Derivative Markets

Agenda An Introduction to Derivatives Types of Derivatives Call Options Put Options Options Resources

What is a derivative? A financial instrument that derives its value from the price of an underlying asset For example, if I have a cow, and sell you the right to its meat once it goes the slaughterhouse, the cow meat is the underlying asset and the contract itself is a the derivative Key concept: a change in the underlying price of the asset changes the price of the derivative itself (ex. Cow meat goes up in value, someone will be willing to buy the rights to the meat for more)

Derivative Markets Options Futures Swaps

Futures Example I own a corn field that produces 100 tons of corn each season. I am approached by a buyer who offers to buy my corn for $750/ton when its trading at $800 now. Since I am unsure of what the price of corn will be 3 months from now when I harvest it and try to sell it, I take the deal

Futures Example Along comes harvest day and the price of corn has changed. Now corn is trading at $850/ton due to larger than expected demand. Since I am contractually obligated to sell my corn at $750/ton, I sell the corn for $750, losing out on an extra $100 per ton. The person who bought my corn buys it from me for the agreed upon $750, then turns around and sells it immediately at the market price of $850, making a $100/ton profit.

Why? Why would I enter this futures contract? I ended up losing out on $100 and even sold my corn at below market price when I issued the contract for $750 instead of $800. – UNCERTAINTY! By giving away the potential upside, I am protecting myself from the downside risk of corn’s price falling.

Corn Futures Example 2 Let’s say the price of corn fell in the previous example. I have a futures contract to sell at $750/ton, but the market price at harvest time is now $500/ton. My buyer is legally obligated to pay me $750/ton for the specified amount, despite the fact he could buy it cheaper on the market. Instead of only making $500/ton, my futures contract protected me from downside market risk and I made $750/ton

Futures Trading Once you own a futures contract, you can trade it to another person, giving them the right to collect the underlying asset at the fixed price. So when the price of the commodity increases and you have a futures contract to buy for less, people are willing to buy your contract

What other kinds of futures are there? Energy – Oil, Natural Gas Agriculture – Corn, wheat, cotton, coffee, sugar Livestock – Cows, chickens, hogs Metals – Gold, silver, copper, platinum Pretty much any kind of commodity (a good that is identical from other similar goods)

Futures Reviews Futures are contracts where one party agrees to purchase some asset at a fixed price in the future. – The selling party will sell a futures contract if it expects price to be uncertain, drop, or if the current price is good – The buying party will buy a futures contract if it expects price to increase in the future

Derivative Markets Options Futures Swaps

A derivative where two or more parties exchange cash flows in return for security against default on payments Credit Default Swaps Interest Rate Swaps

Credit Default Swap Example My company decides to purchase Greek debt bonds (15% interest payments a year) However; I am worried that Greece may fail and default on the bonds, giving me nothing. I go to an insurance company to organize a credit default swap

Credit Default Swap Example AIG (the insuring party) agrees to insure my transaction with Greece. They agree to pay me a lump sum of cash (the principal of my bond to Greece +/- a little) if Greece defaults, and in return, get a cut of the interest payments (5%). Ideally, AIG wants Greece to not default so they don’t have to pay out the claim, and they get to continue to collect their share of the interest.

CDS Trading AIG can then turn around and trade the CDS on a swap market. If Greece increased its ability to pay back the debt, the value of the CDS goes up. Since the CDS was issued for a certain risk level and determined its cut of the interest based on that risk level, and now the risk level is lower, but the cut is the same, the CDS is generating more return for the current risk. This makes the CDS more valuable. AIG can then sell the CDS for a profit.

CDS Trading If Greece becomes more unstable, the chance of default increases. Since the CDS was issued for a certain risk level and determined its cut of the interest based on that risk level, and now the risk level is higher, but the cut is the same, the CDS is not generating enough return for the current risk. This makes the CDS less valuable. AIG would have significant difficulty selling this CDS for a profit

Swaps Conclusion In essence, swaps deal with cash flows being exchanged between two parties, with a third party stepping in to limit the variability and risk of the cash flows. – The issuer of the CDS (the insurer) is betting on the company to not default and to pay out all the interest payments. – The person receiving interest payments buys a CDS to protect against risk of default – The company paying out interest has no direct stake in the CDS

Derivative Markets Options Futures Swaps

An Option Walkthrough Date is currently Friday, Feb 22. CAT is currently trading at $100 per share. I expect that CAT will increase in price between now and Friday, Mar 8 because its earnings report comes out on Mar 5. I could buy 100 shares of CAT for $10,000, or I could use options.

Options Markets Options are the right to buy a security at a fixed strike price for a certain amount of time. Some definitions: – Strike Price- the price your options contract says you can buy 100 shares for – In-the-money- when the strike price of the option is below market price of the shares – Out-of-the-money- when strike price is above the current share price – Expiration Date- the last day you can exercise the option before it expires

Options When you are looking to use options, the first step is buying the option – Options have listed prices based on their strike price, volatility of the underlying stock, time until maturity, etc. – The price that’s listed is not the real price! Since options are rights to buy 100 shares, you have to multiply the option price by 100. – In essence, the option price + strike price is the minimum share price the stock must trade at in order to make a profit

Options Example Strike Price $85 $90 $95 $100 $105 $110 $115 Out of the money In the money $31 $24 $18 $6 $.85 $.02 $.01 Option Cost Note how the cost of the option + share price is greater than the current share price This prevents people from just buying the in- the-money options, exercising them immediately, and making instant profit $116 $114 $113 $105 $ $ $ Price stock has to be in order to make a profit (cost + strike price) Note how as you get deeper in the money, and the risk that your strike price is less than market price declines, you have to pay more for the option, and thus, actually have to have a higher share price to make a profit.

Back to the Options Buy 1 Call Option (Call meaning you have the right to BUY the stock at the strike price) at a strike price of $100 for $6, expiring Mar 8. By buying this call option, I am wagering that sometime before Mar 8, the share price will be greater than $100+$6. On March 5, the earnings report that comes out makes CAT shoot up to $125 per share.

What to do with the option The stock is trading at $125, and my option has a strike price of $100. At this point you have three choices: – Exercise the option, buying 100 shares at $100 and selling them immediately for $125 for a $1900 profit (125-(100+6)*100) – Hold onto the option to see if the share price goes up more – Sell the option to another person for $25, earning a profit of $1900 ((25-6)*100)

What to do with the option Because profit is the same if you exercise or sell the option, many people choose to sell the option so they don’t have to spend $10,000 to buy the shares and turn around and sell them Generally, options are not exercised until they reach their expiration

Return Analysis of the Trade Profit = $1900 Investment = $1100 = 72.7% return If you simply bought 100 shares of the stock for $100 each, then sold at $125, you would have made: Profit = $2500 Investment = $10,000 = 25% return Using options, investors can make much larger returns with less capital.

So why not trade options? Let’s take a look at the situation if share price stayed at $100 at march 8 (expiration). – If you have the right to buy 100 shares at $100 each, but that’s the market price, so there’s no reason to exercise the option. – Since the option expires at the end of March 8 and it won’t be exercised, you lose all of your initial investment of $600 – If you bought the shares themselves, you would have had not lost or made anything

So why not trade options? So call options allow you to create large returns, but are very easy to erase all your money with. – If share price is below the strike price, you lose all your money – If share price between strike price and strike price + option cost, you lose some of your money

Put Options Put Options are options that allow you to SELL a stock at a given strike price. – Use put options when you think that a stock is going to decline in value before the expiration date. On another end, the person who writes the put option and sells it to you is offering to buy 100 shares of the underlying stock from you at a fixed price

Put Options: Concept If a company’s stock price goes down you can buy 100 shares on the market, then turn around and sell them at a higher price than what you paid to the person who wrote the put. In this case, the lower the market price of the stock, the cheaper you can buy it for, and the more money you make when you sell it at the fixed price

Put Option: Example GE is trading at $20 per share, and you think it is going to decline soon. You purchase a put option for $.50 at a strike price of $18. Since exercising the option to sell stock for $18 when you can sell it now for $20 would return less money to you, this is considered an “out of the money“ put.

Profit and Loss If GE goes from $20 to $10, you can: – Exercise the option, buying 100 shares at the market price of $10 and selling them for $18 each. Profit is $750(($18-$10-$.50)*100) If GE goes from $20 to $17.50 you make: – ($18 - $ $.50) *100 shares = $0 If GE goes from $20 to $17.75, – ($18- $ $.50) * 100, you lose $25

Why trade put options? When shorting a company (borrowing shares from an investor, selling them immediately, then buying them back at a lower price in the future to return to the investor), the major risk is that if the company’s share price shoots up, you may not have enough money to buy back the shares to exchange Shorting has unlimited risk

Why trade put options? When using put options to bet on a stock’s price going down, the most money you can lose was what you paid for the options themselves. This protection from the unlimited upside makes trading puts much more attractive than shorting.

Options Strategies Investors combine different options together with different strike prices in order to provide different protections from volatility and allow them to make large profits in any situation, provided the strategy is structured correctly. A number of websites have strategies listed: – Optionsplaybook.com has great illustrations of how to set up different strategies, where you make profit, what you are betting on, etc. We will cover basic options strategies later this semester