Quantitative methods for economics and business

LECTURE N. 1

G. Oggioni
giorgia.oggioni@unibs.it

September 14th , 2020

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Contact information:
Prof. Giorgia Oggioni
e-mail: giorgia.oggioni@unibs.it
Office: Contrada S. Chiara first floor
Office hours: online, using Microsoft Teams, to be fixed by e-mail!

Course information:
Online material: Comunità didattica Quantitative Methods for Economics and Business
(A.A. 2020) https://elearning.unibs.it/course/view.php?id=18249
Textbook
Hull J.C. (2012). “Options, Futures and Derivatives”, 8th edition, Prentice Hall Pearson Education.
Dixit, A.K. and Pindyck R.S. (1994). Investment under Uncertainty, Princeton University Press.
Damodaran A. (2010). The Dark Side of Valuation, 2nd Edition, Pearson Education, Inc. Publishing
as FT PressUpper Saddle River, New Jersey.
Exam: two alternative modalities are allowed
1 Joint work in group (project) and written exam with the following rules:
Joint work in small groups of students and final presentation (40% of final mark).
Written part with exercises (60% of final mark).
A mark of 18 points out of 30 in the written exam is required for considering the exam concluded.
2 Written and oral part with theory and exercises with the following rules:
Access to the oral exam is reserved to students who passed the written exam.
A mark of 18 points out of 30 in the written exam is required for being admitted to the oral exam.

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 Motivation

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. . . (any variable!)

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
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 Motivation

How Derivatives Are Traded

EXCHANGE-TRADED MARKETS OVER-THE-COUNTER (OTC)

⇓ ⇓

Chicago Mercantile Exchange - CME In the over-the-counter (OTC)

Chicago Board Options Exchange - CBOE market where traders working for
LIFFE (London) banks, fund managers and corporate
Eurex (Europe) treasurers contact each other
BM&F (Sao Paulo, Brazil) directly. Once an OTC trade has
TIFFE (Tokyo) been agreed, the two parties can
NYMEX (New York Mercantile Exchange) either present it to a central
counterparty (CCP) or clear the
trade bilaterally.

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 over-the-counter transaction is not the same as its value. An example of an
Motivation
counter transaction is an agreement to buy 100 million U.S. dollars with British
Size of OTC and Exchange-Traded Markets
Figure 1.1 Size of over-the-counter and exchange-traded derivatives marke
800 Size of
market
700 ($ trillion)

600

500

400

300
OTC
200 Exchange

100

0 Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Source: Bank1 for International Settlements. Chart shows total principal amounts underlying
transactions forWhen
OTCamarket
CCP stands between
and value of two sides in assets
underlying an OTC fortransaction, two transactions are consider
exchange market
been created for the purposes of the BIS statistics.

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 Motivation

Some Recent Examples

Systemic risk is the risk that a default by one financial institution will
create a “ripple effect” that leads to defaults by other financial institutions
and threatens the stability of the financial system.

The financial system has survived defaults

Drexel in 1990 (mainly due to an expected crash of the junk bond
market)
Lehman Brothers in 2008
During the market turmoil of 2007 and 2008, many large financial institutions
were bailed out, rather than being allowed to fail, because governments were
concerned about systemic risk.
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 Motivation

The Lehman Bankruptcy (Business Snapshot 1.10)

The Lehman Bankruptcy was due to a combination of high leverage, risky investments, and
liquidity problems. In particular:
Lehman’s filed for bankruptcy on September 15, 2008. This was the biggest bankruptcy in
the US history
Lehman was an active participant in the OTC derivatives markets and got into financial
difficulties because it took high risks
It had hundreds of thousands of transactions outstanding with about 8,000 counterparties
The risks taken by Lehman included large positions in the instruments created from subprime
mortgages
Unwinding these transactions has been challenging for both the Lehman liquidators and their
counterparties
https://www.youtube.com/watch?v=nhCvwiAXL-I

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 Motivation

Just for fun

http://www.overthinkingit.com/2010/01/07/simpsons-economics-financial-crisis/

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 Motivation

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

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 Motivation

Forward Contracts

A forward contract is an agreement to buy or sell an asset at a certain

future time for a certain price.

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.
Delivery price: it is the price at which one party agrees to deliver the underlying commodity
and at which the counterparty agrees to accept delivery.
Forward contracts are traded OTC.

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 Motivation

Example: forward contracts on foreign exchange

Most large banks employ both spot and forward foreign-exchange traders.
Forward contracts can be used to hedge foreign currency risk.

Example (Problem)
Suppose that, on May 24, 2010, the treasurer of a US corporation knows that the corporation will
pay 1 million sterling in 6 months (i.e., on November 24, 2010) and wants to hedge against
exchange rate moves.

Bid Offer
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

Table: Spot and Forward quotes for the US/GBD exchange rate. Number of USD per GBP

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 Motivation

Example: forward contracts on foreign exchange (2)

Example (Solution)
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.
The bank has a short forward contract on GBP. It has agreed that on November 24, 2010, it
will sell £1 million for $1.4422 million.
Both sides have made a binding commitment.

K = 1.4422
Case 1: the spot exchange rate rise to 1.5 at the end of the six months ⇒ ST = 1.5
Case 2: the spot exchange rate fell to 1.35 at the end of the six months ⇒ ST = 1.35
Case 3: the spot exchange rate is equal to 1.4422 at the end of the six months
⇒ ST = 1.4422

What are the possible outcomes at delivery?

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 Motivation

Example: forward contracts on foreign exchange (3)

⇒ What are the possible outcomes for the long forward position held by the corporation?

Case 1: the spot exchange rate rises to 1.5 at the end of the six months
The long forward contract would be worth $57,800 (=$1,500,000 -$1,442,200) to the corporation
because it would purchase £1 million at an exchange rate of 1.4422 rather than 1.5.

Case 2: the spot exchange rate fells to 1.35 at the end of the six months
The long forward contract would have a negative value to the corporation of $92,200 (=$1,350,000
-$1,442,200) because it would lead to the corporation paying $92,200 more than the market price for
the sterling.

Case 3: the spot exchange rate is equal to 1.4422 at the end of the six months
The long forward contract would not give any value $0 (=$1,442,200 -$1,442,200) to the
corporation because it would purchase £1 million at an exchange rate of 1.4422 as contracted.

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 Motivation

Example: forward contracts on foreign exchange (4)

⇒ What are the possible outcomes for the short forward position held by the bank?

Case 1: the spot exchange rate rises to 1.5 at the end of the six months
The short forward contract would have a negative value to the bank of $57,800
(=$1,442,200-$1,500,000) because it would sell £1 million at an exchange rate of 1.4422 rather
than 1.5.

Case 2: the spot exchange rate fells to 1.35 at the end of the six months
The short forward contract would be worth $92,200 (=$1,442,200-$1,350,000) to the bank because
it would lead to the bank selling at an exchange rate of 1.4422 rather than 1.35.

Case 3: the spot exchange rate is equal to 1.4422 at the end of the six months
The short forward contract would not give any value $0 (=$1,442,200 -$1,442,200) to the bank
because it would purchase £1 million at an exchange rate of 1.4422 as contracted.

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 Motivation

Payoff

LONG POSITION SHORT POSITION

⇓ ⇓

ST − K K − ST

K : delivery price
ST : spot price of the asset at maturity of the contract

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 Motivation

Payoff graph (Long Forward Position)

Profit from a Long Forward Position

K : delivery price
ST : spot price of the asset at maturity of the contract

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 Motivation

Payoff graph (Short Forward Position)

Profit from a Short Forward Position

K : delivery price
ST : spot price of the asset at maturity of the contract

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 Motivation

Forward Prices and Spot Prices

Forward Price
The forward price is different from the spot price;
The forward price may be different for contracts of different maturities (as shown by the
table);
The forward price and the delivery price are equal at the time when the contract is written.

Bid Offer
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

Table: Spot and Forward quotes for the US/GBD exchange rate. Number of USD per GBP

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