Investments MBA 536

1. InvestmentsMBA 536 Unit 6: Derivative SecuritiesSpeculative Markets

2. Unit 6: Derivative SecuritiesSpeculative Markets • In Unit 6 we address the top of the asset pyramid - derivative securities. The bottom of the pyramid represents real assets (gold, property, rolling stock, etc.). The next level contains financial claims – debt and equity. Derivatives are at the top not because they are more valuable, but because the represent the most risky securities and carry the most potential return on investment. They are used to speculate and to hedge. Unlike the lower two layers, derivatives securities are a zero sum game: one player wins, the other player loses.

3. Student Learning Objectives • Review the Financial System • Review important concepts in Finance • Speculative Markets • Option value at expiration • Some common option trading strategies • Option valuation • Other securities that resemble options

4. THE FINANCIAL SYSTEM: A Quick Review • Real Assets: tangibles exchanged for money prices = intrinsic values. • Financial Assets: intangibles whose exchange prices are a function of "A". • Derivatives: intangibles whose exchange prices are a function of "B". • Intrinsic values: values derived from possession, use, or utility. • Market Efficiency: how well money prices reflect intrinsic values. • Role of Open Auction Markets and Intrinsic Values • Price takers • Price makers

5. IMPORTANT CONCEPTS IN FINANCE • Risk and Risk Preference • The likelihood of a loss weighed against the magnitude of a gain. • How much the expected magnitude of the gain exceeds the cost. • The greater the cost, the greater the gain sought: Risk vs. Return. • Market Efficiency and Risk • Market price is an identity with economic value. • Economic value is a function of the risk of loss and the time to maturity. • Pricing Models (CAPM, APT, OPM) seek to determine economic value. • Liquidity has an important role in efficient markets

6. IMPORTANT CONCEPTS IN FINANCE • Arbitrage and the Law of One Price • Two identical goods cannot sell for two different prices. • Physical identity versus benefit bundles. • Role of cache and fungible goods. • When prices are not in sync, arbitrage opportunities arise. • Value today versus the value tomorrow a function of expectations

7. DERIVATIVE SECURITIES AND FINANCIAL MARKETS • Risk Management: hedging against adverse future price movements. • Price Discovery: what will tradable commodities be worth tomorrow? • Leverage Plays: Costs are lower than outright purchase of financial assets.

8. SPECULATIVE MARKETS: Derivative Securities • Derivative Securities; values dependent upon the values of other securities: • Price of a call option [premium]  stock price • Derivative Securities may also be called contingent claims. • Types of Derivative Securities: • Options: Contract giving the buyer the right, but not the obligation to buy or sell depending on whether it’s a call or put • Forward Contracts; an agreement to buy or sell in the future • Futures Contracts; like a Forward, only is traded publicly.

9. Characteristics of Option Contracts • Option contract gives the holder the right to: • Buy or sell a stated number of shares (100) • At a specified price (exercise or strike price) X • Until a specified point in time (expiration date) T • An option to buy stock is a call option • An option to sell stock is a put option • Options are called derivatives because their value is derived from the underlying stock

10. Writing an Option • The person who sells an option (writes an option) receives a premium • The price of the option is called the premium • Premiums represent time value and intrinsic value • Intrinsic value exists when there is a positive difference between the exercise price (X) and the stock price (S) • Option writers hope it expires out-of-the-money • Writing options offers unlimited loss to the writer for a limited gain • Only experienced traders who can risk substantial sums should write options – especially naked calls

11. Option Trading Risks and Opportunities • Options can be used to hedge (reduce risk of stock long or short positions) or speculate • Options trading provides leverage opportunities, similar to buying on margin • Leverage is a double-edged sword: losses can occur as readily as gains.

12. PRINCIPLES OF OPTION PRICING • Value of a Call Option at Expiration • C (ST, X) = Max (0, ST - X) • Call value can never be less than zero • Call value can never be greater than St - X • Value of Put Option at Expiration • P (ST, X) = Max (0, X - ST) • Put value can never be less than zero • Put value can never be greater than X

13. PRINCIPLES OF OPTION PRICING • Effects of Dividends on Call Option Premiums • For Dividend paying stocks, it is always better to exercise before the Ex date if the option is in-the-money; drop in call value when stock goes ex-dividend. • If S - X > Dividend then option stays in-the-money after the ex date. This is especially true if D > TVO (time value of the option) • Dividend effects important only if holder wants to establish long position in the underlying stock.

14. PRINCIPLES OF OPTION PRICING • Effects of Dividends on Put Option Premiums • An American put option (non-Dividend stock) should never be exercised early. • Always better to sell put in the market. Why? • (X - S) will always be less than [X (1 + r)-T- S] except at maturity. Why? • For Dividend paying stocks, it is always better to exercise after the ex-date

15. Black-Scholes Model for Pricing Options • Developed for European options which can be exercised only on expiration date • Assumes the risk-free rate and the underlying stock’s price volatility remain constant over the life of the option and the stock pays no dividends • If you know what the stock value will be when the option expires, then the call price equals the current stock price minus the present value of the exercise price

16. BLACK-SCHOLES OPTION PRICING MODEL (OPM) • Assumptions of the B-S OPM • Stock returns follow a lognormal distribution; i. e., Ln of 1 + r. • The risk-free rate and stock price variance are constant. • Perfect and complete markets • Non-dividend paying European options • C = S N(d1) - E e-rt N(d2) • d1 = [ Ln(S/E) + ( r +. 5s2)T ] s√T, d2 = d1 - s√T • N(d1,2) is the area under the bell curve defined by d (a z-value)

17. BLACK-SCHOLES OPTION PRICING MODEL (OPM) • Calculating the B-S Option Price • Recall that r is an annual rate. • Recall also that s2 (variance) is at an annual rate. • And that t = fraction of a year.

18. BLACK-SCHOLES OPTION PRICING MODEL (OPM) • Factors Affecting Option Prices D Premium • Increase in Call Put • Stock Price (S)........................... INCR DECR • Exercise Price (E)...................... DECR INCR • Expiration Date (T).................... INCR INCR • Volatility (s)............................... INCR INCR • Risk-free rate (r).......................... INCR INCR • Dividends (D)............................ DECR INCR

19. BREAK TIME

20. CHAPTER 22: FUTURES MARKETS • Student Learning Objectives • What are futures contracts? • Types of Contracts • How futures are traded • Options on futures

21. Futures Contracts • Forward contract calls for future delivery of an asset at a price agreed on today • Futures contract is a highly standardized version of a forward contract that can be traded in organized exchanges • A person agreeing to accept delivery of the asset has the long position • A person agreeing to deliver the asset has the short position

22. Types of Contracts • Physical commodities • Agricultural products • Nonagricultural products • Financial futures • Currency futures • Stock index futures • Interest rate futures • Requirements for a viable futures market • Ability to be standardized • Active demand • Ability to store asset for a period of time • Relatively high value in proportion to bulk • Relatively high value in proportion to storage and other carrying costs

23. Mechanics of Futures Trading • Daily Settlement • Commodity positions marked-to-market daily to insure market integrity. • All trading conducted in margin accounts. • Initial margin = good faith deposit. • Maintenance margin = minimum amount account may go (after losses). • Margin call = bring account up to initial level. • Booking changes in contract values.. • Gains/losses posted to appropriate accounts. • Net remainder must be greater than maintenance margin level, else 2. c. above.

24. Mechanics of Futures Trading • Delivery and Cash Settlement (99% all positions are closed via offsets) • Non-cash settlement contracts: any day during expiration month. • Cash settlement contracts: on last day of [monthly] series. • Sequence of events. • T-2: notice of intention to deliver (position day). • T-1: assignment day (to oldest open position) (notice of intention day). • T: delivery day - long pays the short, short delivers commodity to long. • If necessary, delivery price is adjusted for differences in quality.

25. Whose In The Pits? • Exchange members and their employees • Memberships are limited and can be traded • Three groups of traders • Commission brokers trading for others • Local traders trading for themselves or their firm • Dual traders performing both functions

26. Who are they trading with? • Hedger: seeks to protect investment in a spot position. • Speculator: attempts to profit from changes in basis. • Spreader: uses strategies similar to option spreaders - low risk level speculator. • Intra-commodity; i. e., like an option time spread. • Inter-commodity; profiting from violations of perceived normal differences. • Position = one long, one short contract.

27. Who are they trading with? • Types of Markets • Normal Backwardation: forward prices less than spot prices. • Contango: forward prices greater than spot prices (positive carry). • Contract Terms and Conditions • Quotation unit and size: i. e., pork bellies - 40,000#. • Minimum price change and maximum price change per day. • Limit moves = when reached trading stopped.

28. Principles Of Spot Pricing • Pricing Fixed-Income Securities • Spot rate = interest rate on FIS for immediate delivery. • Forward rate = interest rate on FIS for future delivery. • Forward rate = interest rate on a FIS issued at time t with a maturity of T. • Term structure defines relation between spot and forward rates. • Forward rates assume pure discount FIS. • Forward rates maintain the integrity of the yield curve.

29. Principles Of Spot Pricing • Computing Forward Rates Ra,b = (1 + R0,b)b / (1+R0,a)a Only if: a > 0 and b > a. • Ra,b = rate of interest for a loan made at the beginning of period a and • Maturing at he end of period b. • If a = 0, then Ra,b = spot rate for a FIS maturing at the end of period b. • R0,a and R0,b are spot rates for FIS delivered today with maturities of a and b, respectively.

30. Principles Of Spot Pricing • Some Last Thoughts on Forward Rates • Any forward rate greater than R(t1, t2) would advantage the lender. • Any forward rate less than R(t1, t2) would advantage the borrower.

31. Trading Strategies • Scalpers quickly trade for small changes in price • Day traders do not hold positions overnight • Position traders hold positions longer

32. Clearinghouse Process • Each futures market operates a not-for-profit corporation owned by members of the exchange as an intermediary and guarantor to every trade • Every trade has a short and a long position • Both parties must meet their obligations • Deliver and take delivery of the asset at the agreed price and time • The clearinghouse guarantees that both parties fulfill their obligations

33. Clearinghouse Process • Margins: set by CH for each category • Margin deposits held by CG • Accounts are marked to market each day • Margin calls occur when maintenance margin levels are breached (on downside) • All commodities subject to daily limit moves • Delivery procedures controlled by the CH

34. MARGIN MAINTENANCE EXAMPLE • Daily Settlement and Margin Calls • Corn (CBT) 5,000 Bu quote in cents per pound 1/4 cent minimum price change • Open position on day 1 at 274 1/2 Contract value = 5000 * 2. 745 = $ 13,725. 00 • Initial margin is 10% = $ 1372. 50 (good faith deposit. ) 80% Maintenance = $ 1098. • Day 2: settle at 267 1/4. Day 3: settle at 264. Day 4. settle at 268 1/2

35. MARGIN MAINTENANCE EXAMPLE B. Daily Marking to Market

36. Futures Price Quotations • Open interest refers to the number of contracts outstanding at a point in time • Basis is the difference between the spot price and futures price for an asset • The difference between prices of two different futures contracts is a spread • An intracommodity spread is the difference between two futures contracts on the same commodity but with different delivery dates