fina3204 01 introduction

The Hong Kong University of Science and Technology

FINA 3204: Derivative Securities Andrew Chiu

Derivative Securities FINA 3204

Introduction to Derivatives

Andrew Chiu, PhD [email protected]

mailto:[email protected]



Course Overview

Forwards & Futures

Market Mechanics

Hedging Strategies

Pricing

Options

Market Mechanics

Properties Trading

Strategies Pricing

Binomial Tree

Black-Scholes

Greeks

Other Derivatives

Warrants, CBBC Swaps Convertible

Bonds Structured Products



History of Derivatives

In Ancient Mesopotamia (~1750 BC), contracts were inscribed on clay tablets.

“Mr. Farmer will sell to Mr. Buyer a certain quantity of grain for a specified price on a future date.” (forward)

Trading took place at the temples (clearinghouse)

//upload.wikimedia.org/wikipedia/commons/e/e8/Prologue_Hammurabi_Code_Louvre_AO10237.jpg



History of Derivatives

In Ancient Greece (~600 BC), Thales predicted an unusually large olive harvest, and he paid a small deposit to reserve the right, but not the obligation, to rent all olive presses in the region for a pre-specified price for the following autumn. (call option)



Derivatives

Derivatives are contracts that derive their value from something else: commodities (agriculture, meat, metal, energy) stocks, bonds, indices, currency rates, volatility,

interest rate, debt, real estate, weather.

Basic types: forwards, futures, options, swaps

“A futures contract is a derivative, but the futures exchange doesn't call them 'derivatives‘, they call them 'futures’.” - Myron Scholes



Forward & Futures

A forward contract is an agreement to buy or sell a certain quantity of an asset at a specific maturity date for a fixed delivery price.

Each party is obligated to buy or sell.

The delivery price is chosen so that the initial value of the contract is zero

No money is exchanged when the contract is written

Potential infinite return? (Return=Profit/Cost)



Payoff of a Stock

0

10

20

30

40

50

60

70

0 10 20 30 40 50 60

Pay

off

Stock Price

Payoff



Profit of a Stock

-30

-20

-10

0

10

20

30

40

50

60

70

0 10 20 30 40 50 60

Pay

off

/ P

rofi

t

Stock Price

Payoff

Profit

Stock purchased at $25



Payoff of a Long Forward at Expiration

-40

-30

-20

-10

0

10

20

30

40

0 10 20 30 40 50 60

Pay

off

Underlying Price at Expiration

X



Payoff of a Short Forward at Expiration

-40

-30

-20

-10

0

10

20

30

40

0 10 20 30 40 50 60

Pay

off

Underlying Price at Expiration

X



Options

An European call option is the right to buy a certain quantity of an underlying asset at a specific maturity date (aka. expiration date) for a fixed strike price (aka. exercise price).

Similarly, an European put option is the right to sell.

The call option holder can choose to exercise its right to buy or not to buy. But the option writer has to sell if the option is exercised.

The option holder pays a premium for the option. The option writer receives the premium.



Payoff of a Long Call at Expiration

-10

-5

0

5

10

15

20

25

30

35

0 10 20 30 40 50 60

Pay

off

Stock Price at Expiration

Payoff

X



Profit of a Long Call at Expiration

-10

-5

0

5

10

15

20

25

30

35

0 10 20 30 40 50 60

Pay

off

/ P

rofi

t


Payoff

ProfitX



Profit of a Short Call at Expiration

-35

-30

-25

-20

-15

-10

-5

0

5

10

0 10 20 30 40 50 60

Pay

off

/ P

rofi

t


Payoff

Profit

X



Payoff of a Long Put at Expiration

-10

-5

0

5

10

15

20

25

30

35

0 10 20 30 40 50 60

Pay

off


Payoff

X



Profit of a Long Put at Expiration

-10

-5

0

5

10

15

20

25

30

35

0 10 20 30 40 50 60

Pay

off

/ P

rofi

t


Payoff

ProfitX



Profit of a Short Put at Expiration

-35

-30

-25

-20

-15

-10

-5

0

5

10

0 10 20 30 40 50 60

Pay

off

/ P

rofi

t


Payoff

Profit

X



Swaps

A swap is an agreement to exchange cash flows at specified future dates according to certain specified rules in the contract. Cash flows can be of different currencies.

Example: Microsoft and Intel enter into a swap to exchange fixed interest rate with a floating interest rate based on LIBOR. This is a 3 year contract on a notional principal of $100 million. Payment occurs every 6 months.

Microsoft: Pay 5% fixed rate, Receives LIBOR rate

Intel: Pay LIBOR rate, Receives 5% fixed rate



Uses of Derivatives

1. Hedging • Transferring risk (ex: commodity producers and buyers)

2. Speculation • Betting on a view

3. Arbitrage • Capturing a risk-free profit

4. Diversification

• Gain exposure to non-traditional assets (ex: weather) • Trade non-traditional views (ex: long volatility)



Hedging Example

You are holding 100 shares of HSBC and are worried it might fall. S=$80. The 1-month put option (X=$80) costs $3.

You buy 1 put contract (100 puts) for $300.

In one month, HSBC’s price falls to $70.

Loss from stock = 100 x ($70-$80) = -$1000

Payoff from put option = 100 x $10 = $1000

Cost of put option = -$300



Profit of each HSBC share with and without Hedging

-40

-30

-20

-10

0

10

20

30

40

50 60 70 80 90 100 110

Pro

fit

at E

xpir

atio

n


Without Hedging

With Hedging



Speculation Example

You are bullish about HSBC and you have $8000 to invest. Current price S=$80. The 1-month call option (X=$80) costs $4. Compare 2 strategies:

A) You buy 100 shares of HSBC

B) You buy 5 call contracts (equals 2000 calls, multiplier=400)

In one month, HSBC’s price rises to $88

A) Profit = $800, Return = $800 / $8000 = 10%

B) Profit = 2000 x ($8 - $4), Ret = $8000/$8000 = 100%

Derivatives are highly levered ! Be careful, what if HSBC falls?



Disasters Involving Derivatives

Barings

This 200-year-old British bank was destroyed in 1995 by the

activities of one trader, Nick Leeson, in Singapore, who made big

bets on the future direction of the Nikkei 225 using futures and

options. The total loss was close to $1 billion.

Société Générale

Jérôme Kerviel lost over $7 billion speculating on the future direction

of European equity indices using futures in January 2008.

Sumimoto

A single trader working for this Japanese company lost about $2

billion in the copper spot, futures, and options market in the 1990s.

More from Hull’s textbook (chapter 35.1)



Disasters Involving Derivatives

A typical pattern

1) A trader is assigned to do hedging or arbitrage trades. These

are relatively dull, whereas speculation is exciting.

2) As time goes by, the trader thinks he or she can outguess the

market.

3) Slowly the trader becomes a speculator.

4) When a loss is made, the trader doubles up the bets in a

desperate attempt to recover the losses.

(Prospect Theory, Kahneman and Tversky 1979)

5) Losses become bigger and bigger.



Derivatives: Good or Bad?

Investing in derivatives is a double-edged sword.

It can bring down companies if used irresponsibly. But the main culprit is greed, not the derivative.

We have been using derivatives for thousands of years and it has served the needs of its users.



Lessons to Learn

There should be strict risk limits, and traders need to be closely monitored

Are they taking excessive risk? Too much leverage?

Are traders speculating when they’re not supposed to?

Keep risk managers separate from traders

Consider liquidity risk in stress tests

Reduce your position when too many people are following the same strategy.

Make sure you fully understand the trades you are doing. If you can’t value the instrument, don’t trade it!

fina3204 01 introduction

Documents

technology fina

derivatives andrew chiu

futures contract

payoffunderlying price

forward contract

derivatives warrants

prespecified price

fixed delivery price