FNCE4030 Investments and Portfolio Management -...

transcript

University of Colorado at Boulder – Leeds School of Business – FNCE4030

FNCE4030 – Investments and

Portfolio Management

Introduction on Derivatives

What is a Derivative?

• A derivative is an instrument whose value

depends on, or is derived from, the value of

another asset.

• Examples:

– Futures

– Forwards

– Swaps

– Options

– Exotics

– …

Why Derivatives Are Important

• Key role in transferring risks in the economy

• Underlying assets include stocks, currencies,

interest rates, commodities, debt instruments,

electricity, insurance payouts, weather, etc.

• Many financial transactions have embedded

derivatives

• The real options approach to assessing

capital investment decisions has become

widely accepted

How Derivatives Are Traded

• On exchanges such as the Chicago Board

Options Exchange

• In the over-the-counter (OTC) market where

traders working for banks, fund managers

and corporate treasurers contact each other

directly

Size of OTC & Exchange-Traded Markets

Source: Bank for International Settlements. Chart shows total principal amounts for

OTC market and value of underlying assets for exchange market

Growth of OTC Market by Product

Jun.98 Jun.99 Jun.00 Jun.01 Jun.02 Jun.03 Jun.04 Jun.05 Jun.06 Jun.07 Jun.08 Jun.09 Jun.10 Jun.11 Jun.12

Commodity

Equity-linked

Credit default swaps

Interest rate

$ trilli

How Derivatives are Used

• To hedge risks – e.g. you are a producer of oil or a consumer of

soy beans, or are paid in a different currency

• 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

Forwards

Forward Price

• DEFINITION: the delivery price that

would be applicable to the contract if

negotiated today

(i.e. the delivery price that would make

the contract worth exactly zero today)

• The forward price may (and will likely)

be different for contracts of different

maturities

Some Terminology (more to come)

• The party that has agreed to buy has a long

position

• The party that has agreed to sell has a short

position

• Selling a derivative is sometimes referred to

writing a derivative (forwards, options, etc.)

• The contract delivery date is sometimes

referred to expiration date, or maturity date

Forward Example

• On Jan 10, 2013 the treasurer of a

corporation enters into a long forward

contract to buy £1 million in six months at an

exchange rate of 1.6115

• This contract obligates the corporation to pay

$1,611,500 for £1 million on the maturity date

(July 10, 2013)

• What are the possible outcomes?

Profit from a Long Forward

• K = delivery price = forward price at time

contract is entered into

Profit

Price of Underlying at

Maturity, ST K

Profit from a Short Forward

• K = delivery price = forward price at time

contract is entered into

Profit

Price of Underlying at

Maturity, ST K

Futures Contracts

• Agreement to buy or sell an asset for a

certain price at a certain time

• Similar to forward contract, but there are

• Differences:

– A forward contract is traded OTC, a futures

contract is traded on an exchange

– A futures contract requires daily settlement of the

value of the contract, a forward contract has a

cash flow only a maturity

• WARNING– This is what the book says but it is not

strictly true. More on this later.

Exchanges Trading Futures

• CME Group (formerly Chicago Mercantile

Exchange and Chicago Board of Trade)

• NYSE Euronext

• BM&F (Sao Paulo, Brazil)

• TIFFE (Tokyo)

• and many more (see list at end of Hull book)

Examples of Futures Contracts

• You think gold will appreciate during the year:

Buy 100 oz. of gold @ 1662 $/oz in Dec.

• You will receive GBP in March but want USD:

Sell £62,500 @ 1.661 US$/£ in March

• You are an oil producer and want to hedge:

Sell 1,000 bbl. of oil @ 92 $/bbl in April

• You are a soybean buyer looking to lock your

input costs:

Buy 1mm bushels of soybean in 6m

Futures/Forwards vs. Options

• A futures/forward

contract gives the

holder the

obligation to buy

or sell at a certain

• An option contract

gives the holder

the right to buy or

sell at a certain

Who Trades Derivatives?

• Hedgers use derivatives to mitigate the risk

they are already exposed to, coming from

their business or assets/liabilities

• Speculators use derivatives to express a

view – often with leverage – on a financial

sector/asset

• Arbitrageurs use derivatives to lock in a

specific payout for a risk-free profit

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 $26.88 per share. A two-

month put with a strike price of $27.00 costs

$1. The investor decides to hedge by buying

10 contracts

Speculation Example

• You have $2,000 to invest

• You believe that a stock price will increase

over the next 2 months

• The current stock price is $20

• The price of a 2-month call option with a

strike of 22.50 is $1

• What are the alternative strategies?

Arbitrage Example

• A stock price is quoted both in London and in

New York. The prices are:

– £100 in London

– $155 in New York

• The current exchange rate is 1.6100

• (ask your self what are the units of that figure)

• Is there an arbitrage opportunity?

• If so what is it?

Dangers

• Traders can switch from being hedgers to

speculators or from being arbitrageurs to

speculators

• It is important to set up controls to ensure that

trades are using derivatives in for their

intended purpose

• SocGen is an example of what can go wrong (see Hull, Business Snapshot 1.3 on page 17)

Hedge Funds (see Business Snapshot 1.2, page 11)

• Mutual Funds must

– disclose investment policies,

– makes shares redeemable at any time

– limit use of leverage

– take no short positions.

• Hedge Funds

– Are not subject to the same rules as mutual funds

– Cannot offer their securities publicly

– Use complex trading strategies are big users of

derivatives for hedging, speculation and arbitrage

C le an up s lid e sC le an up s lid e s

Nature of Swaps

• A swap is an agreement to exchange

cash flows at specified future times

according to certain specified rules – Typically swaps have two legs as there are two

parties…swapping cash flows

Counterparty

Cash flow

Vanilla Interest Rate Swap

• An agreement to swap fixed rate cash flows

for floating cash flows over a specified period

of time

– Tenor

• determines how often payments are made

• In the US

– floating payments are generally every 3 months

– Fixed payments are made every 6 months

– Floating cash flows reference a “trusted”

benchmark rate – e.g. LIBOR

• Generally the reference rate is fixed at the beginning of

a period and paid at the end

E.g. “Plain Vanilla” Int. Rate Swap

• An agreement by Microsoft to

– receive 6-month LIBOR

– pay a fixed rate of 5% per annum every 6 months

– Start date: 5 March 2012,

– Maturity: 5 March 2015

– Notional: $100m

• Next slide illustrates* cash flows that could

* illustrative trade, day count conventions are not

considered, payment frequency not typical

A Possible Outcome for Cash Flows

Date LIBOR Floating Cash

Fixed Cash

Net Cash

Mar 5, 2012 4.20%

Sep 5, 2012 4.80% +2.10 −2.50 −0.40

Mar 5, 2013 5.30% +2.40 −2.50 −0.10

Sep 5, 2013 5.50% +2.65 −2.50 + 0.15

Mar 5, 2014 5.60% +2.75 −2.50 +0.25

Sep 5, 2014 5.90% +2.80 −2.50 +0.30

Mar 5, 2015 +2.95 −2.50 +0.45

Typical Uses of an Int. Rate Swap

• Converting a liability from

– fixed rate to floating rate

– floating rate to fixed rate

• Converting an investment from

– fixed rate to floating rate

– floating rate to fixed rate

Swap Fixed for Floating

• You enter an interest rate swap

– Notional: 100m

– Maturity: 5 March 2015

– Semi-annual payments

– Pay Fixed: 5%

– Receive Floating: 6 Month USD LIBOR

5 March

2.5% 2.5% 2.5% 2.5% 2.5%

6M LIBOR 6M LIBOR 6M LIBOR 6M LIBOR 6M LIBOR

Other types of swaps

• Credit Default Swaps (CDS)

• Currency Swaps

• Commodity Swaps

• Mortgage Swaps

• Equity Swaps (on price or dividends)

• Variance Swaps

• etc.

Options

C le an up s lid e sC le an up s lid e s

Basic Option Terminology

An option gives the holder the

right but not the obligation to

buy(sell) the underlying asset

at some time or times in the

future.

Underlying Assets

• Stocks

• Currencies

• Stock Indices (not indexes)

• Futures

• Commodities (individual and index)

• Interest Rates (swaptions)

• Credit products (credit default swaptions)

• etc.

Option Types

• 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)

Options Style

• An American

option can be

exercised at

any time

during its life

• A European

option can be

exercised only

at maturity

A Bermudan option can be

exercised only at fixed times

before maturity (e.g. monthly)

Option Contracts Specs

• Expiration date

• Strike price (or Exercise price)

• European or American (option style)

• Call or Put (option class or type)

• Delivery details

– Cash or Physical delivery

Mechanics of Options

Markets

Payoff Diagrams

• A common technique for understanding

options is to draw a payoff diagram

• This will usually show the value of the option

at expiry

• Note – you will see payoff diagrams that

deduct the the premium paid from the payoff

– Many diagrams in the Hull book do this

– Generally this is frowned upon in the industry,

because you are adding values at different times

– The following slides will chart just payoffs

Long Call Option

0 1 2 3 4 5 6 7 8 9 10

Terminal Asset Price

Payoff for a European Call option with a strike of $5

𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑀𝑎𝑥[0, 𝑆𝑇 − 𝐾]

Short Call Option

0 1 2 3 4 5 6 7 8 9 10

Payoff for a European Call option with a strike of $5

𝑃𝑎𝑦𝑜𝑓𝑓 = −𝑀𝑎𝑥[0, 𝑆𝑇 − 𝐾]

Long Put Option

0 1 2 3 4 5 6 7 8 9 10

Payoff for a European Put option with a strike of $5

𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑀𝑎𝑥[0, 𝐾 − 𝑆𝑇]

Short Put Option

0 1 2 3 4 5 6 7 8 9 10

Payoff for a European Put option with a strike of $5

𝑃𝑎𝑦𝑜𝑓𝑓 = −𝑀𝑎𝑥[0, 𝐾 − 𝑆𝑇]

FNCE4030 Investments and Portfolio Management -...

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