Ch01HullOFOD10thEdition.pptx

Chapter 1 Introduction 1 What is a Derivative? A derivative is an instrument (an agreement between two parties (counterparties)) to transact an underlying asset or an underlying reference price, interest rate or index at a future date for an agreed upon price (has different names depending on the de...

Chapter 1 Introduction 1 What is a Derivative? A derivative is an instrument (an agreement between two parties (counterparties)) to transact an underlying asset or an underlying reference price, interest rate or index at a future date for an agreed upon price (has different names depending on the derivative contract). The value of the derivative, thus, depends on, or is derived from, the value of the underlying (another asset). Examples: futures, forwards, swaps, options, exotics… 2 What is a Derivative? The derivative market vs the spot (cash) market Derivative market Spot (cash) market Price Forward, future, strike (exercise) price Spot price Payment On the expiry date of the contract Immediate (or some time later using a credit agreement) Delivery On the expiry date Immediate Obligation Depending on the type of the derivative contact Yes (always) 3 Why Derivatives Are Important Derivatives play a key role in allocating risks in the economy by transferring risks between parties such that each holds the risk it is better or more willing to bear The underlying assets can be a financial asset such as stocks, currencies, interest rates, debt instruments, insurance payouts Real assets like agricultural commodities metals and sources of energy. electricity prices, the weather, etc Many financial transactions have embedded derivatives The real options approach to assessing capital investment decisions has become widely accepted 4 How Derivatives Are Traded On organised exchanges such as the Chicago Board Options Exchange (CBOE) Open outcry system (https://www.youtube.com/watch?v=aluuekJIhWI) Electronic trading In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers etc. contact each other directly over the phone usually and execute transactions privately 5 The OTC Market Prior to 2008 Largely unregulated Banks acted as market makers quoting bids and offers (e.g. forward exchange rates quotes offered by Barclays) Master agreements usually defined how transactions between two parties would be handled But some transactions were cleared through central counterparties (CCPs). A CCP stands between the two sides to a transaction in the same way that an exchange does. 6 Since 2008… OTC market has become regulated. Objectives: Reduce systemic risk (see Business Snapshot 1.2, page 5) Reduce counterparty risk Increase transparency to increase liquidity In the U.S and some other countries, standardized OTC products must be traded on swap execution facilities (SEFs) which are electronic platforms similar to exchanges CCPs must be used to clear standardized transactions between financial institutions in most countries All trades must be reported to a central repository (to enhance transparency). 7 Size of OTC and Exchange-Traded Markets (Figure 1.1, Page 5) Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017 8 The Lehman Bankruptcy (Business Snapshot 1.1) Lehman’s 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 9 How Derivatives are Used To hedge risks To speculate or for price discovering (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 10 Forward contracts An agreement that obligates two parties to exchange (buy or sell) an asset @ an agreed upon prices (i.e. Forward price) @ an agreed upon date (settlement date) Traded on OTC and Tailor made (in terms of the size and settlement date of the contract) Forward contract on foreign exchange rates are popular large financial institutions post foreign exchange rates quotes (e.g. Barclays) 11 Foreign Exchange Quotes for GBP, May 26, 2013 (See page 6) Spot Bid 1.5541 Offer 1.5545 1-month forward 1.5538 1.5543 3-month forward 1.5533 1.5538 6-month forward 1.5526 1.5532 12 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 that would make the contract worth exactly zero) No arbitrage principle The forward price may be different for contracts of different maturities (as shown by the table) Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017 13 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 14 Example (pages 6-7) On May 6, 2013, the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.5532 This obligates the corporation to pay $1,553,200 (1.5532*1000000) for £1 million on November 6, 2013 What are the possible outcomes? 15 Example (pages 6-7) Position Payoff Long Spot Price @ maturity – forward price (delivery price) ST – K Unlimited gain potential, theoretically Limited loss potential (i.e. K only if ST is zero) Short forward price (delivery price) – Spot Price @ maturity K – ST Limited gain potential (i.e. K only if ST is zero) Unlimited loss potential, theoretically The short position is inherently riskier 16 Example (pages 6-7) If ST =1.60 Payoffs=ST – K =[(1.60*1000000) – (1,553,200)] =$46800 If ST =1.50 Payoffs=ST – K =[(1.50*1000000) – (1,553,200)] = – $53200 17 Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered into) Profit K Price of Underlying at Maturity, ST K 18 Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into) Profit K K Price of Underlying at Maturity, ST 19 Futures Contracts (page 8) Agreement to buy or sell an asset for a certain price (the future price) at a certain time Whereas a forward contract is traded OTC, a futures contract is traded on an exchange While these contracts are traded differently, they both operate under the same essential framework The differences are enumerated in the sequel 20 Futures vs forward Contracts Forwards Futures Agreement to buy or sell an underlying asset at a later date Agreement to buy or sell an underlying asset at a later date Traded OTC with customized features Exchange traded with standardized features Not guaranteed by a clearinghouse; Limited regulation and reporting Regulated, transparent, and traded through a clearinghouse Gains and losses settled at maturity Daily settlement of gains and losses marked to market 21 Exchanges Trading Futures CME Group (formed when Chicago Mercantile Exchange and Chicago Board of Trade merged) InterContinental Exchange BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book) 22 Examples of Futures Contracts Agreement to: Buy 100 oz. of gold @ US$1300/oz. in December Sell £62,500 @ 1.4500 US$/£ in March Sell 1,000 bbl. of oil @ US$50/bbl. in April 23 Arbitrage In well-functioning markets with low transaction costs and a free flow of information, identical assets must sell for the same price. This is referred to as the Law of One Price. If identical assets do not sell at the same price, a trader could buy the cheaper asset and sell it in the more expensive market, earning a riskless profit. This is known as arbitrage (capturing price differences on identical assets to earn a riskless profit). The combined action of arbitrageurs continues until the prices of identical assets converge. Arbitrage is a relative valuation methodology. It tells us the correct price of one asset or derivative relative to another asset or derivative. 24 Arbitrage and Market Efficiency The forces of arbitrage in financial markets assure us that: the same asset cannot sell for different prices nor can two equivalent combinations of assets that produce the same results sell for different prices Markets in which arbitrage opportunities are either nonexistent or quickly eliminated are relatively efficient markets. Efficient markets fairly compensate investors for risk. Arbitrage opportunities give investors a return above the riskfree rate without taking risk. The abnormal returns generated by arbitrage are a violation of market efficiency. 25 1. Gold: An Arbitrage Opportunity? Suppose that: The current spot price of gold is US$1,200 The 1-year forward price of gold is US$1,300 The 1-year US$ interest rate is 5% per annum The convenience yield on gold equals storage costs equals zero. Is there an arbitrage opportunity? 26 1. Gold: An Arbitrage Opportunity? (fair price calc) The fair price is  F = S (1+r )T IF F – S (1+r )T ≠0  then there exists an arbitrage opportunity F = S (1+r )T 1300 ≠ 1200(1+0.05) 1 1300 ≠1260 Therefore, the answer is Yes there is an arbitrage opportunity. But, how can we formulate a trading strategy to exploit it without having to commit an initial investment and take risk?  I will show you !!! 27 1. Gold: An Arbitrage Opportunity? (trading strategy) T=0 (now) Borrow US$1,200 @ 5% Buy @ spot price US$1,200 Sell it forward @ US$1,300 T=1 (in one year time) Receive the proceeds US$1,300 Repay the loan with the interest US$1260 [1200+(0.05*1200)] Earn a profit of US$40 (1300 – 1260) 28 Gold: An Arbitrage Opportunity? (Cash flows) T=1 +1300 1260- )1.05*1200=( 40 T=0 1200 12000 29 2. Gold: Another Arbitrage Opportunity? Suppose that: - The spot price of gold is US$1,200 - The 1-year forward price of gold is - US$1,200 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity? 30 The 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) riskfree rate of interest. In our examples, S = 1200, T = 1, and r =0.05 so that F = 1200(1+0.05) = 1,260 Since F – S (1+r )T ≠0  then there exists an arbitrage opportunity 31 Arbitrage Opportunity(trading strategy) T=0 (now) Sell @ spot price US$1,200 Lend US$1,200 @ 5% Buy the forward @ US$1,200 T=1 (in one year time) Withdraw the deposit with the interest US$1260 [1200+(0.05*1200)] Buy it back @ 1200 Earn a profit of US$ 60 (1260 – 1200) 32 Gold: An Arbitrage Opportunity? (Cash flows) T=1 1260 )1.05*1200=( 1200 60 Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017 T=0 1200 12000 33 1. Oil: An Arbitrage Opportunity? Suppose that: - The spot price of oil is US$50 - The quoted 1-year futures price of oil is - US$60 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity? 34 2. Oil: Another Arbitrage Opportunity? Suppose that: - The spot price of oil is US$50 - The quoted 1-year futures price of oil is - US$40 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity? 35 Options An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date. A call option is an option to buy a certain asset by a certain date for a certain price (the strike or exercise price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike or exercise price) 36 Options payoffs Notations: ST: the price of the underlying at the expiration date,T X: the exercise or strike price of the option Payoff to the call buyer: cT = Max(0,ST – X) Payoff to the put buyer: pT = Max(0, X – ST) Payoff to the call seller: – cT [i.e. – Max(0, ST – X)] Payoff to the put seller: – pT = [i.e.– Max(0, X – ST)] 37 Options payoffs (show me the money!) For a call option ST – X>0  in the money ST – X0  in the money X – ST 880 say 1000, the option can be excised i.e. obtain the 100 shares @$880 and sell them @1000 and earn a profit of $12000 [($1000*100)-($880*100)] or after taken the premium paid $6370 (12000-5630) 45 Example (sell a Put option) Suppose an investor instructs a broker to sell one September put option contract on Google with a strike price of $840. Which table? The second @ bid or offer? Bid (because we are selling) What is the bid price? $31 On how many shares is the option written? 100 shares How much the investor will pay? Nothing!! He will receive $3100 (=31*100) this amount will be remitted to the seller of the option 46 Example (sell a Put option) There are two potential scenarios the share price of Google >840, the option will expire worthless If the share price of Google < $840 say $800, the option can be excised i.e. buy the 100 shares @$840 and sell them @$800 and incur a loss of $4000 [($800*100)-($840*100)] or after taken the premium received -$900 (3100-4000) 47 Profits from buying a Call and selling a Put 48 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 49 Types of Traders Hedgers: use derivatives to control or eliminate a financial exposure Futures and forward contracts lock-in the price of the underlying asset and not allow for any upside potential Options hedge negative price movements and allow for upside potential since they have asymmetric payoffs 50 Types of Traders Speculators: use derivatives to bet on the market Futures require a small initial investment in the form of an initial margin requirement Because futures unlike option have symmetrical payoffs, they can result in large gains or large losses They main motivation for using derivatives in speculation is the limited initial outlay which create significant leverage 51 Types of Traders Arbitrageurs: seek to earn a riskless profit through the discovery of mispriced securities Riskless profits is earned by entering into equivalent offsetting positions in one or more markets (no initial investment is required). Arbitrage opportunities do not last long as the act of arbitrage brings prices back into equilibrium quickly. 52 Hedging Examples (pages 11-13) 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 $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts 53 Value of Microsoft Shares with and without Hedging (Fig 1.4, page 13) 40,000 Value of Holding ($) 35,000 No Hedging 30,000 Hedging 25,000 Stock Price ($) 20,000 20 22 24 26 28 30 32 34 36 38 54 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? 55 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? 56 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 in for their intended purpose Soc Gen (see Business Snapshot 1.4 on page 18) is an example of what can go wrong High leverage 57 High leverage Example Relatively small price changes in the underlying asset price can cause large swings in the counterparty equity. But how? E.g. One heating oil futures contract is written on 42000 gallons of heating oil @ a futures price of $1/gallon What is the value of the commodity that we control (notional value)? $42000($1*42000 gallon) 58 High leverage Example -A 1 cent increase in the futures price leads to change in the value of the futures contract of $420 ($0.01*42000 gallons) -How much is the as a percentage of the value of the contract? 1%(420/42000) -But where is the problem?! It is because of the small initial outlay in the form of a margin requirement of $5000 in this case 59 High leverage Example So, the 1% change in the price of heating oil, the margin (our equity) changes by 8.4% but how? That is very large change which means that leverage amplify the changes in the underlying asset—it is favorable in this case but prices can move in either directions up or down… 60 Hedge Funds (see Business Snapshot 1.3, page 12) Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. Mutual funds must disclose investment policies, make shares redeemable at any time, limit use of leverage Hedge funds are not subject to these constraints. Hedge funds use complex trading strategies are big users of derivatives for hedging, speculation and arbitrage 61 Types of Hedge Funds Long/Short Equities Convertible Arbitrage Distressed Securities Emerging Markets Global Macro Merger Arbitrage 62