Workshop 7

• Derivative


  A financial instrument where the value is derived from the price of an underlying asset
• The underlying asset could be financial or a commodity
• Derivatives have been around hundreds of years, originating back to agricultural markets
• Financial assets that can be underlying assets for derivatives

  • Bonds
  • Shares
  • Stock market indices
  • Interest rates
• Commodities that can be underlying assets for derivatives

  • Oil
  • Silver
  • Wheat
• Over-the-counter (OTC)


  Trading of derivatives directly between counterparts
• Exchange-traded

  Trading of derivatives on an exchange
• Hedging


  • Reduces the risk of adverse price movements for the buyer and the seller
• Speculating

  • The motive of a party is to make money - they have no interest in the underlying asset
• Types of derivatives


  • Futures
  • Forwards
  • Options
  • Swaps
• Futures have been around for hundreds of years, traced back to agricultural markets
• Forward contract


  An OTC contract where one party agrees to buy and the other agrees to sell a specific asset at a set price on an agreed future date
• Forward contracts


  • No cash changes hands at the outset
  • Default risk exists to the party that is owed the positive amount
• Futures contract


  A standardised contract where one party agrees to buy and the other agrees to sell a specified asset at a set price on an agreed future date, with daily settlement of gains and losses through the clearinghouse, and a credit guarantee from the futures exchange
• Futures contracts


  • Highly regulated by national regulators
  • The futures exchange determines which contracts are traded, their standardised specification, underlying asset, expiration dates, contract sizes, delivery etc
  • A futures price is agreed daily and the clearinghouse 'Marks to market' both long and short positions, daily settlement using margin accounts
  • Most trades are closed out with offsetting trade, with few contracts reaching expiration
• Long


  The buyer committed to buying the underlying asset at the pre-agreed price at a future date
• Short

  The seller committed to delivering the underlying asset in exchange for the pre-agreed price on the specified future date
• Open

  The initial trade, when it first enters a future (can be a buyer or a seller)
• Covered


  The seller has the underlying asset that will be needed for the physical delivery to take place
• Naked


  The seller of the future does not have the asset that will be needed if physical delivery of the commodity is required
• Close


  Most physical assets don't end up being delivered, a closing sale is made by the buyer before delivery date
• Options did not come about until 1973, after two US academics produced a pricing model which allowed them to be readily priced
• Option contract


  The investor pays a premium to the bank for the option, and can decide to exercise the option (buy the shares) or let it lapse
• Options


  • Can be traded on an exchange (standardised sizes and terms) or over-the-counter (determined by two counterparties)
  • There are different classes - call options (right to buy) and put options (right to sell)
• Call option pay-offs (holder)

  • Unlimited profit potential if underlying price rises above strike price, limited loss of premium paid if underlying price stays below strike price
• Call option pay-offs (writer)

  • Limited profit of premium received, unlimited loss if underlying price rises above strike price
• Put option pay-offs (holder)

  • Unlimited profit potential if underlying price falls below strike price, limited loss of premium paid if underlying price stays above strike price
• Put option pay-offs (writer)

  • Limited profit of premium received, unlimited loss if underlying price falls below strike price
• Options exercise - example 1

  • Investor Smith buys a 150p call option, Investor Jones writes the option. If the underlying share price rises above 170p, Investor Smith will exercise the option and make a profit. If the share price rises to 127p, Investor Smith will still exercise the option but only make a small profit. If the share price stays below 150p, Investor Smith will let the option lapse and lose the premium paid.
• Options exercise - example 2

  • Investor Smith buys a put option, Investor Jones believes the share price will rise slightly. The outcome depends on whether the underlying share price falls below the strike price.
• Option


  A contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain time period
• Investor Smith exercises the option

  He has made a profit (he has to pay 150p per share and he has already paid 20p for the option premium)
• Investor Smith exercises the option

  The 5p profit on the purchase of the share will defray part of the 20p cost of the option premium
• Investor Smith does not exercise the option

  He allows it to LAPSE and loses the 20p premium already paid
• "Out of the money"

  When the current market price of the underlying asset is below the option's strike price
• "In the money"


  When the current market price of the underlying asset is above the option's strike price
• "At the money"


  When the current market price of the underlying asset is equal to the option's strike price
• Loss


  When the option expires out of the money, the buyer loses the premium paid
• Profit


  When the option expires in the money, the buyer can exercise the option and make a profit
• Limited loss


  The maximum loss for the buyer of a call option is the premium paid