Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang 14

Copyright © 2010 by Nelson Education Ltd An Overview of Forward and Futures Trading Hedging with Forwards and Futures Valuation of Forward and Futures Financial Futures An Overview of Option Markets and Contracts The Fundamental Option Valuation Swaps Option-Like Securities Chapter 14 Derivatives: Analysis and Valuation

Copyright © 2010 by Nelson Education Ltd Forward contracts are negotiated directly between two parties in the OTC markets Individually designed to meet specific needs Subject to default risk Futures contracts are bought through brokers on an exchange No direct interaction between the two parties Exchange clearinghouse oversees delivery and settles daily gains and losses Customers post initial margin account An Overview of Forward & Futures Trading

Copyright © 2010 by Nelson Education Ltd An Overview of Forward & Futures Trading

Copyright © 2010 by Nelson Education Ltd An Overview of Forward & Futures Trading

Copyright © 2010 by Nelson Education Ltd An Overview of Forward & Futures Trading Futures Contract Mechanics Futures exchange requires each customer to post an initial margin account in the form of cash or government securities when the contract is originated The margin account is marked to market at the end of each trading day according to that day’s price movements Forward contracts may not require either counterparty to post collateral All outstanding contract positions are adjusted to the settlement price set by the exchange after trading ends

Copyright © 2010 by Nelson Education Ltd An Overview of Forward & Futures Trading With commodity futures, it usually is the case that delivery can take place any time during the month at the discretion of the short position FuturesForwards Design FlexibilityStandardizedCan be customized Credit RiskClearinghouse riskCounterparty risk Liquidity RiskDepends on tradingNegotiated risk

Copyright © 2010 by Nelson Education Ltd Hedging with Forwards & Futures Create a position that will offset the price risk of another more fundamental holding Short hedge: Holding a short forward position against the long position in the commodity Long hedge: Supplements a short commodity holding with a long forward position The basic premise behind any hedge is that as the price of the underlying commodity changes, so too will the price of a forward contract based on that commodity

Copyright © 2010 by Nelson Education Ltd Hedging with Forwards & Futures: Defining the Basis Basis is spot price minus the forward price for a contract maturing at date T: B t,T = S t - F t,T where S t the Date t spot price F t,T the Date t forward price for a contract maturing at Date T Initial basis, B 0,T, is always known Maturity basis, B T,T, is always zero. That is, forward and spot prices converge as the contract expires Cover basis: B t, T

Copyright © 2010 by Nelson Education Ltd Hedging with Forwards & Futures: Understanding Basis Risk The terminal value of the combined position is defined as the cover basis minus the initial basis B t, T – B 0, T = (S t - F t,T ) - (S 0 – F 0,T ) Basis Risk Investor’s terminal value is directly related to B t, T B t, T depends on the future spot and forward prices If S t and F t,T are not correlated perfectly, B t, T will change and cause the basis risk

Copyright © 2010 by Nelson Education Ltd Hedging with Forwards & Futures: Understanding Basis Risk Hedging Exposure It is to the correlation between future changes in the spot and forward contract prices Perfect correlation with customized contracts

Copyright © 2010 by Nelson Education Ltd Valuation of Forwards & Futures: The Cost to Carry Model The Cost of Carry Commissions paid for storing the commodity, PC 0,T Cost of financing the initial purchase, i 0,T Cash flows received between Dates 0 and T, D 0,T  TTTTT DiPCSSCSF,0,0,00,00,0 

Copyright © 2010 by Nelson Education Ltd Valuation of Forwards & Futures: Contango & Backwardated Contango Market When F 0,T > S 0 Normally with high storage costs and no dividends Backwardation Market When F 0,T < S 0 Normally with no storage costs and pays dividends Premium for owning the commodity Convenience yield Can results from small supply at date 0 relative to what is expected at date T (after the crop harvest)

Copyright © 2010 by Nelson Education Ltd Financial Futures Interest Rate Futures Interest rate forwards and futures were among the first derivatives to specify a financial security as the underlying asset Forward rate agreements Interest rate swaps Basic Types Long-term interest rate futures Short-term interest rate futures Stock index futures Currency forwards and futures

Copyright © 2010 by Nelson Education Ltd Financial Futures Interest rate futures available at the Montreal Exchange BAX (Three-Month Canadian Bankers’ Acceptance Futures OBX (Options on Three-Month Canadian Bankers’ Acceptance Futures) CGB (Ten-Year Government of Canada Bond Future)

Copyright © 2010 by Nelson Education Ltd Stock Index Futures Intended to provide general hedges against stock market movements and can be applied to a portfolio or individual stocks Hedging an individual stock with an index isolates the unsystematic portion of that security’s risk Can only be settled in cash, similar to the Eurodollar (i.e., LIBOR) contract Stock Index Arbitrage: Use the stock index futures to convert a stock portfolio into synthetic riskless positions Prominent in program trading

Copyright © 2010 by Nelson Education Ltd Overview of Options Markets & Contracts Option Market Conventions Option contracts have been traded for centuries Customized options traded on OTC market In April 1973, standardized options began trading on the Chicago Board Option Exchange Contracts offered by the CBOE are standardized in terms of the underlying common stock, the number of shares covered, the delivery dates, and the range of available exercise prices Options Clearing Corporation (OCC) acts as guarantor of each CBOE-traded options

Copyright © 2010 by Nelson Education Ltd Overview of Options Markets & Contracts Price Quotations for Exchange-Traded Options Equity Options CBOE, AMEX, PHLX, PSE Typical contract for 100 shares Require secondary transaction if exercised Time premium affects pricing Stock Index Options First traded on the CBOE in 1983 Index options can only be settled in cash Index puts are particularly useful in portfolio insurance applications

Copyright © 2010 by Nelson Education Ltd Overview of Options Markets & Contracts Options on Futures Contracts Options on futures contracts have only been exchange-traded since 1982 Give the right, but not the obligation, to enter into a futures contract on an underlying security or commodity at a later date at a predetermined price Leverage is the primary attraction of this derivative

Copyright © 2010 by Nelson Education Ltd Fundamentals of Option Valuation Risk reduction tools when used as a hedge Forecasting the volatility of future asset prices direction and magnitude Hedge ratio is based on the range of possible option outcomes related to the range of possible stock outcomes Risk-free hedge buys one share of stock and sells call options to neutralize risk Hedge portfolio should grow at the risk-free rate

Copyright © 2010 by Nelson Education Ltd Fundamentals of Option Valuation The Basic Approach Assume the WYZ stock price as the following Assume the risk-free rate is 8% Want the price of a call option (C 0 ) with X = $52.50 Stock price now Price in one year $50 $65 $40

Copyright © 2010 by Nelson Education Ltd Fundamentals of Option Valuation Step 1: Estimate the number of call options Calculate the option’s payoffs for each possible future stock price If stock goes to $65, option pays off $12.50 If stock goes to $40, option pays off $0 Determine the composition of the hedge portfolio It contains one share of stock and “h” call options If stock goes up, portfolio will pay: $65 + (h)($12.50) If stock goes down, portfolio will pay: $40 + (h)($0)

Copyright © 2010 by Nelson Education Ltd Fundamentals of Option Valuation Step 1 (Continued) To determine the composition of the hedge portfolio, find the number of options that equates the payoffs $65 + $12.50h = $40 + $0h Implies h = -2 Hedge portfolio is long one share of stock and short two call options Value of hedge portfolio today: $ (C 0 )

Copyright © 2010 by Nelson Education Ltd Fundamentals of Option Valuation Step 2: Determine the PV of the portfolio We know the hedge portfolio will pay $40 in one year with certainty Thus the value of that portfolio right now is 40/(1+RFR) T Step 3: Compute the price of a call option Condition of no risk-free arbitrage $ (C 0 ) = 40/(1+RFR) T When T=1 and RFR=8%, solve for C 0 C 0 =$6.48

Copyright © 2010 by Nelson Education Ltd The Binomial Option Pricing Formula In the jth state in any sub-period, the value of the option can be calculated by Fundamentals of Option Valuation  r CpCp C jdju j   1 where and r = one plus the risk-free rate over the sub-period du dr p   

Copyright © 2010 by Nelson Education Ltd Fundamentals of Option Valuation At Date 0, the binomial option pricing formula can be expressed as follows:       njNj jN j N 0 j o rX S d up p jjN N C               1 ! ! ! m is the smallest integer number of up moves guaranteeing that the option will be in the money at expiration

Copyright © 2010 by Nelson Education Ltd Fundamentals of Option Valuation The hedge ratio for any state j becomes   jujd j j CC Sdu h   

Copyright © 2010 by Nelson Education Ltd The Black-Scholes Valuation Model Binomial model is discrete method for valuing options because it allows security price changes to occur in distinct upward or downward movements Prices can change continuously throughout time Advantage of Black-Scholes approach is relatively simple, closed-form equation capable of valuing options accurately under a wide array of circumstances

Copyright © 2010 by Nelson Education Ltd Assuming the continuously compounded risk-free rate and the stock’s variance (i.e., 2 ) remain constant until the expiration date T, Black and Scholes used the riskless hedge intuition to derive the following formula for valuing a call option on a non-dividend-paying stock: C 0 = SN(d 1 ) – X(e -(RFR)T )N(d 2 ) The Black-Scholes Valuation Model

Copyright © 2010 by Nelson Education Ltd where: C 0 = market value of call option S = current market price of underlying stock X = exercise price of call option e -(RFR)T = discount function for continuously compounded variables N(d 1 ) = cumulative density function of d 1 defined as N(d 2 ) = cumulative density function of d 2 defined as        Sln [T] TRFRXd   [T]dd  The Black-Scholes Valuation Model

Copyright © 2010 by Nelson Education Ltd Properties of the Model Option’s value is a function of five variables Current security price Exercise price Time to expiration Risk-free rate Security price volatility Functionally, the Black-Scholes model holds that C = f (S, X, T, RFR, σ) The Black-Scholes Valuation Model

Copyright © 2010 by Nelson Education Ltd The Black-Scholes Valuation Model

Copyright © 2010 by Nelson Education Ltd Estimating Volatility The standard deviation of returns to the underlying asset can be estimated in two ways 1.Traditional mean and standard deviation of a series of price relatives 2.Estimate implied volatility from Black-Scholes formula If we know the current price of the option (call it C*) and the four other variables, we can calculate the level of σ No simple closed-form solution exists for performing this calculation; it must be done by trial and error The Black-Scholes Valuation Model

Copyright © 2010 by Nelson Education Ltd Problems With Black-Scholes Valuation Stock prices do not change continuously Arbitrageable differences between option values and prices (due to brokerage fees, bid-ask spreads, and inflexible position sizes) Risk-free rate and volatility levels do not remain constant until the expiration date Empirical studies showed that the Black-Scholes model overvalued out-of-the-money call options and undervalued in- the-money contracts Any violation of the assumptions upon which the Black-Scholes model is based could lead to a misevaluation of the option contract The Black-Scholes Valuation Model

Copyright © 2010 by Nelson Education Ltd Swaps They are agreements to exchange a series of cash flows on periodic settlement dates over a certain time period (e.g., quarterly payments over two years). The length of a swap is termed the tenor of the swap that ends on termination date. Forward-Based Interest Rate Contracts Forward Rate Agreement (FRA) Interest Rate Swaps

Copyright © 2010 by Nelson Education Ltd Swaps

Copyright © 2010 by Nelson Education Ltd Swaps

Copyright © 2010 by Nelson Education Ltd Extensions of Swaps Equity Index-Linked Swaps Equivalent to portfolios of forward contracts calling for the exchange of cash flows based on two different investment rates: A variable-debt rate (e.g., three-month LIBOR) Return to an equity index (e.g., Standard & Poor’s 500) Payment is based on: Total return, or Percentage index change for settlement period plus a fixed spread adjustment

Copyright © 2010 by Nelson Education Ltd Extensions of Swaps Credit-Related Swaps These swaps are designed to help investors manage their credit risk exposures One of the newest swap contracting extensions introduced in the late 1990s Credit-related swaps have grown in popularity, exceeding $45 trillion in notional value by mid Types: Total Return Swap Credit Default Swap (CDS) Collateralized Debt Obligations (CDOs)

Copyright © 2010 by Nelson Education Ltd Option-Like Securities Warrants Equity call option issued directly by company whose stock serves as the underlying asset Key feature that distinguishes it from an ordinary call option is that, if exercised, the company will create new shares of stock to give to the warrant holder Thus, exercise of a warrant will increase total number of outstanding shares, which reduces the value of each individual share. Because of this dilutive effect, the warrant is not as valuable as an otherwise comparable option contract.

Copyright © 2010 by Nelson Education Ltd Option-Like Securities Warrants Valuation Expiration Date Value, W T          0,maxX NN XNV W W WT T where: N = the current number of outstanding shares N W = the shares created if the warrants are exercised V T = the value of the firm before the warrants are exercised X = the exercise price

Copyright © 2010 by Nelson Education Ltd Option-Like Securities Warrants Valuation  T W T C NN W         1 1 or where: C T = the expiration date value of a regular call option with otherwise identical terms as the warrant

Copyright © 2010 by Nelson Education Ltd Option-Like Securities Convertible Bonds A convertible security gives its owner the right, but not the obligation, to convert the existing investment into another form Typically, the original security is either a bond or a share of preferred stock, which can be exchanged into common stock according to a predetermined formula A hybrid security Bond or preferred stock holding A call option that allows for the conversion

Copyright © 2010 by Nelson Education Ltd Option-Like Securities Convertible Bonds Conversion ratio number of shares of common stock for which a convertible security may be exchanged Conversion parity price price at which common stock can be obtained by surrendering the convertible instrument at par value

Copyright © 2010 by Nelson Education Ltd Option-Like Securities Callable Bond Provides the issuer with an option to call the bond under certain conditions and pay it off with funds from a new issue sold at a lower yield Bond with an embedded option (Chapter 12)

Copyright © 2010 by Nelson Education Ltd Option Like Securities