FNCE4040 Derivatives Chapter 1 Introduction The Landscape - PowerPoint PPT Presentation

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives FNCE4040 – Derivatives Chapter 1 Introduction The Landscape Forwards and Option Contracts

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives What is a Derivative? • A derivative is an instrument whose value depends on, or is derived from, the value of another asset. • Examples: – Futures – Forwards – Swaps – Options – Exotics – …

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Why Derivatives Are Important • Key role in transferring risks in the economy • Underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, weather, etc. • Many financial transactions have embedded derivatives • The real options approach to assessing capital investment decisions has become widely accepted

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives How Derivatives Are Traded • On exchanges such as the Chicago Board Options Exchange • In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Size of OTC & Exchange-Traded Markets Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Growth of OTC Market by Product

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives How Derivatives are Used • To hedge risks – e.g. you are a producer of oil or a consumer of soy beans, or are paid in a different currency • 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

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Derivatives can be Risky • AIG had been an active participant in writing default protection on multi-sector CDOs – Essentially made a one way bet on the US housing market – AIG essentially ran out of cash to make collateral calls on their sold derivatives. • At its peak the US government committed $182.3b to support AIG • “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions” Mr. Cassano “was wrong by 11 or 12 orders of magnitude, which may be about as wrong as it’s possible to be in human affairs.” “There’s safety in small numbers” FT.com

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Forwards and Futures

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Foreign Exchange – GBP vs USD • http://www.xe.com/currencycharts/?from=GB P&to=USD&view=5Y • Quotes for Jan 9, 2015 USD/GBP USD per GBP Bid Offer Spot 1.5182 1.5186 1-month forward 1.5144 1.5149 3-month forward 1.5073 1.5081 6-month forward 1.4970 1.4984

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Forward Price • DEFINITION: the delivery price that would be applicable to the contract if negotiated today (i.e. the delivery price that would make the contract worth exactly zero today) • The forward price may (and will likely) be different for contracts of different maturities

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Some Terminology (more to come) • The party that has agreed to buy has a long position • The party that has agreed to sell has a short position • Selling a derivative is sometimes referred to writing a derivative (forwards, options, etc.) • The contract delivery date is sometimes referred to expiration date , or maturity date

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Forward Example • On Jan 9, 2015 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months. Which exchange rate does she use? – 1.4984 USD/GBP USD per GBP Bid Offer • This contract obligates the corporation to pay Spot 1.5182 1.5186 $1,498,400 for £1 million on the maturity date 1-month forward 1.5144 1.5149 (July 9, 2015) 3-month forward 1.5073 1.5081 • What are the possible outcomes? 6-month forward 1.4970 1.4984

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Profit from a Long Forward • K = 1.4984. The delivery price or forward price at time contract is entered into Profit Price of Underlying at Maturity, S T K

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Profit from a Short Forward • K = 1.4984. The delivery price or forward price at time contract is entered into Profit Price of Underlying at Maturity, S T K

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Futures Contracts • Agreement to buy or sell an asset for a certain price at a certain time • Similar to forward contract, but there are differences: – A forward contract is traded OTC, a futures contract is traded on an exchange – A futures contract requires daily settlement of the value of the contract, a forward contract has a cash flow only a maturity • WARNING – This is what the book says but it is not strictly true. To be discussed later in the course.

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Exchanges Trading Futures • CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade) • NYSE Euronext • BM&F (Sao Paulo, Brazil) • TIFFE (Tokyo) • and many more (see list at end of book)

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Examples of Futures Contracts • You think gold will appreciate during the year – Buy 100 oz of gold for December Delivery – http://www.cmegroup.com/trading/metals/preciou s/gold.html • You are a soybean buyer looking to lock your input costs: – Buy 1mm bushels of soybean for November Delivery – http://www.cmegroup.com/trading/agricultural/gra in-and-oilseed/soybean.html

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Options

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Option Types • A Call option is • A Put option is an option to buy an option to sell a certain asset by a certain asset by a certain date for a certain date for a certain price a certain price (the strike price) (the strike price)

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Futures/Forwards vs. Options • A futures/forward • An option contract contract gives the gives the holder holder the the right to buy or obligation to buy sell at a certain or sell at a certain price price

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Payout of a Long Call Option • K = strike price of option Profit Price of Underlying at Maturity, S T K

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Payout of a Long Put Option • K = strike price of option Profit Price of Underlying at Maturity, S T K

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Options Style • An American • A European option can be option can be exercised at exercised only any time at maturity during its life A Bermudan option can be exercised only at fixed times before maturity (e.g. monthly)

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Google Option Prices (source: Bbg)

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Types of Traders • Hedgers use derivatives to mitigate the risk they are already exposed to, coming from their business or assets/liabilities • Speculators use derivatives to express a view – often with leverage – on a financial sector/asset • Arbitrageurs use derivatives to lock in a specific payout for a risk-free profit

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Hedging Examples • An investor owns 1,000 Microsoft shares. • She is worried about the price falling over the next two months. She is willing to spend approximately $1/share and can buy put options: – http://www.nasdaq.com/symbol/msft/option- chain?dateindex=2 – Identify some strategies she can follow

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives Hedging Microsoft shares Value of portfolio assuming put with strike 45, purchased for $1.