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1. Futures markets- standardized contracts (same duration, size, collateral)
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Futures contracts
- traded on organized exchanges
- Contracts are standardized
- Chicago Board of Trade - futures for corn, soybeans, ethanol, etc.
- New York Mercantile Exchange - electricity, etc.
- Chicago Mercantile Exchange - currency futures
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Forward contracts
- tailor-made contracts
- Reputation/collateral guarantees the contract
- Usually issued by banks and individuals
- Terminology
-
Short
is agreement to sell
-
Long
is agreement to buy
- Contract size - specifies number of units in each contract
- Maturity date - the date when the transaction is completed
- Futures price - the selling price of the asset on the maturity date
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Margin account
- buyer or seller deposits money with a broker to cover possible losses from a futures/forward contract
- Guarantees the contract will be honored
- Market price has to exceed some threshold before marking to mark is impose.
Example 1 - A Margin Call
- A refinery buys 10 contracts of petroleum that matures in six months.
- Contract size is 10,000 barrels of petroleum
- Contract price is $100 per barrel
What if the petroleum price is $115 per barrel? Which party deposits funds with broker?
- The seller(issuer) deposits 10*10,000*($115 - $100) = $1.5 million with his broker.
- If this contract matured today, then the buyer purchases this oil for $100, and could sell it for $115, making $1.5 million in profits.
- Speculator: profits = ($115 - $100)(10)(10,000) = $1.5 million
What if petroleum price is $85 per barrel? Which party deposits funds with broker?
- The buyer(refinery) deposits 10*10,000*($100 - $85) = $1.5 million with his broker
- If this contract matured today, then the seller could buy oil on the spot market for $85 per barrel, and sell it to the buyer for $100, earning $1.5 million in profits.
- Speculator: profits = ($100 - $85)(10)(10,000) = $1.5 million
Example 2 - Margin Call for a currency futures
- Exxon has U.S. dollars and purchased chemicals from Malaysia
- Exxon needs to make a 3 million ringgit payment in 90 days
- Contract size is 1 million ringgits
- Contract price is $1 / 3 rinngits (or exchange rate is $1 = 3 ringgits)
- Exxon needs the amount = ($1 / 3 ringgits)(3,000,000 ringgits) = $1 million
What if the exchange rate is $1 = 3.1 ringgits (or $1 / 3.1 ringgits)?
- The dollar appreciated, while ringgits depreciated.
- The market value of contract decreased.
- Exxon has U.S. dollars and contracted to pay a lower exchange rate.
- Exxon has to deposit money into the margin account.
- Spot market: amount = ($1 / 3.1 tenge) (3 million ringgits) = $967,742
- Futures market: amount = $1 million - $967,742 = $32,258
- Who issued this contract benefits:
What if the exchange rate is $1 = 2.9 ringgits (or $1 / 2.9 ringgits)?
- The ringgit appreciated, while dollar depreciated.
- The market value of contract increased.
- Who issued this contract would have to put money into a margin account.
- Spot market: amount = ($1 / 2.9 ringgit)(3 million ringgits) = $1,034,482
- Futures market: amount = $1 million - $1,034,482 = $34,482
- Exxon would profit by $34,482
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1. Types of option contracts:
- Call options give the holder the right to buy the asset
- Put options give the holder the right to sell the asset
2. An option specifies:
- Exercise or strike price - the asset price is listed on the option
- Expiration date - date when the right expires
- American options - holder can exercise the option anytime until maturity
- Construct binomial tree diagram
- European options - holder can only exercise the option on expiration date
- European options are priced using Black-Scholes formula
- Note - a mathematical proof shows the call options are the same for both the American and European, while the put is different
3. Holder pays a premium - an option is like insurance
- Currency premiums are affected by five factors:
- Spot market price - the higher the price, the higher the premium
- Strike price - similar to the spot market price
- Expiration date - the longer the expiration date, the higher the premium
- Events could happen that increase likelihood of being exercised
- Volatility (or variance) of commodity price
- From spot market
- The more variable the commodity price, the higher the premium
- More likely to be exercised
- Interest rates
- Increasing interest rates lower option price (like bonds)
- Present value formula
4. All examples are for European options.
- Example 1 - European call option
- The strike price is $80 per barrel of petroleum
- The premium is $0.1 per barrel
- The quantity is 10,000 barrel
- A company buys 10 call options
Petroleum quantity = 10(10,000 barrels) = 100,000 barrels
Premium = ($0.1 per barrel) (10)(10,000 barrels) = $10,000
If the spot price exceeds $80 (strike price), company exercises call option. Company buys petroleum at $80 and could sell petroleum on spot market for a profit.
If spot price (revenue) > premium (cost) + strike price (cost), then holder earns a profit by selling the commodity
If market price (spot) is below $80 per barrel, then company does not exercise option. However, the company losses the premium, which is a loss.
- Example 2 - European put option
- The strike price is $40 per ton of corn
- The premium is $0.07 per ton
- The quantity is 10,000 tons
- A farmer buys 5 put options.
- Corn quantity = 5(10,000 tons) = 50,000 tons
Premium = ($0.07 per ton)(5)(10,000 tons) = $3,500
If spot price exceeds $40 (strike price), farmer does not exercise put option. Farmer can sell corn for a higher price on spot market. Farmer loses the premium.
If spot price is below $40 per ton, then farmer exercises put option. Farmer could buy corn from spot market and sell to party that bought put option.
If strike price (revenue) > premium (cost) + spot price (cost)
5. Currency Options - More complicated
- Two markets for options:
- Interbank (OTC) market located in London, New York, and Tokyo
- OTC options are tailor-made as to size, maturity, and exercise price.
- Exchange markets located in Philadelphia
- Maturities are 1, 3, 6, and 12 months
- Example 3 - European call option
- The strike price is $0.00833 /1 tenge ($1 = 120 tenge)
- The premium is $0.005 / 1 tenge
- Contract size is 50,000 tenge
- Person want to buy 10 million tenge and has U.S. dollars
Person needs (10 million tenge) / (50,000 tenge) = 200 contracts
Premium = ($0.005 / 1 tenge)(10 million tenge) = $50,000
Expiration date and European option
If exchange rate is $0.01 / tenge ($1 = 100 tenge), then calculate both situations
- If person exercises call option, then he needs: ($0.00833 / 1 tenge)(10 million tenge) = $83,300
- If person does not exercise call option, then he needs ($0.01 / 1 tenge) = $100,000
- Thus, exercise call option because it cost less in dollars; the contracts become more valuable
If exchange rate is $0.005 / 1 tenge, then calculate both situations
- If person exercises call option, then he needs $83,300
- If person does not exercise call option, then he needs ($0.005 / 1 tenge)(10 million tenge) = $50,000
- Thus, don't exercise call option, because it is cheaper; the contracts become less valuable
- Example 4 - European put option
- The strike price is $0.8 / 1 Euro
- The premium is $0.03 / 1 Euro
- Contract size is 25,000 Euros
- A person wants to sell 500,000 Euros and has U.S. dollars
The person has to buy (500,000 Euros) / (25,000 Euros) = 20 contracts
Premium = ($0.03 / 1 Euro)(500,000 Euros) = $15,000 for premium.
Expiration date
If the spot exchange rate is $0.9 /1 Euro, then calculate both situations
- If the person exercises the put option, he collects ($0.8 /1 Euro)(500,000 Euros) = $400,000
- If the person does not exercise put option, then he collects ($0.9 / 1 Euro) (500,000 Euros) = $450,000
- Thus, this person does not exercise the put options, because he can sell it for a higher price on spot market
If exchange rate is $0.7 / 1 Euro, then calculate both situations
- If the person exercises the put options, he collects $400,000
- If the person does not exercise the put options, then he collects ($0.7 / 1 Euro)(500,000 Euros) = $350,000
- Thus, he exercises the put options, because he can receive more revenue than the spot market
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Did you notice investors exercise call and put options "as opposites" when investor exercises option.
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1.
The Volatility Index (VIX)
-
Volatility
is a measure of risk
- "Investor fear gauge"
- Chicago Board of Options Exchange (CBOE) - calculates VIX from Standard & Poor's 500 stock index
- Sells put/call options on VIX
- Options are not tied to an asset
- On maturity, if payment exists, then payment is settled in cash
- Exposure - if VIX increases or decreases dramatically, then CBOE may have large losses from exercised options
- If the VIX = 20, investors expect the S&P 500 index to swing by 20% over the next 12 months
- If the VIX increases
- Investors become more pessimistic
- Markets become more volatile
2.
Credit Default Swaps
- Investors want to earn the high returns from risky securities
- Investors lose if the risky company bankrupts
- Investors bought CDS as insurance
- pay a premium
- if company bankrupts, then the bonds become worthless
- CDS would pay the bondholders a payout for the worthless securities
- CDS contracts are sold on the derivatives market
3. Problems with CDSs
- Investors could buy CDS contracts, even if they had no financial ties to the company specified in contract
- Gambling that a certain firm will fail
- Your cost is the premium
- Your revenue is the payout if company bankrupts
- Like buying insurance on your neighbor's house, hoping it will burn down
- Multiple CDS contracts can be layered on the same debt
- An dealer buys a CDS contract on a risky bond from a Company X at 2% premium
- The financial health of Company X deteriorates
- The dealer can issue a new CDS contract with a premium of 4%, earning 2% in profits
- If Company X bankrupts, then the dealer pays out his contract with the money from the first CDS contract
- Lehman Brothers
- Issued $400 billion in CDS contracts on debt valued at $155 billion
- Financial meltdown in October 2008, as Lehman Brothers could not meet its obligations
4. During good times, companies rarely defaulted, usually less than 4%
- Premiums from CDS contracts are pure profits
- CDS contracts were valued at $47 trillion
- U.S. GDP was $15 trillion
- During recession, default rates climb over 10% during a recession for risky companies
- Junk securities (speculative grade)
- Default rates are still low for companies with good credit ratings
- Issuers of CDS contracts did not consider a recession, and had large payouts
5. Some investors bought CDS contracts that the CDOs would lose value
- They bet the real estate market would collapse
- Remember - they do not have to purchase CDOs to get CDS contracts
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