ADMS4503 Chap1

Introduction
Chapter 1
ADMS 4503 Derivatives
Nabil Tahani
ADMS 4503 - Nabil Tahani
The Nature of Derivatives

A derivative is an instrument whose value
depends on the values of other more basic
underlying variables such as stocks, currencies,
interest rates, commodities and more recently
credit, electricity, weather and insurance
Derivatives History
Derivatives have been used for thousands years
Aristotle, 350 BC (Olive)

Netherlands, 1600s (Tulips)
Dojima Rice Exchange in Japan, 1730s (Futures)
USA, 1800s (Grains, Cotton)
Spectacular growth since 70s due to many

factors
Liberalization
Oil Price Shocks
International trade
Increase in volatility
End of Bretton Woods system (1971)
Black-Scholes-Merton model (1973)
Derivatives History
Derivatives in Canada:
Winnipeg Commodity Exchange, 1904 (Oat)
Montreal Exchange, 1975
Size of exchange-listed derivatives worldwide:

$US548 Trillion (Dec 2007) (All: $US1,144 Trillion)
Almost 46 times the size of the US public debt
The total capitalisation for all stock markets was
slightly above $US40 trillion (Sept 2008) (after a peak
at $US57 trillion in May 2008)
Examples of Derivatives
Forward Contracts
Futures Contracts
Swaps
Options
Examples of Underlying Assets
Stocks
Bonds
Exchange rates
Interest rates
Commodities
Energy
Number of
bankruptcies among
a pool of companies
Temperature, quantity
of rain/snow
Real-estate price
index
Loss caused by an
earthquake/hurricane
Volatility
Other Derivatives

Derivatives Markets
Exchange traded
Traditionally exchanges have used the openoutcry system, but increasingly they are switching
to electronic trading
Contracts are standard and there is virtually no
credit risk
Over-the-counter (OTC)
A computer- and telephone-linked network of
dealers at financial institutions, corporations, and
fund managers
Contracts can be non-standard and there is some
small amount of credit risk
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
Forward Contracts
A forward contract is an agreement to buy or
sell an asset at a certain time in the future for a
certain price (the delivery price)
It can be contrasted with a spot contract which
is an agreement to buy or sell immediately
It is traded in the OTC market
Foreign Exchange Quotes for

GBP on Aug 16, 2001
Spot
Bid
1.4452
Offer
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
10
Forward Price
The forward price for a contract is the delivery
price that would be applicable to the contract if it
were negotiated today
it is the delivery price that would make the contract
worth exactly zero
The forward price may be different for contracts

of different maturities
11
Terminology
The party that has agreed to buy has what is
termed a long position
The party that has agreed to sell has what is
termed a short position
12
Example
On August 16, 2001 the treasurer of a corporation
enters into a long forward contract to buy 1
million in six months at an exchange rate of
1.4359
This obligates the corporation to pay $1,435,900 for
1 million on February 16, 2002
What are the possible outcomes?

13
Profit from a Long Forward

Position
Profit
Price of Underlying
at Maturity, ST
Payoff ST K
14
Profit from a Short Forward

Position
Profit
Payoff K ST
K
Price of Underlying
at Maturity, ST
15
Arbitrage Opportunity
Example 1: Gold
Suppose that:
- The spot price of gold is US$1,000
- The 1-year forward price of gold is US$1,080
- The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

(We ignore storage costs and gold lease rate)
16
Example 1: Gold
Borrow $1,000 at 5%
Buy one ounce of gold at $1,000
Take a short forward position to sell the
gold at $1,080 in one year

In one year, use $1,050 from the $1,080
to repay the loan, making a profit of $30
17
Example 2: Gold
Suppose that:
- The spot price of gold is US$1,000
- The 1-year forward price of gold is US$1,000
18
Example 2: Gold
An investor who has the gold can sell it for
$1,000 per ounce

Invest the proceed at 5%
Take a long forward position to repurchase the
gold at $1,000 in one year
Making a profit of $50
19
The Forward Price of Gold

If the spot price of gold is S and the forward
price for a contract deliverable in T years is F,
then
T
F = S (1+r )
where r is the 1-year (domestic currency) riskfree rate of interest.
In our examples, S = $1,000, T = 1, and r =0.05
so that
F = $1,000x(1+0.05) = $1,050
20
10
Example 3: Oil
Suppose that:
- The spot price of oil is US$65

- The quoted 1-year futures price of oil is US$75
- The storage costs of oil are 2% per annum

21
Example 4: Oil
Suppose that:
- The spot price of oil is US$65
- The quoted 1-year futures price of oil is US$60
- The storage costs of oil are 2% per annum

22
11
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
23
Examples of Futures Contracts

There are futures contracts on almost
everything!
buy 100 oz. of gold @ US$1,000/oz. in
December (COMEX)
sell 62,500 @ 1.5000 US$/ in March (CME)
sell 1,000 bbl. of oil @ US$70/bbl. in April
(NYMEX)
Stock indices, Stocks, Interest rates, Live Cattle,
Coffee, and even Weather
24
12
Examples of Futures Contracts
www.NYMEX.com
www.KITCO.com
25
Exchanges Trading Options

or Futures
Chicago Board Options Exchange

Chicago Mercantile Exchange
One Chicago (Stocks Futures, started Nov. 2002)
Montreal Exchange
American Stock Exchange
Philadelphia Stock Exchange
Pacific Stock Exchange
European Options Exchange
Australian Options Market
see the complete list at end of the textbook
26
13
Options
A call option is an option to buy a certain asset
by a certain date for a certain price (the strike
price)
Payoff max(ST K ,0)
A put option is an option to sell a certain asset

by a certain date for a certain price (the strike
price)
Payoff max( K ST ,0)

27
Long Call on Microsoft

Profit/Loss from buying a European call option on
Microsoft: option price = $5, strike price = $60
30 Profit ($)
20
10
30
0
-5
40
50
Terminal
stock price ($)
60
70
80
90
28
14
Short Call on Microsoft

Profit/Loss from writing a European call option on
Microsoft: option price = $5, strike price = $60
Profit ($)
5
0
70
30
40
50 60
80
90
Terminal
stock price ($)
-10
-20
-30
29
Long Put on IBM

Profit/Loss from buying a European put option on
IBM: option price = $7, strike price = $90
30 Profit ($)
20
10
0
-7
Terminal
stock price ($)
60
70
80
90
100 110 120
30
15
Short Put on IBM

Profit/Loss from writing a European put option on
IBM: option price = $7, strike price = $90
Profit ($)
7
60
70
Terminal
stock price ($)
80
90
100 110 120
-10
-20
-30
31
Payoffs from Options

What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff
Payoff
K
Long call
ST
Payoff
Short call
ST
Payoff
K
Long put
ST
Short put
ST
32
16
Example: Google Options

(Jan 9, 2007, Stock Price = 485.50)
Strike
Price
480
Jan. Feb.
Call
Call
11.42 26.60
Jan.
Put
5.20
Feb.
Put
18.50
490
6.10
22.70
9.90
23.00
500
2.80
17.30 16.50 28.00
33
Types of Traders
In the markets, we may find traders that are:
Hedgers
Speculators
Arbitrageurs
Some of the large trading losses in derivatives
occurred because individuals who had a mandate
to hedge risks switched to being speculators
34
17
Hedging Examples
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
The 3-month forward $US- is 1.4407
So, the payment is fixed at $14,407,000 whatever
the $US- will be in 3 months
35
Hedging Examples
An investor owns 1,000 Microsoft shares
currently worth $25 per share.
A six-month put with a strike price of $20 costs
$1.05. The investor decides to hedge by buying
10 contracts (each contract is on 100 shares)
So by paying $1050, the investor has the right to
sell its 1,000 Microsoft shares at least at $20,000
in the six coming months
36
18
Speculation Example
An investor with $4,000 to invest feels that
Ciscos stock price will increase over the next 2
months.
The current stock price is $20 and the price of
a 2-month call option with a strike of 25 is $1
What are the alternative strategies?
37
Speculation Example
The two alternatives are buy the stock or buy
a call option
The profits from the strategies are:
Expected December
Stock Price
Investors
strategy
$15
$35
Buy shares
-$1,000
$3,000
Buy calls
-$4,000
$36,000
38
19
Arbitrage Example
A stock price is quoted as 100 in London and
$152 in New York
The current exchange rate is $1.5500 per
What is the arbitrage opportunity?
Buy 100 shares in New York and sell them in
London
In the absence of transactions costs, the riskfree profit is:
100 x [$155 - $152] = $300
39
Should We Fear Derivatives?

Derivatives are financial weapons of mass
destruction, carrying dangers that, while now
latent, are potentially lethal (Warren Buffet, 2002)
There are numerous big losses caused by (mis)using derivatives:
Metalgesellschaft ($US 1.5 Billion)
Nick Leeson & the Barings bankruptcy ($US1.3 Billion)
http://www.nickleeson.com/biography/index.html
Orange county: the largest municipal bankruptcy in US
($US1.6 Billion)
LTCM (a hedge fund): $US4.6 Billion in four months!!!
Jerome Kerviel & the Societe Generale (5 billion)
40
20
Should We Fear Derivatives?

The answer is no. We should have a healthy
respect for them. We do not fear planes because
they may crash and do not refuse to board them
because of that risk. Instead, we make sure that
planes are as safe as it makes economic sense
for them to be. The same applies to derivatives.
Typically, the losses from derivatives are
localized, but the whole economy gains from the
existence of derivatives markets Rene Stulz (Ohio
State University)
41
Warren Buffet GS deal
42
21
Some interesting books

-Flash Boys, by Michael Lewis (on HF trading)
-The big Short, by Michael Lewis (on the subripme crisis)
-Liars Poker, by Michael Lewis (on 80s and 90s Wall Street)
-FIASCO, by Frank Partnoy (same here)
-When Genius Failed: The Rise and Fall of LTCM, by Roger
Lowenstein (on the first big bailout after a hedge fund collapse)
-The Quants, by Scott Patterson (how a new breed of math
whizzes conquered Wall Street and nearly destroyed it)
-Fooled by Randomness, by Nassim Nicholas Taleb (the hidden
role of chance in life and in the markets)
-The Black Swan, by Nassim Nicholas Taleb (the impact of the
highly improbable)
-Inside the house of Money: Top Hedge Fund Traders Profiting in
the Global Markets, by Steven Drobny (the opaque world of hedge
funds)
43
Basic Finance Concepts

A review
44
22
Measuring Interest Rates

The compounding frequency used for an interest
rate is the unit of measurement
More frequent compounding leads to higher
effective rates
In the limit as we compound more and more
frequently we obtain continuously compounded
interest rates
In this course, interest rates will be measured with
continuous compounding except where otherwise
stated
45

Annual Percentage Rate compounded m times
APR Period rate (i ) Number of periods per year (m)

i
APR
m
Effective Annual Rate

m
APR
m
EAR 1
1 1 i 1
m
46
23

Continuously compounded rate
EARc e APR 1
where EARc is the continuous effective rate
47

Example
Compounding
Annually
Semiannually
Quarterly
Monthly
Weekly
Daily
Continuous
1
2
4
12
52
365
infinity
EAR of an APR of 10%

10.0000%
10.2500%
10.3813%
10.4713%
10.5065%
10.5156%
10.5171%
48
24
Future Value and Present

Value
Discrete
Compounding
Continuous
Compounding
FV PV (1 i ) n
PV FV (1 i ) n
FV PV e rT
PV FV e rT
49
Conversion Formulas
We can convert a rate with one compounding
frequency into an equivalent rate with continuous
compounding
R
Rc m ln1 m
m
Rmc
Rm m e 1
where Rc and Rm are respectively the continuous

rate and the m-time (per annum) compounded
rate
50
25
Conversion Formulas
Example
An interest rate is quoted as 10% per annum
with semi-annual compounding
The equivalent continuous rate is
10%
Rc 2 ln1
9.7580%
2
51
Conversion Formulas
Example
An interest rate is quoted as 8% per annum with
continuous compounding
The equivalent quarterly compounded rate is
84%
R4 4 e 1 8.0805%
52
26

ADMS4503 Chap1

Enviado por

Dados do documento

Título original

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

ADMS4503 Chap1

Enviado por

Direitos autorais:

Formatos disponíveis

Introduction

The Nature of Derivatives

ADMS 4503 - Nabil Tahani

Aristotle, 350 BC (Olive)

Spectacular growth since 70s due to many

Size of exchange-listed derivatives worldwide:

ADMS 4503 - Nabil Tahani

ADMS 4503 - Nabil Tahani

Examples of Underlying Assets

ADMS 4503 - Nabil Tahani

Ways Derivatives are Used

ADMS 4503 - Nabil Tahani

Foreign Exchange Quotes for

ADMS 4503 - Nabil Tahani

The forward price may be different for contracts

ADMS 4503 - Nabil Tahani

ADMS 4503 - Nabil Tahani

What are the possible outcomes?

Profit from a Long Forward

Profit from a Short Forward

ADMS 4503 - Nabil Tahani

Is there an arbitrage opportunity?

ADMS 4503 - Nabil Tahani

gold at $1,080 in one year

ADMS 4503 - Nabil Tahani

Is there an arbitrage opportunity?

ADMS 4503 - Nabil Tahani

An investor who has the gold can sell it for

$1,000 per ounce

ADMS 4503 - Nabil Tahani

The Forward Price of Gold

- The spot price of oil is US$65

Is there an arbitrage opportunity?

Is there an arbitrage opportunity?

ADMS 4503 - Nabil Tahani

Examples of Futures Contracts

Examples of Futures Contracts

ADMS 4503 - Nabil Tahani

Exchanges Trading Options

Chicago Board Options Exchange

Payoff max(ST K ,0)

A put option is an option to sell a certain asset

Payoff max( K ST ,0)

Long Call on Microsoft

ADMS 4503 - Nabil Tahani

Short Call on Microsoft

Long Put on IBM

100 110 120

ADMS 4503 - Nabil Tahani

Short Put on IBM

100 110 120

Payoffs from Options

Example: Google Options

17.30 16.50 28.00

ADMS 4503 - Nabil Tahani

ADMS 4503 - Nabil Tahani

ADMS 4503 - Nabil Tahani

ADMS 4503 - Nabil Tahani

ADMS 4503 - Nabil Tahani

Should We Fear Derivatives?

Should We Fear Derivatives?

Warren Buffet GS deal

ADMS 4503 - Nabil Tahani