Introduction To Financial Markets Unit 6 PDF

Introduction to Financial Markets Unit 6 Derivatives: Forwards, Futures and Swaps Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 33  Setting the Sce...

Introduction to Financial Markets Unit 6 Derivatives: Forwards, Futures and Swaps Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 33  Setting the Scene Section 1 Setting the Scene Prof. Dr. M. De Ceuster Introduction to Financial Markets 2 / 33  Setting the Scene Quote Nb 1 Prof. Dr. M. De Ceuster Introduction to Financial Markets 3 / 33  Setting the Scene Quote Nb 2 “Whether you love derivatives or hate them, you cannot ignore them!” John Hull Prof. Dr. M. De Ceuster Introduction to Financial Markets 4 / 33  Setting the Scene Quote Nb 3 Prof. Dr. M. De Ceuster Introduction to Financial Markets 5 / 33  Setting the Scene Definition A derivative (syn: contingent claim) is an instrument whose payoff depends on one or several other uncertain underlying variables. Prof. Dr. M. De Ceuster Introduction to Financial Markets 6 / 33  Setting the Scene Taxonomy Linear products Forward contracts Futures Swaps Non-linear products Options Prof. Dr. M. De Ceuster Introduction to Financial Markets 7 / 33  Setting the Scene Other Derivative Classifications Based on the underlying Equity derivatives Interest rate derivatives Currency derivatives Commodity derivatives Credit derivatives Property derivatives... Based on the nature of the market Exchange traded OTC Prof. Dr. M. De Ceuster Introduction to Financial Markets 8 / 33  Setting the Scene Why Derivatives Are Important Biggest financial markets with outstanding notionals that are a multiple of world GDP. Derivatives enable us to transfer risks efficiently. Many financial products have embedded derivatives (bonds, structured products,...). In capital budgeting, real options allow enhanced NPV calculations by including value creation through flexibility. Prof. Dr. M. De Ceuster Introduction to Financial Markets 9 / 33  Setting the Scene Users Hedgers Speculators Arbitrageurs Prof. Dr. M. De Ceuster Introduction to Financial Markets 10 / 33  Spot contracts Section 2 Spot contracts Prof. Dr. M. De Ceuster Introduction to Financial Markets 11 / 33  Spot contracts The Spot Contract A spot contract is an agreement concluded today in which two counterparties agree to buy or sell a well specified asset at a certain price with an almost immediate (max. within 3 days) delivery and payment. If you hold an asset you have a long position in that asset. You will gain if the asset price increases. Short selling i.e. selling borrowed securities (on an up-tick except for indices), allows you to take a short position. The short will gain if the asset price decreases. Prof. Dr. M. De Ceuster Introduction to Financial Markets 12 / 33  Spot contracts Spot Contract Payoff Diagram Pay Off Diagram of a Spot Contract 50 40 30 PayOff 20 10 0 0 10 20 30 40 50 S Prof. Dr. M. De Ceuster Introduction to Financial Markets 13 / 33  Forward Contracts Section 3 Forward Contracts Prof. Dr. M. De Ceuster Introduction to Financial Markets 14 / 33  Forward Contracts The Forward Contract A forward contract is an agreement concluded between two coun- terparties in the OTC market in which they agree to buy or sell an underlying asset at a certain time in the future (i.e. the maturity date) for a contracted delivery price. Positions Long = obligation to buy, Short = obligation to sell. Prof. Dr. M. De Ceuster Introduction to Financial Markets 15 / 33  Forward Contracts Delivery Modes P hysical delivery for stocks, currencies, commodities,... Settlement in cash is used whenever physical delivery is not practical or not possible. Examples are indices, volatility,... Prof. Dr. M. De Ceuster Introduction to Financial Markets 16 / 33  Forward Contracts Why Trade a Forward Contract? In order to hedge i.e. to eliminate cash flow uncertainty from a future transaction. The future uncertainty can stem from Exchange rate uncertainty Interest rate uncertainty Commodity price uncertainty... In order to speculate when a position is taken without the existence of an underlying existing exposure. Prof. Dr. M. De Ceuster Introduction to Financial Markets 17 / 33  Forward Contracts Main Characteristics Bilateral contract which is directly negotiated between buyer and seller. Highly customizable contract that can be tailored to the needs of the parties. Settled at the maturity date (expiration date). Both parties are exposed to default risk (credit risk). The obligations can not be transferred unilaterally to another third party. Prof. Dr. M. De Ceuster Introduction to Financial Markets 18 / 33  Forward Contracts The Payoff The payoff from a contract is the net cash flow generated by the contract at maturity date. The payoff is the value of a contract at the maturity date. Forwards are a zero sum game. The payoff of the short position is the negative of the payoff of the long position. Prof. Dr. M. De Ceuster Introduction to Financial Markets 19 / 33  Forward Contracts The Payoff of the Forward Contract Variable Notation Delivery Price DP Maturity date T Spot price S Value of position at date T fTposition Position Long : fTlong = S T ≠ DP Short : fTshort = DP ≠ S T Prof. Dr. M. De Ceuster Introduction to Financial Markets 20 / 33  Forward Contracts The Payoff of the Forward Contract Pay Off Diagram of a Long Forward Pay Off Diagram of a Short Forward 20 20 10 10 PayOff PayOff 0 0 −1 −1 0 0 −2 −2 0 0 0 10 20 30 40 50 0 10 20 30 40 50 S S Prof. Dr. M. De Ceuster Introduction to Financial Markets 21 / 33  Forward Contracts Linearity The payoff profile shows that a forward is a linear product. For every Ä1 increase/decrease in the price of the underlying, the payoff of the derivative increases/decreases also with Ä1. The payoff profile of the forward is a shifted version from the payoff profile of the stock. Prof. Dr. M. De Ceuster Introduction to Financial Markets 22 / 33  Forward Contracts Delivery Price In standard contracts, the delivery price is chosen in such a way that the contract has zero value to both parties (i.e. neither party pays anything to the counterparty). Hence f0long = f0short = 0. Example: Assume a cash market (i.e. a spot market) for buying paintings. A painting costs Ä1000. Assume you can borrow and lend at 5 % p.a. Assume I ask you to buy the painting on the spot market and sell it simultaneously forward to me for delivery in one year. How much would you charge me as the delivery price? The forward price equals €1000 ◊ (1 + 5% ) = Ä1050. Prof. Dr. M. De Ceuster Introduction to Financial Markets 23 / 33  Forward Contracts The Forward Price as Delivery Price Choosing a different delivery price as the forward price will lead to arbitrage. If F>S, borrow S, buy S and go short in the forward to make a riskless arbitrage profit. If F