Lecture 1 Introduction to Derivatives Nicholas Chen

Nicholas Chen, ICMA Centre 1

Introduction
 A little bit about myself
 What I am sharing with you  Knowledge in finance  Applying financial valuation principles to your personal life

Introduction (Con’t)
 Why is it so hard to make decisions  Uncertain consequences  Can I wait to make decisions later on?  Yes, there is a fee for you to delay your decision-making.  In finance, everything, including the right of making

decision, will be priced.

Nicholas Chen, ICMA Centre

3

Rent a Flat in Town Centre  The first decision I need to make is to rent
To Rent: £ 800 – £300 = £ 500 Deposit : £300 Not to Rent: Lose £ 300

 The deposit £300 is the price to have ________ to make

decision later on.
Nicholas Chen, ICMA Centre 4

Objectives
 Describe and characterize derivatives

and markets  Evaluate and apply pricing and trading methods  Perform analysis of financial derivatives data  Construct simple spreadsheets for derivatives pricing and trading

8th ed)  The 7th Edition is ok.  Recommended Financial Times and WSJ .Materials  Required textbook  Options. Futures and Other Derivatives (Hull.

markham@icmacentre.ac.ac.chen@icmacentre.uk  Office hours  Monday 3 pm – 5pm . t.uk  Four option pricing and trading sessions  Tom Markham. x.Course Operation  Attendance  Work on Assignments on your own  Five seminars (where Assignments will not be collected)  Casey Chen.

Assessment  One multiple-choice in-class test (20%)  Four trading sessions (10%)  One 1.5 hour final examination (70%) .

Helpful hints  Spend one hour each day  Practice is the key  Speak up in the class .

What are derivatives? Forward contracts Futures contracts Options Contracts Trading types  Arbitrage and futures pricing Nicholas Chen. 3. ICMA Centre 10 . 5. 2.Today’s Outline 1. 4.

Nicholas Chen. the weather.g. What are derivatives? ‘an instrument whose value depends on the values of other. stocks. The dependence can be of many types. ICMA Centre 11 . exchange rates or fixed income securities. commodities. e. e. underlying variables’ The underlying variables are generally traded assets. But they can be any variable. more basic.g.1. indices.

Spring 2005. Alfonso Dufour .12 Derivative Securities .INVEST II.Underlying Assets: Commodities Categories of commodities with exchange-traded derivatives: Grains and Oil seeds Livestock and Meat Food and Fiber GOLD SILVER COPPER Energy Metals 1. Dr.

Dr. The Index is value-weighted. comprises 500 stocks.13 .Underlying Assets: Common Stocks and Indexes  Popular US common stock indexes with associated exchange-traded derivatives:   S&P 500 Index  Dow Jones Industrial Average FTSE Eurofirst 300  The S&P 500 Index.INVEST II. Spring 2005. for the most part traded on the NYSE. widely diversified across US industries. it includes the most important stocks in their respective industries. Alfonso Dufour 1. and a continuous daily price series exists since 1928. Typically. Derivative Securities .

Dr.14 . Spring 2005. Alfonso Dufour 1.INVEST II.Fixed Income Securities  Popular fixed income securities:  US Treasury bills† Eurodollars†  US Treasury notes/bonds  Mortgages  † Real world candidates for “cash” Derivative Securities .

convertible bonds. ICMA Centre 15 .g. asset-backed securities) Nicholas Chen.Types of derivatives  Forwards: agreements to buy/sell an underlying in the future at a certain price agreed today over the counter  Futures: same as forwards. except that they are standardized and settled daily in exchanges  Options (call/put): contracts offered at a fee (or premium) that give the right to buy/sell an underlying in the future (same as futures but no obligation)  Structured products: contracts with non-standard payoff (e.

ICMA Centre 16 . Forward contracts Forward = agreement to buy/sell an asset at a certain future time for a certain price agreed today  they require no fee! Spot contract = agreement to buy or sell an asset today Specifications: – Underlying – Type of agreement: buy/sell – Time of delivery – Delivery price – Size Nicholas Chen.2.

 Terminology:  Long position: the buyer  Short position: the seller Nicholas Chen. so no fee is exchanged  Forward price = the price that makes the value of forward contract exactly zero. ICMA Centre 17 .Forward contracts  traded over-the-counter  personalized  settled at the end of the contract  they involve some credit risk  have zero value at the time of agreement.

INVEST II. . 2011 I’ll buy your house in July for $350.000. Thanks for the $350. You’ve got a deal. Derivative Securities . Dr. Spring 2005.Forward (and Futures) Contracts October . Nothing is exchanged now. Alfonso Dufour Trade occurs in the future. 2011 December.000. Thanks for the house.

Specification of the above example Specifications of a long forward contract: – Underlying: – _____________ – Type of agreement: – _____________ – Time of delivery: – ______________ – Price: – ______________ – Size: – ______________ Nicholas Chen. ICMA Centre 19 .

ICMA Centre 20 . where is the spot price ST is the spot price and K is the delivery price or the forward price when you enter into the contract. What does “Long such a forward contract” mean? You commit to __ gold at the price of $__ in __ months.Position in forward contracts  The price of a 6-month forward contract of gold is $400. Nicholas Chen. Suppose the spot price is $450 in 6 months. will you make any profit? Profit = ______________  The profit at maturity is ST – K.

Futures. Copyright © John C. and Other Derivatives. Hull 2012 21 . ST Options.Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered into) Profit K Price of Underlying at Maturity. 8th Edition.

Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into) Profit K Price of underlying at Maturity. 8th Edition. and Other Derivatives. Futures. Copyright © John C. Hull 2012 22 . ST Options.

ICMA Centre 23 .3. except:  traded on exchanges  standardized  settled daily  almost no credit risk involved  they require margins Nicholas Chen. Futures contracts Same as forward contracts.

Exchanges  Chicago Board of Trade  Chicago Mercantile Exchange  LIFFE (London)  Eurex (Europe)  TIFFE (Tokyo) Nicholas Chen. ICMA Centre 24 .

those written on indices or FX rates) are settled in cash Nicholas Chen.g. ICMA Centre 25 .Delivery  Most futures contracts are closed out before maturity by entering into an offsetting position  Otherwise they are settled by delivering the underlying assets (when there are alternatives then the counterparty with the short position is making the choice about delivery conditions)  Some contracts (e.

Terminology  Settlement price: the price used in the last trade of the day (________________)  Open interest: the number of contracts outstanding  a new trade can increase/decrease open interest  Trading volume: the total number of trades during the day  a new trade always increases volume Nicholas Chen. ICMA Centre 26 .

Margins ‘Cash or security deposited by an investor with his broker that helps avoid contract defaults‘  Settled daily (marked to market)  Minimize the possibility of a loss due to the default of a counterparty  Types: initial and maintenance  Clearinghouse: holds the margin accounts Nicholas Chen. ICMA Centre 27 .

000 per contract.000 per contract.  If an investor cannot pay the required margin then his contract will be closed  no credit risk Nicholas Chen. ICMA Centre 28 . Contracts are written on 100 stocks.example  An institution takes a long position in a 6-month futures contract on stock A with the futures price being £ 100.  The maintenance margin is £ 1.Margins .  The initial margin requirement is £ 2. Now the stock trades at £ 110.

example Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600 Nicholas Chen.Margins . ICMA Centre 29 .

ICMA Centre 30 .example Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600 Nicholas Chen.Margins .

Margins . ICMA Centre 31 .example Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600 Nicholas Chen.

example Day 09-Jan 10-Jan 11-Jan 12-Jan Futures price 100 95 88 94 -500 -700 600 -500 -1200 -600 Daily profit/loss Cumulative profit/loss Margin balance 2000 1500 800 < 1000 2600 1200 Margin call New margin 2000 1500 2000 2600 Nicholas Chen.Margins . ICMA Centre 32 .

futures contracts Forwards Futures Private contracts between 2 parties Non-standardized contracts 1 specified delivery date Delivery / cash settlement usually occurs Credit risk involved Settled at the end of the contract Profit / loss made on final day Requires no margins Nicholas Chen.Forward vs. ICMA Centre Exchange traded Standardized Range of delivery dates Closed out before maturity No credit risk Settled daily Profit/loss made over the entire period Requires margin payments 33 .

 Futures contract is similar to the rental from a letting agent.Forward vs. which can regarded as an exchange. ICMA Centre 34 . Nicholas Chen. futures contracts  Forward contract is similar to the rental from a private party.

Options ‘contract offered at a fee (price) that gives the right to buy/sell an asset in the future at a pre-defined price’ Nicholas Chen. ICMA Centre. 2011 .4.

2011 .Terminology Call option  gives the right to buy Put option  gives the right to sell Long the option Short the option  the one who has the right  he pays the fee  the one who has the obligation  he receives the fee European option  can be exercised on a specific date American option  can be exercised until a specific date Nicholas Chen. ICMA Centre.

However.  Can you hold it for me? Nicholas Chen. ICMA Centre 37 . I have not decided … I might change my mind in December.A bad decision maker  I like the house.

now.000.000. Dr. $50. Alfonso Dufour That’s OK. . December Housing Prices Rise Thanks for the house. Derivative Securities .(European) Call Options The right (not obligation) to buy an asset a certain time October I’ll buy your house in If you pay me December for $350.000 extra if I want to then.  Housing Prices Fall I’ve decided not to buy.000. Spring 2005. But I get to keep the $50.INVEST II. it’s a deal. Thanks for the $350.

ICMA Centre 39 . I have not decided … I might Change my mind in the future. However.A even worse decision maker  I like the house.  But I do not even know when I will change my mind?  Can you still hold it for me? Nicholas Chen.

November Housing Prices Rise Thanks for the house.INVEST II.000. . October I’ll buy your house before If you pay me December for $350.000.American Call Options The right (not obligation) to buy an asset whenever you change your mind before the expiration day. Dr. Spring 2005. now. it’s a deal.000.  Housing Prices Fall I’ve decided not to buy. But I get to keep the $60.000 extra if I want to then. $60. Thanks for the $350. Derivative Securities . Alfonso Dufour That’s OK.

 Speculators  very risky!  Require investment  Increase risk by taking directional positions  Arbitrageours  Require no initial investments  Take zero risk  What rate of return do arbitrageours expect to receive? Nicholas Chen. ICMA Centre 41 . Traders Types of traders:  Hedgers  Require investment  Reduce risk by ocking in the prices.5.

 No matter how much the exchange rate will be.93 £/€.Hedging example  A British company A will need to pay € 10 mil in 6 months.91 £/€. ICMA Centre 42 . company A will have to buy the euro at the pre-specified rate. Nicholas Chen. then company A made a loss. then company A made a good deal.  If the exchange rate will be less than 0.  If the exchange rate will be 0.91 £/€. Company A will hedge this obligation with a long position in a forward contract. agreeing to buy € 10 mil in 6 months at a specified forward rate 0.

ICMA Centre 43 .Hedging Exercise  A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a ___ position in a forward contract. Nicholas Chen.

000 to invest feels that Amazon. Spring 2005.com’s stock price will increase over the next 2 months. Dr.Speculation Example (pages 10-11)  An investor with $4. Alfonso Dufour 1.44 .INVEST II. 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?  Strategy 1: buy $4000 worth of stock  Strategy 2: buy $4000 worth of options Derivative Securities .

ICMA Centre 45 .Strategy 1: Buy Stock  Strategy 1: buy $4000 worth of stock  4000/40 = 100 shares  Possible outcomes in Dec:  If AMZN share price = $70 Gain ________________  If AMZN share price = $30 lose _______________ Nicholas Chen.

Strategy 2: Buy options • Strategy 2: buy $4000 worth of options  4000/2 = 2000 options (20 Dec contracts)  If AMZN share price = $70 Gain __________________  If AMZN share price = $30 lose _________________ Nicholas Chen. ICMA Centre 46 .

Alfonso Dufour 1. Dr. Spring 2005.47 .INVEST II.Arbitrage Example 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? Derivative Securities .

ICMA Centre 48 .Arbitrage Example (con’t)  Futures price too __________ . yes there is an Arbitrage opportunity Today  Borrow money.410 = 15 Nicholas Chen.05*T=410  risk free profit of 425. buy gold and carry it to maturity of the futures contract $390---> 390* e0.05x1 = 410  short 1 futures contract receive $425 in 1 year One year later  Close the futures contract by selling the gold at 425  cost to pay back loan =390e0.

Alfonso Dufour 1.49 . Spring 2005.Arbitrage Exercise  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? Derivative Securities .INVEST II. Dr.

Arbitrage Exercise (Con’t)  Futures price is ____ Today  take a long position in futures contract  Short sell gold to receive $390 (borrow the gold and sell it to the market)  deposit $390 in bank at 5% interest at maturity  Receive $410 (390* e0.05x1 = 410) from the deposit  buy gold at $390 to close out the futures position  return the gold to the lender to close the short sell position risk free profit = _____________ = $20 per contract Nicholas Chen. ICMA Centre 50 .

T=1. Dr.05 so that F = ___________________ Derivative Securities . and r=0. then F = S e rT or F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. Spring 2005. In our examples. Alfonso Dufour 1.51 . S=390.The Futures Price of Gold If the spot price of gold is S & the futures price for a contract deliverable in T years is F.INVEST II.

Key Q: Why Use Risk-free Rate?  Because forward and futures price is fixed in the contract. ________ risk. Nicholas Chen. ICMA Centre 52 .

Dr. Spring 2005. Alfonso Dufour 1.INVEST II.Exercise Problem of Futures Pricing Suppose that:  The spot price of oil is US$19  The 1-year US$ interest rate is 5% per annum  What is the price of oil futures contract? Derivative Securities .53 .

05 so that F = 19(1+0.05) = 19. S=19. Dr.95 Derivative Securities . Alfonso Dufour 1. Spring 2005.The Futures Price of Oil In our examples.54 .INVEST II. T=1 and r=0.

Convergence of futures to spot price (when T  0) Futures price Spot price Spot price Futures price Nicholas Chen. ICMA Centre 55 .