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University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

FNCE4040 – Derivatives Chapter 1

Introduction The Landscape Forwards and Option Contracts

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

What is a Derivative?

• A derivative is an instrument whose value

depends on, or is derived from, the value of another asset.

• Examples:

– Futures – Forwards – Swaps – Options – Exotics – …

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Why Derivatives Are Important

• Key role in transferring risks in the economy
• Underlying assets include stocks, currencies,

interest rates, commodities, debt instruments, electricity, insurance payouts, weather, etc.

• Many financial transactions have embedded

derivatives

• The real options approach to assessing

capital investment decisions has become widely accepted

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

How Derivatives Are Traded

• On exchanges such as the Chicago Board

Options Exchange

• In the over-the-counter (OTC) market where

traders working for banks, fund managers and corporate treasurers contact each other directly

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Size of OTC & Exchange-Traded Markets

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Growth of OTC Market by Product

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

How Derivatives are Used

• To hedge risks

– e.g. you are a producer of oil or a consumer of soy beans, or are paid in a different currency

• To speculate (take a view on the future

direction of the market)

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

without incurring the costs of selling one portfolio and buying another

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Derivatives can be Risky

• AIG had been an active participant in writing default

protection on multi-sector CDOs

– Essentially made a one way bet on the US housing market – AIG essentially ran out of cash to make collateral calls on their sold derivatives.

• At its peak the US government committed $182.3b

to support AIG

• “It is hard for us, without being flippant, to even see

a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions”

• Mr. Cassano “was wrong by 11 or 12 orders of magnitude, which may be about as wrong as it’s possible to be in human affairs.”

“There’s safety in small numbers” FT.com

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Forwards and Futures

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Foreign Exchange – GBP vs USD

• http://www.xe.com/currencycharts/?from=GB

P&to=USD&view=5Y

• Quotes for Jan 9, 2015 USD/GBP

USD per GBP Bid Offer Spot 1.5182 1.5186 1-month forward 1.5144 1.5149 3-month forward 1.5073 1.5081 6-month forward 1.4970 1.4984

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Forward Price

• DEFINITION: the delivery price that

would be applicable to the contract if negotiated today (i.e. the delivery price that would make the contract worth exactly zero today)

• The forward price may (and will likely)

be different for contracts of different maturities

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Some Terminology (more to come)

• The party that has agreed to buy has a long

position

• The party that has agreed to sell has a short

position

• Selling a derivative is sometimes referred to

writing a derivative (forwards, options, etc.)

• The contract delivery date is sometimes

referred to expiration date, or maturity date

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

USD per GBP Bid Offer Spot 1.5182 1.5186 1-month forward 1.5144 1.5149 3-month forward 1.5073 1.5081 6-month forward 1.4970 1.4984

Forward Example

• On Jan 9, 2015 the treasurer of a corporation

enters into a long forward contract to buy £1 million in six months. Which exchange rate does she use?

– 1.4984 USD/GBP

• This contract obligates the corporation to pay

$1,498,400 for £1 million on the maturity date (July 9, 2015)

• What are the possible outcomes?

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Profit from a Long Forward

• K = 1.4984. The delivery price or forward

price at time contract is entered into

Profit Price of Underlying at Maturity, ST K

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Profit from a Short Forward

• K = 1.4984. The delivery price or forward

price at time contract is entered into

Profit Price of Underlying at Maturity, ST K

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Futures Contracts

• Agreement to buy or sell an asset for a

certain price at a certain time

• Similar to forward contract, but there are

differences:

– A forward contract is traded OTC, a futures contract is traded on an exchange – A futures contract requires daily settlement of the value of the contract, a forward contract has a cash flow only a maturity

• WARNING– This is what the book says but it is not

strictly true. To be discussed later in the course.

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Exchanges Trading Futures

• CME Group (formerly Chicago Mercantile

Exchange and Chicago Board of Trade)

• NYSE Euronext
• BM&F (Sao Paulo, Brazil)
• TIFFE (Tokyo)
• and many more (see list at end of book)

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Examples of Futures Contracts

• You think gold will appreciate during the year

– Buy 100 oz of gold for December Delivery – http://www.cmegroup.com/trading/metals/preciou s/gold.html

• You are a soybean buyer looking to lock your

input costs:

– Buy 1mm bushels of soybean for November Delivery – http://www.cmegroup.com/trading/agricultural/gra in-and-oilseed/soybean.html

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Options

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Option Types

• A Call option is

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

• A Put option is

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

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Futures/Forwards vs. Options

• A futures/forward

contract gives the holder the

• bligation to buy
• r sell at a certain

price

• An option contract

gives the holder the right to buy or sell at a certain price

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Payout of a Long Call Option

• K = strike price of option

Profit Price of Underlying at Maturity, ST K

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Payout of a Long Put Option

• K = strike price of option

Profit Price of Underlying at Maturity, ST K

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Options Style

• An American
• ption can be

exercised at any time during its life

• A European
• ption can be

exercised only at maturity A Bermudan option can be exercised only at fixed times before maturity (e.g. monthly)

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Google Option Prices (source: Bbg)

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Types of Traders

• Hedgers use derivatives to mitigate the risk

they are already exposed to, coming from their business or assets/liabilities

• Speculators use derivatives to express a

view – often with leverage – on a financial sector/asset

• Arbitrageurs use derivatives to lock in a

specific payout for a risk-free profit

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Hedging Examples

• An investor owns 1,000 Microsoft shares.
• She is worried about the price falling over the

next two months. She is willing to spend approximately $1/share and can buy put

• ptions:

– http://www.nasdaq.com/symbol/msft/option- chain?dateindex=2 – Identify some strategies she can follow

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Hedging Microsoft shares

Value of portfolio assuming put with strike 45, purchased for $1.

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Speculation Example

• You have $2,000 to invest
• You believe that a stock price will increase
• ver the next 2 months
• The current stock price is $20
• The price of a 2-month call option with a

strike of 22.50 is $1

• What are the alternative strategies?

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Arbitrage Example

• A stock price is quoted both in London and in

New York. The prices are:

– £100 in London – $155 in New York

• The current exchange rate is 1.6100
• (ask your self what are the units of that figure)
• Is there an arbitrage opportunity?
• If so what is it?

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Dangers

• Traders can switch from being hedgers to

speculators or from being arbitrageurs to speculators

• It is important to set up controls to ensure that

trades are using derivatives in for their intended purpose

– Many trading operations have enforced vacation time for key personnel so that more than one person has to understand the positions in a trading book. – Many derivatives blow-ups have occurred when there was not a clear differentiation between the profit-center and control function.

University of Colorado at Boulder – Leeds School of Business – FNCE4040 Derivatives

Mutual Funds vs Hedge Funds

• Mutual Funds must

– disclose investment policies, – makes shares redeemable at any time – limit use of leverage – take no short positions.

• Hedge Funds

– Are not subject to the same rules as mutual funds – Cannot offer their securities publicly – Use complex trading strategies are big users of derivatives for hedging, speculation and arbitrage