FINM2002 NOTES INTRODUCTION FUTURES'AND'FORWARDS'PAYOFFS' FORWARDS'VS.'FUTURES'

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1 FINM2002 NOTES INTRODUCTION Uses of derivatives: o Hedge risks o Speculate! Take a view on the future direction of the market o Lock in an arbitrage profit o Change the nature of a liability Eg. swap o Change the nature of an investment without incurring the costs of selling one portfolio and buying another FUTURES'AND'FORWARDS'PAYOFFS' Futures/Forward payoffs: o Long: S T F o Short: F - S T FORWARDS'VS.'FUTURES' Page 1 of 32

2 CLOSING'OUT' To close out a futures position you enter into an offsetting trade o Enter opposite position to fill out the futures contract and simultaneously sell or buy in the market If futures contract does not have the desired maturity you take a future with a further maturity and close out early When delivery occurs, the short chooses any alternatives (eg. when and where) TERMINOLOGY' Open interest/position: Total number of contracts (long or short) outstanding/available Settlement price: Price just before the final bell each day Volume of trading: Number of trades in 1 day OPTIONS'VS.'FUTURES/FORWARDS' Futures/forwards contracts give the holder the obligation to buy or sell at a certain price, while options give the holder the right but not the obligation to buy or sell at a certain price o In return for right, holder pays a premium for options Options can be OTC or exchange traded, while forwards are OTC and futures are exchange traded MARKET'PARTICIPANTS' 1. Hedgers Want to avoid exposure to adverse movements in the price of an asset o Have a position in the derivative and the underlying asset 2. Speculators Take a position in the market betting on the movement of the price of an asset o If correct, they make large gains, but if incorrect there is potential for massive losses 3. Arbitrageurs Attempt to lock in a riskless profit by simultaneously entering into transactions in two or more markets FORWARDS AND FUTURES CONSUMPTION'VS.'INVESTMENT'ASSETS' Investment assets: Held by significant number of people purely for investment purposes o Examples: Stocks, bonds, gold and silver Consumption assets: Held primarily for consumption and not usually investment purposes o Examples: Copper, oil and pork bellies Page 2 of 32

3 Can use arbitrage arguments to determine forward and futures prices of an investment asset from its spot price, however, cannot do the same for consumption assets SHORT'SELLING' Selling an asset that is not owned Client you borrow off must be no worse off (dividends) and no better off (storage costs) than if they still held the asset Not always possible and must maintain a margin account with the broker CONTINUOUS'COMPOUNDING'INTEREST'RATE'FORMULAE'!" =!!!"!" =!!!!" ANR to CCR:!! =!!!" 1 +!!! (m is the number of times compounded per year) CCR to AER:!! =!!" 1! ASSUMPTIONS'REGARDING'MARKET'PARTICIPANTS' They are subject to no transaction costs when they trade They are subject to the same tax rate on all net trading profits They can borrow money at the same risk-free rate of interest as they can lend money They take advantage of arbitrage opportunities as they occur COST'OF'CARRY'MODEL' Cost of carry model Forward/futures price is determined as the delivery price that would be applicable to the contract if negotiated today o No difference between buying a forward contract or buying the asset today and storing it for the length of the contract Cost of carry (q) of underlying: Cost of holding a physical quantity of the commodity o Cost of carry is negative in the case of dividends (benefit) If equality does not hold, an arbitrage opportunity exists Formulae) General model:! =!!!!" Known income:! =!!!!!" where D is the present value of the income Known storage costs:!! =!! +!!!" where Q is the present value of storage costs Known yield or stock index:! =!!! (!!!)! where d is the average yield per annum Known storage costs as a percentage:! =!!! (!!!)! Foreign currency:! =!!! (!!!!)! Page 3 of 32

4 OPTION'TRADING'STRATEGIES' Options combined with a position in the underlying: o Covered call o Reverse covered call o Protective put o Reverse protective put Spreads Two or more options on the same stock (all puts or all calls) o Bull spread o Bear spread o Butterfly spread o Calendar spread Combinations o Straddle o Strip o Strap o Strangle Positions)in)an)Option)and)the)Underlying)Asset) Covered'Call' Strategy: Sell call option and buy underlying Long position on stock covers the investor from the payoff on the short call that becomes necessary if there is a sharp rise in the stock price Used when stock price is expected to rise Known as a synthetic short put Reverse'Covered'Call' Strategy: Buy call option and sell underlying Used when stock price is expected to fall Known as a synthetic long put Protective'Put' Page 11 of 32

5 Strategy: Buy put option and buy underlying Used when stock price is expected to rise Known as a synthetic long call Reverse'Protective'Put' Strategy: Sell put option and sell underlying stock Used when stock price is expected to fall Known as a synthetic short call Spreads) Bull'Spread' Using)Calls) Strategy: Buy call option on a stock with a low price and sell call option on the same stock with a higher strike price o Both options have same expiry date o Call option price always decreases at the strike price increases, so the value of the option sold is always less than the value of the option bought Requires initial investment Limits investors upside and downside risk Used when stock price is expected to rise Using)Puts) Page 12 of 32