class1 jose guedes 1
TRANSCRIPT
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Nature of Derivative Securities A derivative security is a security whose
value derives from an underlying
variable;
Frequently the underlying variable is the
price of a traded asset; this traded asset is
referred to as the underlying security, the
underlying asset or the primitive asset.
Jose Correia Guedes Master in Business - FCEE Financial derivatives
Examples of underlying assets
Stocks and Stock Indexes;
Bonds and Bond Indexes;
Foreign Exchange Deposits;
Risky corporate debt;
Commodities: Extractive: oil, natural gas, gold, silver,
Agriculture&Forestry: wheat, soybeans, cotton,coffee, orange juice concentrate, pulp,
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Examples of underlying variables that
are not traded assets
Interest rates;
Inflation rates;
Credit ratings and indexes;
Weather conditions (temperature, quantity ofrain,..)
Binary variables associated to the occurrence ofparticular events:
Corporate defaults; Hostile acquisitions attempts;
Mergers;
Natural Disasters.
Jose Correia Guedes Master in Business - FCEE Financial derivatives
Examples of derivative securities
Forward contrats;
Future contrats;
Swaps;
Options;
Options on future contracts;
Options on swaps (swaptions); Exotics (derivative structures that cannot be
created from forward contracts plus options) Examples: binary options, barrier options
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
1,19,20,54,4Equity linked contracts
8
23,4
27,2
12,8
147,4
248
3
0,06
24,6
0,6
0,1
18,2
47
Notional
amounts
2004
0,15
1,34
0,5
0,03
4,8
9,1
Gross
marketvalue
0,7
1,1
0,7
0,04
5,3
11,1
Gross
marketvalue
43
36,7
52,3
22,8
272
520
8,1
0,1
44,3
1,1
0,2
26,8
80
Notional
amounts
2008
FRAs
Credit Default Swaps
Currency swaps, forwards & forex swaps
Currency options
Interest rate options
Equity index options
Interest rate swaps
Options on interest rates (caps,loors, collars, swaptions...)
Interest rate futures
Currency futures
OTC Instruments
Equity index futures
Exchange-Traded Instruments
Source: BIS (Trillions USD)
Jose Correia Guedes Master in Business - FCEE Financial derivatives
What are derivative securitiesused for?
To hedge risk;
To speculate;
To arbitrage disallignments of prices among
related securities;
What is the commonality among the three
possible uses of derivative securities?
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Types of hybrid securities
Hybrids composed of Debtand Derivatives
Debt plus a forward contractDual -currency bondsPetrobonds
Debt plus a swapInverse floating-rate notes Adjustable-rate convertible notes
Debt plus an optionBonds with warrants
Equity warrantsCommodity & foreign exchange warrants
Convertible bonds
Principal indexed to commodity pricesPrincipal indexed to exchange rates(indexed currency option notes)Principal indexed to interest ratesPrincipal indexed to equity indexes
Bonds with indexed principal
S&P index subordinated notes (Spins)Stack index growth notes (Signs)
Option on issuers creditworthinessPuttable and extendible debtLiquid yield option note(LYON)
Option on natural disasterBonds with earthquake puts
Hybrids composed of Debtand Derivatives
Commodity interest-indexed bondsCopper interest-indexed notesSmart notes
Equity interest-indexed bondsSuns
Debt plus a package of options
Packages of interest rates optionsFloored floating-rate optionsStep-up bondsIndex amortising notes
Range notes(corridor or accrual notes)
Inflation rate interest-indexed bonds
Hybrids composed of Equityand Derivatives
Equity plus a swap Adjustable-rate preferred stock
Equity plus an optionConvertible preferredOptions on equity or on equityindex
Equity-linked preferred stockPers/Elks/Decs
Hybrids designed to decomposeequity claims
Prescribed right to income andmaximum equity (Primes)Special claim on residual equity(Scores)Super SharesUnbundled stock units
Other option typesOption on managementbehaviour - puttable stockOption on the outcome oflitigation
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Derivatives are financial weapons of mass destructionWarren Buffet, 2002 Annual Report of Berkshire Hathaway
1993 MetallgesellschaftOil futures trading resulted in losses of 1.3 billion
1994- Orange CountyInvestments in leveraged interest rate products generated losses of up to 1,7 billion USD
1995 - BaringsTrading in Nikkei-index contracts in Singapore & Osaka exchanges resulted in losses of1,4 billion USD, wiping out the banks capital
1998 Long Term Capital ManagementHedge fund with massive positions in derivatives and facing liquidity shortages, takenover by consortium of creditors in a 3,5 billion rescue operation led by the NY FED.
2006 -AmaranthLosses in natural gas futures of up to 6 billion USD. Positions in futures taken over byJPMorgan, Merril Lynch & Citadel at undisclosed prices.
2008 Bear Stearns
Fear of systemic risk stemming from massive positions in Credit Default Sawps (10trillion of notional value), prompted FED to orchestrate purchase of bank by JPMorganand open discount window to investment banks (for the first time ever). Bank lost over10 billion USD in market value within less than 2 months.
Jose Correia Guedes Master in Business - FCEE Financial derivatives
Forward Contracts
Contract that stipulates the obligation to buy
(long position) or to sell (short position) a
specific asset (underlying asset), at a
specific future date, for a specific price;
A forward is a zero-sum game: the value of
the long position is always the symmetricalof the value of the short position;
Generally, forward contracts trade in the
over-the-counter market.
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Examples of forward contracts purchase of 5000 ounces of gold @ USS400/oz.,
one year from today;
Sale of 1,000,000 @ 1,5 USS/, 6 months from
today;
return of 4% on a 1,000,000 USD deposit, for a
period of 3 months, starting in 6 months (FRA);
Sale of 1,000,000 barrels of crude @ USD52/barrel, 9 months from today;
Jose Correia Guedes Master in Business - FCEE Financial derivatives
How does a forward work?
Two parties - the party who wants to buy at futuredate and party who wants to sell at future date - agreeon a delivery price for the future transaction, suchthat the value of the contract is initially equal to zero.
Hence, when the contract is initiated, no funds haveto be exchanged between the two parties.
Funds are exchanged only at the delivery or maturitydate of contracts, to settle losses and gains.
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Example
On January 5th of 2006 a company purchases S1,000,000 @1,17 (USD/Euro) forward at 3 months, to Bank B;
The company takes a long position in USD and the banktakes a short position in USD;
At maturity date (5th of April of 2006), the spot exchangerate is equal to 0,95:
- the company must pay to the bank (1/1,17)*1,000,000= 854.701 Euros;
- the bank must pay to the company (1/0,95)*1,000,000= 1,052,632 Euros
The settlement of position is in favour of the company: thebank pays to the company 197.931 Euros
Jose Correia Guedes Master in Business - FCEE Financial derivatives
Future Contracts
Contracts traded in Derivatives Exchanges(EUREX, Liffe, CBOE-CBOT, COMEX....);
Standardized Contracts: Characteristics of underlying asset;
N of units of underlying assets per contract;
Maturity dates.
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Dow Jones STOXX 50 Futures (FSTX) andDow Jones Euro STOXX 50 Futures (FESX)
Underlying Index: 50 shares, prices weighed for the respective capitalization (it
includes the impact of technical accidents but it excludes the impact on the value
of the shares from conversion of warrants and convertible debt);
Quote Method: points of the index, with no decimals;
Value of the contract: Points of index * 10 Euros;
Expirations: the three nearest months in the cycle March, June, September and
December;
Liquidation at expiration date: financial liquidation on the basis of the price of
reference at expiration, to pay in the first working day after the last day of
negotiation;
Price of reference at the expiration: Arithmetic mean of the values of the indexbetween 11h50 and 12h00 CET of the last day of negotiation;
Tick: 1 point of the index (corresponds to 10 Euros);
Last negotiation days: 3rd Friday of the expiration month;
Margin: 250 points of the index (2500 Euros) per contract;
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Euro-BUND Futures (FGBL)
Underlying Index: National classic long-term bond emitted by the German federalgovernment, with the expiration date between 8, 5 and 10, 5 years and 6% couponrate;
Quote Method: % of the par, with two decimals;
Contract Value: 100000 Euros;
Expirations: 3 nearest months in cycle March, June, September and December;
Liquidation at expiration: the short positions deliver Treasury bonds of the Germanfederal government (Bundesanleihen) with term to maturity between 8,5 and 10,5years and with an aggregate value of emission over 2 billions Euros. The deliveryday corresponds to 2nd working day after the last day of negotiation;
Notification: members of the exchange with open short positions must notify theEUREX, indicating the specific instruments to use for delivery, after the close ofthe negotiation in the last day of negotiation of the contract;
Last day of negotiation: 2 working days before 1st working day from 10th day ofcalendar of the expiration month (inclusive);
Reference Price at expiration: weighted mean per volumes of the prices registeredin last 10 transactions until 12:30 of the last day of negotiation;
Tick: 0,01% (Euros corresponds to 10 Euros);
Margin: 1,6% (1600 Euros) per contract;
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
CBOT - gold Transaction Unit: 100 troy ounces;
Tick size: $10 per contract;
Daily maximum variation: $5000 per contract relative to priors day
closing price;
Expiration Months: current month, following two months, plus
February, April, June, August, October and December;
Last day of negotiation: the 4th day before the last working day of the
expiration month;
Types of underlying accepted for delivery: Fine gold in bars of 100
ounces "assaying not less than 995 fineness";
Way of delivery: vault receipt emitted by the receiver entity in NewYork or Chicago duly authorized by the CBOT.
Initial margin per contract: $2,000;
Minimum maintenance margin: 75% of the initial margin.
Jose Correia Guedes Master in Business - FCEE Financial derivatives
Clearing House - CH
The purchaser and the seller of a future
contract do not need to know each other.
Once a buy order is matched with a sell
order (through either an electronic trading
platform or a trading pit), the CH takes
over as the counterpart of each of the twotrading parties.
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Investor A(wants to buy n contracts)
Investor B(wants to sell n contracts)
broker is not a member
of exchange
Order to buy
n contracts
broker is a member of
exchange
Order to buy
n contracts
Negotiation system(orders are matched)Order to buy
n contracts
CHbroker is a member
of exchange
Order to sell
n contracts
Order to sell
n contracts
Info. about executed orders
Order executed:
CH buys to B
n contracts
Order executed:
CH sells to A
n contracts
Jose Correia Guedes Master in Business - FCEE Financial derivatives
The CH reduces the credit risk faced by investors
trading future contracts: The counterpart to all contracts is the CH;
The CH has financial reserves (the capital of themembers of the exchange) that guarantee theperformance on its contracts;
How does the CH protects itself against creditrisk? The long and the short positions held by the CH
balance each other;
Only authorized agents are admitted to negotiation;
Traders have to keep margin accounts with theexchange;
Positions are adjusted daily.
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Daily adjustment of positions An investor purchases 10 future contracts
on January 11th (CBOT-gold), at a futures
price equal to $365 per ounce, with
expiration in February. The initial margin
is equal to $20,000 ($2,000*10) and the
maintenance margin is equal to $15,000
(75% of the initial margin).
Jose Correia Guedes Master in Business - FCEE Financial derivatives
Hypothetical adjustment of position during
the first 6 days of the life of the contract
Day Future Price Cash-flow Balance-MA Additions-MA Withdrawals-MA
1/11 365 0 20,000
1/12 362 -3,000 17,000
1/13 359 -3,000 14,000 6,000
1/14 364 +6,000 26,000 6,000
1/15 365 +1,000 21,000 1,000
1/16 367 +2,000 22,000 2,000
What happens if the investor, on January 13th, refuses to add fundsto his margin account?
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Open interest
Most investors close their positions in futures
before the maturity dates of contracts.
- Why?
- How?
The open interest" consists of the number of
positions that are open (either the sum of all long
positions or all short positions), at a particular
date;
What happens to "open interest" when an investortrades a new contract?
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Jose Correia Guedes Master in Business - FCEE Financial derivatives
Can the market be manipulated?
Cornering the marketAn investor "corners the market by simultaneously buying futurecontracts and the underlying asset, and then keeping his position infutures contracts open until the maturity of contracts.
If the available supply of the underlying asset not controlled by the investoris scarce, then the short positions will have to buy the underlying asset (tobe able to deliver it at the expiration date) from the investor at a high
price. In this case, we say that the short positions had been "squeezed".
What it can the stock market make to prevent"cornering"?
- Force the long positions to close its positions;- Suspend negotiation, and force an agreement (between long and short
positions) at a fair price.