1 MGT 821/ECON 873 Financial Derivatives Lecture 1 Introduction.
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Transcript of 1 MGT 821/ECON 873 Financial Derivatives Lecture 1 Introduction.
1
MGT 821/ECON 873
Financial Derivatives
Lecture 1Introduction
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What is a derivative?
A derivative is an instrument whose value depends on the values of other more basic underlying variables
Example:
Forward Contracts, futures contracts
Swaps
Options
Credit derivatives
Derivatives Markets
Exchange Traded standard products trading floor or computer trading virtually no credit risk
Over-the-Counter non-standard products telephone market some credit risk
4
Ways 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
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 The contract is an over-the-counter (OTC) agreement
between 2 companies The delivery price is usually chosen so that the initial
value of the contract is zero No money changes hands when contract is first
negotiated and it is settled at maturity
The 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)
The forward price may be different for contracts of different maturities
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Profit from a Long Forward Position
Profit
Price of Underlying at Maturity, STK
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Profit from a Short Forward Position
Profit
Price of Underlying at Maturity, STK
Example
On August 20, 2006 a trader enters into an agreement to buy £1 million in three months at an exchange rate of 1.6196
This obligates the trader to pay $1,619,600 for £1 million on November 20, 2006
What are the possible outcomes?
Profit from aLong Forward Position
Profit
Price of Underlying
at Maturity, STK
Profit from a Short Forward Position
Profit
Price of Underlying
at Maturity, STK
Futures - similar to forward but feature formalized and standardized characteristics Agreement to buy or sell an asset for a certain price at a certain time
Whereas a forward contract is traded OTC a futures contract is traded on an exchange
Key difference in futures Exchange traded Specifications need to be defined:
What can be delivered, Where it can be delivered, When it can be delivered
Settled daily
Futures
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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)
Exotic options
A put 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 IBM
Profit from buying an IBM European call option: option price = $5, strike price = $100, option life = 2 months
30
20
10
0-5
70 80 90 100
110 120 130
Profit ($)
Terminalstock price ($)
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Short Call on IBM
Profit from writing an IBM European call option: option price = $5, strike price = $100, option life = 2 months
-30
-20
-10
05
70 80 90 100
110 120 130
Profit ($)
Terminalstock price ($)
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Long Put on Exxon
Profit from buying an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths
30
20
10
0
-770605040 80 90 100
Profit ($)
Terminalstock price ($)
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Short Put on Exxon Profit from writing an Exxon European put option: option price =
$7, strike price = $70, option life = 3 mths
-30
-20
-10
7
070
605040
80 90 100
Profit ($)Terminal
stock price ($)
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Payoffs from Options
Payoff Payoff
ST STK
K
Payoff Payoff
ST STK
K
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Swaps
A swap is an agreement to exchange cash flows at specified future times according to certain specified rules
Basic forms of swaps Interest rate swaps; currency swaps
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An Example of a “Plain Vanilla” Interest Rate Swap
An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million
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Cash Flows to Microsoft
---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.5, 2001 4.2%
Sept. 5, 2001 4.8% +2.10 –2.50 –0.40
Mar.5, 2002 5.3% +2.40 –2.50 –0.10
Sept. 5, 2002 5.5% +2.65 –2.50 +0.15
Mar.5, 2003 5.6% +2.75 –2.50 +0.25
Sept. 5, 2003 5.9% +2.80 –2.50 +0.30
Mar.5, 2004 6.4% +2.95 –2.50 +0.45
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Typical Uses of anInterest Rate Swap Converting a liability
from fixed rate to
floating rate floating rate to
fixed rate
Converting an investment from fixed rate to
floating rate floating rate to
fixed rate
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Currency Swap
Example
An agreement to pay 11% on a sterling principal of £10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years
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The Cash Flows
Year$
------millions------
2001 –15.00 +10.002002 +1.20 –1.10
2003 +1.20 –1.10 2004 +1.20 –1.10
2005 +1.20 –1.10 2006 +16.20 -11.10
£
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Typical Uses of a Currency Swap Conversion from a
liability in one currency to a liability in another currency
Conversion from an investment in one currency to an investment in another currency
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Credit Risk
A swap is worth zero to a company initially At a future time its value is liable to be either
positive or negative The company has credit risk exposure only
when its value is positive
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Swaptions
What is a swaption Swap rate
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Credit Derivatives
Credit Default Swap Company A buys default protection from B to
protect against default on a reference bond issued by the reference entity, C.
A makes periodic payments to B In the event of a default by C
A has the right to sell the reference bond to B for its face value, or
B pays A the difference between the market value and the face value
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CDS Structure
Default Protection Buyer, A
Default Protection Seller, B
90 bps per year
Payment if default by reference entity,C
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Other credit derivatives
First-to-default Total return swap Credit spread option CDO