Derivatives

A fresh approach to financial independence for women Contents

What is a ? 3

CFDs 4

Options and Futures 15

Interest Rate Swaps 25

Disclaimer

Unless specifically stated otherwise, any information contained in this ebook is for information purposes only and is not intended to be financial advice as it has been prepared without taking into account your financial objectives, financial situation or needs.

Before acting on any information in this ebook, Ethical Financial Services Pty Ltd recommends that you consider whether it is appropriate for your circumstances.

2 Derivatives What is a Derivative?

There are many different kinds of derivatives. We can only give you a general introduction here.

Let’s look first at the definition of a derivative:

A derivative is a financial instrument that "derives" its value from the intrinsic value and/or change in value of an underlying asset.

Examples of derivative trading instruments are - CFDs, call options, put options, rate swaps, futures contracts, etc.

In general, derivatives are used by sophisticated investors to maximize cash returns and/or minimise negative exposure to uncertain price movements in the underlying asset.

They can also be used by corporations to manage and control commodity supply cost and the sensitivity of net cash flow to changes in variables like interest rates, commodity prices, liquidity, etc.

Wikipedia defines derivatives as follows:

"A derivative is a financial contract whose payoffs over time are derived from the performance of assets (such as commodities, shares or bonds), interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or an index of weather conditions)."

With a derivative, you are neither buying part of a company, as with a stock, nor lending to a company, as with a . Instead, you are making some other kind of bet or deal with some other party where the payoff depends on what some asset (or rate or index) will do in the future.

Derivatives are not for everyone. Derivatives are becoming increasingly popular as tools to transfer ownership risks. They can be used to hedge, or reduce risk, or they can be used for speculation, offering a lot of risk for the possibility of a big reward.

3 Derivatives CFDs

Contracts for Difference (CFDs) are the fastest growing tool in the financial services industry for trading in shares, foreign exchange, and commodities such as gold and oil.

Investors and traders from all backgrounds and levels of experience are now using CFDs to increase their returns and better manage their risk.

You MUST understand that CFD Trading is a dynamic pursuit, with traders needing to stay on top of multiple information streams at any one time to get the best results.

What is a CFD?

A (CFD) is a contract between two parties to exchange the difference in the price of a security from the open and close of a contract. CFDs are a leveraged product and require a trader to deposit a fraction of the total value of the position (known as ) to open a position. The profit & loss is determined by the difference in the entry and exit price of the underlying instrument from when the contract is opened and closed.

CFDs have been used by professional investors for over twenty years and first emerged in the over-the-counter (OTC) or equity market. Equity swaps were used by institutions to cost effectively hedge their equity exposure.

CFDs have become one of the most popular derivative products in the last 3 years. Their popularity has been fuelled by the advantages that they can offer retail clients:

• Leverage: CFDs enable you to obtain full exposure to a share for a fraction of the price of buying the underlying instrument. CFDs require only a small initial margin as a trading deposit. However, leverage, usually involves more risks than a direct investment in the underlying instrument. It is important to understand that leverage can work against you, as well as for you. Using leverage magnifies both your trading profits and losses. 4 Derivatives CFDs

• Through CFDs you can potentially profit from either a rising or falling market. This can be done by taking long or short positions over selected shares, indices, foreign currency pairs and commodities.

• CFDs can be used to go ‘short’- CFDs allow you to sell shares you don’t actually own. With a short position, you'll receive the full benefit of any fall in the share price.

• Low transaction costs: CFD providers pass on volume discounts allowing you to benefit through lower transaction costs. CFDs are a competitive and liquid financial instrument.

• Hedging: CFDs allow you to employ more advanced strategies such as hedging your existing share portfolio.

• Simplicity: CFDs mirror the price of the underlying instrument. You can hold a position as long as you like. Unlike Options trading, there's no expiry date or time decay. You'll never have to take delivery of the underlying securities. You can also trade them online or over the phone.

• Dividends and Corporate actions: When you take a ‘long’ position CFD, you can enjoy the same dividends and capital growth as ordinary shareholders, but with an outlay of only around 5% of the cost of the shares.

CFDs give you the transparency of a regulated market.

5 Derivatives CFDs

There are two different CFD models: Direct Market Access (DMA) and Market Making. The difference between these models relates to the way in which the prices are derived and how orders are placed between yourself and the CFD provider.

Direct Market Access (DMA)

In this scenario your CFD order is placed directly into the real underlying market. This results in real time execution, true market prices, participation in the order book and opening and closing phases of the market.

Transparency is a key ingredient of the DMA CFD market. All CFD orders are transacted in the underlying cash market, ensuring complete pricing transparency. All trades are executed on a strict price/ time priority.

Price/time priority means the first person to enter the best price is traded against first. As such everyone in the central market order book is treated fairly and consistently, no matter how big or small the trader. All market information reflects the cash market. This DMA model of CFD trading is no different to trading shares using leverage.

Market Maker Model.

Some CFD providers use a market maker model by which you trade on synthetic prices that could potentially be different from the real prices of the underlying shares. Market Makers base their prices on those offered in the physical market, but as a middle man they have the flexibility to move prices as they see fit. This can cause which can become a significant cost of trading.

A market maker will often state that they ‘mirror the price’ rather than actually matching the price. This results in orders being filled at inferior prices. Market makers do not hedge 100% of their CFD positions and make money when you lose money.

When trading through a market maker your orders are at the discretion of a dealer. Your CFD order is not placed directly on the market, so trading can be slower, especially in fast moving markets. 6 Derivatives CFDs

Features of a CFD

To gain a thorough understanding of the mechanics of CFDs it is important to become familiar with the key features of the product.

CFDs are traded on margin. Therefore it is essential that you understand what this means.

What is a margin?

A margin is a deposit used as collateral to fund a CFD position. There are two different forms of margin that may be payable when trading CFDs:

1) Initial Margin

An Initial margin is a deposit used as collateral to open a CFD position. The margin is held to ensure you can meet your obligations. A margin rate is expressed as a percentage and is calculated based on the liquidity and of the underlying security.

Margin rates typically range between 3% – 100%.

The margin requirement is calculated using the mark to market concept; meaning the current value of your position is assessed during each trading day. The margin required is adjusted to reflect the current market value of the position as the price of the underlying security fluctuates.

Additional margin amounts will be payable should you fail to maintain the required margin on your position.

7 Derivatives CFDs

Calculating an Initial Margin. Example:

You wish to buy 1,000 Share CFDs at $10.00

The Share CFD has a 5% margin requirement

1,000 x $10.00 = A$10,000 (this is the total value of the trade)

A$10,000 x 5% = $500

$500 is the initial margin requirement for this trade.

2) Variation Margin

In addition to the Initial Margin required to open to hold a CFD position, you may also be required to pay an additional margin incurred by an adverse price movement in the market. This is known as Variation Margin.

For example, if you have a long position and the price falls then you are required to pay a Variation Margin large enough to cover the adverse movement in the value of your position.

Conversely, if you have a short position and the price falls, you would receive a Variation Margin equal to the positive movement in the value of the position.

Failure to pay a Variation Margin call can lead to the position being compulsorily closed out. You as the position holder are obliged to pay for any shortfall in funds if Variation and Initial Margins are insufficient to cover the shortfall.

8 Derivatives CFDs

Features of a CFD

Payment of Margins

Margins are calculated on an intraday basis to ensure an adequate level of margin cover is maintained. This means that you may be obliged to pay more if the market moves against you. If the market moves in your favour, your margin requirement may be reduced.

Margin payments are usually required within 24 hours of being advised. But, in some cases margin call payments may be required on shorter notice. If you do not pay in time, your CFD provider can take action to close out your positions without further notice to you.

Financing

Financing is the daily cost incurred for holding an open position overnight. The financing rate is applied to the full value of your position and paid or received daily on long and short positions. If you hold a long buy position you will be required to pay a financing charge, if you hold a short sell position you will receive financing income.

Financing rates are calculated by your CFD provider. Familiarise yourself with these rates and compare them to other CFD providers, before you start trading.

Let’s look at some practical applications for using CFDs.

9 Derivatives CFDs

Application of CFDs

Using CFDs to Hedge

Hedging is a strategy that allows you to reduce the risk of negative price movements in your portfolio. Hedging refers to opening an equal but opposite position to offset any short term price movements in your physical shares. If you hold shares in your portfolio that you wish to protect from a potential falling share price you can open an equivalent short CFD position to protect their value.

If the CFDs are bought back after a decline, then the profit achieved from the CFD trade should offset the loss incurred on your physical shares.

CFDs are flexible and cost effective way to protect the value of your physical shares while retaining your holdings without incurring a CGT liability. They are an ideal hedging instrument due to their cost effectiveness, flexibility, and the ability to short sell.

CFD Hedging Example

Amy holds 1,000 BHP shares purchased in 2008 @ $20.00

The current price of BHP is $45 which represents a profit of $25,000. If the BHP shares were sold she would incur a significant capital gain liability.

Amy has strong long term growth projections for BHP therefore she wishes to retain her current BHP shares but there has been significant market volatility especially in the resources sector.

She wishes to protect her BHP profits from short term volatility while retaining the shares.

10 Derivatives Application of CFDs

Amy decides to retain her BHP holdings and open an equivalent short CFD position to protect the value of her BHP shares.

The BHP share price breaks below support levels and Amy decides to short sell 1,000 BHP share CFDs at $45.00 to hedge her physical share position.

In this case study the price of BHP dropped to $42.00. This represents a decline to Amy's BHP share position of $3,000 from $45,000 to $42,000.

However, this loss in value is offset by the gain of $3,029.51 on Amy’s short BHP share CFD position

Risks of employing a Hedging Strategy

If the price of BHP rose while Amy held the CFD hedge position a loss would have been incurred on the short CFD position.

Losses incurred on physical shares are only realised when the shares are sold while CFD positions must be met by cash.

Therefore you must ensure you have sufficient cash to fund CFD margins and cover any losses.

Using CFDs for Diversification

Diversification is a risk management technique that involves allocating funds to a variety of shares to spread the risk across a number of companies.

CFDs are an ideal diversification tool due to their lower capital requirement and lower transaction costs. A diversified portfolio allows you to gain exposure to a number of positions across multiple companies, sectors and asset classes. You are able to limit your potential risk in any one position by spreading the risk across a number of positions to enable you to achieve more stable returns.

11 Derivatives Application of CFDs

Using CFDs in Self Managed Super Funds (SMSF)

Following a recent tax ruling by the ATO (ATO ID 2007/56) you are able to use CFDs within your SMSF under certain circumstances.

CFDs can be used within your SMSF to protect the value of the shares you hold in your SMSF and increase your market exposure, through leverage.

They do seem an odd couple - Superannuation is a very long term contract and CFDs are a short term contract. However they can be used in a very complimentary manner.

CFDs, although one of the riskiest financial products can bring certainty to your retirement portfolio. Consider the following:

Imagine you are approaching retirement in the next couple of months. Instead of cashing up by selling shares and incurring capital gains tax, sell CFDs instead.

Make that short-sell because you don't have to buy any CFDs in the first place. This way you're hedging your portfolio and the stock market's volatility won't matter as much.

If share prices rise during the period, before you retire, you're fine. The CFDs won't have been of use but won't have cost much either because of their built-in leverage. A tiny initial deposit means you need only about one-thirtieth of the value of the shares in your portfolio to hedge it.

If the market falls, prior to your retirement, what you lose in the paper value of your shares, you make up for in cash from the CFDs.

The outcome is that CFDs can guarantee that the value of your portfolio now will be the same as on the day you retire in, say, a couple of months.

12 Derivatives Application of CFDs

Using CFDs for Short selling

CFDs offer you the ability to sell shares in a company that you do not own; which allows you to profit from negative price movements. So, if you consider a share price to be overvalued, CFDs allow you to go short to benefit from a negative price movement. When a short CFD position is held overnight, you will receive interest on your position.

Using CFDs for Pairs trading

CFDs allow traders to gain access to a strategy that involves matching two shares against each other; one through a long and the other a short position.

Often opportunities to pair two shares together occur when a divergence in price in shares in the same sector arises. When a pair’s trade is opened a hedge is created. As such profits are made on the movement in price of the long position verses the short position. The offsetting nature of this removes the impact of overall market or sector movements. If the overall market was to move in a particular direction the trader should not be impacted since a gain or loss would be offset.

The strategy is most successful when two highly correlated shares are matched. An example of shares that may be suitable for pairs trading is selecting two highly correlated stocks such as National Australia Bank and Commonwealth Bank. Traditionally both stocks should move together as their businesses are similar. Finding candidates can involve either fundamental or technical factors to measure correlation and divergence.

Historical data can be used to indicate a mean price or comparable ratios such as Price to Earnings. From this information a trader can attempt to profit from being long in the share that is below the mean or underpriced and short the share that is above the mean or overpriced. Profit can be made on both positions if the shares revert to the mean or converge.

13 Derivatives Application of CFDs

Pair’s trades are simple and also inexpensive. The offsetting positions reduce overnight financing costs as the short position generates revenue that can be used to cover the cost of the long. To reduce costs and mitigate risk the position size for each trade should be hedged and matched equally. Although this is a low risk strategy it is possible for stock specific factors to cause the divergence to widen resulting in losses on both positions.

You should maintain stop-losses on both positions should the stocks drift apart rather than come together.

CFDs are versatile and powerful products that can enable you to make more effective use of your capital. They present a flexible and low cost alternative to traditional share trading.

But remember - you must establish a trading plan that covers entry and exit criteria and adopt a sound risk and money management procedure if you’re trading is to be a success.

CFDs are simpler and more versatile than other derivatives such as options, futures contracts and instalment warrants. However, to be a success at CFD trading you will need to stay on top of multiple information streams at any one time.

You should spend ample time trialing the various trading platforms available to ensure you are using the most appropriate system for your trading style.

CFDs won’t suit everyone. CFDs are risky, as they are a highly leveraged class of financial products. Only experienced investors with a high tolerance for risk should use CFDs.

14 Derivatives Options and Futures

Options and futures are common forms of derivatives.

Using futures and options, whether separately or in combination, can offer countless trading opportunities.

Before you can begin to understand options on futures, you must know something about futures markets. This is because futures contracts are the underlying instruments on which the options are traded. So, as a result, prices (referred to as premiums) are directly affected by futures prices.

In addition, the more you know about the markets, the better equipped you will be, based on current market conditions and your specific objectives, to decide whether to use futures or options on futures contracts, to enhance your portfolio.

The History behind Options and Futures

By 1865, the Chicago Board of Trade took a step to formalise grain trading by developing standardized agreements called futures contracts.

Soon after, the exchange’s margining system was established, to prevent customers from defaulting on their contractual agreements.

Over the years, the exchange has grown both in the variety and number of contracts traded. It offers a complete set of agricultural contracts—corn, wheat, oats, rice, soybean, soybean oil, and soybean meal futures as well as options on those contracts.

The Chicago Board of Trade entered into the financial trading arena during the mid 1970's.

Today, more than 80% of the trading volume comes from its financial futures and options contracts including the Treasury Complex, the Equities, and the Precious Metals.

15 Derivatives Options and Futures

Futures

What is a ?

A futures contract is a commitment to make or take delivery of a specific quantity and quality of a given commodity at a predetermined place and time in the future.

All terms of the contract are standardised and established in advance, except for the price, which is determined by open auction in a pit on the trading floor of a regulated commodity exchange or through an exchange’s electronic trading system.

All contracts are ultimately settled either through liquidation by offsetting purchases or sales or by delivery of the actual physical commodity.

An offsetting transaction is the more frequently used method to settle a futures contract. Delivery of the physical commodity occurs in less than 2% percent of all agricultural contracts traded.

Functions of the futures exchange.

The main economic functions of a futures exchange is price risk management and price discovery.

The exchange provides a facility and trading platforms that bring buyers and sellers together.

The exchange also establishes and enforces rules to ensure that trading takes place in an open and competitive environment. For this reason, all bids and offers must be made through the exchange either in a designated trading pit by open auction or through the exchange’s electronic order-entry trading system.

All trades must be made by a member of the exchange. If you are not a member, you work through a commodity broker. The broker calls in your order to an exchange member who executes the order. Once an order is filled, you are notified by your broker. 16 Derivatives Options and Futures

The futures price at any given time reflects the price expectations of both buyers and sellers at the time of delivery. This is how futures prices help to establish a balance between production and consumption. But, a futures price is a price prediction subject to continuous change. Futures prices adjust to reflect extraneous information about supply and demand as it becomes available.

Future Market Participants: Hedgers and Speculators. Futures markets Futures market participants fall into two general categories: hedgers and speculators. exist primarily for hedging. The dictionary states that a hedge is “a counterbalancing investment involving a position in the futures market that is opposite one’s position in the cash market.

Since the cash market price and futures market price of a commodity tend to move up and down together, any loss or gain in the cash market will be roughly offset or counterbalanced in the futures market.

Hedgers include:

• farmers, livestock producers—who need protection against declining prices for crops or livestock, or against rising prices of feed.

• merchandisers, elevators—who need protection against lower prices between the time they purchase or contract to purchase the grain from farmers and the time it is sold.

• food processors, feed manufacturers—who need protection against increasing raw material costs or against decreasing inventory values.

• exporters—who need protection against higher prices for grain contracted for future delivery, but not yet purchased.

• Importers—who want to take advantage of lower prices for grain contracted for future delivery but not yet received.

17 Derivatives Options and Futures

However, the number of investors seeking protection against declining prices is rarely the same as the number seeking protection against rising prices, at any given time. As such, other market participants are needed. These participants are known as speculators.

Speculators facilitate hedging by providing liquidity. Liquidity is having the ability to enter and exit the market quickly, easily and efficiently. Speculators are attracted by the opportunity to make a profit, by correctly anticipating the direction and timing of price changes.

These speculators may be part of the general public or they may be floor traders; members of the exchange operating in one of the trading pits.

Floor traders are noted for their willingness to buy and sell on even the smallest of price changes. As such a seller can, at almost any time, find a buyer at or near the most recently quoted price. Similarly, buyers can find willing sellers without having to significantly bid up the price. Thus the futures market is very liquid.

Margin, in the futures industry, is money that you as a buyer or seller of futures contracts must deposit with your broker. In turn, that broker must deposit with the Chicago Board of Trade Clearing Service Provider. The amount of margin a customer must maintain on deposit with her brokerage firm is set by the firm itself.

If a change in the futures price results in a loss on an open futures position from one day to the next, funds will be withdrawn from the customer’s margin account to cover the loss.

If a customer must deposit additional money into the account, to comply with the margin requirements, this is known as receiving a margin call.

On the other hand, if a price change results in a gain on an open futures position, the amount of gain will be credited to the customer’s margin account.

Since 1925, no customer has ever incurred a loss due to default of a clearing member firm. 18 Derivatives Options and Futures

Hedging

Hedging is really a simple principle, but it often appears complex because of the jargon surrounding it.

The Short Hedge

To give you a better idea of how hedging works, let’s suppose the following:

Imagine it is May and you are a soybean farmer with a crop in the field. In market terminology, you have a long cash market position.

The current cash market price for soybeans to be delivered in October is $6.00 per bushel. To protect yourself against a possible price decline during the coming months, you can hedge by selling a corresponding number of bushels in the futures market now and buying them back later when it is time to sell your crops in the cash market.

If the cash price declines by harvest, any loss incurred will be offset by a gain from the hedge in the futures market. This particular type of hedge is known as a short hedge because of the initial short futures position.

For example, let’s assume cash and futures prices are identical at $6.00 per bushel. What happens if prices decline by $1.00 per bushel?

Although the value of your long cash market position decreases by $1.00 per bushel, the value of your short futures market position increases by $1.00 per bushel. Because the gain on your futures position is equal to the loss on the cash position; your net selling price is still $6.00 per bushel.

What if soybean prices had instead risen by $1.00 per bushel? Once again, the net selling price would have been $6.00 per bushel, as a $1.00 per bushel loss on the short futures position would be offset by a $1.00 per bushel gain on the long cash position.

Notice in both cases the gains and losses on the two market positions cancel out each other. 19 Derivatives Options and Futures

That is, when there is a gain on one market position, there is a comparable loss on the other. This explains why hedging is often said to “lock in” a price level.

In both instances, the hedge accomplished what it set out to do: It established a selling price of $6.00 per bushel for soybeans to be delivered in October. With a short hedge, you give up the opportunity to benefit from a price increase to obtain protection against a price decrease.

The Long Hedge

On the other hand, livestock feeders, grain importers, food processors, and other buyers of agricultural products often need protection against rising prices and would instead use a long hedge involving an initial long futures position.

For example, assume it is July and you are planning to buy corn in November. The cash market price in July for corn delivered in November is $2.50 per bushel, but you are concerned that by the time you make the purchase, the price may be much higher.

To protect yourself against a possible price increase, you buy December corn futures at $2.50 per bushel.

What would be the outcome if corn prices increase 50 cents per bushel by November?

In this example, the higher cost of corn in the cash market was offset by a gain in the futures market.

Conversely, if corn prices decreased by 50 cents per bushel by November, its lower cost in the cash market would be offset by a loss in the futures market.

The net purchase price would still be $2.50 per bushel

20 Derivatives Options and Futures

Remember, whether you have a short hedge or a long hedge, any losses on your futures position may result in a margin call from your broker, requiring you to deposit additional funds to your margin account. Adequate funds must be maintained, at all times, to cover any day-to-day losses.

Options

With an option, one party pays another for the right to buy or sell a specified security at a specified price within a specified period of time. The value of this right to buy or sell will fluctuate depending on the relationship between the option price and the current market price.

For example, if you have an option to buy Telstra at $3 a share, the option is valuable while Telstra is trading at $3.50 a share, and worthless while Telstra is trading at $2.50 a share; except for its speculative future value.

Call and Put Options

A gives you the right to buy shares from the dealer making the contract at the price ruling at the time, within a specified future period. Call options carry a commission to the dealer on the price of the shares traded. They are the opposite of a .

An option or ‘option strategy’ should not be employed by casual investors or by those who don't handle volatility well. They are certainly not for the novice investor, but they can have a place in certain portfolios. You should have a valid reason for using any option strategy. If you're merely speculating on price movements, chances are high that you will fail.

21 Derivatives Options and Futures

However; stock options are not just speculation. They can be used as investing tools that work strongly in your favour; as shown by the following example:

Assuming that your brokerage account meets requirements, anyone can sell (or write) an option at the going bid price. You needn't own the underlying stock to do so.

When you sell an option, you receive all of the premium, or the price that the buyer paid (minus a trade commission). The premium immediately arrives as cash in your account; it is yours to keep (minus taxes).

In the case of selling ‘naked’ put options (naked means you don't own the underlying stock), you're being paid for one reason. That reason being that you are promising the option buyer that you will purchase the underlying stock for a set price, should it decline to that price or lower.

EXAMPLE: Imagine that shares of XXX Pharmaceuticals rose from $10 to $15 per share. You feel that the 50% increase is steep, and are not comfortable buying more shares at the new price. Yet if the shares returned to $10 you'd buy it.

You could either do nothing and wait or you could be paid to wait. Today, you can sell January 2010 XXX pharmaceuticals puts with a $10 for $1.55 per contract.

As the seller (or writer) of the put, you promise the put buyer to purchase the stock at $10 should it decline to that price or lower. For that promise, you are paid $1,550 per 1,000 shares (or 15.5% of your total eventual purchase price). So, you would collect $1,550 cash minus commission.

Then you'd wait.

22 Derivatives Options and Futures

Some possible outcomes:

XXX rises to $25 and the put option you sold expires (because the put owner has no interest in selling shares at $10, of course). You miss the rise in the stock, but at least you made $1,550 for the option sale without committing any capital.

XXX falls to $9.00 and the put holder exercises their option, selling you 1,000 shares at $10. You still keep your premium ($1,550), so in essence you only paid $8.45 per share. You now own your desired stock position at that cost basis.

XXX declines sharply to $7 and you're put (or sold) the shares at $10. After your premium, you have bought your shares at $8.45, and consequently are down $1.45 per share. Nevertheless, you would have been down $3 per share had you bought at $10, as you originally intended. Now you can hold and hope for the shares to rebound.

As you can see, if you were comfortable buying a stock at a lower price than it currently trades, then selling puts and waiting for your price can be better than simply waiting and hoping. You receive income while you wait and you can ultimately buy the stock below your target price, given the premium you are paid.

Essentially, selling puts is a way to potentially buy a desired share at a lower price and get paid something whether you purchase or not. Some investors regularly sell naked puts as a means to generate a steady income.

As shown in the last example, selling a is a ‘bullish move’. Essentially you are anticipating that the underlying share will rise (or not decline) and the below market price put that you sold will expire. This means that you get the premium and needn't take any action. This is a valid strategy only if you want to own the underlying share and are happy to buy the shares should your strategy not work out.

23 Derivatives Options and Futures

In the sale of any put you must be 100% ready to buy the shares because it could be sold to you at any time (if the share falls below the option strike price), not just at the time of .

When Selling Puts Works Best

Specific situations favour put selling. Firstly, the longer it is until the option expires, the higher the premium you will receive when selling.

The best put-selling instances involve:

• A volatile underlying share. This is because the more volatile, the higher the premium you'll be paid when selling a put.

• A lower-priced share, because the premium you receive can translate into a significant discount in your share purchase price (the discount was 15.5% in our XXX example). In fact you can receive 20% or higher discounts.

Remember, that in all put-selling situations:

• You must be financially and emotionally ready to buy the share at the put's strike price, even if the shares fall far below that price.

• You should only sell puts on shares that you understand very well and want to own at specific prices or lower. In other words, you should determine the price where you'd like to own it (if that price is lower than today's price), and then sell puts and get paid to wait for your price.

24 Derivatives Swaps

Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates.

The Bank for International Settlements reports that interest rate swaps are the largest component of the global ‘over-the-counter’ or OTC derivative market. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. Interest Rate swaps can now be traded as an Index through the FTSE MTIRS Index.

An is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments

Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.

Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential which allows both parties to benefit from an interest rate swap.

Interest-rate swaps have become an integral part of the fixed-income market. These derivative contracts, which typically exchange – or swap – fixed-rate interest payments for floating-rate interest payments, are an essential tool for investors who use them to hedge, speculate, and manage risk.

25 Derivatives Interest Rate Swaps

What is a Swap?

An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade ‘over-the- counter’. (OTC)

The most commonly traded and most liquid interest rate swaps are known as ‘vanilla’ swaps. These exchange fixed-rate payments for floating-rate payments based on . The interest rate high-credit quality banks (AA-rated or above) charge one another for short-term LIBOR stands for the financing. LIBOR is the benchmark for floating short-term interest “London Inter-Bank rates which is set daily. Although there are other types of interest rate Offered Rate”. swaps, plain vanilla swaps comprise the vast majority of the market.

By convention, each participant in a vanilla swap transaction is known by its relation to the fixed rate stream of payments. The party that elects to receive a fixed rate and pay floating is called the ‘receiver’. The party that receives floating in exchange for fixed is the ‘payer’. Both the receiver and the payer are known as “counterparties” in the swap transaction.

Investment and commercial banks with strong credit ratings are swap market-makers, offering both fixed and floating-rate cash flows to their clients. The counterparties in a typical swap transaction are a corporation, a bank or an investor on one side (the bank client) and an investment or commercial bank on the other side.

After a bank executes a swap, it usually offsets the swap through an inter-dealer broker and retains a fee for setting up the original swap. If a swap transaction is large, the inter-dealer broker may arrange to sell it to a number of counterparties. Whereby the risk of the swap becomes more widely dispersed. This is how banks that provide swaps routinely shed the risk, or interest-rate exposure, associated with them.

26 Derivatives Interest Rate Swaps

Initially, interest rate swaps helped corporations manage their floating- rate liabilities by allowing them to pay fixed rates, and receive floating-rate payments. In this way, corporations could lock into paying the prevailing fixed rate and receive payments that matched their floating-rate debt. (Some corporations did the opposite – paid floating and received fixed – to match their assets or liabilities.)

However, because swaps reflect the market’s expectations for interest rates in the future, swaps also became an attractive tool for other fixed-income market participants, including speculators, investors and banks. As a result, the swap market has grown immensely in the past 20 years.

Characteristics of Interest Rate Swaps

The ‘swap rate’ is the fixed interest rate a receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time. At any given time, the market’s forecast of what LIBOR will be in the future is reflected in the forward LIBOR curve.

At the time of the swap agreement, the total value of the swap’s fixed rate flows will be equal to the value of expected floating rate payments implied by the forward LIBOR curve. As forward expectations for LIBOR change, so will the fixed rate that investors demand to enter into new swaps. Swaps are typically quoted in this fixed rate, or alternatively in the ‘swap spread,’ which is the difference between the swap rate and the U.S. Treasury bond yield (or equivalent local government bond yield for non-U.S. swaps) for the same maturity.

27 Derivatives Interest Rate Swaps

In many ways, interest rate swaps resemble other familiar forms of financial transactions, and it is helpful to think of swaps in these terms:

Exchanging

Early interest rate swaps were literally an exchange of loans, and this model still provides an intuitive way to think about swaps.

Consider two parties that have taken out loans of equal value, but one has borrowed at the prevailing fixed rate and the other at a floating rate tied to LIBOR.

The two agree to exchange their loans, or swap interest rates. Since the principal is the same, there is no need to exchange it, leaving only the quarterly cash flows to be exchanged.

The party that switches to paying a floating rate might demand a premium or cede a discount on the original fixed borrower’s rate; this depends on how interest rate expectations have changed since the original loans were taken out.

The original fixed rate, plus the premium or minus the discount, would be the equivalent of a swap rate.

The Financed Treasury Note

Receiving fixed rate payments in a swap is similar to borrowing cash at LIBOR and using the proceeds to buy a U.S. Treasury note. The buyer of the Treasury will receive fixed payments, or the ‘coupon’ on the note, and be liable for floating LIBOR payments on the . The concept of a ‘financed Treasury’ illustrates an important characteristic that swaps share with Treasuries: both have a discrete duration, or interest rate sensitivity, that depends on the maturity of the bond or contract.

28 Derivatives Interest Rate Swaps

Uses for Swaps

Interest rate swaps became an essential tool for many types of investors, as well as corporate treasurers, risk managers and banks, because they have so many potential uses. These include:

Portfolio management

Interest rate swaps allow portfolio managers to add or subtract duration, adjust interest rate exposure, and offset the risks posed by interest rate volatility. By increasing or decreasing interest rate exposure in various parts of the yield curve using swaps, managers can either ramp-up or neutralise their exposure to changes in the shape of the curve, and can also express views on credit spreads.

Swaps can also act as substitutes for other, less liquid fixed income instruments. Moreover, long-dated interest rate swaps can increase the duration of a portfolio, making them an effective tool in Liability Driven Investing, where managers aim to match the duration of assets with that of long-term liabilities.

Speculation

Because swaps require little capital up front, they give fixed-income traders a way to speculate on movements in interest rates while potentially avoiding the cost of long and short positions in Treasuries.

For example, to speculate that five-year rates will fall using cash in the Treasury market, a trader must invest cash or borrowed capital to buy a five-year Treasury note. Instead, the trader could ‘receive’ fixed in a five-year swap transaction, which offers a similar speculative bet on falling rates, but does not require significant capital up front.

29 Derivatives Interest Rate Swaps

Corporate finance

Firms with floating rate liabilities, such as loans linked to LIBOR, can enter into swaps where they pay fixed and receive floating, as noted earlier. Companies might also set up swaps to pay floating and receive fixed as a hedge against falling interest rates, or if floating rates more closely match their assets or income stream.

Risk management

Banks and other financial institutions are involved in a huge number of transactions involving loans, derivatives contracts and other investments. The bulk of fixed and floating interest rate exposures typically cancel each other out, but any remaining interest rate risk can be offset with interest rate swaps.

Rate-locks on bond insurance

When corporations decide to issue fixed-rate bonds, they usually lock in the current interest rate by entering into swap contracts. That gives them time to go out and find investors for the bonds.

Once they actually sell the bonds, they exit the swap contracts. If rates have gone up since the decision to sell bonds, the swap contracts will be worth more, offsetting the increased financing cost.

30 Derivatives Interest Rate Swaps

Risks Associated with Interest Rate Swaps

Like most non-government fixed income investments, interest-rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk.

Because actual interest rate movements do not always match expectations, swaps entail interest-rate risk. Put simply, a receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and loses if interest rates rise. Conversely, the payer (the counterparty paying fixed) profits if rates rise and loses if rates fall.

At the time a swap contract is put into place, it is typically considered ‘at the money’, meaning that the total value of fixed interest-rate cash flows over the life of the swap is exactly equal to the expected value of floating interest-rate cash flows.

If a swap becomes unprofitable or if a counterparty wishes to shed the interest rate risk of the swap that counterparty can set up a countervailing swap – essentially a mirror image of the original swap – with a different counterparty to ‘cancel out’ the impact of the original swap. For example, a receiver could set up a countervailing swap in which he pays the fixed rate.

Swaps are also subject to the counterparty’s credit risk: the chance that the other party in the contract will default on its responsibility. Although this risk is very low – banks that deal in LIBOR and interest rate swaps generally have very high credit ratings of double-A or above – it is still higher than that of a risk-free U.S. Treasury bond.

31 Derivatives Interest Rate Swaps

Conclusion

The interest rate swaps market started decades ago as a way for corporations to manage their debt and has since grown into one of the most useful and liquid derivatives markets in the world.

Vanilla swaps, which are the most common and involve the exchange of floating-rate LIBOR for a fixed interest rate, are used across the fixed-income markets to manage risks, speculate, manage duration and lock in interest rates.

Because swaps are highly liquid and have built-in forward rate expectations as well as a credit component, the swap rate curve has become an important interest-rate benchmark for credit markets that in some cases has supplanted the U.S. Treasury yield curve.

The derivatives markets used to be the preserve of banks and financial institutions, but in the last decade it has opened up to the individual investor. It can be a legitimate way of managing risk AND making big trading profits. But BEFORE attempting any deals make sure you fully understand the contracts and the trading platforms you will use. Beware: Many novice investors were "wiped out" by margin calls in 2008.

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