International Monetary Systems. Derivatives – Week 6

International Monetary Systems Derivatives – Week 6 What is a Derivative? A derivative is a financial instrument whose value derives from the value of an underlying asset. The most common underlying are commodities, shares, bonds, currencies, interest rates and stock market indices. Derivatives are used for two main purposes:  Speculating  Hedging or reducing risk There are 4 main types of derivatives: options, futures, forwards and swaps. Main types of derivatives? Options – An option is a contract giving one party the right, but not the obligation to buy or sell a commodity, financial instruments or some other underlying asset at a given price at a future date. In most cases, they are traded on exchanges (e.g., share/stock options). Futures - Unlike options, futures are legally binding agreements to buy or sell an underlying asset at a given price at a future date. Like options, they are traded on exchanges. Forwards - Forwards and futures are very similar financial instruments. However, unlike futures (and options), forwards are over-the-counter derivatives and are not traded on regulated exchanges. Swaps - A swap is an agreement to exchange on set of cash flow for another. Interest rate swaps are the most common type. They involve two parties exchanging interest rates/payments. Options  Options first traded in Chicago (Chicago Board Options Exchange) in 1972  A decade later in 1982 London International Financial Futures Exchange (LIFFE)  ICE Futures Europe is now Europe’s largest Exchange Most popular option types:     Share options Currency options Stock index options Interest rate options Option Contracts An option contract involves two parties: • writer – the person who sells a call or put option contract. • holder – the person who buys a call or put option contract. • Call option – a contract that gives the holder the right but not the obligation to buy an underlying asset/security at a predetermined exercise price at some time in the future. • Put option – a contract that gives the holder the right but not the obligation to sell an underlying asset/security at a predetermined exercise price at some time in the future. Exercise price/strike price – the price at which an option holder has the right to sell or buy an underlying asset/security. • Option premium – fee that is paid by an option holder to the option writer in return for the right to buy or sell an underlying asset/security at a given exercise price. • Maturity date – when the contract expires • American option – a contract that can be exercised at any time up until its maturity date. • European option – a contract that can only be exercised on maturity date. Why buy a call or put option? Call Options – suppose we look at a hypothetical UK company, ABC ltd, and the share price is $1.86. We may be optimistic and believe that the price may well rise to, say, £2.10 in the next 3 months. The option to buy a given quantity of company ABC shares at £1.86 in the next 3 months is very attractive. If we are right and the price goes to $2.10, we can use the option to buy the given quantity of shares at £1.86 and sell them again in the conventional way at £2.10. If the price falls or remains constant, we don’t have to do anything. Put Options – Alternatively, we may be pessimistic about company ABC and believe that their share price will fall to £1.60 in the next 3 months. The option to sell a given quantity of company ABC shares at £1.86 is very attractive. If we are correct, we can buy them later for £1.60 and use the option to sell them at £1.86. If we are wrong and the price rises or remains constant, we don’t have to do anything. Positions in options There are 4 basic positions that can be taken on an options contract: 1. 2. 3. 4. Long call – buying a call option Short call – selling a call option Long put – buying a put option Short put – selling a put option Profit and Loss Profile of a Call option contract Profit or Loss from a put option contract Uses of Options Options provide a cheap and flexible way to control some significant risks and to take highly leveraged speculative positions Options attract: 1. hedgers 2. speculators Hedgers: basic motive is to control their risk exposure Speculators: basic motive is to make profits by taking risk positions in the instruments. Attractive, since a small initial premium gives the opportunity for very large returns. Examples Hedging the risk of an adverse equity price movement  Target: a pension fund with a portfolio of shares needs to realize £50m in three months’ time.   Risk: the stock market might fall within 3 months, requiring more shares to be sold to realize the necessary amount. Solution: purchase put options on individual shares or (even better) a stock market index; if share prices/the market falls exercise the right. Speculating using share options  current share price of Company XYZ is £2  investor with £1,000 is confident that it will rise to £3 per share in 6 months  6-month call on this share at strike £2.20 is currently £0.10 per share  Strategy 1: buy 500 shares now at £2, sell at £3 in 6 months, net profit=£500  Strategy 2: buy now 10 calls of 1,000 shares (i.e. the right to buy 10,000 shares at £2.20), exercise them in 6 months, net profit=£7,000  Net profit comes from the fact that she will exercise the right to buy the shares at £22,000 and immediately sell them at £30,000 (8,000 diff) less the option premium of 1,000.  This spectacular profit comes at a high risk.  Consider if price of shares goes up to £2.10  By buying and selling she makes a profit of £50  By buying the option contract she loses all her money (£1,000) Option pricing: Intrinsic and time value Intrinsic value – value that would be realized if an option were exercised immediately  intrinsic value of a call = cash price – strike price  intrinsic value of a put = strike price – cash price  Note: Intrinsic value is either zero or positive, it cannot be negative State of an option is determined by its intrinsic value:  in-the-money: option has a positive intrinsic value  at-the-money: option has a zero intrinsic value (but maximum time value)  out-of-the-money: has zero intrinsic value Time value – the remainder of an option premium after deducting its intrinsic value  time value = option premium – intrinsic value Option pricing: 5 key factors Basic principle: The greater the probability of an option being exercised, the higher will be the option premium, other things being equal. Five crucial factors that determine the likelihood of a call option being exercised and so influence the price to be paid for the call option: 1. Current price of share – the higher the current price of stock the more likely the option is to be exercised for any given exercise price and consequently the higher the price of a call option. 2. Strike price – the higher the strike price of a call option the less likely it is that it will be exercised and hence the lower its price. 3. Time left to expiration – the longer the time left to expiration, the more the chance of the option being exercised and hence the higher its price. 4. Volatility – the more volatile an option is, the more likely its price will exceed the strike price at expiration and hence the higher the price of the option. 5. Risk-free rate of interest – the purchaser of a call option is paying the issuer cash for an option that can be exercised to buy an underlying security at a future date. A rise in the risk-free rate of interest makes it more attractive to buy the option rather than the underlying security. Thus, the higher the risk-free rate of interest the higher a call option price. Determinants of an option’s premium