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Engines of the Economy or Instruments of Mass Destruction?

Engines of the Economy or Instruments of Mass Destruction?. The magic of Financial Derivatives. Klaus Volpert Villanova University Spring 2005. “Greenspan warns against Rules for Derivatives” headline in Financial Times,1999.

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Engines of the Economy or Instruments of Mass Destruction?

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  1. Engines of the Economy orInstruments of Mass Destruction? The magic of Financial Derivatives Klaus Volpert Villanova University Spring 2005

  2. “Greenspan warns against Rules for Derivatives”headline in Financial Times,1999

  3. I can think of no other area that has the potential of creating greater havoc on a global basis if something goes wrong Dr. Henry Kaufman, May 1992 Derivatives are the dynamite for financial crises and the fuse-wire for international transmission at the same time. Alfred Steinherr, author of Derivatives: The Wild Beast of Finance (1998)

  4. What is a Financial Derivative? • Typically a contract between two parties A and B, stipulating that, - depending on the performance of an underlying asset over a predetermined time - , A will pay so-and-so much money to B. • For A to enter into this contract, B pays A a premium at the outset. • A is called the writer of the contract, B is the holder.

  5. “Example” So in principle, when you make a deal with your child, that says she’ll get $5 for a B on the next math test, and $10 for an A, you are creating a financial derivative.

  6. A More serious Example • A stipulates with B, that if the oil price per barrel is above $70 on April 1st 2006, then A will pay B the difference between the spot price and $70. • Why might B enter into this contract? • Why might A enter into this contract?

  7. Other such Derivatives can be written on underlying assets such as • Copper, Wheat, and other `commodities’ • Currencies • Interest Rates • Credit risks • Even the Weather!

  8. Basic Questions: • What premium should B pay to A?? • What are the parameters that factor into this price?

  9. Crucial Example: Stock Options • A (European) Call Option is the right to buy an underlying stock • At a prescribed future time T (time of expiry) • for a prescribed price X (strike price) • A Put Option is the right to sellan underlying stock at time T for a price X. • The seller of an option is known as the Writer, the buyer is the Holder

  10. Let’s be Concrete : A Call on IBM • Option to buy an IBM share at $90 6 months from now. Currently the price of an IBM share is $83.80. • Question: What would you pay for this option?? • Question: What would you sell it for?

  11. Example: A Put on IBM • Option to SELL an IBM share at $90 6 months from now. Currently the price of an IBM share is $83.80. • What would you pay for this? • What would you sell it for?

  12. What information would like to have to be in a better position to estimate ?

  13. What information would like to have to be in a better position to estimate ?

  14. Price can be determined by • The market (like an auction) • mathematical analysis:in 1973, Black and Scholes came up with a model to price options.It was an instant hit, and became the foundation of the options market.

  15. The prices turn out to be. . . • Call option for strike $90 with expiry in July, when stock is at 83.80: • $2.35 • Put option for strike $90 with expiry in July, when stock is at 83.80: • $6.70

  16. The Black-Scholes PDE What???

  17. Who would invest in options and why? • You profit from holding call options if the market is going up. • You profit from holding put options if prices are going down.

  18. Who would invest in options and why? • Hedging a risk: • if you own IBM and you are worried about a down turn, you buy put options as insurance. • If you are a Starbucks franchise owner + worried about the price of coffee - you buy call options on coffeeOptions allow the redistribution of risk!Derivatives = giant insurance enterprise ?

  19. Buy a call with strike 120, buy a put with strike 80 (a strangle). Then a payoff-minus-cost diagram would look like In addition sell a call and a put with strike 100 (known as a butterfly). payoff-minus-cost diagram : Engineering of derivatives:

  20. Who would invest in options and why? • Speculation: the movement of stocks is greatly amplified by options:Consider the option to buy IBM at $90 in half a year: • if the current price is $83.80, then the price of the option (according to market/Black-Scholes) is $2.35, • if the share price jumps tomorrow by 5% to $88, the price of the option jumps to $4.25, an 80% increase.

  21. So, while the underlying stock price has gone up 5 %, the value of the option has gone up 80%!This is called leveraging or gearingBy buying options instead of assets, you can magnify your risk / your potential payoff almost without limit.

  22. Cause for Concern? • 1987 crash: investors who sold ‘naked puts’ lost everything and then some. • 1994: Orange County: losses of $1.7 billion • 1995: Barings Bank: losses of $1.5 billion • 1996: Sumitomo bank: losses of $2.6 billion • 1998: LongTermCapitalManagement (LTCM) hedge fund, founded by Meriwether, Merton and Scholes. Losses of over $2 billion

  23. 1997: Merton and Scholes win Nobel prize in Economics • Cheers in The Economist: The professors have turned risk management from a guessing game into a science • Jeers in Barron’s: The pair snared the rich honor, and the tidy sum that goes with it, for devising a formula to measure the worth of a stock option, thus paving the way for both the spectacular growth of options and their use as instruments of mass destruction.

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