Lecture 1: a financial instrument (or more simply, an agreement - - PowerPoint PPT Presentation

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Lecture 1: Derivatives: Review

01135532: Financial Instrument and Innovation Nattawut Jenwittayaroje, PhD, CFA NIDA Business School, NIDA Nattawut.jen@nida.ac.th

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Derivatives: Definition

• A derivative can be defined as:

– a financial instrument (or more simply, an agreement between two or more people whose value depends on (i.e., derived from) the values of other financial instruments (i.e. its underlying assets).

– อนุพันธ์ เป็นตราสารทางการเงิน (หรือ เป็นข้อตกลงระหว่างบุคคลสองฝ่ายหรือ มากกว่า) น

– For example,

• the value of PTT Futures depends on the PTT price
• Also, the value of SET50 Index Futures and the value of SET50

Index Options depend on the value of SET 50 stock index.

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Derivatives: Instruments

• Derivatives products

1) Forwards and futures contracts 2) Options 3) Swaps 4) Other derivatives

• e.g., futures options, swaptions

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Futures and Forwards

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Futures and Forwards

Motivations

• Eliminate uncertainty in the future

I need a new car at the end of the year.

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• Let's make an agreement now!

Deal!

1,000,000 December 31, 2013

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Futures and Forwards

Motivations (con’t)

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• A futures/forward contract is an agreement between a buyer and

a seller in which the buyer (seller) agrees to buy (sell) something (i.e., the underlying) at a specific price (i.e., future/forward price) at the end of a designated period of time (i.e., settlement or delivery date).

Buyer Buyer Seller Seller

Agreement date (today) Delivery date

Deliver underlying

Agree on future/forward price And delivery date Pay future/forward price

Futures and Forwards

Definitions

Buyer has what is termed a long position Seller has what is termed a short position

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Forwards/Futures – Main Characteristics

• It can be contrasted with a spot/cash contract, which is an agreement

to buy or sell immediately

– So any asset has now two prices  a spot/cash price, and a forwards/futures price – However, there are also many forwards/futures prices, depending on delivery dates.

• No money changes hands when contract is first negotiated

(contrasted with option contract). Neither party pays anything and neither party receives anything of monetary value.

– The forward contract has initially zero value.

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Forwards - Example

• FX forward contracts are generally used to hedge FX risk.
• On June 6, 2013 a Thai trader enters into an agreement to

buy $USD 1,000 in three months at an exchange rate of 32 from a bank.

– The trader takes a long forward contract on USD to buy USD from the bank for Baht32/USD on 6 Sep 2013.

• Agree today (June 6, 2013), but to deliver 32,000 bahts for $USD

1,000 on Sep 6, 2013 – The bank has a short forward contract on USD because it has agreed to sell USD 1,000 for baht32,000 on 6 Sep 2013.

• Agree today (June 6, 2013), but to deliver $USD 1,000 for 32,000

bahts on Sep 6, 2013

• What are the possible outcomes?

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Profit from a Long Forward Position

Forward buyer: Profit and Loss Table

FX rate at maturity Payoff (before cost) Cost Profit/loss (after cost) 29 = 29 – 32 = -3

• 3

30 = 30 – 32 = -2

• 2

31 = 31 – 32 = -1

• 1

32 = 32 – 32 = 0 33 = 33 – 32 = +1 +1 34 = 34 – 32 = +2 +2 35 = 35 – 32 = +3 +3

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Profit from a Short Forward Position

Forward Seller: Profit and Loss Table

FX rate at maturity Payoff (before cost) Cost Profit/loss (after cost) 29 = 32 – 29 = +3 +3 30 = 32 - 30 = +2 +2 31 = 32 – 31 = +1 +1 32 = 32 - 32 = 0 33 = 32 - 33 = -1

• 1

34 = 32 - 34 = -2

• 2

35 = 32 - 35 = -3

• 3

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ST Profit/loss from a long position Profit/loss X=32 ST Profit/loss from a short position X=32 Profit/loss

ST < X or ST - X < 0 ST > X or ST - X > 0 ST > X or X - ST < 0 ST < X or X - ST > 0 Hope price of the underlying asset (ST) to rise Hope price of the underlying asset (ST) to fall ST – X (32) X (32) - ST

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Options

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Options

Motivations

• Buying a car revisited.

Deal!

1,000,000 December 31, 2013

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• Want the gain...

(Spot) Market

Price on Dec 31, 2013 1,200,000

Options

Motivations(cont.)

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• ... but not the loss.

(Spot) Market

Price on Dec 31, 2013  800,000

Options

Motivations (cont.)

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• Can we do this?

800,000 Market Price On Dec 31, 2013 1,200,000 Market Price On Dec 31, 2013

Options

Motivations (cont.)

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Buyer Seller

Agree on strike price & maturity

Buyer Seller

Maturity date

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Exercise contract, i.e., pay an exercise price Pay option price Option contract take delivery OR Do nothing  Definition: a contract between two parties that gives the

buyer the right to buy from the seller, at a later date at a price agreed upon today. Therefore, the seller has an

• bligation to sell something to the buyer when the buyer

exercises his/her right.

Options - Call

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Buyer Seller

Agree on strike price & maturity

Buyer Seller

Maturity date

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Exercise contract, i.e., receive an exercise price Pay option price Option contract make delivery OR Do nothing  Definition: a contract between two parties that gives the

buyer the right to sell something to the seller, at a later date at a price agreed upon today. Therefore, the seller has an

• bligation to buy something from the buyer when the buyer

exercises his/her right.

Options - Put

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Option Terminology

• Option terminology

– price/premium (ร า ค า /•å ‘øƒ◊ ‡ ¬◊ Ë √ ¬) – the buyer pays the seller a fee for such right. – call/put - “the right to buy” -> call , “the right to sell” -> put – Underlying asset (ส ิน ค ้า อ ้า ง อ ิง ) – “something” – Exercise price/Strike price ( ) – “a price agreed upon today” – Expiration/Maturity date (ว ัน ห ม ด อ า ย ุ) – “at a later date” – American/European

• any time up until expiration -> American
• at expiration date only -> European

– Long/Short – the buyer  buy an option  long position

• the seller  sell/write an option  short position

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• European equity call option

Underlying: One share of IBM stock Type: European call option Strike price: $100 Maturity date: March 31, 2014 Option price: $5

Buyer Seller

Current IBM price is $100

Buyer Seller

March 31, 2014

If IBM price > $100, exercise contract (i.e.,buy IBM at $100) $5 Option contract One share of IBM OR Else do nothing

Options Examples – Call Option

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Options Examples – Call Option

Call Buyer: Profit and Loss Table

Terminal Stock price Exercise? Profit/Loss (before

• ption price)

Option price Profit/loss after option price 80 No 5

• 5

90 No 5

• 5

100 No 5

• 5

110 Yes 10 5 5 120 Yes 20 5 15 130 Yes 30 5 25 140 Yes 40 5 35

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Options Examples –Long Call on IBM

Profit from buying an IBM European call option: option price = $5, strike price = $100, option expiration date  31 March 2014

30 20 10

• 5

70 80 90 100 110 120 130 Profit ($) Terminal stock price ($)

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Options Examples – Call Option

Call Seller: Profit and Loss Table

Terminal Stock price Exercise? Profit/Loss (before

• ption price)

Option price Profit/loss after option price 80 No 5 5 90 N 5 5 100 N 5 5 110 Y

• 10

5

• 5

120 Y

• 20

5

• 15

130 Y

• 30

5

• 20

140 Y

• 40

5

• 35

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Options Examples – Short Call on IBM

Profit from writing an IBM European call option: option price = $5, strike price = $100, option expiration date  31 March 2014

• 30
• 20
• 10

5 70 80 90 100 110 120 130 Profit ($) Terminal stock price ($)

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• European equity put option

Underlying: One share of IBM stock Type: European put option Strike price: $100 Maturity date: March 31, 2014 Option price: $4

Buyer Seller

Current IBM price is $100

Buyer Seller

March 31, 2014

If IBM price < $100, exercise contract (i.e., sell IBM at $100) $4 Option contract $100 OR Else do nothing

Options Examples – Put Option

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Options Examples – Put Option

Put Buyer: Profit and Loss Table

Terminal Stock price Exercise? Profit/Loss (before

• ption price)

Option price Profit/loss after option price 70 Yes 30

• 4

26 80 Yes 20

• 4

16 90 Yes 10

• 4

6 100 No

• 4
• 4

110 No

• 4
• 4

120 No

• 4
• 4

130 No

• 4
• 4

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Long Put on IBM

Profit from buying an IBM European put option: option price = $4, strike price = $100, option expiration date  31 March 2014

30 20 10

• 4

100 90 80 70 110 120 130 Profit ($) Terminal stock price ($)

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Options Examples – Put Option

Put Seller: Profit and Loss Table

Terminal Stock price Exercise? Profit/Loss (before

• ption price)

Option price Profit/loss after option price 70 Yes

• 30

4

• 26

80 Yes

• 20

4

• 16

90 Yes

• 10

4

• 6

100 No 4 4 110 No 4 4 120 No 4 4 130 No 4 4

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Short Put on IBM

Profit from writing an IBM European put option: option price = $4, strike price = $100, option expiration date  31 March 2014

• 30
• 20
• 10

4 100 90 80 70 110 120 130 Profit ($) Terminal stock price ($)

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Payoffs from Options

What is the Option Position in Each Case?

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

Payoff Payoff ST ST X X Payoff Payoff ST ST X X

(a) Long call (b) Short call (d) Short put (c) Long put

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ST X

(a) Long call

ST

Profit/loss

X

(c) Long put

ST X

(b) Short call

ST X

(d) Short put

Profit/loss

Profit/loss Profit/loss

Profit and Loss from Options

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Call option buyers Call option sellers/writers Right to exercise and buy the assets Pays premium Profit from price rising Limited losses, potentially unlimited gain Obligation to sell the assets if exercised Receives premium Profit from price falling or remaining neutral Limited gain, potentially unlimited losses Put option buyers Put option sellers/writers Right to exercise and sell the assets Pays premium Profit from price falling Limited losses, potentially unlimited gain Obligation to buy the assets if exercised Receives premium Profit from price rising or remaining neutral Limited gain, potentially unlimited losses

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Options vs. Forwards/Futures

Options

• Gives holders the right to

do something

 Calls: right to buy the

underlying assets

 Puts: right to sell the

underlying assets

• There is a cost to acquire
• ptions (option premium)

Forwards/Futures

• Holders

have

• bligation

regarding their positions.

 Long futures: obligation

to buy the assets at maturity

 Short futures: obligation

to sell the assets at maturity

• Except brokerage fee and
• ther

transaction cost, it costs nothing to enter futures contracts.