Financial Derivatives

Ch1: Introduction
1. Introduction
• What is Finance?
• What is a Spot Market?
What is Finance?
• At the macro level, finance is the study of
financial institutions and financial markets
and how they operate within the financial
system in both the U.S. and global economies.
• At the micro level, finance is the study of
financial planning, asset management, and
fund raising for businesses and financial
institutions.
 What is Finance?
ABC Company
Balance Sheet
As of December 31, 19xx

Assets: Liabilities & Equity:

Current Assets Current Liabilities
Working Cash & M.S. Accounts payable
Working
Capital Accounts receivable Notes Payable
Capital
Inventory Total Current Liabilities
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities
Gross fixed assets Equity:
Investment Less: Accumulated dep. Common Stock Financing
Decisions Goodw ill Paid-in-capital
Decisions
Other long-term assets Retained Earnings
Total Fixed Assets Total Equity
Total Assets Total Liabilities & Equity

Copyright © 2003 Pearson Education, Inc. Slide 1-4

What is Finance?
• Identify and select the corporate
strategies and individual projects that
add value to their firm.
• Forecast the funding requirements of
their company, and devise strategies for
acquiring those funds.
 What is Spot Market?
• The spot market is where financial instruments, such as
commodities, currencies, and securities, are traded for
immediate delivery.
• The current price of a financial instrument is called the spot
price. It is the price at which an instrument can be sold or
bought immediately.
• A limit order, sometimes referred to as a pending order, allows
investors to buy and sell securities at a certain price in the
future.
What is Spot Market?
 2. What Are
Derivatives?
• A derivative security is a financial security whose
payoff depends on other, more fundamental, variables
such as a stock price, an exchange rate, a commodity
price, an interest rate—or even the price of another
derivative security
• The underlying driving variable is commonly referred
to as simply the underlying
• The simplest kind of derivative—and historically the
oldest form, dating back thousands of years—is a
forward contract
• A forward contract is one in which two parties agree
to the terms of a trade to be completed on a specified
date in the future.
 2. What Are
Derivatives?
• For example, on December 3, a buyer and seller may enter into a forward contract to trade in 100 oz of gold in three
months at a price of $2000/oz
• In this case, the seller is undertaking to sell 100 oz in three months at a price of $ 2000/oz while the buyer is undertaking
to buy 100 oz of gold in three months at $ 2000/oz
• One common motivation for entering into a forward contract is the elimination of cash- flow uncertainty from a future
transaction
• In our example, if the buyer anticipates a need for 100 oz of gold in three months and is worried about price fluctuations
over that period, any uncertainty about the cash outlay required can be removed by entering into a forward contract
• In short, forward contracts may be used to hedge cash-flow risk associated with future market commitments
 2. What Are
Derivatives?
• Forward contracts are commonly
used by importers and exporters
worried about exchange-rate
fluctuations, investors and
borrowers worried about
interest-rate fluctuations,
commodity producers and buyers
worried about commodity price
fluctuations, and so on..
 3. Classifying
Derivatives
• A popular way to classify derivatives is to group them according to
the underlying
• For example, an equity derivative is one whose underlying is an
equity price or stock index level; a currency FX derivative is one
whose underlying is an exchange rate; and so on
• While these are the most common underlyings, derivatives may, in
principle, be defined on just about any underlying variable
• Most derivatives fall into one of two classes: those that involve a
commitment to a given trade or exchange of cash flows in the future
and those in which one party has the option to enforce or opt out of
the trade or exchange
• Commitment: forwards, futures; and swaps; the latter class are
called options
 3. Classifying
Derivatives
• A third classification of derivatives of interest is into
over-the-counter (OTC)
• Over-the-counter derivatives contracts are traded
between two counterparties who deal directly with
each other
• Forwards and swaps are OTC contracts, while futures
are exchange traded
• Options can be both OTC and exchange traded.
 4. Forward and
Futures Contracts
• A forward contract is an agreement between two parties to trade in a
specified quantity of a specified good at a specified price on a
specified date in the future
• The buyer in the forward contract is said to have a long position
in the contract; the seller is said to have a short position
• The good specified in the contract is called the underlying asset
or, simply, the underlying
• The date specified in the contract on which the trade will take
place is called the maturity date of the contract
• The price specified in the contract for the trade is called the
delivery price in the contract
• The underlying in a forward contract may be any commodity or
financial asset
 4. Forward and
Futures Contracts
• Forward contracts may be written on foreign
currencies, bonds, equities, or indices, or physical
commodities such as oil, gold, or wheat
• Forward contracts also exist on such underlyings
as interest rates or volatility which cannot be
delivered physically ; in such cases, the contracts
are settled in cash with one side making a payment
to the other based on rules specified in the contract
• Cash settlement is also commonly used for those
underlyings for which physical delivery is
difficult, such as equity indices
 4. Forward and
Futures Contracts
• A primary motive for entering into a forward
contract is hedging: using a forward contract
results in locking-in a price today for a future
market transaction and this eliminates cash-flow
uncertainty from the transaction
• Forward contracts can also be used for
speculation, that is, without an underlying
exposure already existing
 4. Forward and Futures
Contracts
 Forward contracts can also be used for speculation, that
is, without an underlying exposure already existing.
 An investor who feels that the price of some underlying
is likely to increase can speculate on this view by
entering into a long forward contract on that under-
lying.
 If prices do go up as anticipated, the investor can buy
the asset at the locked-in price on the forward contract
and sell at the higher price, making a profit.
 Similarly, an investor wishing to speculate on falling
prices can use a short forward contract for this purpose.
 5. Payoffs from
Forward Contracts
• The payoff from a forward contract is the profit or loss made by the two
parties to the contract.
• Suppose a buyer (LONG) and seller (SHORT) enter into a forward contract
on a stock with a delivery price of F = 100. Let ST denote the price of the
stock on the maturity date T . Then, on date T ,
• The long position is buying for F = 100 an asset worth ST
• The short position is selling for F = 100 an asset worth ST
• For example:
• If ST = 110, then the long is buying for 100 an asset worth 110, so gains
10, but the short is selling for 100 an asset worth 110, so loses 10
• If ST = 90, the long is buying for 100 an asset worth only 90, so loses
10, while the short is selling for 100 an asset worth only 90, so gains 10
 6. Futures Markets
• A futures contract is, in essence, a forward contract that is traded on
an organized exchange
• First, in a futures contract, buyers and sellers deal through the futures
exchange, not directly
• Second, because buyers and sellers do not meet, futures contracts must
be standardized
• Third, counterparties are not exposed to each other’s default risk
• Fourth, an investor may, at any time, close out or reverse a futures
position
• Fifth, having guaranteed performance on the futures contracts, the
exchange must put safeguards in place to ensure it is not called upon to
honor its guarantee too often. For this purpose, a system based on the
use of “margin accounts” are commonly used.
 7. Options
• An option is a financial security that gives the buyer the right to buy
or sell a specified asset at a specified price on or before a specified
date
• Buyer = Holder = Long Position: The buyer of the option, also
called the holder of the option, is said to have a long position in
the option
• Seller = Writer = Short Position: The seller of the option, also
called the writer of the option, is said to have a short position in
the option
• The asset specified in the option contract is called the underlying
asset or simply the underlying
• The price specified in the contract is called the strike price or the
exercise price of the option
• The date specified in the contract is called the maturity date or
 • We differentiate between options along two fundamental
dimensions

7. Options • Calls vs. Puts: If the option provides the holder with the right
to buy the underlying asset at the specified strike price, we
call it a call option. If the option provides the holder with the
right to sell the underlying at the specified strike price, it is a
put option.
• American vs. European If the right in the option can be
exercised at any time on or before the maturity date, it is
called an American-style option. If the right can be availed of
only on the maturity date, it is called a European-style option.
• Traditional call and put options, whether European or American,
are referred to as plain vanilla options
• Options on equities, equity indices, and foreign currencies are
traded both in the OTC market and on exchanges
• Exchange-traded interest-rate options include options on bond
futures
 7. Options
• In addition to options qua options, many financial securities are
sold with embedded options
• A callable bond is a bond issued by a corporation that may be
purchased back by the issuing entity under specified conditions
at a fixed price
• A more complex example is a convertible bond, that may be
converted, at the holder’s option, into shares of equity of the
issuing company.
• Convertible bonds in the United States are usually also callable,
so both the issuer and the buyer of the bond hold options
 8. Swaps
• A swap is a two-sided contract between two
counterparties that calls for periodic exchanges of
cash flows on specified dates and calculated using
specified rules
• The swap contract specifies the dates on which
cash flows will be exchanged and the rules
according to which the cash flows due from each
counterparty on these dates are calculated
• Importantly, the frequency of payments for the two
counterparties need not be the same
 8. Swaps
• The largest chunk of the swaps market is occupied by interest-rate
swaps, in which each leg of the swap is tied to a specific interest-
rate index
• Currency swaps, in which the Equity swaps, in which one leg
of two legs of the swaps are linked to payments in different
currencies. Libor rate vs. fixed interest rate.
• the swap is linked to an equity price or equity index. S&P 500
equity index vs. fixed interest rate
• Commodity swaps, in which one leg of the swap is linked to a
commodity price
• Credit-risk linked swaps in which one leg of the swap is
linked to occurrence of a credit event on a specified reference
9. Uses of Swaps
• A currency swap that requires the
exchange of USD payments based on
USD-Libor for Japanese yen payments
based on JPY-Libor facilitates
converting floating-rate USD exposure
to floating-rate JPY exposure; and so on
10.Using Derivatives:
Some Comments
• Derivatives can be used for both hedging and
speculation
• Hedging is where the cash flows from the
derivative are used to offset or mitigate the cash
flows from a prior market commitment
• Speculation is where the derivative is used
without an underlying prior exposure; the aim is
to profit from anticipated market movements
 11.Derivatives in
Hedging
• A US-based company learns on December 13 that it will receive 25 million euros in the
coming March for goods that it had exported to Europe. The company is exposed to
exchange-rate risk because the USD it receives in March will depend on the USD/EUR
exchange rate at that point. It identifies three possible courses of action:
• Do nothing
• Use futures
• Use options
• If the company decides to go with futures, it will use the euro futures contracts available
on the Chicago Mercantile Exchange
• If the company decides to use options, it will use the euro options contract available on
the Philadelphia Exchange
• A final decision the company must make concerns the choice of strike price
• There are three important criteria under which we may compare the alternatives
 11.Derivatives in Hedging
• There are three important criteria under which we may compare the
alternatives
1. Cash-flow uncertainty. This is maximal for the do-nothing alternative,
intermediate for the option contract, and least for the futures contract.

2. Up-front cost. The do-nothing and futures contract alternatives cost

nothing. However, there is an up-front cost of $422,500 for entering into
the option contract.

3. Exercise-time regret. With an option contract, exercise-time outcomes are

guaranteed to be favorable (if the USD/EUR exchange rate is greater than
the strike rate, the option is allowed to lapse; otherwise it is exercised).
With the other two alternatives, this is not the case:
12.Derivatives in
Speculation
• Derivative securities can also be used to
speculate i.e., to make profits by taking
views on market direction
• Suppose, for example, that an investor
believes that the Japanese yen will
appreciate significantly with respect to
the US dollar over the next three months
Hedging vs. Speculation