Ngân hàng, tín dụng - Chapter 9: Demystifying derivatives
What Determines Option Premiums? (Cont.)
– Premiums on put options will be higher the lower
the price of the underlying asset, greater volatility of
asset and longer time to expiration
– Options are an expensive way to hedge portfolio
risks if those risks are substantial
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1Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Chapter 9
Demystifying
Derivatives
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-2
Learning Objectives
• Visualize the structure of future market
• Describe how future contracts can be used to
diversity portfolios
• Understand option contracts and their use in
diversifying portfolios
• Recognize swap contracts and see their ability to
limit interest rate risk
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-3
Introduction
• Futures, options, and swaps are complicated
instruments
• However, they have found their way into the
risk management options of just about every
major financial institution
• Derivatives—A financial instrument/contract
that derives its value from some other
underlying asset
2Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-4
An Overview of Financial Futures
• Future Contract is a contractual agreement that calls
for delivery of a specific underlying commodity or
security at some future date at a currently agreed-upon
price
• There are contracts on interest-bearing securities
(Treasury bonds, notes, etc), on stock indices (Standard
& Poors’ and Japan’s Nikkei index), and on foreign
currencies
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-5
An Overview of Financial Futures
(Cont.)
• Trading in these contracts is conducted on the
various commodity exchanges
• Financial futures were introduced about 35 years
ago and volume now exceeds the more
traditional agricultural commodities
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-6
An Overview of Financial Futures
(Cont.)
• Characteristics of Financial Futures
– Standardized agreement to buy/sell a particular asset
or commodity at a future date and a current agreed-
upon price
• Designed to promote liquidity—the ability to buy and sell
quickly with low transactions costs
• Promotes large trading volume which narrows the bid-
asked spreads
• Allows many individuals to trade the identical commodity
3Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-7
An Overview of Financial Futures
(Cont.)
• Characteristics of Financial Futures (Cont.)
– Terms specify the amount and type of asset as well
as the location and delivery period
• Financial futures—underlying asset is either a specific
security or cash value of a group of securities
• Stock index futures—contract calls for the delivery of the
cash value of a particular stock index
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-8
An Overview of Financial Futures
(Cont.)
• Characteristics of Financial Futures (Cont.)
– Precise terms of each contract are established by the
exchange that sponsors trading in the contracts
– Seller of the contract has the right and obligation to deliver
the securities at a specified time
– In futures markets, the buyer of the contract is called long and
the seller is called short
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-9
An Overview of Financial Futures
(Cont.)
• Characteristics of Financial Futures (Cont.)
– The only matter left for negotiations is the price at which
the securities will be delivered
– This price is determined by bidding and offering that occurs
at the location (pit) of the exchange sponsoring the auction
– The auction process insures that all orders are exposed to
highest bid and lowest offer, guaranteeing execution at the
best possible price
4Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-10
An Overview of Financial Futures
(Cont.)
• Characteristics of Financial Futures (Cont.)
– Once the contract has been agreed upon, the clearing
corporation associated with the exchange acts as a
middleman in the transaction
• The clearing corporation satisfies the contractual agreement of the
long and short
• They reduce the credit risk exposure associated with future deliveries
• Longs and shorts do not have to worry that the other party will not
perform their contractual obligations
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-11
An Overview of Financial Futures
(Cont.)
• Characteristics of Financial Futures (Cont.)
– Clearing Corporation (Cont.)
• Requires the short and long to place a deposit (Margin)
which is a performance bond for both the seller and buyer
• Requires that gains and losses be settled each day in the
mark-to-market operation
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-12
An Overview of Financial Futures
(Cont.)
• Characteristics of Financial Futures (Cont.)
– To insure the obligations are met at the delivery date, most
trades in futures market choose settlement by offset rather
than delivery
• Both parties make offsetting sales/purchases to cover the contract
• Permits hedgers, speculators, and arbitrageurs to make legitimate use
of the futures market without getting into technical details of making
or taking delivery of assets
5Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-13
An Overview of Financial Futures
(Cont.)
• Using Financial Futures Contracts
– Provides the opportunity to hedge legitimate commercial
activities
– Hedgers—buy and sell futures contracts to reduce their
exposure to the risk of future price movement
– Permits dealers to cover both the short and long position of a
contract
– Reduces risk since future prices move almost in lockstep with
the price of the underlying asset
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-14
An Overview of Financial Futures
(Cont.)
• Using Financial Futures Contracts (Cont.)
– Legitimate hedging use of the futures markets occurs with
a sale of a futures contract with a subsequent offset
purchase
– “Short hedgers” offset inventory risk by selling futures while
“long hedgers” offset anticipated purchases of securities by
buying futures
– Speculators
• Purposely take on risk of price movement
• Expect to make a profit on the risky transaction
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-15
An Overview of Financial Futures
(Cont.)
• Pricing Financial Futures Contracts
– Buying and selling activities of hedgers and
speculators together determine the price of a futures
contract
– There is a definite relationship between the price of a
futures contract and the price of the underlying asset
6Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-16
An Overview of Financial Futures
(Cont.)
• Pricing Financial Futures Contracts (Cont.)
– Arbitrageurs
• Determine the relationship between the price in the “cash
market” and the price in the futures market
• During the delivery period of a futures contract, the rights
and obligations of the contract force the price of the
futures contract and the price of the underlying security to
be identical
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-17
An Overview of Financial Futures
(Cont.)
• Pricing Financial Futures Contracts (Cont.)
– Arbitrageurs (Cont.)
• If the arbitrageur senses the price relationship between the futures
contract and the underlying asset is not correct, take actions in the
market (buy or sell) to make a profit which forces the prices into
proper relationship
• The activities of arbitrageurs cause the prices to converge on the
delivery date or be in proper alignment during periods prior to
final delivery date
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-18
An Overview of Options Contracts
• Options contracts have both a shorter and
longer history in financial markets than futures
contracts
– Options on individual stocks have been traded in
over-the-counter market since nineteenth century
– Increased visibility in 1972 when the Chicago Board
Options Exchange (CBOE) standardized terms of
contracts and introduced futures-type pit trading
– Listed on most of major future exchange markets
7Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-19
An Overview of Options Contracts
(Cont.)
• Contractual Obligations
– More complicated than futures contracts
– Derive their value from some underlying asset
• A specified number of shares of a particular stock
• Stock Index Option—Basket of equities represented by
some overall stock index such as S&P 500
• In options on future contracts, the contractual obligations
call for delivery of one futures contract
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-20
An Overview of Options Contracts
(Cont.)
• Contractual Obligations (Cont.)
– Calls
• Buyer of a call option has the right (not obligation) to
buy a given quantity of the underlying asset at a
predetermined price (exercise or strike) at any time prior
to the expiration date
• Once order is executed, the buyer is long in the asset
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-21
An Overview of Options Contracts
(Cont.)
• Contractual Obligations (Cont.)
– Calls (Cont.)
• Seller of the call option (short) has the obligation to
deliver the asset at the agreed price
• Therefore, rights and obligations of option buyers and
sellers are not symmetrical
• Buyer of the call option pays a price to the seller for the
rights acquired (option premium)
8Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-22
An Overview of Options Contracts
(Cont.)
• Contractual Obligations (Cont.)
– Puts
• Buyer of a put option has the right (not obligation) to sell
a given quantity of the underlying asset at a predetermined
price before the expiration date
• Seller of the option (short) has the obligation to buy the
asset at the agreed price
• The buyer of the put option pays a premium to the seller
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-23
An Overview of Options Contracts
(Cont.)
• Contractual Obligations (Cont.)
– Summary of calls and puts
• Option buyers have rights; option sellers have obligations
• Call buyers have the right to buy the underlying asset
• Put buyers have the right to sell the asset
• In both puts and calls the option buyer pays a premium to
the option seller
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-24
An Overview of Options Contracts
(Cont.)
• Contractual Obligations (Cont.)
– The exchange sponsoring the options trading established rules
for trading
– Standardization is designed to generate interest by potential
traders, thereby contract liquidity
– Clearing Corporation
• Guarantees the performance of contractual obligations
• Buyers and sellers do not have to be concerned with creditworthiness
of their trading partners
– Only matter up for negotiation is option premium—price
buyer pays to seller for rights
9Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-25
An Overview of Options Contracts
(Cont.)
• Using and Valuing Options
– Investors who buy options (puts or calls) have rights,
but no obligations
– Therefore, option buyers will do whatever is in their
best interest on expiration date
– On expiration date, payoff on expiration of a long
call position is either zero (price below exercise
price) or stock price minus exercise price (intrinsic
value) (price above the exercise price)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-26
An Overview of Options Contracts
(Cont.)
• Using and Valuing Options (Cont.)
– A long put position on expiration date has a value
of zero if price is above the exercise price or a value
equal to the exercise price minus the stock price if
price is below the exercise price
– Option Premium—The asymmetry payoff has the
characteristic of insurance which is why the
premium is charged on the transaction
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-27
An Overview of Options Contracts
(Cont.)
• What Determines Option Premiums?
– Both hedgers and speculators will purchase options
and pay the premium
– Option premiums are determined by supply and
demand
– Call options are worth more (higher premiums) the
higher the price and the greater the volatility of the
underlying asset, and the longer the time to
expiration of the option
10
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-28
An Overview of Options Contracts
(Cont.)
• What Determines Option Premiums? (Cont.)
– Premiums on put options will be higher the lower
the price of the underlying asset, greater volatility of
asset and longer time to expiration
– Options are an expensive way to hedge portfolio
risks if those risks are substantial
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-29
An Overview of Swaps
• Compared to other financial instruments, Swaps
are relatively new having been introduced in
1981 to help firms reduce interest rate risks
• Two broad varieties—Interest rate swaps and
currency swaps
• Swaps are contractual agreement between two
parties (counterparties) and customized to meet
the requirements of both parties
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-30
An Overview of Swaps (Cont.)
• Interest rate swap
(Refer to Figure 9.1)
– One party (fixed-rate payer) agrees to pay the other
party a fixed interest amount each specified period
over the life of the contract
– The other party (floating-rate payer) agrees to pay
the first party, each specified period, an interest
amount based on some reference rate
11
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-31
FIGURE 9.1 Obligations of payments every
six months for the duration of the swap.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-32
An Overview of Swaps (Cont.)
• Interest rate swap (Cont.)
– Therefore, the fixed-rate payer always pays the
same amount while payments by the floating-rate
payer varies according to the reference rate
– The dollar amount of the payments is determined by
multiplying the interest rate by an agreed-upon
principal (notional principal amount)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-33
An Overview of Swaps (Cont.)
• What determines the rates paid by both parties
– Shape of the yield curve—expected rates in the
future
– Risk of default—possibility that counterparties
might default on scheduled interest payments
• Financial institutions facilitate swaps
– Bring the counterparties together
– Impose their own credit between the counterparties
12
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-34
An Overview of Swaps (Cont.)
• Why Swap?
– Financial institution earns a fee for arranging the
swap
– Counterparties reduce their risk exposure
– Able to undo maturity mismatches in the balance
sheets of the counterparties
– However, swaps can generate losses when one of the
counterparties is really a speculator rather than
trying to hedge to cover risk
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-35
An Overview of Swaps (Cont.)
• Valuing a Swap
– Contracts are traded in over-the-counter market
– It is possible for one of the counterparties to sell their
obligation to another party
– Changing market conditions may cause one party to sell
obligation
– The third party will purchase the swap if it is to their
advantage
– Therefore, swaps produce gains or losses which will ultimate
impact the value of the swap
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