University of Colorado at Boulder – Leeds School of Business – FNCE4030 FNCE4030 – Investments and Portfolio Management Introduction on Derivatives
University of Colorado at Boulder – Leeds School of Business – FNCE4030 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 – FNCE4030 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 – FNCE4030 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 – FNCE4030 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 – FNCE4030 Growth of OTC Market by Product Commodity 700 Equity-linked Credit default swaps Interest rate FX 600 500 $ trillions 400 300 200 100 0 Jun.98 Jun.99 Jun.00 Jun.01 Jun.02 Jun.03 Jun.04 Jun.05 Jun.06 Jun.07 Jun.08 Jun.09 Jun.10 Jun.11 Jun.12
University of Colorado at Boulder – Leeds School of Business – FNCE4030 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 – FNCE4030 Forwards
University of Colorado at Boulder – Leeds School of Business – FNCE4030 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 – FNCE4030 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 – FNCE4030 Forward Example • On Jan 10, 2013 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.6115 • This contract obligates the corporation to pay $1,611,500 for £1 million on the maturity date (July 10, 2013) • What are the possible outcomes?
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Profit from a Long Forward • K = delivery price = 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 – FNCE4030 Profit from a Short Forward • K = delivery price = 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 – FNCE4030 Futures Contracts
University of Colorado at Boulder – Leeds School of Business – FNCE4030 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. More on this later.
University of Colorado at Boulder – Leeds School of Business – FNCE4030 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 Hull book)
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Examples of Futures Contracts • You think gold will appreciate during the year: Buy 100 oz. of gold @ 1662 $/oz in Dec. • You will receive GBP in March but want USD: Sell £62,500 @ 1.661 US$/£ in March • You are an oil producer and want to hedge: Sell 1,000 bbl. of oil @ 92 $/bbl in April • You are a soybean buyer looking to lock your input costs: Buy 1mm bushels of soybean in 6m
University of Colorado at Boulder – Leeds School of Business – FNCE4030 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 – FNCE4030 Who Trades Derivatives? • 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 – FNCE4030 Hedging Examples (pages 10-12) • A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract • An investor owns 1,000 Microsoft shares currently worth $26.88 per share. A two- month put with a strike price of $27.00 costs $1. The investor decides to hedge by buying 10 contracts
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Speculation Example • You have $2,000 to invest • You believe that a stock price will increase over the next 2 months • The current stock price is $20 • The price of a 2-month call option with a strike of 22.50 is $1 • What are the alternative strategies?
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Arbitrage Example • A stock price is quoted both in London and in New York. The prices are: – £100 in London – $155 in New York • The current exchange rate is 1.6100 • (ask your self what are the units of that figure) • Is there an arbitrage opportunity? • If so what is it?
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Dangers • Traders can switch from being hedgers to speculators or from being arbitrageurs to speculators • It is important to set up controls to ensure that trades are using derivatives in for their intended purpose • SocGen is an example of what can go wrong (see Hull, Business Snapshot 1.3 on page 17)
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Hedge Funds (see Business Snapshot 1.2, page 11) • Mutual Funds must – disclose investment policies, – makes shares redeemable at any time – limit use of leverage – take no short positions. • Hedge Funds – Are not subject to the same rules as mutual funds – Cannot offer their securities publicly – Use complex trading strategies are big users of derivatives for hedging, speculation and arbitrage
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Swaps
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Nature of Swaps • A swap is an agreement to exchange cash flows at specified future times according to certain specified rules – Typically swaps have two legs as there are two parties…swapping cash flows Cash flow Counterparty Counterparty A B Cash flow
University of Colorado at Boulder – Leeds School of Business – FNCE4030 Vanilla Interest Rate Swap • An agreement to swap fixed rate cash flows for floating cash flows over a specified period of time – Tenor • determines how often payments are made • In the US – floating payments are generally every 3 months – Fixed payments are made every 6 months – Floating cash flows reference a “ trusted ” benchmark rate – e.g. LIBOR • Generally the reference rate is fixed at the beginning of a period and paid at the end
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