1. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 1 Derivative Securities:  A financial instrument whose value depends on (is derived from) the value of some commodity or some other financial asset (the “underlying asset)  The main purpose of derivatives is to transfer risk from one person or firm to another Forward Contract (Forwards):  An agreement between a buyer and seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date  The specified price is referred to as the “delivery price”  Forwards are usually private agreements between two parties  Forwards are usually customized (as opposed to standardized) agreements which are customized to the owner’s specifications and are therefore difficult to resell  The party that agrees to buy the underlying asset is said to have the “long position”  The party that agrees to sell the underlying asset is said to have the “short position”  The prearranged future delivery date is referred to as the “maturity date” or “expiration date”  The holder of the short position delivers the specified quantity of the asset at the specified time and place and in return receives from the holder of the long position a cash payment equal to the delivery price  No cash exchange occurs prior to the delivery date  The main purpose of forward contracts is to reduce risk on behalf of one or both parties Ch 9: Derivatives: Forwards, Futures, Options & Swaps

2. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 2 Forward Contract (Forwards): (continued) Example 1: Kellogg’s Co. enters into a forward contract for 462,000 bushels of corn with a Kansas Co-op for delivery 102 days from now. The delivery price is $3.32 per bushel.  Kellogg’s Co. motivation is its concern at not having sufficient quantities of corn on hand to meet projected production requirements  Kansas Co-op’s motivation is to sell its anticipated harvest as quickly as possible to avoid storage losses (costs, shrinkage and possible spoilage) and possible losses that may be incurred during the upcoming tornado season.  If prices go down in the next 102 days, Kansas Co-op wins out a little and Kellogg’s loses out a little; the opposite occurs if prices rise  However, both parties reduce their respective risks which usually far outweighs possible gain or loss due to changing asset prices Futures Contract (Futures):  Very similar to and same idea as forward contract except:  very standardized in terms of delivery date (i.e. delivery dates coincide with the 1 st of the month, 1 st day of a quarter, 1 st day of the year, etc.)  very standardized in terms of quantity of underlying asset (i.e. 100 bushels of produce, 100 shares of stock, 100 oz. silver, etc.)  sold through organized exchanges  the standardization of delivery date and underlying asset quantity negate the requirement of negotiation between parties; this reduces transaction costs  this standardization makes futures very tradable

3. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 3 Futures Contract (Futures): (continued)  Clearing Corporation  acts as a “middle man” between buyers & sellers  assumes the role of counterparty to both the buyer or seller  operates like an insurance company and dealer  ensures (insures) both the buyer’s and seller’s performance on the contract  this arrangement greatly reduces the risk of dealing in futures which promotes liquidity and economic growth  Margin Account  in order to reduce risk, the clearing corporation requires buyers & sellers to place a deposit with the corporation  this is called “placing a margin” in the “margin account”  the margin account helps guarantee both buyers & sellers will meet their obligation when the contract matures  when the price of the underlying asset changes…..  the margin accounts are adjusted accordingly and either increase or decrease depending on direction of price movement and the position of each party  this is called “marking to market”  when the contract matures, one party pays more than the amount originally deposited in the margin account and the other party gets a portion of its original deposit refunded

4. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 4 Futures Contract (Futures): (continued) Example 2: Kellogg’s Co. buys 4,620 futures contracts for a total of 462,000 bushels of corn (each contract = 100 bushels) through the CME. A Kansas Co-op sells 4,620 such contracts. Both parties make a deposit into their clearing company margin accounts. The delivery price is $3.32 per bushel with a delivery date of 1 November this year.  By the delivery date the price per bushel of corn rises $0.03 to $3.35.  At contact maturity, Kellogg’s pays an additional amount into its margin account for a total sum equal to the specified price of the corn ($1,533,840.00) and Kansas Co-op delivers the specified amount of corn (462,000 bushels).  Due to the price change, Kansas Co-op needs to pay and additional $13,860 to the clearing company and Kellogg’s receives that same amount as a refund. Kansas Co-op needs to compensate Kellogg’s for the price increase since they agreed to sell the corn for a lower price than what it was at maturity. Kellogg’s won out and Kansas Co-op lost.  Both parties still benefited from risk reduction as described in the previous example Hedging and Speculating With Futures  Futures contract allow risk to be transferred from buyer to seller (as described above) or vice versa  This is called “hedging”

5. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 5 Futures Contract (Futures): (continued) Example 3: A bond dealer has a large inventory of bonds he wishes to sell and is worried that spot rates will rise. He is willing to sell bond futures which will fix the price of the bonds he will sell in the future. A pension fund manager will be buying bonds in the future and is worried that spot rates will fall. He will be willing to buy bond futures. Both parties attempt to reduce the uncertainty of future bond prices but only one party will benefit, depending on which direction bond spot rates actually go in the future.  Speculators are not concerned about transferring risk  They are merely betting for the price of the underlying asset to rise or fall (depending on their position) in order to make a profit  Long position holders (buyers) bet that the price will rise  Short position holders (sellers) bet that the price will fall  Futures are popular for speculators because the required margin accounts are relatively small, usually 10% or less than the total value of the futures contract Example 4: A futures contract for the delivery of one hundred $1,000 face value Treasury notes ($100,000 total value of the 100 bonds) with 10 year maturity and 6.0000% coupon, the Chicago Board of Trade (the clearing company) requires a margin account deposit of only $1,200. This is as if the seller is borrowing $98,790 “on the margin”

6. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 6 Options:  An agreement that gives the owner (the holder) the right but not the obligation to buy or sell a fixed quantity of a commodity or financial asset at a fixed price at some specified future date  A seller, called the option “writer” takes/holds the “short position”  A buyer, called the option “holder” takes/holds the “long position”  Call Option:  gives the holder the right but not the obligation to buy or “call away” the specified quantity of the underlying asset at a predetermined price called the “strike price” on or before a specified date  the writer is obligated to sell the specified quantity of the underlying asset at the strike price on or before a specified date if and when the holder choses to exercise (call) the option Example 5: It’s 1 October 2015. A call option written on that date for 100 shares of IBM stock at a strike price of $200 gives the holder the right but not the obligation to buy 100 shares of IBM stock for $200 a piece prior to the third Friday of October 2015. The writer of this call option must sell that number of shares at the strike price if and when the holder choses to exercise the option  Let’s say that the price of this option is $1000 ($10 per share x 100 shares). The holder would call the option and make a profit by re-selling the shares if the price of IBM stock rises above $210 ($200 plus $10 cost per share). He buys the stock at lower than current market price then sells them at the current market price.  When the price of the IBM stock rises above the sum of the strike price and the cost per share of the option ($210) the option is said to be “in the money”  When the price of the IBM stock equals the sum of the strike price and the cost per share of the option ($210) the option is said to be “at the money”  When the price of the IBM stock is below the sum of the strike price and the cost per share of the option ($210) the option is said to be “out of the money”  If the this call option is never “in the money”, the holder will never exercise it and the writer makes a profit of $1,000

7. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 7 Options: (continued)  Put Option:  give the holder the right but not the obligation to sell or “put in the hands of the writer” the specified quantity of the underlying asset at a predetermined strike price on or before a specified date  the writer is obligated to buy the specified quantity of the underlying asset at the strike price on or before a specified date if and when the holder choses to exercise the option Example 6: It’s 1 October 2015. A put option written on that date for 100 shares of Diamond Jim’s stock at a strike price of $100 gives the holder the right but not the obligation to sell 100 shares of Diamond Jim’s stock for $100 a piece prior to 1 December of 2015. The writer of this put option must buy that number of shares at the strike price if and when the holder choses to exercise the option  Let’s say that the price of this option is $600 ($6 per share x 100 shares). The holder would call the option and make a profit if the price of Diamond Jim’s stock falls below $94 ($100 minus the $6 cost of the option). He would sell the stock at higher the current market price.  When the price of the Diamond Jim’s stock falls below the strike price minus the cost per share of the option ($94) the option is said to be “in the money”  When the price of the Diamond Jim’s stock equals the strike price minus the cost per share of the option ($94) the option is said to be “at the money”  When the price of the Diamond Jim’s stock stays above the strike price minus the cost per share of the option ($94) the option is said to be “out the money”  When this option is “out of the money” the holder won’t exercise the option and the writer make a $600 profit

8. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 8 Options: (continued)  Options are used for both speculation and risk transfer (hedging) Example 7: Hedging with Options It is now 1 October 2015. An investor has 100 shares of Diamond Jim’s stock. He is worried that the price of this stock may fall significantly due to an anticipated adverse lawsuit judgement. The current price of this stock is $56. The investor buys a put option on 100 shares of Diamond Jim’s stock with a strike price of $50 for $500 ($5 per share x 100 shares). The expiration date is 15 November 2015. If the price does not fall to $45, then his loss will be between $6 and $11. If the price of Diamond Jim’s stock falls below $45, the investor may choose to exercise the option. He will still incur a $6/share loss as the current price falls to the strike price, but that will be the limit of his loss if the price falls lower than $45. There are two major types of options:  American Option: the holder can exercise the option at any time between the time the option is written and the expiration date (the previous examples are these types of options)  European Option: the holder can only exercise the option at the expiration date Pricing an Option:  Option Price = Intrinsic Value + Time Value of the Option  Intrinsic Value: the value of the option if it is exercised immediately after it is written (this differs greatly between American and European options)  Time Value of the Option: the fee paid for the option reflecting its TVM relation ship to the time span between when the option is written and the expiration date  The option fee can be thought of as the price of the right to make a decision  The Black-Scholes model is most commonly used for option pricing

9. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 9 Options: (continued) CallsPuts Buyer (Long Position) Right to buy the underlying asset at the strike price prior to or on the expiration date Right to sell the underlying asset at the strike price prior to or on the expiration date Seller or Writer (Short Position) Obligation to sell the underlying asset at the strike price prior to or on the expiration date Obligation to buy the underlying asset at the strike price prior to or on the expiration date Option is "in the money" when Price of underlying asset is above the sum of the strike price and the option price Price of underlying asset is below the strike price minus the option price Who buys one (goes long) Someone who: -Wants to buy an asset in the future and insure the price paid will not rise -Wants to bet that the price of the undrlying asset will rise Someone who: -Wants to sell an asset in the future and insure the price paid will not fall -Wants to bet that the price of the underlying asset will fall Who sells/writes one (goes short) Someone who: -Wants to bet that the price of the underlying asset will not rise -A broker who is always willing to sell the underlying asset and is paid (via the option price) to take the risk Someone who: -Wants to bet that the price of the underlying asset will not fall -A broker who is always willing to buy the underlying asset and is paid (via the option price) to take the risk

10. MGT 470 Ch 9 Derivatives (cs3ed) v1.0 Sep 15 10 Swaps:  Allow one party to alter the stream of future cash flows it pays or receives, for a fee Interest-Rate Swaps:  An agreement between two parties to exchange periodic interest rate payments over some specified future period, based on an agreed-upon amount of principle (called the “notional principle”)  The agreed-upon amount of principle is called the “notional principle” because it is not borrowed, lent or exchanged; it is just used to calculate the value of the periodic cash flows to be swapped  In a simple interest rate swap, one party agrees to make payments based on a fixed rate while the counterparty agrees to make payments based on a floating rate.  The effect of this arrangement is to transform fixed-rate payments into floating-rate payments and vice versa  The party that benefits from steady income receives the fixed-rate payments (i.e. a pension fund)  The party that receives the floating-rate payments receives the fee