Presentation on theme: "Derivatives: Forwards, Futures, and Options"— Presentation transcript:
1 Derivatives: Forwards, Futures, and Options BM410: InvestmentsDerivatives: Forwards, Futures, and Options
2 Objectives A. Understand derivatives B. Understand the basics and terminology of ForwardsC. Understand the basics and terminology of FuturesD. Understand the basics and terminology of Options
3 A. Understand Derivatives What are derivatives?Derivatives are financial contracts whose values are determined by (or derived from) a traditional security (stock or bond), an asset (a commodity), or a market index.Derivatives are not ownership, but the right to become (or quit being) owners in the fundamental security
4 Derivatives (continued) What are derivatives based on?Derivatives are based on the same math as particle physics. Most models are based on the Black-Scholes Options Pricing ModelIf you don’t understand the model, its implications, uses, strengths, and weaknesses, you will be at a disadvantage to those who do.
5 Derivatives (continued) What is so risky about derivatives?Derivatives can be either risk creating or risk eliminatingThe key is how they are usedWhat is so hard to understand about derivatives?Conceptually, they are easier to understandMathematically, it is extremely difficult
6 Derivatives (continued) What about derivatives for individual investors?Derivatives are a zero-sum game--for every winner, there is an offsetting loserOn the other side of the transaction, is a multi-billion dollar financial institution with millions in computer systems and truckloads of Ph.D.s who understand the mathThey are inappropriate for virtually all non-professional investorsFor individual investors: stick to what you know
8 B. Basics of Forwards and Futures What is a forward?An agreement calling for a future delivery of an asset at an agreed-upon price and agreed-upon dayExample:Your son wants a puppy really bad, and your neighbor’s dog just had pups.Your son goes and picks his favorite puppy, you and your neighbor agree to the price ($500), and you agree to a date to pick up the puppy (after its weaned in 3 weeks).This is a forward contract
9 Forwards (continued)Now assume the price, between when you made the agreement and when you were to pick up the puppy changed. Your chart would look like this.Buyer of Puppy200300500700-200Seller of Puppy
10 Futures (continued) What are Futures? Similar to forward but feature formalized and standardized characteristics on specific exchangesWhat are the hey difference between forwards and futures?Futures have secondary trading – liquidityFutures are marked to market dailyFutures have standardized contract unitsThe futures clearinghouse warrants performance
11 Key Terms Futures price Agreed-upon price at maturity Long position Agreement to purchaseShort positionAgreement to sellProfits on positions at maturityLong = spot minus original futures priceShort = original futures price minus spotPremiumPrice paid or received for the futures contract
12 Types of ContractsWhat are the major types of forwards and futures contracts?Agricultural commoditiesMetals and minerals (including energy contracts)Foreign currenciesFinancial futuresInterest rate futuresStock index futures
13 Trading Mechanics Clearinghouse Closing out positions Acts as a party to all buyers and sellers.Obligated to deliver or supply deliveryClients benefit as they do not have to do any credit checks on opposite partyClosing out positionsReversing the tradeTake or make deliveryMost trades are reversed and do not involve actual delivery
14 Margin and Trading Arrangements Key terminologyInitial MarginFunds deposited to provide capital to absorb lossesMarking to MarketEach day the profits or losses from the new futures price and reflected in the account.Maintenance or variance marginAn established value below which a trader’s margin may not fall.
15 Margin and Trading Arrangements Margin callWhen the maintenance margin is reached, broker will ask for additional margin fundsConvergence of PriceAs maturity approaches the spot and futures price convergeDeliveryActual commodity of a certain grade with a delivery location or for some contracts cash settlement
16 Trading Strategies What are the different types of trading strategies? SpeculationShort - believe price will fallLong - believe price will riseHedgingLong hedge - protecting against a rise in priceShort hedge - protecting against a fall in price
17 Basis and Basis Risk Basis The difference between the futures price and the spot priceOver time the basis will likely change and will eventually convergeBasis RiskThe variability in the basis that will affect profits and/or hedging performance
18 Futures Pricing Spot-futures parity theorem Two ways to acquire an asset for some date in the future:Purchase it now and store itTake a long position in futuresThese two strategies must have the same market determined costs
19 Parity Example Stock that pays no cash dividend No storage costs No seasonal patterns in pricesStrategy 1:Buy the stock now and hold it until time TStrategy 2:Put funds aside today to perform on a futures contract for delivery at time T that is acquired today
20 Parity Example Outcome Strategy A: Action Initial flows Flows at TBuy stock -So STStrategy B: Action Initial flows Flows at TLong futures 0 ST - FOInvest in BillFO(1+rf)T - FO(1+rf)T FOTotal for B - FO(1+rf)T ST
21 Price of Futures with Parity Since the strategies have the same flows at time TFO / (1 + rf)T = SOFO = SO (1 + rf)TThe futures price has to equal the carrying cost of the stock
22 Problem 18-9A hypothetical futures contract on a non-dividend-paying stock with current price $150 has a maturity of one year. A. If the T-bill rate is 6%, what should the futures price be? B. What should the futures price be if the maturity of the contract is 3 years? C. What if the interest rate is 12% and the maturity of the contract is 3 years?Answers:A. F = S0 (1 + r) = 150 x (1.06) = $159B. F = S0 ( 1 + r)3 = 150 x (1.06)3 = $178.65C. F = 150 x (1.08)3 = $188.96
23 Stock Index ContractsAvailable on both domestic and international stocksAdvantages over direct stock purchaseLower transaction costsBetter for timing or allocation strategiesTakes less time to acquire the portfolio
24 Problem 18-14The Chicago Board of Trade has just introduced a new futures contract on Brandex stock, a company that currently pays no dividends. Each contract calls for delivery of 1,000 shares of stock in one year. The T-bill rate is 6% per year.A. If Brandex stock now sells at $120 per share, what should the futures price be?B. If the Brandex stock price drops by 3%, what will be the change in the futures price and the change in the investors margin account?C. If the margin on the contract is $12,000, what is the percentage return on the investors position?
25 Answer A. The price should be 120 x (1.06) = $127.20 B. The stock price falls to 120 x (1-.03) = The futures price falls to x (1.06) = The investor loses ( ) x 1000 = $3,816C. The percentage loss is 3816/12,000 = 31.8%
26 Index Arbitrage What is index arbitrage? Is it doable? Exploiting mis-pricing between underlying stocks and the futures index contractFutures Price too high - short the future and buy the underlying stocksFutures price too low - long the future and short sell the underlying stocksIs it doable?Yes, but very difficult to do in practiceTransactions costs are often too largeTrades cannot be done simultaneously
27 Problem 18-21The margin requirement on the S&P500 futures contract is 10%, and the stock index is currently at 1,200. Each contract has a multiplier of $250.A. How much margin must be put up for each contract sold?B If the futures price falls by 1% to 1,188, what will happen to the margin account of an investor who holds one contract? What will be the investor’s percentage return based on the amount put up as margin?
28 AnswerA. The dollar value of the index is thus: $250 x 1,200 = $300,000 x 10%= required margin of $30,000B. If the futures price decreases by 1% to 1,188, the decline in the futures price is 1,200-1,188 = 12.The decrease in your margin account would be 12 x $250=$3,000, which is a percent loss of $3,000 / $30,000 = -10%. Cash in the margin account is now $30,000 - $3,000 = $27,000.
29 Problem 18-22The multiplier for a futures contract on a certain stock market index is $500. The maturity of the contract is 1 year, the current level of the index is 400, and the risk-free interest rate is 0.5% per month. The dividend yield on the index is 0.2% per month. Suppose that after one month, the stock index is at 410.A. Find the cash flow from the mark-to-market proceeds on the contract. Assume that the parity condition always holds exactly.B. Find the holding-period return if the initial margin on the contract is $15,000.
30 Problem answerA. The initial futures price is: Fo = 400 x ( )12 = In one month, the maturity of the contract will be only 11 months, so the futures price will be F0 = 410 x ( ) 11 = The increase in the futures price is 9.095, so the cash flow will be x 500 = $4,547.50The rate of return is $4, / $15,000 = 30.3%
31 C. Option Basics What is an option? An option is the right, but not the obligation, to buy or sell a specific security at a specific date and priceOption TerminologyBuy - Long or Sell - ShortCall – right to buy or Put – right to sellWriter – Seller or Holder – Buyer of the optionKey ElementsExercise or Strike PricePremium or PriceMaturity or Expiration
32 Market and Exercise Price Relationships In the MoneyExercise of the option would be profitableHolder of the Call: Market price (MP) > exercise price (EP) (buy at lower price)Holder of the Put: EP > MP (sell at higher price)Out of the MoneyExercise of the option would not be profitableHolder of the Call: MP < EPHolder of the Put: EP < MPAt the MoneyExercise price and asset price are equal
33 American versus European Options The option can be exercised at any time before expiration or maturityEuropeanThe option can only be exercised on the expiration or maturity dateBermudaThe option can be exercised only during specific periods of time, as stated in the contractAsianThe option can be exercised, not based on the final price, but on any price during the entire options history
34 Different Types of Options What are the different types of Options?Stock OptionsIndex OptionsFutures OptionsForeign Currency OptionsInterest Rate OptionsOptions are zero sum games.Remember that for every winner there is a loserUse them at your risk!
35 Problem 16-5Suppose you think Wal-Mart stock is going to appreciate substantially in value in the next six months. Say the stock’s current price, So, is $100, and the call option expiring in 6 months has an exercise price, X, of $100, and is selling at a price, C, of $10. With $10,000 to invest, you are considering three alternatives:A. Invest all $10,000 in the stock, buying 100 sharesB. Invest all $10,000 in 1,000 options (10 contracts)C. Buy 100 options (1 contract) for $1,000 and invest the remaining $9,000 in a money market fund paying 4% interest over six months (8% per year).What is your rate of return for each alternative for four stock prices six months from now: $80, $100, $110, $120
37 Payoffs and Profits on Options at Expiration– Call Holder (buyer) Buyer of the right to buy an asset at the exercise priceNotationStock Price = ST Exercise Price = X Premium = PPayoff to Call Holder(ST - X) if ST >X0 if ST < XProfit to Call HolderPayoff - Purchase Price (ST – X – P)Max. loss: Premium Max. gain: unlimited
38 Payoffs and Profits on Options at Expiration – Call Writer (seller) Call Writer (or seller)Seller of the right to buy an asset at the exercise pricePayoff to Call Writer- (ST - X) if ST >X0 if ST < XProfit to Call WriterPayoff + Premium (P – ST + X)Max. loss: unlimited Max. gain: Premium
39 Profit Profiles of Calls Call HolderCall WriterStock Price
40 Payoffs and Profits at Expiration – Put Holder (buyer) Gives the buyer of the put the right to sell an asset at the exercise pricePayoffs to Put Holder0 if ST > X(X - ST) if ST < XProfit to Put HolderPayoff – Premium - P + X – STMax. loss: Premium Max. gain: unlimited
41 Payoffs and Profits at Expiration – Put Seller (writer) Put WriterSeller of the right to sell an asset at the exercise pricePayoffs to Put Writer0 if ST > X-(X - ST) if ST < XProfits to Put WriterPayoff + Premium P – X + STMax. loss: unlimited Max. gain: Premium
42 Profit Profiles for Puts ProfitsPut WriterPut HolderStock Price
43 Key Note Risk characteristics of Options While return is limited to the premium, the writer of the options have unlimited risk!I do not recommend anyone writing options, unless you already own the stockWhile loss is limited to the premiums, the buyer of the options have unlimited upsideWhile I don’t recommend options, if you must used this, be a buyer and not a seller