Chp01 Derivatives an Overview

© K.Cuthbertson, D. Nitzsche 1

Version 1/9/2001

FINANCIAL ENGINEERING:DERIVATIVES AND RISK MANAGEMENT(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

LECTURE

Derivatives: An Overview


Forwards and Futures Contracts

Options Contracts

Swaps

Topics


Forwards

and

Futures


The buyer(long) in a forward/futures contract:acquires a legal obligation to buy an asset (the underlying)

at some specific future date (maturity/expiry date)

in an amount (contract size).

and at a price (the forward/futures price) which is fixed today.

Forward/Futures Contract


Hedging (removing risk)

In Jan. MacDonalds purchases a forward contract for delivery of live cattle in December at price fixed today ~ holds to maturity

Speculation

Buy a 3m futures contract today at F0 =$100 and sell after 1m at F=$110 ~ close out contract (no delivery) and profit of $10.

Arbitrage

Keeps movement of F in line with S (underlying)

Uses of Forward/Futures Contract


Contract Exchange Contract Size

1. Grains and Oilseed

Corn CBOT 5,000 bu

Wheat MCE 1,000 bu

2. Food

Cocoa CSCE 10 metric tons

Orange NYCTN 15,000 lbs

3. Metals and Petroleum

Gold MCE 33.2 troy oz

Silver CBOT 5,000 troy oz

4. Livestock and Meat

HogsCME 50,000 lbs

Pork Bellies CME 40,000 lbs

Futures Contracts



5. Foreign Currency

British Pound IMM £ 62,500

Swiss Franc CME SFr125,000

Euro CME Euro 125,000

Japanese Yen CME Yen12.5m 6. Stock Indices

S&P500 IOM $500 x Index

Value Line KCBT $500 x Index

FTSE100 LIFFE £10 x index

Eurotop100 LIFFE Euro 20 x index

Nikkei 225 IOM $5 x Index

Futures Contracts


Contract Exchange Contract Size7. Interest Rates

Eurodollar - 90 day IMM $ 1,000,000

Euromark IMM DM 1,000,000

US T-Bills IMM $ 1,000,000

US T-Bonds CBOT $ 100,000

UK 3m-Sterling Int rate LIFFE £500,000

UK 3m EuroLIBOR LIFFE Euro 1m

UK Long Gilt Future LIFFE £100,000

CBOT = Chicago Board of Trade

CME = Chicago Mercantile Exchange

NYCE = New York Cotton Exchange

IMM = International Money Market (Chicago)

LIFFE=LondonInternational Financial Futures Exchange

Futures Contracts


FORWARDS FUTURES

Private contract Traded on an exchange

Delivery at expiry Usually closed out before maturity

Usually one delivery date Range of delivery dates

No cash paid until expiry Cash payments Daily( margin)

Negotiable choice of

delivery dates, size of contract Standardised Contract

Comparison of Forwards and Futures


Options Contracts


Holder has the right to buy or sell an ‘asset’ (underlying)

at some time in the future at a fixed price

but she does not have to exercise this right

can ‘walk away’ from the contract if holder wishes

~ latter is key distinction between options and futures/futures contracts.

E.g. In Jan, purchase an option to buy 100 Microsoft shares in September, at a fixed price of $102

What happens in Sept if actual stock price is $90 or $110?

Options


Insurance (form of hedging)

e.g. can insure a minimum selling price for a stock, at maturity of the option contract (e.g. in 6m time), but can also benefit from higher prices should these occur

Speculation

Can buy an option at a ‘low’ price and may be able to sell it (before maturity) at a ‘high’ price ~ close out the position (hence no delivery at maturity)

Arbitrage

Keeps option price and price of underlying (e.g. stock) moving (broadly) together (but not ‘one-for-one)

Uses of Options



1.Individual Stocks

BOE, NYSE, AMEX,

PHSE, LIFFE, SIMEX Usually 100 stocks

2. Index Options

S&P500 Index CBOE $500 x index

FTSE100 Index LIFFE £10 per index point

NYSE Index NYSE $500 x index

Foreign Currency Options

Sterling PHSE GBP 31,250

Deutsche Mark PHSE DEM62,500

Japanese Yen PHSE JPY6.25m

Canadian Dollar PHSE CND50,000

Swiss Franc PHSE CHF62,500

Options



3.Options on Futures Contracts

Options on interest rate futures:

Eurodollars IMM $1m

US T-Bills IMM $1m

US T-Bond CBOT $100,000

3-month EuroLIBOR LIFFE as for futures

UK Long Gilt LIFFE as for futures

Options on index futures:

S&P500 Index IOM $500 x premium

Nikkei 225 IOM $5 x premium

Most commodities (agriculture and metals) on which there are futures contracts (see above). CBOT,CME,KCBT, COMEX,CTN The same as in the futures contract

Options


A European call option gives the holder (the long) the right (but not an obligation)

to purchase the underlying asset at a specified future date (known as the expiration, expiry or maturity date)

for a certain price (the exercise or strike price)

and in an amount (contract size) which is fixed in advance.

For this privilege you pay today, the call premium/price.

Call Option

© K.Cuthbertson, D. Nitzsche

Figure 1.1 : Buy one European Call Option

ST

Profit

Strike price K = $80

$5

-$3Call premium $88$83

K = $800


Figure 1.8 : Leverage from option (on 100 shares)

OPTIONS MARKET (JULY)

Call premium, C = $3Premium paid = $300Strike price, K = $80

CASH MARKET (JULY)

Spot price, S = $78Cash paid = $7800

OPTIONS MARKET (OCT.)

Profit = $8 = ($88 - $80)Net profit = $800 - $300Return = $500/$300 = 167%

CASH MARKET (OCT.)

Profit = $10 = ($88 - $78)Total profit = $1000Return = $1000/$7800 = 12.8%


Figure 1.2 : Sell (write) a European Call Option

ST

Profit


-$5

$3Call premium

$88$83

K = $800


A European put option gives the holder (the long) the right (but not an obligation)

to sell the underlying asset at a specified future date (known as the expiration, expiry or maturity date)

for a certain price (the exercise or strike price)

and in an amount (contract size) which is fixed in advance.

For this privilege you pay today, the call premium/price.

Put Option


Figure 1.3 : Buy (long) a European Put Option


ST

Profit

$3

-$2Put premium

$68

$65 K = $700


Figure 1.4 : Sell (write) a European Put Option


ST

Profit

$2

-$3

Put premium

$68

$65

K = $700


Swaps


Figure 1.5 : Liabilities : Using Swaps

SwapA negotiated (OTC) agreement between two partiesto exchange cash flows at a set of pre-specified future dates

Plain Vanilla Interest Rate Swap

M/s A. agrees to pay interest at a floating rateandreceive fixed rate payments from the “other side” of the swap transaction (eg. M/s B)

e.g. 5 year swap, with floating rate at 6m LIBOR, with resets every 6 months. Fixed rate is say 5% p.a.

Usually the interest payments are in the same currency


Figure 1.5 : Liabilities : Using Swaps

Floating to Fixed: Liability

Fixed to Floating :Liability

Issue Floating Rate Bond

Firm’s Swap LIBOR

LIBOR + 0.5%

6% fixed

Net Payment = 0.5% + 6% = 6.5% (fixed)

Issue Fixed Rate Bond

Firm’s Swap 6% fixed

6.2% fixed

LIBOR

Net Payment = 0.2% + LIBOR (floating)


Figure 1.6 : Assets : Using Swaps

Floating to Fixed: Asset

Fixed to Floating: Asset

Hold Floating Rate Bond

Firm’s Swap LIBOR

LIBOR - 0.5%

6% fixed

Net Receipts = 6% - 0.5% = 5.5% (fixed)

Hold Fixed Rate Bond


5.7% fixed

LIBOR

Net Receipts = LIBOR - 0.3% (floating)


Figure 1.7 : Swap : financial intermediary

Hold Floating Rate Bond


12% fixed

LIBOR

After swap : Net Receipts = (12% - 11%) + LIBOR - (LIBOR - 1%) = 2% (fixed)

LIBOR - 1%

Without swap if LIBOR > 13% firm’s swap makes a loss.


End of Slides

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Chp01 Derivatives an Overview