financial derivatives

1. © K.Cuthbertson, D. Nitzsche 1
Version 1/9/2001
FINANCIAL ENGINEERING:
DERIVATIVES AND RISK MANAGEMENT
(J. Wiley, 2001)
K. Cuthbertson and D. Nitzsche
LECTURE
Derivatives: An Overview

2. © K.Cuthbertson, D. Nitzsche 2
Forwards and Futures Contracts
Options Contracts
Swaps
Topics

3. © K.Cuthbertson, D. Nitzsche 3
Forwards
and
Futures

4. © K.Cuthbertson, D. Nitzsche 4
The buyer(long) in a forward/futures contract:
acquires a legal obligation to buy an asset
(the underlying)
at some specific future date (maturity/expiry
date)
in an amount (contract size).
and at a price (the forward/futures price)
which is fixed today.
Forward/Futures Contract

5. © K.Cuthbertson, D. Nitzsche 5
Hedging (removing risk)
In Jan. MacDonalds purchases a forward
contract for delivery of live cattle in December at
price fixed today ~ holds to maturity
Speculation
Buy a 3m futures contract today at F0 =$100 and
sell after 1m at F=$110 ~ close out contract (no
delivery) and profit of $10.
Arbitrage
Keeps movement of F in line with S (underlying)
Uses of Forward/Futures Contract

6. © K.Cuthbertson, D. Nitzsche 6
Contract Exchange Contract Size
1. Grains and Oilseed
Corn CBOT 5,000 bu
Wheat MCE 1,000 bu
2. Food
Cocoa CSCE 10 metric tons
Orange NYCTN 15,000 lbs
3. Metals and Petroleum
Gold MCE 33.2 troy oz
Silver CBOT 5,000 troy oz
4. Livestock and Meat
HogsCME 50,000 lbs
Pork Bellies CME 40,000 lbs
Futures Contracts

7. © K.Cuthbertson, D. Nitzsche 7
Contract Exchange Contract Size
5. Foreign Currency
British Pound IMM £ 62,500
Swiss Franc CME SFr125,000
Euro CME Euro 125,000
Japanese Yen CME
Yen12.5m
6. Stock Indices
S&P500 IOM $500 x
Index
Value Line KCBT $500 x
Index
FTSE100 LIFFE £10 x
index
Eurotop100 LIFFE Euro 20 x index
Futures Contracts

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Contract Exchange Contract Size
7. Interest Rates
Eurodollar - 90 day IMM $ 1,000,000
Euromark IMM DM 1,000,000
US T-Bills IMM $ 1,000,000
US T-Bonds CBOT $ 100,000
UK 3m-Sterling Int rate LIFFE £500,000
UK 3m EuroLIBOR LIFFE Euro 1m
UK Long Gilt Future LIFFE £100,000
CBOT = Chicago Board of Trade
CME = Chicago Mercantile Exchange
NYCE = New York Cotton Exchange
IMM = International Money Market (Chicago)
LIFFE=LondonInternational Financial Futures
Exchange
Futures Contracts

9. © K.Cuthbertson, D. Nitzsche 9
FORWARDS FUTURES
Private contract Traded on an exchange
Delivery at expiry Usually closed out before maturity
Usually one delivery date Range of delivery dates
No cash paid until expiry Cash payments Daily( margin)
Negotiable choice of
delivery dates, size of contract Standardised Contract
Comparison of Forwards and Futures

10. © K.Cuthbertson, D. Nitzsche 10
Options Contracts

11. © K.Cuthbertson, D. Nitzsche 11
Holder has the right to buy or sell an ‘asset’ (underlying)
at some time in the future at a fixed price
but she does not have to exercise this right
can ‘walk away’ from the contract if holder wishes
~ latter is key distinction between options and
futures/futures contracts.
E.g. In Jan, purchase an option to buy 100 Microsoft
shares in September, at a fixed price of $102
What happens in Sept if actual stock price is $90 or $110?
Options

12. © K.Cuthbertson, D. Nitzsche 12
Insurance (form of hedging)
e.g. can insure a minimum selling price for a stock, at
maturity of the option contract (e.g. in 6m time), but can
also benefit from higher prices should these occur
Speculation
Can buy an option at a ‘low’ price and may be able to sell
it (before maturity) at a ‘high’ price ~ close out the position
(hence no delivery at maturity)
Arbitrage
Keeps option price and price of underlying (e.g. stock)
moving (broadly) together (but not ‘one-for-one)
Uses of Options

13. © K.Cuthbertson, D. Nitzsche 13
Contract Exchange Contract Size
1.Individual Stocks
BOE, NYSE, AMEX,
PHSE, LIFFE, SIMEX Usually 100 stocks
2. Index Options
S&P500 Index CBOE $500 x index
FTSE100 Index LIFFE £10 per index point
NYSE Index NYSE $500 x index
Foreign Currency Options
Sterling PHSE GBP 31,250
Deutsche Mark PHSE DEM62,500
Japanese Yen PHSE JPY6.25m
Canadian Dollar PHSE CND50,000
Swiss Franc PHSE CHF62,500
Options

14. © K.Cuthbertson, D. Nitzsche 14
Contract Exchange Contract Size
3.Options on Futures Contracts
Options on interest rate futures:
Eurodollars IMM $1m
US T-Bills IMM $1m
US T-Bond CBOT $100,000
3-month EuroLIBOR LIFFE as for futures
UK Long Gilt LIFFE as for futures
Options on index futures:
S&P500 Index IOM $500 x premium
Nikkei 225 IOM $5 x premium
Most commodities (agriculture and metals) on which there
are futures contracts (see above). CBOT,CME,KCBT,
COMEX,CTN The same as in the futures contract
Options

15. © K.Cuthbertson, D. Nitzsche 15
A European call option gives the holder (the long) the right
(but not an obligation)
to purchase the underlying asset at a
specified future date (known as the expiration, expiry or
maturity date)
for a certain price (the exercise or strike price)
and in an amount (contract size) which is fixed in advance.
For this privilege you pay today, the call premium/price.
Call Option

16. © K.Cuthbertson, D. Nitzsche
Figure 1.1 : Buy one European Call Option
ST
Profit
Strike price K = $80
$5
-$3
Call premium $88
$83
K = $80
0

17. © K.Cuthbertson, D. Nitzsche
Figure 1.8 : Leverage from option (on 100 shares)
OPTIONS MARKET (JULY)
Call premium, C = $3
Premium paid = $300
Strike price, K = $80
CASH MARKET (JULY)
Spot price, S = $78
Cash paid = $7800
OPTIONS MARKET (OCT.)
Profit = $8 = ($88 - $80)
Net profit = $800 - $300
Return = $500/$300 = 167%
CASH MARKET (OCT.)
Profit = $10 = ($88 - $78)
Total profit = $1000
Return = $1000/$7800 = 12.8%

18. © K.Cuthbertson, D. Nitzsche
Figure 1.2 : Sell (write) a European Call Option
ST
Profit
Strike price K = $80
-$5
$3
Call premium
$88
$83
K = $80
0

19. © K.Cuthbertson, D. Nitzsche 19
A European put option gives the holder (the long) the right
(but not an obligation)
to sell the underlying asset at a
specified future date (known as the expiration, expiry or
maturity date)
for a certain price (the exercise or strike price)
and in an amount (contract size) which is fixed in advance.
For this privilege you pay today, the call premium/price.
Put Option

20. © K.Cuthbertson, D. Nitzsche
Figure 1.3 : Buy (long) a European Put Option
Strike price K = $70
ST
Profit
$3
-$2
Put premium
$68
$65 K = $70
0

21. © K.Cuthbertson, D. Nitzsche
Figure 1.4 : Sell (write) a European Put Option
Strike price K = $70
ST
Profit
$2
-$3
Put premium
$68
$65
K = $70
0

22. © K.Cuthbertson, D. Nitzsche
Swaps

23. © K.Cuthbertson, D. Nitzsche
Figure 1.5 : Liabilities : Using Swaps
Swap
A negotiated (OTC) agreement between two parties
to exchange cash flows at a set of pre-specified future dates
Plain Vanilla Interest Rate Swap
M/s A. agrees to pay interest at a floating rate
and
receive fixed rate payments from the “other side”
of the swap transaction (eg. M/s B)
e.g. 5 year swap, with floating rate at 6m LIBOR, with
resets every 6 months. Fixed rate is say 5% p.a.
Usually the interest payments are in the same currency

24. © K.Cuthbertson, D. Nitzsche
Figure 1.5 : Liabilities : Using Swaps
Floating to Fixed: Liability
Fixed to Floating :Liability
Issue Floating
Rate Bond
Firm’s Swap
LIBOR
LIBOR + 0.5%
6% fixed
Net Payment = 0.5% + 6% = 6.5% (fixed)
Issue Fixed
Rate Bond
Firm’s Swap
6% fixed
6.2% fixed
LIBOR
Net Payment = 0.2% + LIBOR (floating)

25. © K.Cuthbertson, D. Nitzsche
Figure 1.6 : Assets : Using Swaps
Floating to Fixed: Asset
Fixed to Floating: Asset
Hold Floating
Rate Bond
Firm’s Swap
LIBOR
LIBOR - 0.5%
6% fixed
Net Receipts = 6% - 0.5% = 5.5% (fixed)
Hold Fixed
Rate Bond
Firm’s Swap
6% fixed
5.7% fixed
LIBOR
Net Receipts = LIBOR - 0.3% (floating)

26. © K.Cuthbertson, D. Nitzsche
Figure 1.7 : Swap : financial intermediary
Hold Floating
Rate Bond
Firm’s Swap
11% fixed
12% fixed
LIBOR
After swap :
Net Receipts = (12% - 11%) + LIBOR - (LIBOR - 1%) = 2% (fixed)
LIBOR - 1%
Without swap if LIBOR > 13% firm’s swap makes a loss.

27. © K.Cuthbertson, D. Nitzsche
End of Slides