Derivative Markets and Instruments

Transcription

1 1 Mdule # 6 Cmpnent # 1 This Cmpnent: fcuses n the basics f as part f ur examinatin f Derivatives. assumes a base level f financial thery, but attempts t add a level f practical applicatin. We attempt t fill the gap between thery and practice. is ne f many cmprising the Investr Campus Basics f Series. Objectives This mdule is designed as a basic intrductin Derivatives. The fllwing tpics are cvered: Derivative instrument arbitrage pprtunity, frward cntract futures cntract ptins (bth put and call) ptins n futures and swaps. Fr an nline versin f this dcument, including self assessment, and similar dcuments g t ur website:

2 2 Frward Cntracts Each f the Frward, Futures, Optins and Swaps are dealt with in mre detail in a separate cmpnent. S t are Risk Management Strategies. Distinguish between an ptin buyer and an ptin writer As the wrd implies, a derivative instrument is ne whse value depends n the value f smething else. The derivatives we will deal with are frward cntracts, futures cntracts, ptin cntracts, ptins n futures and swap cntracts. We start by describing what the terms mean. Frward Cntract: A frward cntract always invlves a cntract initiated at the start, with perfrmance in accrdance with the terms f the cntract ccurring at a later time. There is an exchange f assets with the price at which the exchange ccurs being set at the time f the initial cntracting. The actual payment and delivery f the asset ccurs at the later time. An example f a frward cntract wuld be a freign currency frward cntract, which wuld call fr the exchange f sme quantity f a freign currency at a future date in exchange fr a payment at that later date.

3 3 Futures Cntract A futures cntract is a type f frward cntract with highly standardised and clsely specified cntract terms. As in all frward cntracts, a futures cntract calls fr the exchange f sme gd at a future date fr cash, with the payment fr the gd t be made at that future date. The purchaser f a Futures Cntract undertakes t receive delivery f the gd and t pay fr it, while the seller f the Futures prmises t deliver the gd and receive payment.

4 4 Optins Optin cntracts are either put r call ptins. Call Optin. The wner f a Call Optin has the right t purchase the underlying gd at a specific price, and this right lasts until a specific date. Put Optin. The wner f a Put Optin has the right t sell the underlying gd at a specific price, and this right lasts until a specific date. Optin Characteristics Optins are created nly by buying and selling. Therefre, fr every wner f an ptin, there is a seller. Optins n futures An ptin n a futures cntract (als called a futures ptin) is ne that takes a futures ptin cntract as its underlying gd. The structure is similar t that f an ptin n smething physical (as described abve). Fr bth instruments, the ptin wner has the right t exercise and the seller has the duty t perfrm n exercise. Upn exercising the futures ptin, hwever, the call wner receives a lng psitin in the underlying futures at the settlement price prevailing at the time f exercise. The call wner als receives a payment that equals the settlement price minus the exercise price f the futures ptin.

5 5 Swaps A swap is an agreement between tw r mre parties t exchange sequences f cash flws ver a perid in the future. Fr example, Party A may agree t pay a fixed rate f interest n a $1 millin each year fr five years t party B. In return Party B may pay a flating rate f interest n $1 millin each year fr five years. The parties that agree t the swap are knwn as the cunterparties. There are tw cmmn kinds f swap, namely interest rate swaps and currency swaps. Swaps are generally custm-tailred t the needs f the cunterparties, generally develping a cntract that is cmpletely dedicated t meeting their particular needs.

6 6 The N-Arbitrage Principle T discuss the n-arbitrage principle we first need t develp a basic understanding f arbitrage. An arbitrage pprtunity is a chance t make riskless prfit with n investment. An arbitrageur is a persn wh engages in arbitrage. Illustrative Example Shares f IBM trade n bth the New Yrk Stck Exchange and the Pacific Stck Exchange. Suppse the shares f IBM trade fr $65 n the New Yrk market and fr $60 n the Pacific Exchange. A trader culd make the fllwing tw transactins simultaneusly: Buy 1 share f IBM n the Pacific Exchange fr $60 Sell 1 share f IBM n the New Yrk Exchange fr $65 The tw transactins generate a riskless prfit f $5. Because bth trades are assumed t ccur simultaneusly, there is n investment. Thus this pprtunity qualifies as an arbitrage pprtunity. The n-arbitrage principle states that any ratinal price fr a financial instrument must exclude arbitrage pprtunities. This is ne f the minimal requirements fr a feasible r ratinal price fr any financial instrument. In what fllws we will be using the n-arbitrage principle in describing the pricing principles fr each instrument.

7 7 Differences between Futures and Frwards The difference between a futures cntract and a frward cntract In rder t distinguish between a futures cntract and a frward cntract yu first need t understand what they are. The definitins are given abve. Frm there yu will see that a futures cntract is a type f a frward cntract with the fllwing characteristics: 1) Futures cntracts always trade n an rganised exchange. 2) Futures cntracts are always highly standardised with a specified quantity f a gd, with a specific delivery date and delivery mechanism. 3) Perfrmance n futures cntracts is guaranteed by a clearinghuse. 4) All futures cntracts require that traders pst margin in rder t trade. A margin is a gd faith depsit made by a prspective futures trader t indicate his r her willingness and ability t fulfil all financial bligatins that may arise frm trading futures. 5) Futures markets are regulated by an identifiable gvernment agency. A frward cntract n the ther hand trades in an unregulated market and des nt require the five pints abve. Hwever, futures and frwards are essentially similar cntracts and have similar results.

8 8 Financial Derivatives and the Market Hw financial derivatives cntribute t market cmpleteness Cmplete market: A cmplete market is a market in which any and all identifiable payffs can be btained by trading the securities available in the market. Fr example in rder t have a cmplete market a trader must be able t purchase a set f securities in rder t btain any payff he can think f. Frm this definitin we see that a cmplete market is an idealisatin that is mst likely always unbtainable in practice. Nnetheless, cmpleteness is a desirable characteristic f a financial market, because it can be shwn that access t a cmplete market increases the welfare f the agents in the ecnmy. Even if an actual market can never be truly cmplete, the mre clsely the market appraches cmpleteness, the better ff the ecnmic agents are in the ecnmy. Financial derivatives play a valuable rle in financial markets because they help t mve the market clser t cmpleteness. If we cnsider tw financial markets that are the same, except that ne includes financial derivatives, the market with financial derivatives will allw traders t shape the risk and return characteristics f their prtflis mre exactly, thereby increasing the welfare f traders and the ecnmy in general.

9 9 The Majr Applicatins f Financial Derivatives The majr applicatins f financial derivatives are: Market Cmpleteness A cmplete market is a market in which any and all identifiable payffs can be btained by trading the securities available in the market. Speculatin Financial derivatives allw traders the ability t expse themselves t calculated and well understd risks in the pursuit f prfits. Fr example traders can speculate n a rise r fall in interest rates, change in currencies against each ther r n a hst f ther specific prpsitins. Risk Management Financial derivatives are a pwerful tl fr limiting risks. Fr example a crpratin that is planning t issue bnds faces cnsiderable interest rate risk. If interest rates rise befre the bnd is issued, the firm will have t pay cnsiderably mre ver the life f the bnd. This firm can use interest rate futures t cntrl its expsure t this risk. Trading Efficiency Traders can use ne r mre financial derivatives as a substitute fr a psitin in the mre fundamental underlying instruments. Fr example an ptin psitin can mimic the prfit r lss perfrmance f an underlying stck index. In many instances traders find financial derivatives t be a mre attractive instrument than the underlying security wing t substantially lwer transactin csts and higher liquidity in the financial derivatives market.

10 10 Summary 1) A derivative instrument is ne whse value depends n the value f smething else. 2) A frward cntract is a type f a cntract initiated at the start with perfrmance in accrdance with the terms f the cntract ccurring at a later time. There is an exchange f assets and the price at which the exchange ccurs is set at the time f the initial cntracting. The actual payment and delivery f the asset ccur at the later time. 3) A futures cntract is a type f a frward cntract with highly standardised and clsely specified cntract terms. A futures cntract has the fllwing characteristics: a) Futures cntracts always trade n an rganised exchange. b) Futures cntracts are always highly standardised with a specified quantity f a gd, with a specific delivery date and delivery mechanism. c) Perfrmance n futures cntracts is guaranteed by a clearinghuse. d) All futures cntracts require that traders pst margin in rder t trade. e) Futures markets are regulated by an identifiable gvernment agency. 4) A clearinghuse is a financial institutin assciated with the futures exchange that guarantees the financial integrity f the market t all traders. 5) A margin is a gd faith depsit made by the prspective futures trader t indicate his r her willingness and ability t fulfil all financial bligatins that may arise frm trading futures. 6) Call ptin The wner f a call has the right t purchase an underlying gd at a specific price, and this right lasts until a specific date 7) Put ptin The wner f a put ptin has the right t sell the underlying gd at a specific price, and this right lasts until a specific date.