Chapter 9. Derivatives Futures Options Swaps Futures Options Swaps

Derivatives: the basics Financial instrument Value depends on another assets  i.e. value is derived from another Purpose: to transfer risk from one party to another Financial instrument Value depends on another assets  i.e. value is derived from another Purpose: to transfer risk from one party to another

Derivative uses Used to  Profit from expected price changes of certain assets Speculation  Manage the risk associated with price changes Hedging Used to  Profit from expected price changes of certain assets Speculation  Manage the risk associated with price changes Hedging

Futures Contracts Exchange of asset/commodity between two parties on a future date Price of asset/commodity set today Exchange of asset/commodity between two parties on a future date Price of asset/commodity set today

Two parties Buyer  Long position  Obligation to buy asset on settlement date at agreed price Seller  Short position  Obliations to deliver asset on settlement date and receive agreed price Buyer  Long position  Obligation to buy asset on settlement date at agreed price Seller  Short position  Obliations to deliver asset on settlement date and receive agreed price

Standardized  Sold on exchanges  Settlement date  Asset/commodity Exchanges  Chicago: CME, CBOT  New York: NYMEX, NYBOT (NYFE) Standardized  Sold on exchanges  Settlement date  Asset/commodity Exchanges  Chicago: CME, CBOT  New York: NYMEX, NYBOT (NYFE)

what kinds of commodities, assets? agriculture: corn, wheat, livestock, cotton, tobacco mining: metals, oil, natural gas Tbills, Tbonds (interest rate) Stock indexes (cash settlement) Foreign currencies (exchange rate) agriculture: corn, wheat, livestock, cotton, tobacco mining: metals, oil, natural gas Tbills, Tbonds (interest rate) Stock indexes (cash settlement) Foreign currencies (exchange rate)

As price of underlying rises  long position gains  short position loses As price of underlying falls  long position loses  short position gains As price of underlying rises  long position gains  short position loses As price of underlying falls  long position loses  short position gains

Example 1: commodity Baker with a military contract  locked in a price for bread  Risk: fluctuating price of wheat higher costs cannot be passed on to bread buyers Baker with a military contract  locked in a price for bread  Risk: fluctuating price of wheat higher costs cannot be passed on to bread buyers

solution?  hedge with futures contract  wheat futures contract, long position  locks in wheat price for buyer  As wheat price rises, long position gains to offset baker’s costs solution?  hedge with futures contract  wheat futures contract, long position  locks in wheat price for buyer  As wheat price rises, long position gains to offset baker’s costs

but as wheat prices fall  long position loses value to offset lower costs for the baker but as wheat prices fall  long position loses value to offset lower costs for the baker

who is the seller of the wheat futures contract?  wheat farmers, grain elevator companies  speculators who believe wheat prices will fall who is the seller of the wheat futures contract?  wheat farmers, grain elevator companies  speculators who believe wheat prices will fall

Example 2: financial asset Savings and Loan  borrow short term w/ deposits  lend mostly long term fixed rate risk: short term interest rates rise  higher costs without higher income to match solution: short position in Tbill futures Savings and Loan  borrow short term w/ deposits  lend mostly long term fixed rate risk: short term interest rates rise  higher costs without higher income to match solution: short position in Tbill futures

As interest rates rise,  Tbill price falls,  short position gains to offset banking losses As interest rates rise,  Tbill price falls,  short position gains to offset banking losses

Futures trading the exchanges form a clearing corporation that guarantees each party against default  it is the counterparty to each transaction the exchanges form a clearing corporation that guarantees each party against default  it is the counterparty to each transaction

how does the exchange control its default risk?  margin accounts initial margin (10% or less of contract value) daily gains/losses are marked to market margin calls if account gets too low how does the exchange control its default risk?  margin accounts initial margin (10% or less of contract value) daily gains/losses are marked to market margin calls if account gets too low

example: Tbond contract (CBOT) $100,000 face value, 6% coupon initial margin = $2700 Tbond price falls by 16/32 per $100  $500 price decrease buyer account falls to $2200 seller account rises to $3200 $100,000 face value, 6% coupon initial margin = $2700 Tbond price falls by 16/32 per $100  $500 price decrease buyer account falls to $2200 seller account rises to $3200

Options contracts 2 counterparties  buyer/option holder  seller/option writer buyer has rights, seller has obligations 2 counterparties  buyer/option holder  seller/option writer buyer has rights, seller has obligations

call option buyer has right to buy underlying at the strike price on/before a specific date  writer has obligation to sell, if the buyer chooses to buy buyer has right to buy underlying at the strike price on/before a specific date  writer has obligation to sell, if the buyer chooses to buy

put option buyer has right to sell underlying at the strike price on/before a specific date  writer has obligation to buy, if the option holder chooses to sell buyer has right to sell underlying at the strike price on/before a specific date  writer has obligation to buy, if the option holder chooses to sell

note: writer receives option price from buyer in exchange for taking on the obligation

American options  exercised any time until expiration European options  exercised only on the day of expiration American options  exercised any time until expiration European options  exercised only on the day of expiration

P = price of underlying X = strike price Qc = call option price Qp = put option price P = price of underlying X = strike price Qc = call option price Qp = put option price

when will options be exercised? call option – right to buy  if P > X, then this option is in the money  if P < X, then this option is out of the money call option – right to buy  if P > X, then this option is in the money  if P < X, then this option is out of the money

put option – right to sell  if P > X, then this option is out of the money  if P < X, then this option is in the money put option – right to sell  if P > X, then this option is out of the money  if P < X, then this option is in the money

ExampleExample Google stock expiring 10/19/2007  P = $635/share  call option X = $500 Qc = $ This option in the money Google stock expiring 10/19/2007  P = $635/share  call option X = $500 Qc = $ This option in the money

 put option X = $500 Qp = $.10 This option is out of the money  put option X = $500 Qp = $.10 This option is out of the money

Option trading types of assets  commodities  bonds  stocks and stock indexes exchange-traded & standardized Options Clearing Corporation types of assets  commodities  bonds  stocks and stock indexes exchange-traded & standardized Options Clearing Corporation

CBOE  10% options exercised  60% “traded out” (cash settlement)  30% expire worthless CBOE  10% options exercised  60% “traded out” (cash settlement)  30% expire worthless

Uses of options Who buys a call option?  protection from a price increase of the underlying (hedger) option acts as insurance  betting on a price increase of the underlying (speculator) Who buys a call option?  protection from a price increase of the underlying (hedger) option acts as insurance  betting on a price increase of the underlying (speculator)

Who writes a call option?  betting that the underlying price will not rise  broker always selling the underlying and willing to be paid for the risk of the price rising Who writes a call option?  betting that the underlying price will not rise  broker always selling the underlying and willing to be paid for the risk of the price rising

who buys a put option?  protects from price decrease of underlying in the future hopes to sell underlying in the future  betting the price of underlying will fall who buys a put option?  protects from price decrease of underlying in the future hopes to sell underlying in the future  betting the price of underlying will fall

Who writes a put option?  betting that the underlying price will not fall  broker always buying the underlying and willing to be paid for the risk of the price falling Who writes a put option?  betting that the underlying price will not fall  broker always buying the underlying and willing to be paid for the risk of the price falling

The value of options option price has two parts  intrinsic value value of option if exercised/expire now depends on if in/out of the money for a call: max (P-X, 0) for a put: max (X-P, 0)  option premium fee paid for having the option option price has two parts  intrinsic value value of option if exercised/expire now depends on if in/out of the money for a call: max (P-X, 0) for a put: max (X-P, 0)  option premium fee paid for having the option

exampleexample Google, P =$635, X = $500 Qc = $138.20, Qp = $.10 call option  intrinsic value = = 135  premium = – 135 = 3.20 Google, P =$635, X = $500 Qc = $138.20, Qp = $.10 call option  intrinsic value = = 135  premium = – 135 = 3.20

put option  intrinsic value = 0 option is out of the money  premium = $.10 put option  intrinsic value = 0 option is out of the money  premium = $.10

What affects the price of an option? P, price of underlying  as P rises affects the intrinsic value call option price rises put option price falls P, price of underlying  as P rises affects the intrinsic value call option price rises put option price falls

X, the strike price  as X rises affects the intrinsic value call option price falls put option price rises X, the strike price  as X rises affects the intrinsic value call option price falls put option price rises

time to expiration  longer the time, higher the option price of put or call options higher premium greater uncertainty about option being in or out of the money time to expiration  longer the time, higher the option price of put or call options higher premium greater uncertainty about option being in or out of the money

volatility of P  greater the volatility, the greater the option price for both puts and calls higher premium greater uncertainty about option being in or out of the money volatility of P  greater the volatility, the greater the option price for both puts and calls higher premium greater uncertainty about option being in or out of the money

SwapsSwaps Interest rate swaps  plain vanilla swap not standardized or exchange-traded  more default risk  less liquid  BUT customized to specific needs Interest rate swaps  plain vanilla swap not standardized or exchange-traded  more default risk  less liquid  BUT customized to specific needs

How does a swap work 2 counterparties exchange interest rate payments  every 6 months  over so many years one party pays a fixed rate one party pays a floating rate  tied to 6 mo. Tbill 2 counterparties exchange interest rate payments  every 6 months  over so many years one party pays a fixed rate one party pays a floating rate  tied to 6 mo. Tbill

size of interest payments?  based on notional principle the principle never changes hands, just determines the size of the interest payments size of interest payments?  based on notional principle the principle never changes hands, just determines the size of the interest payments

Bank pays 7% to dealer, receiving 6 mo. Tbill +3% from dealer Dealer receives 7% from bank, pays 6 mo. Tbill +3% to bank

notional principle = $100 million suppose 6 mo. Tbill is 4.2% Bank pays 7%, gets 7.2%  bank net gain = $200,000  dealer net loss = $200,000 notional principle = $100 million suppose 6 mo. Tbill is 4.2% Bank pays 7%, gets 7.2%  bank net gain = $200,000  dealer net loss = $200,000

why swap? banks pay floating rates to depositors, but received fixed rates on loans  the swap offsets their interest rate risk dealer willing to assume the risk for profit potential banks pay floating rates to depositors, but received fixed rates on loans  the swap offsets their interest rate risk dealer willing to assume the risk for profit potential

U.S. Treasury debt managers long term bonds have strong demand but short term bonds match up to short term fluctuations in revenue solution?  a swap long term bonds have strong demand but short term bonds match up to short term fluctuations in revenue solution?  a swap

government issues long term debt enters swap as floating rate payer  recession as rates fall swap results in net gain but tax revenues fall as well  expansion as rates rise swap results in net loss but tax revenues rise as well government issues long term debt enters swap as floating rate payer  recession as rates fall swap results in net gain but tax revenues fall as well  expansion as rates rise swap results in net loss but tax revenues rise as well