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DER I VAT I VES WEEK 7

DER I VAT I VES WEEK 7. Financial Markets. Spot/Cash Markets Equity Market (Stock Exchanges) Bill and Bond Markets Foreign Exchange Derivative Markets Futures Markets Options Marktes. Derivatives Markets. OTC Forward (Foreign Exchange) Swaps (CDS, IRS) Options Organized Markets

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DER I VAT I VES WEEK 7

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  1. DERIVATIVESWEEK 7

  2. Financial Markets • Spot/Cash Markets • Equity Market (Stock Exchanges) • Bill and Bond Markets • Foreign Exchange • Derivative Markets • Futures Markets • Options Marktes

  3. Derivatives Markets OTC • Forward (Foreign Exchange) • Swaps (CDS, IRS) • Options Organized Markets • Futures • Options

  4. Why Derivatives? Derivatives are risk management tools! Derivative Instruments can be used to transfer risk!

  5. Derivatives • Main Motives for Derivatives Trading • Risk Management (Hedging) • Speculation • Arbitrage

  6. Derivatives and Underlying Assets Oil Euro/Dollar Energy Forex Natural Gas Yen/Dolar Canadian Dollar/ US Dollar Dow Jones Government Bonds Index S&P 500 Interest Eurodollar Nasdaq 100 Euroyen Gold Cotton Agricultural Wheat Metals Silver Soya Copper Google Inc. Equity Is Bankasi

  7. Futures and Options Exchanges • Important Futures and Options Exchanges include: • NYSE Euronext • Chicago Mercantile Exchange • Eurex • CBOE • In Turkey: • VOB - Vadeli İşlem ve Opsiyon Borsası (Turkish Derivatives Exchange) under the roof of Borsa İstanbul.

  8. Clearing House • FUNCTIONS OF THE CLEARING HOUSE; • IT GUARANTEES THAT THE TWO PARTIES WILL PERFORM THE TRANSACTIONS. • AT THE END OF THE TRADING DAY, IT MATCHES EACH PURCHASE WITH THE CORRESPONDING SALE AND COMPUTES EACH PARTIES GAINS AND LOOSES: “MARK TO MARKET”.

  9. Organized Markets vs OTC Markets • FUTUES AND OPTIONS • TRADED ON O.E. • PRICE, AMOUNT, DATE ETC. ARE STANDARTIZED BY THE EXCHANGE • DAILY SETTLEMET • REQUIRES MARGIN ACCOUNT • REGULATED • FORWARD • TRADED ON OTC MARKETS • NOT STANDARD • SETTLED ONLY AT DELIVERY • DOES NOT REQUIRE A MARGIN ACCOUNT • UNREGULATED

  10. Futures • Futures contract is a agreement between two parties where one party commits to sell or buy a commodity or security (underliers) to the other party at a given price and amount and on a specified future date. • The Buyer is Long Position Holder • The Seller is Short Position Holder Today Future Date Buy/Sell Future Contract Deliver Underlying/ Make Payment

  11. Buy or Sell a Futures Contract Investor sells 10 TRY/USD futures contracts which expire in February 2012 at a price of 1,79. Supposethe spot price on Feb 2012 is 1,7920 Profit/Loss: (1,7900-1,7920)*1.000=8TRY/contract For one contract: Short Position (Seller): 8 TRY Loss Long Position (Buyer): 8 TRY Profit 10 futures contracts have been sold so: 10*8 TRY=80 TRY profit or loss occured -> Zero-Sum Game To close out a futures position investor has to take an offsetting position

  12. FUTURES: LEVERAGE • USE OF CREDIT OR BORROWED FUNDS TO IMPROVE ONE'S SPECULATIVE CAPACITY AND INCREASE THE ROR FROM AN INVESTMENT, AS IN BUYING SECURITIES ON MARGIN. • THE LEVERAGE OF FUTURES TRADING REFERS TO ONLY A SMALL AMOUNT OF MONEY IS DEPOSITED TO BUY OR SELL A FUTURES CONTRACT.

  13. FUTURES: MARGIN • A DEPOSIT TO COVER LOOSES THAT MIGHT BE INCURRED IN THE FUTURES TRADING. • BOTH THE BUYER AND THE SELLER OF A FUTURES CONTRACT ARE REQUIRED TO PROVIDE MARGIN. • THIS LOW INITIAL MARGIN MAGNIFIES THE PERCENTAGE OF LOSS OR PROFIT POTENTIAL.

  14. Physical Delivery or Cash Settlement • Futures/Options are either settled in cash (Cash Settlement) or the underlying asset is delivered and payed for at expiry (Physical Delivery)

  15. HEDGING WITH FUTURES INVESTORS CAN USE FUTURES FOR HEDGING • INVESTORS CAN HEDGE AGAINST CHANGES IN STOCK PRICES OR AN INVESTOR CAN MAKE PROFIT FROM DECLINING PRICES BY SELLING AND FROM RISING PRICES BY BUYING • BORROWERS CAN HEDGE AGAINST HIGHER INTEREST RATES, LENDERS AGAINST LOWER INTEREST RATES. • FARMERS CAN HEDGE AGAINST LOWER COTTON PRICES, MERCHANTS AGAINST HIGHER COTTON PRICES

  16. Example: HedgingForeign Exchange Risk • A company exports goods for 100.000 USD. The company will receive the payment in three months time. • The total cost for the goods produced is 130.000 TRY • In case the value of USD decreases the company may have loss

  17. Example cont. In order to hedge the total amount of 100.000 USD, 100 TRY/USD futures contracts are sold (100*1.000) at $1,5000. By Selling 100 futures contracts the company has hedged itself against possible losses! 1,5000-1,4000=-0,100 0,100*1.000=100TRY/contract 100*100=10.000TRY (100 contract)

  18. OPTIONS AND OPTIONS ON FUTURES • Option contract is an agreement between two parties. • An option contract gives the buyer the right to purchase or sell an economic benchmark, financial underlying or commodity at certain price and quantity at any time till expiry or at a specified date • The seller of an option is obliged to fulfill the obligation if the buyer exercises his right.

  19. Option Types • Call Option Givesthebuyertherightto buy theunderlyingasset at a certainpriceandquantitytillexpiryor at a specifieddatein returnfor a premium. • Put Option Givesthebuyertherighttoselltheunderlyingasset at a certainpriceandquantitytillexpiryor at a specifieddate in returnfor a premium.

  20. Option Types American vs European Options Theright of theoption can be exercisedanytimepriortoexpiry. AmericanOptions Buyingthe Option Expiry of the Option Contract EuropeanOptions Theright of theoption can only be exercised at maturity.

  21. Option Premium • Option Price has two main components:intrinsic value andtime value Option Premium Intrinsic Value + Time Value Underlying Price – Strike Price (Call) Strike Price – Underlying Price (Put) Premium – Intrinsic Value

  22. In the money or out of the money?

  23. Option Positions and Profit/Loss • Long call • Long put • Short call • Short put

  24. Question??? • Strike Price (K) ? • Whatarethepositions? • Whataretheexpectations of thepositionholders? • What is themax/minprofit/lossforeachposition.

  25. Factors Affecting Option Price • Underlying Price (S) • Strike Price (K) • Time to expiry (t) • Volatility (σ) • Risk-free rate (r) • Dividends (d)

  26. Example • A company exports goods for 100.000 USD. The company will receive the payment in three months time. • In case the value of USD decreases the company profit decreases. • To hedge the foreign exchange risk the company buys 100 TRY/USD put options with a strike price of 1,6000 (contract size 1000 USD). • The option premium is 0,0260 TRY. • Total premium paid is 0,0260 TRY*1.000*100=2.600 TRY

  27. Example cont.

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