Foreign Exchange Theory Session 1 Introduction to Derivatives

N. Takezawa (ICU)2 Scenario 1 You are based in the US and exporting Shinjo (NY Mets) and Ichiro (Seattle Mariners) T- shirts to Japan. From your marketing research you expect to price the T-shirts at 3,000 yen. Consumer demand is expected to be 10,000 T-shirts. Expected revenue is 10,000 x 3,000yen = 30 million yen. Revenue is expected one month from today. The current exchange rate is 125 yen/dollar. What should we do?

N. Takezawa (ICU)3 Scenario 2 We have borrowed 100 million yen and must pay interest at a fixed rate of 5% per year ( 固定金利 ). The loan is for ten years. Thus, interest payments are fixed each year at 0.05 x 100 million yen = 5 million yen. However, we would like to pay interest based on a floating rate ( 変動レート ). In other words, the interest payments change each year depending on the current interest rate. What should we do?

N. Takezawa (ICU)4 Derivatives ( デリバティブ、派生証券 ) A derivative (or derivative security) is a financial instrument whose value depends on the values of other, more basic underyling variables. (Hull, p.1) デリバティブとは、ある基準になる資産の価 格（株式）、利子率（短期金融商品）、指数 （株価指数）などの値をもとにして、これら の値に依存し、かつもとの原資産と異なるペ イオフをもつ、新たに作られる契約であると て定義できましょう。 （久保田、２００１、 ｐ ２３４）

N. Takezawa (ICU)5 Underlying Asset: Sony stock- traded on Stock Exchange (TSE) Derivative Contract: Traded separately from Underlying asset Example: option on Sony Stock

N. Takezawa (ICU)6 Instruments and Markets Options Contracts ( オプション契約 ) Forward Contracts ( 先渡契約 ) Futures Contracts ( 先物契約 ) Swap Contracts ( スワップ契約 )

N. Takezawa (ICU)7 Underlying Assets ( 原資産、対象資 産 ) Commodities (foods) such as Rice and Wheat Metals such as Gold Commodities (natural resources) such as Oil and Gas Foreign Exchange Rates (Currency): Yen, DM, etc. Individual Stocks ( 株式個別銘柄 ) Bonds ( 国債、社債 ) Stock Indices such as S&P 500, TOPIX, etc. ( 株価 指数 ) Electricity Weather Emission Permits (SO2, CO2 near future?)( 排出 権 )

N. Takezawa (ICU)8 Why Derivatives? 1) Reduce Financial Risk: Combine instruments to reduce risk. Say a Japanese fund manager invests in a US stock such as IBM. Then the investor faces or is exposed to several financial (price) risks. Exposure includes, 1) IBM stock price, 2) US stock market, 3) Yen/US dollar exchange rate. The investor could “neutralize” some of the risks by entering futures contracts for the SP500 and currency. 2) Leverage “Cost savings” in transaction costs. For example, to take a position in a currency, index, and/or bond, you only need to put-up margin.

N. Takezawa (ICU)9 3) Informational Efficiency ( 効率的市場） Harry Roberts-Eugene Fama: Market Efficiency Weak Form [prices, volume] Semi-strong Form [all public information] Strong Form [all public and private] Joint Hypothesis: Market Efficiency and Correct Model Correct model in our context: example, volatility models, Black-Scholes-Merton option pricing model. Does derivative (trading) provide us with (valuable) information on the underlying spot market and/or other derivative securities markets?

N. Takezawa (ICU)10 Nikkei 225 Futures Market: Hiraki, Maberly, Takezawa (J. Banking and Finance, 1995) Trading in futures market usually extend beyond that of the spot market by minutes. On the Osaka exchange, the Nikkei futures traded until 3: minutes beyond the spot market. Oct. 2, 1990: Futures extended trading reduced to 10 minutes. This feature is eliminated Feb. 7, Does extended trading period result in speculative trading. We show that the information generated from the extended period contains useful information.

N. Takezawa (ICU)11 RISK Business Risk Financial Risk Market Risk Credit Risk, other risks

N. Takezawa (ICU)12 Market Risk 価格変動リスク Also referred to as price risk. This risk comes from a change in price. The price change of financial assets and liabilities (underlying asset prices). The change in price is often referred to as volatility (variability of the price).

N. Takezawa (ICU)13 Some of these derivatives can only be purchased from a financial institution (or corporate). Some of these derivatives can only be purchased on an organized exchange. Well known exchanges are 1) Chicago Board of Trade (CBOT) ( and 2) Chicago Mercantile Exchange (CME) ( Tokyo Stock Exchange (TSE) ( stock options for 167 different companies as of April 2001, TOPIX options ( オプション ), TOPIX futures ( 先物 ),JGB futures ( 国債の先 物 ), options on JGB futures.

N. Takezawa (ICU)14 Futures on the Nikkei 225 Index ( 日経平均株 価指数 ) are traded at the Singapore International Monetary Exchange (SIMEX), Chicago Mercantile Exchange (CME), Osaka Securities Exchange (OSE) Future (or rough equivalent) were traded in Japan during the Edo Period. Rice Futures Exchange (Dojima) in Osaka [ 堂島米会場 ] established in 1730.