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Chapter 7 Financial Derivatives

Chapter 7 Financial Derivatives. Requirement. 1.Grasp (1)how to use forward contract to hedge (2)how to use futures contract to hedge (3)profit and loss on option and futures contract (4)the process of interest rate swap. (5)pros and cons of forward contract

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Chapter 7 Financial Derivatives

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  1. Chapter 7 Financial Derivatives

  2. Requirement • 1.Grasp • (1)how to use forward contract to hedge • (2)how to use futures contract to hedge • (3)profit and loss on option and futures contract • (4)the process of interest rate swap. • (5)pros and cons of forward contract • (6)advantage and disadvantage of interest rate swap

  3. Main point: • 1.how to hedge by forward , futures and option contract. • 2. the process of interest rate swap

  4. 3.Key words • American option • call option, • currency swap • European option • exercise price (strike price) • financial derivatives • financial futures contract • financial futures option (futures option) • forward contract • Hedge • interest-rate forward contract

  5. interest-rate swap • long position • margin requirement • marked to market • Hedge • notional principal • open interest • option • Premium • put option • short position • stock option • Swap • arbitrage

  6. ⅠDefinitions • 1.Financial derivatives • have payoffs that are linked to previously issued securities and are extremely useful risk reduction tools.

  7. 2.Hedging • engage in a financial transaction that reduces or eliminates risk. Hedge risk involves engaging in a financial transaction that offset a long position by taking an additional short position, or offsets a short position by taking an additional long position.

  8. 3.Long position • financial institution has bought an asset, it is said to have taken a long position. • 4.Short position • financial institution has sold an asset that it has agree to deliver to another party at future date, it is said to have taken a short position.

  9. Ⅱ Forward Contracts • Forward contracts are agreements by two parties to engage in a financial transaction at a future (forward) point in time.

  10. 1. interest-rate forward contracts • forward contracts that are linked to debt instruments, called interest-rate forward contracts.

  11. Example : • You have bought RMB50000 6s of 2020 Treasury bonds at par value. You expected the interest rate will rise after a year. How do you hedge the risk of interest rate? • Sell out interest forward contract of RMB 50000 6s of 2020 Treasury bonds at par value. • The return be locked in 6%

  12. 2.foreign exchange forward contract • agreements by two parties to engage in a transaction of foreign exchange at a future (forward) point in time.

  13. example: • You are an importer of China and you are willing to import commodity amount to $50000 from US. Next month, and you fear US dollar to appreciate, how do you hedge the risk of foreign exchange rate. The foreign exchange rate is US$1=RMB7 in the forward market of 1 month US forward contract. • Buy a foreign exchange forward contract amount to $50000

  14. 3.Pros and cons of forward contracts • (1)advantage • flexible • (2) disadvantage • lack of liquidity • default risk

  15. ⅡFinancial Futures Contract and Market • 1.Financial futures contract • A contract specified that financial instrument must be delivered by one party to another on a stated future date.

  16. Prices of Futures Contract

  17. (1)Delivery of the futures contract • long position • short position

  18. (2) Arbitrage At the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered. and we call the elimination of riskless profit opportunities in the futures market as arbitrage

  19. (3)variation margin • The Price of (face value is $100,000) June T-bond futures contract is 115.

  20. (4)profit and loss for futures contract profit profit Price of futures contract at expiration Price of futures contract at expiration Buyer of futures contract(long position) seller of futures contract(short position)

  21. (5)hedge • Discussion: how to use futures to hedge?

  22. Example 1: • company A hold $100,000 treasury bonds, now the interest rate is 5%(interest rate =return, the t-bond sell at par ), and the company fear that the interest rate will decline next year, then what can be do by the company to hedge the interest rate risk. • (If next year interest rate rise to 6%, the price of treasury bonds will fall to $99,000)

  23. If don’t sell out futures of $100,000 treasury bonds. • Next year interest rate rise to 6%, the price of treasury bonds will fall to $99,000, there will be a capital loss of A, the loss is $1,000 • If A sell futures of $100,000 treasury bonds out, a year later: • Interest rate rise to 6%, the price of future contract and treasury bonds are same($99,000)

  24. The capital loss because of interest rate increase is $1000, and the income from futures market is just $1000. the loss and income offset.

  25. Example 2: • a Chinese importer has a pay of US dollar next month amount to US$10,000, the importer afraid that the US dollar will upvalue a month later, how can he do to hedge the risk. (the exchange rate in the futures contract expired one month later is US$1=RMB6.5, and spot exchange rate a month later is US$1=RMB7)

  26. To buy futures contract of us$10,000 now, the exchange rate is US$1=RMB6.5, and month later the exchange rate is US$1=RMB7, in the futures market exporter can gain RMB5,000 • And the loss in spot market is RMB5,000 • Offset

  27. 2.difference between forward and futures contract • (1)standardized • (2)after the futures contract has been bought or sold , it can be traded again at any time until delivery date.

  28. (3) In a futures market, not just one specific type of Treasury bond is deliverable on the delivery date. • (4)Buyer and seller of a futures contract make their contract not with each other but with the clearinghouse associated with the futures exchange. Buyer and seller of futures contracts do not have to worry about default risk.

  29. (5)Most futures contract do not result in delivery of underlying asset on the expiration date.

  30. Ⅲ Options • 1.defination of option • Options: are contracts that give the purchaser the option, or the right , to buy or sell the underlying financial instrument at a specified price, call the exercise price or strike price, within a specific period of time (the term to expiration).

  31. Buyer : exercise or let the contract expire without using it. • Seller :has no choice. • Premium: the owner an option are willing to pay an amount for the right to buy or sell , called premium.

  32. 2.classification of options • (1)according to exercise time • American option: can be exercise at any time up to expiration date of the contract • European option: can be exercise only on the expiration date.

  33. (2)underlying instrument • Stock option: options on individual stock • Futures option: option contract on financial contract.

  34. (3)the right to buy or sell • call option: a contract gives the owner the right to buy a financial instrument at exercise price within a specific period of time. • Put option: a contract that gives the owner the right to sell a financial instrument at the exercise price within a specific period of time.

  35. 3.Option Contract

  36. Example 1.call option • (1)if the market price of the T-bond is 110,000, strike price is 112point, premium is 1-45,what should be done by the buyer of the call option? • let the contract expire (will not exercise the option contract ), what he should pay is the premium 1703. loss =1703

  37. (2)If the market price of the T-bond is 113,000, what should be done by the buyer of the call option? • Exercise the options contract, buy the T-bond at 112,000 according to options contract, and sell them out in the market at 113,000, and get profit 1000. • Premium is 1703, and the net profit is 1000-1703=-703

  38. (3)If the market price of the T-bond is 120,000, what should be done by the buyer of the call option? • Exercise the options contract, buy the T-bond at 112,000 according to options contract, and sell them out in the market at 120,000, and get profit 8000. • Premium is 1703, and the net profit is 8000-1703=6397

  39. Example 2. put option • contract of march • strike price is: us$112×1000=us$112,000 • premium is 0-19: 19/64×1000=297 • (1)if the market price of the T-bond is 110,000, what should be done by the buyer of the put option? • Exercise the options: buy the T-bond from market at 110,000, and sell them out at 112,000 according to options , can gain 2000,and pay premium 297, the net income=1703

  40. (2)If the market price of the T-bond is 111,900, what should be done by the buyer of the put option? • Exercise the options: buy the T-bond from market at 111,900, and sell them out at 112,000 according to options , can gain 100,and pay premium 297, the net income=-179

  41. (3)If the market price of the T-bond is 120,000, what should be done by the buyer of the call option? • Let the option expire, loss=premium=297

  42. profit profit buyer Price of underlying tools Price ofunderlying tools Call option put option 4.Profits And Losses On Option And Futures Contract

  43. 5. Difference Between Futures and Option Contract (1)the profit curves are different (2)Initial investment on the contracts differs. (3)money required to change hands are different .

  44. 6. Hedging With Options. • Asset----afraid price of the asset decrease ----buy put option (to hedge) • Liability (paying)----afraid price of the liability to go up---buy call option (to hedge)

  45. Example1. company A hold 100,000 T-bond, 5% interest rate ,now expected interest rate will increase to 6%, there will be capital loss 1,000, how can the company hedge • Interest rate by option contract. • buy put option. • options contract of march • strike price is: US$100,000 • premium is 0-19: 200 • if the market price of the T-bond is 99,000, what should be done by the buyer of the put option? • Exercise the option contract. Sell the t-bond out and gain 800.

  46. 7.Factors Affecting The Prices of Option Premium • (1)when the strike price is higher the premium for call option is lower and the premium for put option is high. • (2)the period of time over which the option can be exercised (term to expiration) gets longer, the premium for both call and put option rise. • (3)the greater the volatility of prices of underlying financial instrument, everything else being equal, the higher the premiums for both call and put options.

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