Financial Engineering Lecture 1
Lecture 1. Syllabus Class Format Part 1 - Generic Derivatives & Options Part 2 - Futures, Swaps, MBS Grade Assignments/Projects Option Programs.
Dec 19, 2015
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Financial EngineeringLecture 1
Introduction Syllabus Class Format
Part 1 - Generic Derivatives & OptionsPart 2 - Futures, Swaps, MBS
Grade Assignments/Projects Option Programs Exam-Computations Email
Derivatives are financial instruments whose price and value derive from the value of the underlying assets or other variables (ISDA)
Derivatives are a “zero sum game”
Derivatives Definition
1840s Midwest USA farmers 1848 Chicago Board of Trade (CBOT) for
grain 1874 Chicago Produce Exchange for
butter/eggs 1919 Chicago Mercantile Exchange (CME) Risk management Land options Risk management
History of Derivatives
OTC vs. Exchanges
Eurex (E-X) Chicago Board Options Exchange (CBOE) Chicago Mercantile Exchange (CME) Chicago Board of Trade (CBOT) New York Mercantile Exchange (NYMEX) Hong Kong Futures Exchange (HKFE)
Derivative Markets
Source: Bank for International Settlements
Source: WFE/IOMA Derivatives Market Survey 2012
Source: WFE/IOMA Derivatives Market Survey 2012
Source: WFE/IOMA Derivatives Market Survey 2012
Futures Options / Warrant Future options Swaps Mortgage backed securities Forward Rate Agreement Convertible bonds Real options
Derivative Instruments
Stocks (example) Bonds Indices Commodities (examples for metal and ag.) Currencies Weather Carbon emissions Radio bandwidth
Underlying Assets
Arbitrage Speculation Hedging
Derivative Uses
Derivatives Call option Put option Exercise or Strike Price Expiration, Exercise, or Maturity Date Long position Short position
Charting Derivatives
Futures & Forwards Forward Contract Futures Contract-commodities-indexes-interest rates-exchange rates
Swaps An agreement between two firms in
which each firm agrees to exchange (or Swap) the “interest rate characteristics” of two different financial instruments of identical principal.
TypesInterest Rate SwapsCurrency Swaps
Ex - Interest Rate Swaps
Aaa Corp Baa Corp
L.T. Fixed Loan 10% 11.5%
S.T. Variable Loan 7.25%7.50%
Swap
Aaa Corp Borrows $1mil fixed loan @ 10%
BAA Corp Borrows $1mil variable loan @ 7.5%
Aaa assumes pmts on variable loan at 7.5%
Baa assumes pmts on fixed loan @ 10.75%
Aaa Benefit Baa BenefitPay L.T. @ -10.00% Pay S.T. @ - 7.50%
Get L.T. @ +10.75% Get S.T. @ + 7.50%
Pay S.T. @ - 7.50% Pay L.T. @ -10.75%
S.T. Sav @ + 7.25% L.T. Sav @ +11.50%
Net Benefit + .50% Net Benefit + .75%
Ex - Interest Rate Swaps
Aaa Corp Baa Corp
L.T. Fixed Loan 10% 11.5%
S.T. Variable Loan 7.25%7.50%
Mortgage Backed Securities FMAC GNMA
Options
Read McMillan glossary for terminology
IBMSept80CallStock = IBMExpiration Date = 3rd Friday in Sept
(Saturday)Position = Long call Strike Price = $80# of shares = 100
IBMSept80Call is selling for $5Total Cost = 5 x 100 + commissions = $500 +
Options
“In The Money” “Out of The Money”
Ex. IBMSept45Call
Options
45 50
“In The Money” “Out of The Money”
Ex. IBMSept50Put
Options
45 50
Intrinsic Value = P - E
Premium = Option price
Time Premium = O + E - P
Options
Ex. IBMSept60CallPrice = 65Call = 7Strike = 60
Intrinsic Value = 65 - 60 = 5Premium = 7Time Value Premium = 7 + 60 - 65 = 2
Options
Parity = Intrinsic Value = Cost
Over Parity --> E + O - P > 0
Under Parity --> E + O - P < 0
Options
Factors in Option Price1. Stock price2. Strike price3. Time to expiration4. Volatility & distribution5. Risk free rate6. Dividends
Options
Cross Section Pricing
Intrinsic Value
Options
Option Price
Stock Price
Cross Section Pricing / Time Decay Chart
Intrinsic Value
Options
Option Price
Stock Price
Interest Rates Settlement Projects Computer software
Options
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