Download Lecture 3

Introduction
Chapter 1
Geng Niu
Gezhi Building 1220
[email protected]
1
Course evaluation



Assignments + participation (30%)
Midterm exam (30%)
Final exam (40%)
2
Textbook (main)




Options, Futures, and Other Derivatives,
8th edition (John C. Hull)
Classical textbook; many editions (very
similar across editions though).
Used wildly in Master of Finance programs
and MBA programs with finance tracks
around the world.
Less on math, more on intuitions
3
Supplementary materials:



Fixed Income Markets and Their Derivatives,
2th edition (Suresh M. Sundaresan)
Bond Markets, Analysis and Strategies, 5th
edition (Frank J. Fabozz)
FRM (Financial Risk Management) Exam
notes.
4
Some useful online resources







http://www.cmegroup.com/ (Chicago Mercantile
Exchange & Chicago Board of Trade)
http://finance.yahoo.com/
http://www.cffex.com.cn/en_new/ (China Finance
Futures Exchange)
http://www.shfe.com.cn/en/ (Shanghai Futures
Exchange)
http://www.dce.com.cn/portal/cate?cid=1114494099100
(Dalian Commodity Exchange)
http://english.czce.com.cn/ (Zhengzhou Commodity
Exchange)
http://eng.cfachina.org/ (China Futures Association)
5
Dynamics of some assets: what’s in common?
Glod Price
2000.000
1800.000
1600.000
1400.000
1200.000
1000.000
800.000
600.000
400.000
200.000
0.000
Oil Price
120.00
100.00
80.00
60.00
40.00
20.00
0.00
U.S. / Euro
Exchange Rate
S&P 500
2500.00
2.0000
2000.00
1.5000
1500.00
1.0000
1000.00
0.5000
500.00
0.0000
0.00
6
How Derivatives are Used



To hedge risks: risk management
To speculate (bet on the future
direction of the market)
To lock in an arbitrage (riskless)
profit
7
Derivatives are relevant to many
sectors



Financial sector (banks, hedge funds, mutual
funds, asset management company, etc):
provide competitive financial products
Other companies: interest rates, exchange
rates, commodity prices (grain, oil, gold,
copper…)
Government: how to regulate financial market
properly?
8
Why Study Derivatives Pricing






Learn the language of modern finance
Foundation of financial engineering and risk
management
Prepare for graduate studies in finance
Prepare for professional certificates: CFA,
FRM, ect..
Prepare for job interviews
Understand financial news
9




The derivatives pricing literature is very huge.
Mathematical techniques involved can be
quite challenging
Advanced computational skills are also
needed.
Derivatives pricing is
considered “rocket science”.
10






What you will learn in this course are still the
basics.
They are mostly “toy models”.
However, this course prepares you for future
learning.
Intuitions are often more
Impartment and useful.
So, be confident and
have fun !
11
What is a Derivative?


A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset (the underlying asset).
Examples: futures, forwards, swaps, options,
exotics…
12
Examples



Forward & Future: an agreement to buy or
sell an asset at a certain time for a certain
price.
Call Option: the holder has the right to buy
the underlying asset by a certain date for a
certain price.
Put Option: the holder has the right to sell the
underlying asset by a certain date for a
certain price.
13
14
th
19




US grain trade finance
Inland farmers came to east coast to sell
their grain to dealers who, in turn, shipped it
all over the country.
Too much supply right after the harvest.
Unpurchased crops were left to rot.
In the off-season price became too high when
crops were unavailable.
Not good for both the farmers and the
dealers.
15
th
19




US grain trade finance
Farmers (sellers) and dealers (buyers) began
to commit to future exchanges of grain for
cash: forward contract
Such contracts became common and began
to change hands before the delivery date.
The (forward) price would go up and down
depending on market conditions.
people who had no intention buying or selling
grain began to trade: speculators
16
th
19




US grain trade finance
Forward contracts are often not easy to change
hands.
Standardized forward contracts began to
emerge: futures contract.
A counterparty to every trade – its members buy
every contract that traders sell and sell every
contract that traders buy: cleaning house.
Exchanges in Chicago and New York began to
develop.
17
How Derivatives Are Traded


On exchanges such as the Chicago Board
Options Exchange
In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers contact each other
directly
18
Size of OTC and Exchange-Traded Markets
(Figure 1.1, Page 3)
Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
19
Motivating example




On Sep 1, your company, based in the U.S.,
agreed to buy heavy equipment from a German
manufacturer.
Payment of 1 million euro was due upon
delivery, Dec 1.
Between Sep 1 and Dec 1, the price of the euro
in relation to the U.S. dollar will fluctuate: hard to
predict.
What if the value of the euro were to rise, say,
from 1.36 dollar/euro to 1.461 dollar/euro?
20
Motivating example
21
Motivating example:




To get rid of this risk, the U.S company could:
Bought the euros they needed for this
purchase on Sep 1: a large amount of
working capital would be tied up.
Or, hedge their exposure to FX risk by
purchasing forward or futures contracts:
agree to pay 1.36 million U.S. dollar. to buy 1
million euro on Dec 1.
Who would take the other side of this trade?
22
Forward Price


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 (as
shown by the table)
23
Foreign Exchange Quotes for USD/GBP,
May 24, 2010 (See page 5)
Spot
Bid
1.4407
Offer
1.4411
1-month forward
1.4408
1.4413
3-month forward
1.4410
1.4415
6-month forward
1.4416
1.4422
24
Terminology


The party that has agreed to buy
has what is termed a long
position
The party that has agreed to sell
has what is termed a short
position
25
Example (page 5)



On May 24, 2010 the treasurer of a US
corporation enters into a long forward
contract to buy £1 million in six months at an
exchange rate of 1.4422
This obligates the corporation to pay
$1,442,200 for £1 million on November 24,
2010
What are the possible outcomes?
26
Profit from a Long Forward Position
(K= delivery price=forward price at time contract is
entered into)
Profit
K
Price of Underlying at
Maturity, ST: USD/GPB
27
Profit from a Short Forward Position
(K= delivery price=forward price at time contract is entered
into)
Profit
K
Price of Underlying
at Maturity, ST: USD/GPB
Options, Futures, and Other Derivatives, 8th
Edition, Copyright © John C. Hull 2012
28
Futures Contracts (page 7)



Agreement to buy or sell an asset for a
certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded
OTC, a futures contract is traded on an
exchange
29
Exchanges Trading Futures





CME Group (formerly Chicago Mercantile
Exchange and Chicago Board of Trade)
NYSE Euronext
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)
30
Examples of Futures Contracts
Agreement to:



Buy 100 oz. of gold @ US$1400/oz. in
December
Sell £62,500 @ 1.4500 US$/£ in March
Sell 1,000 bbl. of oil @ US$90/bbl. in April
31
Options


A call option is an option to buy a certain
asset by a certain date for a certain price (the
strike price)
A put option is an option to sell a certain
asset by a certain date for a certain price (the
strike price)
32
Long Call
(Figure 9.1, Page 195)
Profit from buying one European call option: option price =
$5, strike price = $100, option life = 2 months
30 Profit ($)
20
10
70
0
-5
80
90
100
Terminal
stock price ($)
110 120 130
33
American vs European Options


An American option can be exercised at any
time during its life
A European option can be exercised only at
maturity
34


Bid price: the price at which the market
maker is prepared to buy
Offer price: the price at which the market
maker is prepared to sell
35
Google Call Option Prices (June 15, 2010; Stock Price is bid 497.07,
offer 497.25); See Table 1.2 page 8; Source: CBOE
Strike
Price
Jul 2010
Bid
Jul 2010
Offer
Sep 2010
Bid
Sep 2010
Offer
Dec 2010
Bid
Dec 2010
Offer
460
43.30
44.00
51.90
53.90
63.40
64.80
480
28.60
29.00
39.70
40.40
50.80
52.30
500
17.00
17.40
28.30
29.30
40.60
41.30
520
9.00
9.30
19.10
19.90
31.40
32.00
540
4.20
4.40
12.70
13.00
23.10
24.00
560
1.75
2.10
7.40
8.40
16.80
17.70
36
Google Put Option Prices (June 15, 2010; Stock Price is bid 497.07,
offer 497.25); See Table 1.3 page 9; Source: CBOE
Strike
Price
Jul 2010
Bid
Jul 2010
Offer
Sep 2010
Bid
Sep 2010
Offer
Dec 2010
Bid
Dec 2010
Offer
460
6.30
6.60
15.70
16.20
26.00
27.30
480
11.30
11.70
22.20
22.70
33.30
35.00
500
19.50
20.00
30.90
32.60
42.20
43.00
520
31.60
33.90
41.80
43.60
52.80
54.50
540
46.30
47.20
54.90
56.10
64.90
66.20
560
64.30
66.70
70.00
71.30
78.60
80.00
37
Options vs Futures/Forwards


A futures/forward contract gives the holder
the obligation to buy or sell at a certain price
An option gives the holder the right to buy or
sell at a certain price
38
Types of Traders



Hedgers: to reduce risk
Speculators: to make profit from taking the
risk
Arbitrageurs: look for riskless profit
39
Hedging Examples (pages 10-12)


A US company will pay £10 million for
imports from Britain in 3 months and
decides to hedge using a long position in
a forward contract
An investor owns 1,000 Microsoft shares
currently worth $28 per share. A twomonth put with a strike price of $27.50
costs $1. The investor decides to hedge
by buying 10 contracts
40
Value of Microsoft Shares with and
without Hedging (Fig 1.4, page 12)
40,000
Value of Holding
($)
35,000
No Hedging
30,000
Hedging
25,000
Stock Price ($)
20,000
20
25
30
35
40
41
Speculation Example


An investor with $2,000 to invest feels
that a stock price will increase over the
next 2 months. The current stock price
is $20 and the price of a 2-month call
option with a strike of 22.50 is $1
What are the alternative strategies?
42
Arbitrage Example




A stock price is quoted as £100 in
London and $140 in New York
The current exchange rate ($/ £ )is
1.4300
What is the arbitrage opportunity?
What if the exchange rate ($/ £ ) is
1.3700
43
Different Opinions on Derivatives


“Derivatives are extremely efficient tools for
risk management”
“Derivatives are financial weapons of mass
destruction”
44
Why Derivatives Are Important




Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc
Many financial transactions have embedded
derivatives
The real options approach to assessing capital
investment decisions has become widely accepted
45
Dangers



Traders can switch from being hedgers to
speculators or from being arbitrageurs to
speculators
It is important to set up controls to ensure
that trades are using derivatives in for their
intended purpose
Soc Gen (see Business Snapshot 1.3 on
page 17) is an example of what can go wrong
46
China Aviation Oil suffers $550
million derivatives loss



China Aviation Oil (CAO): a Singapore listed company
that purchases jet fuel and supplies jet fuel to
China’s civil aviation industry.
In early 2004, the management team judged that oil
price would further decrease and began to heavily sell
calls and buy puts: speculating!
However, the Nymex oil futures contract increased to
$55.17 per barrel on October 26 compared with just $34
at in early 2004: resulting a huge loss for CAO.
47
48
China Aviation Oil suffers $550
million derivatives loss


CAO concealed these losses by accounting
manipulation.
The managing director, Chen Jiulin, was sentenced for
3 years and 4 months by the Singapore court.
Q2
Q3
First 9
months
CAO EBT 19.0
19.3
11.3
49.6
PwC
adjusted
EBT
-58.0
-314.6
-379.0
Q1
-6.4
49
Hedge Funds (see Business Snapshot 1.2, page 11)
Hedge funds are not subject to the same rules as
mutual funds and cannot offer their securities
publicly: only to sophisticated individuals.
Mutual funds must








disclose investment policies,
makes shares redeemable at any time,
limit use of leverage
take no short positions.
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies are big
users of derivatives for hedging, speculation and
arbitrage
50
No Arbitrage Theory and Efficient
Market Hypothesis




No Arbitrage: Two assets with the same
future payoffs must have the same price
today.
Otherwise, you can earn a positive profit for
certain.
How? Buy the cheap asset and sell the
expensive one.
Result: Demand for the cheap asset
increases and so is its price.
51
Assumption



The market is efficient.
If there were arbitrage opportunities, some
investors would have taken these
opportunities already.
Thus, these opportunities will be eliminated
immediately.
52
An old joke




An economist will not pick up a twenty-dollar
bill on the ground.
Why?
If it were really there, someone would have
picked it up already.
Arbitrage opportunities (free money) cannot
exist.
53
Derivatives Market in China
Commodity-based financial derivatives:


The first commodities futures market in China, the China
Zhengzhou Grain Wholesale Market, opened on 12
October 1990.
Subsequently, the Shanghai Futures Exchange and
Dalian Commodity Exchange have also started
operations
54
Derivatives Market in China
Exchange rate derivatives



RMB forwards: In April 1997, the Bank of China started
its RMB forward exchange settlement and sales
business.
RMB foreign exchange swaps: introduced in April 2006.
RMB futures: In August 2006, CME launched futures and
option contracts on the CNY against the US dollar, euro
and Japanese yen.
Wulin Suo
55

China Financial Futures
Exchange (CFFEX) was
jointly founded by
Shanghai Futures
Exchange, Zhengzhou
Commodity Exchange,
Dalian Commodity
Exchange, Shanghai
Stock Exchange and
Shenzhen Stock
Exchange on September
8, 2006 in Shanghaj
56
Derivatives Market in China


CSI 300: 300 largest A-Shares listed on the
Shanghai Stock Exchange and Shenzhen
Stock Exchange.
SSE 50 : 50 largest stocks of good liquidity
and representativeness from Shanghai
security market
57
Derivatives Market in China
Stock index option
 An option based on the SSE 50 Index ETF
was launched as the debut product on
February 9, 2015 in China, traded in
Shanghai stock exchange.

58
Derivatives Market in China


Exchange Traded Fund (ETF): an openended index fund that is listed and traded on
the stock exchange like any other ordinary
stocks.
China 50 ETF: closely track the Shanghai
Stock Exchange 50 (SSE 50) Index
59