TOPIC 10

Page 1: Introduction

  • Title: Analysis of Derivatives Contracts: Options, Futures, and Other Derivatives

Page 2: What is a Derivative?

  • Definition: A derivative is a financial instrument whose value is contingent upon the value of another asset.

  • Examples of Derivatives:

    • Futures

    • Forwards

    • Swaps

    • Options

    • Exotics

Page 3: Importance of Derivatives

  • Risk Transfer: Derivatives play a crucial role in risk management within the economy.

  • Underlying Assets:

    • Stocks

    • Currencies

    • Interest Rates

    • Commodities

    • Debt Instruments

    • Electricity

    • Insurance Payouts

    • Weather

  • Embedded Derivatives: Many financial transactions incorporate derivatives.

  • Real Options Approach: Widely accepted for evaluating capital investments.

Page 4: Trading Derivatives

  • Trading Venues:

    • Exchanges: Example includes Chicago Board Options Exchange (CBOE).

    • Over-the-Counter (OTC) Markets: Involves direct communication among traders (e.g., banks, fund managers).

    • Characteristics:

      • OTC markets lack physical exchanges.

      • Exchange-traded markets involve direct execution on physical exchanges.

      • Currency and bond markets are typically OTC, while stock markets are exchange-traded (e.g., NYSE).

Page 5: Size of OTC and Exchange-Traded Markets

  • Market Size Overview:

    • Graphical representation of growth in OTC vs. exchange-traded markets from 1998 to 2009.

    • OTC market growth outpacing exchange-traded markets.

    • Source: Bank for International Settlements.

Page 6: Uses of Derivatives

  • Risk Management:

    • To hedge against potential losses.

  • Speculation:

    • Making predictions on future market moves.

  • Arbitrage Profits:

    • Locking in profits from price discrepancies.

  • Liability and Investment Management:

    • Altering liabilities or investments without incurring significant costs.

Page 7: Forward Contracts

  • Definition: Similar to futures, but traded in the OTC markets.

  • Common Uses: Popular in currency and interest rate contracts.

Page 8: Forward Price

  • Definition: The forward price is the agreed-upon price for delivery that would make the contract worth zero at initiation.

  • Variable Maturities: Forward prices differ based on the contract's maturity.

Page 9: Foreign Exchange Quotes Example

  • Current Exchange Rates (May 24, 2010) for GBP:

    • Spot Rates:

      • Bid (Buy): 1.4407

      • Offer (Sell): 1.4411

    • Forward Rates:

      • 1-month: 1.4408/1.4413

      • 3-month: 1.4410/1.4415

      • 6-month: 1.4416/1.4422

  • Interpretation of Quotes:

    • Bid: Price bank buys GBP.

    • Offer: Price bank sells GBP.

    • Spread: Difference between bid and offer, influences liquidity.

Page 10: Example of a Forward Contract

  • Scenario: A corporation enters a long forward contract to buy £1 million at an exchange rate of 1.4422.

  • Obligation: Corporation to pay $1,442,200 due in six months.

Page 11: Profit from a Long Forward Position

  • Formula: Profit = Price of Underlying at Maturity - Forward Price (K).

Page 12: Profit from a Short Forward Position

  • Formula: Profit = Forward Price (K) - Price of Underlying at Maturity.

Page 13: Futures Contracts

  • Definition: Agreements to buy/sell an asset at a set price at a future date.

  • Characteristics:

    • Traded on exchanges (unlike forward contracts).

    • Examples of Exchanges: CME Group, NYSE Euronext, BM&F, TIFFE.

Page 14: Futures Price

  • Definition: Futures price is determined by supply and demand, similar to spot prices.

Page 15: Examples of Futures Contracts

  • Various agreements under futures:

    • Buy 100 ounces of gold @ $1400/oz in December

    • Sell £62,500 @ 1.4500 US$/£ in March

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

  • Positions:

    • Long position for buyers.

    • Short position for sellers.

Page 16: Options

  • Call Option: Right to buy an asset at a specified price before/exactly on the expiration date.

  • Put Option: Right to sell an asset under similar conditions.

Page 17: American vs. European Options

  • American Option: Can be exercised anytime during its life.

  • European Option: Only exercisable at maturity.

Page 18: Google Call Option Prices

  • Illustration of Google call option prices as of May 13, 2015, showing bids and offers across different strike prices and expiration months.

Page 19: Review of Option Types

  • Call: Buy option.

  • Put: Sell option.

  • Positions:

    • Long Call

    • Long Put

    • Short Call

    • Short Put

Page 20: Long Call Profit

  • Profit scenario based on strike price and market price at expiration for a given option.

Page 21: Short Call Profit

  • Profit scenario for writing a European call, varying with stock price at expiration.

Page 22: Short Put Profit

  • Profit scenario for writing a European put option, with performance dependent on the stock price.

Page 23: Payoffs from Options

  • Payoff scenarios represented in terms of the strike price (K) and asset price at maturity (S).

Page 24: Assets Underlying Exchange-Traded Options

  • Common underlying assets:

    • Stocks

    • Foreign Currencies

    • Stock Indices

    • Futures

Page 25: Options vs. Futures/Forwards

  • Futures/Forwards: Obligatory for the holder to buy/sell.

  • Options: Right (not obligation) to buy/sell.

Page 26: Types of Traders

  • Categories of traders in derivatives markets:

    • Hedgers

    • Speculators

    • Arbitrageurs

Page 27: Hedging Examples

  • Example 1: US company hedges using a forward contract for future imports.

  • Example 2: Investor uses a put option to hedge stock holdings in Microsoft.

Page 28: Value of Microsoft Shares with and without Hedging

  • Graph showing value of holding with and without hedging over varying stock prices.

Page 29: Speculation Example

  • Scenario for using call options based on expected stock price increase.

Page 30: Arbitrage Example

  • Illustration of arbitrage opportunity between quotes in London and New York with given exchange rate.

Page 31: Gold: An Arbitrage Opportunity?

  • Scenario analyzing spot and forward prices of gold for arbitrage potential.

Page 32: Gold: Pricing Relationship and Arbitrage

  • Evaluating forward pricing equations to identify arbitrage opportunities.

Page 33: Gold Arbitrage Example

  • Steps to realize profit from an arbitrage opportunity using forward selling and borrowing dynamics.

Page 34: Oil Arbitrage Opportunity

  • Description of profit realization through a forward contract for purchasing oil, considering storage costs.

Page 35: Swaps

  • Definition: An agreement to exchange cash flows at specified future times.

Page 36: Interest Rate Swap Example

  • Overview of a plain vanilla interest rate swap arrangement by Microsoft, detailing cash flow structures.

Page 37: One Possible Outcome for Cash Flows to Microsoft

  • Illustrative table with potential cash flows based on varying LIBOR rates and fixed payments.

Page 38: Typical Uses of an Interest Rate Swap

  • Typical applications include converting liabilities or investments between fixed and floating rates.