CFA1. Derivatives Markets and Instruments.pdf, Study notes of Finance

Download CFA1. Derivatives Markets and Instruments.pdf and more Study notes Finance in PDF only on Docsity! Derivatives Markets and Instruments Learning objectives • Understand what a derivative is • Understand its core features • Understand ways in which it is traded • Understand types of derivatives • Calculate Payoffs under various situations, including arbitrage Return on the derivative can be any one of three outcomes a) No profit or loss: If the spot price or the market price of Vimeo shares 90 days from now is $30, equal to the forward price of $30. Ignoring transactions costs, both the buyer and seller make no profit or loss. b) Buyer makes a profit: If the spot price of Vimeo shares is say $40, ($10 more than forward price of $30), the buyer gets 50 shares at $30 at settlement and sell at $40 in the market c) Seller makes a profit: If the spot price is $25 at settlement, seller can buy 50 shares from the market at $25 and deliver the same to the buyer at $30 per share Note: Gain of one party is always equal to the loss of the other party Return on a derivative transaction Spot / market price on Settlement date Who profits? Same as forward rate Neither gains nor lose Higher than forward rate Buyer Lower than forward rate Seller • Derivatives emerged as a way to transfer risk from one party to another • Seller “Hedging”: You owned the shares in Vimeo. You are uncertain if they will grow in the future and do not want to run the risk of the price falling in the future • So you decide to enter a forward contract at a price that you are comfortable with ($30) • This makes you neutral to any price risk in the future • This is called Hedging (or offsetting / reducing) your risk and can be of two types • Fully hedged: E.g. You had bought the shares at 30 and are selling at 30. • Partially hedged: E.g. You had bought the shares at 35 and are ok to sell at 30. • Buyer “Speculation”: The buyer currently has no risk relating to shares of Vimeo, hence buyer is said to be speculating on the future price of Acme shares. • Will buy if speculation is that price will rise in 90 days Why did derivatives emerge? • Derivatives have three potential advantages over selling shares directly in the market for three reasons 1. Investors can gain exposure to a risk at low cost, effectively creating a highly leveraged investment in the underlying security. 2. Transaction costs for a derivatives position may be significantly lower than for the equivalent cash market trade. 3. Initiating a derivatives position may have less impact on market prices of the underlying, relative to initiating an equivalent position in the underlying through a cash market transaction. Selling shares versus using derivatives • Essential differences are as follows Comparison Exchange-traded • Standardized contracts and have lower trading costs. • Subject to the trading rules of the exchange • Require deposits by both parties at initiation, and additional deposits when a position decreases in value. • More liquid and more transparent, as all trades are visible to the exchange Dealer markets (Over The Counter) • Custom instruments • Less liquid and have higher transaction costs. • Less transparent. • Subject to counterparty risk. • More difficult to clear and settle. • Subject to higher trading costs. • Not subject to requirements for the deposit of collateral. Types of derivatives - Forward commitment and contingent claims features and instruments 1. Types of derivatives – Futures and Forward contracts Forward contracts • Between two parties • seller commits to sell a physical or financial asset at a specific price on a specific date (the settlement date) in the future. • the buyer commits to buy the same as per the contract Futures contract • Same as forward contract, but additionally • standardized and exchange-traded. • subject to greater regulation, and more disclosure (transparency) • backed by a central clearinghouse and require daily cash settlement of gains and losses, to minimize counterparty credit risk • On Day 0: Buyer and seller make a trade at a price of $1,950 per gram and both parties deposit the initial margin of $5,000 into their accounts. • On Day 1: The seller has gains and the buyer has losses. The exchange will • credit seller’s account for (1,950 - 1,947.5) × 100 = $250, increasing margin balance to $5,250. • deduct this $250 from the buyer’s account, decreasing buyer’s margin balance to $4,750. • not ask buyer for additional margin, since $4,750 is more than maintenance margin of $4,700 • On Day 2, Again, the seller has gains and the buyer has losses. The exchange will • credit seller’s account for (1,947.5 - 1,945) × 100 = $250, increasing margin balance to $5,500. • deduct this $250 from the buyer’s account, decreasing the margin balance to $4,500. • contact the buyer, as $4,500 is less than maintenance margin amount of $4,700, • ask buyer to deposit 5,000 – 4,500 = $500 so as to return it to initial margin amount of $5,000. Answer • Swaps are netted off, i.e. at each settlement date, all payments are netted so that only one net payment is made. • Swaps are exposed to counterparty credit risk, unless the market has a central counterparty structure to reduce counterparty risk. • Example of a simple swap • a fixed-for-floating interest rate swap for two years with quarterly interest payments based on a notional principal amount of $10 million. • One party makes quarterly payments at a fixed rate of interest (the swap rate) • The other makes quarterly payments based on a floating market reference rate. • Over time, the value of the swap can become positive for one party and negative for the other party. 2. Types of derivatives – Swaps agreements to exchange a series of payments on multiple settlement dates over a specified time period (e.g., quarterly over 2 years) • Consider an interest rate swap with a notional principal amount of $10 million, a fixed rate of 2%, and a floating rate of the 90-day secured overnight financing rate (SOFR). • At each settlement date, the fixed-rate payment will be $10 million × 0.02/4 = $50,000. • The floating-rate payment at the end of the first quarter will be based on 90-day SOFR at the initiation of the swap, so that both payments are known at the inception of the swap. • If, at the end of the first quarter, 90-day SOFR is 1.6%, the floating-rate payment at the second quarterly settlement date will be $10 million × 0.016 / 4 = $40,000. The fixed- rate payment is again $50,000, so at the end of the second quarter the fixed-rate payer will pay the net amount of $10,000 to the other party. Example: • Lets assume • X = the exercise price of a put = $25 at the expiration of the option. • S = Current trader price of the underlying • If S is at or above $25, the put holder will not exercise the option. • There is no reason to exercise the put and sell shares at $25 when they can be sold for more than $25 in the market. • So the put buyer lets the option expire, and the put seller keeps the proceeds from the sale. • This is the outcome for any put option where market price is higher than put option, • If S is below $25, the put buyer will exercise the option. • the put seller must purchase shares for $25 from the put buyer. • On net, the put buyer essentially receives the difference between the stock price at expiration and $25 (times number of shares). Example: How a simple one-way put option works • Unlike forwards, futures, and swaps, options are sold at a price (they do not have zero value at initiation). The price of an option is also referred to as the option premium. • At expiration, the owner of a call option will simple check if profit exists, i.e. • Payoff (Value) = Maximum of (0, S-X) • where S is the price of the underlying at expiration and • X is the exercise price of the put option • 0 = zero = no loss / gain arising from not exercising the call • Similarly, for a put option , Payout (Value) to the owner = Max (0, X – S) • where S is the price of the underlying at expiration and • X is the exercise price of the put option. • 0 = zero = no loss / gain arising from not exercising the call Calculating profit/loss from Options • Consider a call option with a premium of $5 and an exercise price of $50. This means the buyer pays $5 to the writer. • At expiration, if • the price of the stock is less than or equal to the $50 exercise price, the option has zero value, the buyer of the option is out $5, and the writer of the option is ahead $5. • When the stock’s price exceeds $50, the option starts to gain (breakeven will come at $55, when the value of the stock equals the exercise price plus the option premium. • Conversely, as the price of the stock moves upward, the seller of the option starts to lose (negative figures will start at $55, when the value of the stock equals the exercise price plus the option premium). • The sum of the profits between buyer and seller is always zero; thus, trading options is a zero-sum game. Call example Visually: Writer (short put), buyer (long put) The breakeven is X - the premium (i.e. S = $45). The maximum loss for the buyer is the $5 premium (at any S ≤ $50). The maximum profit for the writer is the $5 premium (for S ≥ $50) Loss for writer is = Profit for buyer Maximum profit for buyer is X – premium ($50 - $5 = $45) • Suppose that both a call option and a put option have been written on a stock with an exercise price of $40. The current stock price is $42, and the call and put premiums are $3 and $0.75, respectively. • Question: With an expiration day stock price of $35 and with a price at expiration of $43. 1. Calculate the profit to the long and short positions for the put 2. Calculate the profit to the long and short positions for the call Exercise • Profit will be computed as ending option value – initial option cost. • Stock at $35: • Long call: $0 – $3 = –$3. The option has no value, so the buyer loses the premium paid. • Short call: $3 – $0 = $3. Because the option has no value, the call writer’s gain equals the premium received. • Stock at $43: • Long call: –$3 + $3 = $0. The buyer paid $3 for the option, and it is now in the money by $3. Hence, the net profit is zero. • Short call: $3 – $3 = $0. The seller received $3 for writing the option and now faces a –$3 valuation because the buyer will exercise the option, for a net profit of zero. Solution: Call