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Derivative Markets: Overview
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  1. Derivative Markets: Overview Finance (Derivative Securities) 312 Tuesday, 1 August 2006 Readings: Chapters 1, 2 & 8

  2. Nature of Derivatives • Derivatives are instruments whose values derive from that of an underlying asset • eg. Futures, Forwards, Options, Swaps • Used by: • Hedgers (to protect against existing exposure) • Speculators (to capitalise on anticipated price movements) • Arbitrageurs (to exploit mispricings)

  3. Futures • Agreement to trade between two parties at a fixed price and a specified future time • Rarely result in delivery (less than 3%) • Price determined by demand and supply • Traditionally traded through open outcry system, now traded electronically and over-the-counter • Terminology: party that agrees to buy (sell) has a long (short) position

  4. Market Size Source: Hull (2004)

  5. Margins • Cash or marketable securities offered as collateral • Protects against default risk • Balance adjusted daily to reflect daily settlement • Consider an investor taking a long position in two December gold futures contracts on June 5 • contract size is 100 oz, price is US$400 • margin requirement is US$2,000/contract • maintenance margin is US$1,500/contract

  6. 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 Marking-to-Market

  7. Convergence Futures Price Spot Price Futures Price Spot Price Time Time (a) (b)

  8. Forwards FORWARDS FUTURES Private contract between 2 parties Exchange traded Not standardised Standard contract Usually 1 specified delivery date Range of delivery dates Settled at maturity Settled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity Some credit risk Virtually no credit risk

  9. Foreign Exchange Quotes • Futures exchange rates are quoted as the number of USD per unit of the foreign currency • Forward exchange rates are quoted in the same way as spot exchange rates • GBP, EUR, AUD, and NZD are USD per unit of foreign currency • other currencies are quoted as units of the foreign currency per USD

  10. Profits from Forwards/Futures Profit Profit Long position Short position Price of Underlying Asset at Maturity Price of Underlying Asset at Maturity

  11. Options • Terminology • Puts, Calls • Long, Short • Premium, Strike/Exercise Price • European, American • In-the-money, Out-of-the-money • Intrinsic value, Time value

  12. Payoff and Profit Diagrams $ $ Buy Put Buy Call X X ST ST Payoff – Bold Line Profit – Dashed Line

  13. Margins • Margins are required when options are sold • When a naked option is written the margin is the greater of: • A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money • A total of 100% of the proceeds of the sale plus 10% of the underlying share price

  14. Warrants • Options issued by a corporation or financial institution • Traded the same way as stocks • For call warrants, exercise will lead to new treasury stock being issued

  15. Executive Stock Options • At-the-money, issued to company executives • Exercise will lead to new issue of stock • Become vested after a period of time (usually 1 to 4 years) • Cannot be sold • Often last for as long as 10 or 15 years

  16. Convertible Bonds • Regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio • Call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose

  17. Convertible Bonds Bond Value Market Price Straight Bond Value Conversion Value Market Premium Share Price