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DERIVATIVE INSTRUMENTS and HEDGING Burak Saltoglu. General Definitions Forward and Futures Contrats Options. What is Derivative Product?. Derivative products are the products which derive their values from other (spot or cash) financial products.

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DERIVATIVE INSTRUMENTS and HEDGING Burak Saltoglu

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Derivative instruments and hedging burak saltoglu

DERIVATIVE INSTRUMENTS and HEDGING Burak Saltoglu


Derivative instruments and hedging burak saltoglu

  • General Definitions

  • Forward and Futures Contrats

  • Options


What is derivative product

What is Derivative Product?

  • Derivative products are the products which derive their values from other (spot or cash) financial products.

  • Derivative contract includes future delivery with known exercise prices. But future spot prices would be unknown by the time the derivative contracts are bought.

  • They can be used for speculation, arbitrage and hedging purposes.


Futures and forward contrats

Futures and Forward Contrats

  • They can be issued on a varios product ranges.

    • Single stocks and indexes, ForEx rates and interest rates

    • Commodities: Cotton, tobocco, Crude oil, etc. Precious metals: gold, silver,..,..

  • Futures Contracts are exchanged in exchange traded markets.

  • Product type, delivery etc are determined specifically.

  • Exchange traded markets (VOB, NYMEX,..) or

  • Over The Counter (Forward Contracts)


Global derivative products

FX

Interest

Gov-Debt

Equ-Index

Stocks

Comm

Credit

Global Derivative Products

2004

OTC Derivative Markets

Exchange-Traded Derivatives

US: 35%

EU: 45%

Asia: 20%

23%

14%

68%

80%

$53 trn notional

$10trn mkt value

$220 trn notional

$6 trn mkt value

OTC (bar) and Exchange-Traded (line) Derivatives

(notional outstanding, in billions US$)

Annual growth rates exceed 30%

Sources: BIS (Dec 2004) ; FIBV (Jan 2005)


Derivaties transaction volume bis

Derivaties Transaction Volume (BIS)


Derivaties transaction volume

Derivaties Transaction Volume


Derivative types

Derivative Types

  • Futures and Forward

  • Swap

  • Options

  • Credit Derivatives

  • Other Structural Products


Basic definitions about derivatives

Basic Definitions About Derivatives

  • Exercising Derivative: It means to buy or sell the product , at a future date with a specific price.

  • Exercise Price: It is the price with which the product will be bought or sold at the delivery.

  • Time to Maturity : it is the date at which the contract can be exercised.


Forward and futures contrats

Forward and Futures Contrats

  • The futures and forward contracts set an obligation for the long position to buy the product, at specific date (T) and an exercise price(X).

  • At the same time, they set an obligation for the short position to sell the same product under the same conditions.


Positions in futures forward markets

Positions in Futures-Forward Markets

  • Long Position: Buying a financial instrument with the expectation of a price increase in the future.

  • Short Position: Selling a financial instrument with the with the expectation of a price decrease in the future.

  • Settlement Price: It is the price used for determining the daily profit/losses and margin obligations of position holders in the Future Markets. Generally, it is determined like the weighted average of last transactions.


Cash or spot prices

Cash or spot prices


Futures on dow jones

Futures on Dow Jones


Gold vs crude oil

Gold vs crude oil


Turkdex imkb30 ve 100 futures

TurkDex: IMKB30 ve 100 Futures


Forex futures turkdex 17 12 2008

ForEx Futures: TurkDex, 17.12.2008


Gold futures 9 april 2009

Gold Futures: 9 April 2009


Derivative instruments and hedging burak saltoglu

  • Basic Definitions

  • Forward and Futures Contracts


Differences between futures and forward contracts

Differences Between Futures and Forward Contracts

  • Structural Differences

  • Marking to Market


Forward ve futures contrats

Forward ve Futures Contrats

FORWARDS

FUTURES

Done between 2 parties

Formal MArkets

Standard Contrats

Non-standard Contrats

Daily Payment

Payment at Contract Maturity

Contract is closed down before the

maturity.

Delivery generally occurs.

Default risk exist.

Default risk is minimized.


Credit risk controls in futures markets

Credit Risk Controls in Futures Markets

  • Marking to Market

  • Daily Price Change Limits

    - Limit-Up

    - Limit-Down


Working mechanism of futures markets mar g ins

Working Mechanism of Futures Markets: Margins

Margin: Account which is opened by the broker for the investor in cash(or an asset which have a market)

Margins are priced every day according to future transaction prices.

Margins are valued daily as if the contract will be Expired next day.

Margins are used for to minimize the risk of default of either parties.

13/09/2014

23


Margin accounts and marking to market in futures contracts

Margin Accounts and Marking to Market in Futures Contracts

  • Inıtial Margin: Minimum required margin(cash) to enter a position. Volatility of the market in that day is determinent.

  • Maintenance Margin: Minimum margin level a margin can decrease without a margin maintenance. General it is 75% of Initial Margin.

  • Margin Call: If the margin decreases blow the maintenance margin level, the difference between this level and initial margin must be paid to broker by the position holder. This difference is called margin call.


Usd ytl

USD/YTL


Eur ytl

EUR/YTL


Marking to marketing in futures contracts

Marking to Marketing in Futures Contracts

Example:Consider the Bank A takes a three-month long position try/usd Futures position of 100,000 USD with the future price of 1.60 contract.


Marking to marketing in futures contracts1

Marking to Marketing in Futures Contracts

Margin Calls

Margin Account for YEN/USD

Initial Margin

Margin Account

Maintenance Margin

13/09/2014

28


Derivative instruments and hedging burak saltoglu

Client :

Baring Futures (Singapore) Ltd.

Account No: 88888

Address :

c/o Singapore Office

20 Raffles Place

24th Floor, Ocean Towers

Singapore 0104

Attention:

Nick Leeson

Date: 24/02/95

Page:26

Daily Activity Statement

Barings Futures (Singapore) Pte Ltd.

20 Raffles Place, 24th Floor, Ocean Towers, Singapore 0104

Tel: 5395571 / 5395572

DAILY STATEMENT OF UNREALISED PROFIT AND LOSS

::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::

7. Equity Balance0,0059,239,120,000.00 (JPY)

8. Collateral Securities Held ....... .......................................

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29


Some observations

Some observations

  • You invest only 10% of the notional position.

  • Your leverage ratio is 1 to 10.

  • Inital Margin values are determined on the basis of daily (extreme volatility) estimates and are subject to change.

  • ISE30 and S&P500 should not have the same leverage ratio (in S&P it is 4%: i.e. Leverage ratio is 25!)

  • You might even have some exotic futures contract so that it will be only 2% (i.e. Leverage ratio is 50!!)


How do we close a futures position

How do we close a futures position

  • More than 70% of the futures contracts are not exercised at the maturity.

  • To take advantage of a market move you may sell your futures contract in the VOB.

  • The difference between the price you paid and the price in the second hand market for the same product will be your profit (or loss).

  • All you need to do enter a reverse position that you own in the futures market.

  • In the previous example: if you take a short position of FX futures with 3 months maturity you will take your profit or loss.

  • For instance in the FX futures example if close in June 17 with the futures price of 1.4 you will be making 20,000 TL loss.

  • Of course you don’t know who will buy it but your counterparty will have another counterpf you close your position in You invest only 10% of the notional position.

  • Your leverage ratio is 1 to 10.


Hedging with futures and forward products

Hedging with Futures and Forward Products

  • Long position in spot can be hedged with short position in futures or forward.

  • Short position in spot can be hedged with long position in futures or forwards.

  • Provided that spot product risk, maturity and product directly matches to futures product then this can create a perfect hedge.

    • Example:

      • Short in spot: hedge with long futures:

        • Dollar/TL debt (short position) in six months and 6 month-futures contract(long). Exporters.

      • Long in spot: hedge with short with futures:importers.

b saltoglu Türev ürün notları


Hedging with using futures contracts

Hedging with Using Futures Contracts

Long in ForEx=>Short in Futures

Short in ForEx=> Long in Futures

Long in Futures=> Short in ForEx

Short in Futures=> Long in ForEx

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34


Hedging in companies

Hedging in Companies

  • Companies want to eliminate financial risks other than their main functions(interest rate, currency, or other commodities petrol etc.)

  • Companies’ purpose is to eliminate the volatility of their profits because of the other risky determinents.

  • SEC works on to inform stockholders by rewealing the risks.

  • In the risk management purposes:What other companies doing and the cost of the hedging is the main two problems.

  • For example; hedging continously the cost of petrol worths 147US$ may not be easy process.

  • However, in terms of legislation and transparency there may be expected important changes.


Hedging in practice

Hedging in practice?

  • What is Perfect Hedge?

  • If a hedge product which totally eliminates the risk of the main product, then there would not be a perfect hedge.

    • A written futures product on the same holding term, same risk factor, same currency.

    • Example: If there does not exist a futures instrument on the jet fuel, or on the same currency, or the maturtiy of the instrument which creates risk is shorter

  • What can be done under these circumstances?

  • If the airlines have a jet fuel risk and there exists a futures on the crude oil, then cross hedging might be carried out.

  • If the maturity of the risky product is longer than the maturity of the protective futures product, then you may conduct a rolling hedge.

  • If hedge costs much, then the half can be hedged. (Partial Hedge).


Forex debt exrate 1 7 us dollar

ForEx Debt exRate: 1.7 US Dollar


Futures long

Futures Long


Hedge short spot long futures

Hedge: Short Spot+Long Futures


Introduction to option markets

Introduction to Option Markets


Op tion definitions

Option Definitions

  • Call option, gives option to buy the underlying asset in a determined time and price. Bullish expectation

  • Put option, gives option to sell its underlying asset in with a predetermined time and price.

    • Bearish expectation of holder.

  • European option: contracts can be exercised only in a predtermined date.

  • American option: can be exercised any date between the maturity date and the date contract bought.

  • Option contracts can be traded in secondary markets.


Differences between options and futures contracts

Differences between Options and Futures Contracts

  • In Futures contract, there is an obligation at the maturity, but in options there is optionality

  • Because of this, there is an additional premium paid for the options unlike in the futures.

  • However, in options trade,because the seller should demand a premium to compensate the profit of the buyer.


Op tion positions

Option Positions

  • Long call

  • Long put

  • Short call

  • Short put


Example long call ibm stock hull 2007

Profit ($)

30

20

10

Spot at the maturity of option ($)

70

80

90

100

0

110

120

130

-5

Example Long Call:IBM Stock Hull 2007

Consider a call option contract which has 5$ contract price (call premium) and 100$ exercise price with time to maturity 2 months. The profit/loss graphic of this contract for long position according to the possible prices can be realized at the maturity is:


Long put exxon

Profit ($)

30

20

10

Spot at the maturity

0

40

50

60

70

80

90

100

-7

Long Put:Exxon

Premium for put option on the exxon stock= $7, exercise price = $70


Short call ibm stock

Profit/loss ($)

110

120

130

5

0

70

80

90

100

Spot price at the maturity ($)

-10

-20

-30

Short Call:IBM Stock

Consider a call option contract which has 5$ contract price and 100$ exercise price with time to maturity 2 months. The profit/loss graphic of this contract for short position according to the possible prices can be realized at the maturity is:


Short put exxon

Kar ($)

Vadedeki fiyat ($)

7

40

50

60

0

70

80

90

100

-10

-20

-30

Short Put Exxon

Premium for put option on the exxon stock= $7, exercise price = $70


Call put

Call/Put

  • Investor buys call:profit unlimited, loss limited

  • Person sells call:loss is theorically unlimited, profit limited

  • Put buyer: profit may be very high(until stock price becomes zero) but loss is limited with premium

  • put seller: loss may be unlimited(parallel with stock price increase) but profit is limited(limited with put premium).


Assets underlying to options

Assets Underlying To Options

  • Stocks

  • ForEx Rates

  • Stock Indexes

  • Futures

  • Energy, weather situation, etc.


Some definitions

Some Definitions

Moneyness :

  • At-the-money options: Stock and exercise prices are equal

  • In-the-money option: for call if stock is bigger than exercise price(for put if exercise price is bigger than stock).

  • Out-of-the-money option: for call if stock is lower than exercise (for put if stock is bigger than exercise).


Options according to exercise terms

Options according to Exercise Terms

  • European Type Options:Option type which can be exercised only at maturity.

  • American Type Options: Option type which can be exercised any date till to maturity.


To hedge a stock with a cost of 40

To hedge a stock with a cost of 40$


Option sensitivity

Option Sensitivity

  • Role of Volatility

    • Volatility of yield of an finanicial instrument is linearly realted to potential uncertainity that instrument can face in the future. If this is high possibilty that option(put or call) may be exercised increases and premium also increases .

    • Maturity:As the maturity increases, the value of option increases, too.

    • Exercise Price: As it increases call loses value.

    • Asset Underliying to Option:As its price increases, price of call option increases, too.


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