Derivatives

Derivatives Group 4 Teacher: Ms. Bui Thi Kim Phuc

OVERVIEW

1. Future – Dung Do

2. Forward – Loan Dang

3. Hedging and Speculation – Truc Mai Nguyen

4. Option (Call) – Sam Hoang

5. Option (Put) – Phuong Mai Pham

6. Warrants – Hang Nga Nguyen

7. Swap – Ngoc Huyen Nguyen

1. FUTURES

Definition

Types

When to apply

Strengths & Weaknesses

FUTURES Definition

Contracts to buy or sell fixed quantities of a commodity, currency, or financial assest at a future date, at a price fixed at the time of making contract.

FUTURES Types

Commodities futures

•Metals•Energy•Grains & Oil Seeds•Livestocks•Food & Fiber

Financial futures

•Eurodollar Futures•U.S. Treasury Futures•Foreign Government Debt Futures•Swap Futures•Forex Futures•Single Stocck Futures•Index Futures

FUTURES When to appy

Example:(clip)

FUTURES When to appy

Three Main Uses: • Capital Appreciation• Leverage• Hedge Against Risk

FUTURES Strengths & Weaknesses

Strengths • Futures are extremely useful in reducing unwanted risk.• Futures markets are very active, so liquidating your contracts is usually easy.

FUTURES Strengths & Weaknesses

Weaknesses· Being considered one of the riskiest investments in the financial markets - they are for professionals only.· In volatile markets - very easy to lose your original investment.· The very high amount of leverage can create enormous capital gains and losses, you must be fully aware of any tax consequences

FUTURES Conclusion

There are several ways to participate in the futures market. All of them involve risk - some more than others. You can trade your own account, have a managed account or join a commodity pool.

2. FORWARD

Definition

Distinct feature

Function

Case

FORWARD Definition

A contract between two parties to buy or sell an asset

at a specified future time at a price agreed upon today.

THE SELLER THE BUYER

Future real transaction

Today’s price

FORWARD Case

FARMER A

FORWARD Distinct feature

Non- standardized

Over-the-counter

a zero-sum game

FORWARD Function

Control liquility risk

Speculation

FORWARD Activities

Game 1: FORWARD vs. FUTURE

Game 2: Vocabulary

FORWARD Activities

AFORWARD

TRANSACTION

BFUTURE

TRANSACTION

over-the-counterhighly standardizedprivately negotiated

zero counterparty risktraded in a secondary market

FORWARD VS. FUTURE

COLUMN A COLUMN B

FORWARD Activities

Words guessing

Is likely to take place in FORWARD TRANSACTION

rather than future transaction

There are 2 WORDS: first one has 12, second one has 4

LETTERS

Exists because participants may be unwilling or unable to

follow through the transaction at the time of settlement.

Appears when one party BREAKS the terms of the agreement.

This is a kind of UNCERTAINCY facing in any transaction.

FORWARD Activities

The first word is FOUR- SYLLABLE word. It is a combination of 2 COMPONENTS MEANING:

“against/ opposite” “one site in a contract”

The second word means THE POSSIBILITY OF Sth BAD HAPPENING AT SOME TIME IN THE FUTURE

COUNTERPARTY RISK

FORWARD Activities

It is a contract struck today, for the physical borrowing of funds at a

fixed future date.

The THIRD single word means LOANING.

Containing 3 single words: the FIRST and the SECOND WORDS are

exactly the same and are my topic’s name.

Used in purpose of AVOIDING RISK caused by the votality of exchange

rate.

FORWARD FORWARD BORROWING

3. HEDGING & SPECULATING

Definition1

Characteristic2

Comparison between Hedging and Speculation 3

HEDGING Definition

A method of reducing the risk of loss caused by price fluctuation

A transfer of risk without buying insurance policies

equal quantities of the same commodities

reduce risk by making a transaction in one market to protect against a loss in another

equal quantities of the same commodities

Market A Market B

HEDGING Characteristic

Who are HEDGERs ?

1. Everyone who seek to profit from price fluctuation

2. Producers, processors, and wholesalers

3. Retailers, distributors

4. Only producers

HEDGING Characteristic

reduction in RISK reduction in PROFIT

The goal of hedging is not to make money but to protect from losses.

HEDGING Characteristic

Futures Options Forwards

HEDGING TOOLS

HEDGING Example

Use futures contracts to hedge their exposure to the price of jet fuel to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the U.S. rose dramatically after the 2003 Iraq war and Hurricane Katrina

VOCABULARY GAME

(1)……………. reduce their risk by taking an opposite

position in the market to what they are trying to (2)

…………..... The ideal situation in (3)……………...

would be to cause one effect to cancel out another.

hedgershedging hedge

VOCABULARY GAME

(1)………………….has to do with short-term

expectations. When you (2)..………………, you hope

and anticipate that you will be able to make a profit

from the short-term fluctuations in price of a

particular thing. (3)……………………wants to make

money in a hurry.

a speculatorspeculate speculating

SPECULATION Definition

The activity of buying shares,

property, goods, etc. in the hope

of making a profit by selling

them at a higher price

With the risk of losing money

Comparison between HEDGING and SPECULATION

HEDGING

Risk averseTo protect from

losses

SPECULATION Characteristic

Take advantage of an expected

price movement

Extremely risky

Cause harm to other market participants

???

Now

12/2013

Mark

Phil

100 shares of

Apple Corp.

(427$/share)

What type of derivatives should Mark choose?

C A L L O P T I O N

4. CALL OPTION

Definition

How call option works and how to use call option

Game & Conclusion

1 FREE ICE CREAM

SCOOP OF

HAAGEN-DAZS

Mark

Phil

100 shares of

Apple Corp.

(425$/share)

Buy the call option at 1$

100 call

option

Apple

shares at

425$

5$

430$/share

425$/share

Profit = [430-(425+1)]*100

= 400$

2 months later

EXERCISE THE OPTION

Mark

Phil

100 shares of

Apple Corp.

(425$/share)

Buy the call option at 1$

100 call

option

Apple

shares at

425$

425$/share

Loss= 1 * 100 = 100$

2 months later

5$

420$/share

In call options trading, the option holder has the (1)………, but not the (2) …………, to buy the underlying

instrument at a specified price on or before a specified date in the future.

O B L I G A T I O N

(1)

(2)

R I G H T

If Mark decides to buy or sell the underlying instrument (rather than allowing the contract to expire worthless or closing out the position), he will …..………….. the option, and make use of the right available in the contract.

E X E R C I S E

…………… is the total cost of an option?

P R E M I U M

An option that can be exercised anytime during its life ?

A M E R I C A N O P T I O N

1 FREE ICE CREAM SCOOP

OF HAAGEN-DAZS

Call Option = Buying The Right (Not Obligation)

To Buy An Underlying Asset

CALL OPTION CONCLUSION

Use When You Expect The Price Of The Stock Is Going To Rise

5. PUT OPTION

Definition

When to apply “Put option”?

Some tips to apply PUT OPTION and CALL OPTION

This kind of option is the opposite

of call option.

“This option gives the right to…..security (or a currency, or a commodity) at a certain price during a certain period of time”

PUT OPTION Definition

WHEN TO APPLY “PUT OPTION”?

PUT OPTION

A Sample Quiz:Now: a share is worth $100A’s prediction: share will be worth above $100Adversely, B’s prediction: share will be worth

below $100

PUT OPTION When to apply “PUT OPTION” ?

A sells (or writes) B a put option at $100 (strike/exercise price).

B pays A $1 as the premium of put optionB has the right to sell the share at $100

(strike/exercise price) in the future whatever the market price wil be.

A BPut option at $100

Premium of $1

PUT OPTION When to apply “PUT OPTION” ?

Scenario 1: In the futureMarket price (MP) = 130 > Strike price (SP) =100B (will/will not) exercise his put option

because if he (did not exercise/exercised) his put option, he would lose an amount of $30

(= $130-$100)Outcome: - A (earns/loses) premium of $1 in-the-money- B (earns/loses) premium of $1 out-of-the-

money

PUT OPTION When to apply “PUT OPTION” ?

• Scenario 2: in the futureMP = 90 < SP = 100B (will/will not) exercise his put option Outcome:- A (earns/loses) premium of $1, but

(earns/loses) an amount of $100 overall, A (earns/loses) $99 out-of-the-money

- B (earns/loses) premium of $1, but (earns/loses) an amount of $10 (=$100- $90) overall, B (earns/loses) $9 in-the-money

PUT OPTION When to apply “PUT OPTION” ?

Prediction: MP will INCREASE in the future

BUY the CALL option

SELL/WRITE the PUT option

Prediction: MP will DECREASE in the future

BUY the PUT option

SELL/WRITE the CALL option

PUT OPTION Some tips to apply PUT OPTION and CALL OPTION smartly?

6. WARRANT

Definition

Classification

Comparison between warrant and option

WARRANT Definition

1997

2012

WARRANT Definition

Warrant is a type of investment that gives you the right to buy shares at a fixed price on or by a particular date.

A warrant gives you the right, but not the obligation to buy (call) or sell (put) a pre-determined asset at a pre-determined price (=exercise /strike/striking price) by a pre-determined date.

OXFORD DICTIONARY

STANDARD BANK OF SOUTH AFRICA

WARRANT Classification

The warrants can be exercised at any time up to and including the date of expiry

United States - style warrants

The warrants may be exercised only on the expiry date.

European - style warrants

WARRANT Classification

At-the-money

In-the-money

Out-of-the-money

When a warrants with an exercise price is equal to the current market price of the underlying

When a warrants with the exercise price is at below the current market price of the underlying asset

When a warrants with the exercise price is at above the current market price of the underlying asset

WARRANT Comparison

Warrants Option

• Issued by private parties• Issued by a public options

exchange

• When a warrants is exercised Þ Company issues new shares of

stock Þ The number of shares increasesÞ No voting right

• Warrants’ lifetime is measured in years

• The number of shares is constant (the owner of the call option receives an existing share)

=> Voting right

• Option’s life is measured in months

7. SWAPS

Definition7.1

Purposes7.2

Types of SWAPS 7.3

Interest rate swaps7.2

SWAPS Definition

• Definition A swap is an agreement between two counterparties to exchange two streams of cash flows for a set period of time.

Purposes

Hedging Speculation Changing the character of

an asset or liability without liquidating that asset or liability.

SWAPS Types of SWAPS

Typesof

SWAPS

– Interest Rate Swap– Currency Swap– Credit Default Swap– Forward swap– Total return swap– Circus swap– Commodity swap– Asset swap– ……

• (http://www.businessanalystfaq.com/whatisswap-typesofswaps.)

SWAPS Interest Rate Swaps

Definition: • an exchange of cash flows, CFs.

• a legal arrangement between two parties to exchange specific payments.

• involving the exchange of fixed-rate payments for floating-rate payments.

EXAMPLE• Fixed-rate payer pays 5.5% every six months

• Floating-rate payer pays LIBOR every six months

• Notional Principal = $10 million

• Effective Dates are 3/1 and 9/1 for the next three years

EXAMPLE1 2 3 4 5 6

Effective Dates LIBOR Floating-Rate Fixed-Rate Net Interest Received Net Interest ReceivedPayer's Payment* Payer's Payment** by Fixed-Rate Payer by Floating-Rate Payer

Column 3 - Column 4 Column 4 - Column 33/1/Y1 0.0459/1/Y1 0.050 $225,000 $275,000 -$50,000 $50,0003/1/Y2 0.055 $250,000 $275,000 -$25,000 $25,0009/1/Y2 0.060 $275,000 $275,000 $0 $03/1/Y3 0.065 $300,000 $275,000 $25,000 -$25,0009/1/Y3 0.070 $325,000 $275,000 $50,000 -$50,0003/1/Y4 $350,000 $275,000 $75,000 -$75,000

* (LIBOR/2)($10,000,000)** (.055/2)($10,000,000)

EXAMPLE

Points:• If LIBOR > 5.5%, then …………… receives

the interest differential.

• If LIBOR < 5.5%, then ……………..receives the interest differential.

EXAMPLE1 2 3 4 5 6

Effective Dates LIBOR Floating-Rate Fixed-Rate Net Interest Received Net Interest ReceivedPayer's Payment* Payer's Payment** by Fixed-Rate Payer by Floating-Rate Payer

Column 3 - Column 4 Column 4 - Column 33/1/Y1 0.0459/1/Y1 0.050 $225,000 $275,000 -$50,000 $50,0003/1/Y2 0.055 $250,000 $275,000 -$25,000 $25,0009/1/Y2 0.060 $275,000 $275,000 $0 $03/1/Y3 0.065 $300,000 $275,000 $25,000 -$25,0009/1/Y3 0.070 $325,000 $275,000 $50,000 -$50,0003/1/Y4 $350,000 $275,000 $75,000 -$75,000

* (LIBOR/2)($10,000,000)** (.055/2)($10,000,000)

EXAMPLE

Points:• If LIBOR > 5.5%, then fixed payer receives

the interest differential.

• If LIBOR < 5.5%, then floating payer receives the interest differential.