1. 1.1 550.444 Introduction to Financial Derivatives Introduction Weeks of September 4 and September 9, 2013

2. 1.2 Principals David R Audley, Ph.D.; Sr. Lecturer in AMS david.audley@jhu.edu Office: WH 212A; 410-516-7136 Office Hours: 4:30 – 5:30 Monday Teaching Assistant(s) Huang, Qiushun (qhuang13@jhu.edu)qhuang13@jhu.edu Office Hours: Friday 4pm – 6pm Ward, Brian (bward16@jhu.edu)bward16@jhu.edu Office Hours: Monday & Wednesday 2pm – 3 pm

3. 1.3 Schedule Lecture Encounters Monday & Wednesday, 3:00 - 4:15pm, Mergenthaler 111 Section Section 1: Friday 3:00 - 3:50pm, Hodson 211 Section 2: Thursday 3:00 - 3:50pm, WH 304

4. 1.4 Protocol Attendance Lecture – Mandatory (default) for MSE Fin Math majors Quizzes & Clickers Section – Strongly Advised/Recommended Assignments Due as Scheduled (for full credit) Must be handed in to avoid “incomplete” Exceptions must be requested in advance

5. 1.5 Resources Textbook John C Hull: Options, Futures, and Other Derivatives, Prentice-Hall 2012 (8e) Recommended: Student Solutions Manual On Reserve in Library Text Resources http://www.rotman.utoronto.ca/~hull/ofod/Errata8e/index.html http://www.rotman.utoronto.ca/~hull/TechnicalNotes/index.html

6. 1.6 Resources Supplemental Material As directed AMS Website http://jesse.ams.jhu.edu/~daudley/444 Additional Subject Material Class Resources & Lecture Slides Industry & Street “Research” (Optional) Consult at your leisure/risk Interest can generate Special Topics sessions Blackboard

7. 1.7 Measures of Performance Mid Term Exam (~1/3 of grade) Final Exam (~1/3 of grade) Home work as assigned and designated and Quizzes (~1/3 of grade)

8. 1.8 Assignment Thru week of Sept 9 (Next Week) Read: Hull Chapter 1 (Introduction) Read: Hull Chapter 2 (Futures Markets) Problems (Due September 16) Chapter 1: 17, 18, 22, 23; 34, 35  Chapter 1 (7e): 17, 18, 22, 23; 30, 31 Chapter 2: 15,16, 21, 22; 30  Chapter 2 (7e): 15, 16, 21, 22; 27

9. 1.9 Assignment For week of Sept 16 (in 2 Weeks) Read: Hull Chapters 3 (Hedging with Futures) Problems (Due September 23) Chapter 3: 4, 7, 10, 17, 18, 20, 22; 26  Chapter 3 (7e): 4, 7, 10, 17, 18, 20, 22; 26

10. 1.10 Assets and Cash Stock, Bond, Commodity, … (Assets) Risk vs. Return (Expected Return) Cash (or Currency) Held, on Deposit or Borrowed Terminology Assets – things we “own” (long) Liabilities – what we “owe” (short)

11. 1.11 How Things Work True Assets – A house, a company, oil, … Ownership rights, contracts, & other legal instruments which represent the true asset For us, many are indistinguishable from the asset; are the asset Provide properties that can be quantified, assigned, subordinated and made contingent Can be modeled

12. 1.12 Who Makes it Work Investment Banks: Capital Intermediation Companies into Stock Borrowings into Bonds Broker-Dealers & Markets (Exchanges) Create everything else Facilitate transfer/exchange (trading) Investors Under the Watchful Eyes of Regulators, Professional Associations and the Rule of Law

13. 1.13 Creation & Exchange of Securities and Instruments Create Securities Make Markets Manage Invested Funds Collateral New Issue Securities Securities & Contracts Secondary Issues Investment Banking Broker-Dealers & Exchanges Institutional Investors

14. 1.14 Two Fundamental Ideas in Modeling Cash Flow Cash flow diagram Receive vs. Pay over Time Payoff Cashflow Payoff diagram Gain vs. Loss against Price Cashflows can depend on some other variable Receive Pay LOAN FROM STANDPOINT OF LENDER Amount of Loan, t 0 Repayment of Loan w/Interest at t 0 +T t, time Gain Loss S, Price K LONG STOCK AT PRICE K

15. 1.15 Real World Situation - Cash Japanese Bank; borrow US dollars (USD) to loan to its customers; term, 3 months Go to Euromarket where it might be able to get an Interbank Loan t0t0 t 0 + T USD USD+Lt 0 x(.25)xUSD T = 1/4 year Lt 0 = 3 month interest rate in effect at t 0 Borrow: USD Pay Back: USD x (1 + Lt 0 x T) Receive (Borrow) Pay Back

16. 1.16 Real World Situation - Cash What if Bank did not have credit line? Could perform the same transaction as a Synthetic in the FX and domestic Yen mkt Borrow Yen in local mkt for term T, at L(t 0,Y) Sell Yen and buy USD in spot FX mkt at e(t 0,Y) Finally, the bank buys Yen and sells USD in the forward FX market for delivery at t 0 +T

17. 1.17 Real World Situation - Cash Cash Flows are Additive + + = t0t0 t 0 +T Y Yx(1+L(t 0,Y)xT) USD Y Yx(1+L(t 0,Y)xT) USD USDx(1+L(t 0,$)xT) Borrow Y for T Buy USD sell Y at e(t 0,Y) Y = e(t 0,Y) x USD Buy Y forward for t 0 +T Y x (1 + L(t 0,Y)xT) = f(t 0,T;Y) x USD1 USD1 = USD x (1 + L(t 0,$) x T) USDx(1+L(t 0,$)xT)

18. 1.18 Real World Situation - Cash What’s the difference; what’s interesting International Banks have credit risk in the USD loan For the synthetic, the International Bank exposure is in the forward contract only No principal risk Yen loan default is a domestic issue (central bank) The synthetic can be used to price the derivative, ex- credit risk (what’s the derivative in this example?) Each side could be the other’s hedge Different markets involve many legal & regulatory differences

19. 1.19 Real World Situation - Tax Situation: In Sept ‘02, investor bought asset S, S 0 =$100 EOM Nov, asset target reached at $150 (sell) Sale yields gain of $50 (taxable) Wash-Sale Rule prohibits: Sell winner at $50 gain Sell another asset, Z that’s down $50 to $50 to offset gain Buy asset Z back next day as investor still likes it Prohibited since trade is intentionally washing gain

20. 1.20 Real World Situation - Tax Alternative Synthetic using Options Call Option (Strike = S 0 )  Long has right to buy underlying at pre-specified price, S 0  Short has obligation to deliver underlying at that price Expiration Payoff Chart + - + - S0S0 S S0S0 S For the LONGFor the SHORT

21. 1.21 Real World Situation - Tax Put Option (Struck at S 0 )  Long has right to sell underlying at pre-specified price, S 0  Short has obligation to accept delivery of underlying at S 0 Expiration Payoff Chart + - S + - S S0S0 S0S0 For the LONGFor the SHORT

22. 1.22 Real World Situation - Tax Consider the Synthetic (to offset 50 gain) Buy another Z asset at 50 in Nov (11/26/02) Sell an at-the-money call on Z Strike, Z 0 = 50 Expiration >= 31 days later, but in 2002 (12/30/02) Buy an at-the-money put on Z (same expiry) At expiration, sell the Z asset or deliver into Call

23. 1.23 Real World Situation - Tax Payoff Charts for the Synthetic 50 + - Z + - Z + - Z Short Call Long Put Synthetic Short in Z Price at the expiration of the options, Z e If Z e > 50: Short Call looses money as short has to deliver Z for 50 Long Put is worthless If Z e < 50: Short Call is worthless Long Put gains as the long can sell Z for 50 In either case the investor has locked in the 50 price for the stock bought at 100 (FIFO)

24. 1.24 Real World Situation - Tax The timing issue is important According to US Tax law, wash sale rules apply if the investor acquires or sells a substantially identical property within a 31-day period In the synthetic strategy, the second Z is purchased on 11/20; while the options expire on 12/30 when the first Z is sold (and the tax loss is “booked” – FIFO accounting)

25. 1.25 Real World Examples – Consequences & Implications Strategies are Risk Free and Zero Cost (aside from commissions and fees) We created a Synthetic (using Derivatives) and used it to provide a solution Finally, and most important, these examples display the crucial role Legal & Regulatory frameworks can play in engineering a financial strategy (its the environment)

26. 1.26 Two Points of View Manufacturer (Dealer) vs. User (Investor) Dealer’s View: there are two prices A price he will buy from you (low) A price he will sell to you (high) It’s how the dealer makes money Dealer never has money; not like an investor Must find funding for any purchase Place the cash from any sale Leverage

27. 1.27 Two Points of View Dealers prefer to work with instruments that have zero value at initiation (x bid/ask) Likely more liquid No principal risk Regulators, Professional Organizations, and the Law are more important for market professionals than investors Dealers vs. Investors

28. 1.28 The Nature of Derivatives A derivative is an instrument whose value depends on the values of other more basic underlying variables

29. 1.29 Examples of Derivatives Futures Contracts Forward Contracts Swaps Options

30. 1.30 Derivatives Markets Exchange traded Traditionally exchanges have used the open- outcry system, but increasingly they are switching to electronic trading Contracts are standard; virtually no credit risk Over-the-counter (OTC) A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard and there is some (small) amount of credit risk

31. 1.31 Size of OTC and Exchange Markets Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

32. 1.32 Ways Derivatives are Used To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another

33. 1.33 Forward Price The forward price (for a contract) is the delivery price that would be applicable to a forward contract if were negotiated today (i.e., the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities

34. 1.34 Terminology The party that has agreed to buy has what is termed a long position The party that has agreed to sell has what is termed a short position

35. 1.35 Example On May 24, 2010 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.4422 This obligates the corporation to pay $1,442,200 for £1 million on November 24, 2010 What are the possible outcomes?

36. 1.36 Profit (or Payoff) from a Long Forward Position Profit Price of Underlying at Maturity, S T K Payoff at T = S T – K

37. 1.37 Profit from a Short Forward Position Profit = Payoff at T = K - S T Price of Underlying at Maturity, S T K

38. 1.38 Foreign Exchange Quotes for GBP May 24, 2010 BidOffer Spot1.44071.4411 1-month forward1.44081.4413 3-month forward1.44101.4415 6-month forward1.44161.4422

39. 1.39 Foreign Exchange Quotes for JPY Jan 22, 2007 (16:23 EST) BidOffer Spot121.62121.63 1-month forward121.08121.09 3-month forward120.17120.18 6-month forward118.75118.77

40. 1.40 1. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$900 The 1-year forward price of gold is US$1,020 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

41. 1.41 2. Gold: Another Arbitrage Opportunity? Suppose that: The spot price of gold is US$900 The 1-year forward price of gold is US$900 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

42. 1.42 The Forward Price of Gold – The Principal of Cash and Carry If the spot price of gold is S(t 0 ) and the forward price for a contract deliverable in T years is F(t 0,T), then Can borrow money, buy gold, and sell the commodity forward - where there should be no arbitrage: F(t 0,T) - S(t 0 ) x (1+ r ) T = 0 where r is the 1-year money rate of interest to finance the gold carry trade. In our examples, S = 900, T = 1, and r =0.05 so that F(t 0,T) = 900(1+0.05) = 945 The no arbitrage 1 year forward price of gold is $945

43. 1.43 The Forward Price of Gold – The Principal of Cash and Carry How does this come about? S(t0) t0 receive pay S(t0)x(1+r) Gold S(t0) F(t0) Gold Own Deliver Gold Borrow S(t0) Buy Gold at S(t0) Sell Gold Forward at F(t0) No Arbitrage condition says: F(t0) – S(t0)x(1+r) = 0 + + =

44. 1.44 Gold Arbitrage? The no arbitrage gold, 1-year forward condition is F(t 0,T) - S(t 0 ) x (1+ r ) T = 0 If 1-year forward is $1020, then F(t 0,T) - S(t 0 ) x (1+ r ) T > 0 so our strategy is to borrow money, buy gold, sell it forward, deliver gold, and pay off loan for a riskless profit of $75 If 1-year forward is $900, then F(t 0,T) - S(t 0 ) x (1+ r ) T < 0 and if I own gold, I can sell it, deposit proceeds, buy forward, pay with the proceeds of the deposit and collect a riskless profit of $45 over the 1-year period

45. 1.45 Futures Contracts Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

46. 1.46 Futures Contracts Forward contracts are similar to futures except that they trade in the over-the- counter market Forward contracts are particularly popular on currencies and interest rates

47. 1.47 Exchanges Trading Futures Chicago Board of Trade (CME) Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book)

48. 1.48 Examples of Futures Contracts Agreement to: Buy 100 oz. of gold @ US$1080/oz. in December (NYMEX) Sell £62,500 @ 1.4410 US$/£ in March (CME) Sell 1,000 bbl. of oil @ US$120/bbl. in April (NYMEX)

49. 1.49 Options A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

50. 1.50 American vs European Options An American style option can be exercised at any time during its life A European style option can be exercised only at maturity

51. 1.51 Intel Option Prices (Sept 12, 2006; Stock Price=19.56) Strike Price Oct Call Jan Call Apr Call Oct Put Jan Put Apr Put 15.004.6504.9505.1500.0250.1500.275 17.502.3002.7753.1500.1250.4750.725 20.000.5751.1751.6500.8751.3751.700 22.500.0750.3750.7252.9503.1003.300 25.000.0250.1250.2755.450

52. 1.52 Exchanges Trading Options Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) and many more (see list at end of book)

53. 1.53 Options vs Futures/Forwards A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

54. 1.54 Types of Traders Hedgers Speculators Arbitrageurs Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators (See, for example, SocGen (Jerome Kerviel) in Business Snapshot 1.3, page 17)

55. 1.55 Hedging Examples (pages 10-12) A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put option with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

56. 1.56 Hedging Example A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract Possible strategies: Buy £ now, deposit in bank, withdraw £10 million in 3 months, pay for imports Buy £10 million forward in 3 months, deposit USD, use deposit proceeds to settle and pay for imports Do nothing now and buy £10 million in the spot FX market in 3 months First 2 are riskless, third has currency risk. Which makes most sense?

57. 1.57 Value of Microsoft Shares with and without Hedging

58. 1.58 Speculation Example An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of 22.50 is $1 What are the alternative strategies? Buy 100 shares or Buy 20 Calls (on 100 shares each)

59. 1.59 Arbitrage Example A stock price is quoted as £100 in London and $140 in New York The current exchange rate is 1.4410 What is the arbitrage opportunity? Buy 100 shares in NY; sell 100 in London = 100 [(1.441 x 100) – 140] = 410

60. 1.60 Futures Contracts Available on a wide range of underlyings Exchange traded Specifications need to be defined: What can be delivered, Where it can be delivered, & When it can be delivered Settled daily

61. 1.61 Forward Contracts vs Futures Contracts Private contract between 2 partiesExchange traded Non-standard contractStandard contract Usually 1 specified delivery dateRange of delivery dates Settled at end of contractSettled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity FORWARDSFUTURES Some credit risk Virtually no credit risk

62. 1.62 Margins A margin is cash or marketable securities deposited by an investor with the broker Initial Margin Maintenance Margin The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract

63. 1.63 Example: Futures Trade (page 27-28)

64. 1.64 A Possible Outcome Table 2.1, Page 28

65. 1.65 Other Key Points About Futures They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity

66. 1.66 Collateralization in OTC Markets It is becoming increasingly common for contracts to be collateralized in OTC markets They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)

67. 1.67 Another Detail for Cash and Carry Arbitrage Contract price changes with longer term Higher or Lower To this point we have neglected storage cost Lets re-visit no-arbitrage equation F(t0,T) - S(t0) x [(1+ r ) T ] = Storage (T) Storage costs ignored in earlier gold example No storage costs for FX Convenience Yield

68. 1.68 1. Oil: An Arbitrage Opportunity? Suppose that: - The spot price of oil is US$95 - The quoted 1-year futures price of oil is US$125 - The 1-year US$ interest rate is 5% per annum - The storage costs of oil are 2% per annum Is there an arbitrage opportunity?

69. 1.69 2. Oil: Another Arbitrage Opportunity? Suppose that: - The spot price of oil is US$95 - The quoted 1-year futures price of oil is US$80 - The 1-year US$ interest rate is 5% per annum - The storage costs of oil are 2% per annum Is there an arbitrage opportunity?

70. 1.70 Futures Prices for Gold on Jan 8, 2007: Prices Increase with Maturity

71. 1.71 Futures Prices for Orange Juice on Jan 8, 2007: Prices Decrease with Maturity

72. 1.72 Delivery If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash

73. 1.73 Some Terminology Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of contracts traded in 1 day

74. 1.74 Convergence of Futures to Spot Time (a)(b) Futures Price Futures Price Spot Price

75. 1.75 Questions When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest?

76. 1.76 Regulation of Futures Regulation is designed to protect the public interest CFTC – the Feds Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups NFA – the industry

77. 1.77 The End for Today Questions?