Transcript Forwards, futures swaps and options WORKBOOK By

Forwards, futures swaps
and options
WORKBOOK
By
Ramon Rabinovitch
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Introduction
Chapter 1
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The Nature of Derivatives
A derivative is a financial instrument
whose value depends on the values of
other more basic underlying variables
In particular, it depends on the market
price of the so called:
underlying asset.
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Underlying assets:
Stocks
Bonds
Foreign currencies
Gold, Silver…
Crude oil, Natural gas, Gasoline, heating oil…
Wheat, corn, rice, grain feed, soy beans, pork
bellies…
Stock indexes
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DERIVATIVES ARE CONTRAC TS:
FORWARDS
FUTURES
OPTIONS
SWAPS
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WHY TRADE DERIVATIVES?
THE FUNDAMENTAL
REASON FOR TRADING
DERIVATIVES IS TO HEDGE:
THE PRICE RISK
(VOLATILITY)
Exhibited by the spot price of the
underlying commodity
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PRICE RISK IS THE
VOLATILITY
ASSOCIATED WITH THE COMMODITY’S
PRICE IN THE
CASH MARKET
REMEMBER THAT THE CASH MARKET IS
WHERE FIRMS DO THEIR BUSINESS. I.E., BUY
AND SELL THE COMMODITY.
ZERO PRICE VOLATILITY
NO DERIVATIVES!!!!
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PRICE RISK: At time t, the
asset’s price at time T is not
known.
Probability
distributio
ST
St
t
T
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time
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
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Types of risk:
Price risk
Credit risk
Operational risk
Completion risk
Human risk
Regulatory risk
Tax risk
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IN THIS CLASS WE WILL ONLY
ANALYZE THE
RISK
ASSOCIATED WITH THE
SPOT MARKET PRICE
OF
THE UNDERLYING ASSET
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DERIVATIVES ARE CONTRACTS:
Two parties
Agreement
Underlying security
Contract termination date
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DERIVATIVES ARE CONTRACTSThe
distinction is made by the different stipulations
of the contract
Forwards and Futures are Fixed obligations
A FORWARD
IS A CONTRACT IN WHICH ONE PARTY COMMITS TO BUY
AND THE OTHER PARTY COMMITS TO SELL A SPECIFIED
AMOUNT OF AN AGREED UPON COMMODITY FOR A
PREDETERMINED PRICE ON A SPECIFIC DATE IN THE
FUTURE.
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Buy or sell
a forward
t
Delivery
and
payment
T
Time
BUY = OPEN A LONG POSITION
SELL = OPEN A SHORT POSITION
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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
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EXAMPLE:
GBP
18.5.99
SPOT
USD1,6850/GBP
30 days forward
USD1,7245/GBP
60 days forward
USD1,7455/GBP
90 days forward
USD1,7978/GBP
180 days forward
USD1,8455/GBP
The existence of forward exchange rates implies that there is a
demand and supply for the GBP for future dates.
In the actual market, however, different rates are quoted for buy
(ask) and for sell (bid) orders.
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Foreign Exchange Quotes for
USD/GBP on Aug 16, 2001 ( page 3)
Spot
Bid
1.4452
Offer
1.4456
1-month forward
1.4435
1.4440
3-month forward
1.4402
1.4407
6-month forward
1.4353
1.4359
12-month forward
1.4262
1.4268
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Profit from a
Long Forward Position
Profit
K
Price of Underlying
at Maturity, ST
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Profit from a
Short Forward Position
Profit
K
Price of Underlying
at Maturity, ST
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A FUTURES
A STANDARDIZED FORWARD TRADED ON
AN ORGANIZED EXCHANGE.
STANDARDIZATION
THE COMMODITY
TYPE AND QUALITY
THE QUANTITY
PRICE QUOTES
DELIVERY DATES
DELIVERY PROCEDURES
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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
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AN OPTION
IS A CONTRACT IN WHICH ONE PARTY HAS THE RIGHT,
BUT NOT THE OBLIGATION, TO BUY OR SELL A
SPECIFIED AMOUNT OF AN AGREED UPON COMMODITY
FOR A PREDETERMINED PRICE BEFORE OR ON A
SPECIFIC DATE IN THE FUTURE. THE OTHER PARTY HAS
THE OBLIGATION TO DO WHAT THE FIRST PARTY
WISHES TO DO. THE FIRST PARTY, HOWEVER, MAY
CHOOSE NOT TO EXERCISE ITS RIGHT AND LET THE
OPTION EXPIRE WORTHLESS.
A CALL = A RIGHT TO BUY THE UNDERLYING ASSET
A PUT = A RIGHT TO SELL THE UNDERLYING ASSET
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Long Call on Microsoft (Figure 1.2, Page 7)
Profit from buying a European call option on Microsoft:
option price = $5, strike price = $60
30 Profit ($)
20
10
30
0
-5
40
50
Terminal
stock price ($)
60
70
80
90
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Short Call on Microsoft (Figure 1.4, page 9)
Profit from writing a European call option on Microsoft:
option price = $5, strike price = $60
Profit ($)
5
0
-10
70
30
40
50 60
80
90
Terminal
stock price ($)
-20
-30
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Long Put on IBM (Figure 1.3, page 8)
Profit from buying a European put option on IBM: option
price = $7, strike price = $90
30 Profit ($)
20
10
0
-7
Terminal
stock price ($)
60
70
80
90
100 110 120
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Short Put on IBM (Figure 1.5, page 9)
Profit from writing a European put option on IBM: option
price = $7, strike price = $90
Profit ($)
7
0
60
70
Terminal
stock price ($)
80
90
100 110 120
-10
-20
-30
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A SWAP
IS A CONTRACT IN WHICH THE TWO
PARTIES COMMIT TO EXCHANGE A SERIES
OF CASH FLOWS. THE CASH FLOWS ARE
BASED ON AN AGREED UPON PRINCIPAL
AMOUNT. NORMALLY, ONLY THE NET
FLOW EXCHANGES HANDS.
Principal amount = EUR100,000,000;
semiannual payments.
7%
Party B
Party A
6-months LIBOR
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Types of Derivatives Traders
• Speculators
• Hedgers
•Arbitrageurs
Some of the large trading losses in
derivatives occurred because individuals
who had a mandate to hedge risks
switched to being speculators
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THE ECONOMIC PURPOSES OF
DERIVATIVE MARKETS
HEDGING
PRICE DISCOVERY
SAVING
HEDGING IS THE ACTIVITY OF
MANAGING PRICE RISK EXPOSURE
PRICE DISCOVERY IS THE REVEALING
OF INFORMSTION ABOUT THE FUTURE
CASH MARKET PRICE FOR A PRODUCT.
SAVING IS THE COST SAVING ASSOCIATED WITH SWAPING
CASH FLOWS
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