1 MGT 821/ECON 873 Financial Derivatives Lecture 1 Introduction

2 What is a derivative? A derivative is an instrument whose value depends on the values of other more basic underlying variables Example:  Forward Contracts, futures contracts  Swaps  Options  Credit derivatives

Derivatives Markets Exchange Traded  standard products  trading floor or computer trading  virtually no credit risk Over-the-Counter  non-standard products  telephone market  some credit risk

4 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

Forward Contracts A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price)  It can be contrasted with a spot contract which is an agreement to buy or sell immediately The contract is an over-the-counter (OTC) agreement between 2 companies The delivery price is usually chosen so that the initial value of the contract is zero No money changes hands when contract is first negotiated and it is settled at maturity

The 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

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

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

Example On August 20, 2006 a trader enters into an agreement to buy £1 million in three months at an exchange rate of This obligates the trader to pay $1,619,600 for £1 million on November 20, 2006 What are the possible outcomes?

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

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

Futures - similar to forward but feature formalized and standardized characteristics  Agreement to buy or sell an asset for a certain price at a certain time Whereas a forward contract is traded OTC a futures contract is traded on an exchange Key difference in futures  Exchange traded  Specifications need to be defined: What can be delivered, Where it can be delivered, When it can be delivered  Settled daily Futures

13 Options A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) Exotic options A put is an option to sell a certain asset by a certain date for a certain price (the strike price)

14 Long Call on IBM Profit from buying an IBM European call option: option price = $5, strike price = $100, option life = 2 months Profit ($) Terminal stock price ($)

15 Short Call on IBM Profit from writing an IBM European call option: option price = $5, strike price = $100, option life = 2 months Profit ($) Terminal stock price ($)

16 Long Put on Exxon Profit from buying an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths Profit ($) Terminal stock price ($)

17 Short Put on Exxon Profit from writing an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths Profit ($) Terminal stock price ($)

18 Payoffs from Options Payoff STST STST K K STST STST K K

Examples Insurance as options  Put options is an insurance for an asset one already owns  Call option is insurance for an asset one plans to own in the future Equity linked CDs  Example: a simple 5 ½ year CD with a return linked to the S&P 500 might have the following structure: at maturity the CD is guaranteed to reply the invested amount, plus 65% of the simple appreciation in the S&P 500 over that time.  What is the payoff? 19

20 Swaps A swap is an agreement to exchange cash flows at specified future times according to certain specified rules Basic forms of swaps  Interest rate swaps;  currency swaps

21 An Example of a “Plain Vanilla” Interest Rate Swap An agreement by Microsoft to receive 6- month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million

22 Cash Flows to Microsoft Millions of Dollars LIBORFLOATINGFIXEDNet DateRateCash Flow Mar.5, % Sept. 5, %+2.10–2.50–0.40 Mar.5, %+2.40–2.50–0.10 Sept. 5, %+2.65– Mar.5, %+2.75– Sept. 5, %+2.80– Mar.5, %+2.95–

23 Typical Uses of an Interest Rate Swap Converting a liability from  fixed rate to floating rate  floating rate to fixed rate Converting an investment from  fixed rate to floating rate  floating rate to fixed rate

24 Currency Swap Example An agreement to pay 11% on a sterling principal of £10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years

25 The Cash Flows Year $ millions – – – – – £

26 Typical Uses of a Currency Swap Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency

27 Credit Risk A swap is worth zero to a company initially At a future time its value is liable to be either positive or negative The company has credit risk exposure only when its value is positive  The risk is asymmetric!

28 Swaptions What is a swaption?  Swap + Option = swaption  It is an option written on a swap rate How does it work?

29 Credit Derivatives Credit Default Swap  Company A buys default protection from B to protect against default on a reference bond issued by the reference entity, C.  A makes periodic payments to B  In the event of a default by C A has the right to sell the reference bond to B for its face value, or B pays A the difference between the market value and the face value

30 CDS Structure Default Protection Buyer, A Default Protection Seller, B 90 bps per year Payment if default by reference entity,C

31 Other credit derivatives First-to-default Total return swap Credit spread option CDO