You are on page 1of 71

IAPM

FNC-602
Instructor: Dr. Kumail Rizvi

1
DERIVATIVE MARKETS AND
INSTRUMENTS
2
WHAT IS A DERIVATIVE?
A derivative is an instrument whose value depends
on, or is derived from, the value of another asset.
Examples: futures, forwards, swaps, options,
exotics

3
WHY DERIVATIVES ARE IMPORTANT
Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc
Many financial transactions have embedded
derivatives
The real options approach to assessing capital
investment decisions has become widely accepted

4
HOW DERIVATIVES ARE TRADED
On exchanges such as the Chicago Board Options
Exchange
In the over-the-counter (OTC) market where traders
working for banks, fund managers and corporate
treasurers contact each other directly
5
MAJOR PLAYERS IN DERIVATIVES MARKET
6
DERIVATIVE DEALERS
7
CLEARINGHOUSE
8
EXPOSURE WITHOUT CLEARINGHOUSE
9
EXPOSURE WITH CLEARINGHOUSE
10
EXCHANGES
11
MECHANISM TO REDUCE COUNTERPARTY
RISK
12
EXCHANGES AND CLEARINGHOUSE
13
SIZE OF OTC AND EXCHANGE-TRADED
MARKETS
1
4

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
THE LEHMAN BANKRUPTCY
Lehmans filed for bankruptcy on September 15, 2008.
This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives
markets and got into financial difficulties because it took
high risks and found it was unable to roll over its short
term funding
It had hundreds of thousands of transactions outstanding
with about 8,000 counterparties
Unwinding these transactions has been challenging for
both the Lehman liquidators and their counterparties
15
HOW 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
16
TYPES OF DERIVATIVE INSTRUMENTS
17
FORWARD PAYOFF
18
PAYOFF
19
FORWARD PRICE
The forward price for a contract is the delivery
price that would be applicable to the contract if it
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 (as shown by the table)
20
FOREIGN EXCHANGE (USD)QUOTES FOR
GBP, MAY 24, 2010
2
1

Bid Ask
Spot 1.4407 1.4411
1-month forward 1.4408 1.4413
3-month forward 1.4410 1.4415
6-month forward 1.4416 1.4422
TERMINOLOGY
The party that has agreed to buy has what
is termed a long position
The party that has agreed to sell has what
is termed a short position

22
EXAMPLE
23
HEDGING WITH FORWARDS
24
FOREIGN EXCHANGE (USD)QUOTES FOR
GBP, MAY 24, 2010
2
5

Bid Ask
Spot 1.4407 1.4411
1-month forward 1.4408 1.4413
3-month forward 1.4410 1.4415
6-month forward 1.4416 1.4422
EXAMPLE
On May 24, 2010 the treasurer of a corporation
enters into a long forward contract to buy 1 million
in six months at an exchange rate of 1.4422
This obligates the corporation to pay $1,442,200 for
1 million on November 24, 2010
What are the possible outcomes?
26
PROFIT FROM A LONG FORWARD POSITION (K=
DELIVERY PRICE=FORWARD PRICE AT TIME
CONTRACT IS ENTERED INTO)
27
Profit
Price of Underlying at
Maturity, S
T
K
PROFIT FROM A SHORT FORWARD POSITION (K=
DELIVERY PRICE=FORWARD PRICE AT TIME CONTRACT IS
ENTERED INTO)
28
Profit
Price of Underlying
at Maturity, S
T
K
FUTURES CONTRACTS
Agreement to buy or sell an asset for a certain price
at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a
futures contract is traded on an exchange
29
EXCHANGES TRADING FUTURES
CME Group (formerly Chicago Mercantile
Exchange and Chicago Board of Trade)
NYSE Euronext
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more
30
FUTURES CONTRACTS
Available on a wide range of assets
Exchange traded
Specifications need to be defined:
What can be delivered,
Where it can be delivered, &
When it can be delivered
Settled daily
31
FORWARD VS. FUTURES
32
SPECIFICATIONS OF FUTURES CONTRACT
33
EXAMPLES OF FUTURES CONTRACTS
Agreement to:
Buy 100 oz. of gold @ US$1400/oz. in December
Sell 62,500 @ 1.4500 US$/ in March
Sell 1,000 bbl. of oil @ US$90/bbl. in April
34
OIL FUTURES
35
CORN FUTURES
36
STOCK FUTURES
37
OTHER TYPES OF FUTURES
38
MINI STOCK FUTURES CONTRACTS
39
MARGIN REQUIREMENT
40
EXAMPLE OF A FUTURES TRADE
An investor takes a long position in 2 December
gold futures contracts on June 5
contract size is 100 oz.
futures price is US$1250
initial margin requirement is US$6,000/contract
(US$12,000 in total)
maintenance margin is US$4,500/contract (US$9,000
in total)
41
A POSSIBLE OUTCOME
4
2

Da
y
Trade
Price
($)
Settle
Price
($)
Daily
Gain ($)
Cumul.
Gain ($)
Margin
Balance
($)
Margin
Call ($)
1 1,250.00 12,000
1 1,241.00 1,800 1,800 10,200
2 1,238.30 540 2,340 9,660
..
.. .. ..
6 1,236.20 780 2,760 9,240
7 1,229.90 1,260 4,020 7,980 4,020
8 1,230.80 180 3,840 12,180
.. .. .. ..
16 1,226.90 780 4,620 15,180
ANOTHER EXAMPLE
43
MARGIN CASH FLOWS WHEN FUTURES
PRICE INCREASES
4
4

Long Trader
Broker
Clearing House
Member

Clearing House
Clearing House
Member

Broker
Short Trader
MARGIN CASH FLOWS WHEN FUTURES
PRICE DECREASES
4
5

Long Trader
Broker
Clearing House
Member

Clearing House
Clearing House
Member

Broker
Short Trader
SOME TERMINOLOGY
Open interest: the total number of contracts outstanding
equal to number of long positions or number of short positions
Settlement price: the price just before the final bell each
day
used for the daily settlement process
Volume of trading: the number of trades in one day
46
CRUDE OIL TRADING ON MAY 26, 2010
4
7

Open High Low Settle Change Volume Open Int
Jul 2010 70.06 71.70 69.21 71.51 2.76 6,315 388,902
Aug 2010 71.25 72.77 70.42 72.54 2.44 3,746 115,305
Dec 2010 74.00 75.34 73.17 75.23 2.19 5,055 196,033
Dec 2011 77.01 78.59 76.51 78.53 2.00 4,175 100,674
Dec 2012 78.50 80.21 78.50 80.18 1.86 1,258 70,126
REGULATION OF FUTURES
In the US, the regulation of futures markets is
primarily the responsibility of the Commodity
Futures and Trading Commission (CFTC)
Regulators try to protect the public interest and
prevent questionable trading practices


48
DELIVERY
49
OPTIONS
50
OPTIONS

A call option is an option to buy a certain asset by a
certain date for a certain price (the strike price)
A put option is an option to sell a certain asset by a
certain date for a certain price (the strike price)

51
TYPES OF OPTION
52
OPTIONS VS FUTURES/FORWARDS
A futures/forward contract gives the holder the
obligation to buy or sell at a certain price
An option gives the holder the right to buy or sell at
a certain price
53
OPTION PAYOFF
54
CALL OPTION PAYOFF TO LONG
55
PROFIT TO LONG CALL BUYER
56
OPTION POSITIONS
Long call
Long put
Short call
Short put
57
LONG CALL
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months
58
30
20
10
0
-5
70 80 90 100
110 120 130
Profit ($)
Terminal
stock price ($)
SHORT CALL
Profit from writing one European call option: option
price = $5, strike price = $100
59
-30
-20
-10
0
5
70 80 90 100
110 120 130
Profit ($)
Terminal
stock price ($)
LONG PUT
Profit from buying a European put option: option price
= $7, strike price = $70
60
30
20
10
0
-7
70 60 50 40 80 90 100
Profit ($)
Terminal
stock price ($)
SHORT PUT
Profit from writing a European put option: option price
= $7, strike price = $70
61
-30
-20
-10
7
0
70
60 50 40
80 90 100
Profit ($)
Terminal
stock price ($)
PAYOFFS FROM OPTIONS
WHAT IS THE OPTION POSITION IN EACH
CASE?
K = Strike price, S
T
= Price of asset at maturity
62
Payoff Payoff
S
T
S
T
K
K
Payof
f
Payoff
S
T
S
T
K
K
ASSETS UNDERLYING
EXCHANGE-TRADED OPTIONS

Stocks
Foreign Currency
Stock Indices
Futures
63
SPECIFICATION OF
EXCHANGE-TRADED OPTIONS
Expiration date
Strike price
European or American
Call or Put (option class)
64
TERMINOLOGY
Moneyness :
At-the-money option
In-the-money option
Out-of-the-money option

65
EXAMPLE
66
SOLUTION
67
HEDGING WITH A PUT OPTION
68
SOLUTION
69
SPECULATING WITH OPTIONS
70
SOLUTION
71