Section 15: Introduction to Financial Derivatives, Forward and Future Contracts

ACTS 4308 Natalia A. Humphreys

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Acknowledgement

This work is based on the material in S. Broverman Study Guide for SOA Exam FM/CAS Exam 2, 2011 Edition and on the notes prepared by Professor Ryan Gill at the University of Louisville, KY. Additionally, Study Manual for Exam FM/Exam 2, ASM 2009, 10th Edition by Harold Cherry and Rick Gorvett was used to present the material in this section.

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Financial Derivatives

Financial derivative: nancial instrument related to some other asset and whose value is derived from that asset Purposes of nancial derivatives: risk management (e.g., form of insurance); speculation; reduction of transaction costs; circumventing regulatory limitations, accounting regulations, and taxes Diversiable risks: risks unrelated to other risks; can be shared through markets

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Financial Derivatives (cont.)

Over-the-counter (OTC) trading: trading of nancial instruments (such as forwards and swaps) made directly between two parties (in contrast with exchange trading of stocks or futures) Market maker: rm that is ready to buy and sell a particular asset Credit risk: possibility of failure of payment or delivery on contract expiration date Bid price: price at which an investor can sell the asset Ask price: price at which an investor can buy the asset Bid-ask spread = ask price bid price: compensation to the market-makers for their risk and for keeping the market liquid

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Payo, Prot

The payo at time T is the value of an investment at time T . The prot from time 0 to time T is the dierence between the payo at time T and the amount invested at time 0.

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Positions in the Assets

When you buy a stock (or any other asset), you are said to have a long position in the stock. You enter into this position if you believe the stock will go up in the future. Short position - the opposite of a long position. You enter into this position if you believe the stock will go down in the future.

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Essence of a short sale

You borrow a stock whose price you expect to decline You immediately sell the stock and receive the current price At a later date, you buy the stock to repay the lender Short-selling is a dangerous game. There is theoretically no limit to your losses.

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Short sale: Example 15.1

The bid and ask prices for a certain stock are as follows:

February 25 Bid Ask 35.22 35.37

August 25 39.65 39.80

Fred enters into a short sale on February 25 for 100 shares. He covers his short position on August 25. The brokers commission is $10 per transaction. What is Freds prot or loss on the short sale?

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Short sale: Example 15.1 - Solution.

Solution. Fred has a loss, since the price of the stock went up. On February 25 Fred borrows and then immediately sells 100 shares of stock for 100 35.22 10 = 3, 512. On August 25, he buys 100 shares to close (or cover) his short position for 100 39.80 + 10 = 3, 990. Hence, his loss in this transaction is 3, 512 3, 990 = 478.

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Forward Contract

Forward contract: agreement at time 0 to buy or sell an asset at a certain future time at a certain price T = delivery date F0,T = delivery price The buyer has the long position. The seller has the short position. ST = spot price of the asset at time T Payo of the long position at time T = ST F0,T Payo of the short position at time T = F0,T ST

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Prepaid Forward Contract

If an asset pays no dividends, the prepaid forward price is P =S . F0 0 ,T If an asset pays dividends with amounts D1 , . . . , Dn at times t1 , . . . , tn , the prepaid forward price is n P =S rti . F0 0 k =1 Di e ,T If an asset pays dividends as a percentage of the stock price at a continuous (lease) rate , the prepaid forward price is P = S e T . F0 0 ,T Cost of carry = r P e rT F0,T = F0 ,T Implied fair price: the implied value of S0 when it is unknown based on an equation relating S0 to F0,T Implied repo rate: implied value of r based on the price of a stock and a forward F0,T 1 ln S Annualized forward premium = T 0
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Example 15.2

At time t = 0, a corporation enters into a forward contract with a gold rener to purchase 1000 ounces of gold in one year (T = 1) at the delivery price of K = $300 per ounce. Suppose that at the time of maturity (T = 1) the spot price of gold is $280. What is the payo at time T on the (a) long position? (b) short position?

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Example 15.2. Solution.

Solution: (a) The payo on the long position is S1 F0,1 = 1000 ($280 $300) = 1000 $20 = $20,000. (b) The payo on the short position is F0,1 S1 = 1000 ($300 $280) = 1000 $20 = $20,000.

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Example 15.3

(a) A stock has a current price of $100. The stock will pay a dividend of $5 in 6 months and in 1 year. A prepaid one-year forward contract on the stock arranges for the delivery of the stock just after the dividend is paid in one year. Given a force of interest of 10%, nd the prepaid forward price and the forward price. (b) A stock has a current price of $125. The stock will pay dividends at an annual continuous rate of 3%. Find the prepaid forward price. Also, nd the forward price assuming a force of interest of 10%.

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Example 15.3. Solution.

Solution: (a)
P 0.1(0.5) F0 5e 0.1(1) ,1 = S0 5e

= 100 5e 0.05 5e 0.1 = 90.72

P .1 F 0 ,1 = F 0 ,1 e = 100.26

(b)
P T F0 ,1 = S0 e

= 125e .03 = 121.31

P .1 .07 F 0 ,1 = F 0 = 134.06 ,1 e = 125e
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Types of Purchase Arrangements

The asset value at time 0 is S0 . The continuous compounded risk free rate of interest is r . Four ways that an arrangement can be made at time 0 to purchase an asset:
1. Outright purchase: Pay S0 at time 0 and receive the asset. 2. Fully leveraged purchase: Borrow S0 at time 0 to purchase the asset at time 0, and repay the loan with a payment of S0 e rT at a later time T . P 3. Prepaid forward contract: Pay F0 ,T at time 0 to receive the asset at time T . 4. Forward contract: Pay F0,T at time T and receive the asset at time T .

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Arbitrage
Central to many aspects in nance There are a few dierent versions of arbitrage Riskless arbitrage consists of purchasing an asset at one price and simultaneously selling that same asset at higher price, generating a prot on the dierence. Basic idea: something for nothing Assume In a rational market, arbitrage opportunities do not exist If two investments have exactly the same characteristics, they must have the same price under the assumption of no arbitrage.

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Example 15.4
A non-dividend stock has a price at time 0 of $100. The force of interest is 10%. (a) Suppose that an investor is willing to buy a prepaid forward contract at a prepaid forward price of $105 on a one year prepaid forward contract. Show how to make an arbitrage gain under these circumstances. (b) Suppose that an investor is willing to sell a prepaid forward contract at a prepaid forward price of $95 on a one year prepaid forward contract. Show how to make an arbitrage gain under these circumstances.

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Example 15.4. Solution.

Solution: (a) First note that since the current price of the stock is $100, the P = $100. Thus, price of the pre-paid forward should also be F0 ,T the prepaid forward contract is overpriced and there is an arbitrage opportunity. To realize it, sell prepaid forward to the investor at time 0 for $105. Use $100 to buy the stock. Invest the remaining $5 at the force of interest of 10%. Deliver the stock to the investor at time 1. The arbitrage gain is 5e .10 = $5.53.

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Example 15.4. Solution (cont.)

Solution: (b) First note that since the current price of the stock is $100, the P = $100. Thus, price of the pre-paid forward should also be F0 ,T the prepaid forward contract is underpriced and there is an arbitrage opportunity. To realize it, sell the stock short for $100 at time 0. Use $95 from the short sale to buy the prepaid forward from the investor at time 0. Invest the remaining $5 at the force of interest of 10%. At the end of the year, receive the stock from the investor who sold the prepaid forward and deliver the stock to cover the short sale. The arbitrage gain is 5e .10 = $5.53.

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Strategies with Forward Contracts

Cash-and-carry: at time 0, buy the stock and short the osetting forward contract If the forward price oered is too high, then cash-and-carry arbitrage is possible. Reverse cash-and-carry: short-sell the asset and enter into an osetting long forward contract If the forward price oered is too low, then reverse cash-and-carry arbitrage is possible.

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Cash Flows for Cash-and-Carry

Suppose a stock pays continuous dividends at rate . Transaction Buy e T units of the stock Borrow S0 e T Short one forward Total Time 0 S0 e T S0 e T 0 0 Time T (Expiration) ST S0 e (r )T F0,T ST F0,T S0 e (r )T

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Cash Flows for Reverse Cash-and-Carry

Suppose a stock pays continuous dividends at rate . Transaction Sell e T units of the stock Lend S0 e T Long one forward Total Time 0 S0 e T S0 e T 0 0 Time T (Expiration) ST S0 e (r )T ST F0,T S0 e (r )T F0,T

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Synthetic Contracts

If two nancial investments result in the same payos, then under the assumption of no arbitrage they would have the same value or price. For some types of nancial contracts it is possible to replicate the payos by combining alternative nancial instruments.

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Example 15.5

A stock which does not pay dividends is currently selling for S0 . An investor borrows S0 to purchase the stock with the intention of selling the stock in one year and repaying the loan. Suppose that the force of interest is r . Show that the payo from this transaction at the end of the year is the same as the payo on a long position on one year forward contract on the stock.

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Example 15.5. Solution.

At the end of the year the stock is sold for amount S1 and the amount of the loan repayment is S0 e r . The payo from the transaction is S1 S0 e r , which is the same as the payo on a long position on a one year forward contract on the stock.

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Synthetic Contracts
P and use it to buy Synthetic forward: at time 0, borrow F0 ,T the stock:

forward = stock zero-coupon bond

P e rT = F At time T , we own the stock, but must pay F0 0,T ,T so that the payo is ST F0,T .

Synthetic stock: at time 0, take a long position in a forward (delivery date T ) and purchase a zero-coupon bond (term T ): stock = forward + zero-coupon bond Synthetic bond: at time 0, buy the stock and take the short position in a forward (delivery date T ): zero-coupon bond = stock forward

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Example 15.6
Suppose the price of a stock at time 0 is 1000 and the stock pays continuous dividends at 2%. The force of interest is 3%. (a) Compute the payo for the long position on a 2-year forward contract for 1 unit of stock. (b) Compute the payo and prot at time 2 for buying e T = e .04 units of the stock at time 0. (c) Compute the payo and prot at time 2 for borrowing e T = e .04 at time 0 (selling a zero-coupon bond at P = S0 e T = 1000e .04 ). (d) Show that the payo and prot for (b) and (c) are the same as for (a).

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Example 15.6. Solution.

Solution: (a) S2 F0,2 = S2 S0 e (r )2 = S2 1000e .02 = S2 1020.20 (b) Price = S0 e .04 = 1000e .04 = 960.79; Payo = S2 ; Prot = S2 960.79 (c) Price = S0 e .04 = 960.79; Payo = 960.79e .03(2) = 1020.21; Prot = 1020.21 + 960.79 = 59.41 (d) Payo for buying stock + Payo for selling bond = S2 1020.21 Prot for buying stock + Prot for selling bond = S2 960.79 59.41 = S2 1020.20

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Cash Flows for Synthetic Forward

Suppose a stock pays continuous dividends at rate . Transaction Buy e T units of the stock Borrow S0 e T Total Time 0 S0 e T S0 e T 0 Time T (Expiration) ST S0 e (r )T ST S0 e (r )T

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Cash Flows for Synthetic Stock

Suppose a stock pays continuous dividends at rate . Transaction Long one forward Lend S0 e T Total Time 0 0 S0 e T S0 e T Time T (Expiration) ST F0,T S0 e (r )T ST

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Cash Flows for Synthetic Bond

Suppose a stock pays continuous dividends at rate . Transaction Buy e T units of the stock Short one forward Total Time 0 S0 e T 0 S0 e T Time T (Expiration) ST F0,T ST F0,T

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Hedging and Expected Return

Hedging: making an investment to reduce the risk related to adverse price movements of an asset Reasons to hedge: taxes, avoiding bankruptcy, avoid costly external nancing, protect debt capacity, managerial risk aversion, non-nancial risk management Reasons not to hedge: transaction costs, complex strategy with requires expertise, transactions must be monitored and managed, complicates accounting and tax reporting Nondiversiable risks can be partially controlled by hedging with investments that are less exposed to the risks Expected Return (without hedging): Suppose that the return on an investment will be R1 with probability p1 , R2 with probability p2 , . . ., Rn with probability pn . Then the expected return without hedging is p1 R1 + p2 R2 + . . . + pn Rn .
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Example 15.7

The following example is #18 in Sample Questions For Derivatives Markets. You are a jeweler who buys gold, which is the primary input needed for your products. One ounce of gold can be used to produce one unit of jewelry. Assume that the cost of all other markets is negligible. You are able to sell each unit of jewelry for 700 plus 20% of the market price of gold in one year. In one year, the actual price of gold will be in 1 of 3 possible states, corresponding to the following probability table.

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Example 15.7 (cont.)

Market Price of Gold in 1-year 750 per ounce 850 per ounce 950 per ounce

Probability .2 .5 .3

You are considering utilizing forward contracts to lock in 1-year gold prices, in which case you would charge the customer (one year from now) 700 plus 20% of the forward price. The 1-year forward price for gold is 850 per ounce. How much does your expected 1-year prot, per unit of jewelry sold, increase if you buy forward the 1-year price of gold.

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Example 15.7. Solution.

Solution: Unhedged (without the forward), the return will be 700 + .2(750) 750 = 100 with probability .2, 700 + .2(850) 850 = 20 with probability .5, and 700 + .2(950) 950 = 60 with probability .3. So, the expected return per unit sold without using the forward is 100(.2) + 20(.5) 60(.3) = 20 + 10 18 = 12. Using the forward the return will be 700 + .2(850) 850 = 20 so the dierence between the return based on using the forward and the expected return without using the forward is 20 12 = 8.

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No-Arbitrage Bounds with Transaction Costs

Theoretically, an arbitageur can make costless prot if P e rT . F0,T = F0 ,T However, with transaction costs, there is an interval [F , F + ] where arbitrage is not possible. Let S b < S a be the bid and ask prices for the stock. Let F b < F a be the bid and ask prices for the corresponding forward. Let r < r b be the interest rates for lending (investing) and borrowing. k = transaction cost in the stock or forward contract
a + 2k )e r T If F + F + = (S0 0,T > F , then cash-and-carry arbitrage is possible. b 2k )e r T If F F = (S0 0,T < F , then reverse cash-and-carry arbitrage is possible.
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Futures Contracts
Futures contracts: exchange-traded standardized contracts Futures are tracked daily and marked to market to establish the daily status of buyer and seller, and they are a commonly used instrument for hedging and speculation. Futures are maintained on trading markets or exchanges that have clearly dened rules. Advantages: futures are liquid, minimize credit risk, and have price limits which stop trading when prices change too much Notional value: contract value of a future Margin account: deposit to a futures broker for risk protection Maintenance margin: additional deposit required if the margin account gets too low Margin call: request for additional margin deposit
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Example 15.8
A long futures contract for 100 ounces in gold is opened at the end of trading on December 5, 2006. The contract is for June 2007 delivery. The following table gives the futures price and the gold spot price on successive days. Date December 5 December 6 December 7 June 07 Closing Futures Price 660.30 648.20 649.20

The margin required is $3375 and the maintenance margin is $2500. If the margin balance drops below the maintenance margin, a margin call is made requiring the investor deposit enough to bring the margin account balance to the initial margin. Assuming there is not interest on the margin account, what is the prot if the investor closes out the position on (a) December 6? (b) December 7?
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Example 15.8. Solution.

Solutions: Date Contract value Margin balance (before deposit) 3375 2165 3475 Margin deposit Prot if sold As % of amount invested

12/5 12/6 12/7

66,030 64,820 64,920

1210

1210 1110

35.85% 24.20%

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