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Introduction to Derivatives

by: Brendon Huels

Introduction to Derivatives FINA 4210

Marketplace > University of North Texas > Finance > FINA 4210 > Introduction to Derivatives
Brendon Huels
GPA 3.89


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This 25 page Class Notes was uploaded by Brendon Huels on Sunday October 25, 2015. The Class Notes belongs to FINA 4210 at University of North Texas taught by Staff in Fall. Since its upload, it has received 53 views. For similar materials see /class/229112/fina-4210-university-of-north-texas in Finance at University of North Texas.


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Date Created: 10/25/15
Derivatives Markets Purpose Discuss the structure and function of derivatives markets Background I Derivatives O A derivative is a nancial instrument whose return is derived from the return on another instrument I The Underlying Asset O Called the underlying O A derivative derives its value from the underlying i Size of the derivatives market at yearend 2001 9 111 trillion notional principal 9 3 8 trillion market value Background I The Storage Mechanism Spreading Consumption across Time i Delivery and Settlement Placing an Order i pit i open outcry i electronic systems Role of Derivatives Markets I Risk Management 9 Hedging vs speculation 9 Setting risk to an acceptable level I Price Discovery I Operational Advantages 9 Transaction costs 9 Liquidity 9 Ease of short selling Market Efficiency E Market Ef ciency and Theoretical Fair Value 0 Definition of an efficient market 0 The concept of theoretical fair value Arbitrage and the Law of One Price Criticism of Derivatives Markets I Speculation I Comparison to gambling I High leverage I Inappropriate use Forward Market i Forward Contracts 0 Definition a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today 0 Exclusively overthecounter Futures Markets E Futures Contracts 0 Definition a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default 0 Exclusively traded on a futures exchange Swap Market E Swaps 0 Definition of a swap a contract in which two parties agree to exchange a series of cash flows 0 Exclusively overthecounter 0 Other types of derivatives include swaptions and hybrids Their creation is a process called nancial engineering The futures game has a long history I In Europe 0 Futures trading since the 1600s I In North America 0 Commodity trading mechanisms originated in colonial times 0 Today s organized futures exchanges trace their roots back to the early 1800s Large variety of futures contracts now being traded i fungible agricultural commodities i petroleum products i metals precious and otherwise i Tbills Tbonds and other nancial contracts l currencies I indices Other possibilities in the next twenty years I bulk freight rates I more stock market indices l in ation indices l GNP series real estate indices and other economic indicators I perhaps even electronic components The basics of futures trading I warehouse receipts I spot price I futures contract terms I futures price I basis I basis risk Basis amp Basis Risk W RIMES a31s Spot I The basis is the difference between the futures price and the spot price I Basis risk refers to the risk that the basis may uctuate I Hedging gets rid of price risk replacing it with basis risk The basics of futures trading warehouse receipts I margins and limits spot price futures contract terms I marking to market futures price basis I the clearinghouse basis risk Marking to Market 1000 AM i Closing price 105 0 Smith buys 1 Settlement 9 Jones sells 1 smith makes 5 9 Jones loses 5 Margins and Limits Q Margin equals the maximum that can be lost in one day s trading 1 Upper and lower limits de ne margin Margins normally established by vote among the traders on the exchange 0 What are incentives for keeping margins small 0 What are incentives for increasing margins D Exchanges and regulators can change margin in emergency Clearinghouse I Clearinghouse holds all margin deposits I This amount equals twice the amount that is exposed to risk i Ancestors of modern clearinghouses are also the ancestors of central banks Summary Mechanics of Futures Trading I daily settlement I initial margin I maintenance margin I concept of margin vs performance bond I settlement price I variation margin I open interest The cast of characters in the futures game I Hedgers I Speculators I Arbitrageurs Hedgers i They want to reduce their business risks i They trade risks with one another i There is a long history Speculators I People with valuable information are naturally attracted to futures trading i What good do they do 0 Informed speculators enhance pricing efficiency 9 Uninformed speculators contribute liquidity Arbitrageurs i People with access to several marketplaces i Look for imbalances O profit from them as they arise I What good do they do 0 quickly eliminate imbalances Some trading examples to illustrate arbitrage I crush spread 0 live hogs and pork bellies o any pair of commodities for which the rst is directly convertible into the second 0 soy beans into soy bean meal and soy bean oil o any set of commodities for which the raw material is directly convertible into a standard package of re ned commodities The Cast of Characters I Classification by Trading Style 9 scalpers 9 day traders 9 position traders I OffFloor Futures Traders 9 individuals 9 institutions 9 Others Introducing Broker 1B Commodity Trading Advisor CTA Commodity Pool Operator CPO Associated Person AP um HA Exthzmgcx on Which Fummmde January mow mm a m mum nmm p ammume Memzdnz f m m a uenwxmms Endive Commude mm Swim quotwWmm mum mp Hmbubauam v WWW KW Arum mu SWIMquot 5an rum MW m M 5m 2mm 5mm CW39WW WW hayWWW Wmmm grw39w mwwm mypnlc mambo mm A a u 1 V39 a Y Exdmngc mm BevseAG aw mm m wawxgxmm m Hm hup wwwbumn u 1 5w Mm Belxium mm m Amnn mm mm Eumnexi BmKe s cmm 1w CummudIy mm mnng con KwWme hup wbmmudp quotin a 1 mm Commudwms sum mpu mum MW 1 am 54 Macaw a sum om MW MW mjmmu e quotmyMumqu W WWW Mdmmuwmmc 5mm Yakng Exam m waw mmquot mm mm mwummmw 5mquot llylrwwwiio nldnm mmakom Tokyo Gmn Exmm on Swtkhnlm mum WWW mummy mm quotquotv39MW mnn MwIwwwumyunpmm m mm 0 mm Vnzenuuonal Flnmul mm a Swi mlm m 0mm m My mm W Eu 5mquot sum Eman 7W 5ka mm m wawlurexxmngomm hwWhm mmu m HWucoryp Unikd Kin dam Chin mm WWW mmquot mm muncqu mm m mmm huijwmpcukwm WNW mm pwknm mm Imprruuurul memi Fumm Shrung Fman mm Kern 5m aan 5mm mMmhhmm P whwk hwymun awn Cnlmwmly 2mm Malay mm mm mm D mauwwwmcwuk mm DcnvnrMx mm on mm mm Cepnnhsgnnsxud xihlngt awmmmmm mm mem Mlu llwwwxmedx e quotm U H mm 2mm Amnsrdnm We am mm mm mm cm plWM MW quotW W WWP Wquot New my cum Mam mm Fm NM Zuhnd rum 3 0mm quotquotV MWWMWM u m m mm xquot mam mm hunrwwwemunnxunnuh m m mm uni k auo Germany Mum wave ammnm m Unix aw d um nu mg a Farm rm m am at hm hun lwwwcurud Ixnmm hupl wwwbdppl MaxWWW Hung Kong anquot i mm nmm mm m W exmm m m Wm mm mm mm mgmumk m hummum huerwwwhrmm my Wm m Monthly Seat Prices on the Chicago Board of Trade the Chicago Mercantile Exchange and the NewYork Mercantlle Exchange 000000 900000 gt 800000 700000 600000 500000 400000 300000 gt 200000 00000 Last Sale Price 0 Jan 96 Jan97 Jan98 Jan99 Jan00 Jan0 Month CME NYMEX CBOT Futures Seat Prices m ATransaction on the Futures Exchange 9 Future 6 Buyer Buyer39s BuyeHsBroker39s Exqth Seller sBrokel39S Sellegk Seller Broke Conihiissioank ar quot Cnmvriis ibn rok r mm Buyer39s Broker39s EMS Seller39s Broker s 39 ClearingFifm 39 C39W39nlm Clearing irm e3 Antwan slum t ms t y 4 Information on the trade is mponed m the clearinghuuse Sa5b 39 saxsb y 39 39 mam Buyer and seller deposit margin with their brokers 838b Buyer39s and seller39s brokers deposit margin with their clearing rms w mwu quot1 What are options I Options are nancial contracts Whose value is contingent upon the value of some underlying asset Such arrangements are also known as contingent claims 0 because equilibrium market value of an option moves in direct association with the market value of its underlying asset OPT measures this linkage Everyday examples of options I rain check I discount coupon I airline ticket with cancellation right I right to drop a course The basics of options Calls and puts de ned i Call privilege of buying the underlying asset at a speci ed price and time I Put privilege of selling the underlying asset at a speci ed price and time The basics of options Regional differences I American options can be exercised anytime before expiration date i European options can be exercised only on the expiration date l Asian options are settled based on average price of underlying asset The basics of options i Options may be allowed to expire without exercising them Options game has a long history 0 at least as old as the premium game of 17th century Amsterdam 0 developed from an even older time game 9 which evolved into modern futures markets 0 and spawned modern central banks The Development of Options Markets I Early origins I Put and Call Brokers and Dealers Association i Chicago Board Options Exchange 1973 i Resurgence of overthecounter market Moneyness concepts i Inthemoney i Outofthemoney i At themoney The OvertheCounter Options Market Worldwide scope i Credit risk is present I Customized terms Private transactions i Unregulated l Options on stocks and stock indices bonds interest rates commodities swaps amp currenc1es Organized Option Exchanges i Listing Requirements i Contract Size i Exercise Prices i Expiration Dates i Position and Exercise Limits Option Traders I The Market Maker 9 Bid ask and bidask spread O Scalpers position traders spreaders I The Floor Broker 9 Designated primary market makers 9 Dual trading I The Order Book Official 9 Limit orders 9 Electronic order processing Option Price Quotations i See web sites of newspapers and options exchanges Problems 0 Delayed information 0 Nonsynchronized prices Types of Options I Stock Options Index Options I Currency Options I Other Types of Traded Options 9 interest rate options 9 currency options 9 options attached to bonds 9 exotic options 9 warrants callable bonds convertible bonds 9 executive options PutCall Parity Consider two portfolios Portfolio A contains a call and a bond CSXt BXt Portfolio B contains stock plus put s PSXt PutCall Parity Consider two portfolios Portfolio A contains SltX SgtX a call and a bond 0 8 K CSXt BXt VA ix X 39 arti pzrtm o s PSXt VB 8 8 PutCall Parity I News leaks about negative event I Informed traders sell calls and buy puts PutCall Parity I News leaks about negative event I Informed traders sell calls and buy puts l Arbitrage traders buy the low side and sell the high side PutCall Parity I News leaks about negative event I Informed traders sell calls and buy puts l Arbitrage traders buy the low side and sell the high side I Stock price falls the tail wags the dog TABlE Exchanges on Which Options on Spot Assets Tndeanuary 1002 United sum crnnga IIImoIs Eumnexr Alrlcz 5mm Pan Amxtcrdam Copnnlvagan Smdn Exchangt FUYOPI quotPWquot 5 N amam Cumin Dcmrk u 3 l a huplwwwxundk Annraliz and New zaaxans Helunkw Sumnus and Dcrmuwx Aunmlmn Smtk Exdmuxe Emma Impwwwamex mm Hdmkmnlm myAuun1a Pamh Suxk Exdunge V Hme huplwwasxomau Sm Frzndsm Canvam 5mm Fumu Exchange hupJwwwvan cxmm mum Emmy SyndnyAnumIIa PMhdeIphla slam Exthangn MPWW39W Mama mm hpJwwwsfnum m PhIIaI iprhu Pannsylnm hm Comma mm New 2mm Futures and Opuans 1m Iwwwamyaza Budmsw m a Exdmngc InurnallamI Senurilin Emma I mevmwm Minna New 2mm Nawv New York Wm Smk Exchange Imp llwwwsfc amnu Imp lwww Imopuons cm W W M Emquot 09m MW mayWmham 39 P quotWquoth quot V quotquot quot Balsa a Dznvidus do Pena Haquot Km Exchange smrnlvg 2003 Famhm I Hang Kan Chm an marwwwhaapz 5qu Monruryvflamtm and TH AW 5 ork Exchange MammaI Exthznge Comedian Wham m w mew Manuenmuzbec m Rom Impum mI uplwwwm mg anmm m Takyc Smltk 5mm 5mm Anni Muquot Ruanamblc Jam Mamas I ImpiIwwwuc aqp BoIsa dc Mcmadorm amp Future my 1 Kama hum Exdvmgc Sm Paulo BuzII OM 51mm my Seem Kare hupJwwwhmtcam hr 5 mm em Impwwwka axaam Sanaaga Smltk Exdmng I mm mm Kama Sunk Exzhangc Sin wfh m Landau Imcrnaliaml Fmanml Hum 53930 KN P and 0 Ian Exam ILIFFEI lelkae orkr Europe Loud WM Ki Mmkym Dcnvauves Exchang mu IIIIeco m Lumpm Mama Van r mAG 0M lunan Exchange upwwwmamammy 4cnmAusma Landon 0mm ngdam n WWWWham Imp Iwwwgmgwnp com Enhanch on wluzh own an mums mm are warm m Chaulcr a mm mm Eumnexl m In the process uI mum m CBOE Quarterly Seat Prices 800000 700000 600000 500000 400000 Price of Last Sale 300000 200000 00000 I I974 IIIIIIIIIIIIIIIIIIIIIIII I976 I978 I980 I982 I984 I986 I988 I990 I992 I994 I996 I998 2000 Quarter m ATransaccion on an Options Exchange Seller Buyer and seHer msvuc mew respemve brokers m mam an opuan transaction 4 Inlurmarron on the mag rcpaned to thc lcannghuuse 1531155 new oor brokers report he price obla med a he buyer39 and seuer39s broken mush Buyer39s and scum broker rchrK he prlcu Dbmmed a he buyer and 52 17 r swab Buyer39 and se ler brokers deposr prermum and margm Wm um clemrmg rms amt r


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