Introduction to Financial Derivatives- Hedgers, Speculators and Arbitrageurs PDF

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Introduction to Financial Derivatives: Hedgers, Speculators and Arbitrageurs The Nature of Derivatives • A derivative is an instrument whose value depends on the values of other more basic • Derivatives play a key role in transferring risks in the economy Types of Trader • Hedgers (reduce risk) • Speculators (bet on the future direction) • Arbitrageurs (take offsetting positions)

Why derivatives are important • Derivatives play a key role in transferring risks in the economy • There are many underlying assets: stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etc. • Many financial transactions have embedded derivatives • The real options approach to assessing capital investment decisions, which values the options embedded in investments using derivatives theory, has become widely accepted

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 Examples of Derivatives • Futures Contracts • Forward Contracts • Swaps • Options

Futures contracts • A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price • By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time) Exchanges Trading Futures • CME Group (includes CBT, CME and NYME) • Intercontinental Exchange • NYSE Euronext • Eurex • BM&FBovespa (Sao Paulo, Brazil) • National Stock Exchange of India • China Financial futures Exchange EXAMPLE • In June a trader in New York might contact a broker with instructions to buy 5,000 bushels of corn for September delivery. The broker would immediately communicate the client’s instructions to the CME Group. • At about the same time, another trader in Kansas might instruct a broker to sell 5,000 bushels of corn for September delivery. These instructions would also be passed on to the CME Group. • A price would be determined and the deal would be done.

• The trader in New York who agreed to buy has what is termed a long futures position.

• The trader in Kansas who agreed to sell has what is termed a short futures position.

• The futures prices for a particular contract is the price at which you agree to buy or sell at a future time (lets assume 600 cents or $6) • It is determined by supply and demand in the same way as a spot price. • The two prices are not usually equal.

Electronic trading • Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange • This has now been largely replaced by electronic trading and high frequency (algorithmic) trading has become an increasingly important part of the market • Electronic trading has led to a growth in algorithmic trading, also known as black-box, automated, high frequency or robo trading (no human intervention) Examples of Future Contracts • Agreement to: buy 100 oz. of gold @ US$1100/oz. in December sell £62,500 @ 1.5500 US$/£ in March sell 1,000 bbl. of oil @ US$40/bbl. in April

• The party that has agreed to buy has a long position • The party that has agreed to sell has a short position over-the-counter markets • The over-the counter market is an important alternative to exchanges • Trades are usually between financial institutions, corporate treasurers, and fund managers • Transactions are much larger than in the exchange-traded market Size of OTC and Exchange-Traded Markets

The Lehman Bankruptcy • Lehman’s filed for bankruptcy on September 15, 2008. This was the biggest bankruptcy in US history • Lehman was an active participant in the OTC derivatives markets and got into financial difficulties because it took high risks and found it was unable to roll over its short term funding • It had hundreds of thousands of OTC derivatives transactions outstanding with about 8,000 counter-parties • Unwinding these transactions has been challenging for both the Lehman liquidators and their counter-parties New Regulations for OTC Market • The OTC market is becoming more like the exchange-traded market. New regulations introduced since the crisis mean that: - Standard OTC products traded between financial institutions must be traded on swap execution facilities - A central clearing party must be used as an intermediary for standard products when they are traded between financial institutions - Trades must be reported to a central registry • New regulations were introduced because of concerns about systemic risk • OTC transactions between financial institutions lead to systemic risk because a default by one large financial institution can lead to losses by other financial institutions

forward contracts • Forward contracts are similar to futures except that they trade in the over-thecounter market • Forward contracts are popular on currencies and interest rates EXAMPLE

• On June 22, 2012 the treasurer of a corporation might enter into a long forward contract to sell £100 million in six months at an exchange rate of 1.5573 • This obligates the corporation to pay £1 million and receive $155.73 million on December 22, 2012

Options • Traded on both exchanges and OTC markets • A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)

• A put option is an option to sell a certain asset by a certain date for a certain price (the strike price) • The price in the contract is known as the exercise price or the strike price. • The date in the contract is known as the expiration date or maturity date. Options vs Futures/Forwards • A futures/forward contract gives the holder the obligation to buy or sell at a certain price • An option gives the holder the right to buy or sell at a certain price American vs European Options • An American option can be exercised at any time during its life • A European option can be exercised only at maturity • For an option contract you must pay an up-front price, known as the option premium.

EXAMPLE

• Suppose an investor instructs a broker to buy one December call option contract on Google with a strike price of $580. • The broker will relay these instructions to a trader at the CBOE and the deal will be done. The (offer) price is $35.30, as indicated in Table 1.2. This is the price for an option to buy one share. • In the United States, an option contract is an agreement to buy or sell 100 shares. Therefore, the investor must arrange for $3,530 to be remitted to the exchange through the broker. • The exchange will then arrange for this amount to be passed on to the party on the other side of the transaction. In our example, the investor has obtained at a cost of $3,530 the right to buy 100 Google shares for $580 each. • If the price of Google does not not rise above $580.00 by December 22, 2012, the option is not exercised and the investor loses $3,530.2 • But if Google does well and the option is exercised when the bid price for the stock is $650, the investor is able to buy 100 shares at $580 and immediately sell them for $650 for a profit of $7,000—or $3,470 when the initial cost of the options is taken into account.

EXAMPLE

• An alternative trade would be to sell one September put option contract with a strike price of $540 at the bid price of $19.80. • This would lead to an immediate cash inflow of $100x19.80 = $1,980. • If the Google stock price stays above $540, this option is not exercised and the investor makes a $1,980 profit. • However, if stock price falls and the option is exercised when the stock price is $500 there is a loss. • The investor must buy 100 shares at $540 when they are worth only $500. • This leads to a loss of $4,000, or $2,020 when the initial amount received for the option contract is taken into account

Hedging Examples • A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract • An investor owns 1,000 shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

Speculation Example • An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of $22.50 is $1

Arbitrage Example • A stock price is quoted as £100 in London and $152 in New York • The current exchange rate is 1.5500

Dangers • Derivatives are very versatile instruments. As we have seen they can be used for hedging, for speculation, and for arbitrage. It is this very versatility that can cause problems. Sometimes traders who have a mandate to hedge risks or follow an arbitrage strategy become (consciously or unconsciously) speculators. • The results can be disastrous • To avoid the type of problems it is very important for both financial and nonfinancial corporations to set up controls to ensure that derivatives are being used for their intended purpose. Risk limits should be set and the activities of traders should be monitored daily to ensure that the risk limits are adhered to. • Unfortunately, even when traders follow the risk limits that have been specified, big mistakes can happen....