0 Forwards, futures swaps and options WORKBOOK By Ramon Rabinovitch

1 Introduction Chapter 1

2 The Nature of Derivatives A derivative is a financial instrument whose value depends on the values of other more basic underlying variables In particular, it depends on the market price of the so called: underlying asset.

3 Underlying assets: Stocks Bonds Foreign currencies Gold, Silver… Crude oil, Natural gas, Gasoline, heating oil… Wheat, corn, rice, grain feed, soy beans, pork bellies… Stock indexes

4 DERIVATIVES ARE CONTRAC TS : FORWARDS FUTURES OPTIONS SWAPS

5 WHY TRADE DERIVATIVES? THE FUNDAMENTAL REASON FOR TRADING DERIVATIVES IS TO HEDGE: THE PRICE RISK (VOLATILITY) Exhibited by the spot price of the underlying commodity

6 PRICE RISK IS THE VOLATILITY ASSOCIATED WITH THE COMMODITY’S PRICE IN THE CASH MARKET REMEMBER THAT THE CASH MARKET IS WHERE FIRMS DO THEIR BUSINESS. I.E., BUY AND SELL THE COMMODITY. ZERO PRICE VOLATILITY NO DERIVATIVES!!!!

7 t Probability distributio StSt T time STST PRICE RISK: At time t, the asset’s price at time T is not known.

8 Ways Derivatives are Used To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another

9 Types of risk: Price risk Credit risk Operational risk Completion risk Human risk Regulatory risk Tax risk

10 IN THIS CLASS WE WILL ONLY ANALYZE THE RISK ASSOCIATED WITH THE SPOT MARKET PRICE OF THE UNDERLYING ASSET

11 DERIVATIVES ARE CONTRACTS: Two parties Agreement Underlying security Contract termination date

12 DERIVATIVES ARE CONTRACTSThe distinction is made by the different stipulations of the contract Forwards and Futures are Fixed obligations A FORWARD IS A CONTRACT IN WHICH ONE PARTY COMMITS TO BUY AND THE OTHER PARTY COMMITS TO SELL A SPECIFIED AMOUNT OF AN AGREED UPON COMMODITY FOR A PREDETERMINED PRICE ON A SPECIFIC DATE IN THE FUTURE.

13 BUY = OPEN A LONG POSITION SELL = OPEN A SHORT POSITION t Buy or sell a forward T Time Delivery and payment

14 Forward Price The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities

15 EXAMPLE: GBP SPOT USD1,6850/GBP 30 days forwardUSD1,7245/GBP 60 days forwardUSD1,7455/GBP 90 days forwardUSD1,7978/GBP 180 days forwardUSD1,8455/GBP The existence of forward exchange rates implies that there is a demand and supply for the GBP for future dates. In the actual market, however, different rates are quoted for buy (ask) and for sell (bid) orders.

16 Foreign Exchange Quotes for USD/GBP on Aug 16, 2001 ( page 3) BidOffer Spot month forward month forward month forward month forward

17 Profit from a Long Forward Position Profit Price of Underlying at Maturity, S T K

18 Profit from a Short Forward Position Profit Price of Underlying at Maturity, S T K

19 A FUTURES A STANDARDIZED FORWARD TRADED ON AN ORGANIZED EXCHANGE. STANDARDIZATION THE COMMODITY TYPE AND QUALITY THE QUANTITY PRICE QUOTES DELIVERY DATES DELIVERY PROCEDURES

20 Futures Contracts Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

21 AN OPTION IS A CONTRACT IN WHICH ONE PARTY HAS THE RIGHT, BUT NOT THE OBLIGATION, TO BUY OR SELL A SPECIFIED AMOUNT OF AN AGREED UPON COMMODITY FOR A PREDETERMINED PRICE BEFORE OR ON A SPECIFIC DATE IN THE FUTURE. THE OTHER PARTY HAS THE OBLIGATION TO DO WHAT THE FIRST PARTY WISHES TO DO. THE FIRST PARTY, HOWEVER, MAY CHOOSE NOT TO EXERCISE ITS RIGHT AND LET THE OPTION EXPIRE WORTHLESS. A CALL = A RIGHT TO BUY THE UNDERLYING ASSET A PUT = A RIGHT TO SELL THE UNDERLYING ASSET

22 Long Call on Microsoft ( Figure 1.2, Page 7 ) Profit from buying a European call option on Microsoft: option price = $5, strike price = $ Profit ($) Terminal stock price ($)

23 Short Call on Microsoft (Figure 1.4, page 9) Profit from writing a European call option on Microsoft: option price = $5, strike price = $ Profit ($) Terminal stock price ($)

24 Long Put on IBM (Figure 1.3, page 8) Profit from buying a European put option on IBM: option price = $7, strike price = $ Profit ($) Terminal stock price ($)

25 Short Put on IBM (Figure 1.5, page 9) Profit from writing a European put option on IBM: option price = $7, strike price = $ Profit ($) Terminal stock price ($)

26 A SWAP IS A CONTRACT IN WHICH THE TWO PARTIES COMMIT TO EXCHANGE A SERIES OF CASH FLOWS. THE CASH FLOWS ARE BASED ON AN AGREED UPON PRINCIPAL AMOUNT. NORMALLY, ONLY THE NET FLOW EXCHANGES HANDS. Principal amount = EUR100,000,000; semiannual payments. Party A Party B 7% 6-months LIBOR

27 Types of Derivatives Traders Speculators Hedgers Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

28 THE ECONOMIC PURPOSES OF DERIVATIVE MARKETS HEDGING PRICE DISCOVERY SAVING HEDGING IS THE ACTIVITY OF MANAGING PRICE RISK EXPOSURE PRICE DISCOVERY IS THE REVEALING OF INFORMSTION ABOUT THE FUTURE CASH MARKET PRICE FOR A PRODUCT. SAVING IS THE COST SAVING ASSOCIATED WITH SWAPING CASH FLOWS