1 Derivative Securities- Learning Objectives zWhat is a derivative security? zImportant characteristics of a derivative security; zMarkets for derivative securities; zTerminology is used to describe derivative transactions; zHow are prices for derivative securities quoted?

2 Derivative Securities- Learning Objectives zSimilarities and differences between forward and futures contracts; zPut and Call option contracts; zHow are forward contracts, put options, and call options related to one another?

3 Forward and Futures Contracts - Learning Objectives zHedge ratio and how it is calculated? zWhat economic functions do the forward and futures markets serve? zFutures pricing; zAgricultural futures and financial futures; zStock Index futures; zCurrency futures

4 Derivative Instruments zValue is depends directly on, or is derived from, the value of another security or commodity, called the underlying asset zForward and Futures contracts are agreements between two parties - the buyer agrees to purchase an asset from the seller at a specific date at a price agreed to now zOptions offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date

5 Why Do Derivatives Exist? zAssets are traded in the cash or spot market zIt is sometimes advantageous enter into a transaction now with the exchange of asset and payment at a future time zRisk shifting zPrice formation zInvestment cost reduction

6 Derivative Instruments zForward contracts are the right and full obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined date (maturity date) and at a predetermined price (contract price) yThis is a trade agreement zFutures contracts are similar, but subject to a daily settling-up process

7 Forward Contracts zBuyer is long, seller is short zContracts are OTC, have negotiable terms, and are not liquid zSubject to credit risk or default risk zNo payments until expiration zAgreement may be illiquid

8 Futures Contracts zStandardized terms zCentral market (futures exchange) zMore liquidity zLess liquidity risk - initial margin zSettlement price - daily “marking to market”

9 Options z The Language and Structure of Options Markets yAn option contract gives the holder the right-but not the obligation-to conduct a transaction involving an underlying security or commodity at a predetermined future date and at a predetermined price

10 Options zBuyer has the long position in the contract zSeller (writer) has the short position in the contract zBuyer and seller are counterparties in the transaction

11 Options zOption Contract Terms  The exercise price is the price the call buyer will pay to-or the put buyer will receive from-the option seller if the option is exercised zOption Valuation Basics yIntrinsic value represents the value that the buyer could extract from the option if he or she she exercised it immediately yThe time premium component is simply the difference between the whole option premium and the intrinsic component zOption Trading Markets-options trade both in over-the-counter markets and on exchanges

12 Options zOption to buy is a call option zOption to sell is a put option zOption premium - paid for the option zExercise price or strike price - price agreed for purchase or sale zExpiration date yEuropean options yAmerican options

13 Options zAt the money: ystock price equals exercise price zIn-the-money yoption has intrinsic value zOut-of-the-money yoption has no intrinsic value

14 Investing With Derivative Securities zCall option yrequires up front payment yallows but does not require future settlement payment zForward contract ydoes not require front-end payment yrequires future settlement payment

15 Options Pricing Relationships Factor Call Option Put Option Stock price+- Exercise price-+ Time to expiration++ Interest rate+ - Volatility of underlying ++ stock price

16 Profits to Buyer of Call Option , ,500 2,000 2,500 3,000 (500) (1,000) Exercise Price = $70 Option Price = $6.125 Profit from Strategy Stock Price at Expiration

17 Profits to Seller of Call Option (1,000) (1,500) (2,000) (500) ,000 (2,500) (3,000) Exercise Price = $70 Option Price = $6.125 Stock Price at Expiration Profit from Strategy

18 Profits to Buyer of Put Option , ,500 2,000 2,500 3,000 (500) (1,000) Exercise Price = $70 Option Price = $2.25 Profit from Strategy Stock Price at Expiration

19 Profits to Seller of Put Option (1,000) (1,500) (2,000) (500) ,000 (2,500) (3,000) Exercise Price = $70 Option Price = $2.25 Stock Price at Expiration Profit from Strategy

20 Creating Synthetic Securities Using Put-Call Parity zRisk-free portfolio could be created using three risky securities: ystock, ya put option, yand a call option zWith Treasury-bill as the fourth security, any one of the four may be replaced with combinations of the other three

21 Put-Call-Forward Parity zInstead of buying stock, take a long position in a forward contract to buy stock zSupplement this transaction by purchasing a put option and selling a call option, each with the same exercise price and expiration date zThis reduces the net initial investment compared to purchasing the stock in the spot market

22 An Overview of Forward and Futures Trading zForward contracts are negotiated directly between two parties in the OTC markets. yIndividually designed to meet specific needs ySubject to default risk zFutures contracts are bought through brokers on an exchange yNo direct interaction between the two parties yExchange clearinghouse oversees delivery and settles daily gains and losses yCustomers post initial margin account

23 Hedging With Forwards and Futures zCreate a position that will offset the price risk of another holding yholding a short forward position against the long position in the commodity is a short hedge ya long hedge supplements a short commodity holding with a long forward position

24 Hedging With Forwards and Futures zRelationship between spot and forward price movements ybasis is spot price minus the forward price for a contract maturing at date T: B tT = S t - F t,T yforward price converges to the spot price as the contract expires yhedging exposure is correlation between future changes in the spot and forward contract prices and can be perfectly correlated with customized contracts

25 Hedging With Forwards and Futures zCalculating the Optimal Hedge Ratio ynet profit from the position

26 Forward and Futures Contracts: Basic Valuation Concepts zForward and futures contracts are not securities but, rather, trade agreements that enable both buyers and sellers of an underlying commodity or security to lock in the eventual price of their transaction

27 Valuing Forwards and Futures zValuing forwards Valuing futures contracts are marked to market daily * = the possibility that forward and futures prices for the same commodity at the same point in time might be different

28 The Relationship Between Spot and Forward Prices zIf you buy a commodity now for cash and store it until you deliver it, the price you want under a forward contract would have to cover: ythe cost of buying it now ythe cost of storing it until the contract matures ythe cost of financing the initial purchase

29 The Relationship Between Spot and Forward Prices zThese are the cost of carry necessary to move the asset to the future delivery date

30 Financial Forwards and Futures: Applications and Strategies zOriginally, forward and futures markets were organized largely around trading agricultural commodities zRecent developments in this area have involved the use of financial securities as the asset underlying the contract

31 Financial Forwards and Futures: Applications and Strategies zInterest rate forwards and futures were among the first derivatives to specify a financial security as the underlying asset yforward rate agreements yinterest rate swaps

32 Financial Forwards and Futures: Applications and Strategies zLong-term interest rate futures yTreasury bond and note contract mechanics xCBT $100,000 face value xT-bond >15 year maturity xT-note 10 year - bond with 6.5 to 10 year maturity xT-note 5 year - bond with years xDelivery any day during month of delivery

33 Financial Forwards and Futures: Applications and Strategies zLong-term interest rate futures xLast trading day 7 days prior to the end of the month xQuoted in 32nds xYield quoted is for reference xTreasury bonds pay semiannual interest xConversion factors for differences in deliverable bonds

34 Short-Term Interest Rate Futures zEurodollar and Treasury bill contract mechanics zCreating a synthetic fixed-rate funding with a Eurodollar strip zCreating a TED spread

35 Stock Index Futures zIntended to provide a hedge against movements in an underlying financial asset zHedging an individual stock with an index isolates the unsystematic portion of that security’s risk zStock index arbitrage yprominent in program trading

36 Currency Forwards and Futures zCurrency quotations yDirect (American) quote in U.S. dollars yIndirect (European) quote in non U.S. currency yReciprocals of each other zInterest rate parity and covered interest arbitrage