Transcript 550.444 - Johns Hopkins University
550.444
Introduction to Financial Derivatives
Introduction Weeks of September 4 and September 9, 2013
1.1
Principals
David R Audley, Ph.D.; Sr. Lecturer in AMS [email protected]
Office: WH 212A; 410-516-7136 Office Hours: 4:30 – 5:30 Monday Teaching Assistant(s) Huang, Qiushun ( [email protected]
) Office Hours: Friday 4pm – 6pm Ward, Brian ( [email protected]
) Office Hours: Monday & Wednesday 2pm – 3 pm
1.2
Schedule
Lecture Encounters Monday & Wednesday, 3:00 - 4:15pm, Mergenthaler 111 Section Section 1: Friday 3:00 - 3:50pm, Hodson 211 Section 2: Thursday 3:00 - 3:50pm, WH 304
1.3
Protocol
Attendance Lecture – Mandatory (default) for MSE Fin Math majors Quizzes & Clickers Section – Strongly Advised/Recommended Assignments Due as Scheduled (for full credit) Must be handed in to avoid “incomplete” Exceptions must be requested in advance
1.4
Resources
Textbook John C Hull: Options, Futures, and Other Derivatives, Prentice-Hall 2012 (8e) Recommended: Student Solutions Manual On Reserve in Library Text Resources http://www.rotman.utoronto.ca/~hull/ofod/Errata8e/index.html
http://www.rotman.utoronto.ca/~hull/TechnicalNotes/index.html
1.5
Resources
Supplemental Material As directed AMS Website http://jesse.ams.jhu.edu/~daudley/444 Additional Subject Material Class Resources & Lecture Slides Industry & Street “Research” (Optional) Consult at your leisure/risk Interest can generate Special Topics sessions Blackboard
1.6
Measures of Performance
Mid Term Exam (~1/3 of grade) Final Exam (~1/3 of grade) Home work as assigned and designated and Quizzes (~1/3 of grade)
1.7
Assignment
Thru week of Sept 9 (Next Week) Read: Hull Chapter 1 (Introduction) Read: Hull Chapter 2 (Futures Markets) Problems (Due September 16) Chapter 1: 17, 18, 22, 23; 34, 35 Chapter 1 (7e): 17, 18, 22, 23; 30, 31 Chapter 2: 15,16, 21, 22; 30 Chapter 2 (7e): 15, 16, 21, 22; 27
1.8
Assignment
For week of Sept 16 (in 2 Weeks) Read: Hull Chapters 3 (Hedging with Futures) Problems (Due September 23) Chapter 3: 4, 7, 10, 17, 18, 20, 22; 26 Chapter 3 (7e): 4, 7, 10, 17, 18, 20, 22; 26
1.9
Assets and Cash
Stock, Bond, Commodity, … (Assets) Risk vs. Return (Expected Return) Cash (or Currency) Held, on Deposit or Borrowed Terminology Assets – things we “own” (long) Liabilities – what we “owe” (short)
1.10
How Things Work
True Assets – A house, a company, oil, … Ownership rights, contracts, & other legal instruments which represent the true asset For us, many are indistinguishable from the asset; are the asset Provide properties that can be quantified, assigned, subordinated and made contingent Can be modeled
1.11
Who Makes it Work
Investment Banks: Capital Intermediation Companies into Stock Borrowings into Bonds Broker-Dealers & Markets (Exchanges) Create everything else Facilitate transfer/exchange (trading) Investors Under the Watchful Eyes of Regulators, Professional Associations and the Rule of Law
1.12
Creation & Exchange of Securities and Instruments
Secondary Issues Collateral Create Securities Investment Banking New Issue Securities Make Markets Broker-Dealers & Exchanges Securities & Contracts Manage Invested Funds Institutional Investors
1.13
Two Fundamental Ideas in Modeling
LOAN FROM STANDPOINT OF LENDER
Cash Flow Cash flow diagram Receive vs. Pay over Time
Receive Pay
Repayment of Loan w/Interest at t 0 +T t, time Amount of Loan, t 0 Payoff Cashflow
Gain
Payoff diagram Gain vs. Loss against Price Cashflows can depend
Loss
on some other variable S, Price K
LONG STOCK AT PRICE K 1.14
Real World Situation - Cash
Japanese Bank; borrow US dollars (USD) to loan to its customers; term, 3 months Go to Euromarket where it
might
be able to get an Interbank Loan Receive (Borrow) USD T = 1/4 year Lt 0 = 3 month interest rate in effect at t 0 t 0 + T t 0
Borrow: USD Pay Back: USD
x
(1
+
Lt 0
x
T)
Pay Back USD+Lt 0 x(.25)xUSD
1.15
Real World Situation - Cash
What if Bank did not have credit line?
Could perform the same transaction as a Synthetic in the FX and domestic Yen mkt Borrow Yen in local mkt for term T, at L(t 0 ,Y) Sell Yen and buy USD in spot FX mkt at e(t 0 ,Y) Finally, the bank buys Yen and sells USD in the forward FX market for delivery at t 0 +T
1.16
Real World Situation - Cash
Cash Flows are Additive Y t 0 USD + Y USD + =
Borrow Y for T
Yx(1+L(t 0 ,Y)xT)
Buy USD sell Y at e(t 0 ,Y)
Y = e(t 0 ,Y) x USD Yx(1+L(t 0 ,Y)xT) USDx(1+L(t 0 ,$)xT)
Buy Y forward for t 0 +T
Y x (1 + L(t 0 ,Y)xT) = f(t 0 ,T;Y) x USD1 USD1 = USD x (1 + L(t 0 ,$) x T) t 0 +T USDx(1+L(t 0 ,$)xT)
1.17
Real World Situation - Cash
What’s the difference; what’s interesting International Banks have credit risk in the USD loan For the synthetic, the International Bank exposure is in the forward contract only No principal risk Yen loan default is a domestic issue (central bank) The synthetic can be used to price the derivative, ex credit risk (what’s the derivative in this example?) Each side could be the other’s hedge Different markets involve many legal & regulatory differences
1.18
Real World Situation - Tax
Situation: In Sept ‘02, investor bought asset S, S 0 =$100 EOM Nov, asset target reached at $150 (sell) Sale yields gain of $50 (taxable) Wash-Sale Rule prohibits: Sell winner at $50 gain Sell another asset, Z that’s down $50 to $50 to offset gain
Buy asset Z back next day
as investor still likes it Prohibited since trade is intentionally washing gain
1.19
Real World Situation - Tax
Alternative Synthetic using Options Call Option (
Strike
= S 0 ) Long has right to buy underlying at pre-specified price, S 0 Short has obligation to deliver underlying at that price
Expiration
Payoff Chart + + S 0 S S S 0 For the LONG For the SHORT
1.20
Real World Situation - Tax
Put Option (Struck at S 0 ) Long has right to sell underlying at pre-specified price, S 0 Short has obligation to accept delivery of underlying at S 0 Expiration Payoff Chart + S 0 S + S 0 S For the LONG For the SHORT
1.21
Real World Situation - Tax
Consider the Synthetic (to offset 50 gain) Buy another Z asset at 50 in Nov (11/26/02) Sell an at-the-money call on Z Strike, Z 0 = 50 Expiration >= 31 days later, but in 2002 (12/30/02) Buy an at-the-money put on Z (same expiry) At expiration, sell the Z asset or deliver into Call
1.22
Real World Situation - Tax
Payoff Charts for the Synthetic + Price at the expiration of the options, Z e 50
Short Call
+ Z If Z e > 50: •Short Call looses money as short has to deliver Z for 50 •Long Put is worthless 50
Long Put
+ Z If Z e < 50: •Short Call is worthless •Long Put gains as the long can sell Z for 50 50
Synthetic Short in Z
Z In either case the investor has locked in the 50 price
for the stock bought at 100 (FIFO) 1.23
Real World Situation - Tax
The timing issue is important According to US Tax law, wash sale rules apply if the investor acquires or sells a
substantially identical
property within a 31-day period In the synthetic strategy, the second Z is purchased on 11/20; while the options expire on 12/30 when the first Z is sold (and the tax loss is “booked” – FIFO accounting)
1.24
Real World Examples – Consequences & Implications
Strategies are Risk Free and Zero Cost (aside from commissions and fees) We created a Synthetic (using Derivatives) and used it to provide a solution Finally, and most important, these examples display the crucial role Legal & Regulatory frameworks can play in engineering a financial strategy (its the environment)
1.25
Two Points of View
Manufacturer (Dealer) vs. User (Investor) Dealer’s View: there are two prices A price he will buy from you (low) A price he will sell to you (high) It’s how the dealer makes money Dealer never has money; not like an investor Must find funding for any purchase Place the cash from any sale Leverage
1.26
Two Points of View
Dealers prefer to work with instruments that have zero value at initiation (x bid/ask) Likely more liquid No principal risk Regulators, Professional Organizations, and the Law are more important for market professionals than investors Dealers vs. Investors
1.27
The Nature of Derivatives
A derivative is an instrument whose value depends on the values of other more basic underlying variables
1.28
Examples of Derivatives
• • • • Futures Contracts Forward Contracts Swaps Options
1.29
Derivatives Markets
Exchange traded Traditionally exchanges have used the open outcry system, but increasingly they are switching to electronic trading Contracts are standard; virtually no credit risk Over-the-counter (OTC) A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard and there is some (small) amount of credit risk
1.30
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
1.31
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 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
1.32
Forward Price
The forward price (for a contract) is the delivery price that would be applicable to a forward contract if were negotiated today (i.e., the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities
1.33
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
1.34
Example
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?
1.35
Profit (or Payoff) from a Long Forward Position
Profit
K
Price of Underlying at Maturity,
S T
Payoff at
T
=
S T – K
1.36
Profit from a Short Forward Position
Profit = Payoff at
T
=
K - S T K
Price of Underlying at Maturity,
S T
1.37
Foreign Exchange Quotes for GBP May 24, 2010
Spot 1-month forward 3-month forward 6-month forward Bid 1.4407
1.4408
1.4410
1.4416
Offer 1.4411
1.4413
1.4415
1.4422
1.38
Foreign Exchange Quotes for JPY Jan 22, 2007 (16:23 EST)
Spot Bid 121.62
1-month forward 121.08
3-month forward 120.17
6-month forward 118.75
Offer 121.63
121.09
120.18
118.77
1.39
1. Gold: An Arbitrage Opportunity?
Suppose that: • The spot price of gold is US$900 • The 1-year forward price of gold is US$1,020 • The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?
1.40
2. Gold: Another Arbitrage Opportunity?
Suppose that: • The spot price of gold is US$900 • The 1-year forward price of gold is US$900 • The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?
1.41
The Forward Price of Gold – The Principal of Cash and Carry
If the spot price of gold is
S(t 0 )
a contract deliverable in
T
and the forward price for years is
F(t 0 ,T)
, then Can borrow money, buy gold, and sell the commodity forward -
where there should be no arbitrage: F(t 0 ,T) - S(t 0 )
x (1+
r
)
T = 0
where
r
is the 1-year money rate of interest to finance the gold carry trade.
In our examples,
S
= 900,
T
= 1, and
r
=0.05 so that
F(t 0 ,T)
The
no arbitrage
= 900(1+0.05) = 945 1 year forward price of gold is $945
1.42
The Forward Price of Gold – The Principal of Cash and Carry
How does this come about?
S(t0)
receive
Borrow S(t0) S(t0)x(1+r)
pay t0
+ Gold Buy Gold at S(t0) S(t0) + F(t0) Sell Gold Forward at F(t0) Gold = No Arbitrage condition says:
Own
Gold
Deliver
Gold F(t0) – S(t0)x(1+r) = 0 1.43
Gold Arbitrage?
The no arbitrage gold, 1-year forward condition is
F(t 0 ,T) - S(t 0 )
x If 1-year forward is $1020, then (1+
r
)
T = 0 F(t 0 ,T) - S(t 0 )
x (1+
r
)
T > 0
so our strategy is to borrow money, buy gold, sell it forward, deliver gold, and pay off loan for a riskless profit of $75 If 1-year forward is $900, then
F(t 0 ,T) - S(t 0 )
x (1+
r
)
T < 0
and if I own gold, I can sell it, deposit proceeds, buy forward, pay with the proceeds of the deposit and collect a riskless profit of $45 over the 1-year period
1.44
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
1.45
Futures Contracts
Forward contracts are similar to futures except that they trade in the over-the counter market Forward contracts are particularly popular on currencies and interest rates
1.46
Exchanges Trading Futures
Chicago Board of Trade (CME) Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book)
1.47
Examples of Futures Contracts
Agreement to: Buy 100 oz. of gold @ US$1080/oz. in December (NYMEX) Sell £62,500 @ 1.4410 US$/£ in March (CME) Sell 1,000 bbl. of oil @ US$120/bbl. in April (NYMEX)
1.48
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)
1.49
American vs European Options
An American style option can be exercised at any time during its life A European style option can be exercised only at maturity
1.50
Intel Option Prices (Sept 12, 2006; Stock Price=19.56)
Strike Price 15.00
Oct Call 4.650
Jan Call 4.950
Apr Call 5.150
Oct Put 0.025
Jan Put 0.150
Apr Put 0.275
17.50
2.300
2.775
3.150
0.125
0.475
0.725
20.00
0.575
1.175
1.650
0.875
1.375
1.700
22.50
0.075
0.375
0.725
2.950
3.100
3.300
25.00
0.025
0.125
0.275
5.450
5.450
5.450
1.51
Exchanges Trading Options
Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) and many more (see list at end of book)
1.52
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
1.53
Types of Traders
• Hedgers • Speculators • Arbitrageurs Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators (See, for example, SocGen (Jerome Kerviel) in Business Snapshot 1.3, page 17)
1.54
Hedging Examples
(pages 10-12)
A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put option with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts
1.55
Hedging Example
A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract Possible strategies: Buy £ now, deposit in bank, withdraw £10 million in 3 months, pay for imports Buy £10 million forward in 3 months, deposit USD, use deposit proceeds to settle and pay for imports Do nothing now and buy £10 million in the spot FX market in 3 months First 2 are riskless, third has currency risk.
Which makes most sense?
1.56
Value of Microsoft Shares with and without Hedging
40,000
Value of Holding ($)
35,000 30,000 25,000 20,000 20 25 30
Stock Price ($)
35 40 No Hedging Hedging
1.57
Speculation Example
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? Buy 100 shares or Buy 20 Calls (on 100 shares each)
1.58
Arbitrage Example
A stock price is quoted as £100 in London and $140 in New York The current exchange rate is 1.4410
What is the arbitrage opportunity?
Buy 100 shares in NY; sell 100 in London = 100 [(1.441 x 100) – 140] = 410
1.59
Futures Contracts
Available on a wide range of underlyings Exchange traded Specifications need to be defined: What can be delivered, Where it can be delivered, & When it can be delivered Settled daily
1.60
Forward Contracts vs Futures Contracts
FORWARDS
Private contract between 2 parties Non-standard contract Usually 1 specified delivery date Settled at end of contract Delivery or final cash settlement usually occurs Some credit risk
FUTURES
Exchange traded Standard contract Range of delivery dates Settled daily Contract usually closed out prior to maturity Virtually no credit risk
1.61
Margins
A margin is cash or marketable securities deposited by an investor with the broker Initial Margin Maintenance Margin The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract
1.62
Example: Futures Trade
(page 27-28) 1.63
A Possible Outcome
Table 2.1, Page 28 1.64
Other Key Points About Futures
They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity
1.65
Collateralization in OTC Markets
It is becoming increasingly common for contracts to be collateralized in OTC markets They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)
1.66
Another Detail for Cash and Carry Arbitrage
Contract price changes with longer term Higher or Lower To this point we have neglected storage cost Lets re-visit no-arbitrage equation
F(t0,T) - S(t0)
x
[
(1+
r
)
T ] = Storage (T)
Storage costs ignored in earlier gold example No storage costs for FX Convenience Yield
1.67
1. Oil: An Arbitrage Opportunity?
Suppose that: The spot price of oil is US$95 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 Is there an arbitrage opportunity?
1.68
2. Oil: Another Arbitrage Opportunity?
Suppose that: The spot price of oil is US$95 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 Is there an arbitrage opportunity?
1.69
Futures Prices for Gold on Jan 8, 2007: Prices Increase with Maturity
650 640 630 620 610 600 Jan-07 Apr-07 Jul-07
Contract Maturity Month
Oct-07 Jan-08
1.70
Futures Prices for Orange Juice on Jan 8, 2007: Prices Decrease with Maturity
210 205 200 195 190 185 180 175 170 Jan-07 Mar-07 May-07 Jul-07
Contract Maturity Month
Sep-07 Nov-07
1.71
Delivery
If a futures contract is not closed out before 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.
A few contracts (for example, those on stock indices and Eurodollars) are settled in cash
1.72
Some Terminology
Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of contracts traded in 1 day
1.73
Convergence of Futures to Spot
Spot Price Futures Price Time (a) Futures Price Spot Price Time (b)
1.74
Questions
When a new trade is completed what are the possible effects on the open interest?
Can the volume of trading in a day be greater than the open interest?
1.75
Regulation of Futures
Regulation is designed to protect the public interest CFTC – the Feds Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups NFA – the industry
1.76
The End for Today
Questions?
1.77