Derivative Markets: Overview

Finance (Derivative Securities) 312 Tuesday, 1 August 2006 Readings: Chapters 1, 2 & 8

Nature of Derivatives

 Derivatives are instruments whose values derive from that of an underlying asset • eg. Futures, Forwards, Options, Swaps  Used by: • • Hedgers (to protect against existing exposure) Speculators (to capitalise on anticipated price movements) • Arbitrageurs (to exploit mispricings)

Futures

 Agreement to trade between two parties at a fixed price and a specified future time  Rarely result in delivery (less than 3%)  Price determined by demand and supply  Traditionally traded through open outcry system, now traded electronically and over-the-counter  Terminology: party that agrees to buy (sell) has a long (short) position

Market Size

200 Size of Market ($ trillion) 150 100 50 0 Jun-98 Jun-99 Jun-00 Source: Hull (2004) Jun-01 Jun-02 Jun-03 OTC Exchange

Margins

 Cash or marketable securities offered as collateral  Protects against default risk  Balance adjusted daily to reflect daily settlement  Consider an investor taking a long position in two December gold futures contracts on June 5 • • • contract size is 100 oz, price is US$400 margin requirement is US$2,000/contract maintenance margin is US$1,500/contract

Marking-to-Market

Day Futures Price (US$) Daily Gain (Loss) (US$) Cumulative Margin Gain Account Margin (Loss) (US$) Balance (US$) Call (US$) 400.00

5-Jun 397.00

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13-Jun 393.30

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19-Jun 387.00

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26-Jun 392.30

(600) .

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(420) (1,140) 260 (600) .

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(1,340) .

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(2,600) .

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(1,540) 4,000 3,400 .

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0 .

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2,660 .

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+ 1,340 .

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= 4,000 < 3,000 2,740 .

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+ 1,260 .

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= 4,000 5,060 0

Convergence

Spot Price Futures Price Time (a) Futures Price Spot Price Time (b)

Forwards

FORWARDS Private contract between 2 parties Not date Settled at settlement usually occurs Some credit risk FUTURES Exchange traded Standard dates Settled prior to maturity Virtually no credit risk

Foreign Exchange Quotes

 Futures exchange rates are quoted as the number of USD per unit of the foreign currency  Forward exchange rates are quoted in the same way as spot exchange rates • GBP, EUR, AUD, and NZD are USD per unit of foreign currency • other currencies are quoted as units of the foreign currency per USD

Profits from Forwards/Futures

Profit Profit Long position Short position Price of Underlying Asset at Maturity Price of Underlying Asset at Maturity

Options

 Terminology • • • • • • Puts, Calls Long, Short Premium, Strike/Exercise Price European, American In-the-money, Out-of-the-money Intrinsic value, Time value

$

Payoff and Profit Diagrams

$ Buy Put Buy Call X S T Payoff – Bold Line Profit – Dashed Line X S T

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

Warrants

 Options issued by a corporation or financial institution  Traded the same way as stocks  For call warrants, exercise will lead to new treasury stock being issued

Executive Stock Options

 At-the-money, issued to company executives  Exercise will lead to new issue of stock  Become vested after a period of time (usually 1 to 4 years)  Cannot be sold  Often last for as long as 10 or 15 years

Convertible Bonds

 Regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio  Call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose

Bond Value

Convertible Bonds

Market Price Conversion Value Straight Bond Value Market Premium Share Price