Over the last 20 years, there has been a massive increase in the de- velopment of new financial instruments, many of which have been associated with off-balance sheet activities. The basic instruments and some of their variants used in financial engineering are shown below.
Descriptions and applications of these instruments are discussed in detail by Merna and Dubey (1998).
Forward rates
Forward rate is the price the market sets for an instrument traded today, but where the resulting transaction is executed at some date in the future. The most common forward rates used in the financial world are forward exchange rates and forward interest rates.
Financial futures
Before there were organised grain and commodity markets, farm- ers would bring their harvested crops to major population centres in search of buyers. There were no storage facilities, and many times the harvest would rot before buyers were found. Many farmers would also bring their crops to market at the same time, which resulted in the price of crops or commodities going down. If, however, there was a shortage of crops and commodities then prices would rise sharply.
This was because of a mismatch between supply and demand. There was no organised or central marketplace where competitive bidding could take place.
Initially, the first organised and central marketplaces were created to provide spot prices for immediate delivery. Shortly thereafter, forward contracts were established. These types of ‘forwards’ were forerunners to the present-day futures contract.
Futures market in currency and interest rates gradually spreads to interest-bearing assets and to stock indices. The futures contracts can be classified in the following four categories:
1. Short-term interest rate futures such as the Eurodollar, Euroyen, 3-month sterling and euro;
2. Bond futures such as the US T-Bond, T-Notes, French government bond and British gilt;
3. Stock index futures such as the S&P 500, Nikkei 225 and FTSE 100;
4. Currency futures such as sterling against US dollar.
The four categories shown above and their application are described in detail by Merna and Dubey (1998).
Galitz (1995) defines a futures contract as a legally binding agree- ment to take or make delivery of a given quantity and quality of a commodity at an agreed price on a specific date or dates in the future.
Dixon and Holmes (1992) define futures contract as an agreement to buy or sell a standard quantity of a particular commodity or financial instrument at a future date for a price which is agreed at the time the contract is drawn up. Just like any other contract, a future contract involves an obligation on the part of both the buyer and the seller to fulfil the conditions of the contract.
Swaps
Financial engineers primarily classify swaps in two categories: interest rate swaps and cross-currency swaps.
Interest rate swap
Galitz (1995) defines an interest rate swap as an agreement between two parties to exchange streams of cash flows denominated in the same currency but calculated on different bases.
Other forms of interest rate swaps
❒ Accreting, amortising and roller coaster swaps;
❒ Basis swaps;
❒ Forward-start swaps;
❒ Zero-coupon and back-set swaps;
❒ Cross-currency swaps.
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Options
All the instruments of financial engineering discussed so far – for- wards, futures and swaps – provide immunity against future move- ments in market rates (Galitz 1995). Whereas forwards and futures can provide this guarantee for months or a year, a swap can provide the guarantee for several years. Certainty, however, is not always the best thing. For example, a floating interest rate borrower will like to protect himself or herself against a rise in interest rate but would welcome an interest rate fall. Similarly, a fixed-rate borrower will feel happy if interest rates move up but would like to reap the benefits of a fall in interest rate. None of the instruments discussed above provide this flexibility. They only protect against adverse movements but relative loss if change is favourable.
Caps, floors, collars, swaptions and compound options
These are an important group of option instruments primarily to hedge interest rate risk. Caps, floors and collars among these are quite exten- sively used in project financing.
An interest rate cap provides protection against an increase in in- terest rate, but at the same time allows the benefits of interest rate fall to be enjoyed. For example, a borrower has taken a 5-year loan at London Interbank Offered Rate (LIBOR)+5% and has also bought an 8% 5-year interest rate cap. At each interest rate reset date, if LIBOR comes below 8%, the borrower simply pays the prevailing market rate and takes advantage of the lower rates. On the other hand, if the in- terest rates on any reset date are higher than the cap rate, the cap will provide a payoff to offset the consequences of the higher rate, effectively limiting the borrowing rate to the cap level.
An interest rate floor is used to limit the benefits from a fall in the interest rate once the floor level is reached. In practice, many users of interest rate caps seek to lower the cost of protection by selling a floor at a lower strike price. If interest rate falls through the floor level on any reset date, the floor is exercised against the seller, who must pay the difference between the prevailing rate and floor rate.
A collar is a combination of selling a floor at a lower strike rate and buying a cap at a higher strike rate. It provides protection against
a rise in rates and some benefits from a falling rate. A collar can be tailored to meet a compromise between interest rate protection and cost. By adjusting with the cap and floor rates, it is possible to create a zero-cost collar for which no premium is to be paid.
A swaption is an option to enter into an interest rate swap on some future date. A payer’s swaption is the right to pay the fixed rate on the swap, while a receiver’s swaption is the right to receive the fixed rate.
Compound options are options on options. Just as we have option on swap (swaption), we can have option on caps (captions), on floors (floortions) and on collars (collartions). Compound options come in four possible categories: a call on a call, a call on a put, a put on a call and a put on a put. The first two give the holder the right to buy the underlying option, and the other two give the right to sell option.
The underlying assets can be a call or a put. Galitz (1995) suggests that compound options are bought primarily for two reasons. First, to provide protection in a contingency situation when protection may or may not be needed, and second, as a form of risk insurance cheaper than buying the option itself.
Asset-backed securities
The financial innovation of asset-backed securities (ABS) or asset se- curitisation, during 1980s, dramatically changed the way of financing the acquisition of assets. In the traditional financing system, a bank or an insurance company provides the loan and retains it on its portfolio thereby accepting the credit risk and seeks additional funds from the public to finance its assets. In ABS a group of lendings are packaged together and then issued as a new security whose purchaser has a claim against the cash flows generated by the original lending. In ABS more than one bank or financial institution may be involved in the lending capital. Returns to the investors in ABS may be guaranteed by an insurance company.
The asset securitisation has several benefits. It helps in obtaining a lower cost of funding. The capital is used more efficiently. It also diversifies the funding sources. The original lenders of the loan do not retain the credit risk. Their locked assets are released, which can be used for more funding. This method is widely being used for mortgage loans, home equity loans, loan by manufacturing companies and lease
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receivable. A major disadvantage, prevailing at the time of writing this guide, is when assets lose their values, in this case as a result of subprime lending.