Chapter 9. Derivatives

1. Chapter 9. Derivatives • Futures • Options • Swaps

2. Derivatives: the basics • Financial instrument • Value depends on another assets • i.e. value is derived from another • Purpose: to transfer risk from one party to another

3. Derivative uses • Used to • Profit from expected price changes of certain assets • Speculation • Manage the risk associated with price changes • Hedging

4. Futures Contracts • Exchange of asset/commodity between two parties on a future date • Price of asset/commodity set today

5. Two parties • Buyer • Long position • Obligation to buy asset on settlement date at agreed price • Seller • Short position • Obliations to deliver asset on settlement date and receive agreed price

6. Standardized • Sold on exchanges • Settlement date • Asset/commodity • Exchanges • Chicago: CME, CBOT • New York: NYMEX, NYBOT (NYFE)

7. what kinds of commodities, assets? • agriculture: corn, wheat, livestock, cotton, tobacco • mining: metals, oil, natural gas • Tbills, Tbonds (interest rate) • Stock indexes (cash settlement) • Foreign currencies (exchange rate)

8. As price of underlying rises • long position gains • short position loses • As price of underlying falls • long position loses • short position gains

9. Example 1: commodity • Baker with a military contract • locked in a price for bread • Risk: fluctuating price of wheat • higher costs cannot be passed on to bread buyers

10. solution? • hedge with futures contract • wheat futures contract, long position • locks in wheat price for buyer • As wheat price rises, long position gains to offset baker’s costs

11. but as wheat prices fall • long position loses value to offset lower costs for the baker

12. who is the seller of the wheat futures contract? • wheat farmers, grain elevator companies • speculators who believe wheat prices will fall

13. Example 2: financial asset • Savings and Loan • borrow short term w/ deposits • lend mostly long term fixed rate • risk: short term interest rates rise • higher costs without higher income to match • solution: short position in Tbill futures

14. As interest rates rise, • Tbill price falls, • short position gains to offset banking losses

15. Futures trading • the exchanges form a clearing corporation that guarantees each party against default • it is the counterparty to each transaction

16. how does the exchange control its default risk? • margin accounts • initial margin (10% or less of contract value) • daily gains/losses are marked to market • margin calls if account gets too low

17. example: Tbond contract (CBOT) • $100,000 face value, 6% coupon • initial margin = $2700 • Tbond price falls by 16/32 per $100 • $500 price decrease • buyer account falls to $2200 • seller account rises to $3200

18. Options contracts • 2 counterparties • buyer/option holder • seller/option writer • buyer has rights, seller has obligations

19. call option • buyer has right to buy underlying at the strike price on/before a specific date • writer has obligation to sell, if the buyer chooses to buy

20. put option • buyer has right to sell underlying at the strike price on/before a specific date • writer has obligation to buy, if the option holder chooses to sell

21. note: writer receives option price from buyer in exchange for taking on the obligation

22. American options • exercised any time until expiration • European options • exercised only on the day of expiration

23. P = price of underlying • X = strike price • Qc = call option price • Qp = put option price

24. when will options be exercised? • call option – right to buy • if P > X, then this option is in the money • if P < X, then this option is out of the money

25. put option – right to sell • if P > X, then this option is out of the money • if P < X, then this option is in the money

26. Example • Google stock expiring 10/19/2007 • P = $635/share • call option • X = $500 • Qc = $138.20 • This option in the money

27. put option • X = $500 • Qp = $.10 • This option is out of the money

28. Option trading • types of assets • commodities • bonds • stocks and stock indexes • exchange-traded & standardized • Options Clearing Corporation

29. CBOE • 10% options exercised • 60% “traded out” (cash settlement) • 30% expire worthless

30. Uses of options • Who buys a call option? • protection from a price increase of the underlying (hedger) • option acts as insurance • betting on a price increase of the underlying (speculator)

31. Who writes a call option? • betting that the underlying price will not rise • broker always selling the underlying and willing to be paid for the risk of the price rising

32. who buys a put option? • protects from price decrease of underlying in the future • hopes to sell underlying in the future • betting the price of underlying will fall

33. Who writes a put option? • betting that the underlying price will not fall • broker always buying the underlying and willing to be paid for the risk of the price falling

34. The value of options • option price has two parts • intrinsic value • value of option if exercised/expire now • depends on if in/out of the money • for a call: max (P-X, 0) • for a put: max (X-P, 0) • option premium • fee paid for having the option

35. example • Google, P =$635, X = $500 • Qc = $138.20, Qp = $.10 • call option • intrinsic value = 635- 500 = 135 • premium = 138.20 – 135 = 3.20

36. put option • intrinsic value = 0 • option is out of the money • premium = $.10

37. What affects the price of an option? • P, price of underlying • as P rises • affects the intrinsic value • call option price rises • put option price falls

38. X, the strike price • as X rises • affects the intrinsic value • call option price falls • put option price rises

39. time to expiration • longer the time, higher the option price of put or call options • higher premium • greater uncertainty about option being in or out of the money

40. volatility of P • greater the volatility, the greater the option price for both puts and calls • higher premium • greater uncertainty about option being in or out of the money

41. Swaps • Interest rate swaps • plain vanilla swap • not standardized or exchange-traded • more default risk • less liquid • BUT customized to specific needs

42. How does a swap work • 2 counterparties • exchange interest rate payments • every 6 months • over so many years • one party pays a fixed rate • one party pays a floating rate • tied to 6 mo. Tbill

43. size of interest payments? • based on notional principle • the principle never changes hands, just determines the size of the interest payments

44. Bank pays 7% to dealer, • receiving 6 mo. Tbill +3% from dealer • Dealer receives 7% from bank, • pays 6 mo. Tbill +3% to bank

45. notional principle = $100 million • suppose 6 mo. Tbill is 4.2% • Bank pays 7%, gets 7.2% • bank net gain = $200,000 • dealer net loss = $200,000

46. why swap? • banks pay floating rates to depositors, but received fixed rates on loans • the swap offsets their interest rate risk • dealer willing to assume the risk for profit potential

47. U.S. Treasury debt managers • long term bonds have strong demand • but short term bonds match up to short term fluctuations in revenue • solution? • a swap

48. government issues long term debt • enters swap as floating rate payer • recession • as rates fall swap results in net gain • but tax revenues fall as well • expansion • as rates rise swap results in net loss • but tax revenues rise as well