FIN 580 Derivatives I: Basic Derivatives Strategies and Pricing 01 Introduction

Transcription

1 FIN 580 Derivatives I: Basic Derivatives Strategies and Pricing 01 Introduction Stefan Ruenzi University of Mannheim Tel: +49 (621)

2 Course Outline 1. Introduction 2. Trading Strategies 3. Forwards 4. Futures 5. Swaps 6. Options 7. Impact of Derivatives on Markets & the Macroeonomy 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 2

3 Literature Main Textbooks DM OFD Chapter 1.1 & 1.3 Chapter 1 Supplementary Readings 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 3

4 Introductory Questions What is the definition of a derivative? How are derivatives used? How do basic derivatives contracts (forwards, futures, swaps, options) work? How are derivatives traded and what are their main characteristics? What are the basic valuation principles for derivatives? 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 4

5 Derivative - Defintion Ethymological: derivatum (lat.) derived Options Futures/Forwards Swaps 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 5

6 Introductory Questions What is the definition of a derivative? How are derivatives used? How do basic derivatives contracts (forwards, futures, swaps, options) work? How are derivatives traded and what are their main characteristics? What are the basic valuation principles for derivatives? 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 6

7 Historical Examples Thales of Milet (6th century a.d.) expected a rich olive harvest and agreed with the owners of olive mills to rent their mills longterm, fixing their (low) rent today. During the harvesting season he sub-rented those mills and made a fortune. One tulip bulb costs as much as Two lasts of wheat AND Four lasts of rye AND Four fat oxen AND Eight fat swine AND Twelve fat sheepand Two hogsheads of wine AND Four tuns of beer AND Two tons of butter AND 1,000 lb. of cheese AND A complete bed AND A suit of clothes AND A silver drinking cup During the tulip-mania in the 17th century in The Netherlands, there was an active derivatives market for tulip bulbs. The Dōjima Rice Exchange was the first organized futures exchange. It was established in Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 7

8 Actual Applications Transnational companies buy FX-derivatives to hedge their currency exposure. Airlines enter futures contracts in order to be less vulnerable to oil price changes. A goldmine can use derivatives to lock in the current gold price. Banks use derivatives to manage interest rate and default risks. Asset Managers can use derivatives for portfolio insurance purposes Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 8

9 Actual Applications gone wrong Barings (1995): Nick Leeson engages in arbitrage business using derivatives. To recover his losses, he bets on a quick recovery of the Asian economy after the Kobe earthquake by investing in futures. LTCM (1998): Nobel prize winner advised fund speculates using OTC derivatives. During the Russian crises the counterparties of hedges default. LTCM can not settle its positions due to illiquidity. Societe General (2008): Jérôme Kerviel nearly brings down the bank by massive fraudulent speculation in equity index futures. USA ( ): Role of derivatives in financial crises is debated Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 9

10 Top 10 Trading Losses USD Lost Country Company Source of Loss Year Person responsible 9.0 bn U.S. Morgan Stanely Credit Default Swaps 2008 Howie Hubler 7.2 bn France Société Générale European Index Futures 2008 Jérôme Kerviel 6.5 bn U.S. Amaranth Advisors Gas Futures 2006 Brian Hunter 5.8 bn U.K. JP Morgan Credit Default Swaps 2012 Bruno Iksil 4.6 bn U.S. LTCM Interest Rate and Equity Derivatives 1998 John Meriwether 2.6 bn Japan Sumitomo Corporation Copper Futures 1996 Y. Hamanaka 2.1 bn Brazil Aracruz FX Options 2008 Isac Zagury 2.0 bn U.K. UBS Equities ETF 2011 Kweku Adoboli 1.7 bn U.S. Orange County Interest Rate Derivatives 1994 Robert Citron 1.4 bn Germany Metallgesellschaft Oil Futures 1993 H.Schimmelbusch 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 10

11 Introductory Questions What is the definition of a derivative? How are derivatives used? How do basic derivatives contracts (forwards, futures, swaps, options) work? How are derivatives traded and what are the most important trading venues? What are the basic valuation principles for derivatives? 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 11

12 Forward - Definitions 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 12

13 Forward Working Principle Short Position (Seller) Conclusion of forward contract in t for delivery in T at price f(t,t) Long Position (Buyer) 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 13

14 Futures Contracts - Definitions 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 14

15 Futures Working Principle Short Position (Seller) Conclusion of futures contract in t for delivery in T at price F(t,T) Clearing House Conclusion of futures contract in t for delivery in T at price F(t,T) Long Position (Buyer) 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 15

16 Swap - Definition 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 16

17 Swap Working Principle Short Position (Seller) Conclusion of swap in t for delivery in t 1, t 2,, T at price s(t,t) Long Position (Buyer) 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 17

18 Options - Definitions 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 18

19 Introductory Questions What is the definition of a derivative? How are derivatives used? How do basic derivatives contracts (forwards, futures, swaps, options) work? How are derivatives traded and what are the most important trading venues? What are the basic valuation principles for derivatives? 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 19

20 Classification of Financial Transactions Possible Transactions Derivatives Transaction Spot Transaction Unconditional Contingent 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 20

21 Trading Venues Trading Venues for Derivatives Exchanges OTC (Over-The-Counter) Futures Options Forwards Swaps Options 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 21

22 Derivatives Exchanges Source: Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 22

23 Consolidation in the Exchange Industry (Mergers in 2009) Liffe UK, Amsterdam, Paris, NYC, Brussel, Lisbon) Chicago Mercantile Exchange NYSE Acra Options American Stock Exchange NYSE Euronext Chicago Board Options Exchange Chicago Board of Trade CBOE Holdings New York Mercantile Exchange CME Group CBOE Futures Exchange 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 23

24 Contracts & Regions Exchange Traded Contracts Latin America; 7,8% Other ; 1,7% Contract Type Futures Options Europe; 20,1% North America; 36,7% Source: Asia- Pacific; 33,7% Underlying Category Contracts* Equity Indexes 5,370,863,386 Individual Equities 6,401,526,238 Interest Rate 3,330,719,902 Foreign Currency 2,491,136,321 Ag Commodities 1,213,244,969 Energy Products 1,265,568,992 Non-Precious Metals 646,318,570 Precious Metals 430,681,757 *as of Dec Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 24

25 OTC Volume Total number of contracts Source: Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 25

26 Contracts & Underlyings OTC Contracts Contracts Underlying Category Notional amounts outstanding in billions of US dollars (as of Dec 2011) Forwards & Swaps Options Interest Rates 584,364 Currency 70,553 Credit Default 21,020 Equities 6,560 Commodities 2,206 Source: Bank for International Settlements (BIS) Basel 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 26

27 The contracts traded on EUREX Interest Rate Derivatives (e.g. Euro-Bund Futures) Equity Derivatives (on European and US underlyings) Equity Index Derivatives (on Dow Jones EURO STOXX 50, DAX, SMI ) Equity Index Dividend Derivatives Volatility Index Derivatives Exchange Traded Funds Derivatives Credit Derivatives Inflation Derivatives Commodity Derivtives (on CO2, Gold and Silver, Agricultural Products) Weather Derivatives 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 27

28 Introductory Questions What is the definition of a derivative? How are derivatives used? How are derivatives traded and what are the most important trading venues? How do basic derivatives contracts (forwards, futures, swaps, options) work? What are the basic valuation principles for derivatives? 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 28

29 Valuation Two basic valuation approaches Basic Valuation Methods Equilibrium No-Arbitrage (e.g. Stocks) (e.g. Bonds) 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 29

30 No-Arbitrage Paradigm Arbitrage opportunities cannot exist On markets without frictions, no arbitrage opportunities can exist. If such opportunities would exist, rational traders would immediately take advantage of them. The price of a derivative relative to the price of its underlying can not give rise to arbitrage opportunities. Assumptions: Payments from a derivative can be duplicated There are no frictions (transaction costs, short sale restrictions, etc) There is perfect competition 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 30

31 Types of Arbitrage Opportunities Arbitrage Profit possible safe free lottery ticket free lunch Violation of LOOP 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 31

32 Arbitrage Valuation Two Main Methods: Valuation by Duplication & Valuation by Hedging Portfolios Construct a duplication portfolio consisting of a position in the underlying and in the riskfree asset that delivers future payments that are identical to those of the derivative. No arbitrage requires that the derivative and the duplication portfolio have the same price today. Construct a hedge portfolio consisting of a position in the underlying and in the derivative that is riskfree. No arbitrage requires that this portfolio delivers the same return as the riskfree asset. Construct a hedge portfolio consisting of a position in the underlying, in the derivative, and in the riskfree asset that does never deliver any payments in the future. No arbitrage requires that this portfolio has a price of zero today Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 32

33 No-Arbitrage Valuation Useful for most things we do Advantages Disadvantages Only weak assumptions on investors behavior Only relative valuation Value of assets do not depend on preferences Only applicaple for instruments whose payments can be duplicated using other assets Most of the derivatives we will discuss in this course can be valued based on noarbitrage principles. There are some derivatives, for which duplication (and no-arbitrage valuation) is not possible, because the underlying is not a traded asset Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 33

34 Why do we need valuation models? Observing market prices is not always possible or sufficient! Being able to determine the fair price of a derivative is important, because then 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 34

35 Introductory Questions: Revisited What is the definition of a derivative? How are derivatives used? How do basic derivatives contracts (forwards, futures, swaps, options) work? How are derivatives traded and what are the most important trading venues? What are the basic valuation principles for derivatives? 2014 Stefan Ruenzi FIN 580 Derivatives I: 01 Introduction 35