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Sako Mwakalobo
INTERNATIONAL BOND MARKET
• The international bond market
encompasses two basic market segment
• Foreign bo...
Sako Mwakalobo
EUROBOND
• Eurobond issue is one denominated in a
particular currency but sold to investors in
national cap...
Sako Mwakalobo
EUROBOND
• Eurobonds are known by the currency ibn which
they are denominated, for example, U.S. dollar
Eur...
Sako Mwakalobo
BEARER BONDS AND REGISTERED BONDS
• Eurobond, Bearer bond, possession is evidence
of ownership. The issue d...
Sako Mwakalobo
FOREIGN BONDS
• The foreign bonds must meet the security
regulations of the country in which they
are issue...
Sako Mwakalobo
GLOBAL BONDS
• It is a very larger international bond offering by
a single borrower that is simultaneously ...
Sako Mwakalobo
GLOBAL BOND
• The largest corporate bond issue is the
$14.6 billion Deutsch Telecom
multicurrency offering....
Sako Mwakalobo
PARTICIPANTS IN EUROBOND MARKET
• Private enterprises, for example in France, one
of them is Renault
• Publ...
Sako Mwakalobo
Investors and financial institutions
• The investors in the Euromarkets are
mostly institutional investors,...
Sako Mwakalobo
ORGANISATION OF EUROBOND MARKET
• The market can be bifurcated into two
segments, namely, Primary market in...
Sako Mwakalobo
Issuer
Selection of the lead manager
Selection of co-lead managers by the lead manager
Guarantee syndicate:...
Sako Mwakalobo
Types of instruments ( characteristics of
Eurobonds
• The international bond market has been much
more inno...
Sako Mwakalobo
Types of Instruments
• Floating rate bonds( FRN)- the interest rate of the
bonds is revised every three or ...
Sako Mwakalobo
Types of instruments
• Zero-coupon bonds – are sold at a
discount from face value and do not pay
any coupon...
Sako Mwakalobo
Types of instruments
• Reverse floating rate bonds- the bonds
pay a higher interest rate when the rate
of r...
Sako Mwakalobo
See handout 6 for continuation of
stock markets, stock exchange
procedures and assessment of
shares perform...
Sako Mwakalobo
The Nature of Derivatives
A derivative is an instrument whose
value depends on the values of other
more bas...
Sako Mwakalobo
Examples of Derivatives
•Futures Contracts
•Forward Contracts
•Swaps
•Options
Sako Mwakalobo
Derivatives Markets
• Exchange traded
• Traditionally exchanges have used the
open-outcry system, but incre...
Sako Mwakalobo
Size of OTC and Exchange Markets
Source: Bank for International Settlements. Chart shows total principal am...
Sako Mwakalobo
Ways Derivatives are Used
• To hedge risks
• To speculate (take a view on the
future direction of the marke...
Sako Mwakalobo
Forward Contracts
• Forward contracts are similar to futures
except that they trade in the over-the-
counte...
Sako Mwakalobo
Foreign Exchange Quotes for JPY
Jan 22, 2007 (16:23 EST)
Bid Offer
Spot 121.62 121.63
1-month
forward
121.0...
Sako Mwakalobo
Forward Price
• The forward price for a contract is
the delivery price that would be
applicable to the cont...
Sako Mwakalobo
Terminology
• The party that has agreed to buy
has what is termed a long position
• The party that has agre...
Sako Mwakalobo
Example
• On June 3, 2003 the treasurer of a
corporation enters into a long forward
contract to buy £1 mill...
Sako Mwakalobo
Profit from a
Long Forward Position
Profit
Price of Underlying
at Maturity, ST
K
Sako Mwakalobo
Profit from a
Short Forward Position
Profit
Price of Underlying
at Maturity, ST
K
Sako Mwakalobo
Futures Contracts
• Agreement to buy or sell an asset for a
certain price at a certain time
• Similar to fo...
Sako Mwakalobo
Exchanges Trading Futures
• Chicago Board of Trade
• Chicago Mercantile Exchange
• LIFFE (London)
• Eurex (...
Sako Mwakalobo
Examples of Futures Contracts
Agreement to:
• buy 100 oz. of gold @ US$400/oz.
in December (NYMEX)
• sell £...
Sako Mwakalobo
1. Gold: An Arbitrage
Opportunity?
Suppose that:
The spot price of gold is
US$300
The 1-year forward price ...
Sako Mwakalobo
2. Gold: Another Arbitrage
Opportunity?
Suppose that:
-The spot price of gold is
US$300
-The 1-year forward...
Sako Mwakalobo
The Forward Price of Gold
If the spot price of gold is S and the forward
price for a contract deliverable i...
Sako Mwakalobo
1. Oil: An Arbitrage Opportunity?
Suppose that:
- The spot price of oil is US$19
- The quoted 1-year future...
Sako Mwakalobo
2. Oil: Another Arbitrage
Opportunity?
Suppose that:
- The spot price of oil is US$19
- The quoted 1-year f...
Sako Mwakalobo
Options
• A call option is an option to buy a
certain asset by a certain date for a
certain price (the stri...
Sako Mwakalobo
American vs European Options
• An American option can be exercised at
any time during its life
• A European...
Sako Mwakalobo
Intel Option Prices (Jan 22, 2007;
Stock Price=86.79)
Strike
Price
Feb
Call
Mar
Call
Apr
Call
Feb
Put
Mar
P...
Sako Mwakalobo
Exchanges Trading Options
• Chicago Board Options Exchange
• American Stock Exchange
• Philadelphia Stock E...
Sako Mwakalobo
Options vs Futures/Forwards
• A futures/forward contract gives the
holder the obligation to buy or sell at ...
Sako Mwakalobo
Types of Traders
• Hedgers
• Speculators
• Arbitrageurs
Some of the largest trading losses in derivatives h...
Sako Mwakalobo
Hedging Examples
• A US company will pay £10 million
for imports from Britain in 3 months
and decides to he...
Sako Mwakalobo
Value of Microsoft Shares with
and without Hedging
20,000
25,000
30,000
35,000
40,000
20 25 30 35 40
Stock ...
Sako Mwakalobo
Speculation Example
• An investor with $4,000 to invest feels
that Amazon.com’s stock price will
increase o...
Sako Mwakalobo
Arbitrage Example
• A stock price is quoted as £100 in
London and $172 in New York
• The current exchange r...
Sako Mwakalobo
Hedge Funds
• Hedge funds are not subject to the same rules as mutual
funds and cannot offer their securiti...
Sako Mwakalobo
Real World Situation - Cash
• Japanese Bank: Borrow USD in Interbank
Euromarket for 3 month term, T
• Could...
Sako Mwakalobo
Real World Situation - Cash
• Cash Flows are Additive
+
+
=
t0 t0+T
Y
Yx(1+L(t0,Y)xT)
USD
Y
Yx(1+L(t0,Y)xT)...
Sako Mwakalobo
Real World Situation – Cash
• At t0
•Borrowing rates in USD & Yen are
known
•Exchange rate USD & Yen are kn...
Sako Mwakalobo
Money Rates – Close Friday,
1/26/07
/ YEN /
1WK .345
1MO .35
2MO .435
3MO .47
4MO .505
5MO .515
6MO .545
9M...
Sako Mwakalobo
Spot/Forwards – USD-JPY
U S D -J P Y S P O T / F O R W A R D S Source CMPN Composite (NY)
Close Time of Bid...
Sako Mwakalobo
1. Gold: An Arbitrage
Opportunity?
Suppose that:
The spot price of gold is
US$300
The 1-year forward price ...
Sako Mwakalobo
2. Gold: Another Arbitrage
Opportunity?
Suppose that:
-The spot price of gold is
US$300
-The 1-year forward...
Sako Mwakalobo
The Forward Price of Gold –
The Principal of Cash and
Carry
• If the spot price of gold is S(t0) and the fo...
Sako Mwakalobo
The Forward Price of Gold – The
Principal of Cash and Carry
• How does this come about?
S(t0)
t0
receive
pa...
Sako Mwakalobo
Gold Arbitrage?
• The no arbitrage gold, 1-year forward condition is
F(t0,T) - S(t0) x (1+r )T
= 0
• If 1-y...
Sako Mwakalobo
Hedging Example
• A US company will pay £10 million for imports from
Britain in 3 months and decides to hed...
Sako Mwakalobo
Futures Contracts
• Available on a wide range of underlyings
• Exchange traded
• Specifications need to be ...
Sako Mwakalobo
Forward Contracts vs Futures
Contracts
Private contract between 2 parties Exchange traded
Non-standard cont...
Sako Mwakalobo
Margins
• A margin is cash or marketable
securities deposited by an investor with
his or her broker
• The b...
Sako Mwakalobo
Example of a Futures Trade
• An investor takes a long position in
2 December gold futures contracts
on June...
Sako Mwakalobo
A Possible Outcome
Daily Cumulative Margin
Futures Gain Gain Account Margin
Price (Loss) (Loss) Balance Cal...
Sako Mwakalobo
Other Key Points About Futures
• They are settled daily
• Closing out a futures position
involves entering ...
Sako Mwakalobo
Collateralization in OTC Markets
• It is becoming increasingly common for
contracts to be collateralized in...
Sako Mwakalobo
Another Detail for Cash and Carry
Arbitrage
• Contract price changes with longer term
•Higher or Lower
• To...
Sako Mwakalobo
Futures Prices for Gold on Feb 4, 2004: Prices
Increase with Maturity
Storage Costs < Financing
(a) Gold
39...
Sako Mwakalobo
Futures Prices for Oil on February 4, 2004:
Prices Decrease with Maturity
Storage Cost > Financing
(b) Bren...
Sako Mwakalobo
Delivery
• If a futures contract is not closed out before
maturity, it is usually settled by delivering the...
Sako Mwakalobo
Some Terminology
• Open interest: the total number of contracts
outstanding
• equal to number of long posit...
Sako Mwakalobo
Convergence of Futures to Spot
Time Time
(a) (b)
Futures
Price
Futures
Price
Spot Price
Spot Price
Sako Mwakalobo
Questions
• When a new trade is completed
what are the possible effects on
the open interest?
• Can the vol...
Sako Mwakalobo
Regulation of Futures
• Regulation is designed to
protect the public interest
• Regulators try to prevent
q...
Sako Mwakalobo
Accounting & Tax
• Ideally hedging profits (losses) should be
recognized at the same time as the losses
(pr...
Sako Mwakalobo
Forward Contracts vs Futures
Contracts
Private contract between 2 parties Exchange traded
Non-standard cont...
Sako Mwakalobo
Foreign Exchange Quotes
• Futures exchange rates are quoted as the
number of Tshs per unit of the foreign
c...
Sako Mwakalobo
Long & Short Hedges
• A long futures hedge is appropriate
when you know you will purchase an
asset in the f...
Sako Mwakalobo
Arguments in Favor of Hedging
Companies should focus on the main
business they are in and take steps
to min...
Sako Mwakalobo
Arguments against Hedging
• Shareholders are usually well diversified
and can make their own hedging
decisi...
Sako Mwakalobo
Convergence of Futures to Spot
(Hedge initiated at time t1 and closed out at time t2)
Time
Spot
Price
Futur...
Sako Mwakalobo
Basis Risk
• Basis is the difference
between spot & futures
• Basis risk arises because of
the uncertainty ...
Sako Mwakalobo
Short Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S1 : Initial Asset Price
S2 ...
Sako Mwakalobo
Long Hedge
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S1 : Initial Asset Price
S2 :...
Sako Mwakalobo
Choice of Contract
• Choose a delivery month that is as close
as possible to, but later than, the end of
th...
Sako Mwakalobo
Optimal Hedge Ratio
Proportion of the exposure that should optimally be
hedged is
where
σS is the standard ...
Sako Mwakalobo
Optimal Hedge Ratio – Minimum
Variance Result
• The number of futures, NF, in ratio h (the hedge ratio),
re...
Sako Mwakalobo
Hedging Using Index Futures
To hedge the risk in a portfolio the
number of contracts that should be
shorted...
Sako Mwakalobo
Reasons for Hedging an Equity
Portfolio
• Desire to be out of the market for a short
period of time. (Hedgi...
Sako Mwakalobo
Example
Value of S&P 500 is 1,000
Value of Portfolio is $5 million
Beta of portfolio is 1.5
What position i...
Sako Mwakalobo
Changing Beta
• What position is necessary to reduce the
beta of the portfolio to 0.75?
• What position is ...
Sako Mwakalobo
Hedging Price of an Individual
Stock
• Similar to hedging a portfolio
• Does not work as well because only ...
Sako Mwakalobo
Why Hedge Equity Returns
• May want to be out of the market for a while.
Hedging avoids the costs of sellin...
Sako Mwakalobo
Rolling The Hedge Forward
• We can use a series of futures
contracts to increase the life of a
hedge
• Each...
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Financial markets and financial instruments

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The slides provides basic conception of financial markets and exemplify the financial derivatives, arbitrage and arbitrage position

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Transcript of "Financial markets and financial instruments"

  1. 1. Sako Mwakalobo INTERNATIONAL BOND MARKET • The international bond market encompasses two basic market segment • Foreign bonds • Eurobonds • A foreign bond issue is one offered by foreign borrower to the investor in a national capital market and denominated in that nation’s currency. e.g. a Germany MNC issuing dollar denominated bonds to US investor.
  2. 2. Sako Mwakalobo EUROBOND • Eurobond issue is one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. e.g. a Dutch borrower issuing a dollar denominated bonds to investors in the U.K, Switzerland, and the Netherlands. • The market for foreign bonds and Eurobonds operate in parallel with the domestic national bond markets, and all three market groups compete with one another
  3. 3. Sako Mwakalobo EUROBOND • Eurobonds are known by the currency ibn which they are denominated, for example, U.S. dollar Eurobonds, yen Eurobonds and Swiss franc Eurobonds or correspondingly, Eurodollar bonds, Euroyen bonds, and EuroSF bonds • The Foreign bonds frequently have colorful names that designate the country in which they are issued. e.g. Yankee bonds are dollar – denominated foreign bonds originally sold to US investor, Samurai bonds are yen denominated foreign bonds, sold in Japan, and Bulldogs are pound sterling denominated foreign bonds sold in the UK
  4. 4. Sako Mwakalobo BEARER BONDS AND REGISTERED BONDS • Eurobond, Bearer bond, possession is evidence of ownership. The issue does not keep any records indicating who is the current owner of a bond. • Registered bonds, the owner’s name is on the bond and it is also recorded by the issuer, or else the owner’s name is assigned toe the bond serial number recorded by the issuer. When a registered bond is sold, a new bond certificate is issued with the new owner’s name, or the new owner’s name is assigned to the bond serial number. • Which one would you like and why?
  5. 5. Sako Mwakalobo FOREIGN BONDS • The foreign bonds must meet the security regulations of the country in which they are issued. These may include • Prospectus disclosing the financial information about the issuer and should be available to the would be investors • They may be required to meet all conditions as local bonds. • They may not be sold to the residents of the country concerned.
  6. 6. Sako Mwakalobo GLOBAL BONDS • It is a very larger international bond offering by a single borrower that is simultaneously sold in North America, Europe and Asia • They follow the bond registration requirements of domestic bonds, but have the fee structure of Eurobonds. • They enlarge the borrower’s opportunities for financing at reduced costs. Purchasers mainly institutional investors to date, desire the increased liquidity of the issue and have been willing to accept lower yields.
  7. 7. Sako Mwakalobo GLOBAL BOND • The largest corporate bond issue is the $14.6 billion Deutsch Telecom multicurrency offering. The issue includes three US dollar tranches with 5, 10 and 30 year maturities totaling $9.5 billion, two euro tranches with 5,10 year maturities totalling €3 billion, two British pound sterling tranches with 5 and 30 year maturities totaling £950 million and one 5 year Japanese yen tranche of ¥ 90 billion.
  8. 8. Sako Mwakalobo PARTICIPANTS IN EUROBOND MARKET • Private enterprises, for example in France, one of them is Renault • Public enterprises • Financial institutions • Governments and Central Banks • International organizations, such as World Bank, European Bank of investment The industrialized countries seems to have greater recourse to the market; Western Europe is on the top, followed by Japan and USA
  9. 9. Sako Mwakalobo Investors and financial institutions • The investors in the Euromarkets are mostly institutional investors, such as insurance companies, mutual funds, pension funds. • The principal financial institituions and banks that participate in these issues are of international reputation, namely Dutsche Bank, Paribas, Merril Lynch, Goldman Sachs, Credit Lyonnais.
  10. 10. Sako Mwakalobo ORGANISATION OF EUROBOND MARKET • The market can be bifurcated into two segments, namely, Primary market in which securities are issued and the Secondary market in which securities are traded. • The figure below indicates the steps involved in a primary issue.
  11. 11. Sako Mwakalobo Issuer Selection of the lead manager Selection of co-lead managers by the lead manager Guarantee syndicate: •Lead manager •Co-lead managers •Major Guarantor •Minor Guarantor •Sub-major and sub Minor guarantors Placement syndicate: •Banks •Placements •Establishment Different phases of Euro-issue
  12. 12. Sako Mwakalobo Types of instruments ( characteristics of Eurobonds • The international bond market has been much more innovative than the domestic bond market in the types of instruments offered to investors. • Straight fixed rate issue- these are the most current and represent about three-for the of total volume. The issues have been designated maturity date at which the principal of the bond issue is promised to be repaid. During the life of the bond , fixed coupon payments, which are percentage of face value are paid as interest to the bondholders. In contrast to many domestic bonds, which make semiannual coupon payments, coupon interest on Eurobonds is typically paid annually.
  13. 13. Sako Mwakalobo Types of Instruments • Floating rate bonds( FRN)- the interest rate of the bonds is revised every three or six months. Common reference rates are either three or six months US dollar LIBOR. • Equity related bonds- there are two types of bonds. • Convertible bonds – issue allows the investor to exchange the bond for a predetermined number of equity shares of the issuer. The floor value of convertible bond is its straight rate bond values. • Bonds with warrants – these are straight fixed- rate bonds with the addition of a call option ( or warrant) feature. The warrant entitles the bondholder to purchase a certain number of equity shares in the issuer at the pre-stated price over a predetermined period of time
  14. 14. Sako Mwakalobo Types of instruments • Zero-coupon bonds – are sold at a discount from face value and do not pay any coupon interest over their life. At maturity the investor receives the full face value. • Stripped bond – is a zero coupon bond that results from stripping the coupons and principal from a coupon bond. The results is the series of zero-coupon bonds represented by the individual coupon and principal payments.
  15. 15. Sako Mwakalobo Types of instruments • Reverse floating rate bonds- the bonds pay a higher interest rate when the rate of reference decreases. The coupon is fixed at a rate minus- LIBOR so that when LIBOR decreases, the interest rate increases. e.g. suppose Euro-bank offers a rate of 16- LIBOR %; therefore, a LIBOR of 7.5 per cent, the effective rate is 16 – 8.2%, i.e 7.8%.
  16. 16. Sako Mwakalobo See handout 6 for continuation of stock markets, stock exchange procedures and assessment of shares performance
  17. 17. Sako Mwakalobo The Nature of Derivatives A derivative is an instrument whose value depends on the values of other more basic underlying variables
  18. 18. Sako Mwakalobo Examples of Derivatives •Futures Contracts •Forward Contracts •Swaps •Options
  19. 19. Sako Mwakalobo Derivatives Markets • Exchange traded • Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading • Contracts are standard there is virtually no credit risk • Over-the-counter (OTC) • A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers • Contracts can be non-standard and there is some small amount of credit risk
  20. 20. Sako Mwakalobo Size of OTC and Exchange Markets Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market 0 20 40 60 80 100 120 140 160 180 200 220 240 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Size of Market ($ trillion) OTC Exchange
  21. 21. Sako Mwakalobo Ways 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
  22. 22. Sako Mwakalobo Forward Contracts • Forward contracts are similar to futures except that they trade in the over-the- counter market • Forward contracts are particularly popular on currencies and interest rates
  23. 23. Sako Mwakalobo Foreign Exchange Quotes for JPY Jan 22, 2007 (16:23 EST) Bid Offer Spot 121.62 121.63 1-month forward 121.08 121.09 3-month forward 120.17 120.18 6-month forward 118.75 118.77
  24. 24. Sako Mwakalobo Forward Price • The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) • The forward price may be different for contracts of different maturities
  25. 25. Sako Mwakalobo Terminology • The party that has agreed to buy has what is termed a long position • The party that has agreed to sell has what is termed a short position
  26. 26. Sako Mwakalobo Example • On June 3, 2003 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.6100 • This obligates the corporation to pay $1,610,000 for £1 million on December 3, 2003 • What are the possible outcomes?
  27. 27. Sako Mwakalobo Profit from a Long Forward Position Profit Price of Underlying at Maturity, ST K
  28. 28. Sako Mwakalobo Profit from a Short Forward Position Profit Price of Underlying at Maturity, ST K
  29. 29. Sako Mwakalobo Futures Contracts • Agreement to buy or sell an asset for a certain price at a certain time • Similar to forward contract • Whereas a forward contract is traded OTC, a futures contract is traded on an exchange
  30. 30. Sako Mwakalobo Exchanges Trading Futures • Chicago Board of Trade • Chicago Mercantile Exchange • LIFFE (London) • Eurex (Europe) • BM&F (Sao Paulo, Brazil) • TIFFE (Tokyo) • and many more (see list at end of book)
  31. 31. Sako Mwakalobo Examples of Futures Contracts Agreement to: • buy 100 oz. of gold @ US$400/oz. in December (NYMEX) • sell £62,500 @ 1.5000 US$/£ in March (CME) • sell 1,000 bbl. of oil @ US$20/bbl. in April (NYMEX)
  32. 32. Sako Mwakalobo 1. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$300 The 1-year forward price of gold is US$340 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?
  33. 33. Sako Mwakalobo 2. Gold: Another Arbitrage Opportunity? Suppose that: -The spot price of gold is US$300 -The 1-year forward price of gold is US$300 -The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?
  34. 34. Sako Mwakalobo The Forward Price of Gold 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 = 300, T = 1, and r =0.05 so that F = 300(1+0.05) = 315
  35. 35. Sako Mwakalobo 1. Oil: An Arbitrage Opportunity? Suppose that: - The spot price of oil is US$19 - The quoted 1-year futures price of oil is US$25 - The 1-year US$ interest rate is 5% per annum - The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
  36. 36. Sako Mwakalobo 2. Oil: Another Arbitrage Opportunity? Suppose that: - The spot price of oil is US$19 - The quoted 1-year futures price of oil is US$16 - The 1-year US$ interest rate is 5% per annum - The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
  37. 37. Sako Mwakalobo Options • A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) • A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)
  38. 38. Sako Mwakalobo American vs European Options • An American option can be exercised at any time during its life • A European option can be exercised only at maturity
  39. 39. Sako Mwakalobo Intel Option Prices (Jan 22, 2007; Stock Price=86.79) Strike Price Feb Call Mar Call Apr Call Feb Put Mar Put Apr Put 85.00 4.10 5.70 7.70 2.05 3.30 4.90 90.00 1.85 3.30 5.30 4.70 5.90 7.50
  40. 40. Sako Mwakalobo Exchanges Trading Options • Chicago Board Options Exchange • American Stock Exchange • Philadelphia Stock Exchange • Pacific Exchange • LIFFE (London) • Eurex (Europe) • and many more
  41. 41. Sako Mwakalobo Options vs Futures/Forwards • A futures/forward contract gives the holder the obligation to buy or sell at a certain price • An option gives the holder the right to buy or sell at a certain price
  42. 42. Sako Mwakalobo Types of Traders • Hedgers • Speculators • Arbitrageurs Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators
  43. 43. Sako Mwakalobo Hedging Examples • 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 $1. The investor decides to hedge by buying 10 contracts
  44. 44. Sako Mwakalobo Value of Microsoft Shares with and without Hedging 20,000 25,000 30,000 35,000 40,000 20 25 30 35 40 Stock Price ($) Value of Holding ($) No Hedging Hedging
  45. 45. Sako Mwakalobo Speculation Example • An investor with $4,000 to invest feels that Amazon.com’s stock price will increase over the next 2 months. The current stock price is $40 and the price of a 2-month call option with a strike of 45 is $2 • What are the alternative strategies?
  46. 46. Sako Mwakalobo Arbitrage Example • A stock price is quoted as £100 in London and $172 in New York • The current exchange rate is 1.7500 • What is the arbitrage opportunity?
  47. 47. Sako Mwakalobo Hedge Funds • Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. • Mutual funds must • disclose investment policies, • makes shares redeemable at any time, • limit use of leverage • take no short positions. • Hedge funds are not subject to these constraints. • Hedge funds use complex trading strategies are big users of derivatives for hedging, speculation and arbitrage
  48. 48. Sako Mwakalobo Real World Situation - Cash • Japanese Bank: Borrow USD in Interbank Euromarket for 3 month term, T • Could perform the same transaction as a Synthetic in the FX and domestic yen mkt • Borrow yen in local mkt for term T, at L(t0,Y) • Sell yen and buy USD in spot FX mkt at e(t0,Y) • Finally, the bank buys yen in the forward FX mkt for delivery at t0+T
  49. 49. Sako Mwakalobo Real World Situation - Cash • Cash Flows are Additive + + = t0 t0+T Y Yx(1+L(t0,Y)xT) USD Y Yx(1+L(t0,Y)xT) USD USDx(1+L(t0,$)xT) Borrow Y for T at L(t0,Y) Pay back: Yx(1+L(to,Y)xT) Buy USD sell Y at e(t0,Y) Y=e(t0,Y)xUSD Buy Y forward, t0+T delivery in amount so Yx(1+L(t0,Y)xT) = f(t0,T;Y)xUSD1 USD1=USDx(1+L(t0,$)xT) USDx(1+L(t0,$)xT)
  50. 50. Sako Mwakalobo Real World Situation – Cash • At t0 •Borrowing rates in USD & Yen are known •Exchange rate USD & Yen are known • Forward market for Yen must preclude riskless arbitrage so, e(t0,Y)xUSD x (1+L(t0,Y)xT) = f(t0,T;Y) x USDx(1+L(t0,$)xT) or, f(t0,T;Y) = e(t0,Y) x [(1+L(t0,Y)xT) / (1+L(t0,$)xT)]
  51. 51. Sako Mwakalobo Money Rates – Close Friday, 1/26/07 / YEN / 1WK .345 1MO .35 2MO .435 3MO .47 4MO .505 5MO .515 6MO .545 9MO .585 1YR .655 / US DOLLAR / 1WK 5.265 1MO 5.275 2MO 5.285 3MO 5.295 4MO 5.295 5MO 5.355 6MO 5.365 9MO 5.385 1YR 5.39
  52. 52. Sako Mwakalobo Spot/Forwards – USD-JPY U S D -J P Y S P O T / F O R W A R D S Source CMPN Composite (NY) Close Time of Bid Ask Bid Rate Ask Rate Time of PRD Fri 1/26 Offset Offset Offset Rate 2 Spot 16:59 121.54 121.54 121.54 121.54 16:59 1 Week 16:59 -11.59 -11.59 121.42 121.42 16:59 1 Month 16:59 -47.80 -47.80 121.06 121.06 16:59 2 Month 16:59 -96.20 -96.20 120.58 120.58 16:59 3 Month 16:59 -140.80 -140.80 120.13 120.13 16:59 4 Month 16:59 -192.90 -192.90 119.61 119.61 16:59 5 Month 16:59 -239.41 -239.41 119.15 119.15 16:59 6 Month 16:59 -287.14 -287.14 118.67 118.67 16:59 9 Month 16:59 -424.05 -424.05 117.30 117.30 16:59 1 Year 16:59 -554.20 -554.20 116.00 116.00 16:59 2 Year 16:59 -1022.37 -1022.37 111.32 111.32 16:59 3 Year 16:59 -1422.50 -1422.50 107.32 107.32 16:59 4 Year 16:59 -1789.00 -1789.00 103.65 103.65 16:59 5 Year 16:59 -2146.00 -2146.00 100.08 100.08 16:59 * All forward offset rates on this screen are direct quotes from banks; see FRD for rates calculated through USD
  53. 53. Sako Mwakalobo 1. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$300 The 1-year forward price of gold is US$340 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?
  54. 54. Sako Mwakalobo 2. Gold: Another Arbitrage Opportunity? Suppose that: -The spot price of gold is US$300 -The 1-year forward price of gold is US$300 -The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?
  55. 55. Sako Mwakalobo The Forward Price of Gold – The Principal of Cash and Carry • If the spot price of gold is S(t0) and the forward price for a contract deliverable in T years is F(t0,T), then • Can borrow money, buy gold, and sell the commodity forward - where there should be no arbitrage: F(t0,T) - S(t0) x (1+r )T = 0 where r is the 1-year money rate of interest to finance the gold carry trade. • In our examples, S = 300, T = 1, and r =0.05 so that F(t0,T) = 300(1+0.05) = 315 • The no arbitrage 1 year forward price of gold is $315
  56. 56. Sako Mwakalobo The Forward Price of Gold – The Principal of Cash and Carry • How does this come about? S(t0) t0 receive pay S(t0)x(1+r) Gold S(t0) F(t0) Gold Own Deliver Gold Gold Borrow S(t0) Buy Gold at S(t0) Sell Gold Forward at F(t0) No Arbitrage condition says: F(t0) – S(t0)x(1+r) = 0 + + =
  57. 57. Sako Mwakalobo Gold Arbitrage? • The no arbitrage gold, 1-year forward condition is F(t0,T) - S(t0) x (1+r )T = 0 • If 1-year forward is $340, then F(t0,T) - S(t0) x (1+r )T > 0 so our strategy is to borrow money, buy gold, sell it forward, deliver gold, and pay off loan for a riskless profit of $25 • If 1-year forward is $300, then F(t0,T) - S(t0) x (1+r )T < 0 and if I own gold, I can sell it, deposit proceeds, buy forward, pay with the proceeds of the deposit and collect a riskless profit of $15 over the 1-year period
  58. 58. Sako Mwakalobo Hedging Example • 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 • Possible strategies: • Buy £ now, deposit in bank, withdraw £10 million in 3 months, pay for imports • Buy £10 million forward in 3 months, deposit USD, use deposit proceeds to settle and pay for imports • Do nothing now and buy £10 million in the spot FX market in 3 months • First 2 are riskless, third has currency risk. • Which makes most sense?
  59. 59. Sako Mwakalobo Futures Contracts • Available on a wide range of underlyings • Exchange traded • Specifications need to be defined: • What can be delivered, • Where it can be delivered, & • When it can be delivered • Settled daily
  60. 60. Sako Mwakalobo Forward Contracts vs Futures Contracts Private contract between 2 parties Exchange traded Non-standard contract Standard contract Usually 1 specified delivery date Range of delivery dates Settled at end of contract Settled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity FORWARDS FUTURES Some credit risk Virtually no credit risk
  61. 61. Sako Mwakalobo Margins • A margin is cash or marketable securities deposited by an investor with his or her broker • The balance in the margin account is adjusted to reflect daily settlement • Margins minimize the possibility of a loss through a default on a contract
  62. 62. Sako Mwakalobo Example of a Futures Trade • An investor takes a long position in 2 December gold futures contracts on June 5 • contract size is 100 oz. • futures price is US$400 • margin requirement is US$2,000/contract (US$4,000 in total) • maintenance margin is US$1,500/contract (US$3,000 in total)
  63. 63. Sako Mwakalobo A Possible Outcome Daily Cumulative Margin Futures Gain Gain Account Margin Price (Loss) (Loss) Balance Call Day (US$) (US$) (US$) (US$) (US$) 400.00 4,000 5-Jun 397.00 (600) (600) 3,400 0 . . . . . . . . . . . . . . . . . . 13-Jun 393.30 (420) (1,340) 2,660 1,340 . . . . . . . . . . . . . . . . . 19-Jun 387.00 (1,140) (2,600) 2,740 1,260 . . . . . . . . . . . . . . . . . . 26-Jun 392.30 260 (1,540) 5,060 0 + = 4,000 3,000 + = 4,000 <
  64. 64. Sako Mwakalobo Other Key Points About Futures • They are settled daily • Closing out a futures position involves entering into an offsetting trade • Most contracts are closed out before maturity
  65. 65. Sako Mwakalobo Collateralization in OTC Markets • It is becoming increasingly common for contracts to be collateralized in OTC markets • They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)
  66. 66. Sako Mwakalobo Another Detail for Cash and Carry Arbitrage • Contract price changes with longer term •Higher or Lower • To this point we have neglected storage cost • Lets re-visit no-arbitrage equation F(t0,T) - S(t0) x [(1+r )T ] = - Storage (T) • Storage costs ignored in earlier gold example • No storage costs for FX • Lets look at consequence of storage
  67. 67. Sako Mwakalobo Futures Prices for Gold on Feb 4, 2004: Prices Increase with Maturity Storage Costs < Financing (a) Gold 398 399 400 401 402 403 404 405 406 407 408 Feb-04 Apr-04 Jun-04 Aug-04 Oct-04 Dec-04 Contract Maturity Month FuturesPrice($peroz)
  68. 68. Sako Mwakalobo Futures Prices for Oil on February 4, 2004: Prices Decrease with Maturity Storage Cost > Financing (b) Brent Crude Oil 24 25 26 27 28 29 30 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Contract Maturity Month FuturesPrice($perbarrel)
  69. 69. Sako Mwakalobo Delivery • If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. • A few contracts (for example, those on stock indices and Eurodollars) are settled in cash
  70. 70. Sako Mwakalobo Some Terminology • Open interest: the total number of contracts outstanding • equal to number of long positions or number of short positions • Settlement price: the price just before the final bell each day • used for the daily settlement process • Volume of trading: the number of trades in 1 day
  71. 71. Sako Mwakalobo Convergence of Futures to Spot Time Time (a) (b) Futures Price Futures Price Spot Price Spot Price
  72. 72. Sako Mwakalobo Questions • When a new trade is completed what are the possible effects on the open interest? • Can the volume of trading in a day be greater than the open interest?
  73. 73. Sako Mwakalobo Regulation of Futures • Regulation is designed to protect the public interest • Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups
  74. 74. Sako Mwakalobo Accounting & Tax • Ideally hedging profits (losses) should be recognized at the same time as the losses (profits) on the item being hedged • Ideally profits and losses from speculation should be recognized on a mark-to-market basis • Roughly speaking, this is what the accounting and tax treatment of futures in the U.S.and many other countries attempts to achieve
  75. 75. Sako Mwakalobo Forward Contracts vs Futures Contracts Private contract between 2 parties Exchange traded Non-standard contract Standard contract Usually 1 specified delivery date Range of delivery dates Settled at end of contract Settled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity FORWARDS FUTURES Some credit risk Virtually no credit risk
  76. 76. Sako Mwakalobo Foreign Exchange Quotes • Futures exchange rates are quoted as the number of Tshs per unit of the foreign currency • Forward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are quoted as Tshs per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per Tshs.
  77. 77. Sako Mwakalobo Long & Short Hedges • A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price • A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price
  78. 78. Sako Mwakalobo Arguments in Favor of Hedging Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables
  79. 79. Sako Mwakalobo Arguments against Hedging • Shareholders are usually well diversified and can make their own hedging decisions • It may increase risk to hedge when competitors do not • Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult
  80. 80. Sako Mwakalobo Convergence of Futures to Spot (Hedge initiated at time t1 and closed out at time t2) Time Spot Price Futures Price t1 t2
  81. 81. Sako Mwakalobo Basis Risk • Basis is the difference between spot & futures • Basis risk arises because of the uncertainty about the basis when the hedge is closed out
  82. 82. Sako Mwakalobo Short Hedge • Suppose that F1 : Initial Futures Price F2 : Final Futures Price S1 : Initial Asset Price S2 : Final Asset Price • You hedge the future sale of an asset (one which you might be long) by entering into a short futures contract P/L = (S1– F1) – (S2– F2) = S1– [S2+ (F1 – F2)] = S1– [F1+ (S2 – F2)] • Price Realized = S2+ (F1– F2) = F1+ Basis
  83. 83. Sako Mwakalobo Long Hedge • Suppose that F1 : Initial Futures Price F2 : Final Futures Price S1 : Initial Asset Price S2 : Final Asset Price • You hedge the future purchase of an asset (one you might be short) by entering into a long futures contract P/L = – (S1– F1) + (S2– F2) = – S1+ [S2 – (F2 – F1)] = – S1+ [F1+ (S2 – F2)] • Cost of Asset = S2– (F2– F1) = F1+ Basis
  84. 84. Sako Mwakalobo Choice of Contract • Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge • When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. This is known as cross hedging.
  85. 85. Sako Mwakalobo Optimal Hedge Ratio Proportion of the exposure that should optimally be hedged is where σS is the standard deviation of ∆S, the change in the spot price during the hedging period, σF is the standard deviation of ∆F, the change in the futures price during the hedging period ρ is the coefficient of correlation between ∆S and ∆F. F S σ σ ρ
  86. 86. Sako Mwakalobo Optimal Hedge Ratio – Minimum Variance Result • The number of futures, NF, in ratio h (the hedge ratio), required to hedge NA units of an asset follows from P/L P/L = (NAS1 – NFF1) – (NAS2 – NFF2) = NF ∆F - NA ∆S = NA x (∆Fh – ∆S) where NF = h x NA min [∆Fh – ∆S] when the variance of the linear combination of ∆F & ∆S , v = Var [∆Fh – ∆S] = σS 2 – h2 σF 2 – 2 h ρ σSσF minimize v when h is such that dv/dh = 0 if d2 h/dh2 > 0 or 2 h σF 2 – 2 ρ σSσF = 0 implies h = F S σ σ ρ
  87. 87. Sako Mwakalobo Hedging Using Index Futures To hedge the risk in a portfolio the number of contracts that should be shorted is where P is the value of the portfolio, β is its beta, and A is the value of the assets underlying one futures contract β P A
  88. 88. Sako Mwakalobo Reasons for Hedging an Equity Portfolio • Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) • Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outpeform the market.)
  89. 89. Sako Mwakalobo Example Value of S&P 500 is 1,000 Value of Portfolio is $5 million Beta of portfolio is 1.5 What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
  90. 90. Sako Mwakalobo Changing Beta • What position is necessary to reduce the beta of the portfolio to 0.75? • What position is necessary to increase the beta of the portfolio to 2.0?
  91. 91. Sako Mwakalobo Hedging Price of an Individual Stock • Similar to hedging a portfolio • Does not work as well because only the systematic risk is hedged • The unsystematic risk that is unique to the stock is not hedged
  92. 92. Sako Mwakalobo Why Hedge Equity Returns • May want to be out of the market for a while. Hedging avoids the costs of selling and repurchasing the portfolio • Suppose stocks in your portfolio have an average beta of 1.0, but you feel they have been chosen well and will outperform the market in both good and bad times. Hedging ensures that the return you earn is the risk-free return plus the excess return of your portfolio over the market.
  93. 93. Sako Mwakalobo Rolling The Hedge Forward • We can use a series of futures contracts to increase the life of a hedge • Each time we switch from 1 futures contract to another we incur a type of basis risk
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