CHAPTER 5 INTRODUCTION TO FINANCIAL CULTURE MARKETS Systematic and Unsystematic Risk Systematic risk is the portion of an asset's return variability that can be attributed to a common factor. It is also called undiversifiable risk or market risk. Systematic risk is the minimum level of risk that can be obtained for a portfolio by means of diversification across a large number of randomly chosen assets. As such, systematic risk results from general market and economic conditions that cannot be diversified away. The portion of an asset's retum variability that can be diversified away is referred to as unsystematic risk. It is also sometimes called diversifiable risk, residual risk, or company-specific risk. This is the risk that is unique to a company such as a strike, the outcome of unfavorable litigation, or a natural catastrophe, Quantifying Systematic Risk Quantification of systematic risk can be accomplished by dividing security return into two parts: one perfectly correlated with and proportionate to the market return, and a ‘second independent from (uncorrelated with) the market. The first component of return is usually referred to as systematic, the second as unsystematic or diversifiable return. Thus we have Security return = Systematic return + Unsystematic retum MECHANICS OF FUTURES TRADING | A futures contract is a firm legal agreement between a buyer (seller) and an established exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery of something at a specified price at the end of a designated period of time. The price at which the parties agree to transact in the future is called the futures price. The designated date at which the parties must transact is called the settlement or delivery date. LIQUIDATING APOSITION The contract with the closest settlement date is called the nearby futures contract. The next futures contract is the one that settles just after the nearby contract. The contract farthest away in time from the settlement is called the most distant futures contract. A party to a futures contract has two choices on liquidation of the position. First, the Position can be liquidated prior to the settlement date. For this purpose, the party musttake an offsetting position in the same contract. For the buyer of a futures contract, it means selling the same number of identical futures contracts; for the seller of a futures contract, it means buying the same number of identical futures contracts. A7The Role of the Clearinghouse The clearinghouse exists to meet this problem. When an investor takes a position in the futures market, the clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the contract. Because of the clearinghouse, the investor need not worry about the financial strength and integrity of the party taking the opposite side of the contract. After initial execution of an order, the relationship between the two parties ends. The clearinghouse interposes itself as the buyer for every sale and the seller for every purchase. Thus investors are free to liquidate their positions without involving the other party in the original contract, and without worry that the other party may default. While counterparty risk still exists for both parties, that risk is minimal since the risk is with the exchange, not with the original counterparty. and no exchange has failed. For this reason, we define a futures contract as an agreement between a party and a clearinghouse associated with an exchange. (A UTURES VERSUS FORWARD CONTRACTS, A forward contract, just like a futures contract, is an agreement for the future delivery of something at a specified price at the end of a designated period of time. Futures contracts are standardized agreements as to the delivery date (or month) and quality of the deliverable, and are traded on organized exchanges. A forward contract differs in that it is usually non-standardized (that is, the terms of each contract are negotiated individually between buyer and seller), no clearinghouse coordinates forward contract trading, and secondary markets are often nonexistent or extremely thin. Unlike a futures contract, which is an exchange-traded product, a forward contract is an over-the- Counter instrument. RISK AND RETURN CHARACTERISTICS OF FUTURES CONTRACTS When an investor takes a position in the market by buying a futures contract the investor is said to be in a long position or long futures. If, instead the investor's opening Position is the sale of a futures contract, the investor is said to be in a short position or Short futures.. THE ROLE OF FUTURES IN FINANCIAL MARKETS, Without financial futures, investors would have only one trading location to alter portfolio positions when they get new information that is expected to influence the value of assets—the cash market. If economic news that is expected to impact the value of an asset adversely is received, investors can reduce their price risk exposure to that asset. The opposite is true if the new information is expected to impact the value of that asset favorably: an investor would increase price-tisk exposure to that asset. Of course, transaction costs are associated with altering exposure to an asset—explicit costs (commissions), and hidden or execution costs (bid-ask spreads and market impact costs). Futures provide another market that investors can use to alter their risk exposure to an asset when new information is acquired, But which market—cash or futures— should the investor employ to alter position quickly on the receipt of new information? The answer is simple: the one that is the more efficient to use in order to achieve the objective. Tle factors to consider are liquidity, transaction costs, taxes, and leverage advantages of the futures contract. The market that investors feel is the one that is more efficient to use to achieve their investment objective should be the one where prices will be established that reflect the new economic information. That is, it will be the market where price discovery takes place. Price information is then transmitted to the other market. In many of the markets that we discuss in this book, it is in the futures market that it is easier and less costly to alter a portfolio position. We give evidence for this proposition when we discuss the specific contracts in later chapters. Therefore, it is the futures market that will be the market of choice and will serve as the price discovery market. Effect of Futures on Volatility of Underlying Asset Some investors and the popular press consider that the introduction of a futures market for an asset will increase the price volatility of the asset in the cash market. This criticism of futures contracts is referred to as the "destabilization hypothesis.” Two variants of the destabilization hypothesis are the liquidity variant and the populist variant. According to the liquidity variant, large transactions that are too difficult to accommodate in the cash market will be executed first in the futures markets because Of better liquidity. The increased volatility that may occur in the futures contracts market is only temporary because volatility will return to its normal level once the liquidity problem is resolved, The implication is that no long-term impact on the volatility of the underlying cash market asset will be felt.Pape [a the populist variant, in contrast, asserts that as a result of speculative trading in gefvative contracts, the cash market instrument does not reflect fundamental economic value. The implication here is that the asset price would better reflect economic value in the absence of a futures market. SUMMARY This chapter explains the basic features of financial futures markets. The traditional purpose of futures markets is to provide an important opportunity to hedge against the risk of adverse future price movements. Futures contracts are creations of exchanges, which require initial margin from parties. Each day positions are marked to market. Additional (variation) margin is required if the equity in the position falls .below the maintenance margin. The clearinghouse guarantees that the parties to the futures contract will satisfy their obligations, That is, with a futures contract counterparty risk is minimal. A forward contract differs in several important ways from a futures contract. In contrast to a futures contract, the parties to a forward contract are exposed to counterparty risk (ie., the risk that the other party to the contract will fail to perform). While there is no requirement that the parties to a forward contract mark positions to market, this is typically done to mitigate counterparty risk. Finally, unwinding a position in a forward contract may be difficult. A buyer (seller) of a futures contract realizes a profit if the futures price increases (decreases). The buyer (seller) of a futures contract realizes a loss if the futures price decreases (increases). Because only initial margin is required when an investor takes a futures position, futures markets provide investors with substantial leverage for the money invested.Pape [az ACTIVITY 5. QUESTIONS. Explain each question with a minimum of 5 sentences each. Doit on your own understanding. hen How do you explain the concept of systematic and unsystematic risk? . What do you think is the role of future in financial market? How it affects to it? . Explain what is clearinghouse and its functions to financial market? What is the use of future contract? . Explain the concept of risk and return.Page [43 CHAPTER 6 INTRODUCTION TO OPTION MARKET OPTION CONTRACT DEFINED Anoption is a contract in which the writer of the option grants the buyer of the option the right, but not the obligation, to purchase from or soll to the writer something at a specified price within a specified period of time (or at a specified date), The writer, also referred to as the seller, grants this right to the buyer in exchange for a certain sum of money, Which is called the option price or option premium, The price at which the asset may be bought or sold is called the exercise or strike price. The date after which an option is void is called the expiration date. Margin Requirements The buyer of an option is not subject to margin requirements after the option price is paid in full. Because the option price is the maximum amount the investor can lose, no matter how adverse the price movement of the underlying asset, margin is not necessary. Because the writer of an option agreed to accept all of the risk (and none of the reward) of the position in the underlying asset, the writer is generally required to put up the option price received as margin. In addition, as price changes occur that adversely affect the writer's position, the writer is required to deposit additional margin (with some exceptions) as the position is marked to market. DIFFERENCES BETWEEN OPTIONS AND FUTURES CONTRACTS Notice that, unlike in a futures contract, one party to an option contract is not obligated to transact—specifically, the option buyer has the right but not the obligation to transact. The option writer does have the obligation to perform. In the case of a futures contract, both buyer and seller are obligated to perform. Of course, a futures buyer does not pay the seller to accept the obligation, while an option buyer pays the seller an option price. Consequently, the risk/reward characteristics of the two contracts are also different. In the case of a futures contract, the buyer of the contract realizes a dollar-fordollar gain When the price of the futures contract increases and suffers a dollar-fordollar loss when the price of the futures contract drops. The opposite occurs for the seller of a futures Contract. Options do not provide this symmetric risk/reward relationship. The most ghat the buyer of an option can lose is -the option price. The buyer of an option retains all the Potential benefits, but the gain is always reduced by the amount of the option price, The maximum profit that the writer may realize is the option price; this potential is offset against substantial downside risk. This difference is extremely important because, asPane [4a we shall see in subsequent chapters, investors can use futures to protect against symmetric risk and options to protect against asymmetric risk. Buying Call Options The purchase of a call option creates a financial position referred to as a long call position. To illustrate this position, assume that a call option on Asset XYZ expires in 1 month and states a strike price of $100. The option price is $3. Suppose that the current price of Asset XYZ is $100. What is the profit or loss for the investor who purchases this call option and holds it to the expiration date? The profit and loss from the strategy will depend on the price of Asset XYZ at the expiration date. A number of outcomes are possible. 1. If the price of Asset XYZ at the expiration date is less than $100, then the investor will not exercise the option. It would be foolish to pay the option writer $100 when Asset XYZ can be purchased in the market at a lower price. In this case, the option buyer loses the entire option price of $3. Notice, however, that it is the maximum loss that the option buyer will realize regardless of how low Asset XYZ's price declines. 2. If Asset XYZ's price is equal to $100 at the expiration date, the option buyer would again find no economic value in exercising the option. As in the case where the price is less than $100, the buyer of the call option loses the entire option price, $3. 3. If the price of Asset XYZ at the expiration date is equal to $103, no loss or gain is realized from buying the call option. "The long position in Asset XYZ, however, produces a gain of $3. 4. If Asset XYZ's price at the expiration date is greater than $103, both the call option buyer and the long position in Asset XYZ post a profit, but the profit for the buyer of the call option is $3 less than that for the long position. If Asset XYZ's price is $113, for example, the profit from the call position is $10, while the profit from the long position in Asset XYZ is $13. Basic Components of the Option Price . The option price reflects the option’s intrinsic value and any additional amount over its intrinsic value. The premium over intrinsic value is often referred to as the time value or time premium. The former term is more common; however, we use the term time premium to avoid confusion between the time value of money and the time value of the option.Intrinsic Value Time Premium Poge 14S The intrinsic value of an option is the economic value of the option if it is exercised immediately. If no positive economic value will result from oxercising immediately then the intrinsic value is zero. The intrinsic value of a call option is the difference between the current price of the underlying asset and the strike price if positive: it is othenwise zero, For example, if the strike price for a call option is $100 and the current asset price is $105, the intrinsic value is $5, That is, an option buyer exercising the option and simultaneously selling the underlying asset would realize $105 from the sale of the asset, which would be covered by acquiring the asset from the option writer for $100, thereby netting a $5 gain, When an option holds intrinsic value, it is said to be "in the money." When the strike price of a call option exceeds the current asset price, the call option is said to be "out of the money’; it has no intrinsic value. An option for which the strike price is equal to the current asset price is said to be “at the money.” The intrinsic value of both at-the-money and out-of-the-money options is zero because it is not profitable to exercise the option. Our call option with a strike price ‘of $100 would be (1) in the money when the current asset price is greater than $100, (2) out of the money when the current asset price is less than $100, or (3) at the money when the current asset price is equal to $100. For a put option, the intrinsic value equals the amount by which the current asset price is below the strike price. For example, if the strike price of a put option is $100 and the current asset price is $92, the intrinsic value is $8. That is, the buyer of the put option who exercises the put option and simultaneously sells the underlying asset nets $8 by exercising, The asset is sold to the writer for $100 and purchased in the market for $92. For our put option with a strike price of $100, the option would be (1) in the money when the asset price is less than $100, (2) out of the money when the current asset price exceeds the strike price, or (3) at the money when the strike price is equal to the asset's price. The time premium of an option is the amount by which the option price exceeds its intrinsic value. The option buyer hopes that, at some time prior to expiration, changes in the market price of the underlying asset will increase the value of the rights conveyed by the option. For this prospect, the option buyer is willing to pay a premium above the intrinsic Value. For example, if the price of a call option with a strikePane 146 price of $100 is $9 when the current asset price is $105, the time premium of this option is $4 ($9 minus its intrinsic value of $5). A current asset price of $90 instead of $105 means that the time premium of this option would be the entire $9 because the option has no intrinsic value. Clearly, other things being equal, the time premium of an option increases with the amount of time remaining to expiration, Time to Expiration of the Option An option is a “wasting asset." That is, after the expiration date the option has no value. All other factors being equal, the longer the time to expiration of the option, the greater the option price, because as the time to expiration decreases, less time remains for the underlying asset's price to rise (for a call buyer) or fall (for a put buyer) —that is, to compensate the option buyer for any time premium paid—and therefore the probability of a favorable price movement decreases.ACTIVITY 6 QUESTIONS, Explain each question with a minimum of 5 sentences each. Do it on your own understanding. 1. phen WHAT DO YOU THINK IS THE DIFFERENCES BETWEEN OPTIONS AND. FUTURES CONTRACTS . What is the difference of time premium and instrinsic value? ‘What is the use of option contract? An option is a “wasting asset after the expiration date”, Explain, When to use option contract and future contract?