1 Introduction Chapter 1

2 Chapter Outline 1.1 Exchange-traded markets 1.2 Over-the-counter markets 1.3 Forward contracts 1.4 Futures contracts 1.5 Options 1.6 Types of traders 1.7 Other derivatives

3 The Nature of Derivatives A derivative is an instrument whose value depends on (derives from) the values of other more basic underlying variables

4 Examples of Derivatives Forward Contracts Futures Contracts Swaps Options

5 Ways 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

6 1.1 Exchange-traded markets Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading Contracts are standard there is virtually no credit risk

7 1.2 Over-the-counter markets A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard and there is some small amount of credit risk

8 1.3 Forward Contracts A forward contract specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. –Its not an option: both parties are expected to hold up their end of the deal. –If you have ever ordered a textbook that was not in stock, you have entered into a forward contract. It can be contrasted with a spot contract which is an agreement to buy or sell immediately Forwards are traded in the OTC market

9 Foreign Exchange Rates Thursday, November 1, 2001 Clearly the market participants expect that the yen will be worth MORE in dollars in six months.

10 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

11 Clearly the market participants expect that the GBP will be worth less in dollars in six months. Foreign Exchange Rates Thursday, November 1, 2001

12 Terminology: The Long and the Short of it IF YOU BENEFIT FROM A RISE IN THE PRICE OF THE UNDERLYING COMMODITY, YOU ARE LONG. IF YOU BENEFIT FROM A FALL IN THE PRICE OF THE UNDERLYING COMMODITY, YOU ARE SHORT.

13 Terminology: The Long and the Short of it The party that has agreed to buy (IN THE FUTURE) has what is termed a long position The party that has agreed to sell has what is termed a short position

14 Example (page 3) On August 16, 2002 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of This obligates the corporation to pay $1,435,900 for £1 million on February 16, 2003 What are the possible outcomes?

15 Profit from a Long Forward Position Profit Price of Underlying at Maturity, S T K

16 Profit from a Short Forward Position Profit Price of Underlying at Maturity, S T K

17 Futures Contracts: Preliminaries A futures contract is like a forward contract: –It specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward: –Futures are standardized contracts trading on organized exchanges with daily resettlement (“marking to market”) through a clearinghouse.

18 Futures Contracts: Preliminaries Standardizing Features: –Contract Size –Delivery Month Daily resettlement –Minimizes the chance of default Initial Margin –About 4% of contract value, cash or T-bills held in a street name at your brokerage.

19 Selected Futures Contracts

20 Futures Markets The Chicago Mercantile Exchange (CME) is by far the largest. Others include: –The Philadelphia Board of Trade (PBOT) –The MidAmerica Commodities Exchange –The Tokyo International Financial Futures Exchange –The London International Financial Futures Exchange

Options Contracts: Preliminaries An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset on (or perhaps before) a given date, at prices agreed upon today. Calls versus Puts –Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. When exercising a call option, you “call in” the asset. –Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at prices agreed upon today. When exercising a put, you “put” the asset to someone.

22 Options Contracts: Preliminaries Exercising the Option –The act of buying or selling the underlying asset through the option contract. Strike Price or Exercise Price –Refers to the fixed price in the option contract at which the holder can buy or sell the underlying asset. Expiry –The maturity date of the option is referred to as the expiration date, or the expiry. European versus American options –European options can be exercised only at expiry. –American options can be exercised at any time up to expiry.

23 Options Contracts: Preliminaries In-the-Money –The exercise price is less than the spot price of the underlying asset. At-the-Money –The exercise price is equal to the spot price of the underlying asset. Out-of-the-Money –The exercise price is more than the spot price of the underlying asset.

24 Options Contracts: Preliminaries Intrinsic Value –The difference between the exercise price of the option and the spot price of the underlying asset. Speculative Value –The difference between the option premium and the intrinsic value of the option. Option Premium = Intrinsic Value Speculative Value +

25 Call Options Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset on or before some time in the future, at prices agreed upon today. When exercising a call option, you “call in” the asset.

26 Basic Call Option Pricing Relationships at Expiry At expiry, an American call option is worth the same as a European option with the same characteristics. If the call is in-the-money, it is worth S T - E. If the call is out-of-the-money, it is worthless. C T = Max[S T - E, 0] Where S T is the value of the stock at expiry (time T) E is the exercise price. C T is the value of the call at expiry

27 Call Option Payoffs Stock price ($) Option payoffs ($) Buy a call Exercise price = $50

28 Call Option Payoffs Stock price ($) Option payoffs ($) Write a call Exercise price = $50

29 Call Option Profits Stock price ($) Option profits ($) Write a call Buy a call Exercise price = $50; option premium = $10

30 Put Options Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset on or before some time in the future, at prices agreed upon today. When exercising a put, you “put” the asset to someone.

31 Basic Put Option Pricing Relationships at Expiry At expiry, an American put option is worth the same as a European option with the same characteristics. If the put is in-the-money, it is worth E - S T. If the put is out-of-the-money, it is worthless. P T = Max[E - S T, 0]

32 Put Option Payoffs Stock price ($) Option payoffs ($) Buy a put Exercise price = $50

33 Put Option Payoffs Option payoffs ($) write a put Exercise price = $50 Stock price ($)

34 Put Option Profits Stock price ($) Option profits ($) Buy a put Write a put Exercise price = $50; option premium = $

35 Selling Options The seller (or writer) of an option has an obligation. The purchaser of an option has an option Stock price ($) Option profits ($) Buy a put Write a put Stock price ($) Option profits ($) Write a call Buy a call

36 Exchanges Trading Options Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Stock Exchange European Options Exchange Australian Options Market and many more (see list at end of book)

Types of Traders Hedgers Speculators Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

38 Hedging Examples (page 11) 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 An investor owns 1,000 Microsoft shares currently worth $73 per share. A two-month put with a strike price of $65 costs $2.50. The investor decides to hedge by buying 10 contracts

39 Speculation Example An investor with $4,000 to invest feels that Cisco’s 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 25 is $1 What are the alternative strategies?

40 Arbitrage Example (pages 12-13) A stock price is quoted as £100 in London and $172 in New York The current exchange rate is What is the arbitrage opportunity?

41 Hedging Two counterparties with offsetting risks can eliminate risk. –For example, if a wheat farmer and a flour mill enter into a forward contract, they can eliminate the risk each other faces regarding the future price of wheat. Hedgers can also transfer price risk to speculators and speculators absorb price risk from hedgers. Speculating: Long vs. Short

42 Hedging and Speculating Example You speculate that copper will go up in price, so you go long 10 copper contracts for delivery in 3 months. A contract is 25,000 pounds in cents per pound and is at $0.70 per pound or $17,500 per contract. If futures prices rise by 5 cents, you will gain: Gain = 25,000 ×.05 × 10 = $12,500 If prices decrease by 5 cents, your loss is: Loss = 25,000 × -.05 × 10 = -$12,500

43 Hedging: How many contacts? You are a farmer and you will harvest 50,000 bushels of corn in 3 months. You want to hedge against a price decrease. Corn is quoted in cents per bushel at 5,000 bushels per contract. It is currently at $2.30 cents for a contract 3 months out and the spot price is $2.05. To hedge you will sell 10 corn futures contracts: Now you can quit worrying about the price of corn and get back to worrying about the weather.

44 Hedging in Interest Rate Futures A mortgage lender who has agreed to loan money in the future at prices set today can hedge by selling those mortgages forward. It may be difficult to find a counterparty in the forward who wants the precise mix of risk, maturity, and size. It’s likely to be easier and cheaper to use interest rate futures contracts however.

45 Actual Use of Derivatives Because derivatives don’t appear on the balance sheet, they are present a challenge to financial economists who which to observe their use. Survey results appear to support the notion of widespread use of derivatives among large publicly traded firms. Foreign currency and interest rate derivatives are the most frequently used.