History of Derivatives Market

Document Sample
History of Derivatives Market Powered By Docstoc
					Derivatives market




                     1
Content


  Introduction
  Derivatives Market
  Futures/Forward Market
  Pricing of Futures/Forwards
  Options
  Strategies


                                 2
Introduction




               3
Derivatives market

    Derivative instruments
        Financial instrument, which derive its value from
         the value of an underlying asset. For example, a
         futures contract or an option contract.

    Derivatives
        Derivatives are contracts, commitments or
         agreements to buy or sell assets at a future date.
        These agreements specify in advance the:
             quantity
             price
             expiration date

                                                              4
History

    Derivatives, 2000 years of history
        Romans bought Egyptian wheat harvests under
         contracts
        In the 17th century, Japanese were trading rice
         receipts
        In the 19th century, first futures contracts are
         listed by the Chicago Board of Trade (CBOT)




                                                            5
History

    Derivatives, 2000 years of history
        18th century: Europe and U.S.A. started trading the
         first call and put options.
        19th century: the Put and Call Brokers and Dealers
         Association is established.
        In 1973, Fisher Black, Myron Scholes and Robert
         Merton developed the now famous Black & Scholes
         model.
        In 1973, creation of the Chicago Board Options
         Exchange and listing of the first options.



                                                               6
Derivatives Market




                     7
Types of Derivatives

  Forward contracts
  Futures contracts
  Options contracts
  Rights and Warrants
  Embedded derivatives
  Swaps
  And many more…


                          8
Types of Derivatives
    Futures contract
        A futures contract is a firm commitment to take
         delivery or deliver an underlying asset.
        A futures contract is an exchange-traded
         agreement, where the terms have been
         standardized in order to ensure its liquidity

    Option contract
        An option contract is a conditional commitment
         which allows one to take delivery or make delivery
         of an underlying asset at a price fixed in the
         contract.


                                                              9
Types of Derivatives

    Forward contract

        A forward contract is an agreement
         negotiated between two counterparties,
         where the terms of the contract are
         specifically designed to meet the needs of
         one or both counterparties




                                                      10
Comparing forwards a futures
        Forward Contract                    Futures Contract

  Traded over-the-counter            Exchange-traded
  Tailor-made contract               Standardized contract
  Counterparties communicate         No communication between
   together                            counterparties
  Difficult to close position        Easy to close position
  No third-party guarantor           Clearinghouse acts as a
  Settlement on the delivery date     guarantor
  Much less regulated                Daily settlement

  Frequent Delivery                  Heavily regulated

  Fee included in the pricing        Delivery unlikely
                                      Commission charged



                                                                  11
Derivatives Operations


  Hedging
  Market entry and exit
  Speculation
  Arbitrage
  Cost reduction
  Yield enhancement


                           12
Hedging


    Hedging transactions are executed with
     the intent to reduce or eliminate the risk
     of loss associated with any particular
     position with the use of derivative or
     cash instruments.



                                                  13
Market Entry and Exit


    Derivatives can be used to facilitate entry
     into and exit from a specific market more
     efficiently than in the conventional way




                                               14
Speculation


    Speculators assume risks in order to
     profit from market fluctuations
        Speculators bring liquidity to the market
  Leverage
  Fast transactions
  Low cost


                                                     15
Arbitrage

    Arbitrage
        Simultaneous buy and sell of securities with the
         intent to take advantage of market discrepancies
         between two or more instruments on one or more
         markets.
    Arbitrageurs
        Arbitrageurs execute arbitrage operations and
         contribute to
             market efficiency and
             improved market liquidity
        They have the greatest risk aversion
                                                            16
Cost Reduction

  Reduction of financing costs
  Savings possible through the swap of
   comparative advantage
      Interest rate swaps
      Currency swaps




                                          17
Yield Enhancement

    It is possible to increase the overall
     portfolio return by writing options.
      Proceeds from selling options become extra
       returns earned on the portfolio
      Call writing

      Put writing




                                                    18
Derivatives

    Derivatives may be based on many
     assets, such as:
      stocks
      bonds

      indices

      interest rates

      currencies

      wheat

      commodities, etc.

                                        19
Derivatives

    Example
        An investor is expecting an increase in the
         S&P500 index

         1.   Buy every securities in the index

         2.   Buy one index futures




                                                       20
Market Structure

    Over-the-Counter Market (OTC)

    Exchange Market




                                     21
Over-The-Counter Market (OTC)

    A market where securities not listed on
     an organized exchange are traded

    Trading is executed directly between
     market participants

    Counterparty risk


                                               22
Over-The-Counter Market (OTC)

    Types of available products
        Forward agreement or swap agreement
          Interest rates: forward rate agreement
          Currencies: foreign exchange agreement




                                                    23
Over-The-Counter Market (OTC)


                    RISK



   Counterparty A          Counterparty B




                                            24
Exchange Market


    Physical or virtual location where buyers
     and sellers meet in order to trade
     securities or commodities




                                                 25
Exchange Market


    Anonymous trading

    Risks are assumed by the clearing
     corporation




                                         26
Exchange Market

    Types of available products
        Futures contracts
             Financial futures contracts
                  Interest rates
                  Currencies
                  Indexes
             Commodities
                  Agricultural products
                  Metals
                  Livestock, etc.


                                            27
Exchange Market

  CLIENT A        RISK
                               CLIENT B



   Broker    Exchange Market    Broker



               Clearing
              Corporation
    Margin                     Margin


                                          28
Futures Contract

    A futures contract is an agreement that
     obliges the buyer to take delivery of a
     specific quantity of an underlying asset, at a
     specific date, and at a price established at
     the time of the transaction.
    Conversely, the seller is obliged to deliver a
     specific quantity of an underlying asset, at a
     specific date, and at a price established at
     the time of the transaction.

                                                  29
Futures Contract

    The value of a forward contract is zero
     when initiated
      Delivery price identical to the forward price
      The contract develops value as the forward
       price change
      Zero-sum game
            What is lost by one is gained by the other
    No initial payment
        Performance bond required
                                                          30
The Payoff of a Forward Contract

    The payoff of a long position
     Pt – D
    The payoff of a short position
     D – Pt
     where…
        Pt = Price of the underlying asset at the maturity of
             the contract
        D = Delivery price


                                                            31
The Payoff of a Forward Contract


    Futures contracts have a linear profit and
     loss profile

    Zero-sum game
        What is lost by one is gained by the other




                                                      32
The Payoff of a Forward Contract


   +                                              +


 Profit                                         Profit



                                     Price                                          Price



 Loss                                           Loss

   -                                              -


          Profit and loss for a long position            Profit and loss for a short position




                                                                                                33
Futures Contract

  Example
      Suppose we are in June and a coffee
       producer wants to sell his September
       harvest at the current market price of $2
       per pound. At this price, the producer
       would realize a return of 25%.




                                                   34
Futures Contract

    Example
        A futures contract expiring in September will be
         sold at a price of $2.
        The producer is committing himself to deliver
         the coffee at a price of $2 per pound in
         September. He is obliged to do so even if the
         price of coffee rises.
        However, he is protected against a drop in the
         price since the buyer is obliged to purchase the
         coffee at a price of $2.

                                                            35
Futures Contract


 In September : $3/lb In September : $1/lb

 The  producer is obliged The producer sells
  to sell coffee at $2/lb     coffee at $2/lb
 Opportunity cost of        Profit of $1/lb
  $1/lb                      The counterparty incurs
 The counterparty            a loss of $1/lb
  realizes a profit of $1/lb

                                                        36
Contract Specifications

  Contract size and value
  Minimum price fluctuations
  Daily price limits
  Delivery month
  Trading hours
  Delivery location




                                37
Settlement
  Delivery by an offsetting transaction
     Taking an opposite position to the initial
      position
  Settlement by delivery
     The short position holder initiate the delivery
      process at any time after the first notice day
  Cash settlement
     The long and the short must pay or receive a
      payment in cash instead of having to accept or
      to make delivery of the merchandise


                                                        38
Margin Requirements and Marking
to Market
   Margin
       Good faith deposit or performance bond
       Determined by the exchange or clearinghouse as a fixed
        amount per contract or as a percentage of the total
        contract value (3% to 10% of the contract value)
        depending on the volatility and risk of underlying asset
   Initial margin
       The required deposit at the contract inception
       Adjustments are being made at the end of every days
        (daily settlement, mark to market)
   Maintenance margin
       The amount that must be maintained in the account at all
        time

                                                                   39
Margin Requirements and Marking to
Market

    Margin call
        A margin call is issued when the account falls
         under the maintenance margin level. The account
         must then be immediately brought back to the initial
         margin level.




                                                                40
Swaps




        41
Swaps

    Swaps are forward agreements between
     two counterparties to exchange periodic
     payments in the future according to a
     preset formula.

  Interest rate swaps
  Currency swaps



                                               42
Interest rate swaps

                Fixed rate

    Client A                   Client B

               Floating rate




                                          43
Currency swaps



            US$                               CAN$

                                   Client A          Client B
 Client A          Client B   or
            CAN$                              US$




                                                            44
Swap Dealer
        Fixed Rate - commission   Fixed Rate - commission

      Client A          Swap Dealer           Client B

        Floating Rate             Floating Rate


   The role of the swap operator is to facilitate the
    entire process by finding and bringing together
    the two sides and tailoring a product to meet
    the specific needs of the two end-users.

                                                            45
Interest rate swaps

  Most of the time interest rate swaps
   involve an exchange of a floating interest
   rate against a fixed interest rate payment
  The principal is not exchanged, only the
   cash flows based on a notional
   (theoretical) principal
  Swaps allows firms to reduce financing
   costs and to modify their financial
   structure
                                            46
Interest rate swaps

    Example
        Company ABC inc. can borrow at the floating rate
         of LIBOR + 0.25% and at the fixed rate of 7.50%
        Company DEF inc. can borrow at the floating rate
         of LIBOR + 0.75% and at the fixed rate of 9.00%
        Company ABC inc. wants to borrow 10 M$ short
         term (floating rate) since it holds short term assets
        Company DEF inc. wants to borrow 10 M$ long
         term (fixed rate) since it holds long term assets
        Both companies would like to borrow at a better
         rate


     LIBOR: London Interbank Offer Rate                          47
Interest rate swaps
                             Floating     Fixed

             ABC inc.     LIBOR + 0.25%   7.50%

             DEF inc.     LIBOR + 0.75%   9.00%

             Difference      0.50%        1.50%


    Obviously, company ABC has a better credit
     notation than company DEF

    ABC has a comparative advantage on the fixed
     market

    DEF has a comparative advantage on the floating
     market

                                                       48
Interest rate swaps
                                Floating     Fixed

                ABC inc.     LIBOR + 0.25%   7.50%
                DEF inc.     LIBOR + 0.75%   9.00%
               Difference       0.50%        1.50%


    DEF could borrow at LIBOR + 0.75% and lend it to
     ABC at LIBOR + 0.25%
        DEF’s loss would be of 0.50%

    ABC could borrow at 7.,50% and lend it to DEF at
     8.00%
        ABC’s profit would be of 0.50%
        DEF would save 1.00%

    The net profit for both would be of 0.50%
                                                        49
Interest rate swaps
             Floating       Fixed              Pays        Receives     Pays       Total          Instead of

                                     ABC    LB + 0.25%       8.00%      7.50%   LB – 0.25%       LB + 0.25%
 ABC inc.   LB + 0.25%      7.50%    inc.
                                     DEF    LB + 0.75%     LB + 0.25%   8.00%     8.50%             9.00%
 DEF inc.   LB + 0.75%      9.00%    inc.


                        LB + 0.25%


   ABC                   8.00%          DEF                                      ABC at a floating rate of LB
   inc.                                 inc.             ABC inc.                         – 0.25%




   7.50%                             LB + 0.75%                                   DEF borrows at a fixed rate
                                                         DEF inc.                         of 8.50%




   Bank                                 Bank



                                                                                                                50
Interest rate swaps
                                           Floating          Fixed

                          ABC inc.      LIBOR + 0.25%        7.50%
                          DEF inc.      LIBOR + 0.75%        9.00%



                                 LIBOR + 0.25%

 ABC inc.                                 8.00%                               DEF inc.


  7.50%                                                                       LIBOR +
                                                                               0.75%


  Bank                                                                         Bank
            LIBOR + 0.25% x 10 M$ x 90 / 360
                                                      8% x 10 M$ x 90 / 360


                                                                                      51
Princing interest rate swaps
 ABC swap = Fixed-coupon bond – floating-coupon bond
 DEF swap = Floating-coupon bond – fixed-coupon bond
 Pricing of a swap involves choosing the coupon rate in
  the fixed-coupon bond so that its value equals the value
  of the floating-coupon bond.


                      LIBOR + 0.25%

 ABC inc.                 8.00%                   DEF inc.



                                                         52
Options Market


    An option is an agreement with a precise
     duration which gives its holder:

      the right, but not the obligation,
      to purchase or sell
      an underlying asset
      at a given price.




                                                53
Types of Options



    Call option

    Put option




                   54
Call Option

    The holder (purchaser) of the call option
     has the right, but not the obligation:

      to buy a specific quantity of an underlying
       asset
      at a given price (strike or exercise price)
      for a specified time period (expiry date).


    In order to obtain that right, the holder must
     pay a premium to the writer.
                                                      55
Call Option

    The writer (seller) of the call option has the
     obligation:

      to sell, to the holder, a specific quantity of
       an underlying asset
      at the strike or exercise price indicated, if
       the holder exercises his right.

    In return for this obligation, the writer
     receives the premium paid by the holder.
                                                        56
Call Option


    Example
        As a prospector you believe that there is
         gold on a certain property that is for sale.
         Since there is a risk of not finding gold, you
         decide that buying an option contract to buy
         the property is a better alternative than
         buying it.


                                                          57
Call Option


    Example
      The property is for sale at $200,000
      6-month option contract to buy the property
          Strike price: $200,000
          Option price: $10,000




                                                     58
Call Option

 Example
      At expiry, in 6 months :
           You find gold and the property is worth several
            millions dollars
                In this case, you will exercise your right to buy the
                 property for $200,000.
           There is no gold on the property and the
            property does not interest you anymore
                In this case, you will not exercise your right to buy the
                 property and will lose $10,000.



                                                                             59
Put Option

    The holder (purchaser) of a put option has the
     right, but not the obligation:

        to sell a specific quantity of an underlying asset
        at a given price (strike or exercise price)
        for a specified time period (expiry date).


    In order to obtain that right, the holder must
     pay a premium to the writer.

                                                              60
Put Option

    The writer (seller) of the put option has the
     obligation:

      to buy, from the holder, a specific quantity
       of an underlying asset
      at the strike price indicated, if the holder
       exercises his right.

    In return for this obligation, the writer
     receives the premium paid by the holder.
                                                      61
Put Option

    Example
        You own shares of a corporation trading at
         a price of $20. In order to protect their
         asset you buy put option contracts expiring
         in 3 months with a strike price of $20, for a
         price of $1 per share.




                                                         62
Put Option

    Example
        At expiry, what will you do if the shares are
         trading at:

           $21.00
           $19.50

           $15.00




                                                         63
Put Option

    Example
        At expiry, what should the price of the put
         contract be if the shares are trading at:

           $21.00
           $19.50

           $15.00




                                                       64
Options Market


                Call               Put
 Holder     Right to buy       Right to sell

 Writer   Obligation to sell Obligation to buy




                                                 65
Characteristics of Options



    Security              Strike price                 Premium
    ABC          APRIL        50             C          $2.10
               Expiry month              Option type




                                                                 66
Security


    The underlying asset specified in the
     option contract.
    Generally, a stock option contract is for
     100 shares




                                                 67
Expiry Month


    This is the month during which the
     option and the right to exercise cease to
     exist.
    The option expires on the Saturday
     following the third Friday of the month
     specified in the contract.


                                                 68
Exercise Styles




                  69
Strike or Exercise Price


    The price at which the holder can
     purchase or sell the underlying asset.




                                              70
Option Type



    Identifies if it is a call (C) or a put option
     (P).




                                                      71
Premium

    This term designates the option price,
     meaning the amount paid by the holder
     to the writer of the option. The price is
     identified in terms of a unit of the
     underlying asset.
    Therefore, the total value of an option
     contract with a premium of $2.10 is:
             $2.10 X 100 = $210

                                                 72
Premium


 Premium is equal to intrinsic value plus
 time value
                        P = Iv + Tv
 P = Option premium
 Iv = Intrinsic value
 Tv = Time value



                                            73

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:192
posted:5/10/2011
language:English
pages:73
Description: History of Derivatives Market document sample