Derivative Market Futures Forwards Options What is in today’s lecture? Introduction to Derivative Forward and Futures Financial Derivatives Various aspects of forwards Pricing of forward contracts Options Derivatives     In the last 20 years derivatives have become increasingly important in the world of finance In Pakistan derivative market was developed in 2001 Few banks like SCB, UBL and RBS are allowed by the SBP to deal in derivative transactions SBP regulates the OTC market for ◦ Foreign currency options ◦ Forward rate agreements ◦ Interest rate swaps Derivatives  A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables or asset. Types of Derivatives  Among many variations of derivative contracts, following are the major types: ◦ Forward contracts ◦ Future Contract ◦ Options Forward Contract • • • • Definition: an agreement to buy or sell an asset at a certain future time for a certain price A forward contract is traded in the overthe-counter market A party assuming to buy the underlying asset is said to have assumed a longposition The other party assumes a short-position and agrees to sell the asset A Real life example As you know next football world cup will be played in Brazil. Like South Africa did, Brazil will need to construct football stadiums, seating arrangements, parking areas etc which need heavy consumption of cement. Brazil does not have the required amount of cement, it will call many producers of cement to send their quotations to Brazil. If from Pakistan, Lucky cement company is short-listed and approved for export of cement to Brazil at $10 a bag, 500,000 bags by December 2011, it will be an example of forward contract  In the above contract, lucky cement has a short-position (sold cement now deliverable in future) and Brazil government has a long position  Example continued  The contract exposes lucky cement to few risks. ◦ If the cost of raw material increases, it cannot be passed on to the Brazil government ◦ If the value of rupee against dollar increases, Lucky cement will receive fewer rupees per dollar  To control these risks, lucky cement should use forward/future contracts (HOW?) Solution Lucky cement should buy raw material (coal, oil, chemicals) in advance through future contracts (i.e going long)  Lucky cement should sell dollars derivable in December 2009 (when it will receive them from Brazilian government)  Table Example-2 Suppose on July 20,2007 a US corporation knows that it will have to pay £1 million in 6 months  Risk: exchange rate fluctuations  6 months long forward contract at an exchange rate of $2.0489/£ (according to the previous table)  The bank has a short forward contract for selling £ at the rate of $2.0489/£ after 6 months  Payoffs from the forward contracts However if at the end of 6 months the spot rate becomes $1.9000/£  £1 million will be worth$1,900,000 in the open market whereas under the contract the company will be obligated to buy for $2,048,900  Here the worth of the forward contract will be ($148,900)  The company will be paying $148,900 more for £1 million pounds as compared to the open market  Payoffs from the forward contracts     However if at the end of 6 months the spot rate becomes $1.9000/£ £1 million will be worth$1,900,000 in the open market whereas under the contract the company will be obligated to buy for $2,048,900 Here the worth of the forward contract will be ($148,900) The company will be paying $148,900 more for £1 million pounds as compared to the open market Payoffs from the forward contracts  In general the payoff from the long forward contract on one unit of an asset is, here ST is the spot price and K is the delivery price locked in the forward contract  this shows that since we need to honor the contract so we buy the asset worth ST at the price K.  Payoffs from the forward contracts  Similarly the payoff from the short forward contract on one unit of an asset is,  These payoffs can be negative as well as positive In the example we considered, K = 2.0489 and the corporation has a long position. When ST = 2.1000, the payoff is $0.0511 per £1, and when ST = $1.900, it is -0.1489 per £1.  Graph for payoffs Exchange traded markets A derivatives exchange • A market where individuals trade standardized contracts that have been defined by the exchange • Exchange standardizes contracts with regard to: • • • • • • • • • • Number of units in one contract (quantity) Maturity (usually at the end of a month) Quality/ grade Delivery place Standardization increases liquidity but reduce flexibility Contracts on exchange are marked-to-market on daily basis Margin requirements (usually 5%) Margin call if margin falls due to losses Chicago Mercantile Exchange, NYMEX, NCEL in Pakistan Over the counter market        Contracts outside an organized exchange are traded in over the counter market In over the counter market, there is no standardization, the parties themselves agree on different aspects of the contract Contracts in OTC are flexible, but not liquid Chances of default are comparatively higher in OTC as contracts are not marked-to-themarket The aggrieved party can go to court against the defaulting party In OTC market financial institutions act as market makers OTC market is larger than the exchanges Pros and cons of forward contracts  PROS ◦ Flexibility  CONS ◦ Lack of marketability ◦ Lack of liquidity ◦ High default risk Forward prices and spot prices Consider a non dividend paying stock having a spot price of $60 and the 1 year interest rate prevailing in market is 5%. What should be the forward price for this stock?  Simple this spot price of $60 grosses up by 5% making the forward price equal to $63. this would be the theoretical forward price. Now if the forward market price $67, this indicates that the stock is not fairly priced and the arbitrage can be done. How?  If forward market is $67  If the forward market is $58  Future Contracts • • The exchange provides a mechanism that gives the two parties a guarantee that the contract will be honored. Futures contracts are traded on organized exchanges that are standardize – the size of the contract, – the grade of the deliverable asset, – the delivery month, – and the delivery location. • Traders negotiate only over the contract price. Characteristics of future contracts         Standardized Highly liquid Continuously Tradable – tradable even after bought or sold future contracts are marked to market every day. Margin requirements Margin Mechanism (Book Example) Future prices established on the basis of demand and supply forces If more traders enter as long in the future contracts than as short than the prices go up and vice versa. Options Option is a right to buy or sell a stated number of shares(or other assets) within a specified period at a specified price  There are two types of option contracts: ◦ Put option ◦ Call option  Put option  A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.  Options (Contd.) Call Option:  A call option gives the holder the right to buy the underlying asset by a certain date for a certain price.  The price in the contract is known as the exercise price or strike price;  The date in the contract is known as the expiration date or maturity  American and European options  Table: Prices of options Inferences from the table The price of the call option decreases as the strike price increases  The price of a put option increases as the strike price increases  Options become valuable as the maturity increases so the price also increases  Numerical example to buy one April call option contract on Intel with a strike price of $20.00?  Numerical example to buy one April put option contract on Intel with a strike price of $17.50? (size of 1 contract = 100 shares)  Graphical Representation of profits from option contracts Participants in Options markets       Buyers of calls……….long call option contract Sellers of calls……….short call option contracts or call option writer Buyers of put………..long put option contracts Sellers of put………..short put option contract Intention of call option writer………..the prices of underlying assets will decrease Intention of call option buyer……….the prices of underlying assets will increases Participants in Options markets (Contd.) Intention of put option writer………..the prices of underlying assets will increase  Intention of put option buyer……….the prices of underlying assets will decrease  Some more jargons related to options If price of the common stock S exceeds the exercise price of a call, E, the call is said to be in the money  If the price of common stocks is less than the exercise price, it is said to be out of money  if the price of common stock is equal to the exercise price, it is said to be at the money 