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Derivative Securities

Week 1 Introduction

     

Instructor: Greta Fesechko Email: gfa5@sfu.ca Lecture: 3090 Office: 5047 Tel: (778) 782-7492 Office hours: Thursday 2:30 3:30pm

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Course Resources
Required textbook: Fundamentals of Options and Futures Markets, John C. Hull, 7th edition, Prentice Hall, 2010, ISBN: 013610322-6 Recommended: Solutions Manual and Study Guide for Fundamentals of Options and Futures Markets Course website: webct.sfu.ca/web
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Course Assessment

1. Quizzes (2): 20% 2. Midterm: 30% 3. Final Exam: 40% 4. Participation: 10% Total: 100%

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Course Assessment


Two problem sets will be assigned (not graded; they can be submitted via WebCT): Problem Set 1 is due in Week 5 Problem Set 2 - in Week 12 Nonprogrammable calculators allowed Crib sheets: midterm (half page) and final exams (full page) Final exam is cumulative. Bring ID.
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Illness and Other Problems

  

Medical note required No makeup quizzes or exams Fictitious grade" is assigned based on relative ranking in other assessments If you disagree with any grade, submit your grievance within a week

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Any other questions?

Objectives

  

Definition of Derivatives Forward and Futures, Swaps, Options Derivatives markets, trading strategies and basic pricing models Types of Traders

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What is a Derivative Security?

A derivative is a financial contract that specifies contingent (dependent) payoffs determined by the value of an underlying asset.

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Historical Facts


Derivatives, while seemingly new, have been used for thousands years:
  

Aristotle, 350 BC (Olive) Netherlands, 1600s (Tulips) USA, 1800s (Grains, Cotton)

Derivatives in Canada:
 

Winnipeg Commodity Exchange, 1904 (Oat) Montreal Exchange, 1975 (Stocks)


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Historical Facts
Spectacular growth since 1970s:


  

Liberalization in International trade and capital markets Oil price shocks (Arab Oil Embargo) Increase in volatility End of Bretton Woods (using gold to support the

exchange rate)


Black-Scholes pricing model

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Historical Facts


Size of derivatives markets:


 

OTC $592 trillion Exchange traded $82.2 trillion

Capitalization of the markets (for corporate debts and equity in the world): $51.2 trillion

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Examples of Derivatives


Futures/Forward Contracts:
Agree on price now, trade later

Call Options:
Pay premium and agree on price now, if buyer wants she buys asset later

Put options:
Pay premium and agree on price now, if buyer wants she sells asset later
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Examples of Underlying Assets

     

Stocks Bonds Exchange rates Interest rates Commodities Energy

 

Temperature, quantity of rain/snow Real-estate price index Loss caused by an earthquake/hurricane Derivatives

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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 (taking advantage of a mispricing) To align incentives as performance related compensation To change the nature of an investment without incurring the costs of selling one portfolio and buying another
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Futures Contracts

Futures Contracts

A FUTURES contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a SPOT contract there is an agreement to buy or sell an asset immediately

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Futures Price


The FUTURES PRICE is the price agreed today to buy or sell the underlying asset in the future The futures price is determined by supply and demand in the same way as a spot price Contract specifies:
  

Assets Price of the Asset Date


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Example: Gold
Jan 03, 2012 19:03 NY Time
Bid/Ask Low/High 1 day chg 30 day chg 1 year chg 1607.70 / 1581.60 / +4.10 -137.60 +193.10 1608.90 1609.40 +0.26% -7.88% +13.65% April 2012 June 2012 March 2012 Jan 03, 2012 Feb 2012

1608.50 1607.90 1612.0 1614.2

S0 = $1605.40
Source: www.kitco.com

F= $1608.50 (Feb 2012)


Source: www.nymex.com

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Trading Futures
On organized exchanges:  Chicago Board of Trade (CBOT, USA)  Chicago Mercantile Exchange (CME,USA) now CME Group  Montreal Exchange (Canada)  LIFFE (UK)  Eurex (Europe)  TIFFE (Japan)  Intercontinental Exchange

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Terminology

The party that has agreed to buy the asset has a LONG position The party that has agreed to sell the asset has a SHORT position

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Example of Futures Contract


Agreement to:  buy 100 ounces of gold @ US$1608.20/ounce in February 2012
Basic trading unit: 100 ounce of gold Contract months: current and next two months, and any February, April, August and October falling within the next 23 months and any June and December falling within the next 60 months.
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Example of Futures Contract


Agreement to:  sell 1,000 barrels of oil @ US$70/barrel in March
 

Basic trading unit: 1,000 barrel (42,000 gallons) Deliverable grade: West Texas Intermediate 0.4% sulfur, 40 API gravity (with substitution differentials) Last trading day: 3rd business day prior to 25th day of month preceding contract month.
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Example of Futures Contract




January: an investor enters into a long futures contract to buy 100 ounces of gold @ $1050 in April April: the price of gold $1065 per ounce What is the investors profit?

($1065 - $1050) * 100 = $1500


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Forward Contracts

Forward Contracts

Forward contracts are similar to futures except that they trade in the over-the-counter (OTC) market (not on exchanges) Forward contracts are popular on currencies and interest rates

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Over-the-Counter Markets


The over-the-counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers

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Size of OTC and Exchange Markets

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market 1.28

Canadian Dollar Forward Rates (in USD)


Toronto market on Tuesday, January 3, 2012. (source: http://fx.sauder.ubc.ca)

Spot 1-month forward 2-month forward 3-month forward 6-month forward 1-year forward

0.9912 0.9904 0.9898 0.9892 0.9876 0.9851


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Option Contracts

Options
Call option: is an option to buy a certain asset by a certain date for a certain price (the strike price) Put option: is an option to sell a certain asset by a certain date for a certain price (the strike price)
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American vs. European Options

An American option can be exercised at any time during its life A European option can be exercised only at maturity

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Options vs. Futures/Forwards

A futures/forward contract gives the holder the OBLIGATION to buy or sell at a certain price An option gives the holder the RIGHT to buy or sell at a certain price

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Options vs. Futures/Forwards

No money changes hands when entering a futures/forward contract An option costs money (premium) to buy

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Google Option Prices


(July 17, 2009; Stock Price=430.25)
Calls Sept 2009 54.60 38.30 24.80 14.45 7.45 3.40 Puts Sept 2009 4.40 8.30 14.70 24.25 37.20 53.10

Strike price ($) 380 400 420 440 460 480

Aug 2009 51.55 34.10 19.60 9.25 3.55 1.12

Dec 2009 65.00 51.25 39.05 28.75 20.40 13.75

Aug 2009 1.52 4.05 9.55 19.20 33.50 51.10

Dec 2009 15.00 21.15 28.70 38.35 49.90 63.40

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Exchanges Trading Options

    

Chicago Board Options Exchange (CBOE) International Securities Exchange NYSE Euronext Eurex (Europe) and many more (see list at end of book)

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Types of Traders

Types of Traders

Hedgers
Objective: try to reduce risk Notice that hedging does not imply PROFITING from trading You can understand risk as reducing the spread of the potential outcomes in a given situation

Speculators
Objective: try to profit from guessing future market movements Speculation often implies taking significant risks

Arbitrageurs
Objective: try to profit from mispricing Formally defined, arbitrage implies not taking any risk at all Arbitrage is a riskless transaction that requires no net investment and that generates a positive profit 1.38

Hedging with Futures: Examples




A US company will pay 10 million for imports from Britain in 3 months In order to reduce its risk, the company decides to hedge using a long position in a futures contract (i.e. a contract to buy British Pounds in 3 months) If F (3 months) = 2 USD/ Cost for the company is known today: 10 million v 2 USD/ = USD20 million There is no risk anymore
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Hedging with Options: Examples




An investor owns 1,000 Microsoft shares currently worth $28 per share (S0). A two-month put option with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

Similar to buying insurance as the loss is limited but investor can benefit from favorable price movements.

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Value of Microsoft Shares


with and without Hedging

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Speculation Example

An investor with $4,000 to invest expects that Amazon.coms stock price will increase over the next 2 months. The current stock price is $40 and the price of a 2-month call option with a strike of 45 is $2.

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Speculation Example
(Price increases)

Case I:

He invests in STOCKS

Initial cost = 100 stocks v $40 = $4,000 Cash flow in 2 months if ST = $60 = $6,000 Profit = $2,000

Case II:

He invests in OPTIONS

Initial cost = 2,000 calls v $2 = $4,000 Cash flow in 2 months if ST = $60: -2,000 v $45 + 2,000 v $60 = $30,000 Profit = $26,000
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Speculation Example
(Price falls)

Case I:

He invests in STOCKS

Initial cost = 100 stocks v $40 = $4,000 Cash flow in 2 months if ST = $35 = $3,500 Loss = $500

Case II:

He invests in OPTIONS

Initial cost = 2,000 calls v $2 = $4,000 Cash flow in 2 months if ST = $35 = 0 Loss = $4,000 (100% initial investment)
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Arbitrage Example

A stock price is quoted as 100 in London and $182 in New York The current exchange rate is US$1.8500/GBP What is the arbitrage opportunity?

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Arbitrage Example


Buy 100 shares in NY: (-100*$182=-$18,200) Sell them in LON: (+100*100=10,000) Convert GBP into USD: (10,000*$1.85/=$18,500) Profit from NY-LON $300: ($18,500 - $18,200 = $300)
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Terminology


Short Selling (Ch.5) sale of borrowed securities.


Borrow asset from a securities lender (A) Sell borrowed asset to an investor (B) Later, buy asset from another investor (C) and return equal units of asset to security lender (A) (covering)

Example: Short stock @$100, then cover @$60 , profit $40


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Short Selling
Example with dividends:  In April:
Investor B shorts 500 IBM shares @ $120


In May:
$1 dividend per share paid Firms dividend paid to B, he pays dividend to A.

In July:
Investor B closes position by buying 500 IBM shares @ $100
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Cash flows
Purchase of shares


Short sale of shares




April: Buy 500 shares @ $120 -$60,000 May: Receive dividend +$500 July: Sell 500 shares @ $100 +$50,000 Net profit: -$9,500

April Borrow 500 shares and Sell them @ $120 +$60,000 May: Pay dividend -$500 July: Buy 500 shares @ $100 and return borrowed shares to close position -$50,000 Net profit: +$9,500
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Use of Derivatives Practical Example

Options and Compensation




A substantial component of executives compensation is paid in stock options Example:


$200,000 per year 500 stock options on the firm shares
American type 5-year Vesting period, Maturity in 10 years Spot price today = $100, Strike price = $100 The Vesting Period is the period in which the

employee cannot sell or transfer the stock options.


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Are Derivatives Financial Weapons of Mass Destruction ?




Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
Warren Buffet

Numerous losses caused by (mis)using derivatives (see Chapter 25)

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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)
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