Options and Speculative Markets 2004-2005 Introduction

1. Options and Speculative Markets2004-2005Introduction Professor André Farber Solvay Business School Université Libre de Bruxelles

2. 1.Introduction • Outline of this session • Course outline • Derivatives • Forward contracts • Options contracts • The derivatives markets • Futures contracts OMS 01 Introduction

3. Reference: John HULL Options, Futures and Other Derivatives, Fifth edition, Prentice Hall 2003 • Copies of my slides will be available on my website: www.ulb.ac.be/cours/solvay/farber • Grades: • Cases: 20% • Final exam: 80% OMS 01 Introduction

4. Course outline OMS 01 Introduction

5. Derivatives • A derivative is an instrument whose value depends on the value of other more basic underlying variables • 2 main families: • Forward, Futures, Swaps • Options • = DERIVATIVE INSTRUMENTS • value depends on some underlying asset OMS 01 Introduction

6. Forward contract: Definition • Contract whereby parties are committed: • to buy (sell) • an underlying asset • at some future date (maturity) • at a delivery price (forward price) set in advance • 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 that would make the contract worth exactly zero) • The forward price may be different for contracts of different maturities • Buying forward = "LONG" position • Selling forward = "SHORT" position • When contract initiated: No cash flow • Obligation to transact OMS 01 Introduction

7. Forward contract: example • Underlying asset: Gold • Spot price: $380 / troy ounce • Maturity: 6-month • Size of contract: 100 troy ounces (2,835 grams) • Forward price: $390 / troy ounce Profit/Loss at maturity OMS 01 Introduction

8. Forward contract: Gains and losses OMS 01 Introduction

9. Options contracts: Definition • A call (put) contract gives to the owner • - the right : • - to buy (sell) • - an underlying asset • - on or before some future date (maturity) • on : "European" option • before: "American" option • - at a price set in advance (the exercise price or striking price) • Buyer pays a premium to the seller (writer) OMS 01 Introduction

10. Option contracts: example • Underlying asset: Gold • Spot price: $380 / troy ounce • Maturity: 6-month • Size of contract: 100 troy ounces (2,835 grams) • Exercise price: $390 / troy ounce • Premium Call $30 / troy ounce Put $34 / troy ounce OMS 01 Introduction

11. Exercise option if, at maturity, ST > K then : CT = ST - K otherwise: CT = 0 CT = MAX(0, ST - K) European call option: Terminal payoff OMS 01 Introduction

12. European call option: Profit at maturity OMS 01 Introduction

13. Exercise option if, at maturity, ST < K then PT = K - ST otherwise PT = 0 PT = MAX(0, K - ST ) European put option OMS 01 Introduction

14. Profit Long forward K ST Short put Put, call and forwards: put call parity Long call + Call – Put = + Forward OMS 01 Introduction

15. Derivatives Markets • Exchange traded • Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading • Contracts are standard there is virtually no credit risk • 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 OMS 01 Introduction

16. Global Market Size OMS 01 Introduction Source: BIS Quarterly Review, June 2004 – www.bis.org

17. Evolution of global market OMS 01 Introduction

18. Europe Eurex:http://www.eurexchange.com/ Liffe: http://www.liffe.com Matif : http://www.matif.fr United States Chicago Board of Tradehttp: //www.cbot.com Main Derivative markets OMS 01 Introduction

19. Why use derivatives? • To hedge risks • To speculate (take a view on the future direction of the market) • To lock in an arbitrage profit • To change the nature of a liability • To change the nature of an investment without incurring the costs of selling one portfolio and buying another OMS 01 Introduction

20. Forward contract: Cash flows • Notations STPrice of underlying asset at maturity Ft Forward price (delivery price) set at time t<T Initiation Maturity T Long 0 ST - Ft Short 0 Ft - ST • Initial cash flow = 0 :delivery price equals forward price. • Credit risk during the whole life of forward contract. OMS 01 Introduction

21. Forward contract: Locking in the result before maturity • Enter a new forward contract in opposite direction. • Ex: at time t1 : long forward at forward price F1 • At time t2 (<T): short forward at new forward price F2 • Gain/loss at maturity : • (ST - F1) + (F2 - ST ) = F2 - F1 no remaining uncertainty OMS 01 Introduction

22. Futures contract: Definition • Institutionalized forward contract with daily settlement of gains and losses • Forward contract • Buy  long sell  short • Standardized • Maturity, Face value of contract • Traded on an organized exchange • Clearing house • Daily settlement of gains and losses (Marked to market) OMS 01 Introduction

23. Example : Gold Futures (Comex – Nymex.com) • Trading unit: 100 troy ounces (2,835 grams) • July 3, 2002 Source: Wall Street Journal OMS 01 Introduction

24. Gold futures: contract specifications • Trading MonthsFutures: Trading is conducted for delivery during the current calendar month, the next two calendar months, any February, April, August, and October thereafter falling within a 23-month period, and any June and December falling within a 60-month period beginning with the current month.Options: The nearest six of the following contract months: February, April, June, August, October, and December. Additional contract months - January, March, May, July, September, and November - will be listed for trading for a period of two months. A 24-month option is added on a June/December cycle.The options are American-style and can be exercised at any time up to expiration.On the first day of trading for any options contract month, there will be 13 strike prices each for puts and calls. Price QuotationFutures and Options: Dollars and cents per troy ounce. For example: $301.70 per troy ounce.Minimum Price FluctuationFutures and Options: Price changes are registered in multiples of 10¢ ($0.10) per troy ounce, equivalent to $10 per contract. A fluctuation of $1 is, therefore, equivalent to $100 per contract.Maximum Daily Price FluctuationFutures: Initial price limit, based upon the preceding day’s settlement price is $75 per ounce. Two minutes after either of the two most active months trades at the limit, trades in all months of futures and options will cease for a 15-minute period. Trading will also cease if either of the two active months is bid at the upper limit or offered at the lower limit for two minutes without trading.Trading will not cease if the limit is reached during the final 20 minutes of a day’s trading. If the limit is reached during the final half hour of trading, trading will resume no later than 10 minutes before the normal closing time.When trading resumes after a cessation of trading, the price limits will be expanded by increments of 100%. Options: No price limits.Last Trading DayFutures: Trading terminates at the close of business on the third to last business day of the maturing delivery month.Options: Expiration occurs on the second Friday of the month prior to the delivery month of the underlying futures contract. OMS 01 Introduction

25. Futures: Daily settlement and the clearing house • In a forward contract: • Buyer and seller face each other during the life of the contract • Gains and losses are realized when the contract expires • Credit risk BUYER  SELLER • In a futures contract • Gains and losses are realized daily (Marking to market) • The clearinghouse garantees contract performance : steps in to take a position opposite each party BUYER  CH  SELLER OMS 01 Introduction

26. Futures: Margin requirements • INITIAL MARGIN : deposit to put up in a margin account by a person entering a futures contract • MAINTENANCE MARGIN : minimum level of the margin account • MARKING TO MARKET : balance in margin account adjusted daily • Equivalent to writing a new futures contract every day at the new futures price • (Remember how to close of position on a forward) • Note: timing of cash flows different LONG(buyer) SHORT(seller) + Size x (Ft+1 -Ft) -Size x (Ft+1 -Ft) OMS 01 Introduction

27. Example of a Futures Trade • An investor takes a long position in 2 December gold futures contracts on June 5 • contract size is 100 oz. • futures price is US$400 • margin requirement is US$2,000/contract (US$4,000 in total) • maintenance margin is US$1,500/contract (US$3,000 in total) OMS 01 Introduction

28. A Possible Outcome Daily Cumulative Margin Futures Gain Gain Account Margin Price (Loss) (Loss) Balance Call Day (US$) (US$) (US$) (US$) (US$) 400.00 4,000 5-Jun 397.00 (600) (600) 3,400 0 . . . . . . . . . . . . . . . . . . 13-Jun 393.30 (420) (1,340) 2,660 1,340 4,000 + = . . . . . . . . . . . . . . . . . 3,000 < 19-Jun 387.00 (1,140) (2,600) 2,740 1,260 4,000 + = . . . . . . . . . . . . . . . . . . 26-Jun 392.30 260 (1,540) 5,060 0 OMS 01 Introduction

29. Futures Contracts Example: Barings • Long position on 20,000 Nikkei 225 Futures • 1 index pt = Yen 1,000 = $ 10 • If Nikkei 225 = 20,000 • Size of contract = $ 200,000  position =$ 4,000 mio • Date Nikkei 225 • 30.12.94 19,723 • 25.02.95 17,473  F = - 2,250 • Loss =  F  $/pt  # contracts • = (-2,250)  ($ 10)  (20,000) = $ 450,000,000 OMS 01 Introduction