Derivative Markets - Introduction to Derivatives - Lecture Slides | FINA 4210, Study notes of Finance

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Derivatives Markets Purpose: Discuss the structure and function of derivatives markets Background n Derivatives u A derivative is a financial instrument whose return is derived from the return on another instrument. n The Underlying Asset u Called the underlying u A derivative derives its value from the underlying n Size of the derivatives market at year-end 2001 u $111 trillion notional principal u $3.8 trillion market value Background n The Storage Mechanism: Spreading Consumption across Time n Delivery and Settlement Placing an Order n pit n open outcry n electronic systems Futures Markets n Futures Contracts u Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default u Exclusively traded on a futures exchange Swap Market n Swaps u Definition of a swap: a contract in which two parties agree to exchange a series of cash flows u Exclusively over-the-counter u Other types of derivatives include swaptions and hybrids. Their creation is a process called financial engineering The futures game has a long history n In Europe u Futures trading since the 1600s n In North America u Commodity trading mechanisms originated in colonial times u Today’s organized futures exchanges trace their roots back to the early 1800s Large variety of futures contracts now being traded n fungible agricultural commodities n petroleum products n metals (precious and otherwise) n T-bills, T-bonds, and other financial contracts n currencies n indices Other possibilities in the next twenty years: n bulk freight rates n more stock market indices n inflation indices n GNP series, real estate indices, and other economic indicators n perhaps even electronic components The basics of futures trading n warehouse receipts n spot price n futures contract terms n futures price n basis n basis risk Clearinghouse n Clearinghouse holds all margin deposits n This amount equals twice the amount that is exposed to risk n Ancestors of modern clearinghouses are also the ancestors of central banks Summary, Mechanics of Futures Trading n daily settlement n initial margin n maintenance margin n concept of “margin” vs. performance bond n settlement price n variation margin n open interest The cast of characters in the futures game n Hedgers n Speculators n Arbitrageurs Hedgers: n They want to reduce their business risks n They trade risks with one another n There is a long history Speculators: n People with valuable information are naturally attracted to futures trading n What good do they do? u Informed speculators enhance pricing efficiency u Uninformed speculators contribute liquidity Arbitrageurs: n People with access to several marketplaces n Look for imbalances u profit from them as they arise n What good do they do? u quickly eliminate imbalances What are options? n Options are financial contracts whose value is contingent upon the value of some underlying asset n Such arrangements are also known as contingent claims u because equilibrium market value of an option moves in direct association with the market value of its underlying asset. n OPT measures this linkage Everyday examples of options n rain check n discount coupon n airline ticket with cancellation right n right to drop a course The basics of options Calls and puts defined n Call: privilege of buying the underlying asset at a specified price and time n Put: privilege of selling the underlying asset at a specified price and time The basics of options Regional differences n American options can be exercised anytime before expiration date n European options can be exercised only on the expiration date n Asian options are settled based on average price of underlying asset The basics of options n Options may be allowed to expire without exercising them n Options game has a long history u at least as old as the “premium game” of 17th century Amsterdam u developed from an even older “time game” F which evolved into modern futures markets F and spawned modern central banks Option Traders n The Market Maker u Bid, ask, and bid-ask spread u Scalpers, position traders, spreaders n The Floor Broker u Designated primary market makers u Dual trading n The Order Book Official u Limit orders u Electronic order processing Option Price Quotations n See web sites of newspapers and options exchanges n Problems u Delayed information u Nonsynchronized prices Types of Options n Stock Options n Index Options n Currency Options n Other Types of Traded Options u interest rate options u currency options u options attached to bonds u exotic options u warrants, callable bonds, convertible bonds u executive options Put-Call Parity Consider two portfolios • Portfolio A contains a call and a bond: C(S,X,t) + B(X,t) • Portfolio B contains stock plus put: S + P(S,X,t) Put-Call Parity Consider two portfolios • Portfolio A contains a call and a bond: C(S,X,t) + B(X,t) • Portfolio B contains stock plus put: S + P(S,X,t) S*<X S*>X VA 0 +X =X S-X +X =S VB X-S +S =X 0 +S =S Put-Call Parity C(S,X,t) + B(X,t) = S + P(S,X,t) n News leaks about negative event n Informed traders sell calls and buy puts