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FIN 355 Week 3 Notes

by: Gabby Greenberg

FIN 355 Week 3 Notes FIN 355

Marketplace > Colorado State University > Finance > FIN 355 > FIN 355 Week 3 Notes
Gabby Greenberg
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Derivatives - Options, Futures, Forwards
Principles of Investments
Tianyang Wang
Class Notes
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This 5 page Class Notes was uploaded by Gabby Greenberg on Wednesday September 14, 2016. The Class Notes belongs to FIN 355 at Colorado State University taught by Tianyang Wang in Fall 2016. Since its upload, it has received 5 views. For similar materials see Principles of Investments in Finance at Colorado State University.

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Date Created: 09/14/16
Derivatives What is a derivative? Contract between two parties   Predetermined payoffs  Payoffs are linked to another ('underlying') asset o Stock prices or indexes, bond prices or interest rates, foreign currency, commodity prices, specific events Market and Exercise Price Relationships  In the Money o Exercise of the option would be profitable. o Call: market price (s) > exercise price (x) o Put: exercise price (x) > market price (s)  Out of the Money o Exercise of the option would not be profitable. o Call: market price (s) < exercise price (x) o Put: exercise price (x) < market price (s)  At the Money o Exercise price and asset price are equal The Options Market  The CBOE (Chicago Board Options Exchange) was the world's first listed options exchange, opened in 1973 by CBOT  Derivatives are traded in organized exchanges or over-the-counter  All options traded go through the Option Clearing Corporation (OCC)  Regulated by various entities (Commodity Futures Trading Commission, SEC) Standard/Mini/Jumbo Options  Standard: Each listed stock option contract gives the holder the right to buy or sell 100 shares of stock.  Mini Option: Each listed stock option contract gives the holder the right to buy or sell 10 shares of stock, beginning March 18, 2013. Option Payoff  Call Option W/O Premium o =max(0,ST-K)  S = Market Price of Stock  K = Exercise or Strike Price  T = Expiration Date o If ST < K then you will not exercise the option. They payoff to you is simply 0. o If ST > K then you will exercise the option because you can buy a stock which is worth $ST at the strike price $K. Exercising the option would give you a payoff of (ST-K)>0.  Put Option W/O Premium o Payoff on expiration date PT = Max(0,K-ST) o If ST > K then you will not exercise the option. The payoff would be 0. o If ST < K then you will exercise the option. You can sell the stock which is worth $ST at the strike price $K. Exercising the option gives you a payoff of (K-ST)>0. Put-Call Parity  Two portfolios have the same payoffs at expiration, their current price should be the same. Otherwise, arbitrage exists.  Aligning the payoff chart to the cash for the portfolio - Call Payoff + Cash in Portfolio at expiration = the payoff chart for that portfolio  Call Premium + PV of X = Put Premium + Current Stock Price  Should pay the same price for the same return no matter what, otherwise arbitrage situations arise.   X for Exercise Price or K for Strike Price - used interchangeably  Portfolio A Call Option ST-K 0 Cash K K Total ST K Portfolio B Put Option 0 K-ST Shares ST ST Total ST K Option Strategies  Use options o Speculation (increase risk) o Hedging (reduce risk)  Protective Put: buy insurance against downturns o Buy a stock or a put  Covered Call Writing (VS Naked Call Writing) o Buy a stock and write a call o Gives up upside to increase income  Straddle o Buy a call and a put: value increases with uncertainty  3 Main Option Strategies o What Do You Want? Strategy Call Put Stock Limit Portfolio Downside Risk Protective Put Buy 1 Buy 1 Earn Extra Portfolio Income Covered Call Sell 1 Buy 1 Profit from Uncertain Price Straddle Buy 1 Buy 1 Movement Protective Put/Married Put  Objective: Limit downside portfolio risk  Ingredients: Buy 1 stock, Buy 1 put Covered Call  Objective: Earn extra portfolio income  Ingredients: Buy 1 stock, write 1 call  Exchanging uncertainty for certainty - covering our risk Straddle  Objective: Profit from uncertain stock price movements.  Ingredients: buy 1 call and buy 1 put, same exercise price and maturity o Buying a call option and the same underlying stock at same price and expiration date.  This creates a V shape in the graph - always wasting one side of the contract, but hopefully one profit will exceed the loss and net profit overall.  You know something big is going to happen, you just don't know what so you double bet Other Combinations  Spreads: Multiple call/put options with different exercise prices or expiration dates.  Example: A collar is the use of a protective put and covered call to collar/bracket the value of your portfolio within a narrow range  Collars: To bracket the value of your portfolio within a narrow range Stop-Loss  If an investor places a stop-loss order, the stock will be sold if its price falls to the stipulated level. Stop-Buy  If an investor places this kind of order, the stock will be bought if its price rises above the stipulated level.  Forwards o Forward contract - a contract entered into today which specifies price and quantitates to be transacted in the future  No money changes hands today, but sale prices and quantities are LOCKED IN  There is no limit to the variety of possible forward contracts; can be anything parties want  Difference between option and future is that the future has an obligation, unlike options Futures  o Futures Contract - simply a formalized forward contract using standardized contracts  Particular type of wheat, particular quantity, particular price  Disadvantage is limited variety in terms (types, prices, delivery dates)  Advantages of futures contract over forward contracts is liquidity; trading action concentrated in a few contracts provides liquidity to market participants  Types of Contracts o Foreign Currencies o Agricultural Products  Wheat, hogs, orange juice, sugar o Metals and Energy  Crude oil, heating oil, gasoline, electricity, weather o Interest rates  Treasuries, LIBOR, etc. o Equity Indexes  S&P, DOW, NASDAQ, NYSE  Russell, Nikkei, FTSE, etc.  Futures - Payoff Diagrams o Futures contract calls for delivery of commodity at a specified delivery or maturity date for an agreed-upon price, called the future price.  Long future position commits to buying a maturity at F*  Short future position commits to selling at maturity at F* o  Futures - Profits o Profits to Futures Positions  Profit to long = spot price at maturity - Futures price  Bought for original future price, can sell at maturity for spot  Profit to short = futures price - spot price at maturity  Futures contract, like option contracts, are zero sum  Gain to long is loss to short and vice-versa  Return on Invested Capital o Commodities allow use of leverage for potentially high returns o Return to investors is based upon amount of money actually invested o Return on Capital = (Selling price of commodity contract - Purchase price of contract) / amount of margin deposit Future-Spot Parity  o There are two ways to obtain an asset at some future date:  Purchase the asset now and store it until the target date or  Take a long future position that calls for purchase on the target date o Each strategy yields the same result in the future, and therefore you would expect the cost of each strategy to be equal o If the cost of the two strategies were not equal, you would expect arbitrage opportunities o F0 = S0 (1+rf - dividend yield)^t  Players in the Futures Markets o Hedgers  Producers and processors  Protecting their interests in underlying commodity or financial instrument  Provide the actual products being sold o Speculators  Investors  Trying to earn profit on expected swings in prices of futures contracts  Provide liquidity  Futures - Futures and Options o Futures and options both specify a price in the future at which an asset can be bought or sold o Risk Transfer o Price Discovery o Key Differences:  Option holder is not required to complete the transaction, futures buyer is required to complete the transaction  Futures positions are marked-to-market; options positions are not marked-to-market  Mark to Market o Daily settlement of margin obligations  The clearinghouse eliminates counterpart default risk; this allows anonymous trading since no credit evaluation is needed. Without this feature you would not have liquid markets.  Settlements o Delivery or Cash o Delivery are settled at delivery and cash agrees to settle at cash (cash is more common due to more speculators) o Futures are forwards can be settled at delivery at expiration or buyer and seller can agree to settle in cash at expiration o Speculative and hedging uses of contracts only requires that settlement price at expiration reflects underlying value of the commodity.  Contango Vs Backwardation o Contango: The market condition wherein the price of a forward or futures contract is trading above the expected spot price at maturity  This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the cost of storage and carrying cost of buying the commodity today. o Backwardation (normal): price of contract is trading below expected spot price at maturity. Opposite of contango.  More like a "lease rate," the cost of borrowing a stock or commodity for a period of time  Futures are standardized so that if you don’t want it, it can be easily transferred.  Options have call and put from buyer perspective, mirror image from sellers perspective  For futures and forwards, there is only one perspective of the buyers (combination of buying a call and writing a put)  The short is the opposite side of futures and forward and this is the perspective of the seller


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