Options and Futures Markets Introduction to Derivative Markets Risk Management in Financial Markets. Complexity of Products and Markets

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Basil Taylor
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1 Options and Futures Markets Introduction to Derivative Markets Risk Management in Financial Markets Peter Ritchken Complexity of Products and Markets There are an array of products that firms or exchanges issue: Adjustable Rate Notes Bonds with payouts linked to commodity prices Dual currency bonds puttable common stock options with payouts linked to a time series average options linked to a maximum price adjustable rate preferred stock. Why have products become more complex? Completing the Market The more choices the better? Preferences, Beliefs and Products. The number of new products has grown dramatically over the last two decades. Linear contracts and non linear contracts. Insurance related contracts Contracts that pay out if stocks go up Contracts that pay out if stocks go down Contracts that pay out if stock prices are in an interval. 1

maximum price adjustable rate preferred stock. Why have products become more complex? Completing the Market The more choices the better? Preferences, Beliefs and Products.

2 The world has become a risky place. Living is risky----life Insurance Houses are risky---fire Insurance Stock Markets are risky--- Commodities are risky---- Interest Rates are risky---- Foreign Exchange is risky--- As an individual what risks should I bear? How do I choose which risks to bear, and which risks to hedge? How do I hedge the risks which I do not want to bear? Will I get ripped off when I insure against these risks? What maturity contracts should I purchase? Where do I get these contracts? Some risks are diversifiable, others are not. How do I price them? The world has become a risky place! Financial markets have responded to risk by offering innovative products insurance products hedging products limited liability products # different products Time 2

what risks should I bear? How do I choose which risks to bear, and which risks to hedge? How do I hedge the risks which I do not want to bear?

3 From the Firm s Perspective To what extent is my firm exposed to interest rates, FOREX, commodity price risk? What financial tools are available for managing these exposures? If my firm is exposed, how do I use the tools to manage the exposure? Should a firm hedge risk? Can t the individual hedge more efficently? Examples Reasons for the Firm to hedge What would M. and M. say? Reduce Taxes Reduce Costs of Distress Cheaper ( transaction costs and size) Special Information We will have more to say about this! Regulation and Strategy An Ohio Widget Company Should it hedge against FOREX risk? Should it hedge if we know our competitor is hedging? Consequences of information disclosure? 3

Can t the individual hedge more efficently? Examples Reasons for the Firm to hedge What would M. and M. say?

4 What will you learn? How to use Futures Markets. How to use Option Markets How to use OTC markets How to go about designing a risk management program How to transfer risk that you are not willing to bear, at a reasonable price. How not to get ripped off. How to ask the right questions, and use markets to your advantage. How to communicate the risk management needs faced by your firm, and to isolate the steps needed to solve the problem To understand how technology impacts markets, how foreign competition affects product decisions, and to be aware of how risk managers respond to changes. To explain why certain products and strategies create value while others do not. What will you learn? To PRICE derivative products To understand how all corporate securities can be viewed as complex options, and to value them. To understand how option pricing theory can be used in capital budgeting and strategic planning. To appreciate how flexibility in projects and financial instruments can be valued. To better understand why index ammortization swaps, collateralized mortgage obligations, liquid yield option notes, lookback options, and other exotic contracts exist. To understand a day in the life of a trader and a financial engineer. 4

How not to get ripped off. How to ask the right questions, and use markets to your advantage.

5 An Example of an Exotic Claim Average Rate Options Price Time Background Material Interest Rates 1 (1+ ) r nt n rt 1 e B(0, T) $1 rt B(0, T) = e Example r is 6% continuously compounded. T = 0.25 year. B(0,T) = exp(-rt) = exp( -0.06/4) 5

6 The Law of One Price Two investments that generate exactly the same cash flows at the same times, should be priced the same. If they were not, what would you do? Buy the cheap. Sell the expensive Pocket the difference. We will use this idea, over and over again! Main Topics Forwards and Futures Markets Pricing Forward and Futures Hedging with Futures Option Markets Option Strategies Arbitrage Relationships Pricing with lattices Pricing with Black Scholes Main Topics The Greeks and Risk Management Extension of the Black Scholes Model Exotic Options and Corporate securities Computer Simulation and pricing e xotics Why do firms hedge? Special Topics Real Options Case Studies Disasters with options value at risk 6

Main Topics Forwards and Futures Markets Pricing Forward and Futures Hedging with Futures Option Markets Option Strategies Arbitrage Relationships Pricing with lattices Pricing

Chapter 1: Financial Markets and Financial Derivatives

Chapter 1: Financial Markets and Financial Derivatives 1.1 Financial Markets Financial markets are markets for financial instruments, in which buyers and sellers find each other and create or exchange