risk for Linear and Non-Linear Derivatives by Clemens U. -
Enns for Corporate and Sovereign CDS and FX Swaps
ENNs for Corporate and Sovereign CDS and FX Swaps by Lee Baker, Richard Haynes, Madison Lau, John Roberts, Rajiv Sharma, and Bruce Tuckman1 February, 2019 I. Introduction The sizes of swap markets, and the sizes of market participant footprints in swap markets, are most often measured in terms of notional amount. It is widely recognized, however, that notional amount is a poor metric of both size and footprint. First, when calculating notional amounts, the long and short positions between two counterparties are added together, even though longs and shorts essentially offset each other. Second, notional calculations add together positions with very different amounts of risk, like a relatively low-risk 3-month interest rate swap (IRS) and a relatively high-risk 30- year IRS. The use of notional amount to measure size distorts understanding of swap markets. A particularly powerful example arose around Lehman Brothers’ bankruptcy in September, 2008. At that time, there were $400 billion notional of outstanding credit default swaps (CDS) on Lehman, and Lehman’s debt was trading at 8.6 cents on the dollar. Many were frightened by the prospect that sellers of protection would soon have to pay buyers of protection a total of $400 billion x (1 – 8.6%), or about $365 billion. As it turned out, however, a large amount of protection sold had been offset by protection bought: in the end, protection sellers paid protection buyers between $6 and $8 billion.2 In January, 2018, the Office of the Chief Economist at the Commodity Futures Trading Commission (CFTC) introduced ENNs (Entity-Netted Notionals) as a metric of size in IRS markets.3 To compute IRS ENNs, all notional amounts are expressed in terms of the risk of a 5-year IRS, and long and short positions are netted when they are between the same pair of legal counterparties and denominated in the same currency. -
The Hedging Process
2016 Hedging What is hedging? Why would a business need it? How would it help mitigate risks? How would one be able to get started with it? How can MFX help? Everything it entails can be summarized in a concise, yet detailed step-by-step process. There are several key steps a company must follow in order to go through with this process and benefit. Let the simple flow chart below direct you as you read through this guide. Key Steps to the Hedging Process Why would you need hedging? Hedging using derivatives is a common and popular method for managing different kinds of risk for all different kinds of business. However, before going down the path of contracting a hedge, it is important to understand exactly what risk your institution faces. Without fully understanding how your financial position will react to changes in the risk factors you are trying to hedge, there is a risk that entering into a derivative contract could add additional risk of different kinds of risk than you currently face. It is important to think about other risk factors other than the one you are hedging that could affect the hedge. For example, how certain are you of the cash flows you are trying to hedge? Are you hedging balance sheet or cash risk? Are there natural hedges in other parts of your business that offset the risk you are trying to hedge? MFX’s team can help you consider the decision to hedge, but the client is responsible for assessing its risk and the appropriateness of hedging it. -
Forward and Futures Contracts
FIN-40008 FINANCIAL INSTRUMENTS SPRING 2008 Forward and Futures Contracts These notes explore forward and futures contracts, what they are and how they are used. We will learn how to price forward contracts by using arbitrage and replication arguments that are fundamental to derivative pricing. We shall also learn about the similarities and differences between forward and futures markets and the differences between forward and futures markets and prices. We shall also consider how forward and future prices are related to spot market prices. Keywords: Arbitrage, Replication, Hedging, Synthetic, Speculator, Forward Value, Maintainable Margin, Limit Order, Market Order, Stop Order, Back- wardation, Contango, Underlying, Derivative. Reading: You should read Hull chapters 1 (which covers option payoffs as well) and chapters 2 and 5. 1 Background From the 1970s financial markets became riskier with larger swings in interest rates and equity and commodity prices. In response to this increase in risk, financial institutions looked for new ways to reduce the risks they faced. The way found was the development of exchange traded derivative securities. Derivative securities are assets linked to the payments on some underlying security or index of securities. Many derivative securities had been traded over the counter for a long time but it was from this time that volume of trading activity in derivatives grew most rapidly. The most important types of derivatives are futures, options and swaps. An option gives the holder the right to buy or sell the underlying asset at a specified date for a pre-specified price. A future gives the holder the 1 2 FIN-40008 FINANCIAL INSTRUMENTS obligation to buy or sell the underlying asset at a specified date for a pre- specified price. -
Credit Derivatives
3 Credit Derivatives CHAPTER 7 Credit derivatives Collaterized debt obligation Credit default swap Credit spread options Credit linked notes Risks in credit derivatives Credit Derivatives •A credit derivative is a financial instrument whose value is determined by the default risk of the principal asset. •Financial assets like forward, options and swaps form a part of Credit derivatives •Borrowers can default and the lender will need protection against such default and in reality, a credit derivative is a way to insure such losses Credit Derivatives •Credit default swaps (CDS), total return swap, credit default swap options, collateralized debt obligations (CDO) and credit spread forwards are some examples of credit derivatives •The credit quality of the borrower as well as the third party plays an important role in determining the credit derivative’s value Credit Derivatives •Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives. •There is a contract between both the parties stating the responsibility of each party with regard to its payment without resorting to any asset class Credit Derivatives •The level of risk differs in different cases depending on the third party and a fee is decided based on the appropriate risk level by both the parties. •Financial assets like forward, options and swaps form a part of Credit derivatives •The price for these instruments changes with change in the credit risk of agents such as investors and government Credit derivatives Collaterized debt obligation Credit default swap Credit spread options Credit linked notes Risks in credit derivatives Collaterized Debt obligation •CDOs or Collateralized Debt Obligation are financial instruments that banks and other financial institutions use to repackage individual loans into a product sold to investors on the secondary market. -
Financial Derivatives Classification of Derivatives
FINANCIAL DERIVATIVES A derivative is a financial instrument or contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price. Derivatives are often used for commodities, such as oil, gasoline, or gold. Another asset class is currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. The contract's seller doesn't have to own the underlying asset. He can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price. He can also give the buyer another derivative contract that offsets the value of the first. This makes derivatives much easier to trade than the asset itself. According to the Securities Contract Regulation Act, 1956 the term ‘Derivative’ includes: i. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security. ii. a contract which derives its value from the prices or index of prices, of underlying securities. CLASSIFICATION OF DERIVATIVES Derivatives can be classified into broad categories depending upon the type of underlying asset, the nature of derivative contract or the trading of derivative contract. 1. Commodity derivative and Financial derivative In commodity derivatives, the underlying asset is a commodity, such as cotton, gold, copper, wheat, or spices. Commodity derivatives were originally designed to protect farmers from the risk of under- or overproduction of crops. Commodity derivatives are investment tools that allow investors to profit from certain commodities without possessing them.