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LEARNING OBJECTIVES Explain the nature of options and the

LEARNING OBJECTIVES Explain the nature of options and the distinction between different kinds of options, and demonstrate their application in a wide variety of areas Show the value of the forwards, futures, FRAs, swaps, caps and floors markets by

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LEARNING OBJECTIVES Explain the nature of options and the

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  1. LEARNING OBJECTIVES • Explain the nature of options and the • distinction between different kinds of • options, and demonstrate their application • in a wide variety of areas • Show the value of the forwards, futures, • FRAs, swaps, caps and floors markets by • demonstrating transactions which manage • and transfer risk

  2. A derivative instrument is an asset whose performance is based on (derived from) the behaviour of the value of an underlying asset “Underlyings” Commodities Shares Bonds Share indices Currencies Interest rates Derivatives are contracts that give the holder the right, and sometimes the obligation, to buy or sell a quantity of the underlying, … …. or benefit in another way from a rise or fall in the value of the underlying. DERIVATIVES

  3. It is the legal right that becomes an asset, with its own value. It is the right that is purchased or sold. Derivative instruments include the following: Futures Options Swaps Forward rate agreements Forwards Derivatives can be used to: Speculate Hedge Arbitrage

  4. OPTIONS • An option is a contract giving one party the right, but not the obligation, to buy or sell a financial instrument, commodity or some other underlying asset at a given price, at or before a specified date. • For example, property development options • Share options • A call option gives the purchaser a right, but • not the obligation, to buy a fixed number of • shares at a specified price at some time in the future • On LIFFE, one option contract relates to a • quantity of 1,000 shares • The seller of the option, who receives the • premium, is referred to as the writer • American-style options can be exercised by • the buyer at any time up to the expiry date • European-style options can only be • exercised on a predetermined future date

  5. CALL OPTION HOLDER (CALL OPTION BUYER)Cadbury Schweppes Intrinsic value – the payoff that would be received if the underlying is at its current level when the option expires Time value – the amount by which option premium exceeds the intrinsic value In-the-money-option – an option with intrinsic value Out-of-the-money-option – an option with no intrinsic value At-the-money-option – market price equal to option exercise price

  6. CALL OPTION WRITERS

  7. PUT OPTIONS A put option gives the holder the right, but not the obligation, to sell a specific quantity of shares on or before a specified date at a fixed exercise price. Cadbury Schweppes Purchase, for a premium of 19.5p per share (£195 in total), the right to sell 1,000 shares on or before late January 2002 at 460p.

  8. USING SHARE OPTIONS TO REDUCE RISK: HEDGINGOptions can give protection against unfavourable movements in the underlying while permitting the possibility of benefiting from favourable movementsExample:You hold 1,000 shares in Cadbury Schweppes on 13 Aug. 2001, worth £4,820 (482p per share)Possible takeover bidOr dramatic price fallSell shares? - loss of possible upsideAlternative: Buy put option - a 460 April put purchased, premium £280

  9. If share price falls to 380p in late April:Loss on underlying shares £1,020Intrinsic value of put option £800 ((460-380) x 1000)Below 460p for every 1p lost in share price 1p is gained on the put option.Maximum loss is £500 (£220 intrinsic value + £280 option premium) Hedging reduces the dispersion of possible outcomes. There is a floor below which losses cannot increase, while on the upside the benefit is reduced due to premium.

  10. INDEX OPTIONS • Options on whole share indices can be purchased • Index options are cash settled • The index is regarded as a price and each one-point • movement on the index represents £10 • HEDGING AGAINST A DECLINE IN THE MARKET • A fund manager controlling a £30m portfolio of shares. • Concerned the market might fall. • Number of options needed to hedge: • With the index at 5431 on 13 August 2001 and each • point of that index settled at £10, one contract has a • value of 5431  £10 = £54,310 • To cover a £30m portfolio: • £30m • £54,310 = 552 contracts

  11. Buy 552 December 5425 puts for 229 points per contract. Premium: 229 points £10  552 = £1,264,080 (4.2% premium) The index falls 15% to 4616, and the loss on the portfolio is: £30m  0.15 = £4,500,000 Gain on options: (5425 – 4616)  552  £10 = £4,465,680 Less option premium paid £1,264,080 £3,201,600

  12. CORPORATE USES OF OPTIONS 1 Share options schemes 2 Warrants 3 Convertible bonds 4 Rights issues 5 Share underwriting 6 Commodities

  13. OPERATIONAL AND STRATEGIC DECISIONS WITH OPTIONS (REAL OPTIONS) • The expansion option • The option to abandon • Option on timing • True NPV • True NPV takes into account the value of options. • True NPV = Crude NPV + • + + + NPV of expansion option NPV of the option to abandon NPV of timing option NPV of other option possibilities

  14. FORWARDS AND FUTURES CONTRACTS • Forwards • A forward contract is an agreement between two parties to undertake an exchange at an agreed future date at a price agreed now. • Example: potato crisp manufacturer • Futures • Agreements between two parties to • undertake a transaction at an agreed price on • a specified future date • Exchange-based instruments traded on a • regulated exchange • The clearing house becomes the formal • counterparty to every transaction • Standardised legal agreements traded in • highly liquid markets

  15. FORWARDS AND FUTURES CONTRACTS

  16. MARKING TO MARKET AND MARGINS • Daily marking to market • Member’s margin account • Initial margin • Maintenance margin • Variation margin Day £ Monday T uesday W ednesday Thursday Friday V alue of futur e (based on daily closing price) 50,000 49,000 44,000 50,000 55,000 Buyers’ position Initial mar gin 5,000 V ariation mar gin (+ cr edited) 0 –1,000 –5,000 +6,000 +5,000 (– debited) Accumulated pr ofit (loss) 0 –1,000 –6,000 0 +5,000 Sellers’ position Initial mar gin 5,000 V ariation mar gin (+ cr edited) 0 +1,000 +5,000 –6,000 –5,000 (– debited) Accumulated pr ofit (loss) 0 +1,000 +6,000 0 –5,000 Exhibit 21.16 Example of initial margin and marking to market

  17. Leverage

  18. Settlement: • Physical delivery • Cash

  19. SHORT-TERM INTEREST RATE FUTURES • Notional fixed-term deposits, usually for three-month periods starting at a specific time in • the future. • The buyer of one contract is buying the right to deposit money at a particular rate of • interest for three months at least notionally.

  20. SHORT-TERM INTEREST RATE FUTURES The unit of trading for a three-month sterling time deposit is £500,000. Cash delivery is the means of settlement. Delivery defines the date and time of the expiry of the contact – September, December, March and June. Price is defined as: P = 100 – i where: P = price index; i = the future interest rate in percentage terms. Tick A tick is the minimum price movement on a future. On a three-month sterling interest rate contract a tick is a movement of 0.01 per cent on a trading unit of £500,000. £12.50 is the value of a tick movement in a three-month sterling interest rate futures contract.

  21. FORWARD RATE AGREEMENTS (FRAs) Agreements about the future level of interest rates. The rate of interest at some point in the future is compared with the level agreed when the FRA was established and compensation is paid by one party to the other based on the difference. Certainty over the effective interest cost of borrowing is generated in the future if an FRA is bought. The sale of an FRA by a company protects against a fall in interest rates.

  22. FRA Example: A company needs to borrow £6m in six months’ time for a period of one year It arranges this with bank X The current rate of interest is 7% Concern: interest rates will be higher when the loan is drawn down Purchase FRA at 7% from bank Y to take effect 6 months from now and relate to 12 month loan Six months later: Spot interest rates for 1 year borrowing = 8.5% Payment to bank X: £6m  0.085 = £510,000 (£90,000 more than if rate is 7%) Bank Y pays (0.085-0.07)  £6m = £90,000 If rates fall below 7% company compensates Bank Y. A “sale” of an FRA: protects against a fall in rates.

  23. Exhibit 21.22 A comparison of options, futures and forward rate agreements Options Futur es FRAs Advantages payable. Downside risk is limited but Specific rates ar e locked in. No mar gins or pr emiums the buyer is able to par ticipate No right to let the contract in favourable movements. lapse, as with options. A vailable on or of f exchanges. No pr emium is payable. (However T ailor -made, not standar dised as Exchange r egulation and clearing mar gin payments ar e r equir ed.) to size, duration and ter ms. house r educe counterpar ty default risk for those options traded on exchanges. Usually highly liquid markets. V er y liquid markets. Able to Can cr eate cer tainty . Locks in r everse transactions quickly specific ef fective inter est rate. and cheaply . May be useful if no str ong view Exchange r egulation and clearing is held on dir ection of underlying. house r educe counterpar ty default risk. Disadvantages Pr emium payable r educes r etur ns. If the underlying transaction does Benefits fr om favourable not materialise, potential loss is movements in rates ar e for gone. unlimited. Mar gin r equir ed on written Many exchange r estrictions Gr eater risk of counterpar ty options. on size, duration, trading times. default – not exchange traded. Mar gin calls r equir e daily work Mor e dif ficult to liquidate. for ‘back of fice’.

  24. CAPS • An interest cap is a contract that gives the purchaser the right to effectively set maximum level for interest rates payable. • Compensation is paid to the purchaser of a cap if interest rates rise above an agreed level. • Example: • Oakham borrows £20m for 5 years from Bank A at variable interest rate Libor + 1.5% • (interest reset every 3 months – currently 7%) • Concern: interest rates rise • Buys an interest rate cap set at Libor of 8.5% • Cost, say 2.3% payable now for 5 year cover • (£20m x 0.023=£460,000) • 3rd Year: Libor = 9.5% • Oakham pays to Bank A 9.5+1.5% • Receives 1% from cap seller • If rates fall Oakham benefits • Floors and collars • If the interest rate falls below an agreed level, the seller (the floor writer) makes compensatory payments to the floor buyer.

  25. SWAPS • A swap is an exchange of cash payment obligations. • Cat plc and Dog plc • Cat plc and Dog plc both want to borrow • £150m for eight years • Cat would like to borrow on a fixed-rate • basis because this would better match its • asset position • Dog prefers to borrow at floating rates • because of optimism about future interest- • rate falls • Cat could obtain fixed-rate borrowing at • 10 per cent and floating rate at Libor +2 per • cent • Dog is able to borrow at 8 per cent fixed • and Libor +1 per cent floating: • Fixed Floating • Cat can borrow at 10% Libor +2% • Dog can borrow at 8% Libor +1%

  26. SWAPS CAT AND DOG Fixed 9.5% Cat Dog Libor +2% Libor +2% Fixed 8% Bank A Bank B Exhibit 21.23 An interest rate swap Cat: Pays Libor +2% Receives Libor +2% Pays Fixed 9.5% Net payment Fixed 9.5% Dog: Pays Fixed 8% Receives Fixed 9.5% Pays Libor +2% Net payment Libor +0.5%

  27. DERIVATIVES USERS • Hedgers • To hedge is to enter into transactions which protect a business or assets against changes in some underlying • Speculators • Speculators take a position in financial instruments and other assets with a view to obtaining a profit on changes in value. • Arbitrageurs • The act of arbitrage is to exploit price differences on the same instrument or similar assets

  28. OVER-THE-COUNTER (OTC) AND EXCHANGE-TRADED DERIVATIVES Advantages OTC derivative Contracts can be tailor -made, which allows per fect hedging and per mits hedges of mor e unusual underlyings. Disadvantages Ther e is a risk (cr edit risk) that the counterpar ty will fail to honour the transaction. Low level of market regulation with resultant loss of transparency and price dissemination. Often dif ficult to r everse a hedge once the agr eement has been made. Higher transaction costs. Advantages Exchange-traded derivative Cr edit risk is r educed because the clearing house is counterpar ty . High r egulation encourages transpar ency and openness on the price of r ecent trades. Liquidity is usually much higher than for OTC – lar ge or ders can be clear ed quickly due to high daily volume of trade. Positions can be reversed by closing quickly – an equal and opposite transaction is completed in minutes. Disadvantages Standar disation may be r estrictive, e.g. standar dised ter ms for quality of underlying, quantity , deliver y dates. The limited trading hours and mar gin r equir ements may be inconvenient. Exhibit 21.25 OTC and exchange-traded derivatives

  29. OPTION PRICING • Notation to be used: • C = value of call option • S = current market price of share • X = future exercise price • Rf = risk-free interest rate (per annum) • T = time to expiry (in years) •  = standard deviation of the share price • E = mathematical fixed constants: 2.718.... • Options have a minimum value of zero • C ³ 0 • The market value of an option will be greater than the • intrinsic value at any time prior to expiry • Market value = intrinsic value + time value • Intrinsic value (S – X) rises as share price increases or • exercise price falls • X • (1 + rf)t • The higher the risk-free rate of return the higher will be • intrinsic value • The maximum value of an option is the price of the share • C < S • A major influence boosting the time value is the volatility • of the underlying share price S – Intrinsic value =

  30. BLACK AND SCHOLES’ OPTION PRICING MODEL C = SN(d1) – X ert where: N (.) = cumulative normal distribution function of d1 and d2; ln(S/X) + (rf+ 2/2)t t ln = natural log d2 = d1 – t N (d2) f d1 =

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