Derivative Markets: Overview Finance (Derivative Securities) 312 Tuesday, 1 August 2006 Readings: Chapters 1, 2 & 8

Nature 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)

Futures  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 supply  Traditionally 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 Size Source: Hull (2004)

Margins  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-Market

Convergence Time (a)(b) Futures Price Futures Price Spot Price

Forwards Private contract between 2 partiesExchange traded Not standardised Standard contract Usually 1 specified delivery date Range of delivery dates Settled at maturity Settled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity FORWARDSFUTURES Some credit riskVirtually no credit risk

Foreign 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 Forwards/Futures Profit Price of Underlying Asset at Maturity Profit Price of Underlying Asset at Maturity Long positionShort position

Options  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 Diagrams Buy Call Buy Put $$ STST STST XX Payoff – Bold Line Profit – Dashed Line

Margins  Margins are required when options are sold  When a naked option is written the margin is the greater of: 1A 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 2A total of 100% of the proceeds of the sale plus 10% of the underlying share price

Warrants  Options issued by a corporation or financial institution  Traded the same way as stocks  For call warrants, exercise will lead to new treasury stock being issued

Executive Stock Options  At-the-money, issued to company executives  Exercise will lead to new issue of stock  Become vested after a period of time (usually 1 to 4 years)  Cannot be sold  Often last for as long as 10 or 15 years

Convertible 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 Bonds Bond Value Share Price Straight Bond Value Conversion Value Market Price Market Premium