Essay on Derivatives And How Mutual Funds Use Them

Submitted By hartfund3
Words: 1163
Pages: 5

Derivatives and how mutual funds use them:

Forward contracts:
A customized contract between two parties to buy or sell an asset at a specified price on a future date. Either used to speculate or hedge existing positions to minimize risk.
How it works in a mutual fund:
If shorted (sold) USD and went long foreign currency, fund should expect the exchange rate from foreign currency to USD to move down. At settlement date, money is delivered to each counterparty and gain or loss is recorded in capital accounts (50000) Ex: sold $15,303,838 USD/bought 11,000,000 EUR at 0.718773944, to get a gain, exchange rate Needs to be <0.718773944
A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future.
How it works in a mutual fund:
Contracts are either bought (long) or sold (short). Each future carries a multiplier and underlying cusip, can be seen at BRDM screen per cusip. Futures are settled daily, meaning money is either wired out (if at a loss from prior day) or wired in (if at a gain from prior day), the difference each day is called variation margin. The cumulative value of the futures contract is the margin +/- market movement that day… all the 58500 accounts!
Ex: bought 180 contracts US LONG BOND (CBT) SEP14 ADI07VBR6 at 136.171875. Multiplier is 100,000 for this particular contract. So our cost is 180 contracts * 136.171875 price * 100,000 multiplier / 100 (since it’s a bond) = 24,510,937.50
Now at the end of the night our future is worth 137.172875 on the open market our margin to be delivered the next day is calculated like so: 180 * 137.172875 * 100,000 /100 = 24,691,117.50 – 24,510,937.50 = 180,180 to be delivered to fund since we are in a net gain
A swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument.
Total Return Swap:
A swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment
How it works in a mutual fund:
The fund gets into agreement with a counterparty to ideally obtain the gain or loss on a certain index or equity rather than owning it outright, in exchange they pay an agreed upon fee. At reset date, the underlying index or equity is priced based on its market price. The idea is for the fund to receive the gain minus the total payment in a net gain. Mutual funds generally receive gain/loss and pay out to receive it EX: Two legs- one long leg which is owned by the fund; one short leg not owned by the fund Long leg- Receiving leg. Shares are just units calculated off of cost and price. So if cost is 350,000 and agreed price is 228.6625, your units or shares are 1530.64. 350,000/228.6625 = 1530.64. Short leg- Paying/Finance leg. Shares are booked at cost. 350,000 cost, 100 is always price, shares are 350,000. This leg accrues a swap payable at agreed upon rate. Can be fixed or variable. Say is it 0.15%. Swap payable accrues from settle date to maturity date like so: 350,000 * .0015 /360 = 1.458333 daily factor.
End Result- Say settle date of contract was 6/24/2014 and maturity date was 7/9/2014
Short leg accrues 24.45 as a swap payable leaving its value at 350,024.45
Long leg is valued in the market at 240.044118 leaving its value at 367,421.12
Fund makes $17,396.67 from entering into the swap contract and a subsequent wire should be delivered.

Interest Rate Swap:
An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for