Financial Instruments

Money & Banking

- Derivatives -

Tim Mundhenke

Content Outline
1. 2. 3. Introduction What is a derivative? Reasons to use derivatives

4.
5. 6. 7. 8. 9.

Concepts to understand
Futures Forwards Options Swaps Questions

Introduction (I)
In the financial marketplace some instruments are regarded as fundamentals,
while others are regarded as derivatives.

Financial Marketplace

Derivatives

Fundamentals

Simply another way to catagorize the diversity in the FM*.

*Financial Market

Introduction (II)
Financial Marketplace

Derivatives Futures Forwards Options Swaps

Fundamentals Stocks Bonds Etc.

What is a Derivative? (I)

Options
The value of the derivative instrument is DERIVED from the underlying security

Futures

Forwards

Swaps
Underlying instrument such as a commodity, a stock, a stock index, an exchange rate, a bond, another derivative etc..

What is a Derivative? (II)

Futures
The owner of a future has the OBLIGATION to sell or buy
something in the future at a predetermined price.

Forwards

The owner of a forward has the OBLIGATION to sell or buy

something in the future at a predetermined price. The difference

to a future contract is that forwards are not standardized. The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures contract.

Options

Swaps

A swap is an agreement between two parties to exchange a sequence of cash flows.

Reasons to use derivatives (I)

Derivative markets have attained an overwhelming popularity for a variety of reasons...

Hedging:

Interest rate volatility Stock price volatility Exchage rate volatility Commodity prices volatility

VOLATILITY Speculation:
High portion of leverage Huge returns

EXTREMELY RISKY

Reasons to use Derivatives (II)

Also derivatives create...
a complete market, defined as a market in which all identifiable payoffs can be obtained by trading the securities available in the market*. and market efficiency, characterized by low transaction costs and greater liquidity.

* Futures, Options and Swaps by R.W. Kolb

Concepts to Understand
Short Selling:
Short selling is the selling of a security that the seller does not own.
Short sellers assume the risk that they will be able to buy the stock at a more favorable price than the price at which they sold short.

Holding Long Position:

Investors are legally owning a security. Investors are the legal owners of a security.

Future Contracts (I)

Futures Scenario:
You are a farmer and you know that you will harvest corn in three months from The owner of a future contract has the OBLIGATION to sell or buy something in the future at a predetermined price.

today on. How can you protect yourself from loosing if corn price happens to drop
until March by using corn forward contracts?

t 1/1 3/1 Harvest

Future Contracts (II)

You lock into a price by holding a short position in a corn future contract with a

maturity date a little bit longer than the harvest date.

Suppose the price drops...

You close out the corn contract and the gain in the futures market will offset the loss in the sport market

You either take delivery and lock in a price.

A futures contract makes unfavourable price movements less unfavourable and a favourable price movements less favourable!

Future Contracts (III)

General Rule for Hedgers:
If you are going to sell something in the near future but want to lock in a

secured price, you take a short position.

If you are going to receive/buy something in the future but want to lock in a secured price, you take a long position.

Future Contracts (IV)

The Role of Speculators:
As the name implies, speculators are involved in price betting and take the risk of price movements against them.

Assume the following:

You, as hedger, believe that prices will raise. Thus, you are convinced that a long position will benefit you.

Key Word: Zero-Sum-Gain Large gains due to the concept of leverage

Forward Contracts (I)

Forwards
The owner of a forward has the OBLIGATION to sell or buy something in the future at a predetermined price. The difference

to a future contract is that forwards are not standardized.

A Forward Contract underlies the same principles as a future contract, besides the aspect of non-standardization. Thus, a detail illustration is not necessary as I already elaborated in the mechanism of the futures contract.

Options (I)
Options
The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures.

Some terms to understand:

Call option
Put option Excersice price / strike price Option premium

Moneyness (in-the-money, at-the-money, out-of-money)

European vs. American Options

Options (II)
The four basic positions: Call Option Write

Purchase

Write Put Option

Purchase

Options (III)
Write & Purchase Call Option:

Value

Long Call

x
Stock Price at Expiration

Short Call

Options (IV)
Write & Purchase Call Option:

Profit and Loss

Long Call

Premium Earned x

Zero-Sum-Game

Stock Price at Expiration

Premium Paid
Short Call

Options (V)
Write & Purchase Call Option:

Profit and Loss

Long Put

Stock Price at Expiration

Short Put

Options (VI)
Write & Purchase Call Option:

Profit and Loss

Long Put
Premium Earned
Stock Price at Expiration

Short Put

Premium Paid

Swaps (I)
Swaps
Counterparties Interest rate swaps A swap is an agreement between two parties to exchange a sequence of cash flows.

Currency swaps
Phenomenal growth of the swap market Future and Option markets only provide for short term investment horizon Traded in OTC markets with little regulations No secondary market Market limited to institutional investors

Swaps (II)
A Plain Vanilla Interest Rate Swap:
An interest rate swap is an agreement between two parties to exchange a sequence of fixed interest rate payments against floating interest rate payments.

Terms to understand:
Fixed side Receive-fixed side Tenor Notional amount

Swaps (III)
Example:
5 year tenor; notional amount $1 million; Party A is the fixed side paying 9%, Party B is the receive-fixed side, paying a LIBOR flat rate

Party A 0 Party B 0

Libor*$1m

Libor*$1m Libor*$1m Libor*$1m Libor*$1m

1
$90,000 $90,000

2
$90,000 $90,000

3
$90,000 $90,000

4
$90,000 $90,000

5
$90,000 $90,000

1
Libor*$1m

Libor*$1m Libor*$1m Libor*$1m Libor*$1m

QUESTIONS