CHAPTER 14 Risk Management with Financial Derivatives 377 S U M M A RY Interest-rate forward contracts, which are agreements to sell a debt instrument at a future (forward) point in time, can be used to hedge interest-rate risk The advantage of forward contracts is that they are flexible, but the disadvantages are that they are subject to default risk and their market is illiquid A financial futures contract is similar to an interestrate forward contract in that it specifies that a debt instrument must be delivered by one party to another on a stated future date However, it has advantages over a forward contract in that it is not subject to default risk and is more liquid Forward and futures contracts can be used by financial institutions to hedge (protect against) interest-rate risk Stock index futures are financial futures whose underlying financial instrument is a stock market index Stock index futures can be used to hedge stock market risk by reducing systematic risk in portfolios or by locking in stock prices interest-rate risk in a similar fashion to the way they use financial futures and forward contracts Futures options may be preferred for macro hedges because they suffer from fewer accounting problems than financial futures Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments and have default risk and liquidity problems similar to those of forward contracts As a result, interest-rate swaps often involve intermediaries such as large banks and investment banks that make a market in swaps Financial institutions find that interest-rate swaps are useful ways to hedge interestrate risk Interest-rate swaps have one big advantage over financial futures and options: They can be written for very long horizons Credit derivatives are a new type of derivative that offer payoffs on previously issued securities that have credit risk These derivatives credit options, swaps, and credit-linked notes can be used to hedge credit risk An option contract gives the purchaser the right to buy (call option) or sell (put option) a security at the exercise (strike) price within a specific period of time The profit function for options is nonlinear profits not always grow by the same amount for a given change in the price of the underlying asset The nonlinear profit function for options explains why their value (as reflected by the premium paid for them) is negatively related to the exercise price for call options, positively related to the exercise price for put options, positively related to the term to expiration for both call and put options, and positively related to the volatility of the prices of the underlying asset for both call and put options Financial institutions use futures options to hedge There are two major concerns about the dangers of derivatives: They allow financial institutions to more easily increase their leverage and take big bets (by effectively enabling them to hold a larger amount of the underlying assets than the amount of money put down), and they expose financial institutions to large credit risks because the huge notional amounts of derivative contracts greatly exceed the capital of these institutions The second danger seems to be overplayed, but the danger from increased leverage using derivatives is very real, as events in the subprime financial crisis revealed KEY TERMS American option, arbitrage, p 362 p 351 exercise price (strike price), p 361 long position, p 346 financial futures, macro hedge, p 353 p 349 at the money (trading at par) option, p 363 financial futures option (futures option), p 362 margin requirement, call option, p 362 forward contracts, micro hedge, p 353 call premium, in the money option, p 362 credit derivatives, p 374 credit-linked note, credit options, credit swap, p 375 p 374 p 375 currency swaps, European option, p 370 p 362 p 347 p 363 interest-rate forward contract, p 347 interest-rate futures contract, p 349 interest-rate swaps, p 370 intrinsic value, long in a call, p 363 p 362 long in a put, p 364 p 355 marked to market, p 355 notional principal, open interest, p 371 p 353 option, p 361 out of the money option, p 363 premium, p 362 put option, p 363 put premium, p 364