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Introduction

Chapter 1

Learning Objectives

Understand the transactions of derivative markets

Understand categories of derivatives Understand purposes of using

derivatives

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What is a derivative?

A financial instrument whose value depends on (or derives from) the values of other, more basic, underlyingvariables

Example: A stock option is a derivative whose values is dependent on the price of a stock

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Properties of Derivative A derivative is a kind of contract

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Buyer Seller

Underlying stock commoditybond

derivatives

Initial date: Sign the contract

Expiration date: Deliver or quit the contract

Importance of Derivatives

The most popular financial instrument for risk management

The underlying variables contain tradable assets (stocks, currencies, commodities, electricity ) and non-tradable objects (credit, insurance payouts, the weather )

Application (Using real options) of Evaluating new capital investment

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Categories of Derivatives

Forward Chapter 4, 5 Futures Chapter 2, 3, 5, 6 Option Chapter 9, 10, 11 Swap Chapter 7

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Derivative Markets

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ExchangeTraded

Over TheCounter

Standardize quality and quantity

Mutually negotiation

Bid price

Offer price

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Exchanges Trading Futures

Chicago Board of Trade Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) others (see list at end of book)

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Exchanges Trading Options

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) others (see list at end of book)

The Lehman Bankruptcy (Business Snapshot 1.1, page 3)

Lehman Brothers (investment bank) was an active participant in the OTC derivatives markets

On September 15, 2008, Lehman Brothers filed for bankruptcy (The biggest bankruptcy in US history)

Reasons: High leverage, risky investments, and liquidity problems

It had huge transactions outstanding with about 8,000 counterparties

Liquidation is challenge10

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Size of OTC and Exchange-Traded Markets(June 1998 ~ June 2014)

Source: Bank for International Settlements Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

Size of Market ($ trillion)

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Ways Derivatives are Applied

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

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Foreign Exchange Quotes for GBP, May 24, 2010 (See page 5)

Bid Offer

Spot 1.4407 1.4411

1-month forward 1.4408 1.4413



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Example (page 5) On May 24, 2010 the treasurer of US

corporation knows that the corporation will pay 1 million on November 24, 2010

The treasurer 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

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What are the possible outcomes?

1.5 1.35

The possible spot exchange rate

Forward price = 1.4422

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Profit of the Example Spot exchange = 1.5 Sell 1 million in the market to have

revenue: $1,500,000 Profit: (1.5 1.4422)$1million = $57,800 Spot exchange = 1.35 Sell 1 million in the market to have

revenue: $1,350,000 Loss: (1.4422 1.35)$1million = $92,200

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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

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Terminology

Long position: The party that has agreed to buy

Short position: The party that has agreed to sell

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Profit from aLong Forward Position

Profit

Price of assetat contract maturity

K ST

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Profit from a Short Forward Position

Profit

STK Price of asset

at contract maturity

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Forward and Spot Prices (page 6) A stock is worth $60 and pays no dividend Interest Rate: 5% (borrow or lend) $60e0.05 = 63 (round off the number) The one-year forward price is $67: Borrow $60, buy a share the of stock, and

sell it forward for $67 Profit = $67 $60e0.05 = $4 The one-year forward price is $58: Sell a share of the stock for $60, and enter

the forward to buy it back for $58 in a year Profit = $60e0.05 $58 = $5

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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

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Examples of Futures Contracts

Agreement to: Buy 100 oz. of gold @ US$1080/oz. in

December (NYMEX) Sell 62,500 @ 1.3500 US$/ in

March (CME) Sell 1,000 bbl. of oil @ US$68/bbl. in

April (NYMEX)

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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)

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American vs European Options

An American option can be exercised at any time during its life

A European option can be exercised only at maturity

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Table 1.2, page 8Google call option prices, June 15, 2010; stock price: bid 497.07; offer 497.25 (Source: CBOE)

Strike price($)

July 2010 September2010December

2010Bid Offer Bid Offer Bid Offer

460 43.30 44.00 51.90 53.90 63.40 64.80 480 28.60 29.00 39.70 40.40 50.80 52.30 500 17.00 17.40 28.30 29.30 40.60 41.30 520 9.00 9.30 19.10 19.90 31.40 32.00 540 4.20 4.40 12.70 13.00 23.10 24.00 560 1.75 2.10 7.40 8.40 16.80 17.70

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Table 1.3, page 9Google put option prices, June 15, 2010; stock price: bid 497.07; offer 497.25 (Source: CBOE)

Strike price($)

July 2010 September2010December

2010Bid Offer Bid Offer Bid Offer

460 6.30 6.60 15.70 16.20 26.00 27.30 480 11.30 11.70 22.20 22.70 33.30 35.00 500 19.50 20.00 30.90 32.60 42.20 43.00 520 31.60 33.90 41.80 43.60 52.80 54.50 540 46.30 47.20 54.90 56.10 64.90 66.20 560 64.30 66.70 70.00 71.30 78.60 80.00

Example: Buying Call Option(Page 8, Refer to Table 1.2)

Underlying stock: Google Strike price: $520 Expiration date: December 18 Offer price: $32.0 Size of a contract: 100 shares Ignoring transaction costs, an investor

pays $3,200 for one call option contract with strike price $520

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Profit of the Call Option on December 18 (Expiration Date) In the stock market, the investor sell

shares with the bid price of the stock The stock price is below to $520 The investor doesnt exercise the option Lost $3,200 (The cost of the call) The stock price = $600 (above $520) The investor exercises the option Buy 100 shares at $520 and immediately

sell them at $600 for each share The profit

= 100($600 $520) $3,200 = $4,80029

Net profit of buying a call option contract on Google with strike price = $520

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Profit ($)

Stock price ($)

Example: Selling Put Option(Page 9, Refer to Table 1.3)

Underlying stock: Google Strike price: $480 Expiration date: September 18 Bid price: $22.2 Size of a contract: 100 shares Ignoring transaction costs, an investor

receives $2,220 for one put option contract with strike price $480

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Profit of the Put Option on September 18 (Expiration Date) In the stock market, the investor sell

shares with the offer price of the stock The stock price is above to $480 The investor doesnt exercise the option Lost $2,220 (The cost of the call) The stock price = $420 (below $480) The investor exercises the option Sell 100 shares at $480 and immediately

buy them at $420 for each share The profit

= 100($480 $420) $2,220 = $3,78032

Net profit of selling a put option contract on Google with strike price = $480

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Profit ($)

Stock price ($)

Participants of Options

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Buyer

Call Put

Seller

Short position

Long position

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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

Hedge Funds (Business Snapshot 1.2, page 11) Hedge funds concentrate on reduce

systematic risk of the market Regulation of mutual funds

Disclose investment policies Makes shares redeemable at any time Limit use of leverage Short positions are prohibited

Hedge funds apply many complex trading strategies involving derivatives

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Types of Hedge Funds Long/Short Equities: Purchase undervalued

securities and short overvalued ones Convertible Arbitrage: Long a convertible

bond and short the underlying equity Distressed Securities: Buy securities of

companies in deeply financial distress Emerging Markets: Invest in developing or

emerging countries Global macro: Anticipate global

macroeconomic trends to trade Merger Arbitrage: Trade as the

announcement of merger and profit as the merger realized

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Hedging Using Forward Contracts (1) On May 24, 2010, a US company will

pay 10 million for exports from Britain on August 24

Exchange rate quotes are shown in Table 1.1

Long a 3-month forward contract at 1.4415

The company fixes the payment of $14,415,000

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Hedging Using Forward Contracts (2) On May 24, 2010, a US company will

receive 30 million for imports from Britain on August 24

Exchange rate quotes are shown in Table 1.1

Short a 3-month forward contract at 1.4410

The company fixes the revenue of $43,230,000

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Comparison

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Spot exchange rate

Withhedge

Withouthedge

Company1 1.3 14,415,000 1,300,000 1.5 14,415,000 1,500,000

Company2 1.3 43,230,000 3,900,000 1.5 43,230,000 4,500,000

Hedging Using Options

In may of a particular year, an investor owns 1,000 Microsoft shares worth $28 per share

The investor wants to reduce price risk in two month

A July put with a strike price of $27.50 costs $1

Long 10 the July puts

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Value of Microsoft Shares with and without Hedging (Fig 1.4, page 12)

Profit with and without Hedging 10 option contracts cost: C = $1*10*100 = $1,000 Revenue from option: Rp = 1,000*Max($27.5 ST , 0) Revenue from selling shares of the stock:

Rs = 1,000*ST Profit with hedging: Ph = Rs + Rp C $28*1,000 Profit without hedging: Pw = Rs $28*1,000

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ST Rp Rs Ph Pw21.0 6,500 21,000 -1,500 -7,00022.0 5,500 22,000 -1,500 -6,00026.5 1,000 26,500 -1,500 -1,50027.5 0 27,500 -1,500 -50028.0 0 28,000 -1,000 029.0 0 29,000 0 1,00030.0 0 30,000 1,000 2,000

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Speculation Using Futures A speculator hopes US dollar to

depreciate in two months The futures margin = $5,000 for each

contract Strategy 1: Buy 250,000 in the spot

market and sell it later Strategy 2: Take a long position with

four futures contracts on sterling (Each futures contract for 62,500)

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Speculation Using spot and Futures contracts (Table 1.4, page13)

Spot price = 1.447; Futures price = 1.441 Two month later

Strategy 1 Strategy 2Investment $361,750 $20,000

Profitspot = 1.5 $13,250 $14,750spot = 1.4 -$11,750 -$10,250

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Speculation Using Options

An investor with $2,000 to invest feels that a stock price will increase over the next 2 months

The current stock price is $20 and the price of a 2-month call option with a strike of 22.50 is $1

What are the alternative strategies?

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Using $2,000 to Speculate on a Stock (Table 1.5, page14)

Strategy 1: Buy 100 shares of the stock Strategy 2: Buy 2,000 call options

Profit Strategy 1 Strategy 2

2 months later

spot = $15 -$500 -$2,000spot = $27 $700 $7,000

Profit from 2 strategies for speculating on a stock currently worth $20

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Arbitrage Example

A stock price is quoted as 100 in London and $200 in New York

The current exchange rate is $1.43 What is the arbitrage opportunity? Buy 100 shares of the stock in New

York and sell them in London Profit = 100[$1.43(100) $140]

= 300

Dangers

Traders can switch from being hedgers or arbitrageurs to speculators

It is important to regulate to ensure that trades are using derivatives in for their intended purpose

Socit Gnrale lost huge money in 2008 (Business Snapshot 1.3)

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SocGens big loss in 2008 Socit Gnrale (SocGen): A French

multinational bank Kerviel is an arbitrage trader of Delta One

products team in SocGen Arbitrage opportunity: Futures contracts on an equity index traded in

different exchanges Price difference between equity index futures

and the shares constituting the index Kerviel took big positions in equity indices and

fake trades as if he had hedged In January 2008, the unauthorized trading was

reveled by SocGen Finally, SocGen lost 4.9 billion euros

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Homework

A company will receive 1 million yens 3 months later

What hedging strategy does the company use?

Link to the questionnaire page of the e-learning website and write down your answer before 0:00 am, March 9

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Selected Questions

1.6, 1.7, 1.9, 1.10, 1.15, 1.30, and 1.32 These questions are provided for

practicing by yourselves but not the parts of homework

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