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DER1
DER1
Lecture 1
Instructor: Dr. Junbo Wang Contact: 3442-9492 Email: jwang2@cityu.edu.hk Office: ACAD P7424 Office Hours: Mondays 9:0011:00, Wednesday 9:0011:00
or by appointment
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Examples of Derivatives
Forward Contracts Futures Contracts Swaps Options
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Derivatives Markets
Exchange traded
Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading. Contracts are standard, defined by the exchange, and there is virtually no credit risk. For example: Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME, www.cmegroup.com), Chicago Board Option Exchange (CBOE), Hong Kong future and Option Exchange (www.hkex.com.hk) and etc.
Over-the-counter (OTC)
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.
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Jun/99
Jun/00
Jun/01
Jun/02
Jun/03
Jun/04
Jun/05
Jun/06
Jun/07
Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
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Forward Contracts
A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price). It can be contrasted with a spot contract which is an agreement to buy or sell immediately. It is traded in the OTC marketusually between two financial institutions or between a financial institution and one of its clients.
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Foreign Exchange Quotes for USD/GBP Today (GBP=British Pound; USD=US dollar; quote is
number of USD per GBP)
Offer 1.6285
1-month forward
3-month forward 6-month forward
1.6248
1.6187 1.6094
1.6253
1.6192 1.6100
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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). The forward price may be different for contracts of different maturities. We will discuss in detail the relationship between spot and forward prices in following chapters. For a quick preview of why the two are related, lets check the following example: Suppose a stock that pay no dividend and is worth 60$, you can borrow or lend money for 1 year at 5%. What should the 1-year forward price of the stock be? 60/1.05
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Terminology
The party that has agreed to buy has what is termed a long position. The party that has agreed to sell has what is termed a short position.
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Example
On 3 June, 2013 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months at an exchange rate of 1.6100. This obligates the corporation to pay $1,610,000 for 1 million on 3 December, 2013 What are the possible outcomes?
If the spot exchange rate rise to 1.7000, the forward contract would be worth $90,000 If the spot exchange rate fall to 1.5000, the forward contract would have a negative value, $-110,000
The payoff from a forward contract: (K: delivery price, ST is the spot price at
maturity of the contract.) For a long position: ST-K For a short position: K-ST
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Futures Contracts
Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange. The exchanges specifies certain standardized features of the contract. The two parties to the contract dont necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored.
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buy 100 oz. of gold @ US$1500/oz. in December 2013 (COMEX) sell 62,500 @ 1.5900 US$/ in December 2013 (CME) sell 1,000 bbl. of oil @ US$105/bbl. in December 2013 (NYMEX)
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The Forward Price of Gold (without any income and storage cost)
If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. In our examples, S = 1500, T = 1, and r =0.02 so that F = 1500(1+0.02) = 1530
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Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Stock Exchange European Options Exchange Australian Options Market and many more (see list at end of book)
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Options
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)
A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)
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Profit ($)
0
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Profit ($)
35 15 20 25 30 40 45
Profit ($)
0
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ST
Payoff K ST
ST
ST
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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.
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Hedging Examples
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 $26 per share. A two-month put with a strike price of $24 costs $2.50. The investor decides to hedge by buying 10 contracts.
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Speculation Example
An investor with $4,800 to invest feels that Ciscos stock price will increase over the next 2 months. The current stock price is $24 and the price of a 2-month call option with a strike of 25 is $0.5.
What are the alternative strategies?
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Arbitrage Example
A stock price (HSBC) is quoted as US$53.5 in NYSE (1 for 5 ADR) and HK$82 in Hong Kong. The current exchange rate is 7.7800. What is the arbitrage opportunity?
Buy 400shares of the stock in Hong Kong and sell them in NYSE (53.5*80*7.78-82*400=498.4) Risk-free return is HK$498.4 (assume no transaction cost) Arbitrage opportunities cannot last for long.
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CATASTROPHIC RISK!
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A Shift in Approach
1.
1. 2. 3.
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Insurance : Purchasing insurance involves paying a premium for protection against unfavorable events.
The right approach depends on many factors
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