investment analysis and portfolio...

INVESTMENT ANALYSIS AND

PORTFOLIO MANAGEMENT

Instructor: Dr. Kumail Rizvi

1

DERIVATIVE MARKETS AND

INSTRUMENTS 2

WHAT IS A DERIVATIVE?

A derivative is an instrument whose value depends

on, or is derived from, the value of another asset.

Examples: futures, forwards, swaps, options,

exotics…

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WHY DERIVATIVES ARE IMPORTANT

Derivatives play a key role in transferring risks in the

economy

The underlying assets include stocks, currencies,

interest rates, commodities, debt instruments,

electricity, insurance payouts, the weather, etc

Many financial transactions have embedded

derivatives

The real options approach to assessing capital

investment decisions has become widely accepted

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HOW DERIVATIVES ARE TRADED

On exchanges such as the Chicago Board Options

Exchange

In the over-the-counter (OTC) market where traders

working for banks, fund managers and corporate

treasurers contact each other directly

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MAJOR PLAYERS IN DERIVATIVES MARKET

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DERIVATIVE DEALERS

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CLEARINGHOUSE

8

EXPOSURE WITHOUT CLEARINGHOUSE

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EXPOSURE WITH CLEARINGHOUSE

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EXCHANGES

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MECHANISM TO REDUCE COUNTERPARTY

RISK

12

EXCHANGES AND CLEARINGHOUSE

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SIZE OF OTC AND EXCHANGE-TRADED

MARKETS (FIGURE 1.1, PAGE 3)

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Source: Bank for International Settlements. Chart shows total principal amounts for

OTC market and value of underlying assets for exchange market

THE LEHMAN BANKRUPTCY (BUSINESS

SNAPSHOT 1.10)

Lehman’s filed for bankruptcy on September 15, 2008.

This was the biggest bankruptcy in US history

Lehman was an active participant in the OTC derivatives

markets and got into financial difficulties because it took

high risks and found it was unable to roll over its short

term funding

It had hundreds of thousands of transactions outstanding

with about 8,000 counterparties

Unwinding these transactions has been challenging for

both the Lehman liquidators and their counterparties

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HOW DERIVATIVES ARE USED 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

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TYPES OF DERIVATIVE INSTRUMENTS

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FORWARD PAYOFF

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PAYOFF

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FORWARD PRICE

The forward price for a contract is the delivery

price that would be applicable to the contract if

were negotiated today (i.e., it is the delivery

price that would make the contract worth exactly

zero)

The forward price may be different for contracts

of different maturities (as shown by the table)

20

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

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EXAMPLE

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HEDGING WITH FORWARDS

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FOREIGN EXCHANGE (USD)QUOTES FOR

GBP, MAY 24, 2010

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Bid Ask

Spot 1.4407 1.4411

1-month forward 1.4408 1.4413

3-month forward 1.4410 1.4415

6-month forward 1.4416 1.4422

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?

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PROFIT FROM A LONG FORWARD POSITION (K=

DELIVERY PRICE=FORWARD PRICE AT TIME

CONTRACT IS ENTERED INTO)

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Profit

Price of Underlying at

Maturity, ST K

PROFIT FROM A SHORT FORWARD POSITION (K=

DELIVERY PRICE=FORWARD PRICE AT TIME CONTRACT IS

ENTERED INTO)

27

Profit

Price of Underlying

at Maturity, ST K

FUTURES CONTRACTS (PAGE 7)

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

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EXCHANGES TRADING FUTURES

CME Group (formerly Chicago Mercantile

Exchange and Chicago Board of Trade)

NYSE Euronext

BM&F (Sao Paulo, Brazil)

TIFFE (Tokyo)

and many more

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FUTURES CONTRACTS

Available on a wide range of assets

Exchange traded

Specifications need to be defined:

What can be delivered,

Where it can be delivered, &

When it can be delivered

Settled daily

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FORWARD VS. FUTURES

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SPECIFICATIONS OF FUTURES CONTRACT

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EXAMPLES OF FUTURES CONTRACTS

Agreement to:

Buy 100 oz. of gold @ US$1400/oz. in December

Sell £62,500 @ 1.4500 US$/£ in March

Sell 1,000 bbl. of oil @ US$90/bbl. in April

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OIL FUTURES

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CORN FUTURES

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STOCK FUTURES

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OTHER TYPES OF FUTURES

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MINI STOCK FUTURES CONTRACTS

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MARGIN REQUIREMENT

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EXAMPLE OF A FUTURES TRADE (PAGE 27-29)

An investor takes a long position in 2 December

gold futures contracts on June 5

contract size is 100 oz.

futures price is US$1250

initial margin requirement is US$6,000/contract

(US$12,000 in total)

maintenance margin is US$4,500/contract (US$9,000

in total)

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A POSSIBLE OUTCOME (TABLE 2.1, PAGE 28)

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Da

y

Trade

Price

($)

Settle

Price

($)

Daily

Gain ($)

Cumul.

Gain ($)

Margin

Balance

($)

Margin

Call ($)

1 1,250.00 12,000

1 1,241.00 −1,800 − 1,800 10,200

2 1,238.30 −540 −2,340 9,660

….. ….. ….. ….. ……

6 1,236.20 −780 −2,760 9,240

7 1,229.90 −1,260 −4,020 7,980 4,020

8 1,230.80 180 −3,840 12,180

….. ….. ….. ….. ……

16 1,226.90 780 −4,620 15,180

ANOTHER EXAMPLE

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MARGIN CASH FLOWS WHEN FUTURES

PRICE INCREASES

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Long Trader

Broker

Clearing House

Member

Clearing House

Clearing House

Member

Broker

Short Trader

MARGIN CASH FLOWS WHEN FUTURES

PRICE DECREASES

44

Long Trader

Broker

Clearing House

Member

Clearing House

Clearing House

Member

Broker

Short Trader

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 trades in one day

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CRUDE OIL TRADING ON MAY 26, 2010

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Open High Low Settle Change Volume Open Int

Jul 2010 70.06 71.70 69.21 71.51 2.76 6,315 388,902

Aug 2010 71.25 72.77 70.42 72.54 2.44 3,746 115,305

Dec 2010 74.00 75.34 73.17 75.23 2.19 5,055 196,033

Dec 2011 77.01 78.59 76.51 78.53 2.00 4,175 100,674

Dec 2012 78.50 80.21 78.50 80.18 1.86 1,258 70,126

REGULATION OF FUTURES

In the US, the regulation of futures markets is

primarily the responsibility of the Commodity

Futures and Trading Commission (CFTC)

Regulators try to protect the public interest and

prevent questionable trading practices

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DELIVERY

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ORDERS

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ORDERS (CONT.)

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OPTIONS 51

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)

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TYPES OF OPTION

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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

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OPTION PAYOFF

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CALL OPTION PAYOFF TO LONG

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PROFIT TO LONG CALL BUYER

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OPTION POSITIONS

Long call

Long put

Short call

Short put

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LONG CALL

Profit from buying one European call option: option

price = $5, strike price = $100, option life = 2 months

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30

20

10

0 -5

70 80 90 100

110 120 130

Profit ($)

Terminal

stock price ($)

SHORT CALL

Profit from writing one European call option: option

price = $5, strike price = $100

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-30

-20

-10

0 5

70 80 90 100

110 120 130

Profit ($)

Terminal

stock price ($)

LONG PUT

Profit from buying a European put option: option price

= $7, strike price = $70

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30

20

10

0

-7 70 60 50 40 80 90 100

Profit ($)

Terminal

stock price ($)

SHORT PUT

Profit from writing a European put option: option price

= $7, strike price = $70

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-30

-20

-10

7

0 70

60 50 40

80 90 100

Profit ($) Terminal

stock price ($)

PAYOFFS FROM OPTIONS

WHAT IS THE OPTION POSITION IN EACH

CASE?

K = Strike price, ST = Price of asset at maturity

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Payoff Payoff

ST ST K

K

Payof

f Payoff

ST ST K

K

ASSETS UNDERLYING

EXCHANGE-TRADED OPTIONS

Stocks

Foreign Currency

Stock Indices

Futures

64

SPECIFICATION OF

EXCHANGE-TRADED OPTIONS

Expiration date

Strike price

European or American

Call or Put (option class)

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TERMINOLOGY

Moneyness :

At-the-money option

In-the-money option

Out-of-the-money option

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EXAMPLE

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SOLUTION

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HEDGING WITH A PUT OPTION

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SOLUTION

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SPECULATING WITH OPTIONS

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SOLUTION

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NOTATION

73

c: European call

option price

p: European put

option price

S0: Stock price today

K: Strike price

T: Life of option

s: Volatility of stock

price

C: American call option

price

P: American put option

price

ST: Stock price at option

maturity

D: PV of dividends paid

during life of option

r Risk-free rate for

maturity T with cont.

comp.

FACTORS INFLUENCING OPTION VALUE

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EFFECT OF VARIABLES ON OPTION

PRICING

Variable c p C P

S0 + − + −

K − + − +

T ? ? + +

s + + + +

r + − + −

D − + − +

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AMERICAN VS EUROPEAN OPTIONS

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An American option is worth at least as much as the

corresponding European option

C c

P p

UPPER BOUNDS

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DERIVATION OF LOWER BOUNDS

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DERIVATION OF LOWER BOUNDS

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SUMMARY

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PUT CALL PARITY

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CONTINUOUS TIME FORMAT

85

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CALL AND SYNTHETIC CALL

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PUT AND SYNTHETIC PUT

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ARBITRAGE OPPORTUNITY

Call Price = $7.50

Put Price = $4.25

Exercise Price on Underlying = $100

Current Price of Underlying = $99

Risk Free Rate = 10 percent

Time to Expiration = Half a Year or 6 months

Requirements

Construct Fiduciary Call and Protective Put

Check Whether the Put Call Parity Exists or not

Suggest the Appropriate Arbitrage Strategy

Calculate and Prove the amount of Arbitrage Profit 90