1. Options and Speculative Markets 2004-2005 Introduction Professor André Farber Solvay Business School Université Libre de Bruxelles

2. August 23, 2004 OMS 01 Introduction |2 1.Introduction Outline of this session 1.Course outline 2.Derivatives 3.Forward contracts 4.Options contracts 5.The derivatives markets 6.Futures contracts

3. August 23, 2004 OMS 01 Introduction |3 Reference: John HULL Options, Futures and Other Derivatives, Fifth edition, Prentice Hall 2003 Copies of my slides will be available on my website: www.ulb.ac.be/cours/solvay/farber www.ulb.ac.be/cours/solvay/farber Grades: –Cases: 20% –Final exam: 80%

4. August 23, 2004 OMS 01 Introduction |4 Course outline

5. August 23, 2004 OMS 01 Introduction |5 Derivatives A derivative is an instrument whose value depends on the value of other more basic underlying variables 2 main families: Forward, Futures, Swaps Options = DERIVATIVE INSTRUMENTS value depends on some underlying asset

6. August 23, 2004 OMS 01 Introduction |6 Forward contract: Definition Contract whereby parties are committed: –to buy (sell) –an underlying asset –at some future date (maturity) –at a delivery price (forward price) set in advance 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 Buying forward = "LONG" position Selling forward = "SHORT" position When contract initiated: No cash flow Obligation to transact

7. August 23, 2004 OMS 01 Introduction |7 Forward contract: example Underlying asset: Gold Spot price:$380 / troy ounce Maturity:6-month Size of contract:100 troy ounces (2,835 grams) Forward price:$390 / troy ounce Spot price350370390410430 Buyer (long)-4,000-2,0000+2,000+4,000 Seller (short)+4,000+2,0000-2,000-4,000 Profit/Loss at maturity

8. August 23, 2004 OMS 01 Introduction |8 Forward contract: Gains and losses

9. August 23, 2004 OMS 01 Introduction |9 Options contracts: Definition A call (put) contract gives to the owner - the right : - to buy (sell) - an underlying asset - on or before some future date (maturity) on : "European" option before: "American" option - at a price set in advance (the exercise price or striking price) Buyer pays a premium to the seller (writer)

10. August 23, 2004 OMS 01 Introduction |10 Option contracts: example Underlying asset: Gold Spot price:$380 / troy ounce Maturity:6-month Size of contract:100 troy ounces (2,835 grams) Exercise price:$390 / troy ounce PremiumCall $30 / troy ouncePut $34 / troy ounce Spot price350370390410430 Long call-3,000 -1,000+1,000 Seller (short)+3,000 +1,000-1,000 Long put+600-1,400-3,400 Short put-600+1,400+3,400

11. August 23, 2004 OMS 01 Introduction |11 European call option: Terminal payoff Exercise option if, at maturity, S T > K then : C T = S T - K otherwise: C T = 0 C T = MAX(0, S T - K)

12. August 23, 2004 OMS 01 Introduction |12 European call option: Profit at maturity

13. August 23, 2004 OMS 01 Introduction |13 European put option Exercise option if, at maturity, S T < K then P T = K - S T otherwise P T = 0 P T = MAX(0, K - S T )

14. August 23, 2004 OMS 01 Introduction |14 Put, call and forwards: put call parity Long forward Long call Short put Profit STST K + Call – Put = + Forward

15. August 23, 2004 OMS 01 Introduction |15 Derivatives Markets Exchange traded –Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading –Contracts are standard there is virtually no credit risk Over-the-counter (OTC) –A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers –Contracts can be non-standard and there is some small amount of credit risk

16. August 23, 2004 OMS 01 Introduction |16 Global Market Size Notional amount billions US$Dec. 2002Dec. 2003 OTC Derivatives141,679197,177 - Foreign exchanges contracts18,46024,484 - Interest rate contracts121,799141,991 - Equity-linked contracts2,7993,787 - Commodity contracts9231,040 -Other21,95225,510 Organized Exchanges23,67546,733 - IR Futures9,95613,123 - IR Options11,75920,793 - Currency Futures4780 - Currency Options2738 - Equity Index Futures326502 - Equity Index Options1,7002,197 Source: BIS Quarterly Review, June 2004 – www.bis.org

17. August 23, 2004 OMS 01 Introduction |17 Evolution of global market

18. August 23, 2004 OMS 01 Introduction |18 Main Derivative markets Europe Eurex:http://www.eurexchange.com/ Liffe: http://www.liffe.com Matif : http://www.matif.fr United States Chicago Board of Tradehttp: //www.cbot.com

19. August 23, 2004 OMS 01 Introduction |19 Why use derivatives? 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

20. August 23, 2004 OMS 01 Introduction |20 Forward contract: Cash flows Notations S T Price of underlying asset at maturity F t Forward price (delivery price) set at time t<T Initiation Maturity T Long 0 S T - F t Short 0 F t - S T Initial cash flow = 0 :delivery price equals forward price. Credit risk during the whole life of forward contract.

21. August 23, 2004 OMS 01 Introduction |21 Forward contract: Locking in the result before maturity Enter a new forward contract in opposite direction. Ex: at time t 1 : long forward at forward price F 1 At time t 2 (<T): short forward at new forward price F 2 Gain/loss at maturity : (S T - F 1 ) + (F 2 - S T ) = F 2 - F 1 no remaining uncertainty

22. August 23, 2004 OMS 01 Introduction |22 Futures contract: Definition Institutionalized forward contract with daily settlement of gains and losses Forward contract –Buy  long sell  short Standardized –Maturity, Face value of contract Traded on an organized exchange –Clearing house Daily settlement of gains and losses (Marked to market)

23. August 23, 2004 OMS 01 Introduction |23 Example : Gold Futures (Comex – Nymex.com) Trading unit: 100 troy ounces (2,835 grams) July 3, 2002 Source: Wall Street Journal

24. August 23, 2004 OMS 01 Introduction |24 Gold futures: contract specifications Trading Months Futures: Trading is conducted for delivery during the current calendar month, the next two calendar months, any February, April, August, and October thereafter falling within a 23-month period, and any June and December falling within a 60- month period beginning with the current month. Options: The nearest six of the following contract months: February, April, June, August, October, and December. Additional contract months - January, March, May, July, September, and November - will be listed for trading for a period of two months. A 24-month option is added on a June/December cycle. The options are American-style and can be exercised at any time up to expiration. On the first day of trading for any options contract month, there will be 13 strike prices each for puts and calls. Price Quotation Futures and Options: Dollars and cents per troy ounce. For example: $301.70 per troy ounce. Minimum Price Fluctuation Futures and Options: Price changes are registered in multiples of 10¢ ($0.10) per troy ounce, equivalent to $10 per contract. A fluctuation of $1 is, therefore, equivalent to $100 per contract. Maximum Daily Price Fluctuation Futures: Initial price limit, based upon the preceding day’s settlement price is $75 per ounce. Two minutes after either of the two most active months trades at the limit, trades in all months of futures and options will cease for a 15-minute period. Trading will also cease if either of the two active months is bid at the upper limit or offered at the lower limit for two minutes without trading. Trading will not cease if the limit is reached during the final 20 minutes of a day’s trading. If the limit is reached during the final half hour of trading, trading will resume no later than 10 minutes before the normal closing time. When trading resumes after a cessation of trading, the price limits will be expanded by increments of 100%. Options: No price limits. Last Trading Day Futures: Trading terminates at the close of business on the third to last business day of the maturing delivery month. Options: Expiration occurs on the second Friday of the month prior to the delivery month of the underlying futures contract.

25. August 23, 2004 OMS 01 Introduction |25 Futures: Daily settlement and the clearing house In a forward contract: –Buyer and seller face each other during the life of the contract –Gains and losses are realized when the contract expires –Credit risk BUYER  SELLER In a futures contract –Gains and losses are realized daily (Marking to market) –The clearinghouse garantees contract performance : steps in to take a position opposite each party BUYER  CH  SELLER

26. August 23, 2004 OMS 01 Introduction |26 Futures: Margin requirements INITIAL MARGIN : deposit to put up in a margin account by a person entering a futures contract MAINTENANCE MARGIN : minimum level of the margin account MARKING TO MARKET : balance in margin account adjusted daily Equivalent to writing a new futures contract every day at the new futures price (Remember how to close of position on a forward) Note: timing of cash flows different + Size x (F t+1 -F t )-Size x (F t+1 -F t ) LONG(buyer) SHORT(seller)

27. August 23, 2004 OMS 01 Introduction |27 Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5 –contract size is 100 oz. –futures price is US$400 –margin requirement is US$2,000/contract (US$4,000 in total) –maintenance margin is US$1,500/contract (US$3,000 in total)

28. August 23, 2004 OMS 01 Introduction |28 A Possible Outcome DailyCumulativeMargin FuturesGain AccountMargin Price(Loss) BalanceCall Day(US$) 400.004,000 5-Jun397.00(600) 3,4000.................. 13-Jun393.30(420) (1,340) 2,6601,340................. 19-Jun387.00(1,140) (2,600) 2,7401,260.................. 26-Jun392.30260 (1,540) 5,0600 + = 4,000 3,000 + = 4,000 <

29. August 23, 2004 OMS 01 Introduction |29 Futures Contracts Example: Barings Long position on 20,000 Nikkei 225 Futures 1 index pt = Yen 1,000 = $ 10 If Nikkei 225 = 20,000 Size of contract = $ 200,000  position =$ 4,000 mio DateNikkei 225 30.12.9419,723 25.02.9517,473  F = - 2,250 Loss =  F  $/pt  # contracts = (-2,250)  ($ 10)  (20,000) = $ 450,000,000