Lecture 1 - Introduction

Derivative Securities

Week 1

Introduction

Instructor: Greta Fesechko Email: gfa5@sfu.ca Lecture: 3090 Office: 5047 Tel: (778) 782-7492 Office hours: Thursday 2:30 – 3:30pm

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Course Resources

Required textbook: “Fundamentals of Options and Futures Markets”, John C. Hull, 7th edition, Prentice Hall, 2010, ISBN: 013610322-6

Recommended: Solutions Manual and Study Guide for Fundamentals of Options and Futures Markets

Course website: webct.sfu.ca/web

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Course Assessment

1. Quizzes (2): 20%

2. Midterm: 30%

3. Final Exam: 40%

4. Participation: 10%

Total: 100%

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Course Assessment

Two problem sets will be assigned (not graded; they can be submitted via WebCT):

Problem Set 1 is due in Week 5

Problem Set 2 - in Week 12

Nonprogrammable calculators allowed

Crib sheets: midterm (half page) and final exams (full page)

Final exam is cumulative. Bring ID.

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Illness and Other Problems

Medical note required

No makeup quizzes or exams

“Fictitious grade" is assigned based on relative ranking in other assessments

If you disagree with any grade, submit your grievance within a week

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Any other questions?

Objectives

Definition of Derivatives

Forward and Futures, Swaps, Options

Derivatives markets, trading strategies and basic pricing models

Types of Traders

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What is a Derivative Security?

A derivative is a financial contract that specifies contingent (dependent) payoffs determined by the value of an underlying asset.

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Historical Facts

Derivatives, while seemingly new, have been used for thousands years: Aristotle, 350 BC (Olive) Netherlands, 1600s (Tulips) USA, 1800s (Grains, Cotton)

Derivatives in Canada: Winnipeg Commodity Exchange, 1904 (Oat) Montreal Exchange, 1975 (Stocks)

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Historical Facts

Spectacular growth since 1970’s: Liberalization in International trade and capital

markets Oil price shocks (Arab Oil Embargo) Increase in volatility End of Bretton Woods (using gold to support the

exchange rate) Black-Scholes pricing model

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Historical Facts

Size of derivatives markets:

OTC $592 trillion

Exchange traded $82.2 trillion

Capitalization of the markets (for corporate debts and equity in the world): $51.2 trillion

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Examples of Derivatives

Futures/Forward Contracts:Agree on price now, trade later

Call Options:Pay premium and agree on price now, if buyer

wants she buys asset later

Put options:Pay premium and agree on price now, if buyer

wants she sells asset later

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Examples of Underlying Assets

Stocks Bonds Exchange rates Interest rates Commodities Energy

Temperature, quantity of rain/snow

Real-estate price index Loss caused by an

earthquake/hurricane Derivatives

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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 (taking

advantage of a mispricing) To align incentives as performance related

compensation To change the nature of an investment without

incurring the costs of selling one portfolio and buying another

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Futures Contracts

Futures Contracts

A FUTURES contract is an agreement to buy or sell an asset at a certain time in the future for a certain price

By contrast in a SPOT contract there is an agreement to buy or sell an asset immediately

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Futures Price

The FUTURES PRICE is the price agreed today to buy or sell the underlying asset in the future

The futures price is determined by supply and demand in the same way as a spot price

Contract specifies: Assets Price of the Asset Date

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Example: Gold

Jan 03, 2012

Feb 2012 1608.50

March 2012 1607.90

April 2012 1612.0

June 2012 1614.2

S0 = $1605.40 F= $1608.50 (Feb 2012) Source: www.kitco.com Source: www.nymex.com

Jan 03, 2012 19:03 NY Time

Bid/Ask 1607.70 / 1608.90

 Low/High 1581.60 / 1609.40

 1 day chg +4.10   +0.26%

30 day chg -137.60   -7.88%

1 year chg +193.10 +13.65%

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Trading Futures

On organized exchanges: Chicago Board of Trade (CBOT, USA) Chicago Mercantile Exchange (CME,USA) -

now CME Group Montreal Exchange (Canada) LIFFE (UK) Eurex (Europe) TIFFE (Japan) Intercontinental Exchange

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Terminology

The party that has agreed to buy the asset has a LONG position

The party that has agreed to sell the asset has a SHORT position

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Example of Futures Contract

Agreement to: buy 100 ounces of gold @

US$1608.20/ounce in February 2012

Basic trading unit: 100 ounce of gold

Contract months: current and next two months, and any February, April, August and October falling within the next 23 months and any June and December falling within the next 60 months.

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Example of Futures Contract

Agreement to: sell 1,000 barrels of oil @ US$70/barrel in

March

Basic trading unit: 1,000 barrel (42,000 gallons) Deliverable grade: West Texas Intermediate

0.4% sulfur, 40 API gravity (with substitution differentials)

Last trading day: 3rd business day prior to 25th day of month preceding contract month.

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January: an investor enters into a long futures contract to buy 100 ounces of gold @ $1050 in April

April: the price of gold $1065 per ounce

What is the investor’s profit?

($1065 - $1050) * 100 = $1500

Example of Futures Contract

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Forward Contracts

Forward Contracts

Forward contracts are similar to futures except that they trade in the over-the-counter (OTC) market (not on exchanges)

Forward contracts are popular on currencies and interest rates

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Over-the-Counter Markets

The over-the-counter market is an important alternative to exchanges

It is a telephone and computer-linked network of dealers who do not physically meet

Trades are usually between financial institutions, corporate treasurers, and fund managers

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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

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Canadian Dollar Forward Rates (in USD)Toronto market on Tuesday, January 3, 2012.

(source: http://fx.sauder.ubc.ca)

Spot 0.9912

1-month forward 0.9904

2-month forward 0.9898

3-month forward 0.9892

6-month forward 0.9876

1-year forward 0.9851 

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Option Contracts

Options

Call option:

is an option to buy a certain asset by a certain date for a certain price (the strike price)

Put option:

is an option to sell a certain asset by a certain date for a certain price (the strike price)

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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

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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

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Options vs. Futures/Forwards

No money changes hands when entering a futures/forward contract

An option costs money (premium) to buy

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Google Option Prices (July 17, 2009; Stock Price=430.25)

Calls Puts

Strike price Aug Sept Dec Aug Sept Dec($) 2009 2009 2009 2009 2009 2009380 51.55 54.60 65.00 1.52 4.40 15.00400 34.10 38.30 51.25 4.05 8.30 21.15420 19.60 24.80 39.05 9.55 14.70 28.70440 9.25 14.45 28.75 19.20 24.25 38.35460 3.55 7.45 20.40 33.50 37.20 49.90480 1.12 3.40 13.75 51.10 53.10 63.40

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Exchanges Trading Options

Chicago Board Options Exchange (CBOE)

International Securities Exchange

NYSE Euronext

Eurex (Europe)

and many more (see list at end of book)

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Types of Traders

Types of Traders

• Hedgers– Objective: try to reduce risk– Notice that hedging does not imply PROFITING from trading– You can understand risk as reducing the spread of the potential

outcomes in a given situation

• Speculators– Objective: try to profit from guessing future market movements– Speculation often implies taking significant risks

• Arbitrageurs– Objective: try to profit from mispricing– Formally defined, arbitrage implies not taking any risk at all– Arbitrage is a riskless transaction that requires no netinvestment and that generates a positive profit

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Hedging with Futures: Examples

A US company will pay £10 million for imports from Britain in 3 months

In order to reduce its risk, the company decides to hedge using a long position in a futures contract (i.e. a contract to buy British Pounds in 3 months)

If F (3 months) = 2 USD/ £Cost for the company is known today:£10 million 2 USD/ £ = USD20 million There is no risk anymore

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Hedging with Options: Examples

An investor owns 1,000 Microsoft shares currently worth $28 per share (S0).

A two-month put option with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

Similar to buying insurance as the loss is limited but investor can benefit from favorable price movements.

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Value of Microsoft Shares with and without Hedging

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Speculation Example

An investor with $4,000 to invest expects that Amazon.com’s stock price will increase over the next 2 months.

The current stock price is $40 and the price of a 2-month call option with a strike of 45 is $2.

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Speculation Example(Price increases)

Case I: He invests in STOCKSInitial cost = 100 stocks $40 = $4,000

Cash flow in 2 months if ST = $60 = $6,000 Profit = $2,000

Case II: He invests in OPTIONSInitial cost = 2,000 calls $2 = $4,000

Cash flow in 2 months if ST = $60: -2,000 $45 + 2,000 $60 = $30,000

Profit = $26,000

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Speculation Example (Price falls)

Case I: He invests in STOCKSInitial cost = 100 stocks $40 = $4,000

Cash flow in 2 months if ST = $35 = $3,500 Loss = $500

Case II: He invests in OPTIONSInitial cost = 2,000 calls $2 = $4,000

Cash flow in 2 months if ST = $35 = 0 Loss = $4,000 (100% initial investment)

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Arbitrage Example

A stock price is quoted as £100 in London and $182 in New York

The current exchange rate is US$1.8500/GBP

What is the arbitrage opportunity?

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Arbitrage Example

Buy 100 shares in NY:

(-100*$182=-$18,200)

Sell them in LON:

(+100*£100=£10,000)

Convert GBP into USD:

(£10,000*$1.85/£=$18,500)

Profit from NY-LON $300:

($18,500 - $18,200 = $300)

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Terminology

Short Selling (Ch.5) -

sale of borrowed securities.– Borrow asset from a securities lender (A)

– Sell borrowed asset to an investor (B)

– Later, buy asset from another investor (C) and return equal units of asset to security lender (A) (covering)

Example:

Short stock @$100, then cover @$60 , profit $40

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Short Selling

Example with dividends: In April:

Investor B shorts 500 IBM shares @ $120 In May:

$1 dividend per share paid

Firm’s dividend paid to B, he pays dividend to A.

In July:

Investor B closes position by buying 500 IBM shares @ $100

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Cash flows

Purchase of shares

April: Buy 500 shares @ $120

-$60,000 May: Receive dividend

+$500 July: Sell 500 shares @ $100

+$50,000

Net profit: -$9,500

Short sale of shares April Borrow 500 shares

and Sell them @ $120 +$60,000

May: Pay dividend

-$500 July: Buy 500 shares @

$100 and return borrowed shares to close position

-$50,000 Net profit: +$9,500

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Use of Derivatives Practical Example

Options and Compensation

A substantial component of executives’ compensation is paid in stock options

Example:– $200,000 per year

– 500 stock options on the firm shares

• American type

• 5-year Vesting period, Maturity in 10 years

• Spot price today = $100, Strike price = $100

– The Vesting Period is the period in which the employee cannot sell or transfer the stock options.

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Are Derivatives “Financial Weapons of Mass Destruction” ?

“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Warren Buffet

Numerous losses caused by (mis)using derivatives (see Chapter 25)

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Should We Fear Derivatives?

“The answer is no. We should have a healthy respect for them. We do not fear planes because they may crash and do not refuse to board them because of that risk. Instead, we make sure that

planes are as safe as it makes economic sense for them to be. The same applies to derivatives.

Typically, the losses from derivatives are localized, but the whole economy gains from the existence of

derivatives markets.”

Rene Stulz (Ohio State University)

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