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CFA TutorialDerivativesAnand K. BhattacharyaApril 25, 2012

Background 2009-Date: Professor of Finance Practice, ASU1998-2008: Bank of America/CountrywideManaging Director1993-1998: Prudential Securities IncManaging DirectorVarious positions in research, product management, sales andtrading (Merrill Lynch; Security Pacific Merchant Bank;Imperial Credit and Franklin Savings)ASU Graduate (Ph.D. and MBA)3 Books and 70 academic and professional publications2

Derivatives and Markets Derivative securities Markets Financial instrument that offers a return basedon the return of some underlying assetExchange traded: standardization, traded onorganized exchanges (CBOE, CBOT)OTC: non-standardized, negotiated, tradedanywhere elseUses Hedging, speculation, or arbitrage3

Forward Commitments Agreement between two parties in whichone party, the buyer, agrees to buy from theother party, the seller, an underlying asset ata future date at a price established at thecontract initiation.Main characterization: obligation by partiesTypes: forward contracts, futures contracts,swaps4

Forward Contracts Purchase and sale of underlying asset(stocks, fixed income instruments and rates,currencies, commodities, etc.) at a later dateat a price agreed upon todayNon-standardized, customizable, OTCtransactions between large financialinstitutions and/or corporationsPrivate and largely unregulated market5

Futures Markets Variation on a forward contractPublic, standardized transaction that occurs on afutures exchange Exchange determines expiration dates, underlying assets,size of the contracts, etc.Default risk and the clearinghouse Marking-to-market Exchange is the counterparty in futures transactionsDaily settlement where profits and losses are charged andcredited to the short and long position each dayOffsetting transactions Ability to unwind positions prior to expirationTake an opposite position to the original contract6

Swaps Variation on a forward contractAgreement between two parties toexchange a series of future cash flows Equivalent to a package of forwardsAt least one of the two cash flows aredetermined at a later date (plain vanillainterest rate swap) Fixed and floating payments Make known payments in exchange for somethingunknownConversion of one payment (say a fixed rate) toanother (say a floating rate)Private, OTC transactions7

Contingent Claims and theOption Market Contingent claims are derivatives wherepayoffs occur if a specific event happens.Options are financial instruments that givethe option buyer the right, but not theobligation, to buy (CALL) [or sell (PUT)] anasset from [or to] the option seller at a fixedprice on or before expiration. Asymmetric payoffs Buyer has the right, seller (or writer) has an obligationif the option is exercisedStrike or exercise pricePremium or option priceOTC and exchange traded options8

The Good, The Bad,and The Ugly Purposes of Derivatives Markets Risk management Price discovery and market efficiency:information about the prices of underlying assets Hedging: reduction or elimination of identifiable risksInsuranceCommodity prices, volatilityReduced transaction costs and leverageCriticisms Complexity for un-sophisticated investorsGambling critique9

Arbitrage andDerivatives Pricing Arbitrage: equivalent assets orcombination of assets sell for twodifferent pricesLOOP (law of one price) Arbitrage will drive prices of equivalentassets to a single price so that no risklessprofits can be earned.10

CFA TutorialForward Markets andContracts

Basics Long position: buyer in a forward contractShort position: seller in a forward contractSettlement Delivery Cash settlement Long pays forward price to shortShort delivers underlying assetPay net cash value on delivery dateDefault riskTermination prior to delivery Offsetting position in a new forward (not necessarily zeroprice transaction; credit risk)Cancellation12

Dealers and End-Users Dealer: entity that makes a market in afinancial instrument Provides quotes (bid-ask spread) on the cost ofand stands by as the counterparty to thetransaction Wholesaler of riskEngage in transactions with other dealersand end-users End-users, such a corporations, generally has arisk-management problem13

Equity Forwards Contract for the purchase/sale of anindividual stock, portfolio, or index at a laterdate Lock in a price today for a transaction in thefutureHedging Need to sell stock/portfolio in several monthsConcern that prices declineEnter into a forward today to sell the assets to a dealerat expirationRegardless of price moves, the selling price is lockedin today14

Fixed Income Forwards Forward contracts on bonds, bond portfolios andbond indices are similar in nature to equity forwards Expiration vs. maturityCouponsCallability/convertibilityDefault riskZero-coupon bonds (T-bills) Discount from parQuoted in rates (discount), not pricePrice conversion: 1 – [discount rate*(n/360)]Coupon bonds (T-notes and T-bonds) Interest-bearingPremium or discountPrice Accrued Interest15

FRAs Forward Rate Agreement: interest rateforward contractEurodollar time deposits: deposits in dollarsoutside the US Short-term unsecured loansLIBOR: rate at which London banks lend dollarsto other banks360-day add-on interest rateEuribor: rate at which banks borrow euros16

FRAs (con’t) Buyer of FRA (long): long the rate, benefitsif rates increaseSeller of FRA (short): short the rate, benefitsif rates decreasePayoff (long):Rate at Expiration - Forward rate n 360Notional Principal1 [Rate at Expiration n 360 ] n days in maturity of underlyingTwo-rate notation 1x3, 3x9, 6X1217

Currency Forwards Impetus: move from pegged to floatingexchange rates in late 1970s Widely used by corporations and banks tomanage foreign exchange riskCurrency forwards allow corporations to hedge Lock in exchange rates todayEx: receive euros, convert to dollars Long euro, short dollarsHedge: take a short forward (short euro, long dollars)18

Pricing of Forward Contracts Notation: 0 today, T expiration, underlying asset S0(or t or T),forward F(0,T) What is the value of a forward today? V0 S0 – F(0,T)/(1 r)T, butA forward contract has a value of F(0,T) S0(1 r)T Long value at maturity: VT ST – F(0,T)Short value at maturity: VT F(0,T) – STWe can make adjustments to this basic formula for incomepaying assets, currencies and commoditiesFutures contracts are priced similarly19

CFA TutorialFutures Markets andContracts

Review of Futures Public, standardized transactions onorganized exchanges Underlying asset, quality of asset, expirationdates (months and maturities), size of contract,price and position limits Homogenization and liquidity active secondarymarketAbility to take offsetting positionsClearinghouseMarking to market: daily settlement of gains andlosses between long and short positions Long profits from price increases, short profits fromprice decreases21

Margin and Marking to Market To open a position in the futures market, a partymust deposit monies into a margin account with theclearinghouse Stock market margin leverage (borrow up to 50%)Futures margin good faith or collateral (not borrowed) Initial margin: amount deposited at beginning of thecontract (usually less than 10% of contract value)Maintenance margin: minimum margin balance thattraders can hold before margin call Required by long and short positionsSet by clearinghouse and varies per futures contractGains and losses are charged or credited daily to the marginaccounts by marking to market(1) deposit additional funds (variation margin) or (2) close outposition22Settlement price: price at which marking to market occurs

Marking to Market ExampleLong PositionDay Beg. FundsSettlement PriceBal. Deposited 502.502512551250103.00-0.50-5120A note on margin calls: a price change exceeding the difference betweenthe initial and maintenance margin will trigger a margin call.Marking to market occurs to collect losses and distribute gains in such amanner that losses are paid before becoming large enough to run the riskof default.23

Price Limits Some contracts impose limits on pricechanges that can occur from day today: SP price limit Limit move: if transaction exceeds a pricelimit, price freezes at the limit Limit up: price stuck at upper limitLimit down: price stuck at lower limitLocked limit: transaction cannot occurbecause price is beyond the limits24

Closing Out the Position Three options: Offsetting position: take identical, but opposite contract toexisting position ( 90% of all contracts)Delivery: holder of oldest long contract to accept delivery Accepts delivery and pays the previous day’s settlementprice to the shortCash settlement: Let position expire and margin accountsare settled for final marking to marketComplications: high transactions cost for physicaldelivery, short can often determine when, what andwhere to deliverExchange for physicals: arrangement of alternativedelivery procedure acceptable to the exchange25

The Players Locals: floor traders, liquidity providers,market makers Scalper: buys and sells contracts, profit fromchanges in the spreadDay trader: holds a position longer thanscalpers, but ends the day with zero inventoryPosition trader: holds positions overnight Day and position traders: attempt to profit fromanticipated market movementsBrokers: futures commission merchants26

T-Bill Futures Based on a 90-day, 1 million T-bill Recall: price 1 – (disct rate*(n/360))Example: rate 6.25%; quoted futures price 93.75, actual price 1M*(1-(0.0625(90/360))) 984,375In T-bills, computing price changes is easy 1 bp move 25 price changeTrades on a M/J/S/D calendarCash settlementUsurped by Eurodollar as the important shortterm rate contract27

Eurodollar Contracts CME contracts on 90-day, 1M notionalprincipal of EurodollarsPrices are quoted in the same manner as Tbills Cash settledOne of the most widely traded contractsbecause of use of LIBOR in swaps, FRAs andinterest rate optionsUnlike Eurodollar deposits, which have “add-on”interest, Eurodollar futures are quoted on adiscount basis, like T-bills28

T-Bond Contracts Very actively traded long term interest ratecontracts on CBOT Contract based on delivery of a T-bond with anycoupon and at least 15 years to maturity. Implies many bonds available for deliveryShort gets to determine which bond to deliver Conversion factor puts all bonds on equal footingCheapest to deliver bond: Quoted price – (QFP * CF)Contract 100,000 par value of T-bondsPhysical deliveryQuoted in 32nds29

Stock Index Futures Contracts S&P 500 Index contract (most highly traded) Quoted in terms of price on the same order asthe underlying indexMultiplier 250 times futures priceM/J/S/D expirations (up to 2 yrs), but activetrading limited to near termCash settledOther contracts Mini S&P 500 ( 50 multiplier)S&P Midcap 400, Dow Index, Nasdaq 100,FTSE 100, Nikkei 225, etc.30

CFA TutorialSwap Markets and Contracts

Swaps Agreement to exchange a series of cashflows Generally involve a series of payments One payment generally determined by randomoutcome (rates, currencies, etc.)One payment generally fixedLong: party that receives floatingShort: party that receives fixedLike a package of forward contractsInitial value of the swap is zero32

Basics Settlement date: date on which parties makepayments Settlement period: time between settlement datesNetting: generally parties agree to exchange onlythe net amount owed from one party to the otherTermination date: date of the final paymentOTC market, customizedTermination: cash settlement of market value,offsetting swap (default risk), sell swap, swaption33

Currency Swaps Each party makes interest payments to theother in different currenciesFour types of currency swaps Fixed for fixedFixed for floatingFloating for fixedFloating for floating These can also be reversed in terms of currencies paidWe can also combine currency swaps to eliminatecurrency flows and obtain transactions in only onecurrency34