exotic investments lesson 1 derivatives, including forwards, futures and options bonus
TRANSCRIPT
Exotic InvestmentsLesson 1
Derivatives, including Forwards, Futures and Options
BONUS
Aim: How can derivatives be used to help
businesses succeed?
Do Now: Identify why a person might commit to
purchasing heat oil for his home for a certain price well before the winter months arrive.
Derivatives
Do Now answer: This takes the risk away from the homeowner that he or she would pay for oil if oil prices rose (perhaps do to a prolonged cold winter).
The downside, of course is that if oil prices went down, the homeowner would not be able to take advantage of this.
Derivatives
DerivativesA financial instrument (security) that derives its value from an underlying asset. The price of the underlying asset determines the price of the derivative.
Common underlying assets include: Stocks Bonds Commodities (gold, cattle, etc.) Exchange rates Indexes (NASDAQ 100)
The Uses of Derivatives1. Hedging Allow corporations and individuals to protect
themselves against risk. For example, the risk that the stock will decline in value in the future.
2. Speculation Entering into risky financial transactions in order
to profit from short- or medium-term fluctuations in the market value of tradable investments such as financial instruments.
Types of Derivatives1. Forwards A forward is a private contract to buy or sell a security
at a specific date in the future at a set price
2. Futures A future is a financial contract obligating the buyer to
purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Future contracts are standardized to enable trading on a futures exchange.
Difference between Forwards and Futures
Standardization vs. Non-standardization Futures contracts are standardized. They trade
on an exchange (the central marketplace where futures contracts and options on futures contracts are traded) and are subject to standards of the exchange.
Forward contracts are not standardized.
Difference between Forwards and Futures
Long Position If you buy a futures contract, called buying long, then
you have an obligation to buy the security at a set price at the specific date. That price is called the strike price.
Short Position If you sell the futures contract, called selling short,
you have the obligation to sell the security at a set price at the specified date. That price is also called the strike price.
Difference between Forwards and Futures
Example:
On August 3rd, I.N. Vestor buys a futures contract to buy 100 shares of Company ABC at $30 per share on October 31st.
On October 31st, Company ABC is trading at $18 per share.
I.N. Vestor must pay $30 per share. His loss is $1,200 [($30-$18) x 100 shares]
Options
An agreement that gives the investor a choice of whether or not to buy (called a call) or sell (called a put) an asset at the strike price and set time period in the future
There is no contract in place that obligates the investor to exercise the option
Options Option Premium – Price of the option. Strike Price – Price where the owner of an option can
purchase (call), or sell (put) the underlying security. Put Option (Put) – Option to sell stock at a specific
price by a specific date in the future. Investors purchase a put if they think that the price of the underlying asset will drop.
Call Option (Call) – An option to buy stock at a specific price on a specific date in the future.
Expiration Date – The last date that an options contract is valid.
An Option’s Intrinsic ValueIn the Money If the current price of the stock is above the
call option price, the investor will exercise the option and buy the stock at the strike price.
The call is “in the money” because the investor can then sell the stock at the current price and make a profit.
Current Stock Price > Strike Price
An Option’s Intrinsic Value
Example of an in-the-money option: I.N. Vestor buys a call option on Company ABC
stock with a strike price of $11. Later, the price of the stock is $14. The option is
therefore, “in the money” and I.N. Vestor can exercise the option. This is because the option gives I.N. Vestor the right to buy the stock for $11.
He can then immediately sell the stock for $14, a gain of $3 per share.
An Option’s Intrinsic ValueAt the Money A situation where an option’s strike price is the same as the price of the underlying security
Current Stock Price = Strike Price
Out of the MoneyAn option that would be worthless if it expired today because the price of the underlying security is below the strike price
Current Stock Price < Strike Price
An Option’s Intrinsic ValueExample: I.N. Vestor thinks the Chatpad, a new web
development company, is a good company and that the stock price will increase from its current trading price of $60 per share. I.N. Vestor has two options: He can buy Chatpad stock for $60 right now. He can pay $5 to buy the option to buy Chatpad stock anytime
over the next month for the strike price of $65 per share. The option costs him $500, whereas purchasing 100 shares at $60 per share would be $6,000. I.N. Vestor chooses to buy the option.
Within the next month, Chatpad stock plummets to $30 per share. I.N. Vestor does not exercise the option because it is “out of the money”. He is happy he bought the option rather than the shares!
An Option’s Intrinsic Value
Call Option Put OptionIn the Money
Current Stock Price > Strike Price
Current Stock Price < Strike Price
Out of the Money
Current Stock Price < Strike Price
Current Stock Price > Strike Price
At the Money
Current Stock Price = Strike Price
Current Stock Price = Strike Price
Lesson Summary1. What is the name of the item on which a
derivative security’s value is based?
2. What are the two uses for derivatives?
3. What is the difference between are future and a forward?
4. What are the two types of options?
5. How can derivatives be used to help businesses succeed?
Web Challenge #1Challenge: Mutual funds are limited to mainstream investments such as stock and bonds, while hedge funds are free to pursue more aggressive investments.
Research popular hedge funds investment strategies. What derivative investments do they use and how do they use them?
Web Challenge #2Challenge: One way for producers of commodities to know the price they’ll get for the oil or metals (or other commodity) they produce is to “hedge their production”. That is, they make a deal to sell it to their customers for an agreed upon price even if it has not yet come out of the ground!
Research production hedging. With what type of industry is it most prevalent? How much of their production do firms hedge? How has it worked out for them? (ie: has it protected them from a fall in the market price of the commodity they produce or prevented them from making more?)
Web Challenge #3Challenge: The trading of derivatives is risky. When a person opens a brokerage account with as little as $500 to $1,000, he or she is not “option enabled”. That is, options cannot be bought and sold. At some point though, an investor can be approved for options trading.
Research what is required for an investor to be able to trade options as well as who makes this decision. Because some options are riskier than others, find out which ones an investor will be allowed to trade first, second, etc.