Introduction

Allan Wright Department of Economics Sept. 2011

Introduction

A derivative is an instrument whose value

depends on the values of other more basic underlying variables/assets.
Common examples of underlying assets are stocks, bonds, corn, pork, wheat, etc.

 Examples of derivatives

Futures Contracts Forward Contracts Swaps Options Interest rate

caps and floors futures contracts

Commodity linked bonds Mortgage backed securities

 Basic Purpose of derivatives:

The main purpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance.
Derivatives improve overall performance of the economy

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 - leverage To change the nature of an investment without incurring the costs of selling one portfolio and buying another - liquidity

 Futures contracts: is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time). Exchanges Trading Futures. CBOT and CME (now CME Group) Intercontinental Exchange NYSE Euronext Eurex BM&FBovespa (Sao Paulo, Brazil)

 Futures Price.
The futures prices for a particular contract is the price at which you agree to buy or sell.
The party that has agreed to buy has a long position The party that has agreed to sell has a short position It is determined by supply and demand in the same way as a spot price.

Examples.
Agreement to: buy 100 oz. of gold @ US$1500/oz. in December 2011 sell 62,500 @ 1.5500 US$/ in March 2012 sell 1,000 bbl. of oil @ US$105/bbl. in April, 2012

 Futures Price.
Example
January: an investor enters into a long futures contract to buy 100 oz of gold @ $1500 in April April: the price of gold $1565 per oz

What is the investors profit?

 History of Futures and OTC Market

Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers The over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers

Size of OTC and Exchange Markets

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

 Forward Contracts
Are similar to futures except that they trade in the over-the-counter market
Forward contracts are popular on currencies and interest rates

Spot and Forward Quotes for USD/GBP exchange rate

Bid Spot 1-month forward 3-month forward 1.6382 1.6380 1.6378 Offer 1.6386 1.6385 1.6384

6-month forward

1.6376

1.6383

Forward Contracts vs Futures Contracts

Forward Private contract between two parties Futures Traded on an exchange

Not standardized
Usually one specified delivery date Settled at end of contract Delivery or final settlement usual Some credit risk

Standardized
Range of delivery dates Settled daily Usually closed out prior to maturity Virtually no credit risk

 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)
The price in the contract is known as the exercise price or strike price The date of the contract is known as the expiration or the maturity date. Selling an option is known as writing the option.

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

 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.
It cost nothing, except margin requirements to enter into a futures contract. By contrast, an investor must pay an up-front price known as the option premium for an options contract.

 Exchanges Trading Options

Chicago Board Options Exchange International Securities Exchange NYSE Euronext Eurex (Europe)

Google Option Prices (July 17, 2009; Stock Price=430.25)

Calls Sept 2009 54.60 38.30 24.80 14.45 7.45 3.40 Puts Sept 2009 4.40 8.30 14.70 24.25 37.20 53.10

Strike price ($) 380 400 420 440 460 480

Aug 2009 51.55 34.10 19.60 9.25 3.55 1.12

Dec 2009 65.00 51.25 39.05 28.75 20.40 13.75

Aug 2009 1.52 4.05 9.55 19.20 33.50 51.10

Dec 2009 15.00 21.15 28.70 38.35 49.90 63.40

 Price of a call option decreases as the strike price increases Price of a put option increases as the strike price increases. Both types of options tend to become more valuable as their time to maturity increases.
Example (call option)
Investor wants to buy one December call option on Google with a strike price of $440. The table indicates that the price is $28.75. That is the price for an option to buy one share. If the option contract is a contract to buy or sell 100 shares, the investor will arrange for $2,875 to be remitted to the broker. The party on the other side of the transaction has received $2875 and has agreed to sell 100 Google shares for $440 per share if the investor chooses to exercise the option. If the price of Google does not rise above $440 before December, the option is not exercised and the investor loses $2875, but if the share does well and the option is exercised when at $500, the investor is able to buy 100 shares at $440 = $44,000 when they are worth $50,000, this leads to a gain of $6,000 or $3,125 when the initial cost of the option is accounted for.

 Example (put option)

Investor wants to buy one December put option on Google with a strike price of $400, for 100 shares this would cost $2,115 ($21.15*100). The investor would obtain the right to sell 100 Google shares for $400 prior to December. If the share stays above $400, the option is not exercised and the investor loses $2,115, but if the stock price is $350, the investor gains $2,885 ( buys 100 shares @$350 and sells them @$400) after the cost of the options is taken.

 Types of traders.
Futures, forward and option markets have been outstandingly successful. The main reason is that they have many different types of traders and have a great deal of liquidity. When an investor wants to take one side of a contract, there is usually no problem finding someone that is prepared to take the other side. Three broad categories of traders.
Hedgers:
Uses futures, forwards and options to reduce market risk from potential future movements

Speculators:
Use the same instruments to bet on the future direction of a market variable.

Arbitrageurs:
Take offsetting positions in two or more instruments to lock in a profit.

 Three Reasons for Trading Derivatives: Hedging, Speculation, and Arbitrage.

Hedge funds trade derivatives for all three reasons
When a trader has a mandate to use derivatives for hedging or arbitrage, but then switches to speculation, large losses can result.

Hedging Using Forward Contracts

Forward contracts are designed to neutralize risk by fixing the price that the hedger will pay or receive for the underlying asset
A US company will pay 10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract, if the three month forward market is 1.6384, this fixed the price paid to the British exporter is $16,384,000. Similarly the same US company is exporting goods to the UK and in July knows that it will receive 30M three months later. The US company can hedge its foreign exchange risk by selling the 30M in the three month forward market at 1.6378. This locked in the realized sales at $49,134,000.

 Hedging using Options

Option contracts provide insurance to the hedger, they offer a way for investors to protect themselves against adverse price movements in the future while still allowing them to benefit from favourable price movements.
Payment of an upfront fee.

An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts .
The strategy costs $1000 guarantees that the shares can be sold for at least $27.50 per share during the life of the option. If the share falls below $27.50 the option can be exercised so that $27,500 is realized from the entire holding. When the cost of the options is taken into account, the amount realized is $26,500. If the market price stays above $27.50 the options are not exercised and expire worthless, however the value of the holding is always above $27,500 ( or above $26,500 when the cost of the options is taken into account)

Value of Microsoft Shares with and without Hedging

 Speculation using Futures.

A Speculator thinks that the British pound will strengthen relative to the US dollar over the next two months.
The speculator can purchase 250,000 in the spot market in the hope that the sterling can be sold later at a higher price, above a current spot price of 1.8470 Or take a long position in April futures contracts on sterling with a futures price of 1.8410
Assuming an initial margin of $20,000

Speculation using spot and futures contracts

Buy 250,000 Spot Price 1.8470 Investment $461,750 (250,000*1.8470) (1.90-1.8470)*250,000 =13,250 Buy Futures contracts Futures price 1.8410 $20,000

Profit/(Loss) if 2 month spot rate 1.90

(1.90-1.8410)*250,000 = 14,750

Profit/(Loss) if 2 month spot rate 1.80

(1.80-1.8470)*250,000 = (11,750)

(1.80-1.8410)*250,000= (10,250)

 Differences in alternatives.
First alternative requires an up front investment of $461,750 by contrast other alternative requires only a small amount of cash - $20,000 to be deposited to margin account. Futures market allows the speculator to obtain leverage, with a small initial outlay the investor is able to take a large speculative position.

 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 2month call option with a strike of $22.50 is $1.
One alternative is to purchase of 100 shares Another involves purchasing 2000 call options.

If the share price rises to $27 or fall to $15, the payoff is as follows:

Speculation using options

1st alternative 100 shares* ($27-$20) =$700 100 shares*($15-$20) = ($500)

Call option at share price of $27

2000 options*22.50 strike price =$45,000 2000 options*27.00 selling price =$54,000 Profit (less $2000 for call option) = $7,000

Call option at share price of $15

Call option would not be exercised leading to a loss of $2000

 Futures and options are similar instruments for speculators in that they both provide a way in which a type of leverage can be obtained.
However with futures, speculators potential loss as well as the potential gain is very large, with options the speculators loss is limited to the amount for the options.

 Arbitrage
Involves locking in a riskless profit by simultaneously entering into transactions in tow or more markets. Opportunities for arbitrage usually cannot last long, as the two prices will become equivalent at the current exchange rate.
No arbitrage occurs when the forward price is equal to the replicating portfolio price.

Example
A stock price is quoted as 100 in London and $162 in New York The current exchange rate is 1.6500 A trader does the following:
Buys 100 shares in NYC Sell the shares in London Converts the sale proceeds from pounds to dollars 100*[($1.65*100)-$162] = $300

 Further examples
The spot price of gold is US$1000,the quoted 1-year futures price of gold is US$1100,the 1-year US$ interest rate is 5% per annum and no income or storage costs for gold

F = S (1+r )T
Is there an arbitrage opportunity?

Using the cash and carry method

The trader will buy gold at the spot rate, financed by borrowing at 5% Sell the gold through the forward contract ($1100-[($1000*1.05)]=$50

The spot exchange rate between sterling and the US dollar is $1.7425/. The six-month interest rate is sterling is 3.75 per cent per annum and that in US dollars is 2.5 per cent per annum. The six-month forward foreign exchange rate is $1.7385. An arbitrageur can create an opportunity
The replicating transaction involves [1] borrowing US$1.7425 million for six months (giving $1 764 146.79 to be repaid at maturity, [2] exchanging these dollars into sterling at the spot rate = 1 million, investing this at the sterling interest rate to give 1 018 577.44. [3] Exchanging this into US dollars gives $1 770 796.88, giving a net profit of $6650.

 Examples
The spot price of oil is US$70 the quoted 1-year futures price of oil is US$80, the 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum
Is there an arbitrage opportunity? ($80-[($70*1.07)]=$5.1

The spot price of gold is US$1000, the quoted 1-year futures price of gold is US$990, the 1-year US$ interest rate is 5% per annum No income or storage costs for gold
Is there an arbitrage opportunity? Using the reverse cash and carry method
The trader will borrow gold for a year and sell it, investing the proceeds at 5% Agree to buy gold in the forward market