Stock price

					Introduction




  Chapter 1    1
Chapter Outline

1.1 Exchange-traded markets
1.2 Over-the-counter markets
1.3 Forward contracts
1.4 Futures contracts
1.5 Options
1.6 Types of traders
1.7 Other derivatives

                               2
The Nature of Derivatives


    A derivative is an instrument whose
    value depends on (derives from) the
    values of other more basic underlying
    variables




                                            3
Examples of Derivatives

        •   Forward Contracts
        •   Futures Contracts
        •   Swaps
        •   Options




                                4
Ways Derivatives are Used

    • To hedge risks
    • To speculate (take a view on the future
      direction of the market)
    • To lock in an arbitrage profit
    • To change the nature of a liability
    • To change the nature of an investment
      without incurring the costs of selling one
      portfolio and buying another

                                                   5
1.1 Exchange-traded markets
• Traditionally exchanges have used the
  open-outcry system, but increasingly they
  are switching to electronic trading
  Contracts are standard there is virtually no
  credit risk




                                                 6
1.2 Over-the-counter markets

• A computer- and telephone-linked network
  of dealers at financial institutions,
  corporations, and fund managers
• Contracts can be non-standard and there is
  some small amount of credit risk




                                               7
1.3 Forward Contracts

• A forward contract specifies that a certain
  commodity will be exchanged for another at
  a specified time in the future at prices
  specified today.
   – Its not an option: both parties are expected to hold up
     their end of the deal.
   – If you have ever ordered a textbook that was not in
     stock, you have entered into a forward contract.
• It can be contrasted with a spot contract which is
  an agreement to buy or sell immediately
• Forwards are traded in the OTC market
                                                               8
Foreign Exchange Rates Thursday, November 1, 2001
                             U.S. $ equiv.                Currency per U.S. $
          Country       Thursday    Wednesday           Thursday        Wednesday
 Britain (Pound)           1.4631              1.4540      0.6835               0.6878
 1 Month Forward           1.4608              1.4516      0.6846               0.6889
 3 Months Forward          1.4560              1.4466      0.6868               0.6913
 6 Months Forward          1.4493              1.4400      0.6900               0.6944
 Canada (Dollar)           0.6267              0.6294      1.5957               1.5888
 1 Month Forward           0.6264              0.6291      1.5964               1.5895
 3 Months Forward          0.6262              0.6289      1.5969               1.5901
 6 Months Forward          0.6259              0.6286      1.5976               1.5908
 France (Franc)            0.1376              0.1372      7.2662               7.2896
 1 Month Forward
 3 Months Forward
                               market participants expect
                  Clearly the0.1375
                              0.1372
                                         0.1370
                                         0.1367
                                                    7.2746
                                                    7.2906
                                                                                7.2981
                                                                                7.3143
 6 Months Forward that the yen will be worth MORE in
                              0.1368     0.1364     7.3091                      7.3328
 Germany (Mark)
 1 Month Forward
                  dollars in six months. 0.4601
                              0.4616
                              0.4610     0.4596
                                                    2.1665
                                                    2.1690
                                                                                2.1735
                                                                                2.1760
 3 Months Forward          0.4600              0.4585      2.1738               2.1809
 6 Months Forward          0.4589              0.4574      2.1793               2.1864
 Japan (Yen)             0.008197            0.008168      122.00               122.43
 1 Month Forward         0.008212            0.008184      121.78               122.19
 3 Months Forward        0.008241            0.008213      121.34          9    121.76
 6 Months Forward        0.008283            0.008252      120.73               121.18
Forward Price
 • The forward price for a contract is the
   delivery price that would be applicable to
   the contract if were negotiated today (i.e.,
   it is the delivery price that would make
   the contract worth exactly zero)
 • The forward price may be different for
   contracts of different maturities



                                                  10
Foreign Exchange Rates Thursday, November 1, 2001
                             U.S. $ equiv.                Currency per U.S. $
           Country      Thursday    Wednesday           Thursday        Wednesday
  Britain (Pound)          1.4631              1.4540      0.6835               0.6878
  1 Month Forward          1.4608              1.4516      0.6846               0.6889
  3 Months Forward         1.4560              1.4466      0.6868               0.6913
  6 Months Forward         1.4493              1.4400      0.6900               0.6944
  Canada (Dollar)          0.6267              0.6294      1.5957               1.5888
  1 Month Forward          0.6264              0.6291      1.5964               1.5895
  3 Months Forward         0.6262              0.6289      1.5969               1.5901
  6 Months Forward         0.6259              0.6286      1.5976               1.5908
  France (Franc)           0.1376              0.1372      7.2662               7.2896
  1 Month Forward
  3 Months Forward
                               market participants expect
                   Clearly the0.1375
                              0.1372
                                         0.1370
                                         0.1367
                                                    7.2746
                                                    7.2906
                                                                                7.2981
                                                                                7.3143
  6 Months Forward that the GBP will be worth less in dollars
                              0.1368     0.1364     7.3091                      7.3328
  Germany (Mark)
  1 Month Forward
                   in six months.
                              0.4616
                              0.4610
                                         0.4601
                                         0.4596
                                                    2.1665
                                                    2.1690
                                                                                2.1735
                                                                                2.1760
  3 Months Forward         0.4600              0.4585      2.1738               2.1809
  6 Months Forward         0.4589              0.4574      2.1793               2.1864
  Japan (Yen)            0.008197            0.008168      122.00               122.43
  1 Month Forward        0.008212            0.008184      121.78               122.19
  3 Months Forward       0.008241            0.008213      121.34        11     121.76
  6 Months Forward       0.008283            0.008252      120.73               121.18
Terminology: The Long and the Short of it

 • IF YOU BENEFIT FROM A RISE IN
   THE PRICE OF THE UNDERLYING
   COMMODITY, YOU ARE LONG.
 • IF YOU BENEFIT FROM A FALL IN
   THE PRICE OF THE UNDERLYING
   COMMODITY, YOU ARE SHORT.



                                      12
Terminology: The Long and the Short of it

 • The party that has agreed to buy (IN
   THE FUTURE) has what is termed a
   long position
 • The party that has agreed to sell has
   what is termed a short position




                                           13
Example (page 3)

• On August 16, 2002 the treasurer of a
  corporation enters into a long forward
  contract to buy £1 million in six months at
  an exchange rate of 1.4359
• This obligates the corporation to pay
  $1,435,900 for £1 million on February 16,
  2003
• What are the possible outcomes?

                                                14
Profit from a
Long Forward Position

       Profit



                        Price of Underlying
                K            at Maturity, ST




                                               15
Profit from a
Short Forward Position

       Profit



                    Price of Underlying
                K       at Maturity, ST




                                          16
Futures Contracts: Preliminaries
• A futures contract is like a forward contract:
   – It specifies that a certain commodity will be exchanged
     for another at a specified time in the future at prices
     specified today.
• A futures contract is different from a forward:
   – Futures are standardized contracts trading on organized
     exchanges with daily resettlement (“marking to market”)
     through a clearinghouse.




                                                          17
Futures Contracts: Preliminaries

• Standardizing Features:
  – Contract Size
  – Delivery Month
• Daily resettlement
  – Minimizes the chance of default
• Initial Margin
  – About 4% of contract value, cash or T-bills
    held in a street name at your brokerage.

                                                  18
Selected Futures Contracts
         Contract           Contract Size       Exchange
 Agricultural
                    Corn    5,000 bushels    Chicago BOT
                   Wheat    5,000 bushels    Chicago & KC
                   Cocoa    10 metric tons   CSCE
                      OJ     15,000 lbs.     CTN
 Metals & Petroleum
                  Copper     25,000 lbs.     CMX
                    Gold     100 troy oz.    CMX
       Unleaded gasoline     42,000 gal.     NYM
 Financial
           British Pound      £62,500        IMM
           Japanese Yen     ¥12.5 million    IMM
               Eurodollar    $1 million      LIFFE
                                                            19
Futures Markets

• The Chicago Mercantile Exchange
  (CME) is by far the largest.
• Others include:
  – The Philadelphia Board of Trade (PBOT)
  – The MidAmerica Commodities Exchange
  – The Tokyo International Financial Futures
    Exchange
  – The London International Financial Futures
    Exchange
                                                 20
1.5 Options Contracts: Preliminaries

• An option gives the holder the right, but not the
  obligation, to buy or sell a given quantity of an
  asset on (or perhaps before) a given date, at prices
  agreed upon today.
• Calls versus Puts
   – Call options gives the holder the right, but not the
     obligation, to buy a given quantity of some asset at
     some time in the future, at prices agreed upon today.
     When exercising a call option, you “call in” the asset.
   – Put options gives the holder the right, but not the
     obligation, to sell a given quantity of an asset at some
     time in the future, at prices agreed upon today. When
     exercising a put, you “put” the asset to someone.          21
Options Contracts: Preliminaries
• Exercising the Option
   – The act of buying or selling the underlying asset through the
     option contract.
• Strike Price or Exercise Price
   – Refers to the fixed price in the option contract at which the
     holder can buy or sell the underlying asset.
• Expiry
   – The maturity date of the option is referred to as the
     expiration date, or the expiry.
• European versus American options
   – European options can be exercised only at expiry.
                                                         22
   – American options can be exercised at any time up to expiry.
Options Contracts: Preliminaries

• In-the-Money
  – The exercise price is less than the spot price of
    the underlying asset.
• At-the-Money
  – The exercise price is equal to the spot price of
    the underlying asset.
• Out-of-the-Money
  – The exercise price is more than the spot price of
    the underlying asset.
                                                        23
Options Contracts: Preliminaries

• Intrinsic Value
  – The difference between the exercise price of the option
    and the spot price of the underlying asset.
• Speculative Value
  – The difference between the option premium and the
    intrinsic value of the option.


    Option                Intrinsic      + Speculative
                   =
   Premium                 Value             Value
                                                          24
Call Options

• Call options gives the holder the
  right, but not the obligation, to buy a
  given quantity of some asset on or
  before some time in the future, at
  prices agreed upon today.
• When exercising a call option, you
  “call in” the asset.

                                            25
 Basic Call Option Pricing Relationships at Expiry

• At expiry, an American call option is worth
  the same as a European option with the same
  characteristics.
• If the call is in-the-money, it is worth ST - E.
• If the call is out-of-the-money, it is worthless.
                 CT = Max[ST - E, 0]
• Where
  ST is the value of the stock at expiry (time T)
  E is the exercise price.
  CT is the value of the call at expiry
                                                      26
Call Option Payoffs

                       60

                       40                                      Buy a call
  Option payoffs ($)




                       20

                        0
                             0   10   20   30   40   50   60   70   80      90   100

                       -20                                        Stock price ($)


                       -40

                       -60

                                           Exercise price = $50
                                                                                    27
Call Option Payoffs

                       60

                       40
  Option payoffs ($)




                       20

                        0
                             0    10    20    30   40   50   60   70   80    90   100

                       -20       Stock price ($)
                                                              Write a call
                       -40

                       -60

                                 Exercise price = $50
                                                                                  28
Call Option Profits

                       60

                       40
                                                                    Buy a call
  Option profits ($)




                       20

                        0
                             0    10    20    30   40   50   60    70   80       90   100

                       -20       Stock price ($)
                                                                  Write a call
                       -40

                       -60

                                 Exercise price = $50; option premium = $10
                                                                                      29
Put Options

• Put options gives the holder the
  right, but not the obligation, to sell a
  given quantity of an asset on or
  before some time in the future, at
  prices agreed upon today.
• When exercising a put, you “put” the
  asset to someone.

                                             30
Basic Put Option Pricing Relationships at Expiry

  • At expiry, an American put option
    is worth the same as a European
    option with the same characteristics.
  • If the put is in-the-money, it is
    worth E - ST.
  • If the put is out-of-the-money, it is
    worthless.
            PT = Max[E - ST, 0]
                                              31
Put Option Payoffs
                       60

                       40             Buy a put
  Option payoffs ($)




                       20

                        0
                             0   10    20   30    40   50   60   70 80     90    100
                                                                   Stock price ($)
                       -20

                       -40

                       -60

                                             Exercise price = $50
                                                                                 32
Put Option Payoffs
                       60

                       40
  Option payoffs ($)




                       20

                        0
                             0   10      20    30   40   50   60   70 80     90    100
                                                                     Stock price ($)
                       -20

                       -40            write a put

                       -60

                                                Exercise price = $50
                                                                                   33
Put Option Profits
  Option profits ($)
                       60

                       40

                        20                                        Write a put
                        10
                         0
                             0    10    20    30   40   50   60    70 80        90   100
                       -10
                                                                  Buy a put
                       -20       Stock price ($)


                       -40

                       -60

                                 Exercise price = $50; option premium = $10
                                                                                     34
                                     Selling Options

                                     • The seller (or writer)            • The purchaser of an
Option profitsOption profits ($)




                                   60 of an option has an                  option has an option.
                                       obligation.
                                   40
                                                                                Buy a call
               ($)




                                    20                                        Write a put
                                    10
                                     0
                                         0   10     20    30   40   50   60    70 80         90   100
                                   -10
                                                                              Buy a put
                                   -20       Stock price ($)
                                                                              Write a call
                                   -40

                                   -60
                                                                                                        35
Exchanges Trading Options

•   Chicago Board Options Exchange
•   American Stock Exchange
•   Philadelphia Stock Exchange
•   Pacific Stock Exchange
•   European Options Exchange
•   Australian Options Market
•   and many more (see list at end of book)

                                              36
1.6 Types of Traders

               • Hedgers
               • Speculators
               • Arbitrageurs
Some of the large trading losses in
derivatives occurred because individuals
who had a mandate to hedge risks switched
to being speculators
                                            37
Hedging Examples (page 11)
 • A US company will pay £10 million for
   imports from Britain in 3 months and
   decides to hedge using a long position in a
   forward contract
 • An investor owns 1,000 Microsoft shares
   currently worth $73 per share. A two-month
   put with a strike price of $65 costs $2.50.
   The investor decides to hedge by buying 10
   contracts

                                             38
Speculation Example

• An investor with $4,000 to invest feels that
  Cisco’s stock price will increase over the
  next 2 months. The current stock price is
  $20 and the price of a 2-month call option
  with a strike of 25 is $1
• What are the alternative strategies?




                                                 39
Arbitrage Example (pages 12-13)



• A stock price is quoted as £100 in London
  and $172 in New York
• The current exchange rate is 1.7500
• What is the arbitrage opportunity?



                                              40
Hedging

• Two counterparties with offsetting risks can
  eliminate risk.
  – For example, if a wheat farmer and a flour mill enter
    into a forward contract, they can eliminate the risk each
    other faces regarding the future price of wheat.
• Hedgers can also transfer price risk to
  speculators and speculators absorb price
  risk from hedgers.
• Speculating: Long vs. Short
                                                            41
Hedging and Speculating Example
  You speculate that copper will go up in price,
   so you go long 10 copper contracts for
   delivery in 3 months. A contract is 25,000
   pounds in cents per pound and is at $0.70
   per pound or $17,500 per contract.

  If futures prices rise by 5 cents, you will gain:
    Gain = 25,000 × .05 × 10 = $12,500

  If prices decrease by 5 cents, your loss is:
    Loss = 25,000 × -.05 × 10 = -$12,500         42
Hedging: How many contacts?
 You are a farmer and you will harvest 50,000 bushels
   of corn in 3 months. You want to hedge against a
   price decrease. Corn is quoted in cents per bushel at
   5,000 bushels per contract. It is currently at $2.30
   cents for a contract 3 months out and the spot price
   is $2.05.
 To hedge you will sell 10 corn futures contracts:
                50,000 bushels
                                       10 contracts
           5,000 bushels per contract
 Now you can quit worrying about the price of corn
 and get back to worrying about the weather.      43
Hedging in Interest Rate Futures

• A mortgage lender who has agreed to loan
  money in the future at prices set today can
  hedge by selling those mortgages forward.
• It may be difficult to find a counterparty in
  the forward who wants the precise mix of
  risk, maturity, and size.
• It’s likely to be easier and cheaper to use
  interest rate futures contracts however.

                                                  44
Actual Use of Derivatives

• Because derivatives don’t appear on the
  balance sheet, they are present a challenge
  to financial economists who which to
  observe their use.
• Survey results appear to support the notion
  of widespread use of derivatives among
  large publicly traded firms.
• Foreign currency and interest rate
  derivatives are the most frequently used.
                                                45

				
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