ac103 lecture 10.pdf

7/29/2019 AC103 Lecture 10.pdf

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DerivativeSecuities

Financingabusiness:Summary

Raisingmoneyisdifficult

financed

Ingeneral,

ahigh

risk

form

of

finance

has

to

offer

the

prospectofhighreturns

Raisingsmallscaleinitialfinancingisverydifficult

Aprivateinvestorisinterestedinreturnoninvestmentandtherisktaken.

16/04/2012 IntroductiontoFinance1:AC103 2


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Financingabusiness:

Summary

Governmentsareinterestedin

Becauseofthis,governmentsmayfindit

considersittobetoorisky.


ShouldGovernmentsHelp?

directgrantaid

subsidisedemployees

trainingschemes

taxbreaksforinvestors

backtoworkschemes

loan uarantees

Askthequestion:Ifaprivateinvestorwontfundit,isitworth

doing?



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ShouldGovernments

Help?

Cofunding partfundedbyEnterpriseIreland,butprivate

investors needed as well to kee com anies close to market

realities

Financingisamarketingproblem:thecompanypackagestherighttothecashflowgeneratedbyitsassetsindifferentways

inordertoattractfinancefrombanks,bondholders,equity

holdersandgovernments.

BottomLine:

DoubleBottomLine:

TripleBottomLine:

IntroductiontoFinance1:AC103 5

DerivativeSecurities

Asecurityisanyfinancialinstrument,beite torequ tyorsomecom nat ono t e

two

Aderivative

security

derives

its

value

from

an

underlyingsecurity(orothermeasurable

item

Itisawayoftakingbets,eitherasapuregamble,ortooffsetsomeunderlyingposition


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Hedging

Takingapositionthatpaysoutifsomethinggoesaga ns you

HedgingRisk

Firmsfacemanyriskswhichmaybereduced

Theriskoflossduetofireornaturaldisaster

maybe

hedged

by

taking

out

Insurance

FinancialRisk(exchangeratechanges,interestratechanges)maybehedgedusing

Derivativecontracts


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FinancialDerivative

Securities

Twotypes:

1.Tiesyoutoaparticularaction,nomatter

whatgoesonintheunderlyingmarket

2.Givesyouachoice,whichyoumake

epen ngon

eun e y ng

ma e

(contingentclaim)

FinancialDerivativeSecurities

Twowaysoftrading:

Overthecounter(OTC)

Viaaspecialisedexchange


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FinancialDerivative

Securities

Example:

Easons importsmagazinesforUK,fordistributioninIreland

Knows(roughly)howmanymagazines,andthesterlingcostofthemagazines

Canpurchasecurrencyforward,buyacurrencyfutureorpurchaseacurrencyoption

ForwardContracts

Aforwardcontractisanagreementtobuyorse anassetatacerta nt me nt e uture ora

certainprice

Thereis

no

daily

settlement

. Thecontractisanoverthecounter(OTC)

agreementbetween2parties

Nomoneychangeshandswhenfirstnegotiated&thecontractissettledatmaturity


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ForwardContracts

Aforwardcontractisanagreementtobuyorsellanasset at a certain time in the future for a certain rice

Thecontractisanoverthecounter(OTC)agreementbetween2companies

Nomoneychangeshandswhenfirstnegotiated&thecontractissettledatmaturity

Toda s sterlin s ot rate mi ht be 0.8562 er Euro

andthe

forward

rate

0.8432

for

asix

month

forward

contract

Tiesdownthevalueofthesterlingneeded

ForwardContracts

Aforwardcontractisanagreementtobuyorsellan

price

Youmay

end

up

buy

sterling

at

aworst

rate

than

ifyou

hadnotengagedinthecontract dependsonwhathappenstotheunderlyingmarket

ur ng ecurrencycr s so eau umn , asonswerereportedlybuyingsterlingataveryexpensiverate


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Terminology

Thepartythathasagreedtobuyhasaong pos t on

Thepartythathasagreedtosellhasashort position

FuturesContracts

Afuturescontractisanagreementtobuyorsellanassetatacertaintimeinthe

futureforacertainprice

Itis

astandardised contract

and

traded

on

anexchange

tobuyorselltheassetimmediately


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Examplesof

Futures

Contracts

Agreementto:

Margins

Forwardshavenoupfrontpayments,futureshavemargincalls

Amarginis(usually)cashdepositedbyaninvestorwith

a

broker Marginsminimizethepossibilityofdefaultloss

Theyaresettleddaily markedtomarket

offsettingtrade

Mostcontractsareclosedoutbeforematurity


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Forwardvs

Futures

Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

FORWARDS FUTURES

Settled at maturity Settled daily

Delivery or final cashsettlement usually occurs

Contract usually closed outprior to maturity

HedgingwithFuturesExample Youareahogfarmer.ItisApril

andyouintendtosell300,000lbsof

ogmea n c o er. ou ear a e

pricewilldropinthefuture.The

currentspotpriceforhogsis$0.22per

poundandthe6monthfuturespriceis

$0.20.Eachcontractisfor30,000lbs.

Thus to hed e our rice risk ou short

10HogFutures. Ifthepricedropsto

$0.17centsperpoundwhatisthe

effectofthehedge?


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Hedgingwith

Futures

Youcloseoutyourpositionimmediatelybefore

ProfitonFutures:

Options

AnOPTIONisanothertypeofderivative

Anoptiongivestheholdertheright tobuyor

sellat

acertain

price

Theexpirationdate(maturity)isthedatethecontractfinishes

Thestrikepriceisthepricespecifiedinthecontractatwhichtrademaytakeplace


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OptionTerminology

CallOption

PutOption

OptionTerminology

Foraspecifiedstrikeprice,X;

ASHORTCALL givessomebodyelsethe

rightto

buy

from

you.

ALONGPUT givesyoutherighttosell

toselltoyou


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CurrencyOptions

Easons mightpurchaseacurrencyoptionw c pu saupper m on e urocos o

thesterlingrequired

Ifthecurrencycanbeboughtcheaperinthespotmarket,do tearupyouroption,looking

atitasunneededinsurance

AmericanvsEuropeanOptions

Thesetermsdonotrefertothelocationof

AnAmericanoptioncanbeexercisedatany

timeduring

its

life

AEuropeanoptioncanbeexercisedonlyatmaturity


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OptionPayoff

Thepayoffofanoptionatexpirationisafunction.

Example Stockoptionvaluesgivenaexercisepriceof$40

10080604020$0PriceStock

PayoffPut

PayoffCall

LongCallOptionPayoff


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LongPut

Option

Payoff

ShortCallOptionPayoff


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ShortPut

Option

Payoff

Derivatives:Summary

Waysoftakingbetsonpricemovements

Maybeusedtohedgeortospeculate

Cangivegoodprotection

Cangiverisetolargeloses

WidevarietyinderivativesecuritiesFinancialEngineering

ac103 lecture 10.pdf

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