Week 1 Lecture Notes PDF

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Week 1 Lecture Notes: Thursday, 13 January 2022

11:53

Table of Contents 1. 2.

What is this Course About Course Information

Class Information -

Instructor: Julian Neira, [email protected] Virtual Office hours: Tuesdays 11:3- - 13:30 ○ Permanent Zoom Link: tinyurl.com/55v28k9a Textbook: Fundamentals of Futures and Options Markets By John Hull, 8th edition

What is this course about? -

This course is about financial instruments called derivatives A derivative is a contract whose value depends on the values of other more basic underlying variables

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Main types of derivatives ○ Forward contracts ○ Future contracts ○ Options ○ Swaps

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The goal of the course is to give you and understanding of ○ How these contracts work ○ How they are used ○ How they are priced

Motivation: -

A British companies supplies tools to the EU and US however currency fluctuations can cause a big impact on revenues. How can the firm reduce (or hedge) these risks?

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An airline knows it will need to purchase 20,000 barrels of oil at some point in h f h Fl i i Oil i h h i

the next few months. Fluctuations in Oil prices can have a huge impact on revenues. -

You have the opportunity to buy a mine with 1 million kgs of copper for $400,000. Copper has a price of $2.2/ kg, mining costs are $2/ Kg, and you can delay extraction one year. How valuable is the option to delay? Is the mine a good deal?

Motivation -

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Hedging or Speculation Alternative Tools? ○ Futures, forwards, options, and swaps ○ Insurance ○ Diversification ○ Match duration of assets and liabilities ○ Match sales and expense across countries (currency risk) Should firms hedge with financial derivatives? ○ Derivatives are efficient tools for risk management ○ Derivatives are financial weapons of mass destruction

View 1: Hedging is irrelevant (Modigliani & Miller) ○ Financial transaction, Zero NPV ○ Diversified shareholders don’t care about firm-specific risks View 2: Hedging creates value ○ Ensures cash is available for positive NPV investments

NPV = Net Present Value - "it is the present value of the cashflows at the required rate of return

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○ Ensures cash is available for positive NPV investments ○ Reduces need for external finance ○ Reduces chance of financial distress ○ Improves performance evaluation and compensation Examples ○ Homestake Mining § Does not hedge because "shareholders will achieve maximum benefit from such a policy" ○ American Barrick § Hedges aggressively to provide "extraordinary financial stability… offering investors a predictable, rising earnings profile in the future ○ Battle Mountain Gold § Hedges up to 25% because "a recent study indicates that there may be a premium for hedging"

How many firms use derivatives? -

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Guy and Kothari, Journal of Financial Economics, 2003 ○ Random sample of 413 large firms in the use ○ 57% of firms used derivatives El-Masry, Managerial Finance, 2006 ○ Random sample of 401 large firms in the UK ○ 67% of firms used derivatives

Motivation -

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Forwards and Futures (Weeks 1-3) ○ A contract to exchange an asset in the future at a specified price and time Options (Weeks 4 - 11, Guest speaker on week 10) ○ Gives the holder the right to buy (call option) or sell (put option) an asset at a specified price Swaps ○ An agreement to exchange a series of cashflows at specified prices and times

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of your project compared to your initial investment" This is a method of calculating return on investment (ROI) It does this by looking at all the money you expect to make from the investment and translating those returns into todays dollars, allowing you to decide if the project is worth it...