EF4321: Derivatives & Risk Management

Lecture 1
Instructor: Dr. Junbo Wang Contact: 3442-9492 Email: jwang2@cityu.edu.hk Office: ACAD P7424 Office Hours: Mondays 9:0011:00, Wednesday 9:0011:00
or by appointment
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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. Derivatives can be dependent on almost any variable, from the price of hogs to the amount of snow falling at a certain ski resort.

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Examples of Derivatives
Forward Contracts Futures Contracts Swaps Options

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Derivatives Markets
Exchange traded
Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading. Contracts are standard, defined by the exchange, and there is virtually no credit risk. For example: Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME, www.cmegroup.com), Chicago Board Option Exchange (CBOE), Hong Kong future and Option Exchange (www.hkex.com.hk) and etc.

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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Size of OTC and Exchange Markets

550 500 450 400 350 300 250 200 150 100 50 0 Jun/98

Size of Market ($ trillion) OTC Exchange

Jun/99

Jun/00

Jun/01

Jun/02

Jun/03

Jun/04

Jun/05

Jun/06

Jun/07

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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Derivatives are BIG Business ...

BIS estimates of market size (in trillions of USD):

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... and a Rapidly Growing One

BIS estimates of market size (in trillions of USD):

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Ways Derivatives are Used

To hedge risks(?WHICH and HOW?) To speculate (take a view on the future direction of the market) To lock inan arbitrage profit To change the nature of a liability(?HOW and WHY?) To change the nature of an investment (?What and HOW)without incurring the costs of selling one portfolio and buying another
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Forward Contracts
A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price). It can be contrasted with a spot contract which is an agreement to buy or sell immediately. It is traded in the OTC marketusually between two financial institutions or between a financial institution and one of its clients.
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Foreign Exchange Quotes for USD/GBP Today (GBP=British Pound; USD=US dollar; quote is
number of USD per GBP)

Bid Spot 1.6281

Offer 1.6285

1-month forward
3-month forward 6-month forward

1.6248
1.6187 1.6094

1.6253
1.6192 1.6100

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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). The forward price may be different for contracts of different maturities. We will discuss in detail the relationship between spot and forward prices in following chapters. For a quick preview of why the two are related, lets check the following example: Suppose a stock that pay no dividend and is worth 60$, you can borrow or lend money for 1 year at 5%. What should the 1-year forward price of the stock be? 60/1.05
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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 3 June, 2013 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 3 December, 2013 What are the possible outcomes?

If the spot exchange rate rise to 1.7000, the forward contract would be worth $90,000 If the spot exchange rate fall to 1.5000, the forward contract would have a negative value, $-110,000

The payoff from a forward contract: (K: delivery price, ST is the spot price at
maturity of the contract.) For a long position: ST-K For a short position: K-ST

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Profit from a Long Forward Position

Profit

Price of Underlying at Maturity, ST

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Profit from a Short Forward Position

Profit

Price of Underlying 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 Whereas a forward contract is traded OTC, a futures contract is traded on an exchange. The exchanges specifies certain standardized features of the contract. The two parties to the contract dont necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored.

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Examples of Futures Contracts

Agreement to:

buy 100 oz. of gold @ US$1500/oz. in December 2013 (COMEX) sell 62,500 @ 1.5900 US$/ in December 2013 (CME) sell 1,000 bbl. of oil @ US$105/bbl. in December 2013 (NYMEX)

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The Forward Price of Gold (without any income and storage cost)
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 our examples, S = 1500, T = 1, and r =0.02 so that F = 1500(1+0.02) = 1530

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1. Gold: An Arbitrage Opportunity?

Suppose that:
- The spot price of gold is US$1500 - The 1-year forward price of gold is US$1550 - The 1-year US$ interest rate is 2% per annum

Is there an arbitrage opportunity?

(We ignore storage costs and gold lease rate)

Yes 1500*(1+2%)=1530, while 1530<1550

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2. Gold: Another Arbitrage Opportunity?

Suppose that:
- The spot price of gold is US$1500 - The 1-year forward price of gold is US$1510 - The 1-year US$ interest rate is 2% per annum

Is there an arbitrage opportunity? Yes, since 1530>1510

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The Forward Price of Oil (with some storage cost)

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+r +u)T where r is the 1-year (domestic currency) risk-free rate of interest, u is the storage cost. In our examples, S = 100, T = 1, r =0.02, and u=0.02, so that F =100*(1+0.02+0.02) = 104

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1. Oil: An Arbitrage Opportunity?

Suppose that:
The spot price of oil is US$100 The quoted 1-year futures price of oil is US$105 The 1-year US$ interest rate is 2% per annum The storage costs of oil are 2% per annum

Is there an arbitrage opportunity?

Yes. F=100*(1+2%+2%)=104, while 104<105

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2. Oil: Another Arbitrage Opportunity?

Suppose that:
The spot price of oil is US$100 The quoted 1-year futures price of oil is US$102 The 1-year US$ interest rate is 2% per annum The storage costs of oil are 2% per annum

Is there an arbitrage opportunity? Yes, 104>102

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Exchanges Trading Options

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Stock Exchange European Options Exchange Australian Options Market and many more (see list at end of book)

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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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Long Call on Microsoft

Profit from buying a European call option on Microsoft: option price = $5, strike price = $26 15 10 5 15 20 25 30 35 40

Profit ($)

0
-5

Terminal stock price ($)

45

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Short Call on Microsoft

Profit from writing a European call option on Microsoft: option price = $5, strike price = $26 5 0 -5 -10 -15
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Profit ($)
35 15 20 25 30 40 45

Terminal stock price ($)

Long Put on IBM

Profit from buying a European put option on IBM: option price = $7, strike price = $130 30 20 10

Profit ($)

0
-7

Terminal stock price ($)

100 110 120 130 140 150 160

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Short Put on IBM

Profit from writing a European put option on IBM: option price = $7, strike price = $130 Profit ($) 7 0 -10 -20 -30
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100 110 120

Terminal stock price ($) 130 140 150 160

Payoffs from Options

What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity Payoff Payoff K K Payoff K

ST
Payoff K ST

ST

ST
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Types of Traders
Hedgers Speculators Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators.
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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 $26 per share. A two-month put with a strike price of $24 costs $2.50. The investor decides to hedge by buying 10 contracts.

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Speculation Example
An investor with $4,800 to invest feels that Ciscos stock price will increase over the next 2 months. The current stock price is $24 and the price of a 2-month call option with a strike of 25 is $0.5.
What are the alternative strategies?

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Arbitrage Example
A stock price (HSBC) is quoted as US$53.5 in NYSE (1 for 5 ADR) and HK$82 in Hong Kong. The current exchange rate is 7.7800. What is the arbitrage opportunity?
Buy 400shares of the stock in Hong Kong and sell them in NYSE (53.5*80*7.78-82*400=498.4) Risk-free return is HK$498.4 (assume no transaction cost) Arbitrage opportunities cannot last for long.

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Introduction to Financial Risk Management

1. 2. 3. 4. A classic example of risk A shift in approach Three approaches to managing risk Why manage risk?

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A Classic Example of Risk

The technological advances of sea faring and ocean faring brought wealth in various parts of the world. Increase in trade Increase in consumption

High investment returns

HOWEVER: These high returns were accompanied by

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CATASTROPHIC RISK!
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A Shift in Approach

1.

Risk management for ship owners in the old days:

Pray to God

1. 2. 3.

Risk management for ship owners in more modern times:

Hedge risk by selling the ship (or part of the ship) Diversify risk by organizing a partnership with other ship owners Insure against losing the ship at sea.

Ship owner needs to weigh costs and benefits.

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Three Approaches to Managing Risk

Hedging : Eliminates an exposure by entering into an offsetting position. For example, an oil producer can hedge exposure to falling prices by selling oil futures. Diversification : Reduces risk by holding a large collection of independent assets.

Insurance : Purchasing insurance involves paying a premium for protection against unfavorable events.
The right approach depends on many factors
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Why Manage Risk? Risk and Opportunity

Taking risk is not bad, its just risky
Opportunities come with risk Avoiding risk altogether can also result in failure Higher returns come with higher risk Eliminating Risk is often impossible

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