Portfolio Management Introduction on Derivatives University of - - PowerPoint PPT Presentation

University of Colorado at Boulder – Leeds School of Business – FNCE4030

FNCE4030 – Investments and Portfolio Management

Introduction on Derivatives

University of Colorado at Boulder – Leeds School of Business – FNCE4030

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 – FNCE4030

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 – FNCE4030

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 – FNCE4030

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 – FNCE4030

Growth of OTC Market by Product

100 200 300 400 500 600 700 Jun.98 Jun.99 Jun.00 Jun.01 Jun.02 Jun.03 Jun.04 Jun.05 Jun.06 Jun.07 Jun.08 Jun.09 Jun.10 Jun.11 Jun.12 Commodity Equity-linked Credit default swaps Interest rate FX $ trillions

University of Colorado at Boulder – Leeds School of Business – FNCE4030

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 – FNCE4030

Forwards

University of Colorado at Boulder – Leeds School of Business – FNCE4030

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 – FNCE4030

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 – FNCE4030

Forward Example

• On Jan 10, 2013 the treasurer of a

corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.6115

• This contract obligates the corporation to pay

$1,611,500 for £1 million on the maturity date (July 10, 2013)

• What are the possible outcomes?

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Profit from a Long Forward

• K = delivery price = 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 – FNCE4030

Profit from a Short Forward

• K = delivery price = 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 – FNCE4030

Futures Contracts

University of Colorado at Boulder – Leeds School of Business – FNCE4030

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. More on this later.

University of Colorado at Boulder – Leeds School of Business – FNCE4030

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 Hull book)

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Examples of Futures Contracts

• You think gold will appreciate during the year:

Buy 100 oz. of gold @ 1662 $/oz in Dec.

• You will receive GBP in March but want USD:

Sell £62,500 @ 1.661 US$/£ in March

• You are an oil producer and want to hedge:

Sell 1,000 bbl. of oil @ 92 $/bbl in April

• You are a soybean buyer looking to lock your

input costs: Buy 1mm bushels of soybean in 6m

University of Colorado at Boulder – Leeds School of Business – FNCE4030

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 – FNCE4030

Who Trades Derivatives?

• 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 – FNCE4030

Hedging Examples (pages 10-12)

• A US company will pay £10 million for imports

from Britain in 3 months and decides to hedge using a long position in a forward contract

• An investor owns 1,000 Microsoft shares

currently worth $26.88 per share. A two- month put with a strike price of $27.00 costs $1. The investor decides to hedge by buying 10 contracts

University of Colorado at Boulder – Leeds School of Business – FNCE4030

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 – FNCE4030

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 – FNCE4030

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

• SocGen is an example of what can go wrong

(see Hull, Business Snapshot 1.3 on page 17)

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Hedge Funds (see Business Snapshot 1.2, page 11)

• 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

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Swaps

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Nature of Swaps

• A swap is an agreement to exchange

cash flows at specified future times according to certain specified rules

– Typically swaps have two legs as there are two parties…swapping cash flows Counterparty A Counterparty B

Cash flow

Cash flow

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Vanilla Interest Rate Swap

• An agreement to swap fixed rate cash flows

for floating cash flows over a specified period

• f time

– Tenor

• determines how often payments are made
• In the US

– floating payments are generally every 3 months – Fixed payments are made every 6 months

– Floating cash flows reference a “trusted” benchmark rate – e.g. LIBOR

• Generally the reference rate is fixed at the beginning of

a period and paid at the end

University of Colorado at Boulder – Leeds School of Business – FNCE4030

E.g. “Plain Vanilla” Int. Rate Swap

• An agreement by Microsoft to

– receive 6-month LIBOR – pay a fixed rate of 5% per annum every 6 months – Start date: 5 March 2012, – Maturity: 5 March 2015 – Notional: $100m

• Next slide illustrates* cash flows that could
• ccur

* illustrative trade, day count conventions are not

considered, payment frequency not typical

University of Colorado at Boulder – Leeds School of Business – FNCE4030

A Possible Outcome for Cash Flows

Date LIBOR Floating Cash Flow Fixed Cash Flow Net Cash Flow

Mar 5, 2012 4.20% Sep 5, 2012 4.80% +2.10 −2.50 −0.40 Mar 5, 2013 5.30% +2.40 −2.50 −0.10 Sep 5, 2013 5.50% +2.65 −2.50 + 0.15 Mar 5, 2014 5.60% +2.75 −2.50 +0.25 Sep 5, 2014 5.90% +2.80 −2.50 +0.30 Mar 5, 2015 +2.95 −2.50 +0.45

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Typical Uses of an Int. Rate Swap

• Converting a liability from

– fixed rate to floating rate – floating rate to fixed rate

• Converting an investment from

– fixed rate to floating rate – floating rate to fixed rate

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Swap Fixed for Floating

• You enter an interest rate swap

– Notional: 100m – Maturity: 5 March 2015 – Semi-annual payments – Pay Fixed: 5% – Receive Floating: 6 Month USD LIBOR

5 March 2013 5 Sep 2013 5 March 2014 5 Sep 2014 5 March 2015 2.5% 2.5% 2.5% 2.5% 2.5% 6M LIBOR 6M LIBOR 6M LIBOR 6M LIBOR 6M LIBOR

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Other types of swaps

• Credit Default Swaps (CDS)
• Currency Swaps
• Commodity Swaps
• Mortgage Swaps
• Equity Swaps (on price or dividends)
• Variance Swaps
• etc.

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Options

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Basic Option Terminology

An option gives the holder the right but not the obligation to buy(sell) the underlying asset at some time or times in the future.

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Underlying Assets

• Stocks
• Currencies
• Stock Indices (not indexes)
• Futures
• Commodities (individual and index)
• Interest Rates (swaptions)
• Credit products (credit default swaptions)
• etc.

University of Colorado at Boulder – Leeds School of Business – FNCE4030

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
• ption 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 – FNCE4030

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 – FNCE4030

Option Contracts Specs

• Expiration date
• Strike price (or Exercise price)
• European or American (option style)
• Call or Put (option class or type)
• Delivery details

– Cash or Physical delivery

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Mechanics of Options Markets

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Payoff Diagrams

• A common technique for understanding
• ptions is to draw a payoff diagram
• This will usually show the value of the option

at expiry

• Note – you will see payoff diagrams that

deduct the the premium paid from the payoff

– Many diagrams in the Hull book do this – Generally this is frowned upon in the industry, because you are adding values at different times – The following slides will chart just payoffs

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Long Call Option

1 2 3 4 5 6 1 2 3 4 5 6 7 8 9 10

Payoff Terminal Asset Price

Payoff for a European Call option with a strike of $5

𝑄𝑏𝑧𝑝𝑔𝑔 = 𝑁𝑏𝑦[0, 𝑇𝑈 − 𝐿]

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Short Call Option

• 6
• 5
• 4
• 3
• 2
• 1

1 2 3 4 5 6 7 8 9 10

Payoff Terminal Asset Price

Payoff for a European Call option with a strike of $5

𝑄𝑏𝑧𝑝𝑔𝑔 = −𝑁𝑏𝑦[0, 𝑇𝑈 − 𝐿]

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Long Put Option

1 2 3 4 5 6 1 2 3 4 5 6 7 8 9 10

Payoff Terminal Asset Price

Payoff for a European Put option with a strike of $5

𝑄𝑏𝑧𝑝𝑔𝑔 = 𝑁𝑏𝑦[0, 𝐿 − 𝑇𝑈]

University of Colorado at Boulder – Leeds School of Business – FNCE4030

Short Put Option

• 6
• 5
• 4
• 3
• 2
• 1

1 2 3 4 5 6 7 8 9 10

Payoff Terminal Asset Price

Payoff for a European Put option with a strike of $5

𝑄𝑏𝑧𝑝𝑔𝑔 = −𝑁𝑏𝑦[0, 𝐿 − 𝑇𝑈]