Practical Investment Management by Robert.A.Strong slides ch17
Transcript of Practical Investment Management by Robert.A.Strong slides ch17
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THE ROLE OFDERIVATIVE ASSETS
CHAPTER SEVENTEEN
Practical Investment Management
Robert A. Strong
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Outline
Background The Rationale for Derivative Assets Uses of Derivatives
The Options Market Options Terminology The Financial Page Listing The Origin of an Option
The Role of the Options Clearing Corporation Standardized Option Characteristics
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Outline
The Futures Market Futures vs. Options Market Participants Keeping the Promise
Categories of Futures Contracts
Financial Futures Stock Index Futures
Interest Rate Futures Foreign Currency Futures
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Outline
Derivative Assets and the News Current Events Risk of Derivative Assets Listed vs. Over-the-Counter Derivatives
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Derivative assets get their name from thefact that their value derives from someother asset.
The best-known derivative assets arefutures and options contracts.
Derivatives are not all the same. Some areinherently speculative, while some are
highly conservative.
Introduction
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Background :The Rationale for Derivative Assets
The first organized derivativesexchange in the United States
was developed in order to bringstability to agricultural prices, byenabling farmers to eliminate orreduce theirprice risk.
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Background : Uses of Derivatives
Risk management: The equity managersmarket risk or the bond managers interestrate risk is analogous to the farmers pricerisk.
Risk transfer: Derivatives provide a meansfor risk to be transferred from one personto some other market participant who, for aprice, is willing to bear it.
Derivatives may provide financial leverage.
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Background : Uses of Derivatives
Income generation : Some people usederivatives as a means of generatingadditional income from their investmentportfolio.
Financial engineering: Derivatives can bestable or volatile depending on how theyare combined with other assets.
Whats next?
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Background : Uses of Derivatives
Insert Figure 17-1 here.
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Options Terminology
A call option gives its owner the right to
buy a specified quantity of the underlyingasset at a set price within a set time period.
Aput option gives its owner the right to
sell a specified quantity of the underlyingasset at a set price within a set time period.
The set price is called the striking price or
exercise price, and the last day the optionis valid is called the expiration date.
The price of the option is the premium.
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Options Terminology
Options trade in units called contracts, each of
which normally covers 100 shares.
An options volume indicates how many option
contracts changed hands over some period of
time. It measures trading activity. An options open interestindicates how many
option contracts exist. Open interest goes up when someone creates an
option and does down when two people trade and
each close out an options position.
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The owner of an option will ultimately doone of three things with it:
sell it to someone else;
let it expire; or
exercise it.
Options Terminology
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The Origin of an Option
Options can be created, or destroyed. The
quantity of options in existence changeseveryday.
The first trade someone makes in aparticular option is called an opening
transaction. If an investor sells an optionas an opening transaction, it is calledwriting the option.
Options are fungible, meaning that, for agiven company, all options of the sametype with the same expiration and strikingprice are identical.
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The Role of the Options Clearing Corporation
OCC
Buyer Seller Trading Floor
The Options Clearing Corporation positions
itself between every buyer and seller and actsas a guarantor of all option trades.
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Standardized Option Characteristics
Options have standardized expiration dates,striking prices, and lot size.
option premium = intrinsic value + time value
If an option has no intrinsic value, it is out-of-the-money. Otherwise, it is eitherin-the-moneyorat-the-money.
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Standardized Option Characteristics
IntrinsicValue
Time Value OptionPremium+ =
Components of an Option Premium
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Standardized Option Characteristics
AnAmerican option can be exercised
anytime prior to the expiration of the option.A European option, on the other hand, canonly be exercised at expiration.
The option holder decides if and when toexercise.
Valuable options are usually sold rather than
exercised.
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Standardized Option Characteristics
Fig 17-4 here
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The initial seller of the contract promises todeliver a quantity of a standardized commodity toa designated delivery point during a certain
delivery month. The other party to the trade promises to pay a
predetermined price for the goods upon delivery.
The person who promises to buy is said to belong, while the person who promises to deliver issaid to be short.
The Futures Market
A futures contractis a promise.
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The Futures Market
Futures vs. options : Futures contracts do
not expire unexercised. Note that thecontract obligation may be satisfied bymaking an offsetting trade.
Market participants : Hedgers use futures to reduce price risk.
Speculators assume risk in the hope of
making a profit. Marketmakers provide liquidity for the
marketplace.
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The Futures Market
Insert Figure 17-5 here.
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Financial Futures : Stock Index Futures
A stock index future is a promise to buy orsell the standardized units of a specificindex at a fixed price at a predeterminedfuture date.
Unlike most other commodity contracts,there is no actual delivery mechanismwhen the contract expires. For practicality,
all settlements are in cash.
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Financial Futures : Stock Index Futures
Insert Table 17-2 here.
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Financial Futures : Interest Rate Futures
Interest rate futurescontracts are
customarily grouped into short-term,intermediate-term, and long-termcategories.
The two principal short-term contracts areEurodollars and U.S. Treasury bills.
The Treasury bill futures contract calls for
the delivery of $1 million par value of 90-day T-bills on the delivery date of thefutures contract.
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Financial Futures : Interest Rate Futures
Insert Table 17-3 here.
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Financial Futures : Interest Rate Futures
The contract on U.S. Treasury notes is the
only intermediate-term contract, whileTreasury bonds are the principal long-termcontracts.
The Treasury bond futures contract callsfor the delivery of $100,000 face value ofU.S. Treasury bonds with a minimum of 15years until maturity (and, if callable, with a
minimum of 15 years of call protection).Bonds that meet these criteria are said tobe deliverable.
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Financial Futures : Interest Rate Futures
Insert Table 17-4 here.
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Financial Futures : Interest Rate Futures
invoiceprice
settlementprice
conversionfactor
accruedinterest= [ x ] +
Bonds are standardized as follows:
T-bonds are not all fungible. At any given time,several dozen bonds are usually eligible fordelivery on a T-bond futures contract.
Normally, only one of these bonds will becheapest to deliver.
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Financial Futures : Interest Rate Futures
Insert Table 17-5 here.
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Financial Futures : Foreign Currency Futures
Foreign currency futures contracts call for
delivery of the foreign currency in thecountry of issuance to a bank of theclearing houses choosing.
Most major corporations face at least someforeign exchange risk and quicklydiscovered the convenience of thesefutures as a hedging vehicle, while
speculators saw the contracts as easy tounderstand and use.
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Derivative Assets and the News
Newspapers in recent months havebeen full of reports on variousbusinesses that have lost billionsinvesting in derivatives.
Derivatives are neutral products. Their riskdepends on what an investor does withthem.
Exchange-traded derivative assets andover-the-counter derivatives are markedlydifferent.
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Review
Background The Rationale for Derivative Assets
Uses of Derivatives
The Options Market Options Terminology The Financial Page Listing
The Origin of an Option
The Role of the Options Clearing Corporation
Standardized Option Characteristics
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Review
The Futures Market Futures vs. Options Market Participants
Keeping the Promise
Categories of Futures Contracts
Financial Futures Stock Index Futures
Interest Rate Futures Foreign Currency Futures
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Review
Derivative Assets and the News Current Events
Risk of Derivative Assets
Listed vs. Over-the-Counter Derivatives
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Appendix: Option Pricing
Fig. 17A-1
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Appendix: Option Pricing
Black-Scholes Options Pricing Model
Insert table 17A-1
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Appendix: Option Pricing
Insert fig. 17A2
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Appendix: Option Pricing
Delta: the change in option premium
expected from a small change in the stockprice, all other things being equal