Swaps

1
Swaps

• The swap market developed in the late 1970s.
• Swap is an agreement between two parties (called
  counter parties) to exchange payments with each
  other.
• Four general classifications of swaps
• Interest rates
• Currencies
• Commodities
• Equity

2

• Since it is often difficult for individuals to
  find parties who have need that can be matched
  with their swaps, swap dealers and brokers have
  emerged.
• Swap dealers Take the other side of each deal
  and earn a spread difference for their efforts.
• Brokers Simply match up counter parties and
  receive a fee for their efforts.

3

• The most popular interest rate swap is the fixed
  for floating
• Where one counterparty exchanges (swaps) her
  floating interest rate payment to another
  counterparty for his fixed rate payment.
• Swaps are very flexible. They can be constructed
  to match long-term needs over several time
  periods, for various amounts and can be tailor
  made to suit individual company needs.
• If properly done, they can control interest rate
  risks, currency risks and commodity price risks.

4
Swaps

• A foreign exchange swap is a trade that combines
  both a spot and a forward transactions into one
  deal.
• Example Suppose Citibank wants pounds now. It
  could enter into a swap agreement with another
  bank. Under the swap agreement, it will trade
  dollar to the other bank and in return will
  receive pounds. After the specified time period,
  the trade is reversed. Citibank will pay out
  pounds to the other bank and receive dollars.

5
Futures vs Swaps

• Futures are much more standardized and less
  flexible.
• However, futures are openly traded and backed by
  clearing house at each exchange. Default risk for
  futures is almost nil. Not so with swaps. They
  are only as good as the parties and dealers who
  construct and trade them.

6
Option Hedging Considerations
7
Option Hedging Considerations

• To properly hedge with options, a few
  considerations need to be observed.
• The relationship between the change in the price
  of the underlying futures and the option premium
  will impact the effectiveness of the hedge.
• The relationship between the price of the
  underlying futures and the cash price (i.e.,
  basis) will affect certain hedge.

8
Delta

• The relationship between the change in the option
  premium and the price of the underlying futures
  is called delta (?).
• DeltaChange in the option premium/ Change in
  the price of the futures
• Delta normally ranges between zero and one.
• A delta of 0.9 means that when the underlying
  futures price changes by 1.00, the option
  premium changes by only 0.90.
• Deltas of 1 means perfect correlation between
  changes of the futures price and the option
  premium and deltas of 0 means that the option
  premium did not change when the futures price
  changes.

9
Delta

• Delta (D) is the rate of change of the option
  price with respect to the underlying

10

• As a general rule, delta value increases as the
  option gets deeper in-the-money and becomes the
  value of one.
• As the option goes deeper out of the money the
  delta value becomes close to zero.
• Delta takes on the values of zero or one as the
  option approaches maturity when the time value is
  eroded away and the probability of a significant
  price moves is effectively zero.

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• Delta can be calculated after the fact with
  certainty, but they can serve as a guide for
  future premium values, if only as an estimate.
• General rule of thumb
• If the underlying futures price remains stable,
  deltas will decrease in value for those premiums
  with time value- the more time value in a
  premium, the more the delta will decline.
• If the underlying futures price increases, put
  deltas decrease and call deltas increase.
• If the underlying futures price decreases, put
  deltas increase and call deltas decrease

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• What do deltas mean for hedger Delta can serve
  as guides for what the hedger can expect as price
  protection.

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Effects of Delta on Hedging
Cash
Futures

• Nov. 1
• Buys corn at 3/bu
• Nov.15
• Sells corn at 2.90

• Buys one put option on Dec. corn at strike price
  of 3/bu and a premium of 0.10/bu
• Sells put at a premium of 0.15/bu

14
Multiples

• A multiple is simply a term applied to an options
  hedge that contains more than one option
  contract. Multiples are used to achieve dollar
  equivalency with an option hedge.
• M1/delta
• M number of option contracts necessary to
  achieve dollar equivalency.

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• If the delta is 0.5, then the number of options
  contracts necessary to achieve dollar equivalency
  is two.
• If the price starts to move, the value of delta
  will change and thus the size of the multiple
  will also change

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Effects of Changing Delta on Hedging
Cash
Futures

• Nov. 1
• Buy corn at 3/bu
• Nov.15
• Cash corn at 2.80
• Nov. 20
• Cash corn at 2.75

• Delta0.5
• Buy two put option on Dec. corn at strike price
  of 3/bu and a premium of 0.10/bu
• Delta0.95, premium 0.195
• Sell one put option
• Delta0.95
• Premium 0.2375

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• For an option hedger the most important is not
  knowing about delta for the options premium
  (DeltaF) and the underlying futures but a delta
  for the options premium and the cash market
  (DeltaC) .

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Hedging in Practice

• Traders usually ensure that their portfolios are
  delta-neutral at least once a day
• Whenever the opportunity arises, they improve
  gamma and vega
• As portfolio becomes larger hedging becomes less
  expensive

19

• What does it mean to assert that the delta of a
  call option is 0.7? How can a short position in
  1,000 call options be made delta neutral when the
  delta of each option is 0.7?