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3
The Nature of Derivatives
A derivative is a financial instrument whose value depends on the values of other more basic underlying variables
In particular, it depends on the market price of the so called:
underlying asset.
4
Underlying assets:StocksBondsForeign currenciesGold, Silver…Crude oil, Natural gas, Gasoline, heating oil…Wheat, corn, rice, grain feed, soy beans,
porkbellies…Stock indexes
6
WHY TRADE DERIVATIVES?
THE FUNDAMENTALREASON FOR TRADING
DERIVATIVES IS TO HEDGE: THE PRICE RISK
(VOLATILITY)Exhibited by the spot price of the
underlying commodity
7
PRICE RISK IS THE
VOLATILITYASSOCIATED WITH THE COMMODITY’S
PRICE IN THE CASH MARKET
REMEMBER THAT THE CASH MARKET IS WHERE FIRMS DO THEIR BUSINESS. I.E., BUY
AND SELL THE COMMODITY.
ZERO PRICE VOLATILITYNO DERIVATIVES!!!!
8t
Probability distributio
St
T time
ST
PRICE RISK: At time t, the asset’s price at time T is not
known.
9
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
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Types of risk:Price riskCredit risk
Operational riskCompletion risk
Human riskRegulatory risk
Tax risk
11
IN THIS CLASS WE WILL ONLY ANALYZE THE
RISK ASSOCIATED WITH THESPOT MARKET PRICE
OFTHE UNDERLYING ASSET
13
DERIVATIVES ARE CONTRACTSThe distinction is made by the different stipulations
of the contract
Forwards and Futures are Fixed obligations
A FORWARDIS A CONTRACT IN WHICH ONE PARTY COMMITS TO BUY AND THE OTHER PARTY COMMITS TO SELL A SPECIFIED
AMOUNT OF AN AGREED UPON COMMODITY FOR A PREDETERMINED PRICE ON A SPECIFIC DATE IN THE
FUTURE.
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BUY = OPEN A LONG POSITIONSELL = OPEN A SHORT POSITION
t
Buy or sell a forward T Tim
e
Delivery and payment
15
Forward Price• 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
16
EXAMPLE: GBP 18.5.99
SPOT USD1,6850/GBP
30 days forward USD1,7245/GBP
60 days forward USD1,7455/GBP
90 days forward USD1,7978/GBP
180 days forward USD1,8455/GBP
The existence of forward exchange rates implies that there is a demand and supply for the GBP for future dates.
In the actual market, however, different rates are quoted for buy (ask) and for sell (bid) orders.
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Foreign Exchange Quotes for USD/GBP on Aug 16, 2001 ( page 3)
Bid Offer
Spot 1.4452 1.4456
1-month forward 1.4435 1.4440
3-month forward 1.4402 1.4407
6-month forward 1.4353 1.4359
12-month forward 1.4262 1.4268
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A FUTURES
A STANDARDIZED FORWARD TRADED ON AN ORGANIZED EXCHANGE.
STANDARDIZATION THE COMMODITY
TYPE AND QUALITY
THE QUANTITY
PRICE QUOTES
DELIVERY DATES
DELIVERY PROCEDURES
21
Futures Contracts
• Agreement to buy or sell an asset for a certain price at a certain time
• Similar to forward contract• Whereas a forward contract is
traded OTC, a futures contract is traded on an exchange
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AN OPTION IS A CONTRACT IN WHICH ONE PARTY HAS THE RIGHT,
BUT NOT THE OBLIGATION, TO BUY OR SELL A SPECIFIED AMOUNT OF AN AGREED UPON COMMODITY
FOR A PREDETERMINED PRICE BEFORE OR ON A SPECIFIC DATE IN THE FUTURE. THE OTHER PARTY HAS
THE OBLIGATION TO DO WHAT THE FIRST PARTY WISHES TO DO. THE FIRST PARTY, HOWEVER, MAY
CHOOSE NOT TO EXERCISE ITS RIGHT AND LET THE OPTION EXPIRE WORTHLESS.
A CALL = A RIGHT TO BUY THE UNDERLYING ASSET
A PUT = A RIGHT TO SELL THE UNDERLYING ASSET
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Long Call on Microsoft (Figure 1.2, Page 7)
Profit from buying a European call option on Microsoft: option price = $5, strike price = $60
30
20
10
0-5
30 40 50 60
70 80 90
Profit ($)
Terminalstock price ($)
24
Short Call on Microsoft (Figure 1.4, page 9)
Profit from writing a European call option on Microsoft: option price = $5, strike price = $60
-30
-20
-10
05
30 40 50 60
70 80 90
Profit ($)
Terminalstock price ($)
25
Long Put on IBM (Figure 1.3, page 8)
Profit from buying a European put option on IBM: option price = $7, strike price = $90
30
20
10
0
-790807060 100 110 120
Profit ($)
Terminalstock price ($)
26
Short Put on IBM (Figure 1.5, page 9)
Profit from writing a European put option on IBM: option price = $7, strike price = $90
-30
-20
-10
7
090
807060
100 110 120
Profit ($)Terminal
stock price ($)
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A SWAPIS A CONTRACT IN WHICH THE TWO
PARTIES COMMIT TO EXCHANGE A SERIES OF CASH FLOWS. THE CASH FLOWS ARE BASED ON AN AGREED UPON PRINCIPAL
AMOUNT. NORMALLY, ONLY THE NET FLOW EXCHANGES HANDS.
Principal amount = EUR100,000,000; semiannual payments.
Party A Party B7%
6-months LIBOR
28
Types of Derivatives Traders• Speculators
• Hedgers
•ArbitrageursSome of the large trading losses in
derivatives occurred because individuals who had a mandate to
hedge risks switched to being speculators