Financial Derivatives

Pierre Saint-Laurent
MBA
Summer 2007
 Financial Derivatives
• Contacts:

• 514.998.8076 24/7 (slower response between

midnight and 6AM…)

• Pierre.Saint-Laurent@HEC.ca or
• PSL@AssetCounsel.com
 Financial Derivatives
• 6 lectures- short!
• Concentrated, intensive
• Focus on the three main types of
derivatives
– Forwards and futures
– Swaps
– Options
 Financial Derivatives
• 2 quizzes @ 15% each
• 3rd and 5th lectures
• Short and to the point
• Tests lectures seen since last quiz
• Opportunity to identify weaknesses

• Final@70%
 Financial Derivatives
• Requirements:
– Be or become familiar with PV and FV
– Continuous compounding
– Be (come) familiar with long and
corresponding short positions, i.e., arbitrage
in a broad sense
 Financial Derivatives
• The course’s philosophy:
– Interactive: 2-way
– Adaptive: Fix it as we go, no nuclear explosion at the end
– ‘Supply and Demand’ or the ‘Spanish Inn Approach’:
Within the guidelines of the course, let me know what is
of highest interest and we’ll work towards it
– Applied abstraction: derivatives can be complex, we’ll try
to keep it/start simple and build up
– Use examples as much as practical
– Mixed media: PowerPoints, Word and PDF documents,
board work
– Readings: few mandatory readings, some suggestions,
we’ll build as we go
 Financial Derivatives:
Foreword
W5:

• Emergence of derivatives markets: When

• Importance of derivatives: What
• Role of derivatives: Why
• Players in derivatives markets: Who
• Derivatives markets: Where
 Financial Derivatives:
Some commonalities
Some essential elements are common to
all derivatives :

• Value depends on an underlying asset

• There is an expiration date or maturity date
• Long and short positions are considered
• There are some fundamental relationships between time
periods and asset values (e.g., put-call parity in options,
spot/forward relationships and no-arbitrage clauses in
forwards/futures)
• Derivatives are a zero-sum game
 Financial Derivatives:
Some applications
• Banks manage their books
• Corporations hedge financial and
commodity risk
• Hedge funds and other ‘speculators’ buy
others’ (counterparties’) risk
 Financial Derivatives
I- Forwards and futures
• What is a forward contract?
• Buying/selling today for delivery tomorrow
• ‘delayed purchase’ (can be prepaid, or not)
• How is a forward contract set up?
• Specifies quantity & exact type of asset
• Specifies time, date, place of delivery
• Specifies price (forward price- as opposed to spot
price)
• Creates an obligation for both parties
 Financial Derivatives
I- Forwards and futures
• What is the payoff of a forward?
• Long forward = commitment to BUY at forward
price = spot price at expiration – forward price
– Makes money when price goes up, generally

• Short forward = commitment to SELL at forward

price = forward price – spot price at expiration
– Makes money when price goes down, generally

► OK? Is it clear why?

► Can you think of an example?
 Financial Derivatives
I- Forwards and futures
• What does the payoff of a forward look
like?
• (McDonald, pp. 23-27)
• S&R index: current (spot) price = $1,000
• 6-month forward price = $1,020
• If you hold a long position in the forward,
what is your obligation?
 Financial Derivatives
I- Forwards and futures
• What does the payoff S&R in Long Short
of a forward look like? 6 mos.
• Depends on the value 900 -120 120
of S&R index 6
925 -70 70
months from now
• Zero-sum game: 1,000 -20 20
clear! (no transactions 1,020 0 0
costs here)
1,080 60 -60
1,150 130 -130
 Financial Derivatives
I- Forwards and futures
• What does the payoff of a forward look
like?
• Draw a graph
• (Sorry, I flunked Drawing 101, but bear
with me)
• (in desperation: McDonald, p. 26)
 Financial Derivatives
I- Forwards and futures
• What does the payoff of a forward look
like?
• Draw a graph
• (Sorry, I flunked Drawing 101, but bear
with me)
• (in desperation: McDonald, p. 26)
 Financial Derivatives
I- Forwards and futures
• How do a forward and a physical purchase
compare?
• Again,draw a graph (desperate? McDonald,
Figs. 2.3 & 2.4)
• Conclusions:
• Alternative cost/TVM of money
• When TVM of money taken into account, Forward + zero-
coupon bond paying $1,020 in 6 mos. = spot price at
expiration
• Forward +bond = spot @ expir. -$1,020 + $1,020 (the last
one being the bond payoff)
 Financial Derivatives
I- Forwards and futures
►Some further observations
• Why, then, enter into forward agreements?
• And what about credit risk? What’s that?
How does it impact the forward
agreement?
• What’s the difference between a forward
and a future? Pros and cons?
 Financial Derivatives
I- Forwards and futures
►Gain/loss analysis- example

►Forward pricing and arbitrage analysis

• Board work