FNCE4040 Derivatives Chapter 1 Introduction The Landscape Forwards and Option Contracts
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
Why Derivatives Are Important Key role in transferring risks in the economy Underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, weather, etc. Many financial transactions have embedded derivatives The real options approach to assessing capital investment decisions has become widely accepted
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
Size of OTC & Exchange-Traded Markets Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
Growth of OTC Market by Product
How Derivatives are Used To hedge risks e.g. you are a producer of oil or a consumer of soy beans, or are paid in a different currency 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
Derivatives can be Risky AIG had been an active participant in writing default protection on multi-sector CDOs Essentially made a one way bet on the US housing market AIG essentially ran out of cash to make collateral calls on their sold derivatives. At its peak the US government committed $182.3b to support AIG It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions Mr. Cassano was wrong by 11 or 12 orders of magnitude, which may be about as wrong as it s possible to be in human affairs. There s safety in small numbers FT.com
Forwards and Futures
Foreign Exchange GBP vs USD http://www.xe.com/currencycharts/?from=gb P&to=USD&view=5Y Quotes for Jan 9, 2015 USD/GBP USD per GBP Bid Offer Spot 1.5182 1.5186 1-month forward 1.5144 1.5149 3-month forward 1.5073 1.5081 6-month forward 1.4970 1.4984
Forward Price DEFINITION: the delivery price that would be applicable to the contract if negotiated today (i.e. the delivery price that would make the contract worth exactly zero today) The forward price may (and will likely) be different for contracts of different maturities
Some Terminology (more to come) The party that has agreed to buy has a long position The party that has agreed to sell has a short position Selling a derivative is sometimes referred to writing a derivative (forwards, options, etc.) The contract delivery date is sometimes referred to expiration date, or maturity date
Forward Example On Jan 9, 2015 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months. Which exchange rate does she use? 1.4984 USD/GBP USD per GBP Bid Offer Spot 1.5182 1.5186 This contract obligates the corporation to pay $1,498,400 1-month forward 1 million 1.5144 on the 1.5149 maturity date (July 9, 2015) What are the possible outcomes? 3-month forward 1.5073 1.5081 6-month forward 1.4970 1.4984
Profit from a Long Forward K = 1.4984. The delivery price or forward price at time contract is entered into Profit K Price of Underlying at Maturity, S T
Profit from a Short Forward K = 1.4984. The delivery price or forward price at time contract is entered into Profit K Price of Underlying at Maturity, S T
Futures Contracts Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract, but there are differences: A forward contract is traded OTC, a futures contract is traded on an exchange A futures contract requires daily settlement of the value of the contract, a forward contract has a cash flow only a maturity WARNING This is what the book says but it is not strictly true. To be discussed later in the course.
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 (see list at end of book)
Examples of Futures Contracts You think gold will appreciate during the year Buy 100 oz of gold for December Delivery http://www.cmegroup.com/trading/metals/preciou s/gold.html You are a soybean buyer looking to lock your input costs: Buy 1mm bushels of soybean for November Delivery http://www.cmegroup.com/trading/agricultural/gra in-and-oilseed/soybean.html
Options
Option Types 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)
Futures/Forwards vs. Options A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option contract gives the holder the right to buy or sell at a certain price
Payout of a Long Call Option K = strike price of option Profit K Price of Underlying at Maturity, S T
Payout of a Long Put Option K = strike price of option Profit K Price of Underlying at Maturity, S T
Options Style An American option can be exercised at any time during its life A European option can be exercised only at maturity A Bermudan option can be exercised only at fixed times before maturity (e.g. monthly)
Google Option Prices (source: Bbg)
Types of Traders Hedgers use derivatives to mitigate the risk they are already exposed to, coming from their business or assets/liabilities Speculators use derivatives to express a view often with leverage on a financial sector/asset Arbitrageurs use derivatives to lock in a specific payout for a risk-free profit
Hedging Examples An investor owns 1,000 Microsoft shares. She is worried about the price falling over the next two months. She is willing to spend approximately $1/share and can buy put options: http://www.nasdaq.com/symbol/msft/optionchain?dateindex=2 Identify some strategies she can follow
Hedging Microsoft shares Value of portfolio assuming put with strike 45, purchased for $1.
Speculation Example You have $2,000 to invest You believe that a stock price will increase over the next 2 months The current stock price is $20 The price of a 2-month call option with a strike of 22.50 is $1 What are the alternative strategies?
Arbitrage Example A stock price is quoted both in London and in New York. The prices are: 100 in London $155 in New York The current exchange rate is 1.6100 (ask your self what are the units of that figure) Is there an arbitrage opportunity? If so what is it?
Dangers Traders can switch from being hedgers to speculators or from being arbitrageurs to speculators It is important to set up controls to ensure that trades are using derivatives in for their intended purpose Many trading operations have enforced vacation time for key personnel so that more than one person has to understand the positions in a trading book. Many derivatives blow-ups have occurred when there was not a clear differentiation between the profit-center and control function.
Mutual Funds vs Hedge Funds Mutual Funds must disclose investment policies, makes shares redeemable at any time limit use of leverage take no short positions. Hedge Funds Are not subject to the same rules as mutual funds Cannot offer their securities publicly Use complex trading strategies are big users of derivatives for hedging, speculation and arbitrage