Financial Economics: Speculative Markets UofC, Fernando Alvarez

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Financial Economics Speculative Markets
UofC, Fernando Alvarez
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Grading
PS 4 problem sets, graded pass/fail. M optional
midterm F comprehensive Grade based on curve
on G G 0.1 PS 0.9 MaxF, 1/3 M 2/3 F
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Other Details
-TA sessions review some material, cover special
topics, solutions of PS and Midterm. -TA
Mariano Lanfranoni - No review session during
the 1st week -Office Hours Wed 330 500
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Pre-requisites
- Basic Calculus derivatives (integration for
optional advanced problem) - Basic Statistics
expected values, variances, binomial formulas
(Central Limit Thm, Law of Large numbers for
optional advanced problem) - Intro to Finance,
not required, but helps.
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Class Material

• - I will use my notes (slides) for all the
  topics. Available on my web page
• http//home.uchicago.edu/falvare/
• - I may revise the notes (incorporate new
  examples, different explanations, etc).
• -I will announce whenever there are additions to
  the notes.

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Class Material (cont)

• There are many good books on this topic. I will
  follow closely
• Options, Futures, and Other Derivatives 6th
  Edition, John C. Hull 2005
• - You may want to buy it if you want to have a
  reference for other topics not covered in class
  and plan to work in the industry.

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What would you get from this class?

• Understanding of hedging and pricing of ANY
  derivative
• Implemented (i.e. recommendation of trading
  strategy) in spread-sheets
• Focus on general principle, not catalog of all
  contracts available.

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The Nature of Derivatives

• A derivative is an instrument whose value depends
  on the values of other more basic underlying
  variables
• In this class we will focus on how to price and
  hedge derivatives whose underlying is a traded
  asset (non-traded asset)
• Not covered taxation, institutional details, and
  accounting practices.

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Examples of Derivatives

• Futures Contracts
• Forward Contracts
• Swaps
• Options

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Derivatives contracts considered in this class

• Forwards, Futures, on commodities, stocks,
  indices, foreign currency and bonds.
• - Options on commodities, stocks, indices,
  foreign currency, and futures.
• - If time allows Options on interest rate
  instruments.

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Derivatives contracts considered in this class
(cont.)

• From pricing and hedging perspective
• Futures Contracts, Forward Contracts and Swaps
  are similar use static hedging and
  replication.
• Options require dynamic hedging and
  replication.
• Once you understand options, you understand ANY
  derivative.

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Derivatives Markets

• Exchange traded
• Traditionally exchanges have used the open-outcry
  system, but increasingly they are switching to
  electronic trading (example)
• Contracts are standard there is virtually no
  credit risk
• Over-the-counter (OTC)
• A computer- and telephone-linked network of
  dealers at financial institutions, corporations,
  and fund managers
• Contracts can be non-standard and there is some
  small amount of credit risk

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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 without
  incurring the costs of selling one portfolio and
  buying another

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Forward Contracts

• Forward contracts are similar to futures except
  that they trade in the over-the-counter market
• Forward contracts are particularly popular on
  currencies and interest rates
• Buyer (long) obligation to buy the underlying at
  the delivery price at the maturity date.

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Foreign Exchange Quotes for GBP June 3, 2003
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Forward Price

• The forward price for a contract is the delivery
  price that would be applicable to the contract if
  were negotiated today (i.e., it is the delivery
  price that would make the contract worth exactly
  zero)
• The forward price may be different for contracts
  of different maturities (example)

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Terminology

• 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

• On June 3, 2003 the treasurer of a corporation
  enters into a long forward contract to buy 1
  million in six months at an exchange rate of
  1.6100
• This obligates the corporation to pay 1,610,000
  for 1 million on December 3, 2003
• What are the possible outcomes?

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Cash flow from aLong Forward Position
K
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Cash flow from a Short Forward Position
K
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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)
• BMF (Sao Paulo, Brazil)
• TIFFE (Tokyo)
• and many more (see list at end of book)

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Examples of Futures Contracts

• Agreement to
• buy 100 oz. of gold _at_ US400/oz. in December
  (NYMEX)
• sell 62,500 _at_ 1.5000 US/ in March (CME) or
  (WSJ)j
• sell 1,000 bbl. of oil _at_ US20/bbl. in April
  (NYMEX)

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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
• Example Oil (many other types too!)

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Intel Option Prices (May 29, 2003 Stock
Price20.83) See also wsj

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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 (see list at end of book)

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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 (See for example Barings Bank,
Business Snapshot 1.2, page 15 in Hull book)
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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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Cash Flow of Hedge at maturity (as function of
maturity price S)
b) 1 share short 1 call long (reverse)
a) 1 share long 1 call short
K
S
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Speculation Example

• An investor with 4,000 to invest feels that
  Amazon.coms stock price will increase over the
  next 2 months. The current stock price is 40 and
  the price of a 2-month call option with a strike
  of 45 is 2 (see wsj)
• What are the alternative strategies?