1.1

Introduction

What are Derivatives?

• Derivatives are zero net supply bilateral contracts deriving their values from some underlying asset, reference rate, or index.

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1.2

Examples of Derivatives

• Futures Contracts

• Forward Contracts

• Swaps

• Options

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1.3

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

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1.4

Forward Contracts• Obligates one party to buy (the long position) and the

other party to sell (the short position) an asset or commodity in the future for an agreed-upon price.

• Physical delivery contract• Cash-settled contract• Trade only in an over-the-counter (OTC) market• communication among traders is over the phone• Examples:• buy 5,000 oz. of gold @ US$400/oz. in one year• sell £1,000,000 @ 1.5000 US$/£ in six months• earn a 4% rate of interest on a US$ deposit for a 3-

month period starting in six monthswww.StudsPlanet.com

1.5

How a Forward Contract Works• The contract is a private agreement between

two counterparties• Normally, the price in the contract is chosen

so that the contract’s initial market value is zero– => no money changes hands when first

negotiated & the contract is settled at maturity– Think about a forward contract as the decision to

delay the sale or purchase of an asset three months, for example, from today.

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1.6

Futures Contracts• Like a forward:

– Obligates one party to buy (the long position) and the other party to sell (the short position) an asset or commodity in the future for an agreed-upon price.

• Physical delivery contract• Cash-settled contract

• Unlike a forward:– Trade on a futures exchange and are subject to daily

settlement

• Evolved out of forwards and possess many of the same characteristics

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1.7

Exchanges Trading Futures

• Chicago Board of Trade

• Chicago Mercantile Exchange

• LIFFE (London)

• Eurex (Europe)

• BM&F (Sao Paulo, Brazil)

• TIFFE (Tokyo)

• and many more (see list at end of book)www.StudsPlanet.com

1.8

Options

• An option gives its owner the right to purchase or sell an asset on or before some date in the future.

– Call versus Put options

– American and European Options

– Physical delivery versus cash-settled options

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1.9

Exchanges Trading Options

• Chicago Board Options Exchange

• American Stock Exchange

• Philadelphia Stock Exchange

• Pacific Exchange

• LIFFE (London)

• Eurex (Europe)

• and many more (see list at end of book)www.StudsPlanet.com

1.10

Main Differences between Options and Futures: Hedging Strategies

Feature Futures (or Forwards)

Options

Type of strategy Symmetric Asymmetric

Up-f ront costs $0.00 Option premium

Flexibility Less than option More than f utures

Contract obligation w.r.t. transacting

Obligated to buy or sell at predetermined price

Have the right to buy or sell at predetermined price

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1.11

OTC vs. Exchange-Traded Derivatives:Contract Characteristics

Exchange-Traded• Terms specified by “listing

agents” (i.e. exchange)• The main non-standard

item in most exchange-traded derivatives is the price, which is determined in the market place

– Pure open outcry (CME)– Physical delivery mkt (CBOE)– Electronic dealer market

(AMEX)– Electronic limited order book

(Sydney Futures Exch.)

OTC• Specific terms defined

exclusively by the two counterparties

• General terms set forth in pro forma documentation called “master agreements”

– Can be customized through annexes to master agreements

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1.12

OTC vs. Exchange-Traded Derivatives:Market Characteristics

Exchange-Traded• Organized market with

specific and detailed trading rules

• Exchange defines the rules of the game and enforces them

• Highly transparent• Quotes and prices are

available very rapidly by numerous services

OTC• Deals are negotiated in

opaque “market”• Dealer market where

brokers and dealers make two-way markets

• Sometimes brokered• Often lacks

“transparency”, esp. for customized and new transaction prices

• “Plain vanilla” products are more standardized

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1.13

Types of Traders• Hedgers

– mainly interested in protecting themselves against adverse price changes

– want to avoid risk• Speculators

– hope to make money in the markets by betting on the direction of prices

– “accept” risk• Arbitrageurs

– arbitrage involves locking into riskless profit by simultaneously entering into transactions in two or more markets

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1.14

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 $73 per share. A two-month put with a strike price of $63 costs $2.50. The investor decides to hedge by buying 10 contracts

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1.15

Speculation Example

• An investor with $4,000 to invest feels that Amazon.com’s stock price will increase over the next 2 months. The current stock price is $40 and the price of a 2-month call option with a strike of 45 is $2

• What are the alternative strategies?

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1.16

Arbitrage Example

• A stock price is quoted as £100 in London and $172 in New York

• The current exchange rate is 1.7500

• What is the arbitrage opportunity?

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1.17

1. Gold: An Arbitrage Opportunity?

• Suppose that:– The spot price of gold is US$390– The quoted 1-year futures price of gold

is US$425– The 1-year US$ interest rate is 5% per

annum• Is there an arbitrage opportunity?

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1.18

2. Gold: Another Arbitrage Opportunity?

• Suppose that:– The spot price of gold is US$390– The quoted 1-year futures price

of gold is US$390– The 1-year US$ interest rate is

5% per annum• Is there an arbitrage opportunity?

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1.19

The Futures Price of Gold If the spot price of gold is S & the futures price is

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=390, T=1, and r=0.05 so that

F = 390(1+0.05) = 409.50

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1.20

Derivative Resources on the Web

• Exchange information and contract specifications are available for all major exchanges

• Real-time pricing and volume data

• Educational tools

• Futures Exchange or Gov’t Agency Internet Site

• New York Mercantile Exchangehttp://www.nymex.com

• Kansas City Board of Tradehttp://www.kcbt.com

• Chicago Mercantile Exchangehttp://www.cme.com

• Chicago Board of Tradehttp://www.cbot.com

• Chicago Board Options Exchangehttp://www.cboe.com

• Minneapolis Grain Exchangehttp://www.mgex.com

• New York Cotton Exchangehttp://www.nyce.com

• Coffee, Sugar & Cocoa Exchangehttp://www.csce.com

• CFTC http://www.cftc.gov

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1.21

Forward, Futures, and Swaps

• The first section of the course will cover forward, futures and swaps.

• Relevant Chapters in Textbook (4th edition)– Mechanics of Futures and Forward Markets (Ch.

2)– The Determination of Forward and Futures Prices

(Ch. 3)– Hedging Strategies using Futures (Ch. 4)– Interest-Rate Futures (Parts of Ch. 5)– Swaps (Ch. 6)

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