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Introduction
Risk
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010
The
If a firm can manage its interest rate and exchange rate risk, it
can reduce the volatility of its profits
10
Derivatives
are either:
Examples of Derivatives
Futures Contracts
Forward Contracts
Options
Swaps
12
Applications of Financial
Derivatives
Management
of Risk
13
Price discovery
Another
14
15
Classification of Derivatives
16
Futures Contracts
Financial Futures:
Interest rates, shares, share price indices(stock index)
Futures Price
The
It
19
Electronic Trading
Traditionally
Increasingly
It
Trades
Terminology
The
The
22
OTC
Exchange
Source: Bank for International Settlements. Chart shows total principal amounts
for OTC market and value of underlying assets for exchange market
23
Bid
1.6382
Offer
1.6386
1-month forward
1.6380
1.6385
3-month forward
1.6378
1.6384
6-month forward
1.6376
1.6383
25
Option terminology
Option premium (price)- EXTRA PREMIUM
Call and Put Options
Exercise (strike) price [the agreed price]
Expiration date or maturity date
Options
A call
Types of Options
American
Options
European
Options
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010
28
29
An
30
Bid (Buy)
Offer (Sell)
Spot
1.6382
1.6386
3-month forward
1.6378
1.6384
Hedge the risk by: Buying GBP 10m (selling US$) 3 month forward (OTC market)
The US company could hedge its foreign exchange risk by buying GBP pounds from the
financial institution in the three month forward market at 1.6384. This would have the effect of
fixing the price to be paid to the British exporter at US$16,384,000.
If exchange rate gone lower than 1.6384 the company will do better if it chooses not to hedge.
If exchange rate gone up, more than 1.6384, the company will wish it had hedged.
Bid
Offer
Spot
1.6382
1.6386
3-month forward
1.6378
1.6384
Hedge the risk by: Selling GBP 30m (buying US$) 3 month forward (OTC market)
The US company could hedge its foreign exchange risk by selling GBP pounds from the
financial institution in the three month forward market at 1.6378. This would have the effect of
fixing the price to be received from the British company at US$49,134,000
If exchange rate gone lower than 1.6378 the company will wish it had hedged.
If exchange rate gone up, more than 1.6378, the company will do better if it chooses not to
hedge.
The
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010
41
42
Introduction
Introduction (cont)
The risks and costs of these three alternatives
differ markedly:
a)
b)
c)
Futures Contracts
Note:
a.
b.
Contract grade
For some commodities a range of grades can be delivered.
[e.g. No. 2 Yellow corn]
For financial assets generally well defined and unambiguous. [No need to
specify the grade for British Pounds]
Contract size
The contract size specifies the amount of the assets that has to be
delivered.
Too large : investors with relatively small exposure/position will be unable to
use the exchange
Too small: Trading may be expensive as there is cost associated with each
contract traded.
Quotation unit
The exchange defines how prices will be quoted [e.g. crude oil prices on
NYME are quoted in dollars & cents]
Price limits
For most contracts, daily price movement limits are specified by the exchange.
- Normally the trading ceases for the day once the contract has reached the upper
or lower limits
-In some cases, the exchange has the authority to change the limits.
Propose : to prevent large price movement due to excess speculative exercise
Position limits
When the delivery period of the contract is approaching, the future price
converges to the spot price
Situation 1: The future price is above the spot price. Traders have clear arbitrage
opportunity to:
Sell a future contract
Buy the asset
Make delivery
as traders exploit this arbitrage opportunity, the future price will drop (market supply
increases)
Situation 2: The future price is below the spot price. Traders will:
Hold the future contract and wait for the delivery
it is more attractive to buy a future contact and the future price tend to rise (market demand
increases)
This is the result of the future price tend to be very close to the spot price during the
delivery period.
Spot Price
Futures
Price
Spot Price
Time
(a)
Time
(b)
Contract Months
Minimum Price Fluctuation
Last Trading Day
:
:
:
Delivery Method
Initial Margin
Bid
Ask
3449.0 3451.0
3443.0 3447.0
3383.0 3400.0
Source: http://www.asx.com.au
Notes:
1. Change is current price compared to settlement price on
previous day
2. Volume refers to number of contracts traded on the day
A Possible Outcome
Day
Futures
Price
(US$)
Daily
Gain
(Loss)
(US$)
Cumulative
Gain
(Loss)
(US$)
900.00
Margin
Account Margin
Balance
Call
(US$)
(US$)
4,000
3,400
.
.
.
Margin
maintenance
is $3,000
5-Jun 897.00
.
.
.
.
.
.
(600)
.
.
.
(600)
.
.
.
0
.
.
.
13-Jun 893.30
.
.
.
.
.
.
(420)
.
.
.
(1,340)
.
.
.
19-Jun 887.00
.
.
.
.
.
.
(1,140)
.
.
.
(2,600)
.
.
.
26-Jun 892.30
260
(1,540)
5,060
59
60