Post on 05-Apr-2018
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DERIVATIVES
MARKETS
PRESENTED BY:-
BABASAB PATIL
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Introduction
Futures, options, and swaps are complicatedinstruments
However, they have found their way into the
risk management options of just about everymajor financial institution
DerivativesA financial instrument/contract
that derives its value from some otherunderlying asset
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Futures Markets
Market in standardizedcontracts for futuredelivery of various goods.
Arose in the mid-1800s in Chicago and
institutionalized an ancient form of contractingcalled forward contracting.
1842, Chicago Board of Trade
1871, Fire destroyed all records.
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Futures Contracts vs. ForwardContracts
Futures Contract
trade in an organized exchange.
standardized contract terms.
contract guaranteed by exchange (clearingcorporation)
Forward Contract
transaction in which two parties agree in advance on
the terms of a trade to be executed later.
Non standardized contract terms.
More flexibility.
Difficult to find a trading partner.
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An Overview of FinancialFutures
Future Contract is a contractual agreementthat calls for delivery of a specific underlyingcommodity or security at some future date at a
currently agreed-upon price There are contracts on interest-bearing
securities (Treasury bonds, notes, etc), on stockindices (Standard & Poors and Japans Nikkei
index), and on foreign currencies
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An Overview of FinancialFutures
Trading in these contracts is conducted on thevarious commodity exchanges
Financial futures were introduced about 30
years ago and volume now exceeds the moretraditional agricultural commodities
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Characteristics of FinancialFutures Standardized agreement to buy/sell a particular asset or
commodity at a future date and a current agreed-uponprice
Designed to promote liquiditythe ability to buy and sellquickly with low transactions costs
Promotes large trading volume which narrows the bid-asked spreads
Allows many individuals to trade the identical commodity
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Characteristics of FinancialFutures
Terms specify the amount and type of asset aswell as the location and delivery period Financial futuresunderlying asset is either a
specific security or cash value of a group ofsecurities
Stock index futurescontract calls for thedelivery of the cash value of a particular stockindex
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Characteristics of FinancialFutures
Precise terms of each contract are establishedby the exchange that sponsors trading in thecontracts
Seller of the contract has the obligation todeliver the securities at a specified time
In futures markets, the buyer of the contract iscalled long and the seller is called short
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Price of the Contract
The price is determined by bidding andoffering that occurs at the location (pit) of theexchange sponsoring the auction
The auction process insures that all orders areexposed to highest bid and lowest offer,guaranteeing execution at the best possibleprice
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Market Structure
Open outcry
Traders call out offers to buy or sell.
Gives appearance of chaos.
Gives all traders in the pit the opportunity toaccept the offer.
Seat on the exchange
Floor Traders
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Clearing Corporation
The clearing corporation associated with the exchangeacts as a middleman in the transaction
Reduce the credit risk exposure associated with futuredeliveries
Longs and shorts do not have to worry that the other party willnot perform their contractual obligations
Requires the short and long to place a deposit (Margin) which isa performance bond for both the seller and buyer
Requires that gains and losses be settled each day in the mark-to-market operation
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Settlement by Offset
To insure the obligations are met at the deliverydate, most trades in futures market choosesettlement by offset rather than delivery Both parties make offsetting sales/purchases to cover
the contract
Permits hedgers, speculators, and arbitrageurs tomake legitimate use of the futures market withoutgetting into technical details of making or taking
delivery of assets
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Using Financial FuturesContracts Provides the opportunity to hedge legitimate commercial
activities
Allows participants to alter their risk exposure
Hedgersbuy and sell futures contracts to reduce their
exposure to the risk of future price movement Permits dealers to cover both the short and long position
of a contract
Reduces risk since future prices move almost in
lockstep with the price of the underlying asset
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Hedging Vs. Speculating
Short hedgers offset inventory risk by selling
futures while long hedgers offset anticipated
purchases of securities by buying futures
Speculators Purposely take on risk of price movement
Expect to make a profit on the risky transaction
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Arbitrageurs
Arbitrageurs
Determine the relationship between the price inthe cash market and the price in the futures
marketDuring the delivery period of a futures contract,
the rights and obligations of the contract force theprice of the futures contract and the price of the
underlying security to be identical
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Arbitrageurs
If the arbitrageur senses the price relationshipbetween the futures contract and the underlyingasset is not correct, take actions in the market(buy or sell) to make a profit which forces theprices into proper relationship
The activities of arbitrageurs cause theprices to converge on the delivery date or bein proper alignment during periods prior tofinal delivery date
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Liquidating a Position
Settlement dates
Nearby contract
Distant contract
Cash settlement contracts
Settlement by offset
Open interest
number of contracts obligated for delivery.
Each open transaction has a buyer and a seller, butfor calculation only one side of the contract iscounted.
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Futures Data
Wall Street Journal
Chicago Board of Trade
Chicago Mercantile Exchange
http://online.wsj.com/documents/mktindex.htm?fs-contract-set-frameset-m99ff2.htmlhttp://www.cbot.com/cbot/pub/page/0,3181,1413,00.htmlhttp://www.cme.com/dta/del/product_list.html?ProductType=itrhttp://www.cme.com/dta/del/product_list.html?ProductType=itrhttp://www.cbot.com/cbot/pub/page/0,3181,1413,00.htmlhttp://online.wsj.com/documents/mktindex.htm?fs-contract-set-frameset-m99ff2.html8/2/2019 Derivatives Markets Ppt MBA
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An Overview of OptionsContracts
Options on individual stocks have been tradedin over-the-counter market since nineteenthcentury
Increased visibility in 1972 when the ChicagoBoard Options Exchange (CBOE) standardizedterms of contracts and introduced futures-typepit trading
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Stock Options
Prior to 1973, over-the-counter market
fragmented
high transaction costs
no liquidity
CBOE established April 26, 1973 and begin tradingoptions on 16 stocks
creation of central market place
introduction of a clearing corporation
standardization
secondary market
June 1, 1977, SEC allowed trading in puts
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Options
Contractual Obligations
Derive their value from some underlying asset
A specified number of shares of a particular stock
Stock Index OptionBasket of equities representedby some overall stock index such as S&P 500
In options on future contracts, the contractualobligations call for delivery of one futures contract
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Call Options
Buyer of a call option (long) has the right (notobligation) to buy a given quantity of theunderlying asset at a predetermined price
(exercise or strike) at any time prior to theexpiration date
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Call Options
Seller of the call option (short) has theobligation to deliver the asset at the agreedprice
Therefore, rights and obligations of optionbuyers and sellers are not symmetrical
Buyer of the call option pays a price to the sellerfor the rights acquired (option premium)
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Put Options
Buyer of a put option has the right (notobligation) to sell a given quantity of theunderlying asset at a predetermined price
before the expiration date Seller of the option (short) has the obligation
to buy the asset at the agreed price
The buyer of the put option pays a premium tothe seller
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Summary
Option buyers have rights; option sellers haveobligations
Call buyers have the right to buy the
underlying asset Put buyers have the right to sell the asset
In both puts and calls the option buyer pays apremium to the option seller
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Clearing Corporation
The exchange sponsoring the options tradingestablished rules for trading
Standardization is designed to generate interest bypotential traders, thereby contract liquidity
Clearing Corporation
Guarantees the performance of contractual obligations
Buyers and sellers do not have to be concerned withcreditworthiness of their trading partners
Only matter up for negotiation is option premium
price buyer pays to seller for rights
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Using and Valuing Options
Investors who buy options (puts or calls) haverights, but no obligations
Therefore, option buyers will do whatever is in
their best interest on expiration date On expiration date, payoff on expiration of a
long call position is either zero (price belowexercise price) or stock price minus exercise
price (intrinsic value) (price above the exerciseprice)
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Using and Valuing Options
A long put position on expiration date has avalue of zero if price is above the exerciseprice or a value equal to the exercise priceminus the stock price if price is below theexercise price
Option PremiumThe asymmetry payoff hasthe characteristic of insurance which is why
the premium is charged on the transaction
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Option Premiums - Calls
Option premiums are determined by supplyand demand
Call options are worth more (higher
premiums) the higher the price and thegreater the volatility of the underlying asset,and the longer the time to expiration of theoption
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Option Premiums - Puts
Premiums on put options will be higher thelower the price of the underlying asset, greatervolatility of asset and longer time to expiration
Options are an expensive way to hedgeportfolio risks if those risks are substantial
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Options Terminology
Option price (premium) (V)
Exercise price (strike price) (E)
Expiration date (maturity date) - Saturday following the
3rd Friday of specified month. American vs. European Options
American option - may be exercised at any time up to maturity.
European option - may be exercised only at the date of maturity.
In-the-money Out-of-the money
At-the-money
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Pricing of Options
The Pricing of Call Options at Expiration:
If VS < E, the VC=0
If VS > E, the VC= VS-E
The prices of options on stocks without cash dividendsdepend upon five factors:
Stock price
Exercise Price
Time until Expiration
Volatility of the Underlying Stock
Risk-free Interest Rate
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Options Investors Buy Hedges,Then Hunker Down and Wait
NEW YORK -- Option trading was defensive but noncommittal,mirroring investors' guarded ambivalence as they endured updatesof the Iraq standoff, terrorism alerts and a reminder from the FederalReserve about the precarious state of the economy.
Here is what one investor did: John Jacobs, who runs the Jacobs &Co. mutual fund in Charleston, W.V., this week bought 1,500 March
79 puts on the DJX, which has one-hundredth the value of the DowJones Industrial Average. The puts provide downside insurancethrough mid-March, particularly if the Dow industrials remain below7900. "We're being very defensive to protect the stock side, wherewe have been writing covered calls," he said, referring to the fund'sapproach of investing in blue-chip stocks and selling calloptions
against the stocks for income.
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To help offset the cost of buying the puts, Mr. Jacobs sold 1,000DJX February 77 puts Tuesday, essentially betting the blue-chipindex will hold its ground in the immediate term. Mr. Jacobs said hebelieves blue-chip stocks are oversold and could get a small liftfrom Fed Chairman Alan Greenspan's somewhat-encouragingcomment that capital spending should improve once the Iraq
situation is resolved. Also, he said, any terrorist attacks that wouldroil the markets are less likely to occur until after the hajj, the climaxof the Muslim pilgrimage to Mecca later this week.
Mr. Jacobs plans to buy back the February 77 puts later this week,possibly at a cheaper price because the short-term puts lose theirvalue rapidly as they approach expiration next week.
The Dow industrials fell 77 points to 7843.11. At the Chicago BoardOptions Exchange, the DJX March 79 puts gained 20 cents to$3.70. The DJX February 77 puts gained 20 cents to $1.40.
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Caution remains the watchword. "In this market, youshould be more concerned about protecting profits thangiving up upside," says Elliot Spar, Ryan Beck & Co.option strategist.
One way investors protect profits, Mr. Spar said, is withso-called collars, where an investor sells a call to definea target price at which he is willing to sell stock whileusing the proceeds to buy a put for downside protection."This puts a floor under the stock and caps the upside"
at the strike price of the call, he said.
http://online.wsj.com/mds/companyresearch-quote.cgi?route=BOEH&template=company-research&ambiguous-purchase-template=company-research-symbol-ambiguity&profile-name=Portfolio1&profile-version=3.0&profile-type=Portfolio&profile-format-action=incl%20http://online.wsj.com/mds/companyresearch-quote.cgi?route=BOEH&template=company-research&ambiguous-purchase-template=company-research-symbol-ambiguity&profile-name=Portfolio1&profile-version=3.0&profile-type=Portfolio&profile-format-action=incl%208/2/2019 Derivatives Markets Ppt MBA
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Options Data
Wall Street Journal
Chicago Board Options Exchange
http://online.wsj.com/mds/companyresearch-quote.cgi?route=BOEH&template=company-research&ambiguous-purchase-template=company-research-symbol-ambiguity&profile-name=Portfolio1&profile-version=3.0&profile-type=Portfolio&profile-format-action=incl%20http://online.wsj.com/mds/companyresearch-quote.cgi?route=BOEH&template=company-research&ambiguous-purchase-template=company-research-symbol-ambiguity&profile-name=Portfolio1&profile-version=3.0&profile-type=Portfolio&profile-format-action=incl%20http://online.wsj.com/documents/options.htmhttp://quote.cboe.com/QuoteTable.asphttp://quote.cboe.com/QuoteTable.asphttp://online.wsj.com/documents/options.htm8/2/2019 Derivatives Markets Ppt MBA
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Swaps
The 1st major swap occurred in August of1981. The World Bank issued $290 million ineurobonds and swapped the interest and
principal on these bonds with IBM for Swissfrancs and German marks.
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An Overview of Swaps
Two broad varietiesInterest rate swapsand currency swaps
Swaps are contractual agreement between
two parties (counterparties) and customizedto meet the requirements of both parties
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Counter parties
Fixed-rate payer
Party to a swap that makes fixed-rate paymentsin exchange for floating-rate payments.
Floating-rate payerParty to a swap that makes floating-rate
payments in exchange for fixed-rate payments.
Obli i f i
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Obligations of payments every sixmonths for the duration of the swap
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Interest Rate Swap
The fixed-rate payer always pays the sameamount while payments by the floating-ratepayer varies according to the reference rate
The dollar amount of the payments is determinedby multiplying the interest rate by an agreed-uponprincipal (notional principal amount)
What determines the rates paid
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What determines the rates paidby both parties?
Shape of the yield curveexpected rates in thefuture
Risk of defaultpossibility that counterparties
might default on scheduled interest payments Financial institutions facilitate swaps
Act as the Swap Dealer
Bring the counterparties together
Impose their own credit between the counterparties
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The Swap Dealer
Commission compensates the dealer
For matching parties in the swap.
For risk of default by the counter parties.
Dealer can reduce risk by diversifying swapsacross many unrelated counter parties.
Offers liquidity - willing to cancel contract in
exchange for an appropriate payment.
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Valuing a Swap
Contracts are traded in over-the-counter market
It is possible for one of the counterparties to sell theirobligation to another party
Changing market conditions may cause one party to sellobligation
The third party will purchase the swap if it is to theiradvantage
Therefore, swaps produce gains or losses which willultimate impact the value of the swap
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A Simple Interest Rate Swap
This YearBank One Bank Two
Two-year loans earn9% fixed
Two-year loans earn 8%variable
Deposits cost 5%variable
Deposits cost 6% fixed
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Next yearrates go up.
Bank One Bank Two
Loans earn 9%
fixed
Loans earn 12%variable
Deposits cost 9%variable Deposits cost 6% fixed
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Next Year Rates GoDown
Bank One Bank Two
Loans earn 9% fixed Loans earn 5% variable
Deposits cost 2%variable
Deposits cost 12%variable
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Next Year Rates Go Up They swap.
Bank One Bank Two
Loans earn 9% fixed Loans earn 12%variable
Deposits cost 6% fixed Deposits cost 9%
variable
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Next Year Rates GoDown
They swap.
Bank One Bank Two
Loans earn 9% fixed Loans earn 5%variable
Deposits cost 6% fixed Deposits cost 2%variable
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Interest Rate Swap
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Currency Swaps
Two companies agree to exchange a specificamount of one currency for a specific amountof another at specific dates in the future.