Financial Engineering and Derivatives Usage: An Overview

Suman Banerjee

IIPM, New Delhi July 12-13, 2008

The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other fundamentals (or more basic) underlying variables: Stocks Currencies Commodities

Types of Derivatives
Three common types of derivatives

Options
Future rights

Swaps
Obligated Exchange of future cash flows

Futures (or Forward) Contracts

Obligated future price or rate

Asset Identification Matrix

RECEIPT Presen Futur t e Cash Lending Borrowing Forwar d (Future)

Present PAYMENT Future

Derivatives Markets
Exchange Traded
standard products trading floor or computer trading virtually no credit risk

Over-the-Counter
non-standard products telephone market some credit risk

Sample Derivatives Prices

S&P 500 Futures and Options Contracts
Tuesday, September 5, 2004 Closing S&P 500 Index: 1113.60

Delivery/Expiration Month Type Strike Nov Dec Jan Mar Jun

Future 1117.60 1117.20 1129.00 Call 1113 15.10 22.30 30.70 Call 1123 8.35 15.95 24.05 Call 1133 3.60 10.65 18.10 Put 1113 3.85 11.15 13.35 Put 1123 7.10 14.70 16.60 Put 1133 12.35 19.35 20.50

Ways Derivatives Are Used

To hedge risks To lock in an arbitrage profit To change the nature of an investment without incurring the costs of selling one portfolio and buying another

Common Terminology
The party that has agreed to: BUY has what is termed a LONG position SELL has what is termed a SHORT position

Continuous Compounding
We will calculate the present and future values of cash flows assuming continuous compounding

where r = interest rate t = holding period e = exponential coefficient=2.7183

Example
January: an investor enters into a long futures contract on COMEX to buy 100 oz of gold @ $300/oz in April 2005 April: the price of gold $315 per oz What is the investors profit? $15/oz

Forwards
January July
Ill buy your house in July for $350,000. Thanks for the house. Thanks for the $350,000.

Youve got a deal.

Nothing is exchanged now.

Trade occurs in the future.

Exchanges Trading Futures

Chicago Board of Trade Chicago Mercantile Exchange BM&F (Sao Paulo, Brazil) LIFFE (London) TIFFE (Tokyo)

Gold: Arbitrage Opportunity?

Suppose that: The spot price of gold is US$290 The quoted 1-year futures price of gold is US$315 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

Gold: Another Opportunity?

Suppose that: The spot price of gold is US$290 The todays quoted 1-year futures price of gold is US$315 The 1-year US$ interest rate is 10% per annum Is there an arbitrage opportunity?

Options
A CALL is an option to BUY a certain asset by a certain date for a certain prespecified price A PUT is an option to SELL a certain asset by a certain date for a certain prespecified price

CALLS: Price now; if buyer wants, he

buys asset later.
January
Ill buy your house in July for $350,000, if I want to then.
If you pay me $50,000 extra now, its a deal.

Jul y Housing Prices Rise Thanks for

the house.

Thanks for the $350,000.

Housing Prices Fall

Ive decided not to buy.

Thats OK. But I get to keep the $50,000.

Options: Long Call

Profit from buying an European call option: option price = $50, strike price = $350, option life = 6 months 30 Profit ($) 20 10 0 -50 27 0 28 0 29 0 35 0 41 0 Terminal stock price ($) 42 0 43 0

Options: Short Call

Profit from writing European call option: option price = $50, strike price = $350, option life = 6 Profit ($) months 50 0 -10 -20 -30 41 0 42 0 43 0 Terminal stock price ($)

27 0

28 0

29 35 0 0

PUTS: Price now; if option buyer

wants, she sells asset later.

If you pay me Ill sell you my house $50,000 extra in July for $350, 000 now, its a deal. if I want to then.

Housing Prices Rise

Ive decided not to sell.

Thats OK. But I get to keep the $50,000.

Thanks for the $350,000.

Housing Prices Fall Thanks for

the house.

Options: Long Put

Profit from buying an Tata European put option: option price = INR 7, strike price = INR 70, option life = 3 months 70 Profit (INR) 50 30 0 -50 40 50 60 70 80
Terminal stock price (INR)

90

100

Options: Short Put

Profit from writing an Tata European put option: option price = INR 50, strike price = INR 350, option life = 6 months
Profit (INR)

50 40 0 -10 -20 -30 50 60 70 80 90

Terminal stock price (INR) 100

Options: Zero-sum Game

Long Call Payoff X

Short Call Payoff X

S
T

S
T

Long Put Payoff X S

T

Short Put Payoff X S

T

Options:zero-sum Game
Housing Prices Rise to $410,000 Housing Prices Fall
Im glad I sold the call; I got paid for it and still kept my house.

Im glad I bought the call because now I can buy a $410,000 house for only $350,000.

Too bad I sold Too bad I bought that call; I had that call; it didnt to sell my pay to exercise it. house cheaply.

$410,000 - 350,000 - 50,000 $ 10,000

$- 410,000 350,000 50,000 $ - 10,000

$50,000

$ 50,000

Exchanges Trading Options

Chicago Board Options Exchange (CBOE) American Stock Exchange (AMEX) Philadelphia Stock Exchange Pacific Stock Exchange European Options Exchange Australian Options Market

Futures Vs. Options

A FUTURES contract gives the holder the OBLIGATION to buy or sell at a certain price Even if the price is unfavorable to the holder of the contract, the contracted trade is executed An OPTION gives the holder the RIGHT to buy or sell at a certain price If the prices are unfavorable to the holder of the contract, he can forgo the contracted trade

Motivations
Why use Options instead of Futures?
Preference for non-symmetric payoffs Take advantage of information about the shape of the subjective probability distribution of the underlying asset price

Types of Traders
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.

Hedging Using Options

An investor owns 500 IBM shares currently worth $102 per share. A put with a strike price of $100 costs $4. The investor decides to hedge by buying 5 contracts.
Each contract implies right to sell 100 shares. 5 contracts costs $2000.

Speculation Using Options

An investor with $7,800 to invest feels that Exxons stock price will increase over the next 3 months. The current stock price is $78 and the price of 3-month call options with a strike of 80 is $3. What are the alternative strategies?

Dividends & Stock Splits

Suppose you own N options with a strike price of X : No adjustments are made to the option terms for cash dividends When there is an n-for-m stock split, the strike price is reduced to mX/n the no. of options is increased to nN/m Stock dividends are handled in a manner similar to stock splits

Dividends & Stock Splits

Consider a call option to buy 100 shares for $20/share How should terms be adjusted: for a 2-for-1 stock split? for a 20% stock dividend?
Equivalent to 6-for-5 stock split

Margins
Margins are required when options are sold When a naked option is written the margin is the greater of: 1. 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 2. A total of 100% of the proceeds of the sale plus 10% of the underlying share price

Margins
Suppose you are selling 4 naked call option contracts with a strike price of $37 for $4 when the stock price is $35 The first condition gives 400(4+0.2*35-2) = $3,600 The first condition gives 400(4+0.1*35) = $3,000 Thus, the margin requirement is $3,600 What if the option was a PUT?

Swaps Contracts: Definitions

In a swap, two counter-parties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. There are two types of interest rate swaps:
Single currency interest rate swap
Plain vanilla fixed-for-floating swaps are often just called interest rate swaps.

Cross-Currency interest rate swap

This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

The Swap Bank

A swap bank is a generic term to describe a financial institution that facilitates swaps between counter-parties. The swap bank can serve as either a broker or a dealer.
As a broker, the swap bank matches counter-parties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counter-party.

An Example of an Interest Rate Swap

Consider this example of a plain vanilla interest rate swap. Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.
Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10%. It would make more sense to for the bank to issue floatingrate notes at LIBOR to finance floating-rate Eurodollar loans.

An Example of an Interest Rate Swap

Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life.
Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75%. Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + percent. Firm B would prefer to borrow at a fixed rate.

An Example of an Interest Rate Swap

The borrowing opportunities of the two firms are:

An Example of an Interest Rate Swap

Swap Bank
10 3/8% LIBOR 1/8%

Bank A

The swap bank makes this offer to Bank A: You pay LIBOR 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years

An Example: Interest Rate Swap

% of $10,000,000 = $50,000. Thats quite a cost savings per year for 5 years.

Swap Bank

10 3/8% LIBOR 1/8%

Heres whats in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + (LIBOR 1/8) +10 = LIBOR % which is % better than they can borrow floating without a swap.

Bank A
10%

An Example of an Interest Rate Swap

The swap bank makes this offer to company B: You pay us 10% per year on $10 million for 5 years and we will pay you LIBOR % per year on $10 million for 5 years. Swap Bank
10 % LIBOR %

Company B

An Example of an Interest Rate Swap

Heres whats in it for B: Swap Bank
They can borrow externally at LIBOR + % and have a net borrowing position of 10 + (LIBOR + ) - (LIBOR - ) = 11.25% which is % better than they can borrow fixed.
LIBOR % LIBOR + %

% of $10,000,000 = $50,000 thats quite a cost savings per year for 5 years.
10 %

Company B

An Example of an Interest Rate Swap

The swap bank makes money too. Swap Bank
10 3/8% LIBOR 1/8%

% of $10 million = $25,000 per year for 5 years.

10 % LIBOR %

Bank A

LIBOR 1/8 [LIBOR ]= 1/8 10 - 10 3/8 = 1/8

Company B

An Example of an Interest Rate Swap

The swap bank makes % Swap Bank
10 3/8% LIBOR 1/8% 10 % LIBOR %

Bank A A saves %

Company

B B saves %