Financial Derivatives

Academic Year 2011-12 Trimester IV Lecture 1

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Basic Stuff regarding books, exam, etc.

Required Text Book: Options, Futures, and other derivatives By John C Hull & Sankarshan Basu, 7th Edition Indian Subcontinent Adaptation, 2010 Exams There will be a mid-term exam. 80-100% questions in the mid term exam and final exam will be numerical problems, not requiring too much of calculation but conceptual clarity What to avoid While many of you will score 100%, a few might end up reappearing. Let us make sure that no one in the class has to do the latter. So, you will need to attend classes, and if you end up missing a class, please go through the PPT plus text book at home before coming for the next class.
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First the score card for IFS

M Maximum marks Others who are 90% plus (54-58) 50-53 40-49 30-39 20-29 59 (2 students) 4 10 28 12 1 (score = 24) Roll Numbers 3006 & 3008 3015, 3017, 3025, 3039

Feedback on IFS
Should we be more text book focussed? Any change required in the way the course is handled? Any thing else?

What is a Financial Derivative

Financial Instrument, whose value depends on (or derives from) the value of other, more basic, underlying variable

Whats new in derivatives worldwide?

Highly active trading in electricity derivatives, weather derivatives, insurance derivatives, etc. Creation of many new types of interest rate, foreign exchange and equity derivative products New ideas in risk management and use of derivatives

Size of OTC and Exchange-Traded Market

550 500 450 400 350 300 250 200 150 100 50 0 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

Size of Market ($ trillion)

OTC Exchange

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

Ways Derivatives are Used

To hedge risks 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

Use of forwards since long

Forwards are the simplest of derivatives and have been used for a long time CBOT(Chicago Board of Trade) was established in 1848. Initially, its main task was to standardize the quantity and quality of grains that were traded. It developed a futures like contract in a few years time A rival futures exchange, CME (Chicago Mercantile Exchange) was established in 1919
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The Indian Scene

Derivatives markets started in late 1890s by way of futures in commodities , mainly agricultural The thriving market came to an end in 1952 when GOI banned futures trading in commodities in India. The scenario changed in late 90s / early 2000s In equity markets, an unofficial and therefore unregulated market existed in form of BADLA trading, that stopped in the wake of Harshad Mehta scam of 92 The stock markets introduced derivatives from 2000, and the commodity exchanges took off in 2003. The growth since then has been phenomenal Interest rate futures were introduced by NSE in 2003 and currency futures were launched by NSE in 2008 Transactions in derivatives in OTC markets have been growing at a fast pace since the 1980s, with forwards, options, swaps permitted in a regulated manner
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Terminology: Long/short position

The party that has agreed to buy has what is termed a long position The party that has agreed to sell has what is termed a short position

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Example: Foreign Exchange Quotes for GBP in USD

Bid Spot 1-month forward 3-month forward 6-month forward 2.0558 2.0547 2.0526 2.0483

Offer 2.0562 2.0552 2.0531 2.0489

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Example
On July 20, 2007 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months at an exchange rate of 2.0489 This obligates the corporation to pay $2,048,900 for 1 million on January 20, 2008 What are the possible outcomes?
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Possible outcomes
A company might do better if it chooses not to hedge than if it chooses to hedge The purpose of hedging is to reduce risk There is no guarantee that the outcome with hedging will be better than the outcome without hedging

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Profit from a Long Forward Position

Profit

Price of Underlying at Maturity, ST

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Profit from a Short Forward Position

Profit

Price of Underlying at Maturity, ST

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Futures Contracts
Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

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Exchanges Trading Futures

Chicago Board of Trade Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more
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Examples of Futures Contracts

Agreement to:
Buy 100 oz. of gold @ US$900/oz. in December (NYMEX) Sell 62,500 @ 2.0500 US$/ in March (CME) Sell 1,000 bbl. of oil @ US$120/bbl. in April (NYMEX)

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Gold: An Arbitrage Opportunity?

Suppose that:
The spot price of gold is US$900 The 1-year forward price of gold is US$1,020 The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?

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Gold: Another Arbitrage Opportunity?

Suppose that:

- The spot price of gold is US$900 - The 1-year forward price of gold is US$900 - The 1-year US$ interest rate is 5% per
annum

Is there an arbitrage opportunity?

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The Forward Price of Gold

If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. In our examples, S = 900, T = 1, and r =0.05 so that F = 900(1+0.05) = 945
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Oil: An Arbitrage Opportunity?

Suppose that:

- The spot price of oil is US$95 - The quoted 1-year futures price of oil is US$125 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum

Is there an arbitrage opportunity?

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Options
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)

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American vs European Options

An American option can be exercised at any time during its life A European option can be exercised only at maturity

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Intel Option Prices (Sept 12, 2006; Stock Price=19.56)

Strike Price 15.00 17.50 20.00 22.50 25.00

Oct Call 4.650 2.300 0.575 0.075 0.025

Jan Call 4.950 2.775 1.175 0.375 0.125

Apr Call 5.150 3.150 1.650 0.725 0.275

Oct Put 0.025 0.125 0.875 2.950 5.450

Jan Put 0.150 0.475 1.375 3.100 5.450

Apr Put 0.275 0.725 1.700 3.300 5.450

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Exchanges Trading Options

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) and many more
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Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

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Types of Traders
Hedgers Speculators Arbitrageurs Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators
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Hedging Examples
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 $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

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Value of Microsoft Shares with and without Hedging

40,000 Value of Holding ($) 35,000
No Hedging

30,000

Hedging

25,000 Stock Price ($) 20,000 20 25 30 35 40

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Speculation Example
An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of 22.50 is $1 What are the alternative strategies? What are the possible outcomes?

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Arbitrage Example
A stock price is quoted as 100 in London and $200 in New York The current exchange rate is 2.0300 What is the arbitrage opportunity?

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Hedge Funds
Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. 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 these constraints. Hedge funds use complex trading strategies and are big users of derivatives for hedging, speculation and arbitrage
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