InvestmentsMBA 536

Unit 6: Derivative SecuritiesSpeculative Markets

Unit 6: Derivative SecuritiesSpeculative Markets In Unit 6 we address the top of the asset

pyramid - derivative securities. The bottom of the pyramid represents real assets (gold, property, rolling stock, etc.). The next level contains financial claims – debt and equity. Derivatives are at the top not because they are more valuable, but because the represent the most risky securities and carry the most potential return on investment. They are used to speculate and to hedge. Unlike the lower two layers, derivatives securities are a zero sum game: one player wins, the other player loses.

Student Learning Objectives

A. Review the Financial SystemB. Review important concepts in FinanceC. Speculative MarketsD. Option value at expirationE. Some common option trading

strategiesF. Option valuationG. Other securities that resemble options

THE FINANCIAL SYSTEM: A Quick Review A. Real Assets: tangibles exchanged for money prices =

intrinsic values. B. Financial Assets: intangibles whose exchange prices

are a function of "A". C. Derivatives: intangibles whose exchange prices are a

function of "B". D. Intrinsic values: values derived from possession, use,

or utility. E. Market Efficiency: how well money prices reflect

intrinsic values. F. Role of Open Auction Markets and Intrinsic Values

1. Price takers 2. Price makers

IMPORTANT CONCEPTS IN FINANCE

A. Risk and Risk Preference1. The likelihood of a loss weighed against the

magnitude of a gain. 2. How much the expected magnitude of the gain

exceeds the cost. 3. The greater the cost, the greater the gain sought:

Risk vs. Return. B. Market Efficiency and Risk

1. Market price is an identity with economic value. 2. Economic value is a function of the risk of loss and

the time to maturity. 3. Pricing Models (CAPM, APT, OPM) seek to

determine economic value. 4. Liquidity has an important role in efficient markets

IMPORTANT CONCEPTS IN FINANCE

C. Arbitrage and the Law of One Price1. Two identical goods cannot sell for two

different prices. a. Physical identity versus benefit bundles. b. Role of cache and fungible goods.

2. When prices are not in sync, arbitrage opportunities arise.

3. Value today versus the value tomorrow a function of expectations

DERIVATIVE SECURITIES AND FINANCIAL MARKETS

A. Risk Management: hedging against adverse future price movements.

B. Price Discovery: what will tradable commodities be worth tomorrow?

C. Leverage Plays: Costs are lower than outright purchase of financial assets.

SPECULATIVE MARKETS: Derivative Securities

A. Derivative Securities; values dependent upon the values of other securities:

1. Price of a call option [premium] stock price2. Derivative Securities may also be called

contingent claims.

B. Types of Derivative Securities:1. Options: Contract giving the buyer the right, but

not the obligation to buy or sell depending on whether it’s a call or put

2. Forward Contracts; an agreement to buy or sell in the future

3. Futures Contracts; like a Forward, only is traded publicly.

Characteristics of Option Contracts A. Option contract gives the holder the

right to: 1. Buy or sell a stated number of shares (100) 2. At a specified price (exercise or strike price) X3. Until a specified point in time (expiration

date) T

B. An option to buy stock is a call optionC. An option to sell stock is a put optionD. Options are called derivatives because

their value is derived from the underlying stock

Writing an Option

A. The person who sells an option (writes an option) receives a premium

B. The price of the option is called the premium 1. Premiums represent time value and intrinsic value2. Intrinsic value exists when there is a positive

difference between the exercise price (X) and the stock price (S)

3. Option writers hope it expires out-of-the-money

C. Writing options offers unlimited loss to the writer for a limited gain

D. Only experienced traders who can risk substantial sums should write options – especially naked calls

Option Trading Risks and Opportunities

A. Options can be used to hedge (reduce risk of stock long or short positions) or speculate

B. Options trading provides leverage opportunities, similar to buying on margin

C. Leverage is a double-edged sword: losses can occur as readily as gains.

PRINCIPLES OF OPTION PRICING

A. Value of a Call Option at Expiration1. C (ST, X) = Max (0, ST - X)

2. Call value can never be less than zero3. Call value can never be greater than St - X

B. Value of Put Option at Expiration1. P (ST, X) = Max (0, X - ST)

2. Put value can never be less than zero3. Put value can never be greater than X

PRINCIPLES OF OPTION PRICING

C. Effects of Dividends on Call Option Premiums

1. For Dividend paying stocks, it is always better to exercise before the Ex date if the option is in-the-money; drop in call value when stock goes ex-dividend.

2. If S - X > Dividend then option stays in-the-money after the ex date. This is especially true if D > TVO (time value of the option)

3. Dividend effects important only if holder wants to establish long position in the underlying stock.

PRINCIPLES OF OPTION PRICING

D. Effects of Dividends on Put Option Premiums

1. An American put option (non-Dividend stock) should never be exercised early.

2. Always better to sell put in the market. Why?

a. (X - S) will always be less than [X (1 + r)-T- S] except at maturity. Why?

3. For Dividend paying stocks, it is always better to exercise after the ex-date

Black-Scholes Model for Pricing Options

A. Developed for European options which can be exercised only on expiration date

B. Assumes the risk-free rate and the underlying stock’s price volatility remain constant over the life of the option and the stock pays no dividends

C. If you know what the stock value will be when the option expires, then the call price equals the current stock price minus the present value of the exercise price

BLACK-SCHOLES OPTION PRICING MODEL (OPM) A. Assumptions of the B-S OPM

1. Stock returns follow a lognormal distribution; i. e., Ln of 1 + r.

2. The risk-free rate and stock price variance are constant.

3. Perfect and complete markets 4. Non-dividend paying European options

a. C = S N(d1) - E e-rt N(d2)b. d1 = [ Ln(S/E) + ( r +. 52)T ] √T, d2 = d1 - √Tc. N(d1,2) is the area under the bell curve defined

by d (a z-value)

BLACK-SCHOLES OPTION PRICING MODEL (OPM)

C. Calculating the B-S Option Price 1. Recall that r is an annual rate. 2. Recall also that 2 (variance) is at an

annual rate. 3. And that t = fraction of a year.

BLACK-SCHOLES OPTION PRICING MODEL (OPM)

A. Factors Affecting Option Prices PremiumA. Increase in Call Put

Stock Price (S)........................... INCRDECR

Exercise Price (E)...................... DECRINCR

Expiration Date (T).................... INCR INCRVolatility (s)............................... INCR

INCRRisk-free rate (r).......................... INCR

INCRDividends (D)............................ DECR

INCR

BREAK TIME

CHAPTER 22: FUTURES MARKETS

A. Student Learning Objectives1. What are futures contracts?2. Types of Contracts3. How futures are traded4. Options on futures

Futures Contracts

A. Forward contract calls for future delivery of an asset at a price agreed on today

B. Futures contract is a highly standardized version of a forward contract that can be traded in organized exchanges

C. A person agreeing to accept delivery of the asset has the long position

D. A person agreeing to deliver the asset has the short position

Types of Contracts

A. Physical commodities1. Agricultural products2. Nonagricultural products

B. Financial futures1. Currency futures2. Stock index futures3. Interest rate futures

C. Requirements for a viable futures market1. Ability to be standardized2. Active demand3. Ability to store asset for a period of time4. Relatively high value in proportion to bulk5. Relatively high value in proportion to storage and other

carrying costs

Mechanics of Futures TradingA. Daily Settlement

1. Commodity positions marked-to-market daily to insure market integrity.

2. All trading conducted in margin accounts. a. Initial margin = good faith deposit. b. Maintenance margin = minimum amount account

may go (after losses). c. Margin call = bring account up to initial level.

3. Booking changes in contract values.. a. Gains/losses posted to appropriate accounts. b. Net remainder must be greater than maintenance

margin level, else 2. c. above.

Mechanics of Futures TradingA. Delivery and Cash Settlement (99% all

positions are closed via offsets)1. Non-cash settlement contracts: any day during

expiration month. 2. Cash settlement contracts: on last day of

[monthly] series. 3. Sequence of events.

a. T-2: notice of intention to deliver (position day). b. T-1: assignment day (to oldest open position) (notice

of intention day). c. T: delivery day - long pays the short, short delivers

commodity to long. d. If necessary, delivery price is adjusted for differences

in quality.

Whose In The Pits?

A. Exchange members and their employees

1. Memberships are limited and can be traded

B. Three groups of traders1. Commission brokers trading for others2. Local traders trading for themselves or

their firm3. Dual traders performing both functions

Who are they trading with?

A. Hedger: seeks to protect investment in a spot position.

B. Speculator: attempts to profit from changes in basis.

C. Spreader: uses strategies similar to option spreaders - low risk level speculator.

1. Intra-commodity; i. e., like an option time spread.

2. Inter-commodity; profiting from violations of perceived normal differences.

3. Position = one long, one short contract.

Who are they trading with?

A. Types of Markets1. Normal Backwardation: forward prices less than

spot prices.2. Contango: forward prices greater than spot prices

(positive carry).

B. Contract Terms and Conditions1. Quotation unit and size: i. e., pork bellies -

40,000#. 2. Minimum price change and maximum price

change per day. 3. Limit moves = when reached trading stopped.

Principles Of Spot Pricing

A. Pricing Fixed-Income Securities1. Spot rate = interest rate on FIS for immediate

delivery. 2. Forward rate = interest rate on FIS for future

delivery. 3. Forward rate = interest rate on a FIS issued at

time t with a maturity of T. 4. Term structure defines relation between spot and

forward rates. 5. Forward rates assume pure discount FIS. 6. Forward rates maintain the integrity of the yield

curve.

Principles Of Spot Pricing

A. Computing Forward RatesRa,b = (1 + R0,b)b / (1+R0,a)a

Only if: a > 0 and b > a. 1. Ra,b = rate of interest for a loan made at the

beginning of period a and2. Maturing at he end of period b. 3. If a = 0, then Ra,b = spot rate for a FIS

maturing at the end of period b. 4. R0,a and R0,b are spot rates for FIS delivered

today with maturities of a and b, respectively.

Principles Of Spot Pricing

A. Some Last Thoughts on Forward Rates1. Any forward rate greater than R(t1, t2)

would advantage the lender. 2. Any forward rate less than R(t1, t2) would

advantage the borrower.

Trading Strategies

A. Scalpers quickly trade for small changes in price

B. Day traders do not hold positions overnight

C. Position traders hold positions longer

Clearinghouse Process

A. Each futures market operates a not-for-profit corporation owned by members of the exchange as an intermediary and guarantor to every trade

B. Every trade has a short and a long position

C. Both parties must meet their obligations1. Deliver and take delivery of the asset at the

agreed price and time

D. The clearinghouse guarantees that both parties fulfill their obligations

Clearinghouse Process

A. Margins: set by CH for each category1. Margin deposits held by CG2. Accounts are marked to market each day3. Margin calls occur when maintenance

margin levels are breached (on downside)

B. All commodities subject to daily limit moves

C. Delivery procedures controlled by the CH

MARGIN MAINTENANCE EXAMPLE

A. Daily Settlement and Margin Calls1. Corn (CBT) 5,000 Bu quote in cents per

pound 1/4 cent minimum price change 2. Open position on day 1 at 274 1/2 Contract

value = 5000 * 2. 745 = $ 13,725. 003. Initial margin is 10% = $ 1372. 50 (good

faith deposit. ) 80% Maintenance = $ 1098. 4. Day 2: settle at 267 1/4. Day 3: settle at

264. Day 4. settle at 268 1/2

MARGIN MAINTENANCE EXAMPLE

1372. 50 Day 1 1372. 50

1010. 00 (362. 50) Day 2 1735. 00 362. 50

1372. 50 362. 50 margin call

1210. 00 (162. 50) Day 3 1897. 50 162. 50

1435. 00 225. 00 Day 4 1672. 50 (225. 00)

Buyer (long) Seller (short)

B. Daily Marking to Market

Futures Price Quotations

A. Open interest refers to the number of contracts outstanding at a point in time

B. Basis is the difference between the spot price and futures price for an asset

C. The difference between prices of two different futures contracts is a spread

D. An intracommodity spread is the difference between two futures contracts on the same commodity but with different delivery dates