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The financial system
Indirect finance
Financial markets
Money
Direct finance
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The Nature of Derivatives
• A derivative is a financial instrument (contract) 2paries buyer seller c/f
whose value depends on (is derived from) the value of some
other financial instrument, called the underlying
2paries buyer seller c/f
eg: buy car from ICBC assets value high insurance is useless
assets value low, insurance valuable
• Common examples of underlying assets are stocks, bonds,
corn, pork, wheat, rainfall, etc.
underlying assets can be real assets houses cars/financial
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Basic purpose of derivatives
• In derivatives transactions, one party’s loss is
always another party’s gain (zero-sum game).
• The main purpose of derivatives is to transfer risk
from one person or firm to another, that is, to
provide hedge or insurance.
• If a farmer before planting can guarantee a certain
price she will receive, she is more likely to plant.
• Derivatives improve overall performance of the
economy.
• Eg buy Apple share positive net value (NPV) project
• Hedging: liminates downside/ upside risk; weeds price go up/down; price go up don’t
hedge, go down hedge
• Insuring covers the downside, liability/zero to ICBC
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Increased Volatility (risk/dispersion of returns large standard
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Increased Volatility…Gold Prices
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…Led to New and Big Markets
• Exchange-traded derivatives
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Examples of Derivatives
• Forward (counter) and Futures (exchange) Contracts
Allows parties to trade in the future at a set price at a future
point in time
• Swaps (one party hold the money the other hold the stock
and swap the cash flows)
Can swap from mortgages/ swap interest payments etc
• Options
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Ways Derivatives are Used
• Risk management: To hedge risks
• Speculation: To take a view on the future direction
of the market
• Reduce transaction costs
• Regulatory arbitrage
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Basic Transactions
• Buying and selling a financial asset
• Brokers: commissions
• Market-makers: bid-ask (offer) spread
day trader 2 legs one to sell one to buy
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Futures
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Electronic Trading
• Traditionally futures contracts have been traded
using the open outcry system where traders
physically meet on the floor of the exchange
• This has now been largely replaced by electronic
trading and high frequency (algorithmic) trading
has become an increasingly important part of the
market
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Examples of Futures Contracts
Agreement to:
• buy 100 oz. of gold @ US$1200/oz. in
December
• sell £62,500 @ 1.5500 US$/£ in May
• sell 1,000 bbl. of oil @ US$60/bbl. in April
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Example
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Futures trading
• Exchanges need to provide assurances that the
parties will honor the contract.
• In futures trading, this is done through the clearing
corporation through margin accounts.
• Margin accounts guarantee that when the contract
comes due, the parties will be able to pay.
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Over-the Counter Markets
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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 popular on currencies and
interest rates.
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Foreign Exchange Quotes for USD/GBP
exchange rate on May 13, 2015
Bid Offer
Spot 1.5746 1.5750
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Example
• On May 13, 2015 the treasurer of a corporation
might enter into a long forward contract to sell
£100 million in six months at an exchange rate of
1.5736
• This obligates the corporation to pay £1 million and
receive $157.36 million on December 13, 2015
• What are the possible outcomes?
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Options
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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
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Google Call Option Prices (May 13, 2015
Stock Price: bid 532.20, offer 532.34)
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Google Put Option Prices (June 25, 2015
Stock Price: bid 532.20, offer 532.34; See page 8)
Fundamentals of Futures and Options Markets, 9th Ed, Ch 1, Copyright © John C. Hull 2016
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Net profit from purchasing a contract consisting of 100
December call options with a strike price of $550 for
$29 per option
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Net profit from selling a contract consisting of 100
September put options with a strike price of $525 for
$22.40 per option
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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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Hedging Examples
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Value of Shares with and without Hedging
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Speculation Example
• 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?
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Arbitrage Example
• A stock price is quoted as £100 in London and
$152 in New York
• The current exchange rate is 1.5500
• What is the arbitrage opportunity?
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Gold: An Arbitrage Opportunity?
• Suppose that:
• The spot price of gold is US$1,100 per ounce
• The quoted 1-year futures price of gold is US$1,200
• The 1-year US$ interest rate is 2% per annum
• No income or storage costs for gold
• Is there an arbitrage opportunity?
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Gold: Another Arbitrage Opportunity?
• Suppose that:
• The spot price of gold is US$1,100
• The quoted 1-year futures price of gold is US$1,050
• The 1-year US$ interest rate is 2% per annum
• No income or storage costs for gold
• Is there an arbitrage opportunity?
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