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2014-15

Universitat Pompeu Fabra

Chapter 1

The Derivatives Market

1

Course Overview

Xavier Freixas

Bibliography:

Pearson Education, New Jersey, 8th and 9th edition.

2

Course Overview

Contents:

Chapter 2 - Basic derivatives

Chapter 3 - Option Pricing 1 (Arbitrage Pricing)

Chapter 4 - Option Pricing 2 (Equilibrium

Pricing)

Chapter 5 - Option Pricing 3 (Simulation)

Chapter 6 - Greeks & Hedging

Chapter 7 - Trading Strategies, Exotic Options,

Structured Products

3

Course Overview

Evaluation:

Continuous Evaluation (CE)

During the course students will be graded 1) through

online examinations and 2) through sit in examinations

and 3) two homeworks.

The grade for the continuous evaluation (CE) will be

computed as 50% of the online examination and 50%

of the sit in examination.

Final Grade= MAX(0 .4*FE+0.6*CE, 0.7FE+0.3*CE)

The minimum final passing grade is 5.0 out of 10.

4

Chapter 1

Derivatives Market

DEFINITION:

A derivative is a special type of contract that derives its

value from the performance of an underlying.

- asset

- index

- interest rate

- insuring against price movements (hedging)

- increasing exposure to price movements for speculation

- getting access to otherwise hard to trade assets or markets.

5

Chapter 1

Derivatives Market

the derivative (such as forward, option, swap)

derivatives, foreign exchange derivatives, interest

rate derivatives, commodity derivatives, or credit

derivatives)

traded or over-the-counter); and their pay-off 6

profile.

Chapter 1

Derivatives Market

"lock" or "option" products:

forwards) obligate the contractual parties to the

terms over the life of the contract.

provide the buyer the right, but not the obligation to

enter the contract under the terms specified.

7

Chapter 1

Derivatives Market

compensation in case of an undesired event, a kind of

"insurance")

aspect of operations and financial management for many

firms across many industries; the latter offers managers and

investors a risky opportunity to increase profit, which may

not be properly disclosed to stakeholders.

8

Chapter 1

Derivatives Market

Examples of derivatives:

- Futures

- Forwards

- Swaps

- Options

- Exotics,..

9

Why derivatives are important?

the economy

interest rates, commodities, debt instruments,

electricity, insurance payouts, the weather, etc.

derivatives

investment decisions has become widely accepted 10

Chapter 1

Derivatives Market

Exchange (CBOE)

traders working for banks, fund managers and

corporate treasurers contact each other directly

11

Chapter 1

Derivatives Market

- Largely unregulated

between two parties would be handled

counterparties (CCPs). A CCP stands between the two sides

to a transaction in the same way that an exchange does

12

Chapter 1

Derivatives Market

Since 2008...

- OTC market has become regulated. Objectives:

- Reduce systemic risk

- Increase transparency

- In the U.S and some other countries, standardized

OTC products must be traded on swap execution

facilities (SEFs) which are similar to exchanges

- CCPs must be used for standardized transactions

between dealers in most countries

- All trades must be reported to a central registry

13

Chapter 1

Derivatives Market

Source: Bank for International Settlements. Chart shows total principal amounts for

OTC market and value of underlying assets for exchange market

14

Chapter 1

Derivatives Market

This was the biggest bankruptcy in US history

markets and got into financial difficulties because it took

high risks and found it was unable to roll over its short term

funding

with about 8,000 counterparties

both the Lehman liquidators and their counterparties 15

Chapter 1

Derivatives Market

- To hedge risks

market)

the costs of selling one portfolio and buying another

16

Chapter 1

Derivatives Market

Bid Ask

Spot 1.5541 1.5545

17

Chapter 1

Derivatives Market

Forward Price

price that would be applicable to the contract if

were negotiated today (i.e., it is the delivery price

that would make the contract worth exactly zero)

different maturities (as shown by the table)

18

Chapter 1

Derivatives Market

Terminology

has a long position

a short position

19

Chapter 1

Derivatives Market

Example

enters into a long forward contract to buy 1 million

in six months at an exchange rate of 1.5532

for 1 million on November 6, 2013

20

Chapter 1

Derivatives Market

(K= delivery price = forward price at time contract is

entered into)

Profit

Price of Underlying

K at Maturity, ST

21

Chapter 1

Derivatives Market

(K= delivery price = forward price at time contract is

entered into)

Profit

Price of

K Underlying

at Maturity,

ST

22

Chapter 1

Derivatives Market

Futures Contracts

certain time

contract is traded on an exchange

23

Chapter 1

Derivatives Market

and Chicago Board of Trade merged)

Exchange)

- TIFFE (Tokyo)

24

and many more...

Chapter 1

Derivatives Market

Agreement to:

25

Chapter 1

Derivatives Market

Suppose that:

- The 1-year forward price of gold is US$1,500

- The 1-year US$ interest rate is 5% per annum

26

Chapter 1

Derivatives Market

Suppose that:

- The 1-year forward price of gold is US$1,400

- The 1-year US$ interest rate is 5% per annum

27

Chapter 1

Derivatives Market

contract deliverable in T years is F, then

F = S (1+r )T

interest.

F = 1400(1+0.05) = 1470

28

Chapter 1

Derivatives Market

Suppose that:

- The quoted 1-year futures price of oil is

US$125

- The 1-year US$ interest rate is 5% per

annum

- The storage costs of oil are 2% per annum

29

Is there an arbitrage opportunity?

Chapter 1

Derivatives Market

Suppose that:

- The quoted 1-year futures price of oil is

US$80

- The 1-year US$ interest rate is 5% per

annum

- The storage costs of oil are 2% per annum

Chapter 1

Derivatives Market

OPTIONS

a certain date for a certain price (the strike price)

a certain date for a certain price (the strike price)

31

Chapter 1

Derivatives Market

life

32

Chapter 1

Derivatives Market

Google Call Option Prices from CBOE (May 8 th 2013, Stock price bid

871.23, ask 871.37)

Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013

Price Bid Offer Bid Offer Bid Offer

33

Chapter 1

Derivatives Market

Google Put Option Prices from CBOE (May 8th 2013, Stock price bid 871.23,

ask 871.37)

Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013

Price Bid Offer Bid Offer Bid Offer

34

Chapter 1

Derivatives Market

Options vs Futures/Forwards

obligation to buy or sell at a certain price

at a certain price

35

Chapter 1

Derivatives Market

- Hedgers

- Speculators

- Arbitrageurs

36

Chapter 1

Derivatives Market

Hedging Examples:

from Britain in 3 months and decides to hedge using

a long position in a forward contract

currently worth $28 per share. A two-month put

with a strike price of $27.50 costs $1. The investor

decides to hedge by buying 10 contracts

37

Chapter 1

Derivatives Market

38

Chapter 1

Derivatives Market

Speculation Example:

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 22.50 is $1

39

Chapter 1

Derivatives Market

Arbitrage Example:

$150 in New York

40

Chapter 1

Derivatives Market

Dangers

speculators or from being arbitrageurs to

speculators

trades are using derivatives in for their intended

purpose

41

Chapter 1

Derivatives Market

- Amaranth ($6 billion)

- Barings ($1 billion)

- Enron Counterparties (Several over $1 billion)

- Kidder Peabody ($350 million)

- LTCM ($4 billion)

- Midland Bank ($500 million)

- Socit Gnrale ($7 billion)

- Subprime Mortgages (many billions)

- UBS ($2.3 billion)

42

Chapter 1

Derivatives Market

- Gibsons Greetings ($20 million)

- Hammersmith and Fulham ($600 million)

- Metallgesellschaft ($1.8 billion)

- Orange County ($2 billion)

- Procter and Gamble ($90 million)

- Shell ($1 billion)

- Sumitomo ($2 billion)

43

Chapter 1

Derivatives Market

result

always be right

- Be diversified

44

Chapter 1

Derivatives Market

--Do not give too much independence to star traders

-- Separate the front middle and back office

--Models can be wrong

-- Be conservative in recognizing inception profits

--Do not sell clients inappropriate products

-- Beware of easy profits

--Liquidity risk is important

--There are dangers when many are following the same

strategy

45

Chapter 1

Derivatives Market

term funding requirements are financed with short-

term liabilities

- Manage incentives

are good

Chapter 1

Derivatives Market

trade

department a profit center

47

Chapter 1

Derivatives Market

FUTURES CONTRACTS:

- Exchange traded

- What can be delivered,

- Where it can be delivered, &

- When it can be delivered

48

- Settled daily

Chapter 1

Derivatives Market

Futures

Price Spot Price

Price

Time Time

(a) (b)

49

Chapter 1

Derivatives Market

Margins:

investor with his or her broker

daily settlement

on a contract

50

Chapter 1

Derivatives Market

to the initial margin when it falls below the maintenance

margin level

initial margin and is required to bring the balance in its

account up to that level every day.

margin

51

- A member is also required to contribute to a default fund

Chapter 1

Derivatives Market

December gold futures contracts on June 5

- futures price is US$1,450

- initial margin requirement is

US$6,000/contract (US$12,000 in total)

- maintenance margin is US$4,500/contract

(US$9,000 in total) 52

Chapter 1

Derivatives Market

A Possible Outcome:

Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)

1 1,450.00 12,000

1 1,441.00 1,800 1,800 10,200

2 1,438.30 540 2,340 9,660

.. .. .. ..

6 1,436.20 780 2,760 9,240

7 1,429.90 1,260 4,020 7,980 4,020

8 1,430.80 180 3,840 12,180

.. .. .. ..

16 1,426.90 780 4,620 15,180

53

Chapter 1

Derivatives Market

Clearing House

Member Member

Broker Broker

54

Chapter 1

Derivatives Market

Clearing House

Member Member

Broker Broker

55

Chapter 1

Derivatives Market

Some Terminology

outstanding

- equal to number of long positions or number

of short positions

bell each day

- used for the daily settlement process

day

Chapter 1

Derivatives Market

into an offsetting trade

57

Chapter 1

Derivatives Market

Settle Trade

58

Chapter 1

Derivatives Market

collateralized in OTC markets

with a credit support annex (CSA)

the value to B of its outstanding transactions with B when

this value is positive.

59

Chapter 1

Derivatives Market

collateral

is paid on cash collateral

60

Chapter 1

Derivatives Market

bilaterally in OTC markets

requirement for most standardized OTC derivatives

transactions between dealers to be cleared through central

counterparties (CCPs)

fund contributions from members similarly to exchange

clearing houses

61

Chapter 1

Derivatives Market

62

Chapter 1

Derivatives Market

New Regulations

are not cleared centrally require dealers to post both

initial margin and daily variation margin

63

Chapter 1

Derivatives Market

Delivery

maturity, it is usually settled by delivering the assets

underlying the contract. When there are alternatives

about what is delivered, where it is delivered, and

when it is delivered, the party with the short

position chooses.

indices and Eurodollars) are settled in cash 64

Chapter 1

Derivatives Market

FORWARDS FUTURES

Private contract between 2 parties Exchange traded

settlement usually occurs prior to maturity

Some credit risk Virtually no credit risk

65

Chapter 1

Derivatives Market

of USD per unit of the foreign currency

way as spot exchange rates. This means that GBP,

EUR, AUD, and NZD are quoted as USD per unit of

foreign currency. Other currencies (e.g., CAD and

JPY) are quoted as units of the foreign currency per

USD. 66

Chapter 1

Derivatives Market

Option Types:

- A put is an option to sell

- A European option can be exercised only at the end of its

life

- An American option can be exercised at any time

Option Positions:

- Long Call

- Long Put

- Short Call

- Short Put

67

Chapter 1

Derivatives Market

Long Call

Profit from buying one European call option: option price =

5$, strike price = 100$, option life = 2 months

30 Profit ($)

20

10 Terminal

70 80 90 100 stock price ($)

0

-5 110 120 130

68

Chapter 1

Derivatives Market

Short Call

Profit from writing one European call option: option price =

5$, strike price = 100$, option life = 2 months

Profit ($)

5 110 120 130

0

70 80 90 100 Terminal

-10 stock price ($)

-20

-30

69

Chapter 1

Derivatives Market

Long Put

Profit from buying one European put option: option price =

7$, strike price = 70$

30 Profit ($)

20

10 Terminal

stock price ($)

0

40 50 60 70 80 90 100

-7

70

Chapter 1

Derivatives Market

Short Put

Profit from writing one European put option: option price =

7$, strike price = 70$

Profit ($)

Terminal

7

40 50 60 stock price ($)

0

70 80 90 100

-10

-20

-30

71

Chapter 1

Derivatives Market

What is the position in each case? K=Strike Price, ST=Price

of asset at maturity

Payoff Payoff

K

K ST ST

Payoff

Payoff

K

K ST ST

72

Chapter 1

Derivatives Market

- Stocks

- Foreign Currency

- Stock Indices

- Futures

- Expiration Date

- Strike Price

- European/American

- Call/Put (Option Class)

73

Chapter 1

Derivatives Market

Terminology

- Moneyness :

- At-the-money option

- In-the-money option

- Out-of-the-money option

- Option class

- Option series

- Premium

- Intrinsic value

- Time value

74

Chapter 1

Derivatives Market

cash dividends

1) the strike price is reduced to mK/n

2) the no. of options is increased to nN/m

75

Chapter 1

Derivatives Market

76

Chapter 1

Derivatives Market

Market Makers

trading

requested

requesting the quotes wants to buy or sell

77

Chapter 1

Derivatives Market

Margins

-Margins are required when options are sold

-- When a naked option is written the margin is the greater

of:

- A total of 100% of the proceeds of the sale plus

20% of the

underlying share price less the amount (if any) by

which the option is out of the money

- A total of 100% of the proceeds of the sale plus

10% of the

underlying share price (call) or exercise price (put)

78

Chapter 1

Derivatives Market

Warrants

financial institution

size of the original issue and changes only when they are

exercised or when they expire

exercised

stock, exercise will usually lead to new treasury stock being

79

issued

Chapter 1

Derivatives Market

remuneration issued by a company to its executives

more stock and sells it to the option holder for the

strike price

Chapter 1

Derivatives Market

Convertible Bonds

for equity at certain times in the future according to a

predetermined exchange ratio

conversion at a time earlier than the holder might otherwise

choose

81

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