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What is a Derivative?

What is a Derivative?. A derivative is an instrument whose value depends on, or is derived from, the value of another asset. Examples: futures, forwards, swaps, options , exotics…. Why Derivatives Are Important. Derivatives play a key role in transferring risks in the economy

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What is a Derivative?

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  1. What is a Derivative? • A derivative is an instrument whose value depends on, or is derived from, the value of another asset. • Examples: futures, forwards, swaps, options, exotics…

  2. Why Derivatives Are Important • Derivatives play a key role in transferring risks in the economy • The underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etc • Many financial transactions have embedded derivatives • The real options approach to assessing capital investment decisions has become widely accepted

  3. How Derivatives Are Traded On exchanges such as the Chicago Board Options Exchange In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly

  4. Size of OTC and Exchange-Traded Markets(Figure 1.1, Page 3) Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

  5. How Derivatives are Used To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit

  6. Foreign Exchange Quotes for GBP, May 24, 2010

  7. 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 (as shown by the table)

  8. 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

  9. Example (page 5) On May 24, 2010 the treasurer of a corporation 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 What are the possible outcomes?

  10. Profit Price of Underlying at Maturity, ST Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered into) K

  11. Profit Price of Underlying at Maturity, ST Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into) K

  12. 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

  13. Exchanges Trading Futures CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade) NYSE Euronext BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more

  14. Examples of Futures Contracts Agreement to: • Buy 100 oz. of gold @ US$1400/oz. in December • Sell £62,500 @ 1.4500 US$/£ in March • Sell 1,000 bbl. of oil @ US$90/bbl. in April

  15. 1. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$1,400 The 1-year forward price of gold is US$1,500 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

  16. 2. Gold: Another Arbitrage Opportunity? Suppose that: • The spot price of gold is US$1,400 • The 1-year forward price of gold is US$1,400 • The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

  17. The Forward Price of Gold (ignores the gold lease rate) If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. In our examples, S = 1400, T = 1, and r=0.05 so that F = 1400(1+0.05) = 1470

  18. 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)

  19. 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

  20. Review of Option Types A call is an option to buy 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

  21. Option Positions Long call Long put Short call Short put

  22. Profit ($) 30 20 10 Terminal stock price ($) 70 80 90 100 0 110 120 130 -5 Long Call Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months

  23. Profit ($) 110 120 130 5 0 70 80 90 100 Terminal stock price ($) -10 -20 -30 Short Call Profit from writing one European call option: option price = $5, strike price = $100

  24. Profit ($) 30 20 10 Terminal stock price ($) 0 40 50 60 70 80 90 100 -7 Long Put Profit from buying a European put option: option price = $7, strike price = $70

  25. Profit ($) Terminal stock price ($) 7 40 50 60 0 70 80 90 100 -10 -20 -30 Short Put Profit from writing a European put option: option price = $7, strike price = $70

  26. Payoffs from OptionsWhat is the Option Position in Each Case? Payoff Payoff K K ST ST Payoff Payoff K K ST ST K = Strike price, ST= Price of asset at maturity

  27. Assets UnderlyingExchange-Traded Options Stocks Foreign Currency Stock Indices Futures

  28. 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

  29. Types of Traders Hedgers Speculators Arbitrageurs

  30. Swaps A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

  31. An Example of a “Plain Vanilla” Interest Rate Swap An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million Next slide illustrates cash flows that could occur (Day count conventions are not considered)

  32. One Possible Outcome for Cash Flows to Microsoft (Table 7.1, page 150)

  33. Typical Uses of an Interest Rate Swap • Converting a liability from • fixed rate to floating rate • floating rate to fixed rate • Converting an investment from • fixed rate to floating rate • floating rate to fixed rate

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