DERIVATIVE INSTRUMENTS and HEDGING Burak Saltoglu.
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04/18/23 3
What is Derivative Product?• Derivative products are the products which derive
their values from other (spot or cash) financial products.
• Derivative contract includes future delivery with known exercise prices. But future spot prices would be unknown by the time the derivative contracts are bought.
• They can be used for speculation, arbitrage and hedging purposes.
04/18/23 4
Futures and Forward Contrats• They can be issued on a varios product ranges.
– Single stocks and indexes, ForEx rates and interest rates– Commodities: Cotton, tobocco, Crude oil, etc. Precious
metals: gold, silver,..,..• Futures Contracts are exchanged in exchange traded
markets.• Product type, delivery etc are determined specifically. • Exchange traded markets (VOB, NYMEX,..) or• Over The Counter (Forward Contracts)
04/18/23 5
Global Derivative ProductsExchange-Traded Derivatives
68%
23%
$53 trn notional $10 trn mkt value
Credit
Interest
Gov-Debt
Stocks
Comm
Equ-Index
FX
2004OTC Derivative Markets
80%
14%
$220 trn notional$6 trn mkt value
US: 35%
EU: 45%
Asia: 20%
Sources: BIS (Dec 2004) ; FIBV (Jan 2005)
0
50,000
100,000
150,000
200,000
250,000
1991 1993 1995 1997 1999 2001 2003
0
10,000
20,000
30,000
40,000
50,000
60,000OTC (bar) and Exchange-Traded (line) Derivatives
(notional outstanding, in billions US$)
Annual growth rates exceed 30%
04/18/23 7
Derivaties Transaction Volume
0
100,000
200,000
300,000
400,000
500,000
600,000
2003 2004 2005 2006 2007 2008
Over The Counter Derivative Products(Billion US$)
otc derivative trans.
04/18/23 8
Derivative Types
• Futures and Forward • Swap• Options • Credit Derivatives• Other Structural Products
04/18/23 9
Basic Definitions About Derivatives
• Exercising Derivative: It means to buy or sell the product , at a future date with a specific price.
• Exercise Price: It is the price with which the product will be bought or sold at the delivery.
• Time to Maturity : it is the date at which the contract can be exercised.
04/18/23 10
Forward and Futures Contrats
• The futures and forward contracts set an obligation for the long position to buy the product, at specific date (T) and an exercise price(X).
• At the same time, they set an obligation for the short position to sell the same product under the same conditions.
04/18/23 11
Positions in Futures-Forward Markets
• Long Position : Buying a financial instrument with the expectation of a price increase in the future.
• Short Position: Selling a financial instrument with the with the expectation of a price decrease in the future.
•Settlement Price: It is the price used for determining the daily profit/losses and margin obligations of position holders in the Future Markets. Generally, it is determined like the weighted average of last transactions.
Cash or spot pricesCASH PRICES
Thursday, April 09, 2009
European crude oil Thu Price
Prev Year
Day Ago
Brent 52.29 52.26 108.8
Domestic crude oil
West Texas Intermediate, Cushing 52.24 49.38 110.12
Gold
London p.m. fixing 880.5 880 928
Other metals
Copper, high grade: Comex spot price $ per lb. 2.0705 1.998 3.954
Platinum: free market 1195 1184 2123
Foods
Cocoa, Ivory Coast, $ per metric ton 2907 z 2767
Coffee, Brazilian, Comp. 1.0754 1.0675 1.2976
Grains and Feeds
Corn, No. 2 yellow. Cent. Ill. bu 3.71 3.775 5.58
Soybeans, No. 1 yellow Illinois, bu 9.95 9.945 13.005
Futures on Dow Jones
Month Last Chg Exchange TimeDOW JONES INDUS.-$10 Jun '09 8017 8879 04.09.2009DOW JONES INDUS.-$10 Sep '09 7970 643 04.09.2009DOW JONES INDUS.-$10 Dec '09 7927 0 04.09.2009DOW JONES INDUS.-$10 Mar '10 7887 0 04.09.2009
04/18/23 20
Differences Between Futures and Forward Contracts
• Structural Differences
• Marking to Market
04/18/23 21
Forward ve Futures Contrats
Done between 2 parties Formal MArkets
Non-standard Contrats Standard Contrats
Payment at Contract Maturity Daily Payment
Delivery generally occurs. Contract is closed down before the maturity.
FORWARDS FUTURES
Default risk exist. Default risk is minimized.
04/18/23 22
Credit Risk Controls in Futures Markets
• Marking to Market• Daily Price Change Limits
- Limit-Up- Limit-Down
04/18/23 23
Working Mechanism of Futures Markets: Margins
• Margin: Account which is opened by the broker for the investor in cash(or an asset which have a market)
• Margins are priced every day according to future transaction prices.
• Margins are valued daily as if the contract will be Expired next day.
• Margins are used for to minimize the risk of default of either parties.
04/18/23 24
Margin Accounts and Marking to Market in Futures Contracts
• Inıtial Margin: Minimum required margin(cash) to enter a position. Volatility of the market in that day is determinent.
• Maintenance Margin: Minimum margin level a margin can decrease without a margin maintenance. General it is 75% of Initial Margin.
• Margin Call: If the margin decreases blow the maintenance margin level, the difference between this level and initial margin must be paid to broker by the position holder. This difference is called margin call.
04/18/23 25
USD/YTLUSD/YTL
Contract Size 1.000 USD
Initial Margin 150 TL
Maintenance Margin 112.5 TL
Daily Transaction Limit 10%
Minimum Price Increment 0.0005 TL
04/18/23 26
EUR/YTLEUR/YTL
Contrant Size 1.000 EUR
Initial Margin 200 TL
Maintenance Margin 150 TL
Daily Transaction Limit 10%
Minimum Price Increment 0.0005 TL
04/18/2327
Marking to Marketing in Futures Contracts
Example:Consider the Bank A takes a three-month long position try/usd Futures position of 100,000 USD with the future price of 1.60 contract.
DATE PRICE FUTURES POSITION
VALUE
INITIAL MARGIN
(10%)
MAINTENANCE MARGIN
(7.5%)
MARGIN ACCOUNT
MARGIN CALL
15 JUNE 1.60/ 160,000 16,000 12,000 16,000 -
16 JUNE 1,50 150,000 16,000 12,000 15,000 -
17 JUNE 1.40 140,000 16,000 12,000 14,000 -
18 JUNE 1.20 120,000 16000 12,000 12,000 4,000
04/18/23 28
Marking to Marketing in Futures Contracts
Margin Calls
Margin Account for YEN/USD
Maintenance Margin
Margin Account
Initial Margin
04/18/23 29
Barings Futures (Singapore) Pte Ltd.20 Raffles Place, 24th Floor, Ocean Towers, Singapore 0104
Tel: 5395571 / 5395572
Client : Baring Futures (Singapore) Ltd. Account No: 88888
Address : c/o Singapore Office20 Raffles Place24th Floor, Ocean TowersSingapore 0104
Date: 24/02/95Page:26
Daily Activity Statement
Attention: Nick Leeson
DAILY STATEMENT OF UNREALISED PROFIT AND LOSS
:::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::: 7. Equity Balance 0,00 59,239,120,000.00 (JPY) 8. Collateral Securities Held ....... .......................................
Some observations• You invest only 10% of the notional position.• Your leverage ratio is 1 to 10.• Inital Margin values are determined on the basis of
daily (extreme volatility) estimates and are subject to change.
• ISE30 and S&P500 should not have the same leverage ratio (in S&P it is 4%: i.e. Leverage ratio is 25!)
• You might even have some exotic futures contract so that it will be only 2% (i.e. Leverage ratio is 50!!)
How do we close a futures position
• More than 70% of the futures contracts are not exercised at the maturity.• To take advantage of a market move you may sell your futures contract in
the VOB.• The difference between the price you paid and the price in the second
hand market for the same product will be your profit (or loss).• All you need to do enter a reverse position that you own in the futures
market.• In the previous example: if you take a short position of FX futures with 3
months maturity you will take your profit or loss.• For instance in the FX futures example if close in June 17 with the futures
price of 1.4 you will be making 20,000 TL loss.• Of course you don’t know who will buy it but your counterparty will have
another counterpf you close your position in You invest only 10% of the notional position.
• Your leverage ratio is 1 to 10.
04/18/23 b saltoglu Türev ürün notları 33
Hedging with Futures and Forward Products
• Long position in spot can be hedged with short position in futures or forward.
• Short position in spot can be hedged with long position in futures or forwards.
• Provided that spot product risk, maturity and product directly matches to futures product then this can create a perfect hedge.– Example:
• Short in spot: hedge with long futures:– Dollar/TL debt (short position) in six months and 6 month-futures
contract(long). Exporters.
• Long in spot: hedge with short with futures:importers.
04/18/23 34
Hedging with Using Futures Contracts
• Long in ForEx=>Short in Futures• Short in ForEx=> Long in Futures• Long in Futures=> Short in ForEx• Short in Futures=> Long in ForEx
04/18/23 35
Hedging in Companies• Companies want to eliminate financial risks other than their main
functions(interest rate, currency, or other commodities petrol etc.)• Companies’ purpose is to eliminate the volatility of their profits
because of the other risky determinents.• SEC works on to inform stockholders by rewealing the risks.• In the risk management purposes:What other companies doing and
the cost of the hedging is the main two problems.• For example; hedging continously the cost of petrol worths 147US$
may not be easy process.• However, in terms of legislation and transparency there may be
expected important changes.
04/18/23 36
Hedging in practice?
What is Perfect Hedge?• If a hedge product which totally eliminates the risk of the main product, then there would not be a perfect hedge.
• A written futures product on the same holding term, same risk factor, same currency.• Example: If there does not exist a futures instrument on the jet fuel, or on the same currency, or the maturtiy of the instrument which creates risk is shorter
What can be done under these circumstances?• If the airlines have a jet fuel risk and there exists a futures on the crude oil, then cross hedging might be carried out.•If the maturity of the risky product is longer than the maturity of the protective futures product, then you may conduct a rolling hedge.•If hedge costs much, then the half can be hedged. (Partial Hedge).
04/18/23 37
ForEx Debt exRate: 1.7 US Dollar
-700000
-600000
-500000
-400000
-300000
-200000
-100000
0
100000
200000
1.4000 1.6000 1.8000 2.0000 2.2000 2.4000
pro
fit/
loss
rate
Dollar debt in one month borrowedin 1.7 US$
net profit
04/18/23 38
Futures Long
-200000
-100000
0
100000
200000
300000
400000
500000
600000
700000
1.5000 1.6000 1.7000 1.8000 1.9000 2.0000
futu
res
pro
fit/
loss
exchange rate
futures prof it loss
futures profit loss
04/18/23 39
Hedge: Short Spot+Long Futures
-800000.00-600000.00-400000.00-200000.00
0.00200000.00400000.00600000.00800000.00
1.3000 1.5000 1.7000 1.9000 2.1000 2.3000 2.5000
Spot Exchange Rate
Hedge: Short ForEx+Long Futures
futures profit loss
net profit loss
04/18/23 41
Option Definitions • Call option, gives option to buy the underlying asset
in a determined time and price. Bullish expectation • Put option, gives option to sell its underlying asset in
with a predetermined time and price.– Bearish expectation of holder.
• European option: contracts can be exercised only in a predtermined date.
• American option: can be exercised any date between the maturity date and the date contract bought.
• Option contracts can be traded in secondary markets.
04/18/23 42
Differences between Options and Futures Contracts
• In Futures contract, there is an obligation at the maturity, but in options there is optionality
• Because of this, there is an additional premium paid for the options unlike in the futures.
• However, in options trade,because the seller should demand a premium to compensate the profit of the buyer.
04/18/23 44
Example Long Call:IBM Stock Hull 2007
Consider a call option contract which has 5$ contract price (call premium) and 100$ exercise price with time to maturity 2 months. The profit/loss graphic of this contract for long position according to the possible prices can be realized at the maturity is:
30
20
10
0-5
70 80 90 100
110 120 130
Profit ($)
Spot at the maturity of option ($)
04/18/23 45
Long Put: Exxon
Premium for put option on the exxon stock= $7, exercise price = $70
30
20
10
0
-770605040 80 90 100
Profit ($)
Spot at the maturity
04/18/23 46
Short Call:IBM Stock Consider a call option contract which has 5$ contract price
and 100$ exercise price with time to maturity 2 months. The profit/loss graphic of this contract for short position according to the possible prices can be realized at the maturity is:
-30
-20
-10
05
70 80 90 100
110 120 130
Profit/loss ($)
Spot price at the maturity ($)
04/18/23 47
Short Put Exxon
Premium for put option on the exxon stock= $7, exercise price = $70
-30
-20
-10
7
070
605040
80 90 100
Kar ($)Vadedeki fiyat ($)
04/18/23 48
Call/Put• Investor buys call:profit unlimited, loss limited• Person sells call:loss is theorically unlimited,
profit limited• Put buyer: profit may be very high(until stock
price becomes zero) but loss is limited with premium
• put seller: loss may be unlimited(parallel with stock price increase) but profit is limited(limited with put premium).
04/18/23 49
Assets Underlying To Options
• Stocks• ForEx Rates• Stock Indexes• Futures• Energy, weather situation, etc.
04/18/23 50
Some Definitions
Moneyness :– At-the-money options: Stock and exercise prices are
equal– In-the-money option: for call if stock is bigger than
exercise price(for put if exercise price is bigger than stock).
– Out-of-the-money option: for call if stock is lower than exercise (for put if stock is bigger than exercise).
04/18/23 51
Options according to Exercise Terms
• European Type Options:Option type which can be exercised only at maturity.
• American Type Options: Option type which can be exercised any date till to maturity.
To hedge a stock with a cost of 40$
spot in 3 months spot long put protective put
25 -15 12 -3
30 -10 7 -3
35 -5 2 -3
40 0 -3 -3
45 5 -3 2
50 10 -3 7
55 15 -3 12
04/18/23 54
Option Sensitivity
• Role of Volatility– Volatility of yield of an finanicial instrument is linearly
realted to potential uncertainity that instrument can face in the future. If this is high possibilty that option(put or call) may be exercised increases and premium also increases .
• Maturity:As the maturity increases, the value of option increases, too.
• Exercise Price: As it increases call loses value.• Asset Underliying to Option:As its price increases, price
of call option increases, too.
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