Transcript Document
MGT 821/ECON 873
Financial Derivatives
Lecture 1
Introduction
1
What is a derivative?
A derivative is an instrument whose value
depends on the values of other more basic
underlying variables
Example:
Forward Contracts, futures contracts
Swaps
Options
Credit derivatives
2
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
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
4
Forward Contracts
A forward contract is an agreement to buy or sell an asset
at a certain time in the future for a certain price (the
delivery price)
It can be contrasted with a spot contract which is an agreement to
buy or sell immediately
The contract is an over-the-counter (OTC) agreement
between 2 companies
The delivery price is usually chosen so that the initial
value of the contract is zero
No money changes hands when contract is first
negotiated and it is settled at maturity
The 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
Profit from a
Long Forward Position
Profit
K
Price of Underlying
at Maturity, ST
7
Profit from a
Short Forward Position
Profit
K
Price of Underlying
at Maturity, ST
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Example
On August 20, 2006 a trader enters into an
agreement to buy £1 million in three months at an
exchange rate of 1.6196
This obligates the trader to pay $1,619,600 for £1
million on November 20, 2006
What are the possible outcomes?
Profit from a
Long Forward Position
Profit
Price of Underlying
K
at Maturity, ST
Profit from a
Short Forward Position
Profit
Price of Underlying
K
at Maturity, ST
Futures
Futures - similar to forward but feature formalized and
standardized characteristics
Agreement to buy or sell an asset for a certain price at a certain time
Whereas a forward contract is traded OTC a futures contract is
traded on an exchange
Key difference in futures
Exchange traded
Specifications need to be defined:
What can be delivered,
Where it can be delivered,
When it can be delivered
Settled daily
Options
A call option is an
option to buy a
certain asset by a
certain date for a
certain price (the
strike price)
Exotic options
A put is an option to
sell a certain asset
by a certain date for
a certain price (the
strike price)
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Long Call on IBM
Profit from buying an IBM European call option: option price =
$5, strike price = $100, option life = 2 months
30 Profit ($)
20
10
70
0
-5
80
90
100
Terminal
stock price ($)
110 120 130
14
Short Call on IBM
Profit from writing an IBM European call option: option price =
$5, strike price = $100, option life = 2 months
Profit ($)
5
0
-10
110 120 130
70
80
90 100
Terminal
stock price ($)
-20
-30
15
Long Put on Exxon
Profit from buying an Exxon European put option: option price
= $7, strike price = $70, option life = 3 mths
30 Profit ($)
20
10
0
-7
Terminal
stock price ($)
40
50
60
70
80
90 100
16
Short Put on Exxon
Profit from writing an Exxon European put option: option price =
$7, strike price = $70, option life = 3 mths
Profit ($)
7
0
40
50
Terminal
stock price ($)
60
70
80
90 100
-10
-20
-30
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Payoffs from Options
Payoff
Payoff
K
K
ST
Payoff
ST
Payoff
K
K
ST
ST
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Examples
Insurance as options
Put options is an insurance for an asset one already
owns
Call option is insurance for an asset one plans to own
in the future
Equity linked CDs
Example: a simple 5 ½ year CD with a return linked to
the S&P 500 might have the following structure: at
maturity the CD is guaranteed to reply the invested
amount, plus 65% of the simple appreciation in the
S&P 500 over that time.
What is the payoff?
19
Swaps
A swap is an agreement to exchange cash
flows at specified future times according to
certain specified rules
Basic forms of swaps
Interest rate swaps;
currency swaps
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An Example of a “Plain Vanilla” Interest
Rate Swap
An agreement by Microsoft to receive 6month LIBOR & pay a fixed rate of 5% per
annum every 6 months for 3 years on a
notional principal of $100 million
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Cash Flows to Microsoft
---------Millions of Dollars--------LIBOR FLOATING
FIXED
Net
Date
Rate
Cash Flow Cash Flow Cash Flow
Mar.5, 2001
4.2%
Sept. 5, 2001
4.8%
+2.10
–2.50
–0.40
Mar.5, 2002
5.3%
+2.40
–2.50
–0.10
Sept. 5, 2002
5.5%
+2.65
–2.50
+0.15
Mar.5, 2003
5.6%
+2.75
–2.50
+0.25
Sept. 5, 2003
5.9%
+2.80
–2.50
+0.30
Mar.5, 2004
6.4%
+2.95
–2.50
+0.45
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Typical Uses of an Interest Rate Swap
Converting a liability
from
fixed rate to
floating rate
floating rate to
fixed rate
Converting an
investment from
fixed rate to
floating rate
floating rate to
fixed rate
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Currency Swap
Example
An agreement to pay 11% on a sterling
principal of £10,000,000 & receive 8% on a
US$ principal of $15,000,000 every year for 5
years
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The Cash Flows
Year
2001
2002
2003
2004
2005
2006
$
£
------millions-----–15.00 +10.00
+1.20 –1.10
+1.20 –1.10
+1.20 –1.10
+1.20 –1.10
+16.20 -11.10
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Typical Uses of a Currency Swap
Conversion from a
liability in one
currency to a liability
in another currency
Conversion from an
investment in one
currency to an
investment in
another currency
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Credit Risk
A swap is worth zero to a company initially
At a future time its value is liable to be either
positive or negative
The company has credit risk exposure only
when its value is positive
The risk is asymmetric!
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Swaptions
What is a swaption?
Swap + Option = swaption
It is an option written on a swap rate
How does it work?
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Credit Derivatives
Credit Default Swap
Company A buys default protection from B to
protect against default on a reference bond issued
by the reference entity, C.
A makes periodic payments to B
In the event of a default by C
A has the right to sell the reference bond to B for its face
value, or
B pays A the difference between the market value and
the face value
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CDS Structure
90 bps per year
Default
Protection
Buyer, A
Payment if default by
reference entity,C
Default
Protection
Seller, B
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Other credit derivatives
First-to-default
Total return swap
Credit spread option
CDO
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