Derivative Securities- Learning Objectives
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1 Derivative Securities- Learning Objectives What is a derivative security? Important characteristics of a derivative security; Markets for derivative securities; Terminology is used to describe derivative transactions; How are prices for derivative securities quoted?
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Derivative Securities- Learning Objectives. What is a derivative security? Important characteristics of a derivative security; Markets for derivative securities; Terminology is used to describe derivative transactions; How are prices for derivative securities quoted?. - PowerPoint PPT Presentation
Transcript of Derivative Securities- Learning Objectives
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Derivative Securities- Learning Objectives
What is a derivative security?Important characteristics of a derivative
security;Markets for derivative securities;Terminology is used to describe
derivative transactions;How are prices for derivative securities
quoted?
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Derivative Securities- Learning Objectives
Similarities and differences between forward and futures contracts;
Put and Call option contracts;How are forward contracts, put
options, and call options related to one another?
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Forward and Futures Contracts - Learning Objectives
Hedge ratio and how it is calculated?What economic functions do the
forward and futures markets serve?Futures pricing;Agricultural futures and financial
futures;Stock Index futures;Currency futures
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Derivative InstrumentsValue is depends directly on, or is derived
from, the value of another security or commodity, called the underlying asset
Forward and Futures contracts are agreements between two parties - the buyer agrees to purchase an asset from the seller at a specific date at a price agreed to now
Options offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date
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Why Do Derivatives Exist?Assets are traded in the cash or spot
marketIt is sometimes advantageous enter into
a transaction now with the exchange of asset and payment at a future time
Risk shiftingPrice formationInvestment cost reduction
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Derivative InstrumentsForward contracts are the right and full
obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined date (maturity date) and at a predetermined price (contract price) This is a trade agreement
Futures contracts are similar, but subject to a daily settling-up process
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Forward ContractsBuyer is long, seller is shortContracts are OTC, have
negotiable terms, and are not liquid
Subject to credit risk or default risk
No payments until expirationAgreement may be illiquid
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Futures ContractsStandardized termsCentral market (futures exchange)More liquidityLess liquidity risk - initial marginSettlement price - daily “marking
to market”
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OptionsThe Language and Structure of
Options Markets An option contract gives the
holder the right-but not the obligation-to conduct a transaction involving an underlying security or commodity at a predetermined future date and at a predetermined price
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OptionsBuyer has the long position in
the contractSeller (writer) has the short
position in the contractBuyer and seller are
counterparties in the transaction
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OptionsOption Contract Terms
The exercise price is the price the call buyer will pay to-or the put buyer will receive from-the option seller if the option is exercised
Option Valuation Basics Intrinsic value represents the value that the buyer
could extract from the option if he or she she exercised it immediately
The time premium component is simply the difference between the whole option premium and the intrinsic component
Option Trading Markets-options trade both in over-the-counter markets and on exchanges
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OptionsOption to buy is a call optionOption to sell is a put optionOption premium - paid for the optionExercise price or strike price - price
agreed for purchase or saleExpiration date
European options American options
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OptionsAt the money:
stock price equals exercise price
In-the-money option has intrinsic value
Out-of-the-money option has no intrinsic value
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Investing With Derivative Securities
Call option requires up front payment allows but does not require future
settlement paymentForward contract
does not require front-end payment requires future settlement payment
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Options Pricing Relationships
Factor Call Option Put OptionStock price + -Exercise price - +Time to expiration + +Interest rate + -Volatility of underlying + +stock price
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Profits to Buyer of Call Option
40 50 60 70 80 90 100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise Price = $70Option Price = $6.125
Profit from Strategy
Stock Price at Expiration
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Profits to Seller of Call Option
40 50 60 70 80 90 100
(1,000)
(1,500)
(2,000)
(500)
0
500
1,000
(2,500)
(3,000)
Exercise Price = $70Option Price = $6.125
Stock Price at Expiration
Profit from Strategy
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Profits to Buyer of Put Option
40 50 60 70 80 90 100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise Price = $70Option Price = $2.25
Profit from Strategy
Stock Price at Expiration
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Profits to Seller of Put Option
40 50 60 70 80 90 100
(1,000)
(1,500)
(2,000)
(500)
0
500
1,000
(2,500)
(3,000)
Exercise Price = $70Option Price = $2.25
Stock Price at Expiration
Profit from Strategy
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Creating Synthetic Securities Using Put-Call ParityRisk-free portfolio could be created
using three risky securities: stock, a put option, and a call option
With Treasury-bill as the fourth security, any one of the four may be replaced with combinations of the other three
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Put-Call-Forward ParityInstead of buying stock, take a long
position in a forward contract to buy stock
Supplement this transaction by purchasing a put option and selling a call option, each with the same exercise price and expiration date
This reduces the net initial investment compared to purchasing the stock in the spot market
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An Overview of Forward and Futures Trading
Forward contracts are negotiated directly between two parties in the OTC markets. Individually designed to meet specific needs Subject to default risk
Futures contracts are bought through brokers on an exchange No direct interaction between the two parties Exchange clearinghouse oversees delivery and
settles daily gains and losses Customers post initial margin account
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Hedging With Forwards and FuturesCreate a position that will offset the
price risk of another holding holding a short forward position against
the long position in the commodity is a short hedge
a long hedge supplements a short commodity holding with a long forward position
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Hedging With Forwards and FuturesRelationship between spot and forward
price movements basis is spot price minus the forward price for
a contract maturing at date T:BtT = St - Ft,T
forward price converges to the spot price as the contract expires
hedging exposure is correlation between future changes in the spot and forward contract prices and can be perfectly correlated with customized contracts
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Hedging With Forwards and Futures
Calculating the Optimal Hedge Ratio net profit from the position
NFSNFFSS TTttt ,0,0
FS,FSTt NN COV22222,
pNF
S
F
2FS,COV
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Forward and Futures Contracts:Basic Valuation Concepts
Forward and futures contracts are not securities but, rather, trade agreements that enable both buyers and sellers of an underlying commodity or security to lock in the eventual price of their transaction
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Valuing Forwards and Futures Valuing forwards
tTTTtTt iFFQV 1,0,,
•Valuing futures
•contracts are marked to market daily
* = the possibility that forward and futures prices for the same commodity at the same point in time
might be different TTtTt FFQV ,0,,
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The Relationship Between Spot and Forward PricesIf you buy a commodity now for cash
and store it until you deliver it, the price you want under a forward contract would have to cover: the cost of buying it now the cost of storing it until the contract
matures the cost of financing the initial purchase
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The Relationship Between Spot and Forward Prices
These are the cost of carry necessary to move the asset to the future delivery date TTTTT DiPCSSCSF ,0,0,00,00,0
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Financial Forwards and Futures: Applications and Strategies
Originally, forward and futures markets were organized largely around trading agricultural commodities
Recent developments in this area have involved the use of financial securities as the asset underlying the contract
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Financial Forwards and Futures: Applications and Strategies Interest rate forwards and futures were
among the first derivatives to specify a financial security as the underlying asset forward rate agreements interest rate swaps
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Financial Forwards and Futures: Applications and Strategies
Long-term interest rate futures Treasury bond and note contract mechanics
CBT $100,000 face valueT-bond >15 year maturityT-note 10 year - bond with 6.5 to 10 year
maturityT-note 5 year - bond with 4.25 - 5.25 yearsDelivery any day during month of delivery
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Financial Forwards and Futures: Applications and Strategies
Long-term interest rate futuresLast trading day 7 days prior to the end
of the monthQuoted in 32ndsYield quoted is for referenceTreasury bonds pay semiannual interestConversion factors for differences in
deliverable bonds
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Short-Term Interest Rate FuturesEurodollar and Treasury bill contract
mechanicsCreating a synthetic fixed-rate
funding with a Eurodollar stripCreating a TED spread
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Stock Index FuturesIntended to provide a hedge against
movements in an underlying financial asset
Hedging an individual stock with an index isolates the unsystematic portion of that security’s risk
Stock index arbitrage prominent in program trading
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Currency Forwards and Futures
Currency quotations Direct (American) quote in U.S. dollars Indirect (European) quote in non U.S.
currency Reciprocals of each other
Interest rate parity and covered interest arbitrage
365RateInterest U.S.1
365RateInterest Foreign 1
Spot ForwardT
T
