Derivative Securities Learning Objectives

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?

2
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?

3
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

4
Derivative Instruments

• Value 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

5
Why Do Derivatives Exist?

• Assets are traded in the cash or spot market
• It is sometimes advantageous enter into a
  transaction now with the exchange of asset and
  payment at a future time
• Risk shifting
• Price formation
• Investment cost reduction

6
Derivative Instruments

• Forward 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

7
Forward Contracts

• Buyer is long, seller is short
• Contracts are OTC, have negotiable terms, and are
  not liquid
• Subject to credit risk or default risk
• No payments until expiration
• Agreement may be illiquid

8
Futures Contracts

• Standardized terms
• Central market (futures exchange)
• More liquidity
• Less liquidity risk - initial margin
• Settlement price - daily marking to market

9
Options

• The 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

10
Options

• Buyer has the long position in the contract
• Seller (writer) has the short position in the
  contract
• Buyer and seller are counterparties in the
  transaction

11
Options

• Option 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

12
Options

• Option to buy is a call option
• Option to sell is a put option
• Option premium - paid for the option
• Exercise price or strike price - price agreed for
  purchase or sale
• Expiration date
• European options
• American options

13
Options

• At the money
• stock price equals exercise price
• In-the-money
• option has intrinsic value
• Out-of-the-money
• option has no intrinsic value

14
Investing With Derivative Securities

• Call option
• requires up front payment
• allows but does not require future settlement
  payment
• Forward contract
• does not require front-end payment
• requires future settlement payment

15
Options Pricing Relationships

• Factor Call Option Put
  Option
• Stock price -
• Exercise price -
• Time to expiration
• Interest rate -
• Volatility of underlying
• stock price

16
Profits to Buyer of Call Option
Profit from Strategy
3,000
Exercise Price 70 Option Price 6.125
2,500
2,000
1,500
1,000
500
0
(500)
Stock Price at Expiration
(1,000)
40
50
60
70
80
90
100
17
Profits to Seller of Call Option
Profit from Strategy
1,000
Exercise Price 70 Option Price 6.125
500
0
(500)
(1,000)
(1,500)
(2,000)
(2,500)
Stock Price at Expiration
(3,000)
40
50
60
70
80
90
100
18
Profits to Buyer of Put Option
Profit from Strategy
3,000
2,500
2,000
Exercise Price 70 Option Price 2.25
1,500
1,000
500
0
Stock Price at Expiration
(500)
(1,000)
40
50
60
70
80
90
100
19
Profits to Seller of Put Option
Profit from Strategy
1,000
500
0
Exercise Price 70 Option Price 2.25
(500)
(1,000)
(1,500)
(2,000)
(2,500)
Stock Price at Expiration
(3,000)
40
50
60
70
80
90
100
20
Creating Synthetic Securities Using Put-Call
Parity

• Risk-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

21
Put-Call-Forward Parity

• Instead 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

22
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

23
Hedging With Forwards and Futures

• Create 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

24
Hedging With Forwards and Futures

• Relationship 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

25
Hedging With Forwards and Futures

• Calculating the Optimal Hedge Ratio
• net profit from the position

26
Forward and Futures ContractsBasic 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

27
Valuing Forwards and Futures

• Valuing forwards

• 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

28
The Relationship Between Spot and Forward Prices

• If 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

29
The Relationship Between Spot and Forward Prices

• These are the cost of carry necessary to move the
  asset to the future delivery date

30
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

31
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

32
Financial Forwards and Futures Applications and
Strategies

• Long-term interest rate futures
• Treasury bond and note contract mechanics
• CBT 100,000 face value
• T-bond gt15 year maturity
• T-note 10 year - bond with 6.5 to 10 year
  maturity
• T-note 5 year - bond with 4.25 - 5.25 years
• Delivery any day during month of delivery

33
Financial Forwards and Futures Applications and
Strategies

• Long-term interest rate futures
• Last trading day 7 days prior to the end of the
  month
• Quoted in 32nds
• Yield quoted is for reference
• Treasury bonds pay semiannual interest
• Conversion factors for differences in deliverable
  bonds

34
Short-Term Interest Rate Futures

• Eurodollar and Treasury bill contract mechanics
• Creating a synthetic fixed-rate funding with a
  Eurodollar strip
• Creating a TED spread

35
Stock Index Futures

• Intended to provide a hedge against movements in
  an underlying financial asset
• Hedging an individual stock with an index
  isolates the unsystematic portion of that
  securitys risk
• Stock index arbitrage
• prominent in program trading

36
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