7/30/2019 FMII Lecture 6 2012

1/40

1

Simon Hayleysimon.hayley.1@city.ac.uk

Lecture 6: Derivatives &Behavioural Finance

Financial Markets

Institutions & InstrumentsFR1001

7/30/2019 FMII Lecture 6 2012

2/40

2

Introduction1. Derivatives

Forwards and Futures Spot Markets

Forward Markets

Futures Markets

Options Call options

Put options

Swaps

Interest Rate Swaps Currency Swaps

2. Behavioural Finance

7/30/2019 FMII Lecture 6 2012

3/40

3

Overview

Derivatives are instruments whose value islinked to and derived from something else.

The something else could be a security or an

index. Examples:

Commodities

Interest rates

Equities and equity indices

Bonds

Currencies

Weather

7/30/2019 FMII Lecture 6 2012

4/40

4

Derivatives can be used for both hedging(reducing existing exposures) and speculation(deliberately taking new exposures).

Derivative markets can also be thought of asreallocating risk from those who do not wish to

bear it to those who do.

Many derivatives involve significant amounts ofleverage. This can make them a very effective

financial tool. It also helps explain whyderivatives have been involved in many of thelargest financial disasters!

7/30/2019 FMII Lecture 6 2012

5/40

5

Banks and hedge funds are major players in

derivative markets.

Derivatives are traded on both open outcry andelectronic exchanges, but electronic trading is

gaining. Some of the largest exchanges are CBOT/CME

and LIFFE. Exchanges compete for tradingvolume.

7/30/2019 FMII Lecture 6 2012

6/40

6

Major Types of Derivative

Forward and Futures contracts

Options contracts

Call option Put option

Swaps

Currency swap Interest rate swap

7/30/2019 FMII Lecture 6 2012

7/40

7

Spot, Forward & Futures Contracts

Spot Contract: an agreement between two partiesfor immediate delivery of an asset (by the seller) andimmediate payment of funds in return (by the buyer).

Forward Contract: an agreement between twoparties at time t=0 to exchange a non-standardisedasset for cash at some future date. The details of theasset, price to be paid, and date are all set at t=0.

Futures Contract: like a forward, but agreement attime t=0 is to exchange a standardised asset forcash at some standardised future date.Transactions occur in a centralised market.

7/30/2019 FMII Lecture 6 2012

8/40

8

Forward Contracts

After entering a future or forward contract, theprice for delivery of the asset at maturity is fixed,regardless of what happens to spot prices in themeantime.

For example, a Forward Rate Agreement (FRA)is a forward contract for loans that today fixes theinterest rate on a loan that will be made in the

future. Other forwards are agreements to deliverparticular commodities in the future, at a pricespecified now.

7/30/2019 FMII Lecture 6 2012

9/40

9

Profit from aLong Forward Position

Profit

Price of Underlying

at Maturity, STK

7/30/2019 FMII Lecture 6 2012

10/40

10

Profit from aShort Forward Position

Profit

Price of Underlying

at Maturity, STK

7/30/2019 FMII Lecture 6 2012

11/40

11

Example 1

A cocoa grower wants to remove uncertaintyabout the price he will receive when the crop isharvested. How should he hedge?

7/30/2019 FMII Lecture 6 2012

12/40

12

Example 2

A producer of electronic goods needs to buy a100 tonnes of copper in six months time. Howshould she hedge?

7/30/2019 FMII Lecture 6 2012

13/40

13

Example 3

A UK investor holds $100m of US equities.She is bullish on the performance of theequities, but fears that a fall in the dollar mightstill lead to losses. How should she hedge?

7/30/2019 FMII Lecture 6 2012

14/40

14

Trading in Forwards

Hedging

Speculation

Arbitrage

7/30/2019 FMII Lecture 6 2012

15/40

15

Futures Contracts

Just like a forward, a buyer of a futures contract (long

position) incurs the obligation to pay the price agreedat the time the contract is purchased.

Similarly, a seller of a futures contract(short position)incurs the obligation to deliver the underlying

commodity at contract maturity.

The exchange guarantees payment for both parties sothat counterparty default risk is not a concern.Principles will not normally know the opposing party in

the contract unless delivery is arranged.

To protect themselves, exchanges impose marginrequirements, position limits and daily marking tomarket.

7/30/2019 FMII Lecture 6 2012

16/40

16

Buyers and sellers of futures contracts must post aninitial margin, usually set at about 1%-5% of theface value of the contract.

Losses will be deducted from investors marginaccounts. If futures prices move against them,they will be asked to top up their margin back to

their original level (a margin call). The margin system is designed to ensure that

investors cannot walk away from a deal if pricesmove against them!

By contrast, on a forward contract, no cash is paid orreceived until contract maturity.

7/30/2019 FMII Lecture 6 2012

17/40

17 17

.

7/30/2019 FMII Lecture 6 2012

18/40

18

Forward vs Futures Contracts

Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

FORWARDS FUTURES

Some credit risk Virtually no credit risk

7/30/2019 FMII Lecture 6 2012

19/40

19

Options

An option is a derivative instrument that providesthe holder (long position) with the right, but notthe obligation, to complete a transaction on the

underlying asset at a specific price (strike price)during or at a specific period of time (expirationdate).

If the holder of the option chooses to exercisehis right, the writer (short position) is obliged toact on it.

7/30/2019 FMII Lecture 6 2012

20/40

20

Call Option: gives the holder the right (but not

the obligation) to purchase the underlyingsecurity at the agreed strike price. For this rightshe pays the writer an up-front fee known asthe call premium.

Put Option: gives the holder the right (but notthe obligation) to sell the underlying security atthe agreed strike price. For this right she pays

the writer an up-front fee known as the putpremium.

7/30/2019 FMII Lecture 6 2012

21/40

21

Option Positions

Long call

Long put

Short call Short put

7/30/2019 FMII Lecture 6 2012

22/40

22

Long Call on eBay

Profit from buying one eBay European call option: optionprice = $5, strike price = $100, option life = 2 months

30

20

10

0-5

70 80 90 100

110 120 130

Profit ($)

Terminalstock price ($)

7/30/2019 FMII Lecture 6 2012

23/40

23

Short Call on eBay

Profit from writing one eBay European call option: optionprice = $5, strike price = $100

-30

-20

-10

05

70 80 90 100

110 120 130

Profit ($)

Terminalstock price ($)

7/30/2019 FMII Lecture 6 2012

24/40

24

Long Put on IBM

Profit from buying an IBM European put option: optionprice = $7, strike price = $70

30

20

10

0

-770605040 80 90 100

Profit ($)

Terminal

stock price ($)

7/30/2019 FMII Lecture 6 2012

25/40

25

Short Put on IBM

Profit from writing an IBM European put option: optionprice = $7, strike price = $70

-30

-20

-10

7

070

605040

80 90 100

Profit ($)

Terminalstock price ($)

7/30/2019 FMII Lecture 6 2012

26/40

26

Examples

An airline has calculated that it will beprofitable as long as crude oil prices staybelow $120/barrel, but that it will lose $10m forevery dollar that prices rise above that. How

should it hedge?

I am generally bullish on XYZ company, but Ialso feel that the market is underestimating therisk of a sharp fall. What position should Itake?

7/30/2019 FMII Lecture 6 2012

27/40

27

Call Option Value Prior to Expiration

Value intrinsic value

(option (stock price - exercise price)

premium) Before exercise

price$12.50 Time Value

$10.00 ($2.50)

X = $50 S = $60 Stock Price

7/30/2019 FMII Lecture 6 2012

28/40

28

Option Valuation

The Black-Scholes option pricing model isused to calculate the value of standard(vanilla) options based on certain

assumptions: in particular about future

volatility of the underlying asset. Increasedvolatility makes options more valuable.

Exotic options may need more complex

valuation models.

7/30/2019 FMII Lecture 6 2012

29/40

29

Swaps A swap is as an agreement between two parties

to exchange assets and/or a series of cash flowsin the future

Swaps can be thought of as a series of individualforward agreements stretching into the future.

They are typically used for hedging rather thanspeculation. They are generally used to hedgeinterest rate (fixed vs. floating) and foreignexchange exposures.

Swaps are OTC derivatives, and are highlycustomised to users needs. Many different typesexist.

7/30/2019 FMII Lecture 6 2012

30/40

30

Firm 1 Firm 2

USD

Assets

GBP

Liabilities

GBP

Assets

USD

Liabilities

GBP

USD

7/30/2019 FMII Lecture 6 2012

31/40

31

What Do Derivatives Achieve?

Derivatives allow firms to hedge their risks cheaply

and efficiently. They are also a very effective toolfor speculation.

The sector is very innovative, with new derivatives

being created in response to client need. But they can be controversial. The high gearing and

complexity of some derivatives, sometimes coupledwith outright fraud, has led to some massive losses.

Nick Leeson was just one example.

They are a very powerful tool if used correctly, butdangerous if used badly!

OTC D i ti O t t di

7/30/2019 FMII Lecture 6 2012

32/40

32

OTC Derivatives Outstanding(notional amount, $bn)

Dec-04 Dec-07

FX 29,289 56,238Forwards & swaps 23,174 43,490

Options 6,115 12,748

Interest rates 190,502 393,138

FRAs 12,789 26,599

Swaps 150,631 309,588Options 27,082 56,951

Equity-linked 4,385 8,509

Forwards and swaps 756 2,233

Options 3,629 6,276

Commodity 1,443 9,000

CDS 6,396 57,894

Unallocated 25,879 71,225

Total 257,894 596,004

Source: BIS

7/30/2019 FMII Lecture 6 2012

33/40

33

Summary

Futures/forwards: agreements which obligetwo parties to buy/sell at a specified futuredate at a price agreed now.

Options: give the holder the right to buy (call)or sell (put), but no obligation

Swaps: a longer-term set of cashflow

exchanges, typically to alter interest rate orFX risk.

7/30/2019 FMII Lecture 6 2012

34/40

34

BEHAVIOURAL FINANCE

Why arent we as smart as we think we are?

7/30/2019 FMII Lecture 6 2012

35/40

35

So far we have considered how rational

investors should behave. But it is not alwaysclear that investors do behave rationally. Inparticular it seems strange that we see so manyboom/bust cycles in asset prices.

Behavioural finance is where finance andpsychology overlap. It seeks to identify areas inwhich people dont behave in the rational profit-

maximising way that theory would suggest. Alarge number of effects has been identified,some of which overlap.

7/30/2019 FMII Lecture 6 2012

36/40

36

The endowment effect: we appear to put greatervalue on things that we already own compared to

equally valuable items that we dont. In particular,we tend to fall in love with assets already in our

portfolios.

Confirmation bias: we tend to give more weight to

evidence that supports our existing beliefs.

Over-confidence: we underestimate uncertaintyand overestimate our own abilities.

Attribution bias: we tend to interpret evidence inself-serving ways, eg. profitable investments weredue to our skill, but losses were due to bad luck.

7/30/2019 FMII Lecture 6 2012

37/40

37

Our objective may not be to maximise profit,but to minimise regret. We find it very hard to

sell an asset at a loss, since this requires us toadmit we were wrong!

More generally, prospect theory suggests that

how we respond to choices is very sensitive tothe way in which they are presented to us (howthey are framed).

7/30/2019 FMII Lecture 6 2012

38/40

38

Herd behaviour: we have a strong instinct to

conform, and have a tendency to believesomething when everyone else believes it too(social proof, group-think). For example,everyone knows that internet stocks really are

worth P/E ratios over 100! Anchoring: the price of an asset begins to feel

justified just because it has become familiar.

7/30/2019 FMII Lecture 6 2012

39/40

39

Behavioural finance is a relatively new andgrowing field. It has two key uses:

It may help us understand market

behaviour

It is a useful test of our own behaviour:are we sure that we arent falling into

any of these traps ourselves?

Conclusion

7/30/2019 FMII Lecture 6 2012

40/40

40

Reading

Derivatives

Madura Ch 14 (first half)

Bain/Howells 9.3 - 9.6

Behavioural Finance:

Nofsinger The Psychology of Investing