Derivatives Markets The 600 Trillion Dollar Market

Forward Transactions and Derivatives Derivative securities derive their economic value from underlying assets. Spot markets: settlement is immediate. Forward transactions: settlement is in the future. Although forward transactions provide risk sharing, they have liquidity and information problems.

Futures A futures contract specifies delivery at a future date at a current price. The buyer assumes the long position. The seller assumes the short position. Futures price: set in the futures market. Spot price: price on the date of delivery. Futures contracts can reduce risk through hedging.

Examples of Futures market Interest Rates (on T-bills, notes, bonds, Munis, Eurodollars) Stock Indices, stocks Currencies

Many other types of futures

Example of Futures Market operations Wheat Farmer and Baker. In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery Both are unsure about the fluctuations in price 1 year in the future: F wants to sell 100 bushels of wheat, B wants to buy it. They agree to trade a futures contract in which the farmer agrees to sell to the baker these 100 bushels at $4 each. The farmer takes the short position, the baker takes the long position

How it works continued.. Both people buy a certain amount of money (called their margin) at the trading exchange If the price goes up to $5- that means that the farmer has (notionally) lost $5- his account is debited $100 =(5-4)*100 while the bread maker is credited $100. This happens every day

How it ends After one year if the price remains at $5, the farmer can still sell his wheat at $5 so he gets $500, while the baker can use this $100 that he has got from the futures contract to buy wheat from a wheat market. The derivatives market need not involve the actual transfer of commodities! So it is not necessarily only for people who want to buy wheat, put people who want to bet on the price of wheat

Why use futures? Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices, based on today's and tomorrow's estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell

Two types of players Hedgers- those who are buying/selling a future to correct against fluctuations in the price. Speculators- those who are buying/selling a future to correct against fluctuations in price.

LongShort The Hedger Secure a price now to protect against future rising prices Secure a price now to protect against future declining prices The Speculator Secure a price now in anticipation of rising prices Secure a price now in anticipation of declining prices

Leveraging Because you have only to put down the margin to trade in futures markets, the futures market is usually highly leveraged. (leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital). Due to leverage, if the price of the futures contract moves slightly, then the profits you could make could be huge.

Example You buy a 3 month futures contract for 100 stocks for a company which trading for $100. You put down a margin of $10,000. If the price rises to $105 in the next 3 months, you make 105* *100=$5,000 on an initial investment of $10,000, or a profit of 50%. Without the margin for the futures contract, you would have had to buy $100,000 of the share outright, and you would have made 5000/100000=5%.

Options Option is the right to buy or sell an asset at a predetermined price by a predetermined time. Call option: the right to buy an asset. Put option: the right to sell an asset. Strike price: the price at which the asset is bought or sold. Option premium: the fee for option.

Example of how an option might work Want to buy a house. Unsure about it. Ask the landlord if you could buy it at his price ($100,000) but you need to think a week. Landlord says he’ll keep it for you at that price for a week, but will charge you a non-refundable deposit of $1000. This is like how an option works. You have bought a call option for a $100,000 asset for a $1000 option premium.

Another example of the actual workings You can buy a call option (option to buy) of a stock XYZ chemicals by 20 th June for $60. This gives you the right, but not the obligation to buy this stock.The price now is $58. The option costs you $4. If the price does not change between now and 20 th June, you have lost that $4. But if the price goes up to $70 in March you have gained $6 ( ). Once the price moves up to $60, it has hit the strike price, and all prices above that are considered ‘in the money’ Should you exercise your option now? What if the price goes up even further? What if it goes down?

Another question: how to price an option? Premium =Intrinsic Value+Time Value Intrinsic value- the strike price of the asset (for a call option) options almost always trade above intrinsic value Time value- the value due to uncertainty Black Scholes Option model tries to model this

Determinants of Option Premium Higher volatility in the asset price increases the option premium. Closer to expiration date, the option premium approaches its intrinsic value. The further away from expiration, the higher is the option premium. A higher interest rate reduces the option premium.

Benefits of Derivative Markets Derivative markets provide risk sharing, liquidity, and information. Derivative instruments are liquid because they are standardized. Anonymous trading reduces information costs.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Other sorts of derivatives Credit Derivatives A credit derivative is a financial contract that transfers the credit risk of a reference asset, also known as a “name,” from one counterparty to the other in exchange for payment. Example Credit Default Swap I insure my GM bond by buying a CDS agreement with AIG whom I pay a premium to if GM doesn’t pay me, AIG will.

Figure 9.1 Derivative Markets Add Value