Financial Derivatives: An Introduction

Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 What is a Financial ?

• A derivative is an instrument whose value depends on, or is derived from, the value of other assets. • The underlying assets may be stocks, currencies, interest rates, commodities, debt instruments, insurance payouts, etc. • Derivatives’ types: forwards, futures, options, swaps, exotics, etc. • Example: a stock is a derivative whose value is dependent on the price of a stock.

2 Why Derivatives Are Important?

• Derivatives are actively traded on many exchanges throughout the world. • Many different types of forward contracts, swaps, options, and others have been entered into the Over- The-Counter (OTC) markets by financial institutions, fund managers, and corporate treasurers. • Derivatives are added to bond issues, used in executive compensation plans, embedded in capital investment opportunities, used to transfer risks in mortgages from the original lenders to investors, and so on. • Numerous financial transactions have embedded derivatives.

Why Derivatives Are Important?

• Derivatives play a key role in transferring risks in the economy from one entity to another. • The derivatives market is huge; it is much bigger than the stock market when measured in terms of underlying assets. • The value of the assets underlying outstanding derivatives transactions is several times the world’s GDP.

4 How Derivatives are Used?

• Hedging: traders face a risk exposure to the price of an asset and take a position in a derivative to offset this exposure. • Speculation: traders use derivatives to bet on the future direction of the price of an asset (they have no risk to offset). • : involves taking offsetting positions in two or more different markets to lock in a profit.

Hedge funds have become big users of derivatives for all three purposes.

5 Hedge Funds

• Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. • Mutual funds must • disclose investment policies, • makes shares redeemable at any time, • limit use of leverage, • take no short positions. • Hedge funds are not subject to these constraints.

6 Where Derivatives Are Traded?

In derivatives exchange markets Traditionally, derivatives exchanges have used what is known as the ‘open outcry system.’ This involves traders physically meeting on the floor of the exchange, shouting, and using a complicated set of hand signals to indicate the trades they would like to carryout.

Exchanges are increasingly replacing this system by electronic trading. This involves traders entering their desired trades at a keyboard and a computer being used to match buyers and sellers.

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Where Derivatives Are Traded?

In the OTC markets It is a telephone and computer-linked network of dealers. Trades are usually between two financial institutions or between a financial institution and one of its clients (typically a corporate treasurer or a fund manager).

Financial institutions often act as market makers: they are always prepared to quote both a bid price (a price at which they are prepared to buy) and an offer price (a price at which they are prepared to sell).

9 Where Derivatives Are Traded?

OTC markets • Advantage: the terms of a contract do not have to be those specified by an exchange. Market participants are free to negotiate any mutually attractive deals. • Disadvantage: due to differentiation in OTC derivatives’ contracts, the risk that a contract will not be honoured is higher.

10 Size of OTC and Exchange-Traded Markets

Source: BIS. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

11 Derivatives and the 2007-8 Financial Crisis

• Derivatives markets have come under a great deal of criticism because of their role in the late 2000s crisis. • Derivative products were created from portfolios of risky mortgages in the U.S. using a procedure known as securitisation. Many of the products that were created became worthless when house prices declined. • Financial institutions, and investors throughout the world lost a huge amount of money and the world was plunged into the worst recession it had experienced for many generations. The Lehman Brothers Bankruptcy

• Lehman’s filed for bankruptcy in 2008. This was the biggest bankruptcy in the US history. • Lehman was an active participant in the OTC derivatives markets and got into financial difficulties because it took high risks and found it was unable to roll over its short-term funding. • It had hundreds of thousands of transactions outstanding with about 8,000 counterparties. • Unwinding these transactions has been challenging for both the Lehman liquidators and their counterparties.

13 Forward contracts

. A is an agreement to buy or sell an asset at a certain future time for a certain price. It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today. . Forward traders are trading for delivery at some future time; spot traders are trading for immediate delivery. . The party that agrees to buy the underlying contract assumes a long position to a forward contract. The other party agrees a short position.

14 Forward contracts

• The for a contract is the delivery price that would be applicable to the contract if were negotiated today. • The forward price may be different for contracts of different maturities.

15 Foreign Exchange Quotes for US$/GBP May 24, 2010 (Bank X)

Bid Offer Spot 1.4407 1.4411

1-month forward 1.4408 1.4413

3-month forward 1.4410 1.4415

6-month forward 1.4416 1.4422

16 Foreign exchange forward contracts: Example

• On May 24, 2010 the treasurer of a corporation enters into a long forward contract to buy £1m in six months at an of 1.4422 • This obligates the corporation to pay $1,442,200 for £1 million on November 24, 2010 • Both sides have made a binding commitment.

17 Profit from a Long Forward Position

Profit

Price of Underlying at K Maturity, ST

18 Profit from a Short Forward Position

Profit

Price of Underlying K at Maturity, ST

19 Foreign exchange forward contracts: Exercise

Investor B enters into a short forward contract to sell £100,000 for US $ at an exchange rate of 1.4000 US $ per £. How much does B gain or lose if the exchange rate at the end of the contract is: (a) 1.3900 (b) 1.4200

20 Futures Contracts

• Like a forward contract, a is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. • A wide range of commodities and financial assets form the underlying assets in futures contracts. The commodities include pork bellies, live cattle, sugar, wool, lumber, copper, aluminum, gold, and tin. The financial assets include stock indices, currencies, and Treasury bonds. Futures prices are regularly reported in the financial press.

21 Futures Contracts

• Unlike forward contracts, futures contracts are normally traded on an exchange. Hence, their price is determined by the laws of demand and supply. • As the two parties usually do not know each other, the exchange provides a mechanism that gives the two parties a guarantee that the contract will be honoured.

22 Futures Contracts: Example

A trader enters into a short cotton futures contract when the futures price is £0.5000 per unit of cotton. The contract is for the delivery of 50,000 units. How much does the trader gain or lose if the cotton price at the end of the contract is a) £0.4820 per unit? b) £0.5130 per unit?

23 Options

• Options are traded both on exchanges and in the OTC market. • Two main types of options: • A call option gives the holder the right to buy the underlying asset by a certain date for a certain price. A gives the holder the right to sell the underlying asset by a certain date for a certain price. • The price in an option contract is known as the exercise price or the . • The date in the contract is known as the expiration date or maturity.

24 Options

• American options can be exercised at any time up to the expiration date. • European options can be exercised only on the expiration date itself. • An option gives the holder the right to do something. The holder does not have to exercise this right. This is what distinguishes options from forwards and futures, where the holder is obligated to buy or sell the underlying asset.

25 Options

• There are four types of participants in options markets: 1. Buyers of calls 2. Sellers of calls 3. Buyers of puts 4. Sellers of puts • Buyers are referred to as having long positions; sellers are referred to as having short positions. • Selling an option is also known as writing the option.

26 Options vs forward contracts: Example

• What is the difference between entering into a long forward contract when the forward price is £50 and taking a long position in a call option with a strike price of £50?

27 Options vs forward contracts: Example

• In the forward contract, the trader is obligated to buy the asset for £50. (The trader does not have a choice.) • In the call option, the trader has an option to buy the asset for £50. (The trader does not have to exercise the option.)

28 Hedging using forward contracts: Example

• Suppose that on May 24, 2010 Company L which is based in U.S., has to pay £10m on August 24, 2010 for goods it has purchased from a British supplier. • Company L expects that the $/£ exchange rate will be more than 1.4500 on August 2010. • Company L is a customer of Bank X. • Company L wants to hedge against foreign exchange rate risk. Bid Offer Spot 1.4407 1.4411 1-month forward 1.4408 1.4413 3-month forward 1.4410 1.4415 6-month forward 1.4416 1.4422 29 Hedging using forward contracts: Example

To hedge its foreign exchange risk: Company L can write a forward contract with Bank X and buy £10m in the 3-month forward exchange market for 1.4415. This would have the effect of fixing the price to be paid to the British exporter at $14,415,000 instead of $14,500,000 on August 24, 2010.

30 Hedging using options: Example

• Consider an investor who owns 1,000 Microsoft shares in May 2013. The price is $28/share. • The investor is concerned about a possible share price decline in the next 2 months and wants protection (he expects to decrease to $20/share). • The investor could buy ten July 2013 put option contracts on Microsoft with a strike price of $27.50. This would give the investor the right to sell a total of 1,000 shares for a price of $27.50. • If the quoted option price is $1, this strategy costs $1,000 but guarantees that the shares can be sold for at least $27.50 per share during the life of the option.

31 Hedging using options: Example

• If the market price of Microsoft falls below $27.50, the options will be exercised, so that $27,500 is realised for the entire holding. When the cost of the options is taken into account, the amount realised is $26,500. • If the market price stays above $27.50, the options are not exercised and expire worthless. However, in this case the value of the holding is always above $27,500 (or above $26,500 when the cost of the options is taken into account).

32 Value of Microsoft Shares with and without Hedging

Value of Holding 40,000 ($)

35,000 No Hedging Hedging 30,000

25,000 Stock Price ($)

20,000 20 25 30 35 40

33 Hedging: futures vs. options

 Two fundamental differences in the use of forward contracts and options for hedging:  Forward contracts are designed to neutralise risk by fixing the price that the hedger will pay or receive for the underlying asset.  Option contracts offer a way for investors to protect themselves against adverse price movements in the future while still allowing them to benefit from favourable price movements.  Unlike forwards, options involve the payment of an up-front fee.

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