Chapter 9
Defining Derivatives
A derivative is a financial instrument whose value depends on, is derived from, the value of some other financial instrument, call the underlying asset. Derivatives are different from outright purchases because: 1. Derivatives provide an easy way for investors to profit from price declines. 2. In a derivatives transaction, one person's loss is always another person's gain. While derivatives can be used to speculate, or gamble on future price movements, they allow investors to manage and reduce risk. - Farmers use derivatives regularly to insure themselves against fluctuations in the price of their crops. The purpose of derivatives is to transfer risk from one person or firm to another. By shifting risk to those willing and able to bear it, derivatives increase the risk-carrying capacity of the economy as a whole. - This improves the allocation of resources and increase the level of output. (e.g. airlines would continue to grow despite increase in the jet fuel prices) The downside is that derivatives also allow individuals and firms to conceal the true nature of certain financial transactions. (e.g Fund manager buying stocks with put protection)
Pricing Options: Intrinsic Value and the Time Value of the Option
An option has two parts: 1. Intrinsic value - the value of the option if it is exercised immediately, and 2. Time value of the option - the fee paid for the option's potential benefits. - Option price = Intrinsic value + time value of the option We can calculate the time value of the option by calculating the expected present value of the payoff. - For a call option, we take the probability of a favorable outcome (a higher price), times the payoff. - Increasing the standard deviation of the stock price, an increase in volatility, increases the option's time value.
The Value of Options: What Can we Discover?
At a given price of the underlying asset and time to expiration, the higher the strike price of a call option, the lower its intrinsic value and the less expensive the option. At a given price of the underlying asset and time to expiration, the higher the strike price of a put option, the higher the intrinsic value and the more expensive the option. The closer the strike price is to the current price of the underlying asset, the larger the option's time value. Deep in-the-money options have lower time value. The longer the time to expiration at a given strike price, the higher the option price.
General Considerations
Calculating the price of an option and how it might change means developing some rules for figuring out its intrinsic value and time value. The most important thing to remember is that a buyer is not bound to exercise the option. Because the options can either be exercised or expire worthless, we can conclude that the intrinsic value depends only on what the holder receives if the option is exercised. For an in-the-money call, or the option to buy, the intrinsic value to the holder is the market price of the underlying asset minus the strike price. If the call is at the money or out of the money, it has no intrinsic value. Similarly, the intrinsic value of a put, or the option to sell, equals the strike price minus the market price of the underlying asset, or zero - which ever is greater. Prior to expiration, there is always the chance that the price of the underlying asset will move making the option valuable. The longer the time to expiration, the bigger the likely payoff when the option does expire and, thus, the more valuable it is. The likelihood that an option will pay off depends on the volatility, or standard deviation, of the price of the underlying asset. - The more variability there is in the asset's price, the more chance it has to move into the money. - Therefore the option's time value increases with volatility in the price of the underlying asset. - Increased volatility has no cost to the option holder - only benefits. The bigger the risk being insured, the more valuable the insurance, and the higher the price investors will pay. The circumstances under which the payment is made have an important impact on the option's time value.
Forward and Futures
Forward contract, is an agreement between a buyer and a seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date. - Because they are customized, forward contracts are very difficult to resell. Futures contract, is a forward contract that has been standardized and sold through an organized exchange. - The contract specifies that the seller (short position) will deliver some quantity of a commodity or financial instrument to the buyer (long position) on a specific date, called the settlement or delivery date, for a predetermined price. No payments are made when the contract is agreed to. The seller/short position benefits from declines in the price of the underlying asset. The buyer/long position benefits from increases in the price of the underlying asset. The two parties to a futures contract each make an agreement with a clearing corporation. The clearing corporation operates like a large insurance company and is the counter party to both sides of the transaction. - They guarantee that the parties will meet their obligations. This lowers the risk buyers and sellers face. The clearing corporation has the ability to monitor traders and the incentive to limit their risk taking.
Arbitrage and the Determinants of Futures Prices
On the settlement or delivery date, the price of the futures contract must equal the price of the underlying asset the seller is obligated to deliver. - If not, then it would be possible to make a risk-free profit by engaging in offsetting cash and futures transactions. (e.g. Commodity price =$55/unit, futures contract with $50 settlement price selling for $4) The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price differences is called arbitrage the people who engage in it are called arbitrageurs. If the price of a specific bond is higher in one market (Commodities) than in another (Futures): - The arbitrageur can buy at the low price and sell at the high price. - This increases demand in one market and supply in another. - The increase in demand raises price in that market. - The increase in supply lowers price in the other market. - This continues until the prices are equal in both markets.
Calls, Puts, and All That: Definitions
Options are agreements between two parties. - The seller is an option writer. - A buyer is an option holder. A call option is the right to buy, "call away", a given quantity of an underlying asset at a predetermined price, called the strike price (or exercise price), on or before a specific date. The writer of the call option must sell the share if and when the holder choose to use the call option. The holder of the call is not required to buy the shares - they have the option if it is beneficial. When the price of the stock is above the strike price of the call option, exercising the option is profitable and the option is said to be in the money. If the price of the stock exactly equals the strike price, the option is said to be at the money. If the strike price exceeds the market price of the stock, it is termed out of the money. A put option gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date The writer of the option is obliged to buy the shares should the holder choose to exercise the option. The same terminology that is used to describe calls, is also used to describe puts: - In the money - profitable - At the money - same price - Out of the money - not profitable Although options can be customized, most are standardized and traded on exchanges. A clearing corporation guarantees the obligations embodied in the option -- those of the option writer. - The options writer is required to post margin. - The option holder incurs no obligation, so no margin is needed.
Using Options
Options transfer risk from the buyer to the seller, so can be used for both hedging and speculation. For someone who wants to purchase an asset in the future, a call option ensure that the cost of buying the asset will not rise. For someone who plans to sell the asset in the future, a put option ensures that the price at which the asset can be sold will not go down. Say you think interest rates are going to fall. You can: - Buy a bond but that's expensive as you need money. - Buy a call option that pays off only if the interest rate falls - if you are wrong, only cost is the price of the option. The option writer can take a large loss, so who does this? - Speculators willing to take the risk and bet that prices will not move against them. - Dealers called market makers who engage in the regular purchase and sale of the underlying asset. Market makers both - Own the underlying asset so they can deliver it, and - Are willing to buy the underlying asset so they have it ready to sell to someone else. If you own the underlying asset, writing a call option that obligates you to sell it at a fixed price is not that risky. Market makers write options to get the fees from the buyer. Options are very versatile and can be bought and sold in many combinations. Allow investors to get rid of risks they do not want and keep the ones they do. Options allow investors to bet that prices will be volatile.
Margin Accounts and Marking to Market
The clearing corporation requires both parties to a futures contract to place a deposit with the corporation. - This is called posting margin in a margin account. - This guarantees when the contract comes due, the parties will be able to meet their obligations. The clearing corporation posts daily gains and losses on the contract to the margin account of the parties involved. - This is called marking to market. Doing this each day ensures that sellers always have the resources to make delivery and buyers can always pay. If someone's margin account falls below the minimum, the clearing corporation will sell the contracts, ending the person's participation in the market.
Hedging and Speculating with Futures
Transfer of risk between buyer and seller through hedging or speculation. - For example of the sale of a U.S. Treasury bond future contract, the seller (might be long US Treasuries - Bond Dealer) hedges from the price declines. - The seller of the futures contract can guarantee the price at which the bonds are sold. - The purchaser (might be purchasing the bonds in the future - Pension Fund) wishes to insure against possible price increases (Hedging). Producers and users of commodities employ futures markets to hedge their risks as well: farmers, mining companies, oil drillers, etc. are sellers of future contracts and lock in the prices. Millers, Jewelers, and Oil Distributors are buyers of the futures contracts to hedge against the rise in input prices. Speculators are trying to make a profit. - They bet on price movements. - Sellers of futures are betting that prices will fall. - Buyers of futures are betting that prices will risk. Futures contracts are popular tools for speculation because they are cheap. An investor needs only a small amount to invest at the margin - to purchase the future contract. - Margin requirements of 10% or less are common. Speculators can use futures to obtain very large amounts of leverage at a very low cost.
