Markets Derivatives

8/12/2019 Markets Derivatives

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IAPM

FNC-602

Instructor: Dr. Kumail Rizvi

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DERIVATIVEMARKETSAND

INSTRUMENTS2


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WHATISADERIVATIVE?

A derivative is an instrument whose value dependson, or is derived from, the value of another asset.

Examples: futures, forwards, swaps, options,exotics

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WHYDERIVATIVESAREIMPORTANT

Derivatives play a key role in transferring risks in theeconomy

The underlying assets include stocks, currencies,interest rates, commodities, debt instruments,electricity, insurance payouts, the weather, etc

Many financial transactions have embeddedderivatives

The real options approach to assessing capitalinvestment decisions has become widely accepted

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MAJORPLAYERSINDERIVATIVESMARKET

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DERIVATIVEDEALERS

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CLEARINGHOUSE

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EXPOSUREWITHOUTCLEARINGHOUSE

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EXPOSUREWITHCLEARINGHOUSE

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MECHANISMTOREDUCECOUNTERPARTY

RISK

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EXCHANGESANDCLEARINGHOUSE

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SIZEOFOTCANDEXCHANGE-TRADED

MARKETS

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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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THELEHMANBANKRUPTCY

Lehmans filed for bankruptcy on September 15, 2008.

This was the biggest bankruptcy in US history

Lehman was an active participant in the OTC derivativesmarkets and got into financial difficulties because it tookhigh risks and found it was unable to roll over its shortterm funding

It had hundreds of thousands of transactions outstanding

with about 8,000 counterparties Unwinding these transactions has been challenging for

both the Lehman liquidators and their counterparties

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HOWDERIVATIVESAREUSED To hedge risks

To speculate (take a view on the futuredirection of the market)

To lock in an arbitrage profit To change the nature of a liability

To change the nature of an investmentwithout incurring the costs of selling one

portfolio and buying another

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TYPESOFDERIVATIVEINSTRUMENTS

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FORWARDPAYOFF

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PAYOFF

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FORWARDPRICE

The forward price for a contract is the deliveryprice that would be applicable to the contract if itwere negotiated today (i.e., it is the delivery

price that would make the contract worth exactlyzero)

The forward price may be different for contractsof different maturities (as shown by the table)

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FOREIGNEXCHANGE(USD)QUOTESFOR

GBP, MAY24, 2010

21Bid Ask

Spot 1.4407 1.4411

1-month forward 1.4408 1.4413




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TERMINOLOGY

The party that has agreed to buy has whatis termed a long position

The party that has agreed to sell has what

is termed a short position

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EXAMPLE

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HEDGINGWITHFORWARDS

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FOREIGNEXCHANGE(USD)QUOTESFOR

GBP, MAY24, 2010

25Bid Ask

Spot 1.4407 1.4411





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EXAMPLE

On May 24, 2010 the treasurer of a corporationenters into a long forward contract to buy 1 millionin six months at an exchange rate of 1.4422

This obligates the corporation to pay $1,442,200 for

1 million on November 24, 2010

What are the possible outcomes?

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PROFITFROMALONGFORWARDPOSITION(K=

DELIVERYPRICE=FORWARDPRICEATTIMECONTRACTISENTEREDINTO)

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Profit

Price of Underlying at

Maturity, STK


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PROFITFROMASHORTFORWARDPOSITION(K=DELIVERYPRICE=FORWARDPRICEATTIMECONTRACTIS

ENTEREDINTO)

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Profit

Price of Underlying

at Maturity, STK


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FUTURESCONTRACTS

Agreement to buy or sell an asset for a certain priceat a certain time

Similar to forward contract

Whereas a forward contract is traded OTC, afutures contract is traded on an exchange

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EXCHANGESTRADINGFUTURES

CME Group (formerly Chicago MercantileExchange and Chicago Board of Trade)

NYSE Euronext

BM&F (Sao Paulo, Brazil)

TIFFE (Tokyo)

and many more

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FUTURESCONTRACTS

Available on a wide range of assets

Exchange traded

Specifications need to be defined: What can be delivered,

Where it can be delivered, &

When it can be delivered

Settled daily

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FORWARDVS. FUTURES

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SPECIFICATIONSOFFUTURESCONTRACT

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EXAMPLESOFFUTURESCONTRACTS

Agreement to:

Buy 100 oz. of gold @ US$1400/oz. in December

Sell 62,500 @ 1.4500 US$/ in March

Sell 1,000 bbl. of oil @ US$90/bbl. in April

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OILFUTURES

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CORNFUTURES

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STOCKFUTURES

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OTHERTYPESOFFUTURES

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MINISTOCKFUTURESCONTRACTS

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MARGINREQUIREMENT

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EXAMPLEOFAFUTURESTRADE

An investor takes a long position in 2 Decembergold futures contracts on June 5

contract size is 100 oz. futures price is US$1250

initial margin requirement is US$6,000/contract(US$12,000 in total)

maintenance margin is US$4,500/contract (US$9,000in total)

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A POSSIBLEOUTCOME

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Da

y

Trade

Price

($)

Settle

Price

($)

Daily

Gain ($)

Cumul.

Gain ($)

Margin

Balance

($)

Margin

Call ($)

1 1,250.00 12,0001 1,241.00 1,800 1,800 10,200

2 1,238.30 540 2,340 9,660

.. .. .. ..

6 1,236.20 780 2,760 9,240

7 1,229.90 1,260 4,020 7,980 4,020

8 1,230.80 180 3,840 12,180

.. .. .. ..

16 1,226.90 780 4,620 15,180


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ANOTHEREXAMPLE

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MARGINCASHFLOWSWHENFUTURES

PRICEINCREASES

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Long Trader

Broker

Clearing HouseMember

Clearing House


Broker

Short Trader


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MARGINCASHFLOWSWHENFUTURES

PRICE

DECREASES

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Long Trader

Broker


Clearing House


Broker

Short Trader


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CRUDEOILTRADINGONMAY26, 2010

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Open High Low Settle Change Volume Open Int

Jul 2010 70.06 71.70 69.21 71.51 2.76 6,315 388,902

Aug 2010 71.25 72.77 70.42 72.54 2.44 3,746 115,305

Dec 2010 74.00 75.34 73.17 75.23 2.19 5,055 196,033

Dec 2011 77.01 78.59 76.51 78.53 2.00 4,175 100,674

Dec 2012 78.50 80.21 78.50 80.18 1.86 1,258 70,126


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REGULATIONOFFUTURES

In the US, the regulation of futures markets isprimarily the responsibility of the Commodity

Futures and Trading Commission (CFTC)

Regulators try to protect the public interest andprevent questionable trading practices

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OPTIONS

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OPTIONS

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

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

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TYPESOFOPTION

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OPTIONSVSFUTURES/FORWARDS

A futures/forward contract gives the holder theobligation to buy or sell at a certain price

An option gives the holder the right to buy or sell ata certain price

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OPTIONPAYOFF

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CALLOPTIONPAYOFFTOLONG

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PROFITTOLONGCALLBUYER

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OPTIONPOSITIONS

Long call

Long put

Short call Short put

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SHORTCALL

Profit from writing one European call option: optionprice = $5, strike price = $100

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-30

-20

-10

05

70 80 90 100

110 120 130

Profit ($)

Terminal

stock price ($)


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LONGPUT

Profit from buying a European put option: option price= $7, strike price = $70

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30

20

10

0

-770605040 80 90 100

Profit ($)

Terminal

stock price ($)


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PAYOFFS FROM OPTIONS


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PAYOFFSFROMOPTIONS

WHATISTHEOPTIONPOSITIONINEACH

CASE?

K= Strike price, ST= Price of asset at maturity

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Payoff Payoff

ST

ST

K

K

Payof

f Payoff

ST

ST

K

K


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ASSETSUNDERLYING

EXCHANGE-TRADEDOPTIONS

Stocks

Foreign Currency

Stock Indices

Futures

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SPECIFICATIONOF

EXCHANGE-TRADEDOPTIONS

Expiration date

Strike price European or American

Call or Put (option class)

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TERMINOLOGY

Moneyness :

At-the-money option

In-the-money option

Out-of-the-money option

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EXAMPLE

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SOLUTION

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HEDGINGWITHAPUTOPTION

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SOLUTION

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SPECULATINGWITHOPTIONS

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SOLUTION

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Documents

Markets Derivatives