International Portfolio & Risk Management

Creative solutions by financial engineers

Derivatives

Derivative = obligation to accomplish a transaction in the future

Forward Contract = basic derivative from which all others have evolved

• Repurchase Agreements – Reverse Repurchase Agreements

• Futures Contracts

Derivatives

• Swaps – Futures and Forward Contracts On

Swaps

• Options • Currency Options

– Swaptions – Options On Futures – Futures On Options

Floating-Fixed Swaps

Fixed

If net is positive, underwriter pays party. If net is negative, party pays underwriter.

Illustration of a Floating/Fixed Swap

Party Underwriter CounterpartyVariable

Fixed

Variable

Floating to Floating Swaps

LIBOR

If net is positive, underwriter pays party. If net is negative, party pays underwriter.

Illustration of a Floating/Floating Swap

Party Underwriter CounterpartyT-Bill

LIBOR

T-Bill

Parallel Loan

United States Germany

Loan guarantees

Debt service in $

Illustration of a parallel loan

German Parent

U.S. subsidiary of German

Firm

U.S. Parent

German subsidiary of

U.S. Firm

Principal in $

Debt service in Euro

Principal in Euro

Currency Swap

German rate x €1,000,000

€ 1,000,000

2 2

U.S. rate x $1,500,000

German rate x €1,000,000

U.S. rate x $1,500,000

1 1

€ 1,000,000

$1,500,000$1,500,000

€ 1,000,000

3 3

$1,500,000

€ 1,000,000

$1,500,000

Illustration of a straight currency swap

Step 1 is notionalSteps 2 & 3 are net

Borrow in US, invest in Europe

Borrow in Europe, invest in US

Swaps

Investor UnderwriterLibor ± Spread

Equity Index Return*

*Equity index return includes dividends, paid quarterly or reinvested

Illustration of an Equity Return Swap

Swaps

Investor Underwriter

Foreign Equity Index Return* A

Illustration of an Equity Asset Allocation Swap

*Equity index return includes dividends, paid quarterly or reinvested

Foreign Equity Index Return* B

Equity Call Swap

Investor Underwriter

Illustration of an Equity Call Swap

Equity Index Price Appreciation*

* No depreciation—settlement at maturity

Libor ± Spread

Equity Asset Swap

Underwriter

Equity Index Return*

* Equity index return includes dividends, paid quarterly or reinvested

Income Stream

Investor

Income

Stream

Asset

IRRM Products

• Listed Products– Futures– Options

• Custom Products– Swaps– Caps– Floors– Collars

Caps

PremiumClient UnderwriterToday

*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year

Illustration of a 7% Interest Rate Cap on LIBOR

Max[(LIBOR – 7%), 0]

UnderwriterLater* Client

Floors

PremiumClient UnderwriterToday

*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year

Illustration of a 3% Interest Rate Floor on LIBOR

Max[(3% – LIBOR), 0]

UnderwriterLater* Client

Collars

PremiumClient UnderwriterToday

*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year

Illustration of a 3,7 Collar on LIBOR

Max[(LIBOR – 7%), 0]+ Max[(3% – LIBOR), 0]

UnderwriterLater* Client

Long Call

S

$

0

- CX

X+C

Short Call

S

$

0

- CX

X+CLon

g C

all

XS

$

0X+CC

Long Put

S

$

0

- CX

X+CX

S

$

0X+CC

Lon

g C

all

Sho

rt C

all

S

$

0X

- P

X-P

Short Put

S

$

0

- CX

X+CX

S

$

0X+CC

Lon

g P

utL

ong

Cal

l

Sho

rt C

all

S

$

0X

- P

X-P

S

$

0

P

XX-P

Long Straddle

S

$

0

- CX

X+CX

S

$

0X+CC

Lon

g P

utL

ong

Cal

l

Sho

rt C

all

S

$

0

P

XX-P

S

$

0X

- P

X-P

Sho

rt P

ut

S

$

0X

-(P+C)

X-P-C

X+P+C

Short Straddle

S

$

0

- CX

X+CX

S

$

0X+CC

Lon

g P

utL

ong

Cal

l

Sho

rt C

all

S

$

0

P

XX-P

S

$

0X

- P

X-P

Sho

rt P

ut

S

$

0X

-(P+C)

X-P-C

X+P+C

Lon

gS

trad

dle $

0X

P+C

X-P-C

X+P+C

S