ABN AMRO Futures Capabilities

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1 ABN AMRO Futures Capabilities Prepared for the China Futures Association May 22, 2005 Overview: ABN AMRO Futures Global capabilities - Local presence and expertise Membership on all major futures exchanges around the world 450 Futures professionals in nine offices (Paris, London, New York, Chicago, Singapore, Sydney, Hong Kong, Tokyo and Seoul) Regulatory capital of ABN AMRO Incorporated over $1 billion Full product range including: interest rates, equity indices, energy, metals, grains, soft commodities as well as O-T-C metals and energy products First rate technology for trading and automation of back-office functions. 2 1

2 ABN AMRO Futures is Connected to the Following Exchanges Chicago CBOT CME OneChicago EurexUS New York NYMEX London LIFFE IPE Paris EURONEXT Rome IDEM Amsterdam AEX Frankfurt EUREX Seoul KSE Tokyo OSE TSE Hong Kong HKFE Singapore SGX Exchanges Connection Status Existing Exchanges Coming in 2006 Sydney SFE Futures Offices 3 Overview: ABN AMRO Futures Global capabilities - Local presence and expertise Membership on all major futures exchanges around the world 450 Futures professionals in nine offices (Paris, London, New York, Chicago, Singapore, Sydney, Hong Kong, Tokyo and Seoul) ABN AMRO Incorporated has capital of over $1 billion Full product range including: interest rates, equity indices, energy, metals, grains, soft commodities as well as O-T-C metals and energy products First rate technology for trading and automation of backoffice functions. 4 2

3 Key Areas of Futures Expertise Exceptional Customer Service Designated customer service rep assigned to each account Customer service reps have expertise in client s product, for example: fixed income, metals, stock indices. Customer service rep backed up by a team to ensure continuous coverage Open outcry and electronic execution of all major U.S. and non- U.S. equity futures Electronic access to all major electronic markets and automated web-based back-office access. Client-focused access to global futures markets, including our 24-hour desk, access to our local specialists around the world, and electronic execution where available 5 Our Option clients Many of our clients are option market makers in futuresoptions markets. We have extensive experience in managing the risk of such clients. Option market makers are essential to successful option markets. 6 3

4 Market Makers There are many more option contracts than futures contracts. Both puts and calls at all the different strike prices All successful option markets have market makers to ensure liquidity. ABN AMRO Futures group specializes in serving option market making clients. 7 The Current Situation 8 4

5 Global Futures Volume (ex-china) US-NonUS (In millions) Jan-Dec 03 Jan-Dec 04 % Change U.S. Futures 1, , % Non-U.S. Futures 1, , % Total Futures Volume 2, , % Source: Futures Industry Association 9 Global Option Volume (ex-china) U.S.-NonUS (In millions) U.S. Options Non-U.S. Options Jan-Dec 03 Jan-Dec 04 % Change 1, , % 4, , % Total Options Volume 5, , % Grand Total Futures & Options 8, , % 10 5

6 Global (ex-china) Options on Cash Securities % Change Interest Rate 90,438 90, % Foreign Currency/Index 278, , % Equity Indexes 3,265,600,633 3,020,766, % Individual Equity Options 1,503,340,868 1,914,482, % Total Securities Options 4,769,310,588 4,935,570, % 11 Financials vs. Non-Financials ex-china (Futures & options, excluding options on individual equities) (In millions) Jan-Dec 03 Jan-Dec 04% Change Financials 5, , % Non-financials % Total 6, , % 12 6

7 Interest Rates, Equities, Currencies (In millions) Jan-Dec 03 Jan-Dec 04% Change Equity Indices 3, , % Interest Rates 1, , % Currency % Total 5, , % 13 Agricultural, Metals & Energy (In millions) Jan-Dec 03 Jan-Dec 04% Change Agriculturals % Metals % Energies % Total % 14 7

8 Options Introduction Options have grown enormously in recent years. Options are popular with those averse to risk to benefit from price changes without risking large losses. Such traders can buy puts or calls Options are popular because they provide a flexible tool for hedgers to create more kinds of hedges. Options have made it possible for institutions, such as banks, to offer customers many more kinds of products. Examples: Savings deposit with principal guaranteed but payoff linked to performance of equity market, or gold, or crude oil, etc. Options typically result in higher volumes in the underlying market, such as futures. 15 Developing Trends Options strategies started out relatively simple. Over the years, as individuals, professional traders, and institutions became more familiar with them, more complex strategies developed. Today, simple strategies continue to be used, but more sophisticated strategies are also used by professionals traders, market makers, and institutions. 16 8

9 Key Option Strategies 17 Long short the underlying; long, short puts and calls. P P P L Long Underlying L Long Call L Long Put spot spot spot P P P L Short Underlying L Short Call L Short Put spot spot spot 18 9

10 Option Pricing Time Value Declines--Theta TIME VALUE PREMIUM Both buyers and sellers want to be aware of theta. Theta good for sellers, bad for buyers TIME-REMAINING UNTIL EXPIRATION (MONTHS) 19 Bull Spread Hedge Strategy: Hedger with need for product concerned that prices will rise and desires protection from price rise. Hedger does not expect a large price rise. To reduce the cost of the hedge, hedger buys call at a lower strike price and sells at a higher strike price to reduce the cost of the hedge. Risk to hedger: price could rise more than expected. Trader strategy: Desires to profit from a price rise but reduce the cost of the trade by selling a call at the higher strike price

11 Bull Spread Using Calls Option premiums Profit $8 $2 $80 $90 The bold line is a combination of the two Short call at higher strike price Long call at low strike price 21 Example: Bull call Stock price: $85 Strike 80: premium $8 Strike 90: premium $2 What is: Maximum profit? Maximum loss? Breakeven? Profit if stock is at $79 at expiration? 22 11

12 Bull Call Spread Cost (net premium): 8-2=$6 outflow Possible profit: Difference in strike prices cost (90-80) 6 = 4 Breakeven: lower strike plus cost: = $86 23 Profit at $92, 100 At 92: Profit on 80 strike: 12 Profit on 90 strike: -2 Gross profit: 12-2= $10 Cost: $6 Net profit: $4 At 100 Profit on 80 strike: 20 Profit on 90 strike: -10 Gross profit: 20-10= $10 Cost: $6 Net profit: $

13 Bull Spread Using Puts: Similar payoff; choose strategy with best cost/payoff characteristics Profit Short put at high strike price K 1 K 2 S T Long put at lower strike price 25 Bear Spread Using Puts Profit $50 $58 $1 S T $

14 Example: Bear Put spread Stock price: $55 Strike 58: premium $7 (Buy) Strike 50: premium $1 (Sell) What is: Maximum profit? Maximum loss? Breakeven? 27 Bear Put spread What is: Maximum profit? Difference between strikes minus cost (58-50) 6 = $2 Maximum loss? Investment Premium 7-1 = $6 Breakeven? Get back investment Upper strike net outlay 58 6 =

15 Bear Spread Using Calls Profit K 1 K 2 S T 29 Butterfly Long butterfly: Buy one option at high and low strikes, sell two at middle strike. Profitable if the market remains stable. But risk is very limited

16 Long Butterfly Spread Using Calls: buy one high strike, one low strike, sell two middle $94.56 strike premium: $6.88 Profit Premum $4.15 x 2 = premium: $4.30 $ S T Prem: 2.58 Premium $6.85 Premium $ Butterfly You can see where your max profit is from the diagram the middle strike price Calculate the value of your long position. Add income from the sale of the two middle options. Subtract cost of long premiums. ( ) + 2(4.15) = $3.60 Maximum loss: Maximum profit difference between strike prices =

17 Butterfly Spread Using Puts Butterfly spreads can be created using puts or calls Profit Short put K 1 K 2 K 3 S T Long puts 33 A Straddle Combination: Profit from a big move in either direction Profit Long call K S T Long put 34 17

18 A Strangle Combination Profit from a big move in either direction cheaper than a straddle Profit K 1 K 2 S T 35 Strip & Strap: expected price movement in one direction more likely Profit Profit K S T K S T Strip Buy two puts, one call Strap Buy two calls, one put 36 18

19 Key Hedging Strategies Inventory hedge 0 Cost Collar 37 Inventory Hedging: long soybeans, long put A Grain inventory $6.55 Long Put Put price: $0.14/bushel=$700 Strike: $

20 Protective Put hedge: value of inventory protected A Result $6.55 $6.55 Effective price = = $6.11 Strike: $ Cost Collar Hedger would like protection from a price decline. Hedger would like to keep the cost of the hedge low, maintain some benefit if prices improve

21 0 Cost collar Soybeans Buy one 6.25 $0.14/bushel; sell one $7 net cost 0 Profit The bold line is a combination of the two $7.00 cap $6.25 $7.00 Price $6.25 floor Price of inventory:$6.65/bushell = 0.14 x 5000 = $700 for each put and call 41 0 Cost Collar Hedging protection achieved Cost of the hedge is 0 In exchange for the lower cost of the hedge, the hedger gives up potential higher profits if prices rise very high. Use strategy if a price decline would have a strong negative effect on the company, and a price rise would increase profitability. Hedger is willing to give up possibility of extra profitability if there s a large price rise

22 Delta Hedging A delta hedge is a more complete hedge than simply buying one put or one call as in the previous examples. A delta hedge can be used by a futures market maker to hedge a futures position. An option market maker can use the delta concept to calculate the number of futures to buy/sell to hedge options positions. 43 Put and Call Deltas 44 22

23 Computing hedge ratio The reciprocal of the delta 45 Later 1.The hedge ratio must be continuously monitored!! 2.Like any other hedge, it should earn the risk-free rate

24 Delta hedging Used by market makers to hedge their option positions using other options or futures. The delta of a long futures = 1 The delta of a short futures = Rolling down strategy: Hedge strategy that benefits if prices continue in the same direction. Start with put option with strike price of $6.25. If price falls, sell the 6.25 option and buy more puts at 6.00 This is called rolling down your option position. The profit on the 6.25 option will allow you to buy more puts at 6.00 If the market continues down, the option position generates profits at no additional net cost. If the market goes up, your expenses are no higher than they were before

25 The impact of option markets During the 1980s and 1990s in the U.S. opton markets grew rapidly. Some legislators and regulators and members of the press expressed concern that the large option markets might pose some unique risk. There were even proposals to ban or limit these markets. Many studies were done on the topic of derivatives and their impact on underlying markets. 49 Results of a study of studies done in 1995 The growth of derivatives activity provided substantial benefits to public and private institutions using these financial tools and to the U.S. economy. The risks of derivatives are the same types of risk that public and private institutions face in their traditional businesses and generally have not exposed them to new risks sources. Not a single study reviewed called for banning or severely restricting the use of derivatives

26 Greenspan on derivatives Allan Greenspan s comment on the positive contribution of derivatives: "These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago." Alan Greenspan, Chairman of the Federal Reserve, Greenspan on derivatives Allan Greenspan s comment on the lower counterparty risk of futures relative to over-the-counter instruments: Clearly the degree of counterparty credit risk on derivatives depends critically on the extent to which netting and margining procedures are employed to mitigate the risks. In the case of exchange-traded contracts, of course, daily variation settlements by clearing houses strictly limit, if not totally eliminate, such counterparty risks. Chairman Alan Greenspan, March 19,

27 Comments on by regulators & Government officials When one assesses this field, I think it is not hyperbole to suggest that the development and growth of financial derivatives constitute one of the most dramatic success stories in modern economic history. David W. Mullins, Jr., Vice Chairman, Federal Reserve Board, in In the private sector truly great progress has been, and is being made, in developing the risk management, information and control systems that are so crucial for individual firms and the marketplace in general. E. Gerald Corrigan, Former President, Federal Reserve Bank of New York, There are no fundamentally new or different risks in derivative products, rather familiar kinds of risks are presentated and combined in novel ways. Brian Quinn, Director, Bank of England, Academics Derivatives serve ahighly useful risk-management role for both financial and non-financial firms. Financial Economicsts Roundtable, 1994 Financial futures are the single greatest financial innovation of the last 25 years. Merton Miller, Nobel Laureate in economics (1992), during a 1995 interview. Derivatives markets act to reduce systemic risk by spreading the impact of underlying economic shocks among a larger set of investors in a better position to absorb them. Ludger Hentschel and Clifford W. Smith, Jr., Professors, University of Rochester. The reason so many holders of derivatives positions took large losses in early 1994 is in most cases exactly the same as the reason that many more investors lost money on ordinary bonds: interest rates rose very far and very fast. Stephen Figlewski, Professor, New York University,

28 Academics Efficient risk-sharing is what much of the futures and options revolution has been all about. Merton H. Miller, Nobel Laureate (1992), University of Chicago There is no significant evidence that spot volatilities have increased since the introduction of index futures. Etc. John Board, Charles Goodhart & Charles Sutcliffe, Professors, London School of Economics & University of Southhamption, Impact of options Studies about the impact of options on the underlying market consistently find that options either reduce the volatility of the underlying market or have no impact. Source: A. Damodaran and M. Subrahmanyam, The Effects of Derivative Seccurities on the Markets for Underlying Assets in the United State: A Survey, Financial Markets, INstiuttions and Instruments, V. 1, N.5, December 1992, page

29 Conclusion--options Experience and studies have shown that the introduction of options generally leads to an increase in the volume of the related products. Reasons: Users of futures have more ways to hedge their risks, and therefore are more willing to trade futures. Option market makers use futures to hedge their market making positions. Active market makers ensure that both the options and the futures markets are fairly priced. 57 Contacts Nick Ronalds Michael Deaton

30 Disclaimer This publication is intended for informational purposes only and the opinions set forth herein should not be viewed as an offer or solicitation to buy, sell or otherwise trade futures and/or options. All opinions and information contained in this document constitute ABN AMRO Incorporated s ( AAI ) judgment as of the date of this document and are subject to change without notice. AAI, persons connected with it, members of the ABN AMRO group of companies ("Group Companies") and their respective directors and employees may, directly or indirectly, effect or have effected a transaction for their own account in the investments referred to in the material contained herein before or after the material is published to any customer of a Group Company or may give advice to customers which may differ from or be inconsistent with the information and opinions contained herein. While the information contained herein was obtained from sources believed to be reliable, no Group Company accepts any liability whatsoever for any direct, indirect or consequential loss arising from any inaccuracy herein or from any use of this document or its contents. This document may not be reproduced, distributed or published in electronic, paper or other form for any purpose without the prior written consent of AAI. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. AAI is not a bank. Securities sold, offered or recommended by AAI and deposits made with AAI, are not insured by the Federal Deposit Insurance Corporation, are not guaranteed by or an obligation or responsibility of ABN AMRO Bank N.V., or any other affiliated bank or thrift institution and involve investment risks, including the possible loss in excess of principal

FNCE4830 Investment Banking Seminar

FNCE4830 Investment Banking Seminar Introduction on Derivatives What is a Derivative? A derivative is an instrument whose value depends on, or is derived from, the value of another asset. Examples: Futures