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Tim Mundhenke

Financial Instruments Money & Banking - Derivatives - . Tim Mundhenke. Content Outline. Introduction What is a derivative? Reasons to use derivatives Concepts to understand Futures Forwards Options Swaps Questions. Introduction (I).

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Tim Mundhenke

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  1. Financial Instruments Money & Banking - Derivatives - Tim Mundhenke

  2. Content Outline • Introduction • What is a derivative? • Reasons to use derivatives • Concepts to understand • Futures • Forwards • Options • Swaps • Questions

  3. Introduction (I) In the financial marketplace some instruments are regarded as fundamentals, while others are regarded as derivatives. Financial Marketplace Derivatives Fundamentals Simply another way to catagorize the diversity in the FM*. *Financial Market

  4. Introduction (II) Financial Marketplace Derivatives Fundamentals • Futures • Forwards • Options • Swaps • Stocks • Bonds • Etc.

  5. What is a Derivative? (I) Options The value of the derivative instrument is DERIVED from the underlying security Futures Forwards Swaps Underlying instrument such as a commodity, a stock, a stock index, an exchange rate, a bond, another derivative etc..

  6. What is a Derivative? (II) The owner of a future has the OBLIGATION to sell or buy something in the future at a predetermined price. Futures The owner of a forward has the OBLIGATION to sell or buy something in the future at a predetermined price. The difference to a future contract is that forwards are not standardized. Forwards The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures contract. Options Swaps A swap is an agreement between two parties to exchange a sequence of cash flows.

  7. Reasons to use derivatives (I) Derivative markets have attained an overwhelming popularity for a variety of reasons... Hedging: Speculation: • Interest rate volatility • Stock price volatility • Exchage rate volatility • Commodity prices volatility VOLATILITY • High portion of leverage • Huge returns EXTREMELY RISKY

  8. Reasons to use Derivatives (II) Also derivatives create... • a complete market, defined as a market in which all identifiable payoffs can be obtained by trading the securities available in the market*. • and market efficiency, characterized by low transaction costs and greater liquidity. * Futures, Options and Swaps by R.W. Kolb

  9. Concepts to Understand Short Selling: • Short selling is the selling of a security that the seller does not own. • Short sellers assume the risk that they will be able to buy the stock at a more favorable price than the price at which they sold short. Holding Long Position: • Investors are legally owning a security. • Investors are the legal owners of a security.

  10. Future Contracts (I) The owner of a future contract has the OBLIGATION to sell or buy something in the future at a predetermined price. Futures Scenario: You are a farmer and you know that you will harvest corn in three months from today on. How can you protect yourself from loosing if corn price happens to drop until March by using corn forward contracts? t 1/1 3/1 Harvest

  11. Future Contracts (II) You lock into a price by holding a short position in a corn future contract with a maturity date a little bit longer than the harvest date. Suppose the price drops... You either take delivery and lock in a price. You close out the corn contract and the gain in the futures market will offset the loss in the sport market “A futures contract makes unfavourable price movements less unfavourable and a favourable price movements less favourable“!

  12. Future Contracts (III) General Rule for Hedgers: • If you are going to sell something in the near future but want to lock in a secured price, you take a short position. • If you are going to receive/buy something in the future but want to lock in a secured price, you take a long position.

  13. Future Contracts (IV) The Role of Speculators: • As the name implies, speculators are involved in price betting and take the risk of price movements against them. Assume the following: • You, as hedger, believe that prices will raise. Thus, you are convinced that a long position will benefit you. • Key Word: Zero-Sum-Gain • Large gains due to the concept of leverage

  14. Forward Contracts (I) The owner of a forward has the OBLIGATION to sell or buy something in the future at a predetermined price. The difference to a future contract is that forwards are not standardized. Forwards A Forward Contract underlies the same principles as a future contract, besides the aspect of non-standardization. Thus, a detail illustration is not necessary as I already elaborated in the mechanism of the futures contract.

  15. Options (I) The owner of an options has the OPTION to buy or sell something at a predetermined price and is therefore more costly than a futures. Options Some terms to understand: • Call option • Put option • Excersice price / strike price • Option premium • Moneyness (in-the-money, at-the-money, out-of-money) • European vs. American Options

  16. Options (II) The four basic positions: Write Purchase Call Option Write Purchase Put Option

  17. Options (III) Write & Purchase Call Option: Value Long Call x Stock Price at Expiration Short Call

  18. Options (IV) Write & Purchase Call Option: Profit and Loss Long Call Zero-Sum-Game Premium Earned x Stock Price at Expiration Premium Paid Short Call

  19. Options (V) Write & Purchase Call Option: Profit and Loss Long Put Stock Price at Expiration Short Put

  20. Options (VI) Write & Purchase Call Option: Profit and Loss Long Put Premium Earned Stock Price at Expiration Premium Paid Short Put

  21. Swaps (I) A swap is an agreement between two parties to exchange a sequence of cash flows. Swaps • Counterparties • Interest rate swaps • Currency swaps • Phenomenal growth of the swap market • Future and Option markets only provide for short term investment horizon • Traded in OTC markets with little regulations • No secondary market • Market limited to institutional investors

  22. Swaps (II) A Plain Vanilla Interest Rate Swap: An interest rate swap is an agreement between two parties to exchange a sequence of fixed interest rate payments against floating interest rate payments. Terms to understand: • Fixed side • Receive-fixed side • Tenor • Notional amount

  23. Swaps (III) Example: 5 year tenor; notional amount $1 million; Party A is the fixed side paying 9%, Party B is the receive-fixed side, paying a LIBOR flat rate Party A Libor*$1m Libor*$1m Libor*$1m Libor*$1m Libor*$1m 0 1 2 3 4 5 $90,000 $90,000 $90,000 $90,000 $90,000 Party B $90,000 $90,000 $90,000 $90,000 $90,000 0 1 2 3 4 5 Libor*$1m Libor*$1m Libor*$1m Libor*$1m Libor*$1m

  24. QUESTIONS

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