DERIVATIVE INSTRUMENTS and HEDGING Burak Saltoglu

1. DERIVATIVE INSTRUMENTS and HEDGING Burak Saltoglu

2. General Definitions • Forward and Futures Contrats • Options

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.

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)

5. FX Interest Gov-Debt Equ-Index Stocks Comm Credit Global Derivative Products 2004 OTC Derivative Markets Exchange-Traded Derivatives US: 35% EU: 45% Asia: 20% 23% 14% 68% 80% $53 trn notional $10trn mkt value $220 trn notional $6 trn mkt value OTC (bar) and Exchange-Traded (line) Derivatives (notional outstanding, in billions US$) Annual growth rates exceed 30% Sources: BIS (Dec 2004) ; FIBV (Jan 2005)

6. Derivaties Transaction Volume (BIS)

7. Derivaties Transaction Volume

8. Derivative Types • Futures and Forward • Swap • Options • Credit Derivatives • Other Structural Products

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.

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.

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.

12. Cash or spot prices

13. Futures on Dow Jones

14. Gold vs crude oil

15. TurkDex: IMKB30 ve 100 Futures

16. ForEx Futures: TurkDex, 17.12.2008

18. Gold Futures: 9 April 2009

19. Basic Definitions • Forward and Futures Contracts

20. Differences Between Futures and Forward Contracts • Structural Differences • Marking to Market

21. Forward ve Futures Contrats FORWARDS FUTURES Done between 2 parties Formal MArkets Standard Contrats Non-standard Contrats Daily Payment Payment at Contract Maturity Contract is closed down before the maturity. Delivery generally occurs. Default risk exist. Default risk is minimized.

22. Credit Risk Controls in Futures Markets • Marking to Market • Daily Price Change Limits - Limit-Up - Limit-Down

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. 13/09/2014 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.

25. USD/YTL

26. EUR/YTL

27. 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.

28. Marking to Marketing in Futures Contracts Margin Calls Margin Account for YEN/USD Initial Margin Margin Account Maintenance Margin 13/09/2014 28

29. Client : Baring Futures (Singapore) Ltd. Account No: 88888 Address : c/o Singapore Office 20 Raffles Place 24th Floor, Ocean Towers Singapore 0104 Attention: Nick Leeson Date: 24/02/95 Page:26 Daily Activity Statement Barings Futures (Singapore) Pte Ltd. 20 Raffles Place, 24th Floor, Ocean Towers, Singapore 0104 Tel: 5395571 / 5395572 DAILY STATEMENT OF UNREALISED PROFIT AND LOSS :::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::: 7. Equity Balance0,00 59,239,120,000.00 (JPY) 8. Collateral Securities Held ....... ....................................... 13/09/2014 29

30. 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!!)

31. 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.

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. b saltoglu Türev ürün notları

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 13/09/2014 34

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.

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).

37. ForEx Debt exRate: 1.7 US Dollar

38. Futures Long

39. Hedge: Short Spot+Long Futures

40. Introduction to Option Markets

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.

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.

43. Option Positions • Long call • Long put • Short call • Short put

44. Profit ($) 30 20 10 Spot at the maturity of option ($) 70 80 90 100 0 110 120 130 -5 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:

45. Profit ($) 30 20 10 Spot at the maturity 0 40 50 60 70 80 90 100 -7 Long Put:Exxon Premium for put option on the exxon stock= $7, exercise price = $70

46. Profit/loss ($) 110 120 130 5 0 70 80 90 100 Spot price at the maturity ($) -10 -20 -30 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:

47. Kar ($) Vadedeki fiyat ($) 7 40 50 60 0 70 80 90 100 -10 -20 -30 Short Put Exxon Premium for put option on the exxon stock= $7, exercise price = $70

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).

49. Assets Underlying To Options • Stocks • ForEx Rates • Stock Indexes • Futures • Energy, weather situation, etc.

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).