Version 1/9/2001

FINANCIAL ENGINEERING: DERIVATIVES AND RISK MANAGEMENT (J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

LECTURE Derivatives: An Overview

K.Cuthbertson, D. Nitzsche 1

Topics Forwards and Futures Contracts Options Contracts

Swaps

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Forwards and Futures

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Forward/Futures Contract
The buyer(long) in a forward/futures contract: acquires a legal obligation to buy an asset (the underlying)
at

some specific future date (maturity/expiry date)

in

an amount (contract size).

and

at a price (the forward/futures price) which is fixed today.

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Uses of Forward/Futures Contract

Hedging (removing risk) In Jan. MacDonalds purchases a forward contract for delivery of live cattle in December at price fixed today ~ holds to maturity

Speculation Buy a 3m futures contract today at F0 =$100 and sell after 1m at F=$110 ~ close out contract (no delivery) and profit of $10.
Arbitrage Keeps movement of F in line with S (underlying)
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Futures Contracts
1. Contract Exchange Contract Size Grains and Oilseed Corn CBOT 5,000 bu Wheat MCE 1,000 bu Food Cocoa CSCE 10 metric tons Orange NYCTN 15,000 lbs Metals and Petroleum Gold MCE 33.2 troy oz Silver CBOT 5,000 troy oz Livestock and Meat Hogs CME 50,000 lbs Pork Bellies CME 40,000 lbs
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2.

3.

4.

Futures Contracts
5. Contract Exchange Foreign Currency British Pound IMM Swiss Franc CME Euro CME Japanese Yen Yen12.5m
6. Index Stock Indices S&P500

Contract Size 62,500 SFr125,000 Euro 125,000

CME

IOM

$500 x

Value Line
Index FTSE100 index Eurotop100 LIFFE

KCBT
LIFFE

$500 x
10 x Euro 20 x index
7

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Futures Contracts
Contract
7.

Exchange

Contract Size

Interest Rates Eurodollar - 90 day IMM $ 1,000,000 Euromark IMM DM 1,000,000 US T-Bills IMM $ 1,000,000 US T-Bonds CBOT $ 100,000 UK 3m-Sterling Int rate LIFFE 500,000 UK 3m EuroLIBOR UK Long Gilt Future LIFFE Euro 1m LIFFE 100,000

CBOT = Chicago Board of Trade CME = Chicago Mercantile Exchange NYCE = New York Cotton Exchange IMM = International Money Market (Chicago) LIFFE=LondonInternational Financial Futures K.Cuthbertson, D. Nitzsche Exchange

Comparison of Forwards and Futures

FORWARDS Private contract Delivery at expiry FUTURES Traded on an exchange Usually closed out before maturity

Usually one delivery date

No cash paid until expiry

Range of delivery dates

Cash payments Daily( margin)

Negotiable choice of delivery dates, size of contract

Standardised Contract

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Options Contracts

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10

Options
Holder has the right to buy or sell an asset (underlying) at some time in the future at a fixed price but she does not have to exercise this right can walk away from the contract if holder wishes

~ latter is key distinction between options and futures/futures contracts.

E.g. In Jan, purchase an option to buy 100 Microsoft shares in September, at a fixed price of $102 What happens in Sept if actual stock price is $90 or $110?
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Uses of Options
Insurance (form of hedging) e.g. can insure a minimum selling price for a stock, at maturity of the option contract (e.g. in 6m time), but can also benefit from higher prices should these occur Speculation Can buy an option at a low price and may be able to sell it (before maturity) at a high price ~ close out the position (hence no delivery at maturity)

Arbitrage Keeps option price and price of underlying (e.g. stock) moving (broadly) together (but not one-for-one)
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Options
Contract Exchange Contract Size

1.Individual Stocks BOE, NYSE, AMEX, PHSE, LIFFE, SIMEX 2. Index Options S&P500 Index CBOE FTSE100 Index LIFFE NYSE Index NYSE Foreign Currency Options Sterling PHSE Deutsche Mark PHSE Japanese Yen PHSE Canadian Dollar PHSE Swiss Franc PHSE
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Usually 100 stocks $500 x index 10 per index point $500 x index GBP 31,250 DEM62,500 JPY6.25m CND50,000 CHF62,500
13

Options
Contract Exchange Contract Size

3.Options on Futures Contracts Options on interest rate futures: Eurodollars IMM $1m US T-Bills IMM $1m US T-Bond CBOT $100,000 3-month EuroLIBOR LIFFE as for futures UK Long Gilt LIFFE as for futures Options on index futures: S&P500 Index IOM $500 x premium Nikkei 225 IOM $5 x premium Most commodities (agriculture and metals) on which there are futures contracts (see above). CBOT,CME,KCBT, COMEX,CTN The same as in the futures contract
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Call Option
A European call option gives the holder (the long) the right (but not an obligation)
to

purchase the underlying asset at a specified future date (known as the expiration, expiry or maturity date)
for

a certain price (the exercise or strike price)

and

in an amount (contract size) which is fixed in advance.

this privilege you pay today, the call premium/price.

For

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15

Figure 1.1 : Buy one European Call Option

Strike price K = $80 Profit

$5
0
Call premium

K = $80 $83 $88 ST

-$3

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Figure 1.8 : Leverage from option (on 100 shares)

OPTIONS MARKET (JULY)

Call premium, C = $3 Premium paid = $300 Strike price, K = $80

CASH MARKET (JULY)

Spot price, S = $78 Cash paid = $7800

OPTIONS MARKET (OCT.)

Profit = $8 = ($88 - $80) Net profit = $800 - $300 Return = $500/$300 = 167%

CASH MARKET (OCT.)

Profit = $10 = ($88 - $78) Total profit = $1000 Return = $1000/$7800 = 12.8%

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Figure 1.2 : Sell (write) a European Call Option

Strike price K = $80 Profit

$3
Call premium

0 -$5

$83 K = $80 $88 ST

K.Cuthbertson, D. Nitzsche

Put Option
A European put option gives the holder (the long) the right (but not an obligation)
to

sell the underlying asset at a specified future date (known as the expiration, expiry or maturity date)
for

a certain price (the exercise or strike price)

and

in an amount (contract size) which is fixed in advance.

this privilege you pay today, the call premium/price.

For

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19

Figure 1.3 : Buy (long) a European Put Option

Strike price K = $70

Profit

$3 0 -$2 $68 $65 K = $70 ST

Put premium

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Figure 1.4 : Sell (write) a European Put Option

Strike price K = $70

Profit $2 0 -$3 $65 $68 K = $70

Put premium

ST

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Swaps

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Figure 1.5 : Liabilities : Using Swaps

Swap A negotiated (OTC) agreement between two parties to exchange cash flows at a set of pre-specified future dates Plain Vanilla Interest Rate Swap M/s A. agrees to pay interest at a floating rate and receive fixed rate payments from the other side of the swap transaction (eg. M/s B) e.g. 5 year swap, with floating rate at 6m LIBOR, with resets every 6 months. Fixed rate is say 5% p.a. Usually the interest payments are in the same currency
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Figure 1.5 : Liabilities : Using Swaps

Floating to Fixed: Liability

LIBOR + 0.5% LIBOR

Issue Floating Rate Bond

Firms Swap
6% fixed

Net Payment = 0.5% + 6% = 6.5% (fixed)

Fixed to Floating :Liability

6.2% fixed 6% fixed

Issue Fixed Rate Bond

Firms Swap

LIBOR

Net Payment = 0.2% + LIBOR (floating)

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Figure 1.6 : Assets : Using Swaps

Floating to Fixed: Asset

LIBOR - 0.5% LIBOR

Hold Floating Rate Bond

Firms Swap
6% fixed

Net Receipts = 6% - 0.5% = 5.5% (fixed)

Fixed to Floating: Asset

5.7% fixed 6% fixed

Hold Fixed Rate Bond

Firms Swap

LIBOR

Net Receipts = LIBOR - 0.3% (floating)

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Figure 1.7 : Swap : financial intermediary

12% fixed

Hold Floating Rate Bond

LIBOR - 1%

Without swap if LIBOR > 13% firms swap makes a loss.

11% fixed

Firms Swap

LIBOR

After swap : Net Receipts = (12% - 11%) + LIBOR - (LIBOR - 1%) = 2% (fixed)

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End of Slides

K.Cuthbertson, D. Nitzsche