1. DER I VAT I VES WEEK 7

2. Financial Markets  Spot/Cash Markets  Equity Market (Stock Exchanges)  Bill and Bond Markets  Foreign Exchange  Derivative Markets  Futures Markets  Options Marktes

3. Derivatives Markets OTC  Forward (Foreign Exchange)  Swaps (CDS, IRS)  Options Organized Markets  Futures  Options

4. Why Derivatives? Derivatives are risk management tools! Derivative Instruments can be used to transfer risk!

5. Derivatives  Main Motives for Derivatives Trading  Risk Management (Hedging)  Speculation  Arbitrage

6. Derivatives and Underlying Assets Forex Euro/Dollar Yen/Dolar Canadian Dollar/ US Dollar Energy Oil Natural Gas Interest Government Bonds Eurodollar Euroyen Index Dow Jones S&P 500 Nasdaq 100 Agricultural Cotton Wheat Soya Metals Gold Silver Copper Equity Google Inc. Is Bankasi

7. Futures and Options Exchanges  Important Futures and Options Exchanges include:  NYSE Euronext  Chicago Mercantile Exchange  Eurex  CBOE  In Turkey:  VOB - Vadeli İ şlem ve Opsiyon Borsası (Turkish Derivatives Exchange) under the roof of Borsa İ stanbul.

8. Clearing House  FUNCTIONS OF THE CLEARING HOUSE;  IT GUARANTEES THAT THE TWO PARTIES WILL PERFORM THE TRANSACTIONS.  AT THE END OF THE TRADING DAY, IT MATCHES EACH PURCHASE WITH THE CORRESPONDING SALE AND COMPUTES EACH PARTIES GAINS AND LOOSES: “MARK TO MARKET”.

9. Organized Markets vs OTC Markets  FUTUES AND OPTIONS  TRADED ON O.E.  PRICE, AMOUNT, DATE ETC. ARE STANDARTIZED BY THE EXCHANGE  DAILY SETTLEMET  REQUIRES MARGIN ACCOUNT  REGULATED  FORWARD  TRADED ON OTC MARKETS  NOT STANDARD  SETTLED ONLY AT DELIVERY  DOES NOT REQUIRE A MARGIN ACCOUNT  UNREGULATED

10. Futures  Futures contract is a agreement between two parties where one party commits to sell or buy a commodity or security (underliers) to the other party at a given price and amount and on a specified future date.  The Buyer is Long Position Holder  The Seller is Short Position Holder Buy/Sell Future Contract Today Deliver Underlying/ Make Payment Future Date

11. Buy or Sell a Futures Contract Investor sells 10 TRY/USD futures contracts which expire in February 2012 at a price of 1,79. Suppose the spot price on Feb 2012 is 1,7920 Profit/Loss: (1,7900-1,7920)*1.000=8TRY/contract For one contract: Short Position (Seller): 8 TRY Loss Long Position (Buyer): 8 TRY Profit 10 futures contracts have been sold so: 10*8 TRY=80 TRY profit or loss occured -> Zero-Sum Game To close out a futures position investor has to take an offsetting position

12. FUTURES: LEVERAGE  USE OF CREDIT OR BORROWED FUNDS TO IMPROVE ONE'S SPECULATIVE CAPACITY AND INCREASE THE ROR FROM AN INVESTMENT, AS IN BUYING SECURITIES ON MARGIN.  THE LEVERAGE OF FUTURES TRADING REFERS TO ONLY A SMALL AMOUNT OF MONEY IS DEPOSITED TO BUY OR SELL A FUTURES CONTRACT.

13. FUTURES: MARGIN  A DEPOSIT TO COVER LOOSES THAT MIGHT BE INCURRED IN THE FUTURES TRADING.  BOTH THE BUYER AND THE SELLER OF A FUTURES CONTRACT ARE REQUIRED TO PROVIDE MARGIN.  THIS LOW INITIAL MARGIN MAGNIFIES THE PERCENTAGE OF LOSS OR PROFIT POTENTIAL.

14. Physical Delivery or Cash Settlement  Futures/Options are either settled in cash (Cash Settlement) or the underlying asset is delivered and payed for at expiry (Physical Delivery)

15. HEDGING WITH FUTURES INVESTORS CAN USE FUTURES FOR HEDGING  INVESTORS CAN HEDGE AGAINST CHANGES IN STOCK PRICES OR AN INVESTOR CAN MAKE PROFIT FROM DECLINING PRICES BY SELLING AND FROM RISING PRICES BY BUYING  BORROWERS CAN HEDGE AGAINST HIGHER INTEREST RATES, LENDERS AGAINST LOWER INTEREST RATES.  FARMERS CAN HEDGE AGAINST LOWER COTTON PRICES, MERCHANTS AGAINST HIGHER COTTON PRICES

16. Payment (USD) COST (TRY) TRY/USD Rate (TRY) Income (TRY) Net Income (TRY) 100.000130.0002,0000200.00070.000 100.000130.0001,8000180.00050.000 100.000130.0001,5000150.00020.000 100.000130.0001,4000140.00010.000 100.000130.0001,2000120.000-10.000 A company exports goods for 100.000 USD. The company will receive the payment in three months time. The total cost for the goods produced is 130.000 TRY In case the value of USD decreases the company may have loss Example: Hedging Foreign Exchange Risk

17. Example cont. In order to hedge the total amount of 100.000 USD, 100 TRY/USD futures contracts are sold (100*1.000) at $1,5000. Spot USD Rate (TRY) Futures Profit/Loss (TRY) Cost (TRY) Income (TRY)Net Income (TRY) 2,0000-50.000130.000200.00020,000 1,8000-30.000130.000180.00020,000 1,50000130.000150.00020,000 1,400010.000130.000140.00020,000 1,300020.000130.000 20,000 1,100040.000130.000110.00020,000 By Selling 100 futures contracts the company has hedged itself against possible losses! 1,5000-1,4000=-0,100 0,100*1.000=100TRY/contract 100*100=10.000TRY (100 contract)

18. OPTIONS AND OPTIONS ON FUTURES  Option contract is an agreement between two parties.  An option contract gives the buyer the right to purchase or sell an economic benchmark, financial underlying or commodity at certain price and quantity at any time till expiry or at a specified date  The seller of an option is obliged to fulfill the obligation if the buyer exercises his right.

19. Option Types  Call Option Gives the buyer the right to buy the underlying asset at a certain price and quantity till expiry or at a specified date in return for a premium.  Put Option Gives the buyer the right to sell the underlying asset at a certain price and quantity till expiry or at a specified date in return for a premium.

20. Option Types American vs European Options The right of the option can be exercised anytime prior to expiry. American Options European Options Expiry of the Option Contract Buying the Option The right of the option can only be exercised at maturity.

21. Option Premium  Option Price has two main components: intrinsic value and time value Option Premium Intrinsic Value +Time Value Underlying Price – Strike Price (Call) Strike Price – Underlying Price (Put) Premium – Intrinsic Value

22. In the money or out of the money? CALL OPTION PUT OPTION S>K in the moneyout of the money S<K out of the moneyin the money S=K at the money

23. Option Positions and Profit/Loss  Long call  Long put  Short call  Short put

24. Question???  Strike Price (K) ?  What are the positions?  What are the expectations of the position holders?  What is the max/min profit/loss for each position.

25. Factors Affecting Option Price  Under l ying Price (S)  Strike Price (K)  Time to expiry (t)  Volatility ( σ )  Risk-free rate (r)  Dividends (d)

26. Example  A company exports goods for 100.000 USD. The company will receive the payment in three months time.  In case the value of USD decreases the company profit decreases.  To hedge the foreign exchange risk the company buys 100 TRY/USD put options with a strike price of 1,6000 (contract size 1000 USD).  The option premium is 0,0260 TRY.  Total premium paid is 0,0260 TRY*1.000*100=2.600 TRY

27. Example cont. Spot TRY/USD Rate Profit from Exercising the Option Income in TRYOpsiyon Premium Net Income 1,2000(1,6000-1,2000)*1000*100 = 40.000 TL 1,2000*100.000 =120.000 TL 2.600 TL157.400 TL 1,3000(1,6000-1,3000)*1000*100 = 30.000 TL 1,3000*100.000 =130.000 TL 2.600 TL157.400 TL 1,4000(1,6000-1,4000)*1000*100 = 20.000 TL 1,4000*100.000 =140.000 TL 2.600 TL157.400 TL 1,5740(1,6000-1,5740)*1000*100 = 2.600 TL 1,5740*100.000 =157.400 TL 2.600 TL157.400 TL 1,6000Opsiyon kullanılmaz1,6000*100.000 =160.000 TL 2.600 TL157.400 TL 1,7000Opsiyon kullanılmaz1,7000*100.000 =170.000 TL 2.600 TL167.400 TL 1,8000Opsiyon kullanılmaz1,8000*100.000 =180.000 TL 2.600 TL177.400 TL