Derivatives Markets Ppt MBA

8/2/2019 Derivatives Markets Ppt MBA

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DERIVATIVES

MARKETS

PRESENTED BY:-

BABASAB PATIL


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Introduction

Futures, options, and swaps are complicatedinstruments

However, they have found their way into the

risk management options of just about everymajor financial institution

DerivativesA financial instrument/contract

that derives its value from some otherunderlying asset


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Futures Markets

Market in standardizedcontracts for futuredelivery of various goods.

Arose in the mid-1800s in Chicago and

institutionalized an ancient form of contractingcalled forward contracting.

1842, Chicago Board of Trade

1871, Fire destroyed all records.


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Futures Contracts vs. ForwardContracts

Futures Contract

trade in an organized exchange.

standardized contract terms.

contract guaranteed by exchange (clearingcorporation)

Forward Contract

transaction in which two parties agree in advance on

the terms of a trade to be executed later.

Non standardized contract terms.

More flexibility.

Difficult to find a trading partner.


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An Overview of FinancialFutures

Future Contract is a contractual agreementthat calls for delivery of a specific underlyingcommodity or security at some future date at a

currently agreed-upon price There are contracts on interest-bearing

securities (Treasury bonds, notes, etc), on stockindices (Standard & Poors and Japans Nikkei

index), and on foreign currencies


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An Overview of FinancialFutures

Trading in these contracts is conducted on thevarious commodity exchanges

Financial futures were introduced about 30

years ago and volume now exceeds the moretraditional agricultural commodities


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Characteristics of FinancialFutures Standardized agreement to buy/sell a particular asset or

commodity at a future date and a current agreed-uponprice

Designed to promote liquiditythe ability to buy and sellquickly with low transactions costs

Promotes large trading volume which narrows the bid-asked spreads

Allows many individuals to trade the identical commodity


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Characteristics of FinancialFutures

Terms specify the amount and type of asset aswell as the location and delivery period Financial futuresunderlying asset is either a

specific security or cash value of a group ofsecurities

Stock index futurescontract calls for thedelivery of the cash value of a particular stockindex


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Characteristics of FinancialFutures

Precise terms of each contract are establishedby the exchange that sponsors trading in thecontracts

Seller of the contract has the obligation todeliver the securities at a specified time

In futures markets, the buyer of the contract iscalled long and the seller is called short


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Price of the Contract

The price is determined by bidding andoffering that occurs at the location (pit) of theexchange sponsoring the auction

The auction process insures that all orders areexposed to highest bid and lowest offer,guaranteeing execution at the best possibleprice


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Market Structure

Open outcry

Traders call out offers to buy or sell.

Gives appearance of chaos.

Gives all traders in the pit the opportunity toaccept the offer.

Seat on the exchange

Floor Traders


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Clearing Corporation

The clearing corporation associated with the exchangeacts as a middleman in the transaction

Reduce the credit risk exposure associated with futuredeliveries

Longs and shorts do not have to worry that the other party willnot perform their contractual obligations

Requires the short and long to place a deposit (Margin) which isa performance bond for both the seller and buyer

Requires that gains and losses be settled each day in the mark-to-market operation


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Settlement by Offset

To insure the obligations are met at the deliverydate, most trades in futures market choosesettlement by offset rather than delivery Both parties make offsetting sales/purchases to cover

the contract

Permits hedgers, speculators, and arbitrageurs tomake legitimate use of the futures market withoutgetting into technical details of making or taking

delivery of assets


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Using Financial FuturesContracts Provides the opportunity to hedge legitimate commercial

activities

Allows participants to alter their risk exposure

Hedgersbuy and sell futures contracts to reduce their

exposure to the risk of future price movement Permits dealers to cover both the short and long position

of a contract

Reduces risk since future prices move almost in

lockstep with the price of the underlying asset


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Hedging Vs. Speculating

Short hedgers offset inventory risk by selling

futures while long hedgers offset anticipated

purchases of securities by buying futures

Speculators Purposely take on risk of price movement

Expect to make a profit on the risky transaction


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Arbitrageurs

Arbitrageurs

Determine the relationship between the price inthe cash market and the price in the futures

marketDuring the delivery period of a futures contract,

the rights and obligations of the contract force theprice of the futures contract and the price of the

underlying security to be identical


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Arbitrageurs

If the arbitrageur senses the price relationshipbetween the futures contract and the underlyingasset is not correct, take actions in the market(buy or sell) to make a profit which forces theprices into proper relationship

The activities of arbitrageurs cause theprices to converge on the delivery date or bein proper alignment during periods prior tofinal delivery date


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Liquidating a Position

Settlement dates

Nearby contract

Distant contract

Cash settlement contracts

Settlement by offset

Open interest

number of contracts obligated for delivery.

Each open transaction has a buyer and a seller, butfor calculation only one side of the contract iscounted.


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Futures Data

Wall Street Journal

Chicago Board of Trade

Chicago Mercantile Exchange
http://online.wsj.com/documents/mktindex.htm?fs-contract-set-frameset-m99ff2.htmlhttp://www.cbot.com/cbot/pub/page/0,3181,1413,00.htmlhttp://www.cme.com/dta/del/product_list.html?ProductType=itrhttp://www.cme.com/dta/del/product_list.html?ProductType=itrhttp://www.cbot.com/cbot/pub/page/0,3181,1413,00.htmlhttp://online.wsj.com/documents/mktindex.htm?fs-contract-set-frameset-m99ff2.html


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An Overview of OptionsContracts

Options on individual stocks have been tradedin over-the-counter market since nineteenthcentury

Increased visibility in 1972 when the ChicagoBoard Options Exchange (CBOE) standardizedterms of contracts and introduced futures-typepit trading


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Stock Options

Prior to 1973, over-the-counter market

fragmented

high transaction costs

no liquidity

CBOE established April 26, 1973 and begin tradingoptions on 16 stocks

creation of central market place

introduction of a clearing corporation

standardization

secondary market

June 1, 1977, SEC allowed trading in puts


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Options

Contractual Obligations

Derive their value from some underlying asset

A specified number of shares of a particular stock

Stock Index OptionBasket of equities representedby some overall stock index such as S&P 500

In options on future contracts, the contractualobligations call for delivery of one futures contract


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Call Options

Buyer of a call option (long) has the right (notobligation) to buy a given quantity of theunderlying asset at a predetermined price

(exercise or strike) at any time prior to theexpiration date


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Call Options

Seller of the call option (short) has theobligation to deliver the asset at the agreedprice

Therefore, rights and obligations of optionbuyers and sellers are not symmetrical

Buyer of the call option pays a price to the sellerfor the rights acquired (option premium)


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Put Options

Buyer of a put option has the right (notobligation) to sell a given quantity of theunderlying asset at a predetermined price

before the expiration date Seller of the option (short) has the obligation

to buy the asset at the agreed price

The buyer of the put option pays a premium tothe seller


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Summary

Option buyers have rights; option sellers haveobligations

Call buyers have the right to buy the

underlying asset Put buyers have the right to sell the asset

In both puts and calls the option buyer pays apremium to the option seller


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The exchange sponsoring the options tradingestablished rules for trading

Standardization is designed to generate interest bypotential traders, thereby contract liquidity


Guarantees the performance of contractual obligations

Buyers and sellers do not have to be concerned withcreditworthiness of their trading partners

Only matter up for negotiation is option premium

price buyer pays to seller for rights


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Using and Valuing Options

Investors who buy options (puts or calls) haverights, but no obligations

Therefore, option buyers will do whatever is in

their best interest on expiration date On expiration date, payoff on expiration of a

long call position is either zero (price belowexercise price) or stock price minus exercise

price (intrinsic value) (price above the exerciseprice)


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Using and Valuing Options

A long put position on expiration date has avalue of zero if price is above the exerciseprice or a value equal to the exercise priceminus the stock price if price is below theexercise price

Option PremiumThe asymmetry payoff hasthe characteristic of insurance which is why

the premium is charged on the transaction


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Option Premiums - Calls

Option premiums are determined by supplyand demand

Call options are worth more (higher

premiums) the higher the price and thegreater the volatility of the underlying asset,and the longer the time to expiration of theoption


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Option Premiums - Puts

Premiums on put options will be higher thelower the price of the underlying asset, greatervolatility of asset and longer time to expiration

Options are an expensive way to hedgeportfolio risks if those risks are substantial


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Options Terminology

Option price (premium) (V)

Exercise price (strike price) (E)

Expiration date (maturity date) - Saturday following the

3rd Friday of specified month. American vs. European Options

American option - may be exercised at any time up to maturity.

European option - may be exercised only at the date of maturity.

In-the-money Out-of-the money

At-the-money


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Pricing of Options

The Pricing of Call Options at Expiration:

If VS < E, the VC=0

If VS > E, the VC= VS-E

The prices of options on stocks without cash dividendsdepend upon five factors:

Stock price

Exercise Price

Time until Expiration

Volatility of the Underlying Stock

Risk-free Interest Rate


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Options Investors Buy Hedges,Then Hunker Down and Wait

NEW YORK -- Option trading was defensive but noncommittal,mirroring investors' guarded ambivalence as they endured updatesof the Iraq standoff, terrorism alerts and a reminder from the FederalReserve about the precarious state of the economy.

Here is what one investor did: John Jacobs, who runs the Jacobs &Co. mutual fund in Charleston, W.V., this week bought 1,500 March

79 puts on the DJX, which has one-hundredth the value of the DowJones Industrial Average. The puts provide downside insurancethrough mid-March, particularly if the Dow industrials remain below7900. "We're being very defensive to protect the stock side, wherewe have been writing covered calls," he said, referring to the fund'sapproach of investing in blue-chip stocks and selling calloptions

against the stocks for income.


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To help offset the cost of buying the puts, Mr. Jacobs sold 1,000DJX February 77 puts Tuesday, essentially betting the blue-chipindex will hold its ground in the immediate term. Mr. Jacobs said hebelieves blue-chip stocks are oversold and could get a small liftfrom Fed Chairman Alan Greenspan's somewhat-encouragingcomment that capital spending should improve once the Iraq

situation is resolved. Also, he said, any terrorist attacks that wouldroil the markets are less likely to occur until after the hajj, the climaxof the Muslim pilgrimage to Mecca later this week.

Mr. Jacobs plans to buy back the February 77 puts later this week,possibly at a cheaper price because the short-term puts lose theirvalue rapidly as they approach expiration next week.

The Dow industrials fell 77 points to 7843.11. At the Chicago BoardOptions Exchange, the DJX March 79 puts gained 20 cents to$3.70. The DJX February 77 puts gained 20 cents to $1.40.


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Caution remains the watchword. "In this market, youshould be more concerned about protecting profits thangiving up upside," says Elliot Spar, Ryan Beck & Co.option strategist.

One way investors protect profits, Mr. Spar said, is withso-called collars, where an investor sells a call to definea target price at which he is willing to sell stock whileusing the proceeds to buy a put for downside protection."This puts a floor under the stock and caps the upside"

at the strike price of the call, he said.
http://online.wsj.com/mds/companyresearch-quote.cgi?route=BOEH&template=company-research&ambiguous-purchase-template=company-research-symbol-ambiguity&profile-name=Portfolio1&profile-version=3.0&profile-type=Portfolio&profile-format-action=incl%20http://online.wsj.com/mds/companyresearch-quote.cgi?route=BOEH&template=company-research&ambiguous-purchase-template=company-research-symbol-ambiguity&profile-name=Portfolio1&profile-version=3.0&profile-type=Portfolio&profile-format-action=incl%20


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Options Data

Wall Street Journal

Chicago Board Options Exchange
http://online.wsj.com/mds/companyresearch-quote.cgi?route=BOEH&template=company-research&ambiguous-purchase-template=company-research-symbol-ambiguity&profile-name=Portfolio1&profile-version=3.0&profile-type=Portfolio&profile-format-action=incl%20http://online.wsj.com/mds/companyresearch-quote.cgi?route=BOEH&template=company-research&ambiguous-purchase-template=company-research-symbol-ambiguity&profile-name=Portfolio1&profile-version=3.0&profile-type=Portfolio&profile-format-action=incl%20http://online.wsj.com/documents/options.htmhttp://quote.cboe.com/QuoteTable.asphttp://quote.cboe.com/QuoteTable.asphttp://online.wsj.com/documents/options.htm


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Swaps

The 1st major swap occurred in August of1981. The World Bank issued $290 million ineurobonds and swapped the interest and

principal on these bonds with IBM for Swissfrancs and German marks.


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An Overview of Swaps

Two broad varietiesInterest rate swapsand currency swaps

Swaps are contractual agreement between

two parties (counterparties) and customizedto meet the requirements of both parties


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Counter parties

Fixed-rate payer

Party to a swap that makes fixed-rate paymentsin exchange for floating-rate payments.

Floating-rate payerParty to a swap that makes floating-rate

payments in exchange for fixed-rate payments.

Obli i f i


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Obligations of payments every sixmonths for the duration of the swap


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Interest Rate Swap

The fixed-rate payer always pays the sameamount while payments by the floating-ratepayer varies according to the reference rate

The dollar amount of the payments is determinedby multiplying the interest rate by an agreed-uponprincipal (notional principal amount)

What determines the rates paid


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What determines the rates paidby both parties?

Shape of the yield curveexpected rates in thefuture

Risk of defaultpossibility that counterparties

might default on scheduled interest payments Financial institutions facilitate swaps

Act as the Swap Dealer

Bring the counterparties together

Impose their own credit between the counterparties


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The Swap Dealer

Commission compensates the dealer

For matching parties in the swap.

For risk of default by the counter parties.

Dealer can reduce risk by diversifying swapsacross many unrelated counter parties.

Offers liquidity - willing to cancel contract in

exchange for an appropriate payment.


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Valuing a Swap

Contracts are traded in over-the-counter market

It is possible for one of the counterparties to sell theirobligation to another party

Changing market conditions may cause one party to sellobligation

The third party will purchase the swap if it is to theiradvantage

Therefore, swaps produce gains or losses which willultimate impact the value of the swap


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A Simple Interest Rate Swap

This YearBank One Bank Two

Two-year loans earn9% fixed

Two-year loans earn 8%variable

Deposits cost 5%variable

Deposits cost 6% fixed


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Next yearrates go up.

Bank One Bank Two

Loans earn 9%

fixed

Loans earn 12%variable

Deposits cost 9%variable Deposits cost 6% fixed


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Next Year Rates GoDown

Bank One Bank Two

Loans earn 9% fixed Loans earn 5% variable




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Next Year Rates Go Up They swap.

Bank One Bank Two

Loans earn 9% fixed Loans earn 12%variable

Deposits cost 6% fixed Deposits cost 9%

variable


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Next Year Rates GoDown

They swap.

Bank One Bank Two

Loans earn 9% fixed Loans earn 5%variable

Deposits cost 6% fixed Deposits cost 2%variable


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Interest Rate Swap


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Currency Swaps

Two companies agree to exchange a specificamount of one currency for a specific amountof another at specific dates in the future.

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Derivatives Markets Ppt MBA