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Derivatives are financial instruments that derive their value from something else, an underlying asset . The purpose of a derivative is the transfer of risk . Definition Of Derivatives. Derivatives . 1. Range of Derivatives. Exchange-Traded Futures. Interest-Only MBS Strip. Treasury
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Derivatives are financial instruments that derive their value from something else, anunderlying asset. The purpose of a derivative is the transfer of risk. Definition Of Derivatives Derivatives 1
Range of Derivatives Exchange-Traded Futures Interest-Only MBS Strip Treasury Strip OTC Swap ADR CMO Residual Narrower Definition 2
Exchange-traded futures and options Over-the-counter (OTC) swaps, forwards and options Derivatives We Will Discuss 3
Range of Derivatives Exchange-TradedFutures Interest-Only MBSStrip Treasury Strip OTC Swap ADR CMOResidual Narrower Definition ForClass 4
Extreme liquidity - supporting efficient and rapid portfolio adjustments Only practical way to implement certain strategies Support very fine tuning of risk exposures Do I want this risk? Risk vs. risk premium Advantages Of Derivatives VsCash Positions (Underlying Asset) 7
Economic leverage can be introduced quickly and easily (leverage vs borrowings) The size of positions may not be obvious to inexperienced readers of portfolio reports Complications In Oversight Process ForExchange-Traded Derivatives 8
Forward - an agreement calling for a future delivery of an asset at an agreed-upon price. Futures - similar to forward but feature formalized and standardized characteristics. Key differences in futures: Secondary trading - liquidity Marked to market (daily margin transactions) Standardized contract units Exchange Traded Clearinghouse warrants performance (credit guarantee) Futures and Forwards 9
Spot Price Price for purchase or sale for immediate delivery or settlement Forward or Futures Price Price for purchase or sale for future delivery 10
Futures price - agreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity Long = spot (underlying) minus original futures price Short = original futures price minus spot (underlying) Key Terms for Futures Contracts 11
Contract Specifications Underlying asset Contract size Delivery arrangements Delivery Cash settlement Delivery Months Daily Limits Establish clearing corporation Margins 12
Less price transparency Credit risk related to counter-parties Additional Complications In Oversight Process For Over-The-Counter Derivatives 13
Pricing Futures Contracts • At the moment of expiration: • Futures price = Cash price • Gain/loss on long = cash price – entry price • Prior to expiration: • Futures price is the “plug number” to make holding cash security = holding a long futures contract + earnings on funds saved invested at short term rate
Making Cash Position = Futures Position Long Futures Position Cash Bond +Gain/loss on price** +Interest on bond =Total Return Futures Contract +Gain/loss on price* +Money market interest =Total Return Must be equal * = expiration price – entry price ** = price at expiration – cash price
Essence of Options “the writer of the option grants the buyer of the option the right, but not the obligation, to purchase from or sell to the writer something at a specified price within a specified period of time (or at a specific time)”
Options Terminology • Option price or option premium • Exercise price or strike price • Expiration date or maturity date • Call option or put option • American option or European option • Maximum profit or maximum loss • Exchange-traded options or over-the-counter options
Risk/Return Characteristics of Call Options • The purchase of a call is like taking a long position in the underlying asset with a fixed, maximum loss. • Benefits the buyer if the price of the underlying asset rises. • Benefits the seller if the price of the underlying asses falls or is unchanged.
Risk/Return Characteristics of Put Options • The purchase of a put is like taking a short position in the underlying asset with a known maximum loss. • Benefits the buyer if the price of the underlying asset falls. • Benefits the seller if the price of the underlying asset rises or is unchanged.
Option Ownership Terms • Selling = writing = going short • Buying = going long • Put = Right to “put” asset to writer at afixed price (strike) • Call = Right to “call” asset from writer at fixed price (strike)
Payoff/Profit Based Upon Intrinsic Value • Long Call: • Payoff = Max(0,PU – strike price) • Profit = -premium +Max(0,PU – strike price) • Short Call: • Payoff = Min(0,strike price – PU) • Profit = premium +Min(0,strike price – PU) Note: PU = price of underlying asset
Payoff/Profit Based Upon Intrinsic Value • Long Put: • Payoff = Max(0,strike - PU) • Profit = -premium +Max(0,strike price-PU) • Short Put: • Payoff = Min(0,PU - strike price ) • Profit = premium +Min(0,PU - strike price ) Note: PU = price of underlying asset
Intrinsic Value of Option Intrinsic value = value if you close out option contract right now
Premium Factors Impacting Option Price Contract Terms • Term to expiration • Strike Price Market Factors • Price of underlying • Asset volatility
Differences Between Options and Futures Contracts • Both parties to a futures contract accept an obligation to transact, while only the options writer has such an obligation. • The option buyer has a limited, known maximum loss. • The risk/return profile of an option position is asymmetric, while that of a futures position is symmetric.
Differences Between Options and Futures Contracts Think of it this way: • Futures returns are symmetrical and options “one-sided” • The execution price on the futures contract is like the strike price on the options
Trading Volatility • VIX is an index measuring volatility for S&P 100 options (OEX) • Volatility = annual standard deviation • VIX futures trade on CBOE Note: Volatility = Option price