Lecture 1: Introduction to Derivatives
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1 Derivatives: Definition Lecture 1: Introduction to Derivatives A derivative can be defined as: a financial instrument (or more simply, an agreement between two or more people whose value depends on (i.e., derived from) the values of other financial instruments (i.e. its underlying assets). อน พ นธ เป นตราสารทางการเง น (หร อ เป นข อตกลงระหว างบ คคลสองฝ ายหร อ มากกว า) ซ งม ลค าของม นถ กก าหนดด วยม ลค าหร อราคาของส นค าอ น : Financial Modelling Nattawut Jenwittayaroje, PhD, CFA NIDA Business School National Institute of Development Administration For example, the value of PTT Futures depends on the PTT Also, the value of SET5 Index Futures and the value of SET5 Index Options depend on the value of SET 5 stock index. 1 2 Simple Examples of Derivatives Simple Examples of Derivatives Car wash example A coupon for free car wash if raining within 24 hours. Free Car wash example (Con t) Value of the coupon depends on the current weather condition. Value of Coupon Free 3 7 4
2 Simple Examples of Derivatives Rice example Government offers to buy rice at a fixed. Simple Examples of Derivatives Rice example (cont.) Price of rice determines the value of this guarantee. Value of Government Guarantee 5 Rice 6 1 Derivatives: Instruments Derivatives products 1) Forwards and futures contracts 2) Options 3) Swaps 4) Other derivatives e.g., futures options, swaptions Futures and Forwards 7 8
3 Futures and Forwards Motivations Eliminate uncertainty in the future Futures and Forwards Motivations (con t) Let's make an agreement now! I need a new car at the end of the year. 1,, December 31, 213 Deal! Futures and Forwards Forwards/Futures Main Characteristics Definitions A futures/forward contract is an agreement between a buyer and a seller in which the buyer (seller) agrees to buy (sell) something (i.e., the underlying) at a specific (i.e., future/forward ) at the end of a designated period of time (i.e., settlement or delivery date). It can be contrasted with a spot/cash contract, which is an agreement to buy or sell immediately So any asset has now two s a spot/cash, and a forwards/futures However, there are also many forwards/futures s, depending on delivery dates. Agree on future/forward And delivery date Pay future/forward Deliver underlying has what is termed a long position has what is termed a short position Agreement date (today) Delivery date 11 No money changes hands when contract is first negotiated (contrasted with option contract). Neither party pays anything and neither party receives anything of monetary value. The forward contract has initially zero value. 12
4 Forwards - Example F forward contracts are generally used to hedge F risk. On June 6, 213 a Thai trader enters into an agreement to buy $USD 1, in three months at an exchange rate of 32 from a bank. The trader takes alongforwardcontracton USD to buy USD from the bank for Baht32/USD on 6 Sep 213. Agree today (June 6, 213), but to deliver 32, bahts for $USD 1, on Sep 6, 213 The bank has a short forward contract on USD because it has agreed to sell USD 1, for baht32, on 6 Sep 213. Agree today (June 6, 213), but to deliver $USD 1, for 32, bahts on Sep 6, 213 Profit from a Long Forward Position Forward buyer: Profit and Loss Table F rate at maturity Payoff (before cost) Cost (after cost) 29 = = = 3 32 = = = = = 33 = = = = What are the possible outcomes? 35 = = Profit from a Short Forward Position Forward : Profit and Loss Table F rate at maturity Payoff (before cost) Cost (after cost) 29 = = from a long position (32) > or - > from a short position (32) - < or - > 3 = 32-3 = = = =32 =32 32 = = 33 = = -1-1 < or - < 34 = = -2-2 > or - < 35 = = Hope of the underlying asset ( ) to rise Hope of the underlying asset ( ) to fall 16
5 Forward Contracts - Quotes Spot and forward quotes for the GBP/USD by an international bank on 16 August 21 were as: Bid (buy) Offer (sell) Spot 1-month forward 3-month forward 6-month forward 1-year forward $ $ $1.442 $ $ $ $1.444 $1.447 $ $ Options Delivery or forward s Options Options Motivations Motivations (cont.) Buying a car revisited. Deal! Want the gain... (Spot) Market Price on Dec 31, 213 1,2, 1,, December 31,
6 Options Options Motivations (cont.)... but not the loss. (Spot) Market Price on Dec 31, 213 8, Motivations (cont.) Can we do this? Market Price On Dec 31, 213 1,2, Market Price On Dec 31, 213 8, Options - Call Definition: a contract between two parties that gives the buyer the right to buy from the seller, at a later date at a agreed upon today. Therefore, the seller has an obligation to sell something to the buyer when the buyer exercises his/her right. Options - Put Definition: a contract between two parties that gives the buyer the right to sell something to the seller, at a later date at a agreed upon today. Therefore, the seller has an obligation to buy something from the buyer when the buyer exercises his/her right. Pay option Option contract Agree on strike & maturity Pay option Option contract Agree on strike & maturity Exercise contract, i.e., pay an exercise Exercise contract, i.e., receive an exercise take delivery OR Do nothing Maturity date 2326 make delivery OR Do nothing Maturity date 2427
7 Options Everyday examples of options rain check allowing us to return and purchase a sale item that is temporarily out of stock. discount coupon allowing you to buy an item for a special at any time up to an expiration date. airline ticket with cancellation right right to drop a course Government offers to buy rice at a fixed. In each example, you hold the right to do something. If it turns out to be worth it to you, you will exercise that right. Otherwise, just throw that right away. You could also give or even sell it to Option terminology Option Terminology /premium (ราคา/ค าพร เม ยม) the buyer pays the seller a fee for such right. call/put - the right to buy -> call, the right to sell -> put Underlying asset (ส นค าอ างอ ง) something Exercise /Strike (ราคาใช ส ทธ ) a agreed upon today Expiration/Maturity date (ว นหมดอาย ) at a later date American/European any time up until expiration -> American at expiration date only -> European Long/Short the buyer buy an option long position - the seller sell/write an option short position someone else Options Examples Call Option Options Examples Call Option European equity call option Underlying: One share of IBM stock Type: European call option Strike : $1 Maturity date: March 31, 214 Option : $5 Call : Profit and Loss Table Stock Exercise? Profit/Loss (before option ) Option after option 8 No No 5-5 $5 Option contract Current IBM is $1 1 No Yes If IBM > $1, exercise contract (i.e.,buy IBM at $1) One share of IBM OR Else do nothing March 31, Yes Yes Yes
8 Options Examples Long Call on IBM Profit from buying an IBM European call option: option = $5, strike = $1, option expiration date 31 March Profit ($) Options Examples Call Option Call : Profit and Loss Table Stock Exercise? Profit/Loss (before option ) Option after option 8 No N stock ($) 1 N Y Y Y Y Options Examples Short Call on IBM Profit from writing an IBM European call option: option = $5, strike = $1, option expiration date 31 March Profit ($) stock ($) 31 Options Examples Put Option European equity put option Underlying: One share of IBM stock Type: European put option Strike : $1 Maturity date: March 31, 214 Option : $4 $4 Option contract If IBM < $1, exercise contract (i.e., sell IBM at $1) $1 OR Else do nothing Current IBM is $1 March 31,
9 Options Examples Put Option Put : Profit and Loss Table Stock Exercise? Profit/Loss (before option ) Option after option 7 Yes Yes Yes No No No No -4-4 Long Put on IBM Profit from buying an IBM European put option: option = $4, strike = $1, option expiration date 31 March Profit ($) stock ($) Options Examples Put Option Put : Profit and Loss Table Stock Exercise? Profit/Loss (before option ) Option after option 7 Yes Yes Yes No No No No 4 4 Short Put on IBM Profit from writing an IBM European put option: option = $4, strike = $1, option expiration date 31 March Profit ($) stock ($)
10 Payoffs from Options What is the Option Position in Each Case? = Strike, = Price of asset at maturity (a) Long call (b) Short call Payoff Payoff Payoff (c) Long put Payoff (d) Short put (a) Long call (c) Long put (b) Short call Profit and Loss from Options (d) Short put Call option buyers Right to exercise and buy the assets Pays premium Profit from rising Limited losses, potentially unlimited gain Put option buyers Right to exercise and sell the assets Pays premium Profit from falling Limited losses, potentially unlimited gain Call option sellers/writers Obligation to sell the assets if exercised Receives premium Profit from falling or remaining neutral Limited gain, potentially unlimited losses Put option sellers/writers Obligation to buy the assets if exercised Receives premium Profit from rising or remaining neutral Limited gain, potentially unlimited losses 39 Options vs. Futures Options Gives holders the right to do something Calls: right to buy the underlying assets Puts: right to sell the underlying assets There is a cost to acquire options (option premium) Futures Holders have obligation regarding their positions. Long futures: obligation to buy the assets at maturity Short futures: obligation to sell the assets at maturity Except brokerage fee and other transaction cost, it costs nothing to enter futures contracts. 4
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