Tim Mundhenke

Financial Instruments

Money & Banking

- Derivatives -

Content Outline1. Introduction 2. What is a derivative?3. Reasons to use derivatives4. Concepts to understand5. Futures 6. Forwards 7. Options 8. Swaps 9. Questions

Introduction (I)In the financial marketplace some instruments are regarded as fundamentals, while others are regarded as derivatives.

Financial Marketplace

Derivatives Fundamentals

Simply another way to catagorize the diversity in the FM*.

*Financial Market

Financial Marketplace

Derivatives Fundamentals

•Stocks •Bonds •Etc.

•Futures•Forwards•Options•Swaps

Introduction (II)

What is a Derivative? (I)Options

Swaps

ForwardsFuturesThe value of the

derivative instrument is DERIVED from the underlying security

Underlying instrument such as a commodity, a stock, a stock index, an exchange rate, a bond, another derivative etc..

Options

Swaps

Forwards

Futures

The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures contract.

The owner of a forward has the OBLIGATION to sell or buy something in the future at a predetermined price. The difference to a future contract is that forwards are not standardized.

The owner of a future has the OBLIGATION to sell or buy something in the future at a predetermined price.

What is a Derivative? (II)

A swap is an agreement between two parties to exchange a sequence of cash flows.

Reasons to use derivatives (I)

Hedging:

Speculation:

• Interest rate volatility • Stock price volatility • Exchage rate volatility • Commodity prices volatility

VOLATILITY

• High portion of leverage • Huge returns

EXTREMELY RISKY

Derivative markets have attained an overwhelming popularity for a variety of reasons...

Reasons to use Derivatives (II)Also derivatives create...

• a complete market, defined as a market in which all identifiable payoffs can be obtained by trading the securities available in the market*.

• and market efficiency, characterized by low transaction costs and greater liquidity.

* Futures, Options and Swaps by R.W. Kolb

Concepts to UnderstandShort Selling: • Short selling is the selling of a security that

the seller does not own.

• Short sellers assume the risk that they will be able to buy the stock at a more favorable price than the price at which they sold short.

Holding Long Position:

• Investors are legally owning a security.

• Investors are the legal owners of a security.

Future Contracts (I)Futures The owner of a future contract has the OBLIGATION to

sell or buy something in the future at a predetermined price.

Scenario: You are a farmer and you know that you will harvest corn in three months from today on. How can you protect yourself from loosing if corn price happens to drop until March by using corn forward contracts?

t1/1 3/1

Harvest

Future Contracts (II)You lock into a price by holding a short position in a corn future contract with a maturity date a little bit longer than the harvest date.

Suppose the price drops...

You either take delivery and lock in a price.

You close out the corn contract and the gain in the futures market will offset the loss in the sport market

“A futures contract makes unfavourable price movements less unfavourable and a favourable price movements less favourable“!

Future Contracts (III)General Rule for Hedgers:

• If you are going to sell something in the near future but want to lock in a secured price, you take a short position.

• If you are going to receive/buy something in the future but want to lock in a secured price, you take a long position.

Future Contracts (IV)The Role of Speculators:

• As the name implies, speculators are involved in price betting and take the risk of price movements against them.

Assume the following: • You, as hedger, believe that prices will raise. Thus, you are convinced

that a long position will benefit you.

• Key Word: Zero-Sum-Gain• Large gains due to the concept of leverage

Forward Contracts (I)Forwards The owner of a forward has the OBLIGATION to sell or buy

something in the future at a predetermined price. The difference to a future contract is that forwards are not standardized.

A Forward Contract underlies the same principles as a future contract, besides the aspect of non-standardization. Thus, a detail illustration is not necessary as I already elaborated in the mechanism of the futures contract.

Options (I)Options The owner of an options has the OPTION to buy or sell

something at a predetermined price and is therefore more costly than a futures.

Some terms to understand:

• Call option• Put option • Excersice price / strike price• Option premium • Moneyness (in-the-money, at-the-money, out-of-money)• European vs. American Options

Options (II)

Call Option

Put Option

Write

Purchase

Write

Purchase

The four basic positions:

Options (III)Write & Purchase Call Option:

x

Long Call

Short Call

Value

Stock Price at Expiration

Options (IV)Write & Purchase Call Option:

Profit and Loss

xStock Price at Expiration

Long Call

Short Call

Premium Paid

Premium EarnedZero-Sum-Game

Options (V)Write & Purchase Call Option:

Profit and Loss

Stock Price at Expiration

Long Put

Short Put

Options (VI)Write & Purchase Call Option:

Profit and Loss

Stock Price at Expiration

Long Put

Short Put Premium Paid

Premium Earned

Swaps A swap is an agreement between two parties to exchange a sequence of cash flows.

Swaps (I)

• Counterparties • Interest rate swaps• Currency swaps • Phenomenal growth of the swap market • Future and Option markets only provide for short term investment

horizon • Traded in OTC markets with little regulations • No secondary market• Market limited to institutional investors

Swaps (II)A Plain Vanilla Interest Rate Swap:

An interest rate swap is an agreement between two parties to exchange a sequence of fixed interest rate payments against floating interest rate payments.

• Fixed side• Receive-fixed side• Tenor• Notional amount

Terms to understand:

Swaps (III)Example: 5 year tenor; notional amount $1 million; Party A is the fixed side paying 9%, Party B is the receive-fixed side, paying a LIBOR flat rate

0 1 2 3 4 5

0 1 2 3 4 5

$90,000 $90,000 $90,000 $90,000 $90,000

$90,000 $90,000 $90,000 $90,000 $90,000

Libor*$1m Libor*$1m Libor*$1mLibor*$1m Libor*$1m

Libor*$1m Libor*$1m Libor*$1mLibor*$1m Libor*$1m

Party A

Party B

QUESTIONS