FIN301 PPT slides - Session 5 PDF

Preview

Summary

lecture notes lecture notes...

Description

FIN301 Session 5: Thank You. • Derivatives Market

What&is&a&derivative? •

•

A&derivative&is&a&contract – Between&two&counterparties – Involves&a&set&of&payments&or&payoff • Some&are&one&way,&some&the&other&way • Some&are&now,&perhaps,&and&some&later – Payoffs&relate&to&one&or&more&of&the&following: • Stock&prices&and&stock&indexes • Bond&prices&and&interest&rates • Foreign¤cy&exchange&rates • Commodity&prices • Specific&events&such&as&earthquakes Derivatives&include: – Options – Forwards&and&futures – Swaps – Insurance 2

DERIVATIVE MARKETS

Over-the-counter market contracts • between private parties • terms and conditions of the contract are decided between two parties • generally unregulated and less transparent Exchange-traded contracts • traded on derivatives exchanges • exchanges decide on terms of the contract • traded like shares in a stock exchange • regulated and offer transparency

MAJOR DERIVATIVES CONTRACTS

Four distinct classes of derivative securities •

Forward contracts

•

Futures contracts

•

Options contracts

•

Swaps contracts

Forward Ø

Agree&on&price&now,&trade&later

January I’ll buy your house in July for $350,000.

July You’ve got a deal.

Nothing.is.exchanged.now.

Thanks for the house.

Thanks for the $350,000.

Trade.occurs.in.the.future.

Call Ø

Agree&on&price&now,&if&option&buyer&wants,&he&buys asset& later

January I’ll buy your house in July for $350,000, if I want to then.

July If you pay me $50,000 extra now, it’s a deal.

Housing.Prices.Rise Thanks for the house.

Thanks for the $350,000.

¯ Housing.Prices.Fall I’ve decided not to buy.

That’s OK. But I get to keep the $50,000.

Put Ø

Agree&on&price&now,&if&option&buyer&wants,&she&sells asset&later

January I’ll sell you my house in July for $350,000 if I want to then.

If you pay me $50,000 extra now, it’s a deal.

July Housing.Prices.Rise I’ve decided not to sell.

That’s OK. But I get to keep the $50,000.

¯ Housing.Prices.Fall Thanks for the $350,000.

Thanks for the house.

Swap Ø

Exchange&assets&now;&return&them&later;&in&the& meantime,&pay&differential&rent January

I’ll use your house until July for $4,000/mo.

I’ll use your boat until July for $3,000/mo.

July Here’s your house back; thanks for returning my boat.

($4,000.- $3,000)/mo..=..$1,000/mo

Thanks for returning my house; here’s your boat back.

Derivative&markets&- Participants •

Participants – Hedgers • Individuals&or&companies&who&face&risks&and&use&the&derivative& market&to&offset&the&risks – Speculators • Those&who&go&into&the&market&hoping&to&profit&by&taking&bets&on& the&movement&of&the&asset&prices – Arbitrageurs • Those&who&seek&to&profit&from&price&discrepancies,&e.g.&betting& that&spreads&will&widen&or&narrow

9

FORWARD CONTRACT Forward contract • • • •

provides holder the right to buy or sell the underlying asset at a future time at a price that is agreed short-term, non-negotiable customised, bilateral OTC contracts mainly used by hedgers

Example: • currency forwards used to hedge exchange rate risk

Forward&contract •

Example:&An&agreement&or&contract&between&two&traders&for&delivery&of&a&specific& asset&at&a&fixed&time&in&the&future&for&a&specified&price.& – E.g.&US$&forward • Quantity:&US$1m • Delivery&date:&1&year&from&date&of&contract • Price:&S$1.45

•

Liquidity& – Terms&of&the&contract&relating&to&characteristics&of&the&assets,&the&method&and& place&of&delivery&and&settlement&procedures&are¬&standardized:&a&party&that& wants&to&get&out&of&contract&needs&to&find&another&party&willing&to&assume&its& position – No&secondary&market&for&forward&contracts.

•

Counterparty&risk – Risk&of&non-performance&by&counterparty 11

FUTURES CONTRACT Futures contract •

provides holder the right to buy or sell the underlying asset at a future time at a price that is agreed

•

negotiable and are traded on derivatives exchanges

•

terms of futures contracts are determined by the exchange

Futures&contract •

Overcomes&deficiencies&of&forward&contract& – Contract&terms&are&standardized,&i.e.&contracts&are&fungible • Results&in&higher&liquidity – Performance&guaranteed&by&clearinghouse • Clearinghouse&(set&up&by&the&exchange)&plays&the&role&of&buyer&to&any& contract&that&has&been&sold,&and&as&seller&to&any&contract&bought. – Marking-to-market reduces&risk&of&non-performance Contract Forward&contract: Futures&contract:&&&& Buyer&&&&&&&&

Buyer&&&& Clearinghouse&&&&&&&&&

Seller Seller

13

Features&of&futures&trading •

•

•

Marking&to&market – Daily&adjustment&of&account&to&reflect&price&changes – Any&shortfall&has&to&be&made&good&while&any&profit&may&be&withdrawn – Marking&to&market&reduces&the&probability&of&non-performance&as& contracts&are&closed&out&if&margin&requirements&are¬&met Margins – Futures&contract&involves&promise&to&buy/sell&in&the&future,&hence&full& purchase&price&need¬&be&made&up&front. – Instead&margins,&or&good&faith&deposits,&are&posted. Types&of&margins – Initial&margin • Amount&posted&at&initiation&of&contract

– Maintenance&margin • A&pre-established&amount&below&the&initial&margin. • When&the&margin&falls&below&the&maintenance&margin,&the&investor& receives&a&margin&call • Inability&to&meet&the&margin&call&results&in&position&being&closed 14

FUTURES.VS.FORWARD.CONTRACT

•

Forward&contracts&are&non-negotiable. This&means&that&one&of&the& parties&to&the&contract&cannot&transfer&the&obligations&under&the& contract&to&a&third&party.&However,&futures&contracts&are&negotiable.&The& contract&can&be&transferred&to&another&party&before&maturity.

•

Forward&contracts&are&over-the-counter.contracts.between&two&private& parties.&Futures&contracts&are&traded&in&organized&derivatives&exchanges& in&which&one&can&trade&the&futures&in&a&similar&manner&as&shares&are& traded&in&stock&exchanges.&

•

Forward&contracts&are&custom.made.contracts.in&which&the&underlying& asset,&maturity&of&the&contact,&quantity&of&the&underlying&asset&and&the& forward&price. 15

OPTIONS Option contract • gives option buyer right to either buy or sell underlying asset at a specified price on or before a specified date Advantage of Option Contracts • if price moves against the option buyer, he can chose not to exercise the option • maximum loss is a fixed loss, which is the premium paid for the option

CALL AND PUT OPTIONS A call option • gives the option buyer the right to buy the underlying asset at a specified price at a future time A put option • gives the option buyer the right to sell the underlying asset at a specified price at a future time Option buyer • no obligation to either buy or sell the underlying asset • will exercise the option to buy or sell underlying asset at the specified price only if it does not result in a loss Option writer • person who sells an option, whether it is a call or put option • has to fulfil his obligation when the option buyer exercise the right to buy or sell • receives option premium from option buyer in return for writing the option

Option&terminology •

Exercise a call – tender a call option together with the exercise price and receive the asset (e.g. one share)

•

Exercise a put – tender a put option together with the asset (e.g. one share) and receive the exercise price

•

Covered option – Seller of call owns underlying asset

•

Naked option – Seller of call does not own underlying asset – Note: Going around naked is risky! 18

AMERICAN AND EUROPEAN OPTIONS

American option • can be exercised at any time during the life of the option European option • can be exercised only on the exercise date and not before

In general, • exchange-traded options are American options • over-the- counter options are European options

OPTION EXERCISE PRICE & CONTRACT SIZE Exercise price • also known as strike price • specified price in the options contract at which the option buyer can buy (call option) or sell (put option) the asset • remains constant during the life of the option

Contract size • specifies units of underlying asset that can be bought or sold • exchange sets contract price for exchange traded options

Profit&diagrams&for&buying/selling&stock Profit

Profit S*

S*

Stock&Price

S*

Stock&Price

- S*

Long.Stock S*&=&price&at&which&stock&was&bought&(or&sold&short)

Short.stock 21

Profit&diagrams&for&buying/selling&call Profit

Profit

Exercise& Price

C Stock&Price

X

Stock&Price

X

-C Breakeven&&Price&=&X& +&C

Long.Call Note:&C&=&Price&of&Call

Short.Call 22

Profit&diagrams&for&buying/selling&put Profit

Profit

Breakeven&&Price&=&X&- P

P X -P

Long.Put

Stock&Price

X

Stock&Price

Short.Put 23

OTC OPTIONS AND EXCHANGE-TRADED OPTIONS

Options traded in over-the-counter markets • contracts between two private parties • constructed based on the requirements of the two parties • usually, one party is a hedger and the other party is a financial institution • low volume, mostly interest rate options and currency options Options traded in Exchanges • option terms are decided by the exchange • trading takes place according to the rules and regulations of the exchange

IN-THE-MONEY, AT-THE-MONEY AND OUT-OF-MONEY OPTIONS

In-the-money • if exercising the option will provide a gain Out-of-money • if exercising the option will result in a loss At-the-money • if the market price of asset is close to the exercise price

Components&of&the&option&price •

Intrinsic&value – For&call:&&Max&[0,&S&– X] – For&put:&&Max&[0,&X&– S]

•

Time&value – Difference&between&option&price&and&intrinsic&value – Reflects&insurance&feature&(limited&loss)&as&well&as&potential&for& increase&in&the&intrinsic&value

26

Components&of&the&option&price&– intrinsic&value Intrinsic&value&of&a&call - Value&of&option&upon&immediate&exercise For.call:&&Max&[0,&S&– X] E.g.&Stock&price&=&$15,&Exercise&price&=&$10 Intrinsic&value&=Max&[&0,&$15&- $10&]&=&$5 For&call:&&&If&S&>&X,&call&is&“in-the-money” If&S&=&X,&call&is&“at-the-money” If&S&...