FMII Lecture 6 2012
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Transcript of FMII Lecture 6 2012
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Simon [email protected]
Lecture 6: Derivatives &Behavioural Finance
Financial Markets
Institutions & InstrumentsFR1001
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Introduction1. Derivatives
Forwards and Futures Spot Markets
Forward Markets
Futures Markets
Options Call options
Put options
Swaps
Interest Rate Swaps Currency Swaps
2. Behavioural Finance
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Overview
Derivatives are instruments whose value islinked to and derived from something else.
The something else could be a security or an
index. Examples:
Commodities
Interest rates
Equities and equity indices
Bonds
Currencies
Weather
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Derivatives can be used for both hedging(reducing existing exposures) and speculation(deliberately taking new exposures).
Derivative markets can also be thought of asreallocating risk from those who do not wish to
bear it to those who do.
Many derivatives involve significant amounts ofleverage. This can make them a very effective
financial tool. It also helps explain whyderivatives have been involved in many of thelargest financial disasters!
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Banks and hedge funds are major players in
derivative markets.
Derivatives are traded on both open outcry andelectronic exchanges, but electronic trading is
gaining. Some of the largest exchanges are CBOT/CME
and LIFFE. Exchanges compete for tradingvolume.
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Major Types of Derivative
Forward and Futures contracts
Options contracts
Call option Put option
Swaps
Currency swap Interest rate swap
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Spot, Forward & Futures Contracts
Spot Contract: an agreement between two partiesfor immediate delivery of an asset (by the seller) andimmediate payment of funds in return (by the buyer).
Forward Contract: an agreement between twoparties at time t=0 to exchange a non-standardisedasset for cash at some future date. The details of theasset, price to be paid, and date are all set at t=0.
Futures Contract: like a forward, but agreement attime t=0 is to exchange a standardised asset forcash at some standardised future date.Transactions occur in a centralised market.
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Forward Contracts
After entering a future or forward contract, theprice for delivery of the asset at maturity is fixed,regardless of what happens to spot prices in themeantime.
For example, a Forward Rate Agreement (FRA)is a forward contract for loans that today fixes theinterest rate on a loan that will be made in the
future. Other forwards are agreements to deliverparticular commodities in the future, at a pricespecified now.
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Profit from aLong Forward Position
Profit
Price of Underlying
at Maturity, STK
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Profit from aShort Forward Position
Profit
Price of Underlying
at Maturity, STK
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Example 1
A cocoa grower wants to remove uncertaintyabout the price he will receive when the crop isharvested. How should he hedge?
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Example 2
A producer of electronic goods needs to buy a100 tonnes of copper in six months time. Howshould she hedge?
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Example 3
A UK investor holds $100m of US equities.She is bullish on the performance of theequities, but fears that a fall in the dollar mightstill lead to losses. How should she hedge?
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Trading in Forwards
Hedging
Speculation
Arbitrage
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Futures Contracts
Just like a forward, a buyer of a futures contract (long
position) incurs the obligation to pay the price agreedat the time the contract is purchased.
Similarly, a seller of a futures contract(short position)incurs the obligation to deliver the underlying
commodity at contract maturity.
The exchange guarantees payment for both parties sothat counterparty default risk is not a concern.Principles will not normally know the opposing party in
the contract unless delivery is arranged.
To protect themselves, exchanges impose marginrequirements, position limits and daily marking tomarket.
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Buyers and sellers of futures contracts must post aninitial margin, usually set at about 1%-5% of theface value of the contract.
Losses will be deducted from investors marginaccounts. If futures prices move against them,they will be asked to top up their margin back to
their original level (a margin call). The margin system is designed to ensure that
investors cannot walk away from a deal if pricesmove against them!
By contrast, on a forward contract, no cash is paid orreceived until contract maturity.
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.
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Forward vs Futures Contracts
Private contract between 2 parties Exchange traded
Non-standard contract Standard contract
Usually 1 specified delivery date Range of delivery dates
Settled at end of contract Settled daily
FORWARDS FUTURES
Some credit risk Virtually no credit risk
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Options
An option is a derivative instrument that providesthe holder (long position) with the right, but notthe obligation, to complete a transaction on the
underlying asset at a specific price (strike price)during or at a specific period of time (expirationdate).
If the holder of the option chooses to exercisehis right, the writer (short position) is obliged toact on it.
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Call Option: gives the holder the right (but not
the obligation) to purchase the underlyingsecurity at the agreed strike price. For this rightshe pays the writer an up-front fee known asthe call premium.
Put Option: gives the holder the right (but notthe obligation) to sell the underlying security atthe agreed strike price. For this right she pays
the writer an up-front fee known as the putpremium.
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Option Positions
Long call
Long put
Short call Short put
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Long Call on eBay
Profit from buying one eBay European call option: optionprice = $5, strike price = $100, option life = 2 months
30
20
10
0-5
70 80 90 100
110 120 130
Profit ($)
Terminalstock price ($)
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Short Call on eBay
Profit from writing one eBay European call option: optionprice = $5, strike price = $100
-30
-20
-10
05
70 80 90 100
110 120 130
Profit ($)
Terminalstock price ($)
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Long Put on IBM
Profit from buying an IBM European put option: optionprice = $7, strike price = $70
30
20
10
0
-770605040 80 90 100
Profit ($)
Terminal
stock price ($)
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Short Put on IBM
Profit from writing an IBM European put option: optionprice = $7, strike price = $70
-30
-20
-10
7
070
605040
80 90 100
Profit ($)
Terminalstock price ($)
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Examples
An airline has calculated that it will beprofitable as long as crude oil prices staybelow $120/barrel, but that it will lose $10m forevery dollar that prices rise above that. How
should it hedge?
I am generally bullish on XYZ company, but Ialso feel that the market is underestimating therisk of a sharp fall. What position should Itake?
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Call Option Value Prior to Expiration
Value intrinsic value
(option (stock price - exercise price)
premium) Before exercise
price$12.50 Time Value
$10.00 ($2.50)
X = $50 S = $60 Stock Price
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Option Valuation
The Black-Scholes option pricing model isused to calculate the value of standard(vanilla) options based on certain
assumptions: in particular about future
volatility of the underlying asset. Increasedvolatility makes options more valuable.
Exotic options may need more complex
valuation models.
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Swaps A swap is as an agreement between two parties
to exchange assets and/or a series of cash flowsin the future
Swaps can be thought of as a series of individualforward agreements stretching into the future.
They are typically used for hedging rather thanspeculation. They are generally used to hedgeinterest rate (fixed vs. floating) and foreignexchange exposures.
Swaps are OTC derivatives, and are highlycustomised to users needs. Many different typesexist.
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Firm 1 Firm 2
USD
Assets
GBP
Liabilities
GBP
Assets
USD
Liabilities
GBP
USD
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What Do Derivatives Achieve?
Derivatives allow firms to hedge their risks cheaply
and efficiently. They are also a very effective toolfor speculation.
The sector is very innovative, with new derivatives
being created in response to client need. But they can be controversial. The high gearing and
complexity of some derivatives, sometimes coupledwith outright fraud, has led to some massive losses.
Nick Leeson was just one example.
They are a very powerful tool if used correctly, butdangerous if used badly!
OTC D i ti O t t di
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OTC Derivatives Outstanding(notional amount, $bn)
Dec-04 Dec-07
FX 29,289 56,238Forwards & swaps 23,174 43,490
Options 6,115 12,748
Interest rates 190,502 393,138
FRAs 12,789 26,599
Swaps 150,631 309,588Options 27,082 56,951
Equity-linked 4,385 8,509
Forwards and swaps 756 2,233
Options 3,629 6,276
Commodity 1,443 9,000
CDS 6,396 57,894
Unallocated 25,879 71,225
Total 257,894 596,004
Source: BIS
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Summary
Futures/forwards: agreements which obligetwo parties to buy/sell at a specified futuredate at a price agreed now.
Options: give the holder the right to buy (call)or sell (put), but no obligation
Swaps: a longer-term set of cashflow
exchanges, typically to alter interest rate orFX risk.
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BEHAVIOURAL FINANCE
Why arent we as smart as we think we are?
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So far we have considered how rational
investors should behave. But it is not alwaysclear that investors do behave rationally. Inparticular it seems strange that we see so manyboom/bust cycles in asset prices.
Behavioural finance is where finance andpsychology overlap. It seeks to identify areas inwhich people dont behave in the rational profit-
maximising way that theory would suggest. Alarge number of effects has been identified,some of which overlap.
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The endowment effect: we appear to put greatervalue on things that we already own compared to
equally valuable items that we dont. In particular,we tend to fall in love with assets already in our
portfolios.
Confirmation bias: we tend to give more weight to
evidence that supports our existing beliefs.
Over-confidence: we underestimate uncertaintyand overestimate our own abilities.
Attribution bias: we tend to interpret evidence inself-serving ways, eg. profitable investments weredue to our skill, but losses were due to bad luck.
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Our objective may not be to maximise profit,but to minimise regret. We find it very hard to
sell an asset at a loss, since this requires us toadmit we were wrong!
More generally, prospect theory suggests that
how we respond to choices is very sensitive tothe way in which they are presented to us (howthey are framed).
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Herd behaviour: we have a strong instinct to
conform, and have a tendency to believesomething when everyone else believes it too(social proof, group-think). For example,everyone knows that internet stocks really are
worth P/E ratios over 100! Anchoring: the price of an asset begins to feel
justified just because it has become familiar.
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Behavioural finance is a relatively new andgrowing field. It has two key uses:
It may help us understand market
behaviour
It is a useful test of our own behaviour:are we sure that we arent falling into
any of these traps ourselves?
Conclusion
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Reading
Derivatives
Madura Ch 14 (first half)
Bain/Howells 9.3 - 9.6
Behavioural Finance:
Nofsinger The Psychology of Investing