Basic Knowledge about Derivatives

1. Derivatives Group 4
Teacher: Ms. Bui Thi Kim Phuc

2. 1. Future – Dung Do
2. Forward – Loan Dang
3. Hedging and Speculation – Truc Mai Nguyen
4. Option (Call) – Sam Hoang
5. Option (Put) – Phuong Mai Pham
6. Warrants – Hang Nga Nguyen
7. Swap – Ngoc Huyen Nguyen

3. Definition
Types
When to apply
Strengths & Weaknesses

4. Definition
Contracts to buy or sell fixed
quantities of a commodity, currency,
or financial assest at a future date, at
a price fixed at the time of making
contract.

5. Types
Commodities futures
• Metals
• Energy
• Grains & Oil Seeds
• Livestocks
• Food & Fiber
Financial futures
• Eurodollar Futures
• U.S. Treasury Futures
• Foreign Government
Debt Futures
• Swap Futures
• Forex Futures
• Single Stocck Futures
• Index Futures

6. When to appy
Example:(clip)

7. When to appy
Three Main Uses:
• Capital Appreciation
• Leverage
• Hedge Against Risk

8. Strengths & Weaknesses
• Futures are extremely useful in reducing
unwanted risk.
• Futures markets are very active, so
liquidating your contracts is usually easy.

9. Strengths & Weaknesses
· Being considered one of the riskiest investments in the
financial markets - they are for professionals only.
· In volatile markets - very easy to lose your original
investment.
· The very high amount of leverage can create enormous
capital gains and losses, you must be fully aware of any
tax consequences

10. Conclusion

11. Definition
Distinct feature
Function
Case

12. Definition
A contract between two parties to buy or sell an asset
at a specified future time at a price agreed upon today.
THE SELLER THE BUYER
Future real transaction
Today’s price

13. Case
FARMER A

14. Distinct feature
Non- standardized
Over-the-counter
a zero-sum game

15. Function
Control liquility risk
Speculation

16. Activities
Game 1: FORWARD vs. FUTURE
Game 2: Vocabulary

17. Activities
A
FORWARD
TRANSACTION
B
FUTURE
TRANSACTION
over-the-counter
highly standardized
privately negotiated
zero counterparty risk
traded in a secondary market
FORWARD VS. FUTURE
COLUMN A COLUMN B

18. Activities
Words guessing
Is likely to take place in FORWARD TRANSACTION
rather than future transaction
There are 2 WORDS: first one has 12, second one has 4
LETTERS
               
Exists because participants may be unwilling or unable to
follow through the transaction at the time of settlement.
Appears when one party BREAKS the terms of the
agreement.
This is a kind of UNCERTAINCY facing in any
transaction.

19. Activities
The first word is FOUR- SYLLABLE word. It is a combination of 2
COMPONENTS MEANING:
“against/ opposite” “one site in a contract”
The second word means THE POSSIBILITY OF Sth BAD
HAPPENING AT SOME TIME IN THE FUTURE
COUNTERPARTY
RISK

20. Activities
It is a contract struck today, for the physical borrowing of funds at a
fixed future date.
The THIRD single word means LOANING.
Containing 3 single words: the FIRST and the SECOND WORDS are
exactly the same and are my topic’s name.
Used in purpose of AVOIDING RISK caused by the votality of exchange
rate.
FORWARD FORWARD
BORROWING

21. Definition1
Characteristic2
Comparison between Hedging and
Speculation3

22. Definition
 A method of reducing the risk of loss caused by price fluctuation
 A transfer of risk without buying insurance policies
equal quantities of the
same commodities
 reduce risk by making a transaction in one market to protect
against a loss in another
equal quantities of the
same commodities

23. Characteristic
1. Everyone who seek to profit from price fluctuation
2. Producers, processors, and wholesalers
3. Retailers, distributors
4. Only producers

24. Characteristic
reduction in RISK reduction in PROFIT
 The goal of hedging is not to make money
but to protect from losses.

25. Characteristic
Futures Options Forwards

26. Example
Use futures contracts to hedge their exposure to the price of
jet fuel  to save a large amount of money when buying fuel
as compared to rival airlines when fuel prices in the U.S. rose
dramatically after the 2003 Iraq war and Hurricane Katrina

27. (1)……………. reduce their risk by taking an opposite
position in the market to what they are trying to
(2)…………..... The ideal situation in (3)……………...
would be to cause one effect to cancel out another.

28. (1)………………….has to do with short-term
expectations. When you (2)..………………, you hope
and anticipate that you will be able to make a profit
from the short-term fluctuations in price of a
particular thing. (3)……………………wants to make
money in a hurry.

29. Definition
The activity of buying shares,
property, goods, etc. in the hope
of making a profit by selling
them at a higher price
With the risk of losing money

30. Comparison between HEDGING and SPECULATION
Risk
averse
To protect
from losses
Risk
lovers
To make a
profit

31. Characteristic
Take advantage of an
expected price movement
Extremely risky
Cause harm to other market
participants

32. ???
Now
12/2013
Mark
Phil

33. What type of derivatives should Mark
choose?
C A L L O P T I O N

35. Definition
How call option works and how to use call option
Game & Conclusion

36. 1 FREE
ICE CREAM
SCOOP
OF
HAAGEN-DAZS

37. Mark
Phil
Buy the call option at 1$
5
$
430$/share
425$/share
Profit = [430-(425+1)]*100
= 400$
2 months
later
EXERCISE THE OPTION

38. Mark
Phil
Buy the call option at 1$
425$/share
Loss= 1 * 100 = 100$
2 months
later
5$
420$/share

39. In call options trading, the option holder
has the (1)………, but not the (2)
…………, to buy the underlying
instrument at a specified price on or
before a specified date in the future.
O B L I G A T I O N
(1)
(2)
R I G H T

41. If Mark decides to buy or sell the
underlying instrument (rather than
allowing the contract to expire worthless
or closing out the position), he will
…..………….. the option, and make use
of the right available in the contract.
E X E R C I S E

43. …………… is the total cost of an
option?
P R E M I U M

45. An option that can be exercised
anytime during its life ?
A M E R I C A N O P T I O N

46. 1 FREE
ICE CREAM SCOOP
OF
HAAGEN-DAZS

47. Call Option = Buying The Right
(Not Obligation)
To Buy An Underlying Asset
CONCLUSION
Use When You Expect The Price Of
The Stock Is Going To Rise

48. Definition
When to apply “Put option”?
Some tips to apply PUT OPTION and CALL
OPTION

49. This kind of option is the opposite
of call option.
“This option gives the right to…..security (or a
currency, or a commodity) at a certain price
during a certain period of time”
Definition

50. WHEN TO APPLY
“PUT OPTION”?

51. A Sample Quiz:
Now: a share is worth $100
A’s prediction: share will be worth above $100
Adversely, B’s prediction: share will be worth
below $100
When to apply “PUT OPTION” ?

52. A sells (or writes) B a put option at $100
(strike/exercise price).
B pays A $1 as the premium of put option
B has the right to sell the share at $100
(strike/exercise price) in the future whatever
the market price wil be.
A B
Put option at $100
Premium of $1
When to apply “PUT OPTION” ?

53. Scenario 1: In the future
Market price (MP) = 130 > Strike price (SP)
=100
B (will/will not) exercise his put option
because if he (did not exercise/exercised) his
put option, he would lose an amount of $30
(= $130-$100)
Outcome:
- A (earns/loses) premium of $1 in-the-money
- B (earns/loses) premium of $1  out-of-the-
money
When to apply “PUT OPTION” ?

54. • Scenario 2: in the future
MP = 90 < SP = 100
B (will/will not) exercise his put option
Outcome:
- A (earns/loses) premium of $1, but
(earns/loses) an amount of $100  overall, A
(earns/loses) $99  out-of-the-money
- B (earns/loses) premium of $1, but
(earns/loses) an amount of $10 (=$100- $90)
 overall, B (earns/loses) $9  in-the-money
When to apply “PUT OPTION” ?

55. Prediction: MP
will INCREASE
in the future
BUY the CALL option
SELL/WRITE the
PUT option
Prediction: MP
will DECREASE
in the future
BUY the PUT option
SELL/WRITE the
CALL option
Some tips to apply PUT OPTION and CALL OPTION smartly?

56. Definition
Classification
Comparison between warrant and option

57. Definition
2012

58. Definition
Warrant is a type of investment that gives you the right to buy
shares at a fixed price on or by a particular date.
A warrant gives you the right, but not the obligation to buy (call) or
sell (put) a pre-determined asset at a pre-determined price
(=exercise /strike/striking price) by a pre-determined date.
OXFORD DICTIONARY
STANDARD BANK OF SOUTH AFRICA

59. Classification
The warrants can be exercised
at any time up to and
including the date of expiry
United States - style warrants
The warrants may be
exercised only on the expiry
date.
European - style warrants

60. Classification
At-the-money
In-the-money
Out-of-the-money
When a warrants with an exercise price is equal to the
current market price of the underlying
When a warrants with the exercise price is at below the
current market price of the underlying asset
When a warrants with the exercise price is at above the
current market price of the underlying asset

61. Comparison
Warrants Option
• Issued by private parties
• Issued by a public options
exchange
• When a warrants is exercised
Company issues new shares of
stock
The number of shares increases
No voting right
• Warrants’ lifetime is
measured in years
• The number of shares is
constant (the owner of the call
option receives an existing
share)
=> Voting right
• Option’s life is measured in
months

62. Definition7.1
Purposes7.2
Types of SWAPS7.3
Interest rate swaps7.2

63. Definition
• Definition
A swap is an agreement between two
counterparties to exchange two streams of cash
flows for a set period of time.

64. Purposes
 Hedging
 Speculation
 Changing the character of
an asset or liability
without liquidating that
asset or liability.

65. Types of SWAPS
Types
of
SWAPS
– Interest Rate Swap
– Currency Swap
– Credit Default Swap
– Forward swap
– Total return swap
– Circus swap
– Commodity swap
– Asset swap
– ……
• (http://www.businessanalystfaq.com/whatiss
wap-typesofswaps.)

66. Interest Rate Swaps
Definition:
• an exchange of cash flows, CFs.
• a legal arrangement between two parties to
exchange specific payments.
• involving the exchange of fixed-rate
payments for floating-rate payments.

67. EXAMPLE
• Fixed-rate payer pays 5.5% every six months
• Floating-rate payer pays LIBOR every six months
• Notional Principal = $10 million
• Effective Dates are 3/1 and 9/1 for the next three
years

68. EXAMPLE
1 2 3 4 5 6
Effective Dates LIBOR Floating-Rate Fixed-Rate Net Interest Received Net Interest Received
Payer'sPayment* Payer'sPayment** by Fixed-Rate Payer by Floating-Rate Payer
Column 3 - Column 4 Column 4 - Column 3
3/1/Y1 0.045
9/1/Y1 0.050 $225,000 $275,000 -$50,000 $50,000
3/1/Y2 0.055 $250,000 $275,000 -$25,000 $25,000
9/1/Y2 0.060 $275,000 $275,000 $0 $0
3/1/Y3 0.065 $300,000 $275,000 $25,000 -$25,000
9/1/Y3 0.070 $325,000 $275,000 $50,000 -$50,000
3/1/Y4 $350,000 $275,000 $75,000 -$75,000
* (LIBOR/2)($10,000,000)
** (.055/2)($10,000,000)

69. EXAMPLE
Points:
• If LIBOR > 5.5%, then …………… receives
the interest differential.
• If LIBOR < 5.5%, then ……………..receives
the interest differential.

70. EXAMPLE
1 2 3 4 5 6
Effective Dates LIBOR Floating-Rate Fixed-Rate Net Interest Received Net Interest Received
Payer'sPayment* Payer'sPayment** by Fixed-Rate Payer by Floating-Rate Payer
Column 3 - Column 4 Column 4 - Column 3
3/1/Y1 0.045
9/1/Y1 0.050 $225,000 $275,000 -$50,000 $50,000
3/1/Y2 0.055 $250,000 $275,000 -$25,000 $25,000
9/1/Y2 0.060 $275,000 $275,000 $0 $0
3/1/Y3 0.065 $300,000 $275,000 $25,000 -$25,000
9/1/Y3 0.070 $325,000 $275,000 $50,000 -$50,000
3/1/Y4 $350,000 $275,000 $75,000 -$75,000
* (LIBOR/2)($10,000,000)
** (.055/2)($10,000,000)

71. EXAMPLE
Points:
• If LIBOR > 5.5%, then fixed payer receives
the interest differential.
• If LIBOR < 5.5%, then floating payer receives
the interest differential.