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Asset Allocation 101 - Derivatives
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- 2. A REPUTATION? It isnot surprising that perhaps the word ‘Derivatives’ comes with a bit of a reputation due to its role in causing the Great Financial Crisis’ (remember Ryan Gosling and Steve Carrell in The Big Short?? :-)) Well, it was actually the subprime mortgage-backed bonds back then.. But still, because of its perceived complexity, only accredited or sophisticated investors can get access to these most of the time.. It is however, a very important building block of modern finance and we shall delve into it...! WELCOME MESSAGE LETS GET STARTED
- 3. LIST OF CONTENT PRESENTATION In‘lay-man’ terms.. OVERVIEW OF DERIVATIVES 01 How to price derivatives! PRICING OF DERIVATIVES 02 Understand what it means.. STRUCTURED PRODUCTS 03 Learning the more common structures TYPES OF STRUCTURED PRODUCTS 04 05 Final discussion and next steps.. CONCLUSION
- 4. OVERVIEW.. You will almostalways hear structured products mentioned in the same breath as derivatives.. But are they the same? Well technically, you may say that Structured Products are composed of derivatives but you would not say that derivatives are composed of Structured Products.. So derivatives are more of like building blocks... Contracts whose value is derived from its underlying... The 4 main types of derivatives are: Options, Forwards, Futures and Swaps. Options give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date, Forwards is an agreement to buy or sell an asset at a specific price on a specified date in the future.. Futures is somewhat similar to Forwards but it is a standardized contract and Swaps allow two parties to exchange cash flows or liabilities from two different financial instruments.. ARE DERIVATIVES AND STRUCTURED PRODUCTS THE SAME THING? SOME SMALL TECHNICAL DIFFERENCES..
- 5. PRICING OF DERIVATIVES.. Giventhat the value of derivatives come from its underlying assets or pool of assets it should come as no surprise that the pricing of derivative or structured products is also based on the underlying assets.. In particular, the pricing of options deserve a mention because options is the building blocks of so many different types of structured products. Value of an Option = Intrinsic Value + Extrinsic Value (Time Value / Implied volatility) There are also 4 main sensitivities of an option called Greeks used for risk management: DELTA: Measures how much an option's price can be expected to move for every $1 change in the price of the underlying security or index GAMMA: Measures rate of change in an option’s delta when the stock price changes by $1. THETA: Measures rate at which option’s price decline with each passing day. VEGA: Measures rate of change in an option’s price based on a 1% change in implied volatility. They are extremely important to traders who need to understand the risk exposure of their book of options; they can use them to either make hedges against or bets on it! BASED ON ITS UNDERLYING ASSET OR POOL OF ASSETS
- 6. Now, the abovecharts should not look unfamiliar to most of you.. A simple search would display all these graphs.. Left is what payoff would be to you if you bought a call option. You do not immediately earn a profit once underlying stock moves past your strike price because remember, you had to pay for the option!! So your break-even is higher. Same logic for long put. THE FUNDAMENTALS IN ALL DERIVATIVES CLASSES X AXIS AS STOCK PRICE AND Y AXIS AS PROFIT / LOSS OPTION PAYOFF GRAPHS Break-even point X strike price Profit / Loss LONG CALL LONG PUT Break-even point X strike price Profit / Loss PROFIT ZONE! PROFIT ZONE!
- 7. Well, just somewhatof an opposite compared to Long call and Long Put, but one big difference is that unlike a Long Call and Put where the maximum loss to an investor is just the option price paid (he or she can just not exercise the option..) there is somewhat of an unlimited potential loss for SHORT CALL (because the stock can keep on rising..) and a potential huge loss for SHORT PUT investor (his or her maximum loss is when the underlying stock reaches 0).. Why would anyone do this then? Well answer is that these options can be combined with other options to limit losses or to change its payoff structure. See next page!!!! THE FUNDAMENTALS IN ALL DERIVATIVES CLASSES X AXIS AS STOCK PRICE AND Y AXIS AS PROFIT / LOSS OPTION PAYOFF GRAPHS Break-even point X strike price Profit / Loss SHORT CALL SHORT PUT Break-even point X strike price Profit / Loss PROFIT ZONE! PROFIT ZONE!
- 8. MORE MORE ANDMORE PAYOFFS! A WORD. AND SO THE PAYOFF OF THE OPTION CHANGES... For instance, although a long call option technically has the possibility of UNLIMITED LOSSES, one can add on say a LONG CALL overlay at another strike price to limit losses.. There are a lot of flexibility in terms of using options to create a payoff chart that is aligned with your view of the markets and underlying asset.. But it has to make economic sense to structure such a structure... Specialists can also take advantage of certain price movements to create attractive structured products... Well the truth is there are countless of option types and countless of payoff graphs structure.. There are KICK IN, KICK OUT, KNOCK IN, KNOCK OUT OPTIONS which in general are also known as BARRIER OPTIONS (option whose payoff is dependent on the underlying asset's price breaching a barrier level during option lifetime)
- 9. STRUCTURED PRODUCTS As mentionedat the beginning, derivatives and structured products have quite a reputation due to what transpired during the Great Financial Crisis.. But structured products are also flexible instruments that allow individuals to express their views on financial markets.. For instance an individual who believes that the underlying stock or asset would move sideways in the next 1-3 months may invest in an investment that may cap his or her upside, but allows him or her to receive a periodic coupon during the time period.. Some individuals also appreciate the extra yield that such products can provide.. You will hear all sorts of product names that banks give to their in-house structured products; synonyms such as PERLES, KIKO, but DON’T FRET !!!!! Just remember that structured products are simply made up of options.. Once you understand the individual option’s payoff, you can learn how to combine them together to form the payoff of the structured product. Remember also that structured products can have equities, bonds or FX as underlying; all across asset classes!!!! ACROSS ALL ASSET CLASSES UNDERSTANDING THAT THEY ARE FORMED BY OPTIONS
- 10. A DUAL CURRENCYINVESTMENT (DCI) Well, this is a popular FX structured products which is relatively simple as well so let’s delve into it... Imagine that a USD investor (base currency USD) has some needs in EUR and does not mind being converted into EUR... In the meantime he or she is happy earning some yield in USD in the event that this conversion does not happen... DCI always involve one selling call option on BASE CURRECY.. So you must have a slightly bearish view on the currency... However, if USD does appreciate over threshold level, you are ok with being converted into EUR at the strike price... In other words EURUSD continues to fall, such that you would have to convert your USD at agreed strike price as opposed to market FX rate... FOR INSTANCE, EURUSD.. UNDERLYING AS 2 CURRENCIES.. The next thing you may be interested to understand is is there then a maximum loss for a DCI investment? Well, the answer is technically, if your converted EUR is not worth anything then you would have suffered maximum losses in USD terms... But your be your own verdict of what the ‘maximum loss’ may mean for you!!!! IS THERE A MAXIMUM LOSS?
- 11. CONCLUSION We are notexaggerating when we say the content covered here is just the tip of the iceberg because it IS!! Derivatives is a very interesting subject where one can delve a lot further into the details... But what this course deck covers is a broad overview of its function which allows one to be able to speak more confidently on the subject of derivatives and structured products... There are tons and tons of structured products out there and in some ways, the flexibility of it all may be what continues to to draw knowlegeable people in deep finance into the financial and derivatives field.. MUCH MORE TO LEARN.. JUST THE TIP OF THE ICEBERG
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