Introduction

Chapter 1

Learning Objectives

Understand the transactions of

derivative markets
Understand categories of derivatives
Understand purposes of using
derivatives

What is a derivative?

A financial instrument whose value

depends on (or derives from) the values
of other, more basic, underlying
variables
Example: A stock option is a derivative
whose values is dependent on the price
of a stock
3

Properties of Derivative

A derivative is a kind of contract

Initial date:
Sign the contract

Buyer

Seller
Expiration date:
Deliver or quit the contract

Underlying

derivatives
stock
commodity
bond
4

Importance of Derivatives

The most popular financial instrument for

risk management
The underlying variables contain tradable
assets (stocks, currencies, commodities,
electricity ) and non-tradable objects
(credit, insurance payouts, the weather )
Application (Using real options) of
Evaluating new capital investment
5

Categories of Derivatives

Forward
Futures
Option
Swap

Chapter 4, 5
Chapter 2, 3, 5, 6
Chapter 9, 10, 11
Chapter 7

Derivative Markets
Exchange
Traded

Bid price
Over The
Counter
Offer price

Standardize
quality and quantity

Mutually
negotiation
7

Exchanges Trading Futures

Chicago Board of Trade

Chicago Mercantile Exchange
LIFFE (London)
Eurex (Europe)
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
others (see list at end of book)
8

Exchanges Trading Options

Chicago Board Options Exchange

American Stock Exchange
Philadelphia Stock Exchange
Pacific Exchange
LIFFE (London)
Eurex (Europe)
others (see list at end of book)
9

The Lehman Bankruptcy

(Business Snapshot 1.1, page 3)

Lehman Brothers (investment bank) was an

active participant in the OTC derivatives
markets
On September 15, 2008, Lehman Brothers
filed for bankruptcy (The biggest bankruptcy
in US history)
Reasons: High leverage, risky investments,
and liquidity problems
It had huge transactions outstanding with
about 8,000 counterparties
Liquidation is challenge
10

Size of OTC and Exchange-Traded Markets

(June 1998 ~ June 2014)
Size of Market
($ trillion)

Source: Bank for International Settlements

Chart shows total principal amounts for OTC market and value of underlying assets
for exchange market

11

Ways Derivatives are Applied

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
12

Foreign Exchange Quotes for

GBP, May 24, 2010 (See page 5)
Bid

Offer

Spot

1.4407

1.4411

1-month forward

1.4408

1.4413

3-month forward

1.4410

1.4415

6-month forward

1.4416

1.4422
13

Example

(page 5)

On May 24, 2010 the treasurer of US

corporation knows that the corporation
will pay 1 million on November 24, 2010
The treasurer enters into a long forward
contract to buy 1 million in six months
at an exchange rate of 1.4422
This obligates the corporation to pay
$1,442,200 for 1 million on November
24, 2010
14

The possible spot exchange rate

1.5

1.35

Forward price = 1.4422

What are the possible outcomes?

15

Profit of the Example

Spot exchange = 1.5

Sell 1 million in the market to have
revenue: $1,500,000
Profit: (1.5 1.4422)$1million = $57,800
Spot exchange = 1.35
Sell 1 million in the market to have
revenue: $1,350,000
Loss: (1.4422 1.35)$1million = $92,200
16

Forward Price

The forward price for a contract is

the delivery 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)
The forward price may be different
for contracts of different maturities

17

Terminology

Long position: The party that

has agreed to buy
Short position: The party that
has agreed to sell

18

Profit from a
Long Forward Position
Profit

ST
Price of asset
at contract maturity

19

Profit from a
Short Forward Position
Profit

ST
K

Price of asset
at contract maturity

20

Forward and Spot Prices

(page 6)

A stock is worth $60 and pays no dividend

Interest Rate: 5% (borrow or lend)
$60e0.05 = 63 (round off the number)
The one-year forward price is $67:
Borrow $60, buy a share the of stock, and
sell it forward for $67
Profit = $67 $60e0.05 = $4
The one-year forward price is $58:
Sell a share of the stock for $60, and enter
the forward to buy it back for $58 in a year
Profit = $60e0.05 $58 = $5
21

Futures Contracts

(page 7)

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

22

Examples of Futures Contracts

Agreement to:
Buy 100 oz. of gold @ US$1080/oz. in
December (NYMEX)
Sell 62,500 @ 1.3500 US$/ in
March (CME)
Sell 1,000 bbl. of oil @ US$68/bbl. in
April (NYMEX)

23

Options

A call option is an option to buy a

certain asset by a certain date for a
certain price (the strike price)
A put option is an option to sell a
certain asset by a certain date for a
certain price (the strike price)

24

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

25

Table 1.2, page 8

Google call option prices, June 15, 2010; stock

price: bid 497.07; offer 497.25 (Source: CBOE)

September December
Strike price July 2010
2010
2010
($)
Bid Offer Bid Offer Bid Offer
460
43.30 44.00 51.90 53.90 63.40 64.80
480
28.60 29.00 39.70 40.40 50.80 52.30
500
17.00 17.40 28.30 29.30 40.60 41.30
520
9.00 9.30 19.10 19.90 31.40 32.00
540
4.20 4.40 12.70 13.00 23.10 24.00
560
1.75 2.10 7.40 8.40 16.80 17.70
26

Table 1.3, page 9

Google put option prices, June 15, 2010; stock

price: bid 497.07; offer 497.25 (Source: CBOE)

September December
Strike price July 2010
2010
2010
($)
Bid Offer Bid Offer Bid Offer
460
6.30 6.60 15.70 16.20 26.00 27.30
480
11.30 11.70 22.20 22.70 33.30 35.00
500
19.50 20.00 30.90 32.60 42.20 43.00
520
31.60 33.90 41.80 43.60 52.80 54.50
540
46.30 47.20 54.90 56.10 64.90 66.20
560
64.30 66.70 70.00 71.30 78.60 80.00
27

Example: Buying Call Option

(Page 8, Refer to Table 1.2)

Underlying stock: Google

Strike price: $520
Expiration date: December 18
Offer price: $32.0
Size of a contract: 100 shares
Ignoring transaction costs, an investor
pays $3,200 for one call option contract
with strike price $520
28

Profit of the Call Option on

December 18 (Expiration Date)

In the stock market, the investor sell

shares with the bid price of the stock
The stock price is below to $520
The investor doesnt exercise the option
Lost $3,200 (The cost of the call)
The stock price = $600 (above $520)
The investor exercises the option
Buy 100 shares at $520 and immediately
sell them at $600 for each share
The profit
= 100($600 $520) $3,200 = $4,800
29

Net profit of buying a call option contract

on Google with strike price = $520
Profit ($)

Stock price ($)

30

Example: Selling Put Option

(Page 9, Refer to Table 1.3)

Underlying stock: Google

Strike price: $480
Expiration date: September 18
Bid price: $22.2
Size of a contract: 100 shares
Ignoring transaction costs, an investor
receives $2,220 for one put option
contract with strike price $480
31

Profit of the Put Option on

September 18 (Expiration Date)

In the stock market, the investor sell

shares with the offer price of the stock
The stock price is above to $480
The investor doesnt exercise the option
Lost $2,220 (The cost of the call)
The stock price = $420 (below $480)
The investor exercises the option
Sell 100 shares at $480 and immediately
buy them at $420 for each share
The profit
= 100($480 $420) $2,220 = $3,780
32

Net profit of selling a put option contract

on Google with strike price = $480
Profit ($)

Stock price ($)

33

Participants of Options
Long
position

Short
position

Buyer

Seller

Call

Put
34

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

35

Hedge Funds

Hedge funds concentrate on reduce

systematic risk of the market
Regulation of mutual funds

(Business Snapshot 1.2, page 11)

Disclose investment policies

Makes shares redeemable at any time
Limit use of leverage
Short positions are prohibited

Hedge funds apply many complex

trading strategies involving derivatives
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Types of Hedge Funds

Long/Short Equities: Purchase undervalued

securities and short overvalued ones
Convertible Arbitrage: Long a convertible
bond and short the underlying equity
Distressed Securities: Buy securities of
companies in deeply financial distress
Emerging Markets: Invest in developing or
emerging countries
Global macro: Anticipate global
macroeconomic trends to trade
Merger Arbitrage: Trade as the
announcement of merger and profit as the
merger realized

37

Hedging Using Forward Contracts (1)

On May 24, 2010, a US company will

pay 10 million for exports from Britain
on August 24
Exchange rate quotes are shown in
Table 1.1
Long a 3-month forward contract at
1.4415
The company fixes the payment of
$14,415,000
38

Hedging Using Forward Contracts (2)

On May 24, 2010, a US company will

receive 30 million for imports from
Britain on August 24
Exchange rate quotes are shown in
Table 1.1
Short a 3-month forward contract at
1.4410
The company fixes the revenue of
$43,230,000
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Comparison
Spot
With
Without
exchange rate
hedge
hedge
1.3
14,415,000 1,300,000
Company1
1.5
14,415,000 1,500,000
1.3
43,230,000 3,900,000
Company2
1.5
43,230,000 4,500,000

40

Hedging Using Options

In may of a particular year, an investor

owns 1,000 Microsoft shares worth $28
per share
The investor wants to reduce price risk
in two month
A July put with a strike price of $27.50
costs $1
Long 10 the July puts
41

Value of Microsoft Shares with

and without Hedging (Fig 1.4, page 12)

42

Profit with and without Hedging

10 option contracts cost: C = $1*10*100 = $1,000

Revenue from option: Rp = 1,000*Max($27.5 ST , 0)
Revenue from selling shares of the stock:
Rs = 1,000*ST
Profit with hedging: Ph = Rs + Rp C $28*1,000
Profit without hedging: Pw = Rs $28*1,000
ST
Rp
Rs
Ph
Pw
21.0 6,500 21,000 -1,500 -7,000
22.0 5,500 22,000 -1,500 -6,000
26.5 1,000 26,500 -1,500 -1,500
27.5
0 27,500 -1,500 -500
28.0
0 28,000 -1,000
0
29.0
0 29,000
0 1,000
30.0
0 30,000 1,000 2,000

43

Speculation Using Futures

A speculator hopes US dollar to

depreciate in two months
The futures margin = $5,000 for each
contract
Strategy 1: Buy 250,000 in the spot
market and sell it later
Strategy 2: Take a long position with
four futures contracts on sterling (Each
futures contract for 62,500)
44

Speculation Using spot and

Futures contracts (Table 1.4, page13)
Spot price = 1.447; Futures price = 1.441
Two month later

Investment
spot = 1.5
Profit
spot = 1.4

Strategy 1 Strategy 2
$361,750
$20,000
$13,250
$14,750
-$11,750 -$10,250
45

Speculation Using Options

An investor with $2,000 to invest

feels that a 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 22.50 is $1
What are the alternative strategies?
46

Using $2,000 to Speculate on a

Stock (Table 1.5, page14)
Strategy 1: Buy 100 shares of the stock
Strategy 2: Buy 2,000 call options
Profit
2 months spot = $15
later
spot = $27

Strategy 1 Strategy 2
-$500
-$2,000
$700
$7,000

47

Profit from 2 strategies for speculating

on a stock currently worth $20

48

Arbitrage Example

A stock price is quoted as 100 in

London and $200 in New York
The current exchange rate is $1.43
What is the arbitrage opportunity?
Buy 100 shares of the stock in New
York and sell them in London
Profit = 100[$1.43(100) $140]
= 300
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Dangers

Traders can switch from being hedgers

or arbitrageurs to speculators
It is important to regulate to ensure that
trades are using derivatives in for their
intended purpose
Socit Gnrale lost huge money in
2008 (Business Snapshot 1.3)
50

SocGens big loss in 2008

Socit Gnrale (SocGen): A French

multinational bank
Kerviel is an arbitrage trader of Delta One
products team in SocGen
Arbitrage opportunity:
Futures contracts on an equity index traded in
different exchanges
Price difference between equity index futures
and the shares constituting the index
Kerviel took big positions in equity indices and
fake trades as if he had hedged
In January 2008, the unauthorized trading was
reveled by SocGen
Finally, SocGen lost 4.9 billion euros
51

Homework

A company will receive 1 million yens

3 months later
What hedging strategy does the
company use?
Link to the questionnaire page of the
e-learning website and write down
your answer before 0:00 am, March 9
52

Selected Questions

1.6, 1.7, 1.9, 1.10, 1.15, 1.30, and 1.32

These questions are provided for
practicing by yourselves but not the
parts of homework

53