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IC301
Derivative Securities

IC301 Module Objectives
Understand the uses of derivatives
Be able to apply pricing & strategies of different derivative transactions
Cite main risks associated with derivatives
Explain and develop effective hedging & trading strategies
Text book – Options, Futures and other Derivatives: John C. Hull (9th edition)
See: https://www.reading.ac.uk/modules/document.aspx?modP=IC301&modYR=1920
https://www.cmegroup.com/futures_challenge/dashboard

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Course structure
Topic 1 – Introduction to forwards and futures
Topic 2 – Forwards and futures hedging
Topic 3 – Option markets & trading strategies
Topic 4 – Introduction to option pricing + SIM 1
Topic 5 – Options on stock indices, currencies, futures + SIM 2
Topic 6 – STIRs + SIM 3
Topic 7 – Bond futures + SIM 4
Topic 8 – Interest rate swaps
Topic 9 – Credit derivatives
Topic 10 – Exotic options, ETFs, CFDs

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IC301 – Topic 1
Introduction to Forwards & Futures

Pay out profile – Forward contract
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Spot (ST)

Profit or Loss (+/-)

Contract Rate (K)

Spot (ST)

Profit or Loss (+/-)

K
Long Position
Short Position

Derivatives Markets
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Foreign Exchange
Interest Rates
Equities
Commodities
Credit

Types of Derivatives
Forwards
Futures
Options
Swaps

Futures and Forwards
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A Forward Contract
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Profit or Loss (+/-)

Contract Rate (K)

Profit or Loss (+/-)

K
Long Position
Short Position
Forward (F)

Forward (F)

Payoff Formulae
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Long Position
At maturity date
On trade date
ST – K
df * (F – K)
Short Position
At maturity date
On trade date
K – ST
df * (K – F)

What are derivatives?

Derivatives are financial instruments that have no intrinsic value, but derive their value from an underlying asset.
Examples: forwards, futures, options, swaps
They can hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks or government bonds.

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A couple of charts
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How big is a trillion? http://www.pagetutor.com/trillion/index.html
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Growth of derivatives

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Derivatives relative to Global GDP

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?
Which one is derived from the other ?
Oil well
Oil futures & options exchange – Nymex
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EXCHANGES
OPEN OUTCRY
SCREEN BASED
ORDER DRIVEN
QUOTE DRIVEN
ORDER DRIVEN
QUOTE DRIVEN

Exchanges and Clearing Houses

Nymex LME
CME Eurex Nasdaq
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Exchange traded Vs

Over the counter

Which one has more counterparty risk ?
Who are you dealing with ?
Open outcry or screen based
Between two counterparties
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Bigger profits!
+
(bigger losses)
Leverage

Trading on Margin – initial margin
– maintenance
margin

Hedging vs Speculation
Uses of derivatives

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What are the advantages of using futures and options on a futures exchange?

Standardised contracts
Guaranteed by exchange
Leverage
Ease of shorting
Liquid and low transaction costs
Daily mark to markets.
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The OTC Market Prior to 2008
Largely unregulated
Banks acted as market makers quoting bids and offers
Master agreements usually defined how transactions between two parties would be handled
But some transactions were handled by central counterparties (CCPs). A CCP stands between the two sides to a transaction in the same way that an exchange does
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Since 2008…
OTC market has become regulated. Objectives:
Reduce systemic risk (see Business Snapshot 1.2, page 27)
Increase transparency
In the U.S and some other countries, standardized OTC products must be traded on swap execution facilities (SEFs) which are similar to exchanges
CCPs must be used for standardized transactions between dealers in most countries
All trades must be reported to a central registry.
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The FX Forward market
A forward FX contract is a deal to exchange currencies – to buy or sell a particular currency – at an agreed date in the future, at a rate – a price – agreed now.
This rate is called the forward rate. Banks will provide forward FX quotes on more or less any currency pair.

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International Trade
creates the need for
FX forwards
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$1 million
“Spot”: $1 = INR65
$1m = INR 65,000,000
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If 6 month forward FX = 2.26 points
65.00
02.26 +
67.26 outright forward price to sell $ and buy INR

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Forward Swap Exchange Rates

Outright forward = Spot rate + Forward Swap Rate

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Where v = variable currency interest rate
b = base currency interest rate

Calculate forward swap rate
USD/INR 65.00
USD 6 month 1%
INR 6 month 8%
180 days
Calculate the forward swap points for 6 month USD/INR
Is it a premium or discount?

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$1mm
INR 65mm
Start Today
180 days 8%
180 days 1%
6 months
INR 67.6 mm
$1,005,000
67,600,000 / 1,005,000
= 67.26
USD/INR 65.00

FX Forwards
 
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USINR FX Forwards

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More slides from

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EURUSD Forward FX

Recent Eur-Usd forward swap points – are they premium or discount?

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USDJPY Forward FX

Premium or discount?
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Anatomy of a Transaction
(and the “time and currency” diagram)

EUR
USD
spot
2m


+
1m
3m

time

currencies
the deal
currency bought
currency sold
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Types of FX Deal

EUR
USD
spot
3m

Spot Deal

+

EUR
USD

Outright Forward Deal

+

EUR
USD

Swap Deal

+

+

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Futures
Standardised on exchanges
Rice futures Osaka 1670s
Agricultural futures Chicago 1860s
Counterparty risk is with exchange
Margin – initial & variation
Mark to market
Delivery.
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Futures
Financial futures 1970s
Floating currencies
Volatile interest rates
Valuation models to measure risk.

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Top 5 trading losses

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The Lehman Bankruptcy (Business Snapshot 1.1)
Lehman’s filed for bankruptcy on September 15, 2008. This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives markets and got into financial difficulties because it took high risks and found it was unable to roll over its short term funding
It had hundreds of thousands of transactions outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging for both the Lehman liquidators and their counterparties
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How Derivatives are Used
To hedge risks
To speculate (take a view on the future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring the costs of selling one portfolio and buying another
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1. Gold: An Arbitrage Opportunity?
Suppose that:
The spot price of gold is US$1,400
The 1-year forward price of gold is US$1,500
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?
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2. Gold: Another Arbitrage Opportunity?
Suppose that:
The spot price of gold is US$1,400
The 1-year forward price of gold is US$1,400
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?
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The Forward Price of Gold (ignores the gold lease rate)
If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free rate of interest.
In our examples, S = 1400, T = 1, and r =0.05 so that
F = 1400(1+0.05) = 1470
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Gold Futures

1497(1.02)^1=1527 [forward one year is actually 1.9% so spot is cheap as IR are falling (negative in some currencies) so buy spot sell forward]

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Types of Traders
Hedgers
Speculators
Arbitrageurs
Market makers
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Hedging Examples (pages 33-35)
A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract
An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts
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Value of Microsoft Shares with and without Hedging (Fig 1.4, page 35)
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Comparison – fwds neutralise risk, options provide insurance (can still benefit from favourable price movements)

No Hedging 20 22 24 26 27.5 28 30 32 34 36 20000 22000 24000 26000 27500 28000 30000 32000 34000 36000 Hedging 20 22 24 26 27.5 28 30 32 34 36 26500 26500 26500 26500 26500 27000 29000 31000 33000 35000 Stock Price ($)

Value of Holding ($)

Speculation Example
An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of 22.50 is $1
What are the alternative strategies?
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Speculation using leverage
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[Hull, p37]
Investor has $2,000 to speculate
Choice is to buy


100 shares at $20
2,000 call options with a strike of $22.50 at a premium of $1 per share

Leverage
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[Hull, p38]

Arbitrage Example
A stock price is quoted as £100 in London and $150 in New York
The current exchange rate is 1.5300
What is the arbitrage opportunity?
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Sell stock in London receive £100, convert to $153 ; buy $150 stock in NY > profit $3

Dangers
Traders can switch from being hedgers to speculators or from being arbitrageurs to speculators
It is important to set up controls to ensure that trades are using derivatives in for their intended purpose
Soc Gen (see Business Snapshot 1.4 on page 40) is an example of what can go wrong

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Hedge Funds (see Business Snapshot 1.3, page 34)
Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly.
Mutual funds must
disclose investment policies,
makes shares redeemable at any time,
limit use of leverage
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies & are big users of derivatives for hedging, speculation and arbitrage
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Types of Hedge Funds
Long/Short Equities
Convertible Arbitrage
Distressed Securities
Emerging Markets
Global Macro
Merger Arbitrage.

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GENERAL VIEW OF FLOOR OF NEW YORK STOCK EXCHANGE

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