INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT Instructor: Dr. Kumail Rizvi 1
DERIVATIVE MARKETS AND INSTRUMENTS 2
WHAT IS A DERIVATIVE? A derivative is an instrument whose value depends on, or is derived from, the value of another asset. Examples: futures, forwards, swaps, options, exotics 3
WHY DERIVATIVES ARE IMPORTANT Derivatives play a key role in transferring risks in the economy The underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etc Many financial transactions have embedded derivatives The real options approach to assessing capital investment decisions has become widely accepted 4
HOW DERIVATIVES ARE TRADED On exchanges such as the Chicago Board Options Exchange In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly 5
MAJOR PLAYERS IN DERIVATIVES MARKET 6
DERIVATIVE DEALERS 7
CLEARINGHOUSE 8
EXPOSURE WITHOUT CLEARINGHOUSE 9
EXPOSURE WITH CLEARINGHOUSE 10
EXCHANGES 11
MECHANISM TO REDUCE COUNTERPARTY RISK 12
EXCHANGES AND CLEARINGHOUSE 13
SIZE OF OTC AND EXCHANGE-TRADED MARKETS (FIGURE 1.1, PAGE 3) 14 Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
THE LEHMAN BANKRUPTCY (BUSINESS SNAPSHOT 1.10) Lehman s filed for bankruptcy on September 15, 2008. This was the biggest bankruptcy in US history Lehman was an active participant in the OTC derivatives markets and got into financial difficulties because it took high risks and found it was unable to roll over its short term funding It had hundreds of thousands of transactions outstanding with about 8,000 counterparties Unwinding these transactions has been challenging for both the Lehman liquidators and their counterparties 15
HOW DERIVATIVES ARE USED To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another 16
TYPES OF DERIVATIVE INSTRUMENTS 17
FORWARD PAYOFF 18
PAYOFF 19
FORWARD PRICE The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities (as shown by the table) 20
TERMINOLOGY The party that has agreed to buy has what is termed a long position The party that has agreed to sell has what is termed a short position 21
EXAMPLE 22
HEDGING WITH FORWARDS 23
FOREIGN EXCHANGE (USD)QUOTES FOR GBP, MAY 24, 2010 Bid Ask Spot 1.4407 1.4411 24 1-month forward 1.4408 1.4413 3-month forward 1.4410 1.4415 6-month forward 1.4416 1.4422
EXAMPLE On May 24, 2010 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months at an exchange rate of 1.4422 This obligates the corporation to pay $1,442,200 for 1 million on November 24, 2010 What are the possible outcomes? 25
PROFIT FROM A LONG FORWARD POSITION (K= DELIVERY PRICE=FORWARD PRICE AT TIME CONTRACT IS ENTERED INTO) Profit K Price of Underlying at Maturity, S T 26
PROFIT FROM A SHORT FORWARD POSITION (K= DELIVERY PRICE=FORWARD PRICE AT TIME CONTRACT IS ENTERED INTO) Profit K Price of Underlying at Maturity, S T 27
FUTURES CONTRACTS (PAGE 7) Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange 28
EXCHANGES TRADING FUTURES CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade) NYSE Euronext BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more 29
FUTURES CONTRACTS Available on a wide range of assets Exchange traded Specifications need to be defined: What can be delivered, Where it can be delivered, & When it can be delivered Settled daily 30
FORWARD VS. FUTURES 31
SPECIFICATIONS OF FUTURES CONTRACT 32
EXAMPLES OF FUTURES CONTRACTS Agreement to: Buy 100 oz. of gold @ US$1400/oz. in December Sell 62,500 @ 1.4500 US$/ in March Sell 1,000 bbl. of oil @ US$90/bbl. in April 33
OIL FUTURES 34
CORN FUTURES 35
STOCK FUTURES 36
OTHER TYPES OF FUTURES 37
MINI STOCK FUTURES CONTRACTS 38
MARGIN REQUIREMENT 39
EXAMPLE OF A FUTURES TRADE (PAGE 27-29) An investor takes a long position in 2 December gold futures contracts on June 5 contract size is 100 oz. futures price is US$1250 initial margin requirement is US$6,000/contract (US$12,000 in total) maintenance margin is US$4,500/contract (US$9,000 in total) 40
A POSSIBLE OUTCOME (TABLE 2.1, PAGE 28) Da y Trade Price ($) Settle Price ($) Daily Gain ($) Cumul. Gain ($) Margin Balance ($) 1 1,250.00 12,000 1 1,241.00 1,800 1,800 10,200 2 1,238.30 540 2,340 9,660........ 6 1,236.20 780 2,760 9,240 Margin Call ($) 7 1,229.90 1,260 4,020 7,980 4,020 8 1,230.80 180 3,840 12,180........ 16 1,226.90 780 4,620 15,180 41
ANOTHER EXAMPLE 42
MARGIN CASH FLOWS WHEN FUTURES PRICE INCREASES Clearing House 43 Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader
MARGIN CASH FLOWS WHEN FUTURES PRICE DECREASES Clearing House 44 Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader
SOME TERMINOLOGY Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of trades in one day 45
CRUDE OIL TRADING ON MAY 26, 2010 46 Open High Low Settle Change Volume Open Int Jul 2010 70.06 71.70 69.21 71.51 2.76 6,315 388,902 Aug 2010 71.25 72.77 70.42 72.54 2.44 3,746 115,305 Dec 2010 74.00 75.34 73.17 75.23 2.19 5,055 196,033 Dec 2011 77.01 78.59 76.51 78.53 2.00 4,175 100,674 Dec 2012 78.50 80.21 78.50 80.18 1.86 1,258 70,126
REGULATION OF FUTURES In the US, the regulation of futures markets is primarily the responsibility of the Commodity Futures and Trading Commission (CFTC) Regulators try to protect the public interest and prevent questionable trading practices 47
DELIVERY 48
ORDERS 49
ORDERS (CONT.) 50
51 OPTIONS
OPTIONS A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price) 52
TYPES OF OPTION 53
OPTIONS VS FUTURES/FORWARDS A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price 54
OPTION PAYOFF 55
CALL OPTION PAYOFF TO LONG 56
PROFIT TO LONG CALL BUYER 57
OPTION POSITIONS Long call Long put Short call Short put 58
LONG CALL Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months 30 Profit ($) 20 10 0-5 70 80 90 100 110 120 130 Terminal stock price ($) 59
SHORT CALL Profit from writing one European call option: option price = $5, strike price = $100 Profit ($) 5 0-10 -20-30 70 80 90 100 110 120 130 Terminal stock price ($) 60
LONG PUT Profit from buying a European put option: option price = $7, strike price = $70 30 Profit ($) 20 10 0-7 40 50 60 70 80 90 100 Terminal stock price ($) 61
SHORT PUT Profit from writing a European put option: option price = $7, strike price = $70 7 0 Profit ($) 40 50 60 70 80 90 100 Terminal stock price ($) -10-20 -30 62
PAYOFFS FROM OPTIONS WHAT IS THE OPTION POSITION IN EACH CASE? K = Strike price, S T = Price of asset at maturity Payoff Payoff K S T K S T Payof f Payoff K S T K S T 63
ASSETS UNDERLYING EXCHANGE-TRADED OPTIONS Stocks Foreign Currency Stock Indices Futures 64
SPECIFICATION OF EXCHANGE-TRADED OPTIONS Expiration date Strike price European or American Call or Put (option class) 65
TERMINOLOGY Moneyness : At-the-money option In-the-money option Out-of-the-money option 66
EXAMPLE 67
SOLUTION 68
HEDGING WITH A PUT OPTION 69
SOLUTION 70
SPECULATING WITH OPTIONS 71
SOLUTION 72
NOTATION c: European call option price p: European put option price S 0 : Stock price today K: Strike price T: Life of option s: Volatility of stock price C: American call option price P: American put option price S T : Stock price at option maturity D: PV of dividends paid during life of option r Risk-free rate for maturity T with cont. comp. 73
FACTORS INFLUENCING OPTION VALUE 74
EFFECT OF VARIABLES ON OPTION PRICING Variable c p C P 75 S 0 + + K + + T?? + + s + + + + r + + D + +
76
AMERICAN VS EUROPEAN OPTIONS An American option is worth at least as much as the corresponding European option C c P p 77
UPPER BOUNDS 78
DERIVATION OF LOWER BOUNDS 79
DERIVATION OF LOWER BOUNDS 80
SUMMARY 81
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83
PUT CALL PARITY 84
CONTINUOUS TIME FORMAT 85
86
87
CALL AND SYNTHETIC CALL 88
PUT AND SYNTHETIC PUT 89
ARBITRAGE OPPORTUNITY Call Price = $7.50 Put Price = $4.25 Exercise Price on Underlying = $100 Current Price of Underlying = $99 Risk Free Rate = 10 percent Time to Expiration = Half a Year or 6 months Requirements Construct Fiduciary Call and Protective Put Check Whether the Put Call Parity Exists or not Suggest the Appropriate Arbitrage Strategy Calculate and Prove the amount of Arbitrage Profit 90