Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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Borrowers, on the other hand, usually prefer to borrow at fixed ratesfor longer periods of time. For example, if the bank offers a relativelylow mortgage rate today, you would probably want to arrange a fixedrate mortgage for say the next 10 years so that you would be certainthat you get a good offer for a long period of time. In the absence ofany incentive to do otherwise, this is how people would behave, i.e.investors would deposit their money for short time periods, andborrowers would choose to borrow for longer periods. Banks wouldthen find themselves financing substantial amounts of longer-term fixedrate loans with short-term deposits. This would involve a high degreeof interest rate risk. In practice, in order to match depositors withborrowers and avoid the risk, banks raise long-term interest rates relativeto expected future short-term interest rates. This reduces the demandfor long-term fixed rate borrowing and encourages investors to deposittheir money for long terms.This theory leads to a situation that long rates are higher than theexpected future short-term rates. It is consistent with the empiricalresult that yield curves tend to be upward sloping more often than theyare downward sloping.These three theories or the combination thereof provide the fundamentalframework explaining the term structure of interest rates.Pricing of a Forward Contract and the Yield Curve
4INTEREST RATE FUTURES AND FORWARD RATE AGREEMENTSIn the last chapter we have looked at some theories about the yield curve.In this chapter, we will look at some applications. The simplest kinds ofinterest rate derivatives are futures and forward rate agreements (FRAs).These two types of contracts are essentially identical; one major differenceis that a futures contract is an exchange-traded contract and has fixed termsfor the notional amount, length of contract, expiry date etc. whereas an FRAis an over-the-counter (OTC) contract which is a binding agreement betweentwo parties. Another difference is that, as with other exchange-tradedproducts, a minimum margin payment is required for the futures contract,whereas the actual payment for the FRA would only be settled at the expirydate. Other than these differences, the two types of instruments are pricedin the same way.For instance, today is 24/1/97 and assume that we have the following termstructure of interest rate: 6-month rate of 5%, 9-month rate of 5.5%. Whatis the 3-month forward rate in 6-months' time, using today's market rate?.5%-5.5%-today 6 month 9 month' This chapter was written by Mr Chau KO-/O/CForwards and Futures
Page 2 and 3: THE UNIVERSITY OF HONG KONGLIBRARIE
Page 4 and 5: VI- . .7 « i8^p ! ««^^OOSHSlVCJ
Page 6 and 7: Ever since derivatives took centre-
Page 8 and 9: denominator, value at risk, which c
Page 10 and 11: the kind of information that superv
Page 12 and 13: This book is a team effort of the H
Page 14 and 15: While most market participants defi
Page 16 and 17: of this investment is 6.32 percent
Page 18 and 19: Mathematically, the relation betwee
Page 20 and 21: $10,000. (For simplification of pre
Page 22 and 23: Hong Kong does go up and the HSI ri
Page 24 and 25: 3OF ATHEPRICING OF A FORWARD CONTRA
Page 26 and 27: COST OF CARRYIn the above example,
Page 28 and 29: interest rate swap rates. From thes
Page 32 and 33: Again we use our method of having t
Page 34 and 35: ates, the forward rate for the peri
Page 36 and 37: 5In this chapter, we will discuss w
Page 38 and 39: often complain that there is too mu
Page 40 and 41: ABC also has three cash flows:1. It
Page 42 and 43: Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59: Percentage change in price due to d
Page 60 and 61: 8OFOptions are generally perceived
Page 62 and 63: OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65: Volatility is the most important fa
Page 66 and 67: fANDTrading options becomes more po
Page 68 and 69: You need to hold 7 shares of stock
Page 70 and 71: di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73: is10In the previous chapter, we dis
Page 74 and 75: stock will go up in the near future
Page 76 and 77: If the stock price of A continues t
Page 78 and 79: OF AN11In the previous two chapters
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at-the-money option approaches its
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12Mortgage-backed securities (MBS)
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NEGATIVE CONVEXITYFor MBS, there is
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MULTI-CLASSIn 1983, Freddie Mac int
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13What is a hedge? According to the
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management to enter into swap and o
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transaction. For this criterion to
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CREDIT DEFAULT SWAPThe simplest for
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APPLICATION OF CREDIT DERIVATIVESYo
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in the US. Equally innovative, cred
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THE VARIANCE-COVARIANCE METHODThe t
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"cell" would have a cash flow expos
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Daily profit and loss ranked in asc
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of the market factor. Through this
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3. Most value at risk models use hi
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16ANDIn Chapter 5, we talked about
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price) of 9,000. For this transacti
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and the June 3-month futures rate i
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needs to take the necessary busines
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ief, the policies and procedures sh
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The derivatives industry can be com
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ANDONOFINTRODUCTION1. The Monetary
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MANAGEMENT AND CORPORATE5. As the B
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ensure that there is sufficient awa
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15. Branches of foreign banks which
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20. Where the institution considers
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RISK MEASUREMENT25. Having identifi
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) the tendency of the relevant mark
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38. The measurement of the market r
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market, credit and liquidity risk o
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Consideration must be given to the
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55. As noted earlier, the market or
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changes in portfolio value;d) the r
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66. A basic and essential safeguard
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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addition and deletion of operators,
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• Profits and losses resulting fr
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This book is due for return or rene
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