16/04/2012

DerivativeSecuities

Financingabusiness:Summary
Raisingmoneyisdifficult There is no limit to the variety of ways a company can be Thereisnolimittothevarietyofwaysacompanycanbe financed Ingeneral,ahighriskformoffinancehastoofferthe prospectofhighreturns Raisingsmallscaleinitialfinancingisverydifficult Aprivateinvestorisinterestedinreturnoninvestmentand therisktaken.
16/04/2012 IntroductiontoFinance1:AC103 2

16/04/2012

Financingabusiness:Summary
Governmentsareinterestedin

Becauseofthis,governmentsmayfindit worthwhiletoinvestwhereaprivateinvestors worthwhile to invest where a private investors considersittobetoorisky.

16/04/2012

IntroductiontoFinance1:AC103

ShouldGovernmentsHelp?
directgrantaid softloans soft loans subsidisedemployees trainingschemes taxbreaksforinvestors backtoworkschemes loanguarantees g

Askthequestion:Ifaprivateinvestorwontfundit,isitworth doing?
16/04/2012 IntroductiontoFinance1:AC103 4

16/04/2012

ShouldGovernmentsHelp?
Cofunding partfundedbyEnterpriseIreland,butprivate investorsneededaswell,tokeepcompaniesclosetomarket investors needed as well, to keep companies close to market realities Financingisamarketingproblem:thecompanypackagesthe righttothecashflowgeneratedbyitsassetsindifferentways inordertoattractfinancefrombanks,bondholders,equity holdersandgovernments. BottomLine: DoubleBottomLine: TripleBottomLine:
IntroductiontoFinance1:AC103 5

DerivativeSecurities
Asecurityisanyfinancialinstrument,beit debtorequityorsomecombinationofthe d bt it bi ti f th two Aderivativesecurityderivesitsvaluefroman underlyingsecurity(orothermeasurable item) ) Itisawayoftakingbets,eitherasapure gamble,ortooffsetsomeunderlyingposition

16/04/2012

Hedging
Takingapositionthatpaysoutifsomething goesagainstyou i t

HedgingRisk
Firmsfacemanyriskswhichmaybereduced oreliminated or eliminated Theriskoflossduetofireornaturaldisaster maybehedgedbytakingoutInsurance FinancialRisk(exchangeratechanges, interestratechanges)maybehedgedusing g ) y g g Derivativecontracts

16/04/2012

FinancialDerivativeSecurities
Twotypes: 1.Tiesyoutoaparticularaction,nomatter whatgoesonintheunderlyingmarket 2.Givesyouachoice,whichyoumake dependingontheunderlyingmarket depending on the underlying market (contingentclaim)

FinancialDerivativeSecurities
Twowaysoftrading: Overthecounter(OTC) Viaaspecialisedexchange

16/04/2012

FinancialDerivativeSecurities
Example: Easons importsmagazinesforUK,fordistributionin Ireland Knows(roughly)howmanymagazines,andthesterling costofthemagazines Doesn tknowtheEuropriceofsterlingrequired Doesnt know the Euro price of sterling required Canpurchasecurrencyforward,buyacurrencyfutureor purchaseacurrencyoption

ForwardContracts
Aforwardcontractisanagreementtobuyor sellanassetatacertaintimeinthefuturefora ll t t t i ti i th f t f certainprice Thereisnodailysettlement. Thecontractisanoverthecounter(OTC) agreementbetween2parties Nomoneychangeshandswhenfirstnegotiated &thecontractissettledatmaturity

16/04/2012

ForwardContracts
Aforwardcontractisanagreementtobuyorsellan assetatacertaintimeinthefutureforacertainprice asset at a certain time in the future for a certain price Thecontractisanoverthecounter(OTC)agreement between2companies Nomoneychangeshandswhenfirstnegotiated&the contractissettledatmaturity Todays sterling spot rate might be 0.8562 per Euro, Today ssterlingspotratemightbe0.8562perEuro, andtheforwardrate0.8432forasixmonthforward contract Tiesdownthevalueofthesterlingneeded

ForwardContracts
Aforwardcontractisanagreementtobuyorsellan assetatacertaintimeinthefutureforacertain asset at a certain time in the future for a certain price Youmayendupbuysterlingataworstratethanifyou hadnotengagedinthecontract dependsonwhat happenstotheunderlyingmarket Duringthecurrencycrisisoftheautumn1992,Easons D i th i i f th t 1992 E werereportedlybuyingsterlingataveryexpensive rate

16/04/2012

Terminology
Thepartythathasagreedtobuyhasa long position l ii Thepartythathasagreedtosellhasa short position

FuturesContracts
Afuturescontractisanagreementtobuy orsellanassetatacertaintimeinthe futureforacertainprice Itisastandardised contractandtradedon anexchange By contrast a Spot contract is an agreement BycontrastaSpotcontractisanagreement tobuyorselltheassetimmediately

16/04/2012

ExamplesofFuturesContracts
Agreementto:

Margins
Forwardshavenoupfrontpayments,futureshavemargin calls Amarginis(usually)cashdepositedbyaninvestorwith abroker Marginsminimizethepossibilityofdefaultloss Theyaresettleddaily markedtomarket Closing out a futures position involves entering into an Closingoutafuturespositioninvolvesenteringintoan offsettingtrade Mostcontractsareclosedoutbeforematurity

16/04/2012

ForwardvsFutures

FORWARDS Private contract between 2 parties Non-standard contract Usually 1 specified delivery date Settled at maturity Delivery or final cash settlement usually occurs

FUTURES Exchange traded Standard contract Range of delivery dates Settled daily Contract usually closed out prior to maturity

HedgingwithFutures
Example Youareahogfarmer.ItisApril

andyouintendtosell300,000lbsof hogmeatinOctober.Youfearthatthe hog meat in October You fear that the pricewilldropinthefuture.The currentspotpriceforhogsis$0.22per poundandthe6monthfuturespriceis $0.20.Eachcontractisfor30,000lbs. Thus,tohedgeyourpriceriskyoushort Thus, to hedge your price risk you short 10HogFutures.Ifthepricedropsto $0.17centsperpoundwhatisthe effectofthehedge?

10

16/04/2012

HedgingwithFutures
Youcloseoutyourpositionimmediatelybefore sellingyourproduceonthespotmarket selling your produce on the spot market ProfitonFutures:

Options
AnOPTIONisanothertypeofderivative instrument Anoptiongivestheholdertheright tobuyor sellatacertainprice Theexpirationdate(maturity)isthedatethe contractfinishes Thestrikepriceisthepricespecifiedinthe contractatwhichtrademaytakeplace

11

16/04/2012

OptionTerminology
CallOption

PutOption

OptionTerminology
Foraspecifiedstrikeprice,X; A LONG CALL gives you the right to buy ALONGCALL givesyoutherighttobuy ASHORTCALL givessomebodyelsethe righttobuyfromyou. ALONGPUT givesyoutherighttosell A SHORT PUT gives somebody else the right ASHORTPUT givessomebodyelsetheright toselltoyou

12

16/04/2012

CurrencyOptions
Easons mightpurchaseacurrencyoption whichputsaupperlimitontheEurocostof hi h t li it th E t f thesterlingrequired Ifthecurrencycanbeboughtcheaperinthe spotmarket,do tearupyouroption,looking atitasunneededinsurance

AmericanvsEuropeanOptions
Thesetermsdonotrefertothelocationof trade AnAmericanoptioncanbeexercisedatany timeduringitslife AEuropeanoptioncanbeexercisedonlyat maturity y

13

16/04/2012

OptionPayoff
Thepayoffofanoptionatexpirationisafunction ofthestockpriceandtheexerciseprice. of the stock price and the exercise price Example Stockoptionvaluesgivenaexerciseprice of$40

Stock Price Call Payoff Put Payoff

$0

20

40

60

80

100

LongCallOptionPayoff

14

16/04/2012

LongPutOptionPayoff

ShortCallOptionPayoff

15

16/04/2012

ShortPutOptionPayoff

Derivatives:Summary
Waysoftakingbetsonpricemovements Maybeusedtohedgeortospeculate Cangivegoodprotection Cangiverisetolargeloses WidevarietyinderivativesecuritiesFinancial Engineering

16