ADVANCED FINANCIAL INSTRUMENTS AND MARKETS

Fall 2013

LectureNo. No 09
MarketforDerivativeInstruments
Hammad HassanMirza AssistantProfessor(Finance) DepartmentofBusinessAdministration UniversityofSargodha

WaysDerivativesareUsed
Tohedgerisks Tospeculate(takeaviewonthefuture directionofthemarket) Tolockinanarbitrageprofit Tochangethenatureofaliability Tochangethenatureofaninvestmentwithout incurringthecostsofsellingoneportfolioand buyinganother

ForeignExchangeQuotes
Bid Spot 1-month forward 3-month forward 6-month forward Offer

ForwardPrice

Theforwardpriceforacontractisthedelivery pricethatwouldbeapplicabletothecontractif werenegotiatedtoday(i.e.,itisthedeliveryprice th twould that ldmake k the th contract t tworth thexactly tl zero) ) Theforwardpricemaybedifferentforcontracts ofdifferentmaturities

Terminology

Thepartythathasagreedtobuyhaswhatis termedalongposition Thepartythathasagreedtosellhaswhatis termedashortposition

Example
OnJuly20, 20 2007thetreasurerofacorporationenters intoalongforwardcontracttobuy1millioninsix monthsatanexchangerateof2.0489 Thisobligatesthecorporationtopay$2,048,900for 1milliononJanuary20,2008 Whatarethepossibleoutcomes?

Profitfroma LongForwardPosition
Profit

Price of Underlying at Maturity, ST

Profitfroma ShortForwardPosition
Profit

Price of Underlying at Maturity, ST

FuturesContracts
Agreementtobuyorsellanassetforacertainpriceat acertaintime Similartoforwardcontract Whereas Wh aforward f dcontract t t i ist traded d dOTC OTC,af futures t contractistradedonanexchange

ExchangesTradingFutures

ChicagoBoardofTrade ChicagoMercantileExchange ( ) LIFFE(London) Eurex(Europe) BM&F(SaoPaulo,Brazil) TIFFE(Tokyo) Pakistan?????

10

ExamplesofFuturesContracts
Ag Agreement tto: t
Buy100oz.ofgold@US$900/oz.inDecember (NYMEX) Sell62,500@2.0500US$/inMarch(CME) Sell1,000bbl.ofoil@US$120/bbl.inApril(NYMEX)

11

1.Gold:AnArbitrage Opportunity?
Supposethat:
Thespot p p priceofg goldisUS$900 9 The1yearforwardpriceofgoldisUS$1,020 The1yearUS$interestrateis5%perannum

Isthereanarbitrageopportunity?

12

2 Gold:AnotherArbitrageOpportunity? 2.
Supposethat:

ThespotpriceofgoldisUS$900 The1yearforwardpriceofgoldisUS$900 The1yearUS$interestrateis5%perannum

Isthereanarbitrage g opportunity? pp y

13

Th F The Forward d P Price i of fG Gold ld

IfthespotpriceofgoldisS andtheforwardpricefor acontractdeliverableinT yearsisF,then F =S (1 (1+r )T wherer isthe1year(domesticcurrency)riskfree rateofinterest. I ourexamples, In l S =900, 900 T =1, 1 and dr =0.05 0 05sothat th t F =900(1+0.05)=945

14

1 Oil:AnArbitrageOpportunity? 1.
S Suppose that: h

ThespotpriceofoilisUS$95 Theq quoted1y yearfuturesp priceofoilisUS$125 5 The1yearUS$interestrateis5%perannum Thestoragecostsofoilare2%perannum

Isthereanarbitrageopportunity?

15

2.Oil:AnotherArbitrage Opportunity?
S Suppose that: th t

ThespotpriceofoilisUS$95 Thequoted1yearfuturespriceofoilisUS$80 The1yearUS$interestrateis5%perannum Thestoragecostsofoilare2%perannum

Isthereanarbitrageopportunity?

16

Options

Acalloptionisanoptiontobuyacertainassetbya certaindateforacertainprice(thestrikeprice) Aputoptionisanoptiontosellacertainassetbya certaindateforacertainprice(thestrikeprice)

17

AmericanvsEuropeanOptions
AnAmericanoptioncanbeexercisedatanytime duringitslife AEuropeanoptioncanbeexercisedonlyatmaturity

18

ExchangesTradingOptions

ChicagoBoardOptionsExchange AmericanStockExchange p StockExchange g Philadelphia PacificExchange LIFFE(London) Eurex(Europe) Pakistan????

19

OptionsvsFutures/Forwards
Afutures/forwardcontractgivestheholderthe obligationtobuyorsellatacertainprice Anoptiongivestheholdertherighttobuyorsellata certainprice

20

TypesofTraders
Hedgers H d Speculators p Arbitrageurs
Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrage arbitrageurs rs switched s itched to being speculators spec lators (See for example Barings Bank, Business Snapshot 1.2, page 15)

21

HedgingExamples

AUScompanywillpay10millionforimportsfrom Britainin3monthsanddecidestohedgeusingalong positioninaforwardcontract Aninvestorowns1,000 1 000Microsoftsharescurrently worth$28pershare.Atwomonthputwithastrike priceof$27.50costs$1.Theinvestordecidestohedge bybuying10contracts

22

ValueofMicrosoftShareswithand withoutHedging
40,000 Value of Holding ($) 35,000
No Hedging

30,000

Hedging

25,000 Stock Price ($) 20,000 20 25 30 35 40

23

SpeculationExample
Aninvestorwith$2,000toinvestfeelsthatastock price i will illincrease i overthe h next2months. h The h currentstockpriceis$20andthepriceofa2month calloption p withastrikeof22.50 5 is$1 Whatarethealternativestrategies?

24

ArbitrageExample
Astockpriceisquotedas100inLondonand$200in NewYork Thecurrentexchangerateis2.0300 Whatisthearbitrage g opportunity? pp y

25

HedgeFunds

Hedgefundsarenotsubjecttothesamerulesas mutualfundsandcannotoffertheirsecurities publicly. Mutualfundsmust

discloseinvestmentpolicies, policies makessharesredeemableatanytime, limituseofleverage takenoshortpositions. positions

Hedgefundsarenotsubjecttotheseconstraints. Hedgefundsusecomplextradingstrategiesarebig usersofderivativesforhedging,speculationand arbitrage 26

Options, p ,Futures, ,andOther Derivatives,7thEdition, py g JohnC.Hull2008 Copyright

ThankYou!