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Lecture 2: Derivatives

Based on Chapter 1 from


John C. Hull (2012). Options, Futures &
Other Derivatives, 8th ed., Prentice Hall.
Derivatives: What and Why?
A derivative is a financial instrument whose value depends on,
or is derived from, the values of other (more basic) assets.
Examples: futures, forwards, swaps, options, exotics
Why derivatives are important?
Derivatives play a key role in transferring risks in the economy.
The underlying assets include stocks, currencies, interest rates,
commodities, debt instruments, electricity, insurance payouts, the
weather, etc.
Many financial transactions have embedded derivatives.
The real options approach to assessing capital investment decisions has
become widely accepted.

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How Derivatives Are Traded?
On exchanges such as the Chicago Board Options Exchange
(CBOE).
Traditionally exchanges used the open-outcry system (),
but increasingly they are switching to electronic trading.
Contracts are standard; there is virtually no credit risk.
In the over-the-counter (OTC) market where traders working
for banks, fund managers and corporate treasurers contact each
other directly.
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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The OTC Market Prior to 2008
Largely unregulated.
Banks acted as market makers quoting bids and offers.
Master agreements usually defined how transactions
between two parties would be handled.
But some transactions were handled by central
counterparties (CCPs). A CCP stands between the two sides
to a transaction in the same way that an exchange does.

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Since 2008
OTC market has become regulated. Objectives:
Reduce systemic risk
Increase transparency
In the U.S and some other countries, standardized OTC
products must be traded on swap execution facilities
(SEFs) which are similar to exchanges.
CCPs must be used for standardized transactions between
dealers in most countries.
All trades must be reported to a central registry.
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Size of OTC and Exchange-Traded Markets

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market.

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The Lehman Bankruptcy
Lehman Brothers filed for bankruptcy on September 15,
2008. This was the biggest bankruptcy in US history.
Lehman was an active participant in the OTC derivatives
markets and got into financial difficulties because it took
high risks and found it was unable to roll over its short
term funding.
It had hundreds of thousands of transactions outstanding
with about 8,000 counterparties.
Unwinding these transactions has been challenging for
both the Lehman liquidators and their counterparties.

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How 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
An agreement to buy or sell an asset at a certain
future time for a certain price.
Forward contracts are similar to futures except
that they trade in the over-the-counter (OTC)
market.
Forward contracts are particularly popular on
currencies and interest rates.

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Foreign Exchange Quotes for GBP
(May 26, 2013)
Bid Offer

Spot 1.5541 1.5545

1-month forward 1.5538 1.5543

3-month forward 1.5533 1.5538

6-month forward 1.5526 1.5532

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Terminology
The forward price for a contract is the delivery
price that would be applicable to the contract if it
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 (as shown by the table).
The party that has agreed to buy (or sell) has what
is termed a long (or short) position.
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Example
On May 26, 2013, the treasurer of a firm enters into a long
forward contract to buy 1 million in six months at an
exchange rate of $1.5532/.
This obligates the firm to pay $1,553,200 for 1 million six months
later, i.e., on Nov 26, 2013. Then what are the possible outcomes?
1. If the spot exchange rate rises to, say, $1.6000/ on Nov 26, 2013, the
forward contract would be worth $46,800 (= $1,600,000 - $1,553,200)
to the firm, which can buy 1 million at an exchange rate of $1.5532/
rather than the higher market rate of $1.6000/.
2. If the spot exchange rate falls to, say, $1.4000/ on Nov 26, 2013, the
forward contract would have a loss of $53,200 to the firm, because it
must buy 1 million at a rate of $1.5532/ rather than the lower market
rate of $1.4000/. ---- how to hedge against this big loss?
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Profit from a Long Forward Position
(K = delivery price = forward price at time contract is entered into)

Profit

Price of underlying ($/)


0
K at Maturity, ST

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Profit from a Short Forward Position
(K = delivery price = forward price at time contract is entered into)

Profit

0 Price of underlying ($/)


K at Maturity, ST

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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.
While a forward contract is traded OTC, a futures contract
is traded on an exchange such as:
CME Group (formed when Chicago Mercantile Exchange and
Chicago Board of Trade merged)
NYSE Euronext (acquired by InterContinental Exchange)
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
And many more (see list at end of textbook)
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Exchanges in China Trading Futures
Shanghai Financial Futures Exchange
Shanghai Futures Exchange
Copper, aluminum, natural rubber, fuel oil, zinc and gold
China Financial Futures Exchange
CSI 300 index futures
Dalian Commodity Exchange
Corn, Soybeans
Zhengzhou Commodity Exchange
Wheat, Cotton, Rapeseed Oil, Sugar

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Examples of Futures Contracts
Agreements to:
Buy 100 oz. of gold @ US$1400/oz. in
December.
Sell 62,500 @ 1.5500 US$/ in March.
Sell 1,000 bbl. of oil @ US$50/bbl. in April.
Barrel (bbl):

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Gold: Any Arbitrage Opportunities?
Example G1. Suppose that:
The spot price (S) of gold is US$1,400.
The 1-year forward price (F1) of gold is US$1,500.
The 1-year US$ interest rate (r) is 5% per annum.
Is there an arbitrage opportunity?
Example G2. Suppose that:
The spot price of gold is US$1,400.
The 1-year forward price (F2) of gold is US$1,400.
The 1-year US$ interest rate is 5% per annum.
Is there an arbitrage opportunity?
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Forward Price of Gold (ignores the gold lease rate)
If the spot price of gold is S and the forward price 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 the previous examples, S = 1,400, T = 1, and r = 0.05, so
F = 1,400(1 + 0.05) = 1,470.
In Example G1, F1 = 1,500 > F. You can sell or take a short position
to earn arbitrage profit.
In Example G2, F1 = 1,400 < F. You can buy or take a long position
to earn arbitrage profit.
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Oil: Any Arbitrage Opportunities?
Example O1. Suppose that:
The spot price (S) of oil is US$95.
The quoted 1-year futures price (F1) of oil is US$125.
The 1-year US$ interest rate (r) is 5% per annum.
The storage cost (c) of oil is 2% per annum.
Is there an arbitrage opportunity?
Example O2. Suppose that:
The spot price (S) of oil is US$95.
The quoted 1-year futures price (F2) of oil is US$80.
The 1-year US$ interest rate (r) is 5% per annum.
The storage cost (c) of oil is 2% per annum.
Is there an arbitrage opportunity?
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Forward Price of Oil
If the spot price of oil is S, and the forward price for a contract
deliverable in T years is F, then
F = S (1 + c + r)T
where r is the 1-year (domestic currency) risk-free rate of
interest, and c is the storage cost for oil.
In the previous examples, S = 95, T = 1, r = 0.05, c = 0.02, so
F = 95(1 + 0.02 + 0.05) = 101.65.
In Example O1, F1 = 125 > F. You can sell or take a short position to
earn arbitrage profit.
In Example O2, F1 = 80 < F. You can buy or take a long position to
earn arbitrage profit.

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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).
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.
Exchanges trading options
Chicago Board Options Exchange (CBOE); American Stock Exchange
LIFFE (London); Eurex (Europe)
Hong Kong Exchanges and Clearing; Shanghai Stock Exchange
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Google Call Option Prices from CBOE
(May 8, 2013; Stock Price is bid 871.23, offer 871.37)
Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer

820 56.00 57.50 76.00 77.80 88.00 90.30

840 39.50 40.70 62.90 63.90 75.70 78.00

860 25.70 26.50 51.20 52.30 65.10 66.40

880 15.00 15.60 41.00 41.60 55.00 56.30

900 7.90 8.40 32.10 32.80 45.90 47.20

920 n.a. n.a. 24.80 25.60 37.90 39.40

The price of a call option decreases as the strike price increases,


and increases as the time to maturity increases.
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Google Put Option Prices from CBOE
(May 8, 2013; Stock Price is bid 871.23, offer 871.37)
Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer

820 5.00 5.50 24.20 24.90 36.20 37.50

840 8.40 8.90 31.00 31.80 43.90 45.10

860 14.30 14.80 39.20 40.10 52.60 53.90

880 23.40 24.40 48.80 49.80 62.40 63.70

900 36.20 37.30 59.20 60.90 73.40 75.00

920 n.a. n.a. 71.60 73.50 85.50 87.40

The price of a put option increases as the strike price increases,


and increases as the time to maturity increases.
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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 (i.e., the option holder does not have to exercise the right).
Most of the options that are traded on exchanges are American.
In the exchange-traded equity option market, one contract is usually an
agreement to buy or sell 100 shares.
While it costs nothing to enter into a forward or futures
contract (because it is an obligation), there is a cost to
acquiring an option (because it is a right).

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Types of Traders
Hedgers
Use derivatives to reduce the risk they face from potential future
movements in a market variable (e.g., equity index).
Speculators
Use derivatives to bet on the future direction of a market variable.
Arbitrageurs
Take osetting positions in two or more instruments to lock in a prot.
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,
the case of Barings Bank on page 15 of textbook (7th ed.)
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Hedging Examples
1. A US company will pay 10 million for imports from Britain in
3 months and decides to hedge (against exchange rate changes)
using a long position in a forward contract.
2. An investor owns 1,000 Microsoft shares currently worth $28
per share. A two-month put option with a strike price of $27.50
costs $1. The investor decides to hedge by buying 10 put
contracts (one put contract has the right to sell 100 shares).
Value of 1,000 shares (without hedging) = 1,000ST, where ST is the share
price two-month later.
Value of 10 put contracts = 10 {100 [Max(27.5 ST, 0) 1]}.
Value of 1,000 shares (with hedging) = 1,000ST + 1,000[Max(27.5 ST, 0) 1]
= 1,000 [ST 1 + Max(27.5 ST, 0)] = 1,000 [Max(ST, 27.5) 1] { 26,500}

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Values of 1,000 Microsoft Shares
(with and without hedging)
40,000 Value of Holding
($)

35,000 No Hedging

Hedging
30,000

25,000

20,000 ST: Stock Price ($)


20 25 30 35 40

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Speculation Example (using options)
An investor with $2,000 to invest feels that a stock price will
increase over the next 2 months.
The current stock price is $20 and the price of a 2-month call
option with a strike of $22.50 is $1.
What are the alternative strategies?
Comparison of prots from two alternative strategies
for using $2,000 to speculate on a stock worth $20 now.
Stock price 2-month later
$15 $27
Strategy 1: Buy 100 shares -$500 $700
Strategy 2: Buy 2,000 call options -$2,000 $7,000

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Arbitrage Example
A stock price is quoted as 100 in London and
$150 in New York.
The current exchange rate is $1.5300/.
What is the arbitrage opportunity?
Buy in New York and sell in London.
Arbitrage definition:
no negative cash flow at any state;
a positive cash flow in at least one state;
possibility of a risk-free profit at zero cost.
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Dangers
Traders can switch from being hedgers to speculators
or from being arbitrageurs to speculators.
It is important to set up controls to ensure that trades
are using derivatives for their intended purpose.
SocGen is an example of what can go wrong. See page
18/39 of the textbook (9th /8th ed.).
Taking huge positions (tens of billions of euros) in
equity indices without hedged!

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Hedge Funds
Hedge funds are not subject to the same rules as mutual
funds and cannot offer their securities publicly.
Mutual funds must
disclose investment policies,
makes shares redeemable at any time,
limit use of leverage.
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies, and are big
users of derivatives for hedging, speculation and arbitrage.
Types of hedge funds:
Convertible Arbitrage Distressed Securities Emerging Markets
Global Macro Long/Short Equities Merger Arbitrage
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