Bank Management. 3 Basic Finance. 3.1 Financial Products. Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 45

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1 Bank Management 3 Basic Finance 3.1 Financial Products Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 45

2 Types of Financial Markets and Types of Securities Types of financial markets: Exchange (organized market) vs. OTC market (non-organized) Primary market vs. secondary market Spot/cash market vs. forward market Bond market, stock market, derivatives market, money market, FX market, Securities: Stocks Bonds (see later chapter) Derivatives Forwards Futures Options and warrants Swaps Caps and floors Structured products Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 46

3 Definitions of a Derivative According to ISDA: A derivative is an agreement, the value of which is derived from the value/performance of an underlying asset. The underlying asset could be a physical commodity, an interest rate, a company s stock, a stock index, a currency or virtually any other tradable instrument upon which two parties can agree. According to IAS 39: A derivative is a financial instrument or other contract with all three of the following characteristics: (a) its value changes in response to the change in a specified interest t rate, financial i instrument t price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the underlying ); (b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and (c) it is settled at a future date. Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 47

4 Forwards and Futures Forward and future contracts are both contracts between two parties a buyer and a seller to purchase (long position) respectively sell (short position) an underlying asset at a later date (T) for a price (F 0 ) agreed upon today The payoff in T from a long position in a forward contract on one unit of an asset is: long position F 0T 0,T The payoff from a short position respectively: F 0T 0,T ST F 0,T F 0,T = Forward price, = Price of asset at maturity short position Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 48

5 Forward vs. Future Contracts Despite the fact that forwards and futures have lots of characteristics in common, there are some important t differences: FORWARDS Non-standardized contract Settled at maturity No margin requirements Private agreements between two parties Usually 1 specified delivery date Delivery or final cash settlement usually occurs Some credit risk No clearing house FUTURES Standardized contract Settled daily (Marked-to-market) Margin requirements Exchange traded Range of delivery dates Contract usually closed out prior to maturity Virtually no credit risk Interacting over clearing house Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 49

6 Arbitrage-Free Valuation of Forwards and Futures: Investment Assets The forward price F of an investment asset that provides no income is F 0,T = S 0 e rt = S 0 / ZB 0,T (or in discrete time: F 0 = S 0 (1+i) T ) Where S 0 = Spot price, T = Time to maturity of the contract, and r = the continuously compounded risk-free rate for maturity T. When the asset provides income during it s contract life that has a present value I, this becomes F 0,T = (S 0 I)e rt = (S 0 I)/ ZB 0,T = (S 0 I) (1+i) T When the asset provides a (continuously compounded) yield at rate q, we get F 0,T = S 0 e (r-q)t Arbitrage strategies: Cash-and-Carry y( (long asset, credit, short forward) or Reverse Cash-and-Carry (short asset, deposit, long forward) Exercise: Show that the prices above are actually arbitrage-free. Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 50

7 Arbitrage-Free Valuation of Forwards and Futures: Non-Investment Assets These arbitrage arguments are limited for non-investment assets (e.g. most commodities) due to: Costs-of-carry Convenience yields Absence of price adjustment forces For valuation: The convenience yield can be handled d like an income/yield i on the asset (see above) Costs-of-carry can be handled like a negative income/yield on the asset (see above) But: Still no strong arbitrage arguments Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 51

8 Forward Curves Forward prices for different maturities of forward/future contracts Contango: 0 F 0 t t 1 2 Global: Forward prices are higher with increasing maturity, t 0, t 1 2 Local: Forward price is higher than spot price Backwardation: F Global: Forward prices are lower with increasing maturity Local: Forward price is lower than spot price F 0, t F0, 0 1 t t 2 1 t2 Contango (Example: Gold 10/20/2010) Backwardation (Example: Copper 10/20/2010) Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 52

9 Options An option is a contract between two parties a buyer and a seller that gives the buyer the right, but not the obligation, to purchase (call option) or sell (put option) an underlying asset at a future date at a price agreed upon today. American Option: the option can be exercised anytime during its lifetime European Option: the option can only be exercised on expiration The option buyer pays the seller a sum of money called the option price or option premium. The option seller stands ready to sell or buy according to the contract terms. Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 53

10 Payoff Profiles and Moneyness Payoff Payoff OTM ATM ITM K K Long Call Option: max 0, S K Long Put Option: max 0, K S Payoff Payoff K K Short Call Option: min0, Short Put Option: min0, K K (ITM = In-the-money; OTM = Out-of-the-money; ATM = At-the-money; = Price of the underlying at exercise date) Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 54

11 References Hull, John (2009): Options, Futures and other Derivatives, 7. edit., Pearson publishing. Hull, John (2010): Risk Management and Financial Institutions, 2. edit., Pearson publishing. Berk, Jonathan and Peter DeMarzo (2010/11): Corporate Finance, 2. edit., Pearson publishing. Chance, Don and Robert Brooks (2007): Derivatives and Risk Management, 7. edit., Thomson publishing. Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management 55