Professional Documents
Culture Documents
1.1
Principals
Teaching Assistant(s)
Huang, Qiushun (qhuang13@jhu.edu)
Office Hours: Friday 4pm 6pm
Schedule
Lecture Encounters
Monday & Wednesday, 3:00 - 4:15pm, Mergenthaler 111
Section
Section 1: Friday 3:00 - 3:50pm, Hodson 211 Section 2: Thursday 3:00 - 3:50pm, WH 304
1.3
Protocol
Attendance
Lecture Mandatory (default) for MSE Fin Math majors
Quizzes & Clickers
Assignments
Due as Scheduled (for full credit)
Must be handed in to avoid incomplete
Resources
Textbook
John C Hull: Options, Futures, and Other Derivatives, Prentice-Hall 2012 (8e)
Recommended: Student Solutions Manual
1.5
Resources
Supplemental Material
As directed
AMS Website
http://jesse.ams.jhu.edu/~daudley/444 Additional Subject Material
Class Resources & Lecture Slides
Blackboard
1.6
Measures of Performance
Mid Term Exam (~1/3 of grade) Final Exam (~1/3 of grade) Home work as assigned and designated and Quizzes (~1/3 of grade)
1.7
Assignment
1.8
Assignment
1.9
Terminology
Assets things we own (long) Liabilities what we owe (short)
1.10
True Assets A house, a company, oil, Ownership rights, contracts, & other legal instruments which represent the true asset
For us, many are indistinguishable from the asset; are the asset Provide properties that can be quantified, assigned, subordinated and made contingent Can be modeled
1.11
Investors Under the Watchful Eyes of Regulators, Professional Associations and the Rule of Law
1.12
Collateral
Make Markets
Investment Banking
Institutional Investors
1.13
Cash Flow
Cash flow diagram
Receive vs. Pay over Time
Receive
Payoff Cashflow
Payoff diagram
Gain vs. Loss against Price
Gain
S, Price
K
Loss
1.14
Japanese Bank; borrow US dollars (USD) to loan to its customers; term, 3 months Go to Euromarket where it might be able to get an Interbank Loan
Receive (Borrow) USD t0 + T t0 Pay Back USD+Lt0x(.25)xUSD T = 1/4 year Lt0 = 3 month interest rate in effect at t0
1.15
What if Bank did not have credit line? Could perform the same transaction as a Synthetic in the FX and domestic Yen mkt
Borrow Yen in local mkt for term T, at L(t0,Y) Sell Yen and buy USD in spot FX mkt at e(t0,Y) Finally, the bank buys Yen and sells USD in the forward FX market for delivery at t0+T
1.16
USD Y
Yx(1+L(t0,Y)xT)
Buy Y forward for t0+T Y x (1 + L(t0,Y)xT) = f(t0,T;Y) x USD1 USD1 = USD x (1 + L(t0,$) x T)
=
USD
USDx(1+L(t0,$)xT)
The synthetic can be used to price the derivative, excredit risk (whats the derivative in this example?) Each side could be the others hedge Different markets involve many legal & regulatory differences
1.18
Situation:
In Sept 02, investor bought asset S, S0=$100 EOM Nov, asset target reached at $150 (sell) Sale yields gain of $50 (taxable) Wash-Sale Rule prohibits:
Sell winner at $50 gain Sell another asset, Z thats down $50 to $50 to offset gain Buy asset Z back next day as investor still likes it Prohibited since trade is intentionally washing gain
1.19
S0
S
1.21
Short Call
+
Long Put
50 Z +
Synthetic Short in Z
50 Z
1.24
Strategies are Risk Free and Zero Cost (aside from commissions and fees) We created a Synthetic (using Derivatives) and used it to provide a solution Finally, and most important, these examples display the crucial role Legal & Regulatory frameworks can play in engineering a financial strategy (its the environment)
1.25
Manufacturer (Dealer) vs. User (Investor) Dealers View: there are two prices
A price he will buy from you (low) A price he will sell to you (high) Its how the dealer makes money
Dealers prefer to work with instruments that have zero value at initiation (x bid/ask)
Likely more liquid No principal risk
Regulators, Professional Organizations, and the Law are more important for market professionals than investors
Dealers vs. Investors
1.27
A derivative is an instrument whose value depends on the values of other more basic underlying variables
1.28
Examples of Derivatives
1.29
Derivatives Markets
Exchange traded
Traditionally exchanges have used the openoutcry system, but increasingly they are switching to electronic trading Contracts are standard; virtually no credit risk
Over-the-counter (OTC)
A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard and there is some (small) amount of credit risk
1.30
Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market 1.31
To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another
1.32
Forward Price
The forward price (for a contract) is the delivery price that would be applicable to a forward contract if were negotiated today (i.e., the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities
1.33
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
1.34
Example
On May 24, 2010 the treasurer of a 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?
1.35
1.37
3-month forward
6-month forward
1.4410
1.4416
1.4415
1.4422
1.38
Foreign Exchange Quotes for JPY Jan 22, 2007 (16:23 EST)
Bid 121.62 121.08 Offer 121.63 121.09
3-month forward
6-month forward
120.17
118.75
120.18
118.77
1.39
1.40
1.41
If the spot price of gold is S(t0) and the forward price for a contract deliverable in T years is F(t0,T), then Can borrow money, buy gold, and sell the commodity forward - where there should be no arbitrage:
where r is the 1-year money rate of interest to finance the gold carry trade. In our examples, S = 900, T = 1, and r =0.05 so that F(t0,T) = 900(1+0.05) = 945 The no arbitrage 1 year forward price of gold is $945
1.42
Borrow S(t0)
S(t0)x(1+r)
+
Gold
+
F(t0) Gold
=
Own Deliver Gold Gold
Gold Arbitrage?
Futures Contracts
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
1.45
Futures Contracts
Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are particularly popular on currencies and interest rates
1.46
Chicago Board of Trade (CME) Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book)
1.47
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)
1.49
An American style option can be exercised at any time during its life A European style option can be exercised only at maturity
1.50
22.50
25.00
0.075
0.025
0.375
0.125
0.725
0.275
2.950
5.450
3.100
5.450
3.300
5.450
1.51
Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) and many more (see list at end of book)
1.52
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
1.53
Types of Traders
Hedgers
Speculators Arbitrageurs
Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators (See, for example, SocGen (Jerome Kerviel) in Business Snapshot 1.3, page 17)
1.54
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 two-month put option with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts
1.55
Hedging Example
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 Possible strategies:
Buy now, deposit in bank, withdraw 10 million in 3 months, pay for imports Buy 10 million forward in 3 months, deposit USD, use deposit proceeds to settle and pay for imports Do nothing now and buy 10 million in the spot FX market in 3 months
First 2 are riskless, third has currency risk. Which makes most sense?
1.56
1.57
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?
1.58
Arbitrage Example
A stock price is quoted as 100 in London and $140 in New York The current exchange rate is 1.4410 What is the arbitrage opportunity? Buy 100 shares in NY; sell 100 in London
= 100 [(1.441 x 100) 140] = 410
1.59
Futures Contracts
Settled daily
1.60
Margins
The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract
1.62
1.63
A Possible Outcome
Table 2.1, Page 28
1.64
They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity
1.65
It is becoming increasingly common for contracts to be collateralized in OTC markets They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)
1.66
To this point we have neglected storage cost Lets re-visit no-arbitrage equation
F(t0,T) - S(t0) x [(1+r )T ] = Storage (T)
Storage costs ignored in earlier gold example No storage costs for FX Convenience Yield
1.67
Futures Prices for Gold on Jan 8, 2007: Prices Increase with Maturity
650
1.70
Futures Prices for Orange Juice on Jan 8, 2007: Prices Decrease with Maturity
195
190 185 180 175 170 Jan-07 Mar-07 May-07 Jul-07
1.71
Delivery
If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash
1.72
Some Terminology
Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of contracts traded in 1 day
1.73
Time
Time
(a)
(b)
1.74
Questions
When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest?
1.75
Regulation of Futures
Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups
NFA the industry
1.76
Questions?
1.77