Demystifying (Understanding) Derivatives Chapter 9 Demystifying (Understanding) Derivatives

Derivatives – underlying asset Futures, Options and Swaps KEY WORDS AND CONCEPTS Derivatives – underlying asset Futures, Options and Swaps Contract (Agreement between 2 parties Commodity – product such as oil, gas, gold or simply a product Volatility – up and down Hedging, Hedgers - protection Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Right (don’t have to buy or sell) and Obligation (must buy or sell) KEY WORDS AND CONCEPTS OPTIONS Puts and Calls Right (don’t have to buy or sell) and Obligation (must buy or sell) OPTION PREMIUM (FEE) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Futures, options, and swaps are complicated derivative instruments Introduction Futures, options, and swaps are complicated derivative instruments However, they are risk management financial instruments (tools)of just about every major financial institution Derivatives—A financial instrument/contract that derives or gets its value from some other asset Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Financial Futures Futures Contract is a contractual agreement that calls for delivery of a specific commodity or security at some future date at a currently agreed-upon price There are contracts on interest-bearing securities (Treasury bonds, notes, etc), on stocks, commodities and on foreign currencies. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Futures: An Example The Future of Healthy Hen Farms and it’s owner Gail. A Futures Contract Gail, the owner of Healthy Hen Farms, is worried about the volatility 波动 (Bōdòng) of the chicken market. With all the reports of bird flu coming that is in the news. Gail wants a way to protect (hedge) her business against another report of bad news. Gail meets with an investor who enters into a futures contract with her.

Futures Example – Gail & Happy Hen Farms Healthy Hen Farms Owner Gail Investor Joe Investor Joe agrees to pay $30 per bird when the birds are ready for slaughter in six months' time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as Joe will be able to buy the birds for less than market cost and sell them on the market at a higher price for a gain. If the price goes below $30, then Gail will get the benefit because she will be able to sell her birds for more than the current market price, or more than what she would get for the birds in the open market.

Futures Example – Gail & Happy Hens Farms By entering into a futures contract, Gail is protected from price changes in the market, as she has a price of $30 per bird. She may lose out if the price goes up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak. By hedging (insurance or protection) with a futures contract, Gail is able to focus on her business and limit her worry about price changes.

An Overview of Financial Futures (Cont.) Characteristics of Financial Futures An agreement to buy/sell a particular asset or commodity at a future date and a current agreed-upon price Promotes, encourages liquidity—the ability to buy and sell quickly with low transactions costs Allows many individuals to trade the same commodity Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Financial Futures (Cont.) Characteristics of Financial Futures Terms specify the amount and type of asset as well as the location and delivery period Financial futures—underlying asset is either a specific security or cash value of a group of securities. In our example it was a commodity – chickens. In futures markets, the buyer of the contract is called LONG and the seller is called SHORT. Gail has a short position in our example. She is wanting the price to go down. Buyer = Long Seller = Short Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Financial Futures (Cont.) Using Financial Futures Contracts Provides the opportunity to hedge (to protect, like insurance) commercial activities Hedgers—People who buy and sell futures contracts to reduce their exposure to the risk of future price movement Permits dealers to cover both the short and long position of a contract (whether price goes up or down) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Options Contracts An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with defined terms and properties. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Options – An Example 1.You want to buy a house for 1 million rmb 2. You won’t have the money for 3 months. 3. You talk with the owner and make a deal to have an option to buy the house for 1 million rmb in 3 months, but it costs you 18,000 rmb to buy the option contract. You have the right to buy but not the obligation – you don’t have to buy it. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Options – An Example Two scenarios 脚本 (Jiǎoběn) or situations: 1. You find out the house is very valuable and worth 5 million rmb. Because the owner sold you the option, you have the right to buy the house cause you paid 18,000 rmb for the right to buy it. In this case, you could then sell the house and make 4 million rmb! Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Options – An Example Two scenarios 脚本 (Jiǎoběn) or situations: On looking over the house you see that it has all kinds of problems and rats and bugs have nests in the house. You thought this was going to be your “dream” house but now you don’t want it. You paid 18,000 rmb for the right to buy the house but not the obligation. In this case, you lose the 18,000 rmb because you made an options contract. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Options – An Example Sumarized For this reason, options are called derivatives, which means an option derives (gets) 衍生出来 (Yǎnshēng chūlái) its value from something else. In our example, the house is the underlying asset. In the financial world, the underlying asset is a security, a stock or bond. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) Calls Buyer of a call option has the right (not obligation) to buy a given quantity of the underlying asset at a predetermined price (exercise or strike) at any time prior to the expiration date Once order is executed, the buyer is long in the asset Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) Calls (Cont.) Seller of the call option (short) has the obligation to deliver the asset at the agreed price Therefore, rights and obligations of option buyers and sellers are not symmetrical, not the same Buyer of the call option pays a price to the seller for the rights acquired (option premium) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) Puts Buyer of a put option has the right (not obligation) to sell a given quantity of the underlying asset at a predetermined price before the expiration date Seller of the option (short) has the obligation to buy the asset at the agreed price The buyer of the put option pays an option premium (fee) to the seller Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) Summary of calls and puts Option buyers have rights; option sellers have obligations Call buyers have the right to buy the underlying asset Put buyers have the right to sell the asset In both puts and calls the option buyer pays a premium to the option seller Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Swaps Relatively new having been invented in 1981 to help firms reduce interest rate risks Two broad varieties—Interest rate swaps and currency swaps Swaps are contractual agreement between two parties (counterparties) and customized to meet the requirements of both parties Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Swaps (Cont.) Interest rate swap (Refer to Figure 9.1) One party (fixed-rate payer) agrees to pay the other party a fixed interest amount each specified period over the life of the contract The other party (floating or adjustible-rate payer) agrees to pay the first party, each specified period, an interest amount based on some reference rate Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Figure 9.1 Obligations of payments every six months for the duration of the swap Basically, swaps are an agreement between 2 parties to exchange, swap interest rates on their securities (stocks and bonds) or with their loan. Usually from fixed rate to a variable rate and vice versa. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Swaps (Cont.) Interest rate swap (Cont.) Therefore, the fixed-rate payer always pays the same amount while payments by the floating (adjustible)-rate payer varies according to the referenced rate The dollar amount of the payments is determined by multiplying the interest rate by an agreed-upon principal (notional principal amount) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Swaps (Cont.) What determines the rates paid by both parties Shape of the yield curve—expected rates in the future Risk of default—possibility that one of the two parties might not make their scheduled interest payments Financial institutions facilitate swaps Bring the counterparties together Impose their own credit between the two parties Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

An Overview of Swaps (Cont.) Why Swap? Financial institution earns a fee for arranging the swap The two parties reduce their risk exposure Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Chapter 9 Summary Financial Futures contracts are used by financial institutions to reduce risk of price changes. Long hedgers reduce risk by buying futures contracts, short hedgers by selling futures contracts. Options are divided into puts and calls. Buyers of puts have right to sell at a fixed price while buyers of calls have the right to buy at a fixed price. The buyers have the rights to do what they want since they are paying a premium Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Chapter 9 Summary (cont) 3. Financial Institutions can use options to hedge (protect) their risks 4. The prices of all options are their premiums (costs). 5. Interest rate swaps are agreements between 2 parties to exchange interest rates over a certain period of time. Swaps are also used to reduce risk. 6. Derivatives are financial instruments that derive their value from some other underlying asset. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.