Derivative Markets: Derivative Markets: OverviewOverview

Finance (Derivative Securities) 312

Tuesday, 1 August 2006

Readings: Chapters 1, 2 & 8

Nature of DerivativesNature of Derivatives

Derivatives are instruments whose values derive from that of an underlying asset• eg. Futures, Forwards, Options, Swaps

Used by:• Hedgers (to protect against existing exposure)• Speculators (to capitalise on anticipated price

movements)• Arbitrageurs (to exploit mispricings)

FuturesFutures

Agreement to trade between two parties at a fixed price and a specified future time

Rarely result in delivery (less than 3%)Price determined by demand and supplyTraditionally traded through open outcry

system, now traded electronically and over-the-counter

Terminology: party that agrees to buy (sell) has a long (short) position

Market SizeMarket Size

Source: Hull (2004)

0

50

100

150

200

Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03

Size of Market ($ trillion)

OTC

Exchange

MarginsMargins

Cash or marketable securities offered as collateral

Protects against default risk Balance adjusted daily to reflect daily settlement Consider an investor taking a long position in

two December gold futures contracts on June 5• contract size is 100 oz, price is US$400• margin requirement is US$2,000/contract• maintenance margin is US$1,500/contract

Marking-to-MarketMarking-to-Market

Daily Cumulative Margin

Futures Gain Gain Account Margin

Price (Loss) (Loss) Balance Call

Day (US$) (US$) (US$) (US$) (US$)

400.00 4,000

5-Jun 397.00 (600) (600) 3,400 0. . . . . .. . . . . .. . . . . .

13-Jun 393.30 (420) (1,340) 2,660 1,340 . . . . . .. . . . .. . . . . .

19-Jun 387.00 (1,140) (2,600) 2,740 1,260 . . . . . .. . . . . .. . . . . .

26-Jun 392.30 260 (1,540) 5,060 0

+

= 4,000

3,000

+

= 4,000

<

ConvergenceConvergence

Time Time

(a) (b)

FuturesPrice

FuturesPrice

Spot Price

Spot Price

ForwardsForwards

Private contract between 2 parties Exchange traded

Not standardised

Standard contractUsually 1 specified delivery

dateRange of delivery datesSettled at

maturitySettled dailyDelivery or final cash

settlement usually occursContract usually closed out

prior to maturity

FORWARDS FUTURES

Some credit risk Virtually no credit risk

Foreign Exchange QuotesForeign Exchange Quotes

Futures exchange rates are quoted as the number of USD per unit of the foreign currency

Forward exchange rates are quoted in the same way as spot exchange rates• GBP, EUR, AUD, and NZD are USD per unit

of foreign currency• other currencies are quoted as units of the

foreign currency per USD

Profits from Profits from Forwards/FuturesForwards/Futures

Profit

Price of Underlying Asset at Maturity

Profit

Price of Underlying Asset at Maturity

Long position Short position

OptionsOptions

Terminology• Puts, Calls• Long, Short• Premium, Strike/Exercise Price• European, American• In-the-money, Out-of-the-money• Intrinsic value, Time value

Payoff and Profit Payoff and Profit DiagramsDiagrams

Buy Call Buy Put$ $

ST STX X

Payoff – Bold Line

Profit – Dashed Line

MarginsMargins

Margins are required when options are sold When a naked option is written the margin is the

greater of:1 A total of 100% of the proceeds of the sale

plus 20% of the underlying share price less the amount (if any) by which the option is out of the money

2 A total of 100% of the proceeds of the sale plus 10% of the underlying share price

WarrantsWarrants

Options issued by a corporation or financial institution

Traded the same way as stocksFor call warrants, exercise will lead to new

treasury stock being issued

Executive Stock OptionsExecutive Stock Options

At-the-money, issued to company executives

Exercise will lead to new issue of stockBecome vested after a period of time

(usually 1 to 4 years)Cannot be soldOften last for as long as 10 or 15 years

Convertible BondsConvertible Bonds

Regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio

Call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose

Convertible BondsConvertible BondsBond Value

Share Price

Straight Bond Value

Conversion Value

Market Price

Market Premium