Topic 8 - Derivative Markets

• Derivative


  A financial instrument whose value depends on, is derived from, the value of some other financial instrument, called the underlying asset
• Derivatives


  • Provide an easy way for investors to profit from price declines
  • In a derivatives transaction, one person's loss is always another person's gain
• Purpose of derivatives


  • To transfer risk from one person or firm to another
  • By shifting risk to those willing and able to bear it, derivatives increase the risk-carrying capacity of the economy as a whole
• The downside is that derivatives also allow individuals and firms to conceal the true nature of certain financial transactions
• Forward contract


  An agreement between a buyer and a seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date
• Futures contract


  A forward contract that has been standardised and sold through an organized exchange
• Futures contract


  1. The seller (short position) will deliver some quantity of a commodity or financial instrument

  2. To the buyer (long position) on a specific date

  3. Called the settlement or delivery date, for a predetermined price
• Because they are customised, forward contracts are very difficult to resell
• No payments are made when the futures contract is agreed to
• The seller/short position benefits from


  Declines in the price of the underlying asset
• The buyer/long position benefits from


  Increases in the price of the underlying asset
• Clearing corporation


  • It operates like a large insurance company and is the counter party to both sides of the futures transaction
  • It guarantees that the parties will meet their obligations
  • This lowers the risk buyers and sellers face
• Margin account


  • The clearing corporation requires both parties to a futures contract to place a deposit with the corporation
  • This guarantees that when the contract comes due, the parties will be able to meet their obligations
• Marking to market


  The clearing corporation posts daily gains and losses on the futures contract to the margin account of the parties involved
• If someone's margin account falls below the minimum, the clearing corporation will sell the contracts, ending the person's participation in the market
• Hedging


  Producers and users of commodities employ futures markets to hedge their risks
• Speculation


  • Speculators trying to make a profit by betting on price movements
  • Futures contracts are popular tools for speculation because they are cheap - an investor needs only a small amount to invest - the margin - to purchase the futures contract
• Arbitrage


  1. The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price differences

  2. The arbitrageur can buy at the low price and sell at the high price

  3. This increases demand in one market and supply in another

  4. The increase in demand raises price in that market

  5. The increase in supply lowers price in the other market

  6. This continues until the prices are equal in both markets
• Call option


  • The right to buy, "call away", a given quantity of an underlying asset at a predetermined price, called the strike price (or exercise price), on or before a specific date
  • The writer of the call option must sell the share if and when the holder choose to use the call option
  • The holder of the call is not required to buy the shares - has the option if it is convenient
• In the money


  When the price of the stock is above the strike price of the call option, exercising the option is profitable
• At the money


  If the price of the stock exactly equals the strike price
• Out of the money

  If the strike price exceeds the market price of the stock
• Put option


  • Gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date
  • The writer of the option is obliged to buy the shares if the holder chooses to exercise the option
• Although options can be customised, most are standardised and traded on exchanges
• American options


  Can be exercised on any date from the time they are written to the expiration's date
• European options


  Can be exercised only on the day they expire
• Options transfer risk


  From the buyer to the seller, so can be used for both hedging and speculation
• Option writer


  • Speculators willing to take the risk and bet that prices will not move against them
  • Dealers, called market makers, who engage in the regular purchase and sale of the underlying asset
• Options are very versatile and can be bought and sold in many combinations
• Options allow investors to bet that prices will be volatile
• Option price


  Intrinsic value + time value of the option
• Intrinsic value


  The value of the option if it is exercised immediately
• Time value of the option


  The fee paid for the option's potential benefits
• Calculating time value of the option


  1. Take the probability of a favorable outcome (a higher price), times the payoff

  2. Increasing the standard deviation of the stock price, an increase in volatility, increases the option's time value
• Factors determining value of financial instrument


  • The size of the promised payment
  • The timing of the payment
  • The likelihood that the payment will be made
  • The circumstances under which the payment will be made
• Intrinsic value of in-the-money call

  The market price of the underlying asset minus the strike price
• Intrinsic value of put

  The strike price minus the market price of the underlying asset, or zero - which ever is greater
• Time value of option


  • The potential benefit represented by the chance that the price of the underlying asset will move making the option valuable
  • The longer the time to expiration, the bigger the likely payoff when the option does expire and, thus, the more valuable it is
  • The likelihood that an option will pay off depends on the volatility, or standard deviation, of the price of the underlying asset
  • The more variability there is in the asset's price, the more chance it has to move into the money
  • Therefore the option's time value increases with volatility in the price of the underlying asset
  • Increased volatility has no cost to the option holder - only benefits
  • The bigger the risk being insured, the more valuable the insurance, and the higher the price investors will pay
• Interest-rate swap


  • Agreements between two counterparties to exchange periodic interest-rate payments over some future periods, based on an agreed-upon amount of principal: notional principal
  • One party agrees to make payments based on a fixed interest rate, and in exchange the counterparty agrees to make payments based on a floating interest rate
• Pricing interest-rate swaps means figuring out the fixed interest rate to be paid