1.1

Introduction

What are Derivatives?

• Derivatives are zero net supply bilateral contracts deriving their values from some underlying asset, reference rate, or index.

1.2

Examples of Derivatives

• Futures Contracts

• Forward Contracts

• Swaps

• Options

1.3

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

1.4

Forward Contracts• Obligates one party to buy (the long position) and the

other party to sell (the short position) an asset or commodity in the future for an agreed-upon price.

• Physical delivery contract• Cash-settled contract• Trade only in an over-the-counter (OTC) market• communication among traders is over the phone• Examples:• buy 5,000 oz. of gold @ US$400/oz. in one year• sell £1,000,000 @ 1.5000 US$/£ in six months• earn a 4% rate of interest on a US$ deposit for a 3-

month period starting in six months

1.5

How a Forward Contract Works• The contract is a private agreement between

two counterparties• Normally, the price in the contract is chosen

so that the contract’s initial market value is zero– => no money changes hands when first

negotiated & the contract is settled at maturity– Think about a forward contract as the decision to

delay the sale or purchase of an asset three months, for example, from today.

1.6

Futures Contracts• Like a forward:

– Obligates one party to buy (the long position) and the other party to sell (the short position) an asset or commodity in the future for an agreed-upon price.

• Physical delivery contract• Cash-settled contract

• Unlike a forward:– Trade on a futures exchange and are subject to daily

settlement

• Evolved out of forwards and possess many of the same characteristics

1.7

Exchanges Trading Futures

• Chicago Board of Trade

• Chicago Mercantile Exchange

• LIFFE (London)

• Eurex (Europe)

• BM&F (Sao Paulo, Brazil)

• TIFFE (Tokyo)

• and many more (see list at end of book)

1.8

Options

• An option gives its owner the right to purchase or sell an asset on or before some date in the future.

– Call versus Put options

– American and European Options

– Physical delivery versus cash-settled options

1.9

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)

1.10

Main Differences between Options and Futures: Hedging Strategies

Feature Futures (or Forwards)

Options

Type of strategy Symmetric Asymmetric

Up-f ront costs $0.00 Option premium

Flexibility Less than option More than f utures

Contract obligation w.r.t. transacting

Obligated to buy or sell at predetermined price

Have the right to buy or sell at predetermined price

1.11

OTC vs. Exchange-Traded Derivatives:Contract Characteristics

Exchange-Traded• Terms specified by “listing

agents” (i.e. exchange)• The main non-standard

item in most exchange-traded derivatives is the price, which is determined in the market place

– Pure open outcry (CME)– Physical delivery mkt (CBOE)– Electronic dealer market

(AMEX)– Electronic limited order book

(Sydney Futures Exch.)

OTC• Specific terms defined

exclusively by the two counterparties

• General terms set forth in pro forma documentation called “master agreements”

– Can be customized through annexes to master agreements

1.12

OTC vs. Exchange-Traded Derivatives:Market Characteristics

Exchange-Traded• Organized market with

specific and detailed trading rules

• Exchange defines the rules of the game and enforces them

• Highly transparent• Quotes and prices are

available very rapidly by numerous services

OTC• Deals are negotiated in

opaque “market”• Dealer market where

brokers and dealers make two-way markets

• Sometimes brokered• Often lacks

“transparency”, esp. for customized and new transaction prices

• “Plain vanilla” products are more standardized

1.13

Types of Traders• Hedgers

– mainly interested in protecting themselves against adverse price changes

– want to avoid risk• Speculators

– hope to make money in the markets by betting on the direction of prices

– “accept” risk• Arbitrageurs

– arbitrage involves locking into riskless profit by simultaneously entering into transactions in two or more markets

1.14

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 $73 per share. A two-month put with a strike price of $63 costs $2.50. The investor decides to hedge by buying 10 contracts

1.15

Speculation Example

• An investor with $4,000 to invest feels that Amazon.com’s 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

• What are the alternative strategies?

1.16

Arbitrage Example

• A stock price is quoted as £100 in London and $172 in New York

• The current exchange rate is 1.7500

• What is the arbitrage opportunity?

1.17

1. Gold: An Arbitrage Opportunity?

• Suppose that:– The spot price of gold is US$390– The quoted 1-year futures price of gold

is US$425– The 1-year US$ interest rate is 5% per

annum• Is there an arbitrage opportunity?

1.18

2. Gold: Another Arbitrage Opportunity?

• Suppose that:– The spot price of gold is US$390– The quoted 1-year futures price

of gold is US$390– The 1-year US$ interest rate is

5% per annum• Is there an arbitrage opportunity?

1.19

The Futures Price of Gold If the spot price of gold is S & the futures price is

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=390, T=1, and r=0.05 so that

F = 390(1+0.05) = 409.50

1.20

Derivative Resources on the Web

• Exchange information and contract specifications are available for all major exchanges

• Real-time pricing and volume data

• Educational tools

• Futures Exchange or Gov’t Agency Internet Site

• New York Mercantile Exchangehttp://www.nymex.com

• Kansas City Board of Tradehttp://www.kcbt.com

• Chicago Mercantile Exchangehttp://www.cme.com

• Chicago Board of Tradehttp://www.cbot.com

• Chicago Board Options Exchangehttp://www.cboe.com

• Minneapolis Grain Exchangehttp://www.mgex.com

• New York Cotton Exchangehttp://www.nyce.com

• Coffee, Sugar & Cocoa Exchangehttp://www.csce.com

• CFTC http://www.cftc.gov

1.21

Forward, Futures, and Swaps

• The first section of the course will cover forward, futures and swaps.

• Relevant Chapters in Textbook (4th edition)– Mechanics of Futures and Forward Markets (Ch.

2)– The Determination of Forward and Futures Prices

(Ch. 3)– Hedging Strategies using Futures (Ch. 4)– Interest-Rate Futures (Parts of Ch. 5)– Swaps (Ch. 6)