Derivatives 101. February 2014. CONFIDENTIAL. DRAFT. Global FX: Markets, Language, and Conventions Foreign Exchange Workshop: Section 1A. Agenda. Derivatives 101 Workshop. 1. By the end of this session, participants should understand: the history and nature of derivative securities
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Derivatives 101
February 2014
CONFIDENTIAL
DRAFT
Agenda
Derivatives 101 Workshop
1
By the end of this session, participants should understand:
the history and nature of derivative securities
the basic structural features and definitions of forwards, futures, options, and swaps
the motivation for buyers and sellers of these securities
practical applications for derivatives.
Course Objectives
3
Agenda
4
The Nature of Derivatives
5
Evolution of Interest Rate Derivatives
10year Treasury Yield
Source: Bloomberg, Bank of America Merrill Lynch
6
Evolution of FX Derivatives
$US/Pound Sterling
Source: Bloomberg, Bank of America Merrill Lynch
7
Evolution of Commodity Derivatives
Dollar Per Barrel of Crude
Source: Bloomberg, Bank of America Merrill Lynch
8
Derivatives Defined
9
Derivatives Defined
10
Derivatives Defined
11
Derivatives Defined
12
Derivatives Markets
13
Derivatives Markets
Source: World Federation of Exchanges, 2013 WFE Market Highlights
14
Derivatives Markets  Stocks
Source: World Federation of Exchanges, 2013 WFE Market Highlights
15
Derivatives Markets  Index
Source: World Federation of Exchanges, 2013 WFE Market Highlights
16
Derivatives Markets – Interest Rate
Source: World Federation of Exchanges, 2013 WFE Market Highlights
17
Derivatives Markets – Commodity
Source: World Federation of Exchanges, 2013 WFE Market Highlights
18
Derivatives Markets
19
Derivatives Markets – OTC Derivatives
Amounts outstanding of overthecounter (OTC) derivatives
By risk category and instrument
In billions of US dollars
Source: Bank for International Settlements, Annual Survey, November 2013
20
Derivatives Markets – Ways Derivatives Can Be Used
21
Agenda
22
Forward Contract
23
Forward Contract
Concept Check:
What are the bid/offer prices for the 2month forward?
24
Forward Contract
Source: Bloomberg, January 28, 2013
25
Forward Contract – Concept Check
26
Profit
Price of Underlying
at Maturity, ST
Forward Contract – Concept Check : Long Forward
+
0
K, delivery price
K = $1.6546/GBP

27
Profit
Price of Underlying
at Maturity, ST
Forward Contract – Short Forward
+
0

28
Forward vs. Futures Contract
29
Agenda
30
Interest Rate Swap
31
Interest Rate Swap Application
32
Interest Rate Swap Application
$100 million notional, semiannual, 0.946097% fixed
Dollars
LIBOR
FLOATING
FIXED
Net
Date
Rate
Cash Flow
Cash Flow
Cash Flow
Jan 30, 2014
0.33200%
Jul 30, 2014
+166,922.22
–473,048.50
–306,126.28
$100,000,000 x [0.332000% x (181/360) = $166,922.22 uses ACT/360
$100,000,000 x [0.946097% x (180/360)] = $473,048.50 uses 30i/360
33
Interest Rate Swap Application
Dollars
LIBOR
FLOATING
FIXED
Net
Date
Rate
Cash Flow
Cash Flow
Cash Flow
Jan 30, 2014
0.33200%
Jul 30, 2014
0.42437%
+166,922.22
–473,048.50
306,126.28
Jan 30, 2015
0.61379%
+216,900.33
–473,048.50
256,148.17
Jul 30, 2015
0.89853%
+308.598.93
–473,048.50
164,449.57
Jan 29, 2016
1.40161%
+456,754.85
–470,420.45
13,665.60
Jul 29, 2016
1.93679%
+708,591.72
–473,048.50
+235,543.22
+995,294.44
–475,676.55
+519,617.89
Jan 30, 2017
34
Interest Rate Swap Application
35
Interest Rate Swap Application
36
Interest Rate Swap Example
Financial Institution earns spread of 0.8392 bps p.a.
0.937705%
0.946097%
1.625%
Firm A
F.I.
Firm B
LIBOR+0.25%
LIBOR
LIBOR
Firm A issued a bond paying 1 5/8% annually. This firm wants to pay floating and has swapped to receive fixed at 0.937705% creating a floating rate instrument where Firm A pays Libor + 68.7295 bps.
Firm B pays Libor + 25 bps on a loan and wants to pay fixed. With the swap, Firm B pays fixed rate of 0.946097% and receives Libor flat. The fixed cost to Firm B is 0.946097% plus 25 bps or 1.196097%
37
Currency Swap Example
38
The Cash Flows
Dollars
Pounds
$
£
Year
millions
2014
–16.50
+10.00
+ 0.165
2015
–0.20
+ 0.165
–0.20
2016
2017
+ 0.165
–0.20
+ 0.165
–0.20
2018
2019
+16.165
10.20
39
Typical Use of Currency Swap
40
Swaps and Forwards
41
Agenda
42
Options
43
Profit ($)
30
20
10
Terminal
stock price ($)
30
40
50
60
0
70
80
90
5
Long Call
Profit from buying a European call option on stock X: option price = $5, strike price = $60
44
Profit ($)
70
80
90
5
0
30
40
50
60
Terminal
stock price ($)
10
20
30
Short Call
Profit from writing a European call option on stock X: option price = $5, strike price = $60
45
Profit ($)
30
20
10
Terminal
stock price ($)
0
60
70
80
90
100
110
120
7
Long Put
Profit from buying a European put option on stock X: option price = $7, strike price = $90
46
Profit ($)
Terminal
stock price ($)
7
60
70
80
0
90
100
110
120
10
20
30
Short Put
Profit from writing a European put option on stock X: option price = $7, strike price = $90
47
Payoff
Payoff
K
K
ST
ST
Payoff
Payoff
K
K
ST
ST
Option Concept Check
K = Strike price, ST = Price of asset at maturity
A.
C.
D.
B.
48
Combinations of Options and Underlying Asset
Suppose that we combine an option position with either a long or short position in the underlying asset.
Long Stock
+
Long Put
=
Combination
0
0
0
K
ST
ST
ST
49
Combinations of Options and Underlying Asset
Profit
Profit
K
ST
ST
K
(a)
(b)
Profit
Profit
K
K
ST
ST
(c)
(d)
50
Combinations of Options and Other Options
51
Bull Spread Using Two Call Options
Long Call 1
Profit
K1
ST
Short Call 2
What Would Be The Motivation For This Position?
52
Profit
K
ST
Long Straddle Using Long Call and Long Put
Long Call
Long Put
What Would Be The Motivation For This Position?
53
Long Strangle Using Long Call and Long Put, Different Strikes
Profit
Long Call
K1
K2
ST
Long Put
What Would Be The Motivation For This Position?
54
Concepts to Consider
55
Conclusion
56