Financial Markets and Institutions Week 10 - Derivatives
Option Styles
American-style option •Can be exercised at any time up to the expiration date European-style option •The name has nothing to do with the national origins of the reference securities or the options themselves
What is a derivative security
Derivative Security- a financial instrument whose value is derived from the value of the underlying asset. Futures, forwards, options and swaps are some common types of derivative instruments. They are one of the important components of the financial system. Derivative is basically a financial contract between two parties(Buyer and Seller of the contract) who agree to enter into a transaction of buying or selling the contract at a specific price on a predetermined time period. The contract can be on a purchase or sale of an asset, property, commodity, stock, currency or other security. Derivative securities can be traded over-the-counter(OTC) or on standardized stock exchanges. OTC derivatives involve high risk as compared to the exchange traded derivatives. Value from underlying asset. These underlying assets are traded separately in the market. The most common underlying assets are stocks, currency, bonds and commodities. Derivative contracts are basically used for gaining leverage and for hedging.
What is an option? How does an option differ from a forward or futures contract?
Option- a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a prespecified price for a prespecified time period. Key difference is that option has no obligation to trade whereas futures and forwards are legally binding. However, forwards and futures pay nothing at the time of the agreement.
Clearinghouse
•The unit that oversees trading on the exchange and guarantees all trades made by the exchange
What are the differences between a cap, a floor, and a collar? When would a firm enter any of these derivative security positions?
Cap- actually a limitation just like a stop loss. It creates a maximum limit say for interest rate so that higher interest liability can be avoided. EX: if a person has taken a loan on floating rates of LIBOR and he buys a cap for 5%, then if the interest rate increases above 5%, he will get the amount equal to excess paid by him above 5% Floor- sets a base level interest rate. It is the least rate of interest that the lender will expect to earn in case of failing interest rates EX: Lender lends to LIBOR and buys a floor of 3.5%. If LIBOR falls below 3.5%, the lender will receive the balance amount from the seller of the floor, making his effective interest earning approx. equals 3.5% Collar- mix of cap and floor. It includes the feature of both the cap and floor. The investor can fix the higher limit as well as the lower limit. This will create a band or say a range within which the interest rate will fluctuate. Using this, high fluctuation can be avoided A firm would enter into these derivative securities when there is a high level of uncertainty or fluctuations in the interest rate market. These derivatives will work as an effective hedge against the flux's in the interest rates.
What are the three ways on option holder can liquidate his or her position?
Closing Position- Once the option contract is bought or sold, the trader can hold the contract till maturity. If the trader wants to get out of the position before maturity he or she will square off the position by closing the contract before the expiry period. Exercise- Exercising option means buying or selling the underlying asset of the option contract. It means exercising the right to buy or sell the contract on the expiry day Expire- On mentioned expiry date, if the option contract is not exercised and is still with the holder of the contract, it is considered as an expired contract. On expiry the left over value of the contract is transferred to buyer's account and the seller has to pay the amount. Most of the option contracts are closed by the traders rather than exercising or waiting till expiry. Few contracts are actually excerised.
An American firm has British pound- denomination accounts payable on its balance sheet. Managers believe the exchange rate of British pounds to US Dollars will depreciate before the accounts will be paid. What type of currency swap should the firm enter?
Currency swap has the following main uses: -to buy debt at cheaper rate -to hedge against exchange rate flux's -to convert a liability in one currency to other currency -to convert an asset in one currency to other currency Thus, the American firm will convert the fixed rate liability to floating rate liability by swapping the contract. Hence, the American firm will take the Fixed for-Floating currency swap to protect itself from the floating rate risk
A commercial bank has fixed-rate, long term loans in its asset portfolio and variable-rate CDs in its liability portfolio. Bank managers believe interest rates will increase in the future. What side of a fixed-floating rate swap would the commercial bank need to take to protect against this interest rate risk?
Bank would pay fixed and receive floating. The bank would earn fixed rate on its assets but would have to pay variable rates on its' liabilities. Bank would want to protect against this. Bank would want to receive variable or floating and pay fixed. Basically what the bank would receive from the loan, it would pass on to the counterparty of the swap and what it would receive from swap would pass on on to the CD investors. Here in, the spread over LIBOR it would receive in swap compared to the spread over LIBOR it would pay to the CD investor, and fixed rate it would receive from loan compared to the fixed rate it would pay in the swap would determine net profit/loss
What is the meaning of a Treasury Bond futures price quote of 103-13?
Bond- known as a debentures. Bonds are kind of a debt investment, under which the amount is paid by the investor for the purchase of bonds and are shown on the liability side of the issuer. They carry a fixed or variable rate of interest payable at the end of period by the issuer which is mentioned in the instrument. Treasury Bonds- bonds issued by the government or public sector undertaking to raise funds. Guaranteed by the government. these are issued at a discount and redeemed at face value. Interest is not payable on these bonds. The treasury bond quote of 103-13 provides that the buying price of the bond is $103 against its face value of $100 and the interest rate is 13%
What are the differences among a spot contract, a forward contract, and a futures contract?
Futures contract- Agreement between a buyer and seller at time 0 to exchange a standardized asset for cash at some future date. Each contract has a standardized expiration and transactions occur in a centralized market. The price of the futures contract changes daily as the market value of the asset underlying the futures fluctuates. Forward contract- Agreement between a buyer and seller at time 0 to exchange a nonstandardized asset for cash at some future date. The details of the asset and the price to be paid at the forward contract expiration date are set at time 0. the price of the forward contract is fixed over the life of the contract. Spot Contract- an agreement between a buyer and a seller at time 0, when the seller of the asset agrees to deliver it immediately and the buyer agrees to pay for that asset immediately.
What is the difference between an interest rate swap and a currency swap?
Interest rate swaps- Most common swap. Generally when an individual or a firm is in need of money, it will look for some sources to barrow. However, a borrower will look for sources charging a cheaper interest rate. A swap can transform a fixed rate into floating rate and vice versa, which makes it easier for the borrower as well as the lender to benefit from the transaction. Currency swap- Same as interest rate risk where the borrower and the lender have a comparative advantage. Here, loan is taken in one currency and is paid in other currency. It is generally used for hedging.
What is a swap?
It is a contract where financial instruments are exchanged for a certain time period. Generally, banks act as an intermediary in swap trading. The most common types of swaps: -interest rate swaps -currency swaps -Inflation swaps -commodity swaps
What is the purpose of requiring a margin on a futures or options transaction? What is the difference between an initial margin and a maintenance margin?
Money Margin- It is a good faith deposit one needs to deposit with the exchange to control a futures or options contract. It is the amount of cash which acts as a down payment on the underlying asset and it helps ensure that both parties are able to fulfill their obligations on the date settlement. In derivatives markets, the sale and purchase of shares are able to be settled on a future date and there is only a contract executed in the current. Therefore if a client occurs loss at the future date there may arise a situation of default of non-payment. To curb these stock exchanges have certain regulations related to margin. There are two types of margin that are deducted from the account of the traders when they enter into a future or options transactions( initial margin and maintenance margin) Initial Margin- Post only a portion of the value of the futures(and options) contracts any time they request a trade. Minimum margin levels are set by each exchange. Maintenance Margin- The margin a futures trader must maintain once a futures position is taken. If losses on the customer's futures position occur and level of the funds in the margin account drop below the maintenance margin, a customer is required to deposit additional funds into his margin account, bringing the balance back up to the initial margin.
What are the functions of floor brokers and professional traders on the futures exchange? 10-1
Only futures exchange members are allowed to transact on futures exchanges. Trades from public are placed with floor brokers. When the order is placed, a floor broker may trade with another floor broker or with a professional trader. Professional traders- similar to designated market makers on the stock exchanges in that they trade for their own account. Professional traders are also referred to as position traders, day traders, or scalpers. Position traders- take a position in the futures market based on their expectations about the future direction of prices of the underlying assets. Day traders- generally take a position within a day and liquidate it before the days' end. Scalpers- take positions for very short periods of time, sometimes only minutes, in an attempt to profit from this active trading.
Who are the major regulators of futures and options markets?
The stock market overall is regulated by the SEC. This is an independent commission that prevents all the malicious practices in the stock market. Apart from SEC, there is a commission that specifically regulates the futures market. The primary regulator of futures markets is the Commodity Futures Trading Commission (CFTC)The purpose of this org is to protect investors from unfair dealings or misrepresentations. It works to stop the manipulation in the future market. The options market, however is under the surveillance of SEC. The above-mentioned departments are statutory departments whose directions are equivalents to laws. Together with these regulation stock exchanges where the trading actually takes place also formulates some rules and norms to be followed by all the participant of the market
What must happen to the price of the underlying T-bond futures contract for the purchaser of a call option on T-bond futures to make money? How does the writer of the call option make money?
The writer of the call option means the seller of the call options. When the price of an asset increases the seller will have the obligation to fulfill the transaction that means he has to bear the losses but if the price of the underlying asset goes down then the buyer of the call option will not exercise his option to buy. Therefore, the profit of a seller of a call option is limited to the amount of premium he received for selling the option.
What factors affect the value of an option?
1. The prevailing market price of the securities on the spot for which option has been provided 2. The strike price of the option at which the option shall be exercised, that is related to the market price of the security in the market 3. The cost or recovery from holding a position in the contract, including interests on the amount invested or paid as premium and dividends if any received 4. The time to expiration. It is very important factor which differentiates the price at same strike price according to the period of expiration
What is the difference between a call option and a put option?
Call Option- gives the purchaser(buyer) the right to buy an underlying asset at a prespecified price called an exercise or strike price. In return, the buyer of the call option must pay the writer(seller) an up-front fee known as a call premium. Put Option- Gives the option buyer the right to sell an underlying security at a prespecified price to the writer of the put option. In return, the buyer of the put option must pay the writer the put premium
What must happen to the price of the underlying stock for the purchaser of a put option on the stock to make money? How does the writer of the put option make money?
If the underlying stock's price is less than the exercise price, the buyer will buy the underlying stock in the market at less than X is currently trading and then sell the stock immediately by exercising the put option. If the price of the underlying stock is greater than X, the buyer of the put option would not exercise the option.
Which party is the swap buyer and which is the swap seller in an interest rate swap transaction?
Swap buyer is the party who is having the fixed rate cash flows in the contract and wants to exchange it for a floating rate. Swap buyer party is also called the party that longs for the swap Swap seller is the party who has the floating cash flows in the contract and wants to exchange it for a fixed amount. Swap seller party is also called the party that shorts the swap
When is a futures or options trader in a long versus short position in the derivatives contract?
long position- order for the purchase of the futures or options contract short position- is an order for a sale of the futures contract
The intrinsic value of an option is the difference between an option's exercise price and the underlying asset price
•The intrinsic value of a call option = max{S - X, 0} •The intrinsic value of a put option = max{X - S, 0}
The Black-Scholes option pricing model (the model most commonly used to price and value options) is a function of:
•The spot price of the underlying asset •The exercise price on the option •The option's exercise date •The price volatility of the underlying asset •The risk-free rate of interest
Open interest
•The total number of the futures, put options, or call options outstanding at the beginning of the day •Contracts that have not been settled (e.g., more long positions than short positions)
