1. Brief history of Derivatives History of derivatives is quite colorful and surprisingly a lot longer than most people think In Genesis Chapter 29, believed to be about the year 1700 B.C., Jacob purchased an option costing him seven years of labor that granted him the right to marry Laban's daughter Rachel Futures contracts can be traced to Ancient Greece, in Aristotle's writings. Thales, a poor philosopher, predicted that olive harvest would be exceptionally good. He made agreements with olive-press owners to guarantee him exclusive use of their olive presses. When the harvest-time came, and many presses were wanted all at once, he let them out at inflated rates. Dutch Tulip bulb mania was characterized by forward contracts on tulip bulbs around 1637 First futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s, to meet the needs of Samurai who, being paid in rice and after a series of bad harvests, needed a stable conversion to coin.Dōjima Rice Exchange

2. Introduction Chapter 1

3. What is a derivative?

4. Derivatives Derivative = a financial engineering tool = a type of investment = an instrument whose value depends on the value of other more basic underlying assets –Agreement with your parents to get $100 for every 1% that you get in this course over and above 90% Primary objectives of any investor are to maximize returns and minimize risks. Derivatives are contracts that originated from the need to minimize risk. Not creating value but redistributing it – zero sum game

5. Examples of Derivatives Futures Contracts Forward Contracts Options

6. Derivatives Markets Spot vs Derivatives Markets Exchange traded –Traditionally exchanges have used the open-outcry system (mosh pit), but increasingly they are switching to electronic trading –Contracts are standard and there is virtually no credit risk (1 contract of corn = 5000 bushels) –Value of assets underlying the contracts: US $344 trillion as of Q4 2005 Over-the-counter (OTC) –Computer and telephone-linked network of dealers at financial institutions, corporations, and fund managers –Contracts can be non-standard and there is some credit risk –Value of assets underlying the contracts: US $684 trillion as of June 2008

7. Futures Contracts Agreement to buy or sell an asset for a certain price at a certain time in the future Example of futures/forwards contract: –Farmer growing corn and Kellogg’s Spot Price vs Futures Price Similar to forward contract but standardized Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

8. Examples of Futures Contracts Agreement to: –Buy (long futures position) 100 oz. of gold @ US$903/oz. in December –Sell (short futures position) £62,500 @ 1.7666 CDN$/£ in September –Sell (short futures positions) 1,000 bbl. of oil @ US$53/bbl. in July

9. Positions in Futures Contracts If you buy the contract: –you take a long futures position –you believe the futures price will increase –profit graph If you sell the futures contract: –you take a short futures position –you believe the futures price will decrease –profit graph

10. Profit from a Long Futures Position Profit Price of Underlying Asset at Maturity, S T F

11. Profit from a Short Futures Position Profit Price of Underlying at Maturity, S T F

12. US Exchanges Trading Futures Chicago Board of Trade –Corn, oats, wheat, Treasury bonds and notes –http://www.cbot.com/cbot/pub/page/0,3181,21,00.htmlhttp://www.cbot.com/cbot/pub/page/0,3181,21,00.html New York Mercantile Exchange (NYMEX) –futures and options contracts for crude oil, gasoline, heating oil, natural gas, electricity, gold, silver, copper, aluminum, and platinum, etc –http://www.nymex.com/CL_spec.aspxhttp://www.nymex.com/CL_spec.aspx Chicago Mercantile Exchange (CME Group, 1919) –Chicago Produce Exchange (1874): butter, eggs, poultry –Chicago Butter and Egg Board (1898) –Futures and options based on interest rates, equity indexes, foreign exchange, energy, agricultural commodities, metals, and alternative investment products such as weather and real estate –http://www.cmegroup.com/http://www.cmegroup.com/

13. Canadian Exchanges Trading Futures ICE Futures Canada (formerly, Winnipeg Commodity Exch.) –Established in 1887 and located in Winnipeg, Manitoba –WCE does not trade stocks. The Exchange trades agricultural commodity futures contracts and options on futures contracts which include canola, wheat, and western barley –https://www.theice.com/wce.jhtmlhttps://www.theice.com/wce.jhtml Montreal Exchange: –Equity derivatives (equity options) –Currency derivatives (options on the US dollar) –Index derivatives –Interest rate derivatives (bond and money markets) –http://www.m-x.ca/produits_indices_sxf_en.phphttp://www.m-x.ca/produits_indices_sxf_en.php

14. Forward Contracts A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery or settlement price) It can be contrasted with a spot contract which is an agreement to buy or sell immediately Similar to futures contract but customized to investors’ needs Whereas a futures contract is traded on an exchange, a forward contract is traded over-the- counter

15. Terminology The party that has agreed to buy has a long position The party that has agreed to sell has a short position

16. Ways Derivatives are Used To hedge risks: reduce risk from potential futures market movements To speculate: bet on future direction of market To lock in an arbitrage profit: offsetting positions in two or more instruments to lock in a riskless profit

17. Options Option is the right to buy or sell an asset (underlying asset) for a certain price by a certain date Two types: CALL OPTION and PUT OPTION Spot Price vs Strike Price http://www.m-x.ca/nego_cotes_en.php?symbol=L*&image.x=15&image.y=14 A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put is an option to sell a certain asset by a certain date for a certain price (the strike price)

18. Call Options CALL OPTION: gives an investor the right to buy the underlying asset; an investor can buy (holder) or sell (writer) a call option –If you buy the call option: you buy (or GET or HAVE) the right to buy the underlying asset from someone you are now the holder of the call option we call this taking a long position in a call option long = buy –If you sell the call option: you sell (or GIVE) someone the right to buy the underlying asset from you you are now the writer of the call option we call this taking a short position in a call option short = sell

19. Put Options PUT OPTION: gives an investor the right to sell the underlying asset; an investor can buy (holder) or sell (writer) a put option –If you buy the put option: you buy (or GET or HAVE) the right to sell the underlying asset to someone you are now the holder of the put option we call this taking a long position in a put option long = buy –If you sell the put option: you sell (or GIVE) someone the right to sell the underlying asset to you you are now the writer of the put option we call this taking a short position in a put option short = sell

20. Options 4 positions: buyers of calls and puts and sellers of calls and puts American options: can be exercised at any time during its life European options: can be exercised only on the maturity date Offsetting orders (Kellogg’s)

21. Exchanges Trading Options Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Stock Exchange European Options Exchange Australian Options Market Montreal Exchange

22. Long Call on Microsoft Profit from buying a European call option on Microsoft: option price = $5, strike price = $60 30 20 10 0 -5 30405060 708090 Profit ($) Terminal stock price ($)

23. Short Call on Microsoft Profit from writing a European call option on Microsoft: option price = $5, strike price = $60 -30 -20 -10 0 5 30405060 708090 Profit ($) Terminal stock price ($)

24. Long Put on IBM Profit from buying a European put option on IBM: option price = $7, strike price = $90 30 20 10 0 -7 90807060100110120 Profit ($) Terminal stock price ($)

25. Short Put on IBM Profit from writing a European put option on IBM: option price = $7, strike price = $90 -30 -20 -10 7 0 90 807060 100110120 Profit ($) Terminal stock price ($)

26. Payoffs from Options What is the Option Position in each case? K = Strike price, S T = Price of asset at maturity Payoff STST STST K K STST STST K K

27. Types of Traders Hedgers Speculators Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators Barings Bank (1762): http://en.wikipedia.org/wiki/Barings_Bank http://en.wikipedia.org/wiki/Barings_Bank It collapsed in 1995 after one trader, Nick Leeson, lost $1.4 billion in speculation of Singapore International Monetary Exchange primarily on futures contracts. Purchased by ING for 1 GPB. WLU professors

28. Questions 5 th and 6 th Edition: 1.8, 1.11, 1.15 1.16, 1.21, 1.23, 1.26 7 th Edition: 1.8, 1.11, 1.15 1.16, 1.21, 1.23, 1.30