Eiichiro Kazumori January 16, 2012

1/17,19
1/24,26 1/31, 2/2 2/7,9 2/14,16 2/21,23 2/28,3/1 3/6,8

Logistics, Ch1
Ch2 Ch3 Ch4 Ch5, HW1 Ch6, Exam 1 Ch7 Ch8

3/13,15
3/20,22 3/27,29 4/3,5 4/10,12 4/17,19 4/24,26

Recess
Ch9 Ch10 Ch11, HW2 Exam2, Presentations Presentations Presentations, End of the class party

Questions from this chapter

1. 2.

3.
4. 5.

6.
7.

What are derivatives? Where do people trade derivatives? What are forward contracts? What are futures contracts? What are options? Who trade these derivatives? Summary

Q1
What are derivative securities?

Answer
A derivative is a financial instrument whose value

depends on (or derives from) the values of other, more basic, underlying variables.
Example: a stock option, for example, is a derivative

whose value is dependent on the price of a stock

Further examples
A bushel of corn is not a derivative; it is a commodity

with a value determined by the price of corn However, you could enter into an agreement with a friend that says:
If the price of a bushel of corn in one year is greater than

$3, you will pay the friend $1. If the price of corn is less than $3, the friend will pay you $1

This is a derivative in the sense that you have an

agreement with a value depending on the price of something else (corn, in this case) That's just a bet on the price of corn.

Q2
What are the uses of derivatives?

Answer
Risk managements Speculation

Regulatory Arbitrage

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Q3
Give an example of use of derivatives for risk

managements.

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Answer
The farmer (seller of corn), enters into a contract

which makes a payment when the price of corn is low This contract reduces the risk of loss for the farmer, who we therefore say is hedging

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How Farmers Use Derivatives

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Q4
Provide an example of use of derivatives in

speculation.

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Answer
If you want to bet that the S&P 500 stock index will be

between 1300 and 1400 one year from today, derivatives can be constructed to let you do that.

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Trading simulations game

http://www.cmegroup.com/education/getting-started.html

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Q5
What are the uses of derivative securities for

regulatory arbitrage?

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Answer
Derivatives are often used to eliminate the risk of price

fluctuation while still maintaining physical possession of the stock. Using derivatives, the owner of the stock can defer taxes on the sale of the stock, or retain voting rights, without the risk of holding the stock

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Q6
Where are derivatives traded?

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Answer
Derivatives exchange OTC markets

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Size of the markets

Futures Markets: The total notional amount of all the

outstanding positions at the end of June 2004 stood at $53 trillion. (source: Bank for International Settlements (BIS): [1]). That figure grew to $81 trillion by the end of March 2008 (source: BIS [2]) OTC Markets: The total notional amount of all the outstanding positions at the end of June 2004 stood at $220 trillion. (source: BIS: [3]). By the end of 2007 this figure had risen to $596 trillion and in 2009 it stood at $615 trillion. (source: BIS: [4])
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Q7
What are derivative exchanges?

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Answer
It is a market where individuals trade standardized

contracts that have been defined by the exchange

The Chicago Board of Trade (CBOT, www.cbot.com)

The Chicago Mercantile Exchange (CME,

www.cme.com The Chicago Board Options Exchange (CBOE, www.cboe.com) The CBOE now trades options on well over 1,000 stocks and many different stock indices
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In other words
A futures exchange or futures market is a central

financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of contracts fall into the category of derivatives. Such instruments are priced according to the movement of the underlying asset (stock, physical commodity, index, etc.).
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Visiting CBOE

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CME

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http://www.youtube.com/watch?v=2GaiHq Pupgc

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What CME trades: Snowfall Futures

http://www.cmegroup.com/trading/weather /hedging-the-storm-snowfall-futures-andoptions.html

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Q8
What are OTC markets?

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Answer
Telephone- and computer-linked network of dealers Trades are done over the phone and are usually

between two financial institutions or between a financial institution and one of its clients (typically a corporate treasurer or fund manager Financial institutions often act as market makers for the more commonly traded instruments
They are always prepared to quote both a bid price (a

price at which they are prepared to buy) and an offer price (a price at which they are prepared to sell)
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How does OTC market work

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Q9
What are the differences between OTC markets and

derivatives exchanges?

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Answer: Pros and cons of OTC markets

Pros: the terms of a contract do not have to be those

specified by an exchange. Market participants are free to negotiate any mutually attractive deal Cons: there is usually some credit risk in an over-thecounter trade (i.e., there is a small risk that the contract will not be honored)

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Q11
What are forward contracts?

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Answer
An agreement to buy or sell an asset for a certain time

in future at a certain price

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Q12
What is a long position and what is a short position?

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Answer
A parties with a long position agrees to buy the

underlying asset on a certain specified future date for a certain specified price The other party assumes a short position and agrees to sell the asset on the same date for the same price

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Q13
Provide an example of a forward contract.

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Answer
July 20, 2007, US corporation will pay 1 million in 6

months (i.e., on January 20, 2008) and wants to hedge against exchange rate moves The company can agree to buy 1 million 6 months forward at an exchange rate of 2.0489

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The company and the bank

The company then has a long forward contract on GBP.

It has committed that on January 20, 2008, it will buy 1 million from the bank for $2.0489 million The bank has a short forward contract on GBP. It has committed that on January 20, 2008, it will sell 1 million for $2.0489 million

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Q14
Explain how to calculate the payoffs from the forward

contract.

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Answer Step 1
It depends on the purchase price and the future price

of the asset The payoff from a long position is St-K where K is the delivery price and St is the spot price of the asset at maturity of the contract

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Answer step 2

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Q15 Pricing of the forward price

Consider a stock that pays no dividend that is worth

$60. You can borrow or lend money for 1 year at 5%. What should the 1-year forward price of the stock be?

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Answer
The answer is $60 grossed up at 5% for 1 year, or $63 If the forward price is more than this, say $67, you

could borrow $60, buy one share of the stock, and sell it forward for $67 After paying off the loan, you would net a profit of $4 in 1 year.

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Q16
What are futures contracts?

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Answer
A futures contract is an agreement between two parties to buy

or sell an asset at a certain time in the future for a certain price Unlike forward contracts, futures contracts are normally traded on an exchange

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In other words
In finance, a futures contract is a

standardized contract between two parties to buy or sell a specified asset (eg. oranges, oil, gold) of standardized quantity and quality at a specified future date at a price agreed today (the futures price). The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.
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First futures exchange

Begun at Dojima, Osaka, Japan, in 1670s. Worlds only

futures market until 1860s. Dojima was center for rice trade, with 91 rice warehouses in 1673. Dojima futures exchange had precise definitions of quality, delivery date and place, experts who evaluated rice quality, and clearinghouses for contracts. Trading floor, daily resettlement, burning fuse, and watermen

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Q17
Provide an example of future contracts.

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Answer
Suppose that, on September 1, the December futures price of

gold is quoted as $680. This is the price, exclusive of commissions, at which traders can agree to buy or sell gold for December delivery. It is determined on the floor of the exchange in the same way as other prices (i.e., by the laws of supply and demand). If more traders want to go long than to go short, the price goes up; if the reverse is true, then the price goes down

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What does a gold futures look like?

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Q18
What are options?

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Answer
An option is a derivative financial instrument that

establishes a contract between two parties concerning the buying or selling of an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in some specific transaction on the asset, while the seller incurs the obligation to fulfill the transaction if so requested by the buyer. In return for granting the option, called writing the option, the originator of the option collects a payment, the premium, from the buyer.
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A history of options
It was mid-winter, and the owner of the olive presses

was happy to sell the right to use the olive presses during the harvest season. It generated income for the olive press owner during the off season. The man purchasing the rights ensured that he would have use of the presses during the busy season. If the olive harvest was really good, the purchaser might be able to even resell his right to use the olive presses for a profit.
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Q19
What are call options?

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Answer
A call option gives the holder the rights to buy the

underlying asset by a certain date for a certain price Rights not an obligation
The price in the contract is known as the exercise price

or strike price The date in the contract is known as the expiration date or maturity

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In other words
A call option, often simply labeled a "call", is a financial

contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
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Call Options on Wal-Mart

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Check
The buyer of a call option wants the price of the

underlying instrument to (rise, fall) in the future The seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price

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Q20
What are put options?

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Answer for (b)

A put option (usually just called a "put") is

a financial contract between two parties, the writer (seller) and the buyer of the option. The buyer acquires a short position by purchasing the right to sell the underlying instrument to the seller of the option for a specified price (the strike price) during a specified period of time. If the option buyer exercises his right, the seller is obligated to buy the underlying instrument from him at the agreedupon strike price, regardless of the current market price. In exchange for having this option, the buyer pays the seller or option writer a fee (the option premium).
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Q19
What are American and European options?

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Answer
American options can be exercised at any time up to

the expiration date. European options can be exercised only on the expiration date itself. Most of the options that are traded on exchanges are American.

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Q20
Provide an example of options.

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Answer

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Explanations
Table 1.2 gives the midpoint of the bid and offer quotes

for some of the American options trading on Intel (ticker symbol: INTC) on September 12, 2006 The quotes are taken from the CBOE website. The Intel stock price at the time of the quotes was $19.56 The option strike prices are $15.00, $17.50, $ 20.00, $22.50, and $25.00. The maturities are October 2006, January 2007, and April 2007
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Q21
True or false. The price of a call option decreases as the strike price

increases; the price of a put option increases as the strike price increases. Both types of options tend to become more valuable as their time to maturity increase.

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Answer

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Q22
Explain the payoff from call options and put options.

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Answer

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Q23
Who trade these derivatives?

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Answer
Derivatives have attracted many different types of

traders and have a great deal of liquidity Hedgers use derivatives to reduce the risk that they face from potential future movements in a market variable Speculators use them to bet on the future direction of a market variable Arbitrageurs take offsetting positions in two or more instruments to lock in a profit
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Q24
Suppose that it is October and a speculator considers

that a stock is likely to increase in value over the next 2 months The stock price is currently $20, and a 2-month call option with a $22.50 strike price is currently selling for $1 Calculate the payoffs from
(1) purchasing 100 shares.

(2) purchasing 100 contracts of call option.

(3) compare the results.
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Answer from (1)

If that the speculator's hunch is correct and the price

of the stock rises to $27 by December. The profit is: 100 x ($27-$20) = $700 Suppose the stock price falls to $15 by December. The first alternative of buying stock yields a loss of: 100 x ($20 - $15) = $500

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Answer from (2)

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Answer from (3)

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Q25
Who are arbitrageurs?

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Answer
Arbitrage involves locking in a riskless profit by

simultaneously entering into transactions in two or more markets

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Q26
A stock that is traded on both the New York Stock

Exchange (www.nyse.com) and the London Stock Exchange (www.stockex.co.uk) The stock price is $200 in New York and 100 in London at a time when the exchange rate is $2.0300 per pound Construct an arbitrage.

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Answer
An arbitrageur could simultaneously buy 100 shares of

the stock in New York and sell them in London to obtain a risk-free profit of 100 x [($2.03 x 100) - $200] = $300 *without considering transaction cost

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Conclusion
We studied questions such as What are derivatives? Where are derivatives traded? What are forward contracts? What are futures contracts? What are options? Who trade these derivatives?

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