DERIVATIVESWEEK 7

Financial Markets

Spot/Cash Markets Equity Market (Stock Exchanges) Bill and Bond Markets Foreign Exchange

Derivative Markets Futures Markets Options Marktes

Derivatives Markets

OTC Forward (Foreign Exchange) Swaps (CDS, IRS) Options

Organized Markets Futures Options

Why Derivatives?

Derivatives are risk management tools!

Derivative Instruments can be used to transfer risk!

Derivatives

Main Motives for Derivatives Trading

Risk Management (Hedging)

Speculation

Arbitrage

Derivatives and Underlying Assets

Forex

Euro/Dollar

Yen/Dolar

Canadian Dollar/ US Dollar

EnergyOil

Natural Gas

Interest

Government Bonds

Eurodollar

Euroyen

Index

Dow Jones

S&P 500

Nasdaq 100

Agricultural

Cotton

Wheat

Soya

Metals

Gold

Silver

Copper

EquityGoogle Inc.

Is Bankasi

Futures and Options Exchanges Important Futures and Options Exchanges

include: NYSE Euronext Chicago Mercantile Exchange Eurex CBOE

In Turkey: VOB - Vadeli İşlem ve Opsiyon Borsası (Turkish

Derivatives Exchange) under the roof of Borsa İstanbul.

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”.

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

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

Buy or Sell a Futures ContractInvestor 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 1,7920Profit/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

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.

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.

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)

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

Payment (USD)COST (TRY)

TRY/USD Rate (TRY)

Income (TRY)

Net Income (TRY)

100.000 130.000 2,0000 200.000 70.000

100.000 130.000 1,8000 180.000 50.000

100.000 130.000 1,5000 150.000 20.000

100.000 130.000 1,4000 140.000 10.000

100.000 130.000 1,2000 120.000 -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

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 -50.000 130.000 200.000 20,000

1,8000 -30.000 130.000 180.000 20,000

1,5000 0 130.000 150.000 20,000

1,4000 10.000 130.000 140.000 20,000

1,3000 20.000 130.000 130.000 20,000

1,1000 40.000 130.000 110.000 20,000

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)

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.

Option Types

Call OptionGives 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 OptionGives 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.

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.

Option Premium

Option Price has two main components: intrinsic value and time value

OptionPremium

Intrinsic Value +

Time Value

Underlying Price – Strike Price (Call)Strike Price – Underlying Price (Put)

Premium – Intrinsic Value

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 money in the money

S=K at the money at the money

Option Positions and Profit/Loss

Long call Long put Short call Short put

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.

Factors Affecting Option Price Underlying Price (S) Strike Price (K) Time to expiry (t) Volatility (σ) Risk-free rate (r) Dividends (d)

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

Example cont.

Spot TRY/USD Rate

Profit from Exercising the Option

Income in TRY Opsiyon Premium

Net Income

1,2000 (1,6000-1,2000)*1000*100= 40.000 TL

1,2000*100.000=120.000 TL

2.600 TL 157.400 TL

1,3000 (1,6000-1,3000)*1000*100= 30.000 TL

1,3000*100.000=130.000 TL

2.600 TL 157.400 TL

1,4000 (1,6000-1,4000)*1000*100= 20.000 TL

1,4000*100.000=140.000 TL

2.600 TL 157.400 TL

1,5740 (1,6000-1,5740)*1000*100= 2.600 TL

1,5740*100.000=157.400 TL

2.600 TL 157.400 TL

1,6000 Opsiyon kullanılmaz 1,6000*100.000=160.000 TL

2.600 TL 157.400 TL

1,7000 Opsiyon kullanılmaz 1,7000*100.000=170.000 TL

2.600 TL 167.400 TL

1,8000 Opsiyon kullanılmaz 1,8000*100.000=180.000 TL

2.600 TL 177.400 TL