DERIVATIVES
WEEK 7
Financial Markets

Spot/Cash Markets
 Equity
Market (Stock Exchanges)
 Bill and Bond Markets
 Foreign Exchange

Derivative Markets
 Futures
Markets
 Options Marktes
Derivatives Markets
OTC
 Forward
(Foreign Exchange)
 Swaps (CDS, IRS)
 Options
Organized Markets
 Futures
 Options
Why Derivatives?
Derivatives are risk management tools!
Derivative Instruments can be used to transfer risk!
Derivatives

Main Motives for Derivatives Trading
 Risk
Management (Hedging)
 Speculation
 Arbitrage
Derivatives and Underlying Assets
Oil
Euro/Dollar
Forex
Energy
Yen/Dolar
Natural Gas
Canadian Dollar/ US Dollar
Dow Jones
Government Bonds
Interest
Eurodollar
Index
S&P 500
Nasdaq 100
Euroyen
Gold
Cotton
Agricultural
Wheat
Metals
Soya
Silver
Copper
Google Inc.
Equity
Is Bankasi
Futures and Options Exchanges

Important Futures and Options Exchanges include:
 NYSE
Euronext
 Chicago Mercantile Exchange
 Eurex
 CBOE

In Turkey:
 VOB
- Vadeli İşlem ve Opsiyon Borsası (Turkish
Derivatives Exchange) under the roof of Borsa İstanbul.
Clearing House

FUNCTIONS OF THE CLEARING HOUSE;
 IT
GUARANTEES THAT THE TWO PARTIES WILL
PERFORM THE TRANSACTIONS.
 AT THE END OF THE TRADING DAY, IT MATCHES EACH
PURCHASE WITH THE CORRESPONDING SALE AND
COMPUTES EACH PARTIES GAINS AND LOOSES:
“MARK TO MARKET”.
Organized Markets vs OTC Markets

FUTUES AND OPTIONS





TRADED ON O.E.
PRICE, AMOUNT, DATE ETC.
ARE STANDARTIZED BY THE
EXCHANGE
DAILY SETTLEMET
REQUIRES MARGIN
ACCOUNT
REGULATED

FORWARD





TRADED ON OTC MARKETS
NOT STANDARD
SETTLED ONLY AT DELIVERY
DOES NOT REQUIRE A
MARGIN ACCOUNT
UNREGULATED
Futures



Futures contract is a agreement between two parties
where one party commits to sell or buy a commodity
or security (underliers) to the other party at a given
price and amount and on a specified future date.
The Buyer is Long Position Holder
The Seller is Short Position Holder
Today
Future Date
Buy/Sell Future
Contract
Deliver
Underlying/
Make Payment
Buy or Sell a Futures Contract
Investor sells 10 TRY/USD futures contracts which expire in February 2012 at a price
of 1,79.
Suppose the spot price on Feb 2012 is 1,7920
Profit/Loss:
(1,7900-1,7920)*1.000=8TRY/contract
For one contract:
Short Position (Seller): 8 TRY Loss
Long Position (Buyer): 8 TRY Profit
10 futures contracts have been sold so:
10*8 TRY=80 TRY profit or loss occured -> Zero-Sum Game
To close out a futures position investor has to take an offsetting position
FUTURES: LEVERAGE


USE OF CREDIT OR BORROWED FUNDS TO IMPROVE
ONE'S SPECULATIVE CAPACITY AND INCREASE THE ROR
FROM AN INVESTMENT, AS IN BUYING SECURITIES ON
MARGIN.
THE LEVERAGE OF FUTURES TRADING REFERS TO ONLY
A SMALL AMOUNT OF MONEY IS DEPOSITED TO BUY
OR SELL A FUTURES CONTRACT.
FUTURES: MARGIN



A DEPOSIT TO COVER LOOSES THAT MIGHT BE
INCURRED IN THE FUTURES TRADING.
BOTH THE BUYER AND THE SELLER OF A FUTURES
CONTRACT ARE REQUIRED TO PROVIDE MARGIN.
THIS LOW INITIAL MARGIN MAGNIFIES THE
PERCENTAGE OF LOSS OR PROFIT POTENTIAL.
Physical Delivery or Cash Settlement

Futures/Options are either settled in cash (Cash
Settlement) or the underlying asset is delivered and
payed for at expiry (Physical Delivery)
HEDGING WITH FUTURES
INVESTORS CAN USE FUTURES FOR HEDGING



INVESTORS CAN HEDGE AGAINST CHANGES IN STOCK
PRICES OR AN INVESTOR CAN MAKE PROFIT FROM
DECLINING PRICES BY SELLING AND FROM RISING PRICES BY
BUYING
BORROWERS CAN HEDGE AGAINST HIGHER INTEREST RATES,
LENDERS AGAINST LOWER INTEREST RATES.
FARMERS CAN HEDGE AGAINST LOWER COTTON PRICES,
MERCHANTS AGAINST HIGHER COTTON PRICES
Example:
Hedging Foreign Exchange Risk
A company exports goods for 100.000 USD. The company will
receive the payment in three months time.

The
total cost for the goods produced is 130.000 TRY
Payment (USD)
COST
(TRY)
TRY/USD
Rate (TRY)
Income
(TRY)
Net Income
(TRY)
100.000
130.000
2,0000
200.000
70.000
100.000
130.000
1,8000
180.000
50.000
100.000
130.000
1,5000
150.000
20.000
100.000
130.000
1,4000
140.000
10.000
100.000
130.000
1,2000
120.000
-10.000
In
case the value of USD decreases the company may have loss
Example cont.
In order to hedge the total amount of 100.000 USD, 100 TRY/USD futures
contracts are sold (100*1.000) at $1,5000.
Spot
USD Rate (TRY)
Futures
Profit/Loss (TRY)
Cost
(TRY)
Income
(TRY)
Net Income (TRY)
2,0000
-50.000
130.000
200.000
20,000
1,8000
-30.000
130.000
180.000
20,000
1,5000
0
130.000
150.000
20,000
1,4000
10.000
130.000
140.000
20,000
1,3000
20.000
130.000
130.000
20,000
1,1000
40.000
130.000
110.000
20,000
By Selling 100 futures contracts the company has hedged itself against possible losses!
1,5000-1,4000=-0,100
0,100*1.000=100TRY/contract
100*100=10.000TRY (100 contract)
OPTIONS AND OPTIONS ON FUTURES



Option contract is an agreement between two
parties.
An option contract gives the buyer the right to
purchase or sell an economic benchmark, financial
underlying or commodity at certain price and
quantity at any time till expiry or at a specified
date
The seller of an option is obliged to fulfill the
obligation if the buyer exercises his right.
Option Types

Call Option
Gives the buyer the right to buy the underlying asset at a
certain price and quantity till expiry or at a specified
date in return for a premium.

Put Option
Gives the buyer the right to sell the underlying asset at a
certain price and quantity till expiry or at a specified
date in return for a premium.
Option Types
American vs European Options
The right of the option can be exercised anytime prior to expiry.
American Options
Buying the
Option
Expiry of the
Option Contract
European Options
The right of the option can only be exercised at
maturity.
Option Premium

Option Price has two main components: intrinsic value and time
value
Option
Premium
Intrinsic Value
+
Underlying Price – Strike Price (Call)
Strike Price – Underlying Price (Put)
Time Value
Premium – Intrinsic Value
In the money or out of the money?
CALL
OPTION
PUT
OPTION
S>K
in the money
out of the money
S<K
out of the money
in the money
S=K
at the money
at the money
Option Positions and Profit/Loss
40
25
10
Break
Even=
K-Premium
35
5
20
5
30
0



Long call
Long put
Short call
Short put
5
0
5
0
0
15
0
25
-5
Profit/Loss
Profit/Loss

0
15
20
25
30
35
40
Break
20 25 30 35 40
Even= KBreak Even=
StrikePremium
K+Premium
Price
Strike
Break
Even
Price
=
Strike
Price K+Premium
Strike
Price (K)
45
50
45
50
55
5
10
15
20
25
30
35
40
45
50
55
60
65
5
10
15
20
25
30
35
40
45
50
55
60
65
5
-10
10
-20
60
65
15
15
-15
55
60
10
20
-10
10
-5
5
-25
0
-15
10
65
0
-30
-5
-20
-5
-35
-10
-40
-25
Underlying Price (S)
Underlying Price (S)
Question???




Strike Price (K) ?
What are the
positions?
What are the
expectations of
the position
holders?
What is the
max/min
profit/loss for
each position.
Factors Affecting Option Price
Underlying Price (S)
 Strike Price (K)
 Time to expiry (t)
 Volatility (σ)
 Risk-free rate (r)
 Dividends (d)

Example





A company exports goods for 100.000 USD. The company
will receive the payment in three months time.
In case the value of USD decreases the company profit
decreases.
To hedge the foreign exchange risk the company buys 100
TRY/USD put options with a strike price of 1,6000 (contract
size 1000 USD).
The option premium is 0,0260 TRY.
Total premium paid is 0,0260 TRY*1.000*100=2.600 TRY
Example cont.
Spot
TRY/USD
Rate
1,2000
Profit from Exercising the
Option
Income in TRY
Opsiyon
Premium
Net Income
(1,6000-1,2000)*1000*100
= 40.000 TL
1,2000*100.000
=120.000 TL
2.600 TL
157.400 TL
1,3000
(1,6000-1,3000)*1000*100
= 30.000 TL
1,3000*100.000
=130.000 TL
2.600 TL
157.400 TL
1,4000
(1,6000-1,4000)*1000*100
= 20.000 TL
1,4000*100.000
=140.000 TL
2.600 TL
157.400 TL
1,5740
(1,6000-1,5740)*1000*100
= 2.600 TL
1,5740*100.000
=157.400 TL
2.600 TL
157.400 TL
1,6000
Opsiyon kullanılmaz
1,6000*100.000
=160.000 TL
2.600 TL
157.400 TL
1,7000
Opsiyon kullanılmaz
1,7000*100.000
=170.000 TL
2.600 TL
167.400 TL
1,8000
Opsiyon kullanılmaz
1,8000*100.000
=180.000 TL
2.600 TL
177.400 TL