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Derivatives Fundamentals

Describes what derivatives are and explains the differences between over-the-counter and exchange-traded
derivatives, Identify types of underlying assets on which derivatives are based, describes the participants in and use of derivative trading, describes what options are and how they are traded, and evaluate call and put option strategies for
individual and institutional investors and corporations.
5. Describe what forwards are, distinguish futures contracts from forward agreements, and evaluate
futures strategies for investors and corporations, define and describe rights and warrants, explaining why they are issued,

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Derivatives Fundamentals

  1. 1. Fortuna Favi et Fortus Ltd.
  2. 2. Derivatives Fundamentals
  3. 3. What is a Derivative? • Common Features • Derivative Markets • Exchange-Traded versus OTC Derivatives Types of Underlying Assets • Commodities • Financials Why Investors Use Derivatives • Individual Investors, Corporations and Businesses • Derivative Dealers Options • Option Exchanges • Option Strategies for Individual and Institutional Investors • Option Strategies for Corporations Forwards and Futures • Key Terms and Definitions • Futures Exchanges • Futures Strategies for Investors
  4. 4. Derivative : Defined A derivative is a financial contract between two parties whose value is derived from, or dependent upon, the value of some other asset. The other asset, known as the derivative’s underlying asset or underlying interest or security, could be a financial asset, e.g. stock or bond, currency, or even an interest rate, a futures contract or an equity index. It could also be a real asset or commodity, such as crude oil, gold or wheat. i.e. A derivative is an asset whose value is derived from the value of some other asset, known as the underlying. Due to this link between a derivative and its underlying asset derivatives can act as a substitute for, or as an offset to, a position in the underlying asset.
  5. 5. Example: If you have a legal contract that, with the payment of a premium, gives you the option to buy a fixed quantity of kola nuts at a fixed price of $100 at any time in the next three months. The kola nuts is currently worth $90 in the world market. The option is a derivative and the underlying is kola nuts. Should Kola nuts value increase, then the value of your option increases, because of your right (but not the obligation) to buy the metal at a pre- determined price.
  6. 6. Example: Obasanjo Farms Contract with Odumegwu to Buy @ specified price per kilo within three months Odumegwu Nut Processing Thus, Odumegwu Nut processing has the ‘OPTION’ to purchase specific amount of nuts within a specified time – i.e an Option Thus derivatives are: • used to manage the risk of an existing or anticipated position in the underlying asset • Used to speculate on the value of the underlying asset.
  7. 7. Types: Derivatives - Option Two basic types: Options Or Forwards. • Options are contracts between two parties: a buyer and a seller. The buyer of an option has the right, but not the obligation, to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today. The seller of the option is obligated to complete the transaction if called upon to do so. An option that gives its owner the right to buy the underlying asset is known as a call option; the right to sell the underlying asset is known as a put option.
  8. 8. Forwards are also contracts between a buyer and a seller. With forwards, both parties obligate themselves to trade the underlying asset in the future at a price agreed upon today. Neither party has given the other any right; they are both obligated to participate in the future trade. Nature of the contract as a ‘right’ or an ‘obligation’ is the fundamental difference between an option and a forward Types: Derivatives - Forwards
  9. 9. Features Common to All Derivatives • Derivatives are contractual agreements between two parties - known as counterparties. • Agreements spell out the rights and/or obligations of each party. • Derivatives have a price - Buyers try to buy derivatives cheaply, sellers try to sell them for as much as possible. • Both parties must fulfill their obligations or exercise their rights under the contract on or before the expiration date.
  10. 10. • Derivatives contract is drawn up, it includes a price or formula for determining the price of an asset to be bought and sold in the future, either on or before the expiration date. • Derivatives can be considered a zero-sum game i.e. aside from commission fees and other transaction costs, the gain from an option or forward contract by one counterparty is exactly offset by the loss to the other counterparty i.e. gain by one party represents loss by counterparty to contract. • With forwards, no up-front payment is required. At times one or both parties make a performance bond or good-faith deposit, giving the party on the other side of the transaction some assurance that the terms of the forward will be honored. Features Common to All Derivatives
  11. 11. With options, the buyer makes a payment to the seller when the contract is drawn up. - known as a premium, it gives the buyer the right to buy or sell the underlying asset at a preset price on or before the expiration date. Features Common to All Derivatives
  12. 12. Derivative Markets Derivatives can and do trade ‘Over-the –Counter’ or can be traded on ‘The Stock Exchange’. Over-the-counter Derivatives - OTC derivatives market is an active and vibrant market that consists of a loosely connected and lightly regulated network of brokers and dealers who negotiate transactions directly with one another primarily over the telephone and/or computer terminals. Market is dominated by financial institutions, e.g., banks and brokerage houses, that trade with their large corporate clients and other financial institutions. OTC market has no trading floor and no regular trading hours - contracts can be custom designed to meet specific needs and can be more complex than exchange-traded derivatives - as special features can be added to the basic properties of options and forwards.
  13. 13. Exchange-traded Derivatives A derivative exchange: a legal corporate entity organized for the trading of derivative contracts. The exchange provides the facilities for trading, either a trading floor or an electronic trading system or, in some cases, both. The exchange also stipulates the rules and regulations governing trading in order to maintain fairness, order and transparency in the marketplace. Derivative exchanges evolved in response to the OTC issues of standardization, liquidity and credit risk. Derivative Markets
  14. 14. Exchange-traded Derivatives cont’d: Exchange trades include: options on stocks, bonds and indexes, and futures (forwards that are exchange-traded) on bonds and indexes on bonds and indexes, futures and future options on agricultural goods such as canola and western barley Derivative Markets
  15. 15. Exchange-Traded vs. OTC Derivatives Co-existence of both the OTC market and the Exchange traded market in derivatives has proven successful because each market offers advantages to users depending on their particular needs. • Standardization And Flexibility: In the OTC market, the terms and conditions of a contract can be tailored to the specific needs of their users i.e users may choose the most appropriate terms to meet their particular needs. With exchange-traded derivatives, the exchange specifies the contracts that are available to be traded on the exchange; each contract has standardized terms and other specifications, which may or may not meet the needs of certain derivative users.
  16. 16. • Privacy : With OTC derivative transactions, neither the general public nor others (including competitors) know about the transaction. On exchanges, transactions are recorded and known to the general public, although the exchanges do not announce, nor do they necessarily know, the identities of the ultimate counterparties to every transaction. Liquidity and Offsetting: Due to the private and custom design, OTC derivatives cannot be easily terminated or transferred to other parties in a secondary market-usually they contracts can only be terminated through negotiations between the two parties. But the standardized and public nature of exchange-traded derivatives can be terminated easily by taking an offsetting position in the contract. Exchange-Traded vs. OTC Derivatives
  17. 17. Liquidity and Offsetting cont’d Default Risk: With OTC transactions default risk is a major concern. Default risk is the risk that one of the parties to a derivative contract cannot meet its obligations to the other party. Thus, the need by OTC dealers to establish a level of credit worthiness amongst parties to a transaction. Also size of most contracts in the OTC market may be greater than most investors can manage. Thus, the OTC market is restricted to large institutional and corporate customers. Exchange-Traded vs. OTC Derivatives
  18. 18. With exchange-traded derivatives. Clearinghouses, are set up by exchanges to ensure that markets operate efficiently, guarantee the financial obligations of every party and contract – market participants need not be concerned with the honesty or reliability of other trading parties -the integrity of the clearinghouse is the only concern. The clearing corporation is in effect, the buyer for every seller and the seller for every buyer. By being on the opposite side of all trades, the clearing corporation minimizes the risk of default. Though individual trades are negotiated between the two parties through the exchange, once the contract has been made, the clearing corporation is the counterparty. Exchange-Traded vs. OTC Derivatives
  19. 19. Regulation: OTC contracts are private and exchange-traded contracts are public i.e. derivative transactions on exchanges are extensively regulated by the exchanges themselves and government agencies, OTC derivative transactions are generally unregulated. The largely unregulated environment in the OTC markets permits unrestricted and explosive growth in financial innovation and engineering but the regulated environment of exchange-traded derivatives brings about fairness, transparency and an efficient secondary market. Exchange-Traded vs. OTC Derivatives
  20. 20. Difference b/W OTC and Exchange traded Derivatives Exchange-Traded • Traded on an exchange • Standardized contract • Transparent (public) • Easy termination prior to contract expiry • Clearinghouse acts as third-party guarantor ensuring contract’s performance to both trading partners • Performance bond required, depending on the type of derivative Over-the-Counter • Traded largely through computer and/or phone lines • Terms of the contract agreed to between buyer and seller • Private • Early termination more difficult • No third-party guarantor • Performance bond not required in most cases
  21. 21. Exchange-Traded • losses accrue on a day-to-day • Heavily regulated • Delivery rarely takes place • Commission visible • Used by retail investors, corporations and institutional investors Over-the-Counter • Contracts are generally not marked- to market; basis (marking-to- market) gains and losses are generally settled at the end of the Contract • Much less regulated • Delivery or final cash settlement usually takes place • Fee usually built into price • Used by corporations and financial institutions Difference b/W OTC and Exchange traded Derivatives
  22. 22. Types Of Underlying Assets Generally 2 major categories of underlying assets for derivative contracts – commodities and financial assets. • Commodities: futures and options are commonly used by producers, merchandisers and processors of commodities to protect themselves against fluctuating commodity prices. Types of commodities that underlie derivative contracts include:  Grains and Oilseeds e.g., wheat, corn, soybeans and canola  Livestock and Meat e.g., pork bellies, hogs, live cattle and feeder cattle  Forest, Fiber and Food e.g., lumber, cotton, orange juice, sugar, cocoa and coffee
  23. 23.  Precious and Industrial metals e.g., gold, silver, platinum, copper and aluminum  Energy Products e.g., crude oil, heating oil, gasoline, natural gas and propane Other than the energy category, most commodity derivatives are exchange-traded contracts. Types Of Underlying Assets
  24. 24. Types Of Underlying Assets • Financial Derivatives. – these include: Equity Indexes: Equity is the underlying asset of a large category of financial derivatives. The predominant equity derivatives are equity options i.e., options on individual stocks. - Traded mainly on organized exchanges e.g., the Bourse de Montréal in Canada, Chicago Board Options Exchange (CBOE), International Securities Exchange (ISE) etc
  25. 25. Interest Rates: generally based on interest rate-sensitive securities rather than on interest rates directly - underlying assets include bankers’ acceptances and Government bonds. In the OTC market, interest rate derivatives are generally based on well- defined floating interest rates, which are not easily manipulated by market participants. Examples of underlying assets include LIBOR or the London Interbank Offer Rate (the interest earned on Eurodollar deposits in London) and the yields on Treasury bills and Treasury bonds. * These contracts are cash settled. Types Of Underlying Assets
  26. 26. Currencies: commonly used underlying assets in currency derivatives are the U.S. dollar, British pound, Japanese yen, Swiss franc and Euro. Types of contracts traded include currency futures and options on organized exchanges and currency forwards and currency swaps in the OTC market. Types Of Underlying Assets
  27. 27. Why Investors Use Derivatives Users can be divided into four groups: • Individual Investors • Institutional Investors • Businesses And Corporations • Derivative Dealers. Individual and institutional investors, including businesses and corporations, are end users - use derivatives either to speculate on price or value of an underlying asset, or to protect the value of an anticipated or existing position in the underlying asset – i.e. hedging Derivative dealers - these are intermediaries in the markets that buy and sell to meet the demands of the end users. - balancing their risks and earning profits from the volume of deals done with customers.
  28. 28. • Individual Investors: Normally individual investors are able to trade exchange-traded derivatives only – being active investors in exchange-traded options markets and, to a lesser extent, futures markets. Adequate understanding of all of their potential risks and rewards is required due to their highly speculative nature – i.e. potential for extreme losses. Though risk management strategies, can be beneficial to all investors, from the most conservative to the most aggressive. Why Investors Use Derivatives
  29. 29. • Institutional Investors: These include mutual fund managers, hedge fund managers, pension fund managers, insurance companies and more. Institutional investors use derivatives for both speculation and risk management and are able to trade OTC derivatives in addition to exchange-traded derivatives. Institutional investors may use derivatives to quickly carry out changes to their portfolio’s asset allocation—the mix of stocks, bonds, and cash held in a portfolio avoiding excessive hidden transaction costs. i.e., portfolio managers frequently need to shift funds from one market segment to another market segment, from one type of market to another type of market, and from one country to another country. Why Investors Use Derivatives
  30. 30. • Corporations and Businesses: Tend to be larger companies that make use of borrowed money, have multinational operations that generate or require foreign currency, or produce or consume significant amounts of one or more commodities. Use of derivatives primarily for hedging purposes – they tend to focus on derivatives that help them hedge interest rate, currency and commodity price risk. Hedging is the attempt to eliminate or reduce the risk of either holding an asset for future sale or anticipating a future purchase of an asset. With derivatives this involves taking a position in a derivative with a payoff that is opposite to that of the asset to be hedged. Why Investors Use Derivatives
  31. 31. Corporations and Businesses: (cont’d) E.g., a hedger who owns an asset, and is concerned that the price of the asset could fall in the future, a short position in a forward contract based on the asset would be appropriate. A decline in the price of the asset will result in a loss on the asset being held, but would be offset by a profit on the short forward contract. Another solution would be to buy a put option on the underlying asset. - Corporations hedge with derivatives in order to focus their efforts on running their primary business instead of trying to guess where interest rates, currencies or commodity prices are going. Why Investors Use Derivatives
  32. 32. On the other hand, if a hedger anticipates buying an asset in the future, and is concerned that the price could rise by the time the purchase is made, buying a forward contract or a call option would be appropriate. A price increase will result in the higher price being paid by the hedger, but this would be offset by a profit on he forward or call option. A hedger starts with a pre-existing risk that is generated from a normal course of business. E.g., a farmer growing wheat has a pre-existing risk that the price of wheat will decline by the time it is harvested and ready to be sold. Also, an oil refiner that holds storage tanks of crude oil waiting to be refined has a pre-existing risk that the price of the refined product may decline in the interim. Why Investors Use Derivatives
  33. 33. To reduce or eliminate these price risks, the farmer and the refiner could take derivative positions that will profit if the price of their assets declined. Any losses in the underlying assets would be offset by gains in the derivative instruments. Thus, any gains in these assets might be offset by derivative losses of roughly the same size, depending on the type of derivative chosen and the overall effectiveness of the hedge. Effectively companies use derivatives in an appropriate fashion as a risk management tool. **But Hedging does not always result in the complete elimination of all risks. Why Investors Use Derivatives
  34. 34. • Derivative Dealers: This group; Derivative dealers, play a crucial role within OTC markets by taking the other side of the positions entered into by end users. Dealers in exchange traded markets take the form of market makers that stand ready to buy or sell contracts at any time. Exchange-traded market makers include banks and investment dealers as well as professional individuals. Why Investors Use Derivatives
  35. 35. Option Contracts
  36. 36. Options - A contract between two parties, a buyer (also known as the long position or holder) and a seller (also known as the short position or the writer). -Contract gives certain rights or obligations to buy or sell a specified amount of an underlying asset, at a specified price (known as the strike price or exercise price), within a specified period of time. - Buyer has the right but is not obligated to exercise her contract, whilst seller is obligated to fulfill his part of the contract, if called upon to do so. For the right to buy or sell the underlying asset, option buyers must pay sellers a fee, known as the ‘option price or option premium’. Upon payment, the option buyer has no further obligation to the writer, unless the buyer decides to exercise the option. Thus, the most that the buyer of an option can lose is the premium paid.
  37. 37. Options Writers must always be ready to fulfill their obligation to buy or sell the underlying asset. As evidence of constant ability to fulfill their obligations, writers of exchange-traded options are required to provide and maintain sufficient margin in their option accounts. Writers of OTC options typically do not have this requirement. An option that gives its holder the right to buy and its writer the obligation to sell the underlying asset is known as a call option. An option that gives its holder the right to sell and its writer the obligation to buy the underlying asset is referred to as a put option. Options
  38. 38. Rights And Obligations Associated With Option Positions Call Pays premium to the writer for the right to BUY the underlying asset. Receives premium from the buyer and has the obligation to SELL the underlying asset, if called upon to do so. Put Pays premium to the writer for the right to SELL the underlying asset. Receives premium from the buyer and has the obligation to BUY the underlying asset, if called upon to do so. Buyer or Holder Writer or Seller Buyer or Holder Writer or Seller
  39. 39. Syntax to Describe an Option - summarizing the option’s most salient features into a phrase: “{Underlying Asset} + {Expiration Month} + {Strike Price} + {Option Type}” i.e. investor wants to buy 10 exchange-traded call options on XYZ stock with an expiration date in December and a strike price of $50, would say that he wanted to “buy 10 XYZ December 50 calls.” Same as buying a stock, the investor would also indicate the price at which he is willing to pay. He could purchase “at market,” in which case he agrees to accept the best price currently available, or he could enter a limit order by specifying the highest price at which he is willing to pay.
  40. 40. An option’s trading unit describes the size or amount of the underlying asset represented by one option contract. E.g, all exchange-traded stock options in North America have a trading unit of 100 shares. Thus, a holder of one call option has the right to buy 100 shares of the underlying stock, while the holder of one put option has the right to sell 100 shares. Premium of an option is always quoted on a “per unit” basis, i.e. the premium quote for a stock option is the premium for each share of the underlying stock calculated by multiplying the premium quote by the option’s trading unit. E.g., if a stock option is quoted with a premium of $1, it will cost the buyer $100 for each contract. Options
  41. 41. Options : American and European Style Options that can be exercised at any time up to and including the expiration date are referred to as American-style options. Options that can only be exercised on the expiration date are referred to as European-style options. Traditionally, options have been listed with relatively short terms of nine months or less to expiration but there are exchanges that have listed options with much longer expirations (2-3yrs) called Long-Term Equity Anticipation Securities (LEAPS). LEAPS are long term option contracts and offer the same risks and rewards as regular options.
  42. 42. Option Transactions Establishment of a new position in an option contract by an investor is referred to as an Opening Transaction. An opening buy transaction results in a long position in the option. An opening sell transaction results in a short position in the option. On or before an option’s expiration date, one of three things will happen to long and short option positions. • For exchange traded options, positions may be liquidated prior to expiration by way of an offsetting transaction, which, in effect, cancels the position. Offsetting a long position involves selling the same type and number of contracts, while offsetting a short position involves buying the same type and number of contracts. OTC Contracts can be offset by negotiation
  43. 43. • The party holding the long position can exercise the option. i.e, the party holding the short position is said to be assigned on the option. For the owners of call options, the act of exercising involves buying the underlying asset from the assigned writer at a price equal to the strike price. For the owners of put options, exercising involves selling the underlying asset to the assigned put writer at a price equal to the strike price. • Parties holding a long position can let the option expire. Buyers of options have rights, not obligations. If they do not want to exercise their options before they expire, they don’t have to; it’s a right not an obligation. Owners of options will exercise only if it is in their best financial interest, which can only occur when an option is in-the-money. Option Transactions
  44. 44. • A call option is in-the-money when the price of the underlying asset is higher than the strike price. If this be the case, the call option holder can exercise the right to buy the underlying asset at the strike price and then turn around and sell it at the higher market price. • A put option is in-the-money when the price of the underlying asset is lower than the strike price. If this be the case, the put option holder can exercise the right to sell the underlying asset at the higher strike price, which would create a short position, and then cover the short position at the lower market price. Option Transactions
  45. 45. The in-the-money portion of a call or put option is referred to as the option’s intrinsic value. E.g., if XYZ stock is trading at $60, a call option on XYZ stock with a strike price of $55 has $5 of intrinsic value. Similarly, a put option on XYZ with a strike price of $65 has $5 of intrinsic value. Thus, Intrinsic Value of an In-the-Money Call Option = Price of Underlying – Strike Price; $5 = $60 – $55 Intrinsic Value of an In-the-Money Put Option = Strike Price–Price of Underlying; $5 = $65 – $60 Option Transactions
  46. 46. If an option is not in-the-money, it has zero intrinsic value. For example, a call option on XYZ with a $65 strike price has no intrinsic value, as does a put option with a strike price of $55. Option Transactions
  47. 47. Prior to the expiration date, most options trade for more than their intrinsic value. The amount by which an option is trading above its intrinsic value is known as the option’s time value. E.g., if a call option on XYZ with a strike price of $55 is trading for $6 when XYZ stock is trading at $60, the option has $1 of time value. Time Value of an Option = Option Price – Option’s Intrinsic Value $1 = $6 – $5 Rearranging the equation: Option Price = Intrinsic Value + Time Value Option Transactions: Time Value
  48. 48. Intrinsic Value is the amount that the owner of an in-the- money option would earn by immediately exercising the option and offsetting any resulting position in the underlying asset. Time Value represents the value of uncertainty. Option buyers want options to be in-the-money at expiration; option writers want the reverse. The greater the uncertainty about where the option will be at expiration, either in-the-money or out-of-the-money, the greater the option’s time value. Option Transactions: Intrinsic Value & Time Value
  49. 49. ‘Out of’ or ‘At the Money’ Options Owners of options will definitely not exercise if they are out-of-the-money or at-the-money. • A call option is out-of-the-money when the price of the underlying asset is lower than the strike price. • A put option is out-of-the-money when the price of the underlying asset is higher than the strike price. • Call and put options are at-the-money when the price of the underlying asset equals the strike price. If a call option is out-of-the-money, it does not make financial sense for the call option holder to buy the underlying asset at the strike price (by exercising the call) when it can be purchased at a lower price in the market.
  50. 50. if a put option is out-of-the-money, it does not make financial sense for the put option holder to sell the underlying asset at the strike price (by exercising the put) when it can be sold at a higher price in the market. There is generally no advantage to exercising an at-the-money option (for which the strike price equals the market price of the underlying asset), at-the-money options are normally left to expire worthless. ‘Out of’ or ‘At the Money’ Options
  51. 51. Equity Option Quotation XYZ Inc. 17 3/4 Bid Ask Last Opt Vol Opt Int Mar $17.50 3.80 4.05 3.95 50 1595 $17.50P 2.35 2.60 2.40 5 3301 Sept $17.50 1.10 1.35 1.25 41 3403 $17.50P 0.95 1.05 1.00 30 1058 Dec. $20.00P 1.85 2.00 1.90 193 1047 Total 319 10404 Explanation: XYZ Inc. The underlying equity for the option., 17 ¾ - The closing market price of the underlying equity., Mar. The options’ expiration month (March, September, December).,
  52. 52. Explanation: Equity Option Quotes XYZ Inc. The underlying equity for the option., 17 ¾ - The closing market price of the underlying equity., Mar. The options’ expiration month (March, September, December)., $17.50 - The exercise price of each series., $17.50P - The option is a put., 3.80 - closing bid price for each XYZ option expressed as a per share price., 4.05 - closing asked price for each XYZ option expressed as a per share price., 3.95 - The last sale price (last premium traded) of an option contract for the day expressed as a per share price. E.g., the 3.95 figure for the XYZ March 17.50 calls is the last sale price for this series on the trading day in question.
  53. 53. Op Int – i.e. open interest – the total number of option contracts in the series that are currently outstanding and have not been closed out or exercised. E.g., the figure 1595 refers to the open interest for the XYZ March 17.50 calls. The figure 10,404 refers to the open interest of all series of XYZ options, including the series that did trade as well as the series that did not trade. Explanation: Equity Option Quotes
  54. 54. Option Strategies For Individual And Institutional Investors Range and complexity of trading strategies are practically limitless. Eight option strategies used by individual and institutional investors will be discussed involving either a long or short position in an XYZ call or put option. Strategies will either be a speculative or risk management based on exchange- traded options. At times, the option position will be the only part of the strategy, but in other cases the option position will be combined with a position or expected position in XYZ stock. There are other, more complex strategies that are commonly employed.
  55. 55. The strategies assume that it is currently June and that XYZ Inc. stock is trading at $52.50 per share. If XYZ Inc. was a real company and it had options listed on its stock, there would typically be a variety of expiration dates and strike prices to choose from. –see four options listed in Table. General assumption: it is currently June and XYZ Inc. stock is trading at $52.50 per share. Option Strategies For Individual And Institutional Investors
  56. 56. Four Options on XYZ Inc. Stock Trading At $52.50 Option Type Expiration Strike Price Premium Call September $50 4.55 Call December $55 2.00 Put September $50 1.5 Put December $55 4.85 For simplicity, commissions, margin requirements and dividends are ignored in all of the examples XYZ Inc. has options listed on its stock, with a variety of expiration dates and strike prices to choose from. –see Table.
  57. 57. Buying Call Options Reasons: to profit from an expected increase in the price of the underlying stock – a speculative strategy that relies on the fact that call option prices tend to rise as the price of the stock rises. Challenge: selecting the appropriate expiration date and strike price to generate maximum profit given the expected increase in the price of the stock. Two ways to realize profit on call options when the underlying increases in price: • Investors can exercise the option and buy the stock at the lower exercise price • They can sell the option directly into the market at a profit.
  58. 58. Calls may be bought to establish a maximum purchase price for the stock, or to limit the potential losses on a short position in the stock. - buying options act much like insurance, protecting the investor when the stock price moves higher. Buying Call Options
  59. 59. Strategy #1: Buying Calls to Speculate An investor buys 5 XYZ December 55 call options at the current price of $2. Pays a premium of $1,000 ($2 × 100 shares × 5 contracts) to obtain the right to buy 500 shares of XYZ Inc. at $55 a share on or before the expiration date in December. The options are out-of-the-money (the strike price is greater than the stock price of $52.50), the $2 premium consists entirely of time value. The options have no intrinsic value.
  60. 60. For the speculative investor - intent of the call purchase is to profit from an expectation of a higher XYZ stock price. The call buyer will want to sell the 5 XYZ December 55 calls before they expire, preferably at a higher price than what was paid for them. But if the price of XYZ shares rise, the price of the calls will likely rise, and the call buyer will be able to sell them at a profit. Of course, the call buyer faces the risk that if the stock price does not rise or, worse, it falls. Strategy #1: Buying Calls to Speculate
  61. 61. E.g., if by September the price of XYZ stock is $60, the XYZ December 55 calls will be trading for at least their intrinsic value, which in this case is $5. Since there are still three months remaining before the options expire, the premium will also include some time value. Assuming the calls have $1.70 of time value, they will be trading at $6.70. Therefore, the investor could choose to sell the options at $6.70 and realize a profit of $4.70 a share, equal to the difference between the current premium minus the premium paid, or $2,350 total ($4.70 × 100 shares × 5 contracts). Strategy #1: Buying Calls to Speculate
  62. 62. However, XYZ shares are trading at $45 a share in September, the XYZ December 55 calls might be worth only $0.25. At this time, and indeed, at all other times before expiration, the investor will have to decide whether to sell the options or hold on in the hope that the stock price (and the options’ price) recovers. If the investor sells at this time, a loss equal to $1.75 a share, or $875 total ($1.75 × 100 shares × 5 contracts) will result. Selling before expiration allows the call buyer to earn any time value that remains built into the option premium. Also, the option buyer gives up any chance of reaping any further increases in the option’s intrinsic value. The call buyer’s outlook for the stock price plays a crucial role in the decision. Strategy #1: Buying Calls to Speculate
  63. 63. Strategy #2: Buying Calls to Manage Risk Investors buy call options is to manage risk. E.g., a fund manager intends to buy 50,000 shares of XYZ stock, but will not receive the funds until December. Buying 500 XYZ December 55 call options will protect the fund manager from any sharp increase in the price of XYZ above the $55 strike price, because they will establish a maximum price at which the shares can be purchased. E.g., if XYZ shares increase to $60 just prior to the expiration date in December, the options will be trading for their intrinsic value only, in this case $5 = ($60 – $55).
  64. 64. Since the call buyer now has the money to buy the shares, the calls can be exercised, at which point the call buyer will purchase 50,000 shares of XYZ at the strike price of $55. Thus, the call buyer’s net purchase price is actually $57 a share, considering the $2 paid for the option. But If, XYZ shares are trading at $45 just prior to the expiration date, the call buyer will let the options expire and will buy the shares at the going price of $45 each. The investor’s effective cost is $47, which includes the $2 paid for the calls. Strategy #2: Buying Calls to Manage Risk
  65. 65. Writing Call Options Investors write call options primarily for the income they provide. i.e. the premium, which is the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does. Call-writing strategies are primarily speculative in nature, but it can also be used to manage risk. Two classifications of call option writers: • Covered call writers own the underlying stock, and will use this position to meet their obligations if they are assigned. • Naked call writers do not own the underlying stock and if assigned, the underlying stock must first be purchased in the market before it can be sold to the call option buyer.
  66. 66. Call option buyers will only exercise if the price of the stock is above the strike price, assigned naked call writers must buy the stock at one price (the market price) and sell at a lower price (the strike price). Naked call writers hope, that this loss is less than the premium they originally received, so that the overall result for the strategy is a profit. Since all exchange-traded stock options have an American-style exercise feature, call writers (and put option writers) face the risk of being assigned at any time prior to expiration. Prior to expiration, it is more advantageous for call buyers to sell their options rather than exercise them - because by selling they receive the option’s time value as well as its intrinsic value. Writing Call Options
  67. 67. Only the intrinsic value is captured when an option is exercised. So the chance of being assigned before expiration is not as great as one might think. Though this happens, particularly when the time value is small, and option writers must be aware of this. Writing Call Options
  68. 68. Strategy #1: Covered Call Writing Assume an investor writes 10 XYZ September 50 call options at the current price of $4.55. The investor receives a premium of $4,550 ($4.55 × 100 shares × 10 contracts) to take on the obligation of selling 1,000 shares of XYZ Inc. at $50 a share on or before the expiration date in September. Because the options are in-the-money (the strike price is less than the stock price), the $4.55 premium consists of both intrinsic and time value. Intrinsic value is equal to $2.50 and time value is equal to $2.05. If the investor already owned (or purchased at the same time as the options were written) 1,000 shares of XYZ, the overall position is known as a covered call. i.e. covered call writer.
  69. 69. At expiration in September, the price of XYZ stock is greater than $50 (i.e., the options are in-the-money), the covered call writer will be assigned and thus have to sell the stock to the call buyer at $50 a share. From the covered call writer’s perspective, however, the effective sale price is $54.55, because of the initial premium of $4.55. Strategy #1: Covered Call Writing
  70. 70. But If, the price of the stock at expiration in September is less than $50, the covered call writer will not be assigned and the options will expire worthless. Call buyers will not elect to buy stock at $50 when it can be purchased for less in the market. The covered call writer will retain the shares and the initial premium. Thus, the premium reduces the covered call writer’s effective stock purchase price by $4.55 a share. i.e., if the covered call writer bought the XYZ stock at, $50, and the options expired worthless, the covered call writer’s effective purchase price is now $45.45 ($50 – $4.55). In this sense, writing the call slightly reduces the risk of owning the stock. Strategy #1: Covered Call Writing
  71. 71. Strategy # 2: Naked Call Writing Assume an investor writes 10 XYZ September 50 call options at the current price of $4.55. if call is not already owned - a naked call writer. The best the naked call writer could hope for is, that the price of XYZ stock will be lower than $50 at expiration. In this instance, the calls will expire worthless and the naked call writer will earn a profit equal to $4.55 a share, the initial premium received. This is the most that this call writer can expect to earn from this strategy.
  72. 72. But if the price of the shares increases, the naked call writer will realize a loss if the stock price is higher than the strike price plus the premium received, in this case $54.55. In this instance, the naked call writer will be forced to buy the stock at the higher market price and then turn around and sell them to the call buyer at the $50 strike price. When the stock price is greater than $54.55, the cost of buying the stock is greater than the combined proceeds from selling the stock and the premium initially received. Strategy # 2: Naked Call Writing
  73. 73. For example, if the price of the XYZ rose to $60 at expiration, the naked call writer will suffer a $10 loss on the purchase and sale of the shares (buy at $60, sell at $50). This loss is offset somewhat by the initial premium of $4.55, so that the actual loss is $5.45 a share, or $5,450 in total ($5.45 × 100 shares × 10 contracts). Strategy # 2: Naked Call Writing; Example
  74. 74. Buying Put Options Investors buy put options for: • To profit from an expected decline in the price of the stock. - speculative strategy relies on the fact that put option prices tend to rise as the price of the stock falls. Just like buying calls, the selection of an expiration date and strike price is crucial to the success (or lack thereof ) of the strategy. • For risk management purposes. - puts can be used to lock in a minimum selling price for a stock, they are very popular with investors who own stock. Buying puts can protect investors from a decline in the price of a stock below the strike price.
  75. 75. Strategy #1: Buying Puts to Speculate Assume an investor buys 10 XYZ September 50 put options at the current price of $1.50. The put buyer pays a premium of $1,500 ($1.50 × 100 shares × 10 contracts) to obtain the right to sell 1,000 shares of XYZ Inc. at $50 a share on or before the expiration date in September. Because the options are out-of-the-money (the strike price is less than the stock price), the $1.50 premium consists entirely of time value. The option has no intrinsic value. Opinion of put buyer might be the exact opposite of the opinion of put seller. If the stock price falls, the XYZ September 50 put options will likely rise in value. This will allow the put buyer to sell his options for a profit. Of course, if the stock price rises, the put options will most likely lose value and the put buyer may be forced to sell the options at a loss.
  76. 76. E.g., if XYZ stock is trading at $45 one month before the September expiration date, the XYZ September 50 puts will be trading for at least their intrinsic value, or $5. Since there is still one month before the expiration date, the options will have some time value as well. Assuming they have time value of $0.25, the options will be trading at $5.25. Therefore, the put buyer could choose to sell the puts for $5.25 and realize a profit of $3.75 a share, which is equal to the difference between the current put price and the put buyer’s original purchase price. Based on 10 contracts, the put buyer’s total profit is $3,750 i.e. ($3.75 × 100 shares × 10 contracts). Strategy #1: Buying Puts to Speculate
  77. 77. But if, XYZ were trading at $60 a share, the XYZ September 50 puts might be worth only $0.05. Because the options are so far out-of-the-money, and because there is only one month left until the options expire, the options will not have a lot of time value. The low option price tells us the market does not believe there is much of a chance for XYZ shares to fall below $50 anytime over the next month. Put buyer has to decide whether to sell the options at this price, or hold on in hope that the price of XYZ does fall to below $50. If the stock does fall, the price of puts will rise. If the stock doesn’t fall below $50, the puts will be worthless when they expire. If the put buyer decides to sell the options at $0.05, a loss equal to $1.45 a share ($0.05 – $1.50) or $1,450 i.e. ($1.45 × 100 shares × 10 contracts) would result. Strategy #1: Buying Puts to Speculate
  78. 78. Strategy #2: Buying Puts to Manage Risk Assume an investor buys 10 XYZ September 50 put options at the current price of $1.50, but in this case the put buyer actually owns 1,000 shares of XYZ. – thus the put purchase acts as insurance against a drop in the price of the stock. - Recall that put buyers have the right to sell the stock at the strike price. Buying a put in conjunction with owning the stock, a strategy known as a married put or a put hedge, gives the put buyer the right to sell the stock at the strike price. If the price of the stock is below the strike price of the put when the puts expire, the put buyer will most likely exercise the puts and sell the stock to the put writer. The strike price acts as a floor price for the sale of the stock.
  79. 79. E.g., if XYZ shares are trading at $45 just prior to the expiration date in September, the puts will be trading very close to their intrinsic value of $5, because the puts are in-the-money and there is very little time left until the expiration date. The put buyer may choose to exercise the puts and sell the stock at the $50 strike price. The put buyer has been protected from the drop in the stock price below $50. The protection was not free, because the put buyer had to pay $1.50 for the puts. The put buyer’s effective sale price is actually only $48.50, after deducting the cost of the puts. But this sale price is still better than the stock’s $45 market price. Example: Strategy #2: Buying Puts to Manage Risk
  80. 80. The put buyer, may not want or even be able to sell the stock. If so, the puts should be sold. Any profit on the sale of the puts reduces the put buyer’s effective stock purchase price. If the put buyer originally bought the stock at a price of, $40, and then sold the puts at $5, for a net profit of $3.50, the effective stock purchase price becomes $36.50. Eventually, when the shares are sold, the put buyer will measure the total profit on the stock purchase as the difference between the sale price and the effective purchase price of $36.50. Example: Strategy #2: Buying Puts to Manage Risk
  81. 81. Writing Put Options Primarily done for the income they provide - in the form of premium, - the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does. Like call-writing, put-writing strategies are primarily speculative in nature, but they can also be used to manage risk. • Put option writers can be classified as either covered or naked. Covered put writing, is not nearly as common as covered call writing because, technically, a covered put write combines a short put with a short position in the stock. More common is a “nearly” covered put writing strategy is known as a cash-secured put write. A cash-secured put write involves writing a put and setting aside an amount of cash equal to the strike price.
  82. 82. • Naked put writers have no position in the stock and have not specifically earmarked an amount of cash to buy the stock. They must be prepared to buy the stock, so they should always have the financial resources to do so. They hope to profit from a stock price that stays the same or goes up. If this happens, the price of the puts will likely decline as well, and the chance of being assigned will also be less. The naked put writer may then choose to buy back the options at the lower price to realize a profit. If the stock price does not rise, the put writer may be assigned, and may suffer a loss. Based on how low the stock price is and the amount of premium received, naked put writers may still profit even if they are assigned. Writing Put Options
  83. 83. Strategy # 1: Cash-Secured Put Writing Assume investor writes 5 XYZ December 55 put options at the current price of $4.85. The put writer receives a premium of $2,425 ($4.85 × 100 shares × 5 contracts) to take on the obligation of buying 500 shares of XYZ Inc. at $55 a share on or before the expiration date in December. Because the options are in-the-money (the strike price is greater than the stock price), the $4.85 premium consists of both intrinsic value and time value. Intrinsic value is equal to $2.50 and time value is equal to $2.35. If the put writer set aside cash equal to the purchase value of the stock, the strategy is known as a cash-secured put write. The put writer in this case would have to set aside $27,500 ($55 strike price × 100 shares × 5 contracts).
  84. 84. Some investors actually use cash-secured put writes as a way to buy the stock at an effective price that is lower than the current market price. The effective price is equal to the strike price minus the premium received. Strategy # 1: Cash-Secured Put Writing
  85. 85. Example: Strategy # 1: Cash-Secured Put Writing E.g., if at expiration in December the price of XYZ stock is less than $55, the put writer will be assigned and will have to buy 500 shares of XYZ at the strike price of $55 a share. The effective purchase price is actually $50.15, because the put writer received a premium of $4.85 when the options were written. This effective purchase price is less than the $52.50 price of the stock when the cash-secured put write was established.
  86. 86. If at expiration in December the price of XYZ stock is greater than $55, the cash-secured put writer will not be assigned because the options are out-of-the- money. The cash-secured put writer, however, gets to keep the premium of $4.85, and will have to decide whether to use the cash to buy the stock at the market price. Example: Strategy # 1: Cash-Secured Put Writing (b)
  87. 87. Strategy #2: Naked Put Writing Suppose a different investor writes 5 XYZ December 55 put options at the current price of $4.85. If the put writer does not set aside a specific amount of cash to cover the potential purchase of the stock, the put writer is considered a naked put writer. The naked put writer desires the price of XYZ to be higher than $55 at expiration. If this happens, the puts will expire worthless and the put writer will earn a profit equal to $4.85 a share, the initial premium received.
  88. 88. Strategy #2: Naked Put Writing (b) If the price of XYZ stock falls, the naked put writer will most likely realize a loss, as put buyers will exercise their options to sell the stock at the higher strike price. (The naked put writer in this case will suffer a loss only if XYZ stock is trading for less than $50.15 at option expiration.) The naked put writer will have to buy stock at a price that is higher than the market price. If the put writer does not want to hold the shares in anticipation of a higher price, they could be sold.
  89. 89. Example: Strategy #2: Naked Put Writing E.g., if the price of XYZ fell to $45 at expiration, the naked put writer will suffer a $10 loss on the purchase and sale of the shares (buy at the strike price of $55, sell at the market price of $45). This loss is offset somewhat by the initial premium of $4.85, so that the actual loss is $5.15 a share, or $2,575 in total ($5.15 × 100 shares × 5 contracts).
  90. 90. Option Strategies for Corporations Normally, corporations do not speculate with derivatives. They are interested in managing risk, and often use options to do it. These risks are often related to interest rates, exchange rates or commodity prices. E.g., corporations take on debt to help finance their operations and attimes the interest rate on the debt is a floating rate that rises and falls with market interest rates. Just like the investor who buys a call to establish a maximum purchase price for a stock, corporations can buy a call to establish a maximum interest rate on floating-rate debt.
  91. 91. Call Option Strategies: Corporations Suppose a Canadian company knows it will buy US$1 million worth of goods from a U.S. supplier in three months’ time. If the exchange rate is C$1.12 per U.S. dollar, the U.S. dollar purchase will cost the company C$1.12 million. The company can either buy the US$1 million now and pay C$1.12 million, or wait three months and pay whatever the exchange rate is at that time. If company chooses to do the latter and wait, by doing this, it faces the risk that the value of the U.S. dollar will strengthen relative to the Canadian dollar. Thus, the Canadian dollar cost of the purchase would be higher than C$1.12 million. To protect itself against this risk, the corporation can buy a call option on the U.S. dollar.
  92. 92. Suppose the corporation buys a three-month U.S. dollar call option with a strike price of C$1.15. This option is an OTC option and would most likely be written by the corporation’s bank. If at the end of three months the exchange turns out to be C$1.20, the corporation will exercise the call and buy the U.S. dollars from its bank for C$1.15 million. If, however, the U.S. dollar weakens so that in three months the exchange rate is C$1.10, the corporation will let the option expire and will buy the U.S. dollars at the lower exchange rate. The purchase of the call option has capped the exchange rate at C$1.15 plus the cost of the option. Call Option Strategies: Corporations
  93. 93. Put Option Strategies - Corporations Assume a Canadian oil company will have 1 million barrels of crude oil to sell in six months’ time and present price of crude oil is US$70 a barrel but unsure of what the price will be in six months. To lock in a minimum sale price, the company buys a put option on one million barrels of crude oil with a strike price of US$68 a barrel. This will protect the company from an oil price lower than US$68 a barrel. in six months, if price of crude oil is less than US$68, the company will exercise its put option and sell the oil to the put option writer at the strike price. But if the price is greater than US$68, the company will let the option expire and will sell the oil at the going market price.
  94. 94. Forwards And Futures
  95. 95. This is a contract between two parties: a buyer and a seller. The buyer of a forward agrees to buy the underlying asset from the seller on a future date at a price agreed upon today. **Both parties are obligated to participate in the future trade. Forwards can trade on an exchange or over the counter. • When traded on an exchange, they are referred to as futures contract. Futures contracts can further be classified into 2 groups:  Contracts that have a financial asset – a stock, bond, currency, interest rate or index – as the underlying asset are referred to as financial futures.  Contracts with physical assets (e.g. gold, crude oil, soybeans etc) as the underlying asset are known as Commodity futures.
  96. 96. A forward contract traded over the counter, it is generally referred to as a forward agreement. Predominant types of forward agreements are based on interest rates and currencies. Forward agreements on commodities exist, but the size of trading in these contracts is small compared to trading in interest rate and currency forwards. The market is dominated by institutional traders and large corporations. But Futures, are accessible to a much broader segment of the market, including investment advisors and individual investors. Thus, we focus on the key features of futures and some basic futures strategies.
  97. 97. Futures – Key Terms Futures are simply exchange-traded forward contracts. They are agreements between two parties to buy or sell an underlying asset at some future point in time at a predetermined price. They are standardized with respect to the amount of the asset underlying each contract, expiration dates and delivery locations. The expiration date on a futures contract is set by the exchange on which the contract is listed. Many commodity futures require additional standardization; such as the quality of the underlying asset and the delivery location. Standardization allows users to offset their contracts prior to expiration and provides the backing of a clearinghouse.
  98. 98. The party that agrees to buy the underlying asset holds a long position in the futures contract. This party is also said to have bought the futures contract. The party that agrees to sell the underlying asset holds a short position in the futures contract, and is said to have sold the futures contract. The buyer of a futures contract does not pay anything to the seller when the two enter into the contract and the seller does not deliver the underlying asset right away. The futures contract simply establishes the price at which a trade will take place in the future. Most parties end up offsetting their positions prior to expiration, so that few deliveries actually take place. Futures – Key Terms
  99. 99. Futures – Key Terms If a contract is not offset and is held to the expiration date, delivery will occur. Longs will have to accept delivery of the underlying asset and make payments to the shorts. Shorts have to make delivery of the underlying asset and accept payments from the longs.
  100. 100. Cash-Settled Futures Financial futures are based on underlying assets that are difficult or even impossible to deliver. For these futures, delivery involves an exchange of cash from one party to the other based on the performance of the underlying asset from the time the future was entered into until the time that it expires. These futures are known as cash-settled futures contracts e.g., equity index futures contract. Those who are long a stock index futures contract are not obligated to accept delivery of the stocks that make up the index, nor are those who are short required to make delivery of the stocks.
  101. 101. Instead, if the position is held to the expiration date, either the long or the short will make a cash payment - based on the difference between the price agreed to in the futures contract and the price of the underlying asset on the expiration date. • If the price agreed to in the futures contract is greater than the price of the underlying asset at expiration, prices have fallen, and the long must pay the short. • If the price agreed to in the futures contract is less than the price of the underlying asset at expiration, prices have risen, and the short must pay the long. **Cash-settled futures can be offset prior to expiration Cash-Settled Futures
  102. 102. Margin Requirements And Marking-to-market Buyers and sellers of futures contracts must deposit and maintain adequate margin in their futures accounts. futures margins are meant to provide a level of assurance that the financial obligations of the contract will be met i.e. a good-faith deposit or performance bond. Two levels of margin used in futures trading: • Initial or original margin is required when the contract is entered into. • Maintenance margin is the minimum account balance that must be maintained while the contract is still open. Minimum initial and maintenance margin rates for a particular futures contract are set by the exchange on which it trades,
  103. 103. Chief feature of futures trading is the daily settlement of gains and losses a process known as marking-to-market. At the end of each trading day, those who are long a contract make a payment to those who are short, or vice versa, depending on the change in the price of the contract from the previous day. If either party accumulates losses that cause their account balance to fall below the maintenance margin level, they must deposit addition margin to their futures accounts. Margin Requirements And ‘Marking-to-market’
  104. 104. Futures Quotation Contract High Contract Low Month Open High Low Settled Change (I) Open Interest (I) 3 month Bankers Acceptance 97.38 97.23 Mar 97.29 97.33 97.28 97.29 -0.04 98,446 97.27 97.05 Sep 97.21 97.26 97.19 97.19 -0.05 56,749 96.75 96.55 Dec 96.71 96.75 96.70 96.70 -0.03 7,759 Est Sales Previous sales Open Interest (2) Change (2) 24,522 64,264 278,061 +23,558
  105. 105. Explanation 3-Month Bankers’Acceptances, $1M The underlying interest Contract High The highest price the contract has reached since it started trading. Contract Low The lowest price the contract has reached since it started trading. Month Delivery month. E.g., the first contract listed has a delivery month of March 2007. Open The price the contract opened at that day. E.g., the March contract opened at 97.29 High The highest the contract traded that day. Low The lowest the contract traded that day.
  106. 106. Settled The price the contract closed at that day. Change (1) The difference between the closing price that day and the closing price previous trading day. E.g., the March future closed down 0.04 per cent from the previous day Open Interest (1) The open interest in that specific futures contract. Est Sales Estimated volumes for that trading day. Previous Sales Volumes for the previous trading day. Open Interest (2) The total number of futures contracts open on the underlying interest. Change (2) The change in the number of futures contracts open on the underlying interest. In this case, there are 23,558 more contracts open than at the end of the previous trading day. Explanation!
  107. 107. Futures Strategies for Investors . . Only two basic positions with futures contracts – long and short. number of strategies that can be designed with futures is limited because there are only two basic positions for each expiration date. Buying Futures: • To profit from an expected increase in the price of the underlying asset, • To lock in a purchase price for the asset on some future date i.e. speculation
  108. 108. Strategy #1: Buying Futures to Speculate Done by Investors either to profit from an expected increase in price of the underlying asset, or to lock in a purchase price for the asset on some future date. The former being speculation and the latter is risk management.
  109. 109. Strategy #1: Buying Futures to Speculate E.g., investor buys 10 December gold futures at a price of US$575 an ounce. Each gold futures contract has an underlying asset of 100 ounces of gold, the investor has agreed to buy 1,000 ounces of gold from the futures seller on a specific date in December for a total cost of US$575,000 ($575 × 100 ounces × 10 contracts). If investor bought in order to profit from future higher price, he/she would prefer to sell the 10 December gold futures, preferably at a higher price than what was paid for them – i.e., no intention of actual delivery. This is dependent on the spot price of gold in the spot/ cash market.
  110. 110. Example: Strategy #1; Buying Futures to Speculate E.g., if in early November the price of December gold futures have risen to $600 in response to a rising gold spot price, the investor could choose to sell the futures at $600 and realize a profit of $25 an ounce, or $25,000 total ($25 × 100 ounces × 10 contracts). If, however, December gold futures were trading at $550, the investor would have to decide whether to sell the futures or hold on in the hope that the price recovers before the expiration date. If the investor decided to sell at this price, a loss equal to $25 an ounce, or $25,000 total – ($25 X 100 ounces X 10 contracts)
  111. 111. Strategy #2: Buying Futures to Manage Risk If an a different investor buys 10 December gold futures at a price of US$575 an ounce with the intention of actually buying 1,000 ounces of gold in December. The gold purchase may actually be a speculative decision, but the purchase of futures to lock in a purchase price is considered a risk management decision. In this case, all the investor needs to do is not offset the contract. At expiration, the investor will be required to take delivery of 1,000 ounces of gold for a payment of US$575,000. The purchase of the futures contracts locks the investor in to a purchase price of US$575 an ounce regardless of what happens to the price of gold in the spot market.
  112. 112. Selling Futures Investors sell futures either to profit from an expected decline in the price of the underlying asset or to lock in a sale price for the asset on some future date.
  113. 113. Strategy #1: Selling Futures to Speculate If an investor sells 5 December Government of Canada ten-year bond futures at a price of 105. (- like prices in the bond market, prices of bond futures contracts are quoted on a “per $100 of face value” basis.) Each bond futures contract has a $100,000 face value bond as its underlying asset, thus the investor has agreed to sell a $500,000 face value bond to the buyer on a specific date in December for total proceeds of $525,000 ([105 ÷ 100] × $100,000 bond × 5 contracts).
  114. 114. In the earlier described the investor scenario could have sold the futures simply to profit from an expectation of a lower bond futures price. The investor probably has no intention of actually selling $500,000 of bonds. Rather, the investor might buy back the 5 December bond futures in the market, preferably at a lower price than what they were sold for. The chances of this happening depend primarily on the price of ten-year Government bonds in the spot or cash market. If bond prices fall in the cash market, then the price of bond futures will fall, too. Of course, the investor faces the risk that bond prices will rise - If this so, price of bond futures will rise as well, and the investor may be forced to buy back the contracts at a loss. Strategy #1: Selling Futures to Speculate (b)
  115. 115. Example: Strategy #1; Selling Futures to Speculate if in early November the price of December bond futures have declined from 105 to 100, the investor could choose to buy back the futures at 100 and realize a profit of 5 points, or $25,000 total ([5 ÷ 100] × $100,000 face value × 5 contracts). If, however, December bond futures were trading at 107.50, the investor would have to decide whether to buy the futures or hold on in the hope that the price falls before the expiration date. If the investor decided to buy them back, a loss equal to 2.5 points, or $12,500 total would be the result. ([2.5 ÷ 100] × $100,000 face value × 5 contracts)
  116. 116. Strategy #2: Selling Futures to Manage Risk If an investor decides to sell 5 December Government of Canada ten-year bond futures at a price of 105 and that, for whatever reason, the investor actually wanted to sell $500,000 of bonds in December. Thus, all the investor needs to do is not offset the contracts. At expiration, the investor will be required to make delivery of $500,000 of bonds and in return will receive $525,000. The sale of the futures contracts locks the investor in to a sale price of 105 regardless of what happens to bond prices.
  117. 117. Futures Strategies For Corporations Corporations use futures to manage risk in the same way that investors do. If a company needs to lock in the purchase price of an asset, it may decide to buy futures on the asset. Also, when a company needs to lock in the sale price of an asset, it may decide selling futures on the asset. Though companies take futures positions consistent with risk management needs, many offset their positions prior to expiration rather than actually making or taking delivery of the underlying assets. Also, futures can satisfy a company’s risk management needs by providing price protection.
  118. 118. Forwards Contract Futures Contract Private contract b/w two parties bilateral contracts Traded on exchanges Not Standardized (customized) Standardized contracts Normally one specified delivery date Range of delivery dates Settled at end of maturity. No cash exchange prior to delivery date Daily Settled. Profit/Loss is/are paid in cash More than 90% of forwards contracts are settled by actual delivery of assets Not ,more than 5% of futures contracts are settled by delivery Delivery or final cash settlement usually takes place Contract normally closed out prior to delivery Difference b/w Futures & Forwards Contract
  119. 119. Rights & Warrants
  120. 120. Rights & Warrants Rights and Warrants are securities that give their owners the right, but not the obligation, to buy or sell a specific amount of stock at a specified price on or before the expiration date. They are usually issued by a company as a method of raising capital - though they may dilute the positions of existing shareholders if they are exercised, but they allow the company raise capital quickly and cost-effectively. Major Difference: Rights are usually very short term, with an expiration date often as little as four to six weeks after they are issued, while warrants tend to be issued with three to five years to expiration.
  121. 121. Rights This is a privilege granted to an existing shareholder to acquire additional shares directly from the issuing company. To raise capital by issuing additional common shares, a company/s may give shareholders rights that allow them to buy additional shares in direct proportion to the number of shares they already own. E.g., shareholders may be given one right for each share they own, and the offer may be based on the right to buy one additional share for each ten shares held. Thus, the company wants to increase its outstanding shares by 10%, and each shareholder is given the opportunity to increase their own holdings by 10%.
  122. 122. The exercise price of a right; known as the subscription or offering price, is almost always lower than the market price of the shares at the time the rights are issued. making them valuable and giving shareholders an incentive to exercise such rights. A record date is announced when the decision to do a rights offering is taken – used to determine the list of shareholders to receive the rights, similar to issuance of a dividend i.e. common shareholders who are in the record books on the record date receive rights. Two business days before the record date, the shares trade ex rights i.e. anyone buying shares on or after the ex rights date is not entitled to receive the rights from the company. Rights (b)
  123. 123. Anyone who buys the stock is entitled to receive the rights if they hold the stock until at least the record date - between the day of the announcement that rights will be issued and the ex rights date, the stock is said to be trading cum rights. Investors need the correct number of rights required to purchase shares, the subscriber must pay the subscription price to the company to acquire these additional shares. No commission is levied when a rights holder exercises the rights and acquires shares – fractional shares are at the discretion of the company. A secondary market might develop for the rights as holders who do not want to subscribe can sell - price of the rights tend to rise and fall in the secondary market as the price of the common stock fluctuates, though not necessarily to the same degree. Rights (c)
  124. 124. Course Of Action for the Rights Holder 4 Options: • Exercise some or all of the rights and acquire the shares • Sell some or all of the rights • Buy additional rights to trade or exercise later • Do nothing and let the rights expire worthless - provides no benefit. Rights are not automatically exercised on behalf of their Holders. Holders must select a course of action appropriate for his or her circumstances. More in-depth treatment of topic in our more advanced module!
  125. 125. Warrants A security that gives its holder/s the right to buy shares in a company from the issuer at a set price for a set period of time. Similar to call options, but warrants are issued by the company itself, whilst call options are issued – that is, written – by other investors. They are often issued as part of a package that also contains a new debt or preferred share issue - warrants help make issues more attractive to buyers by giving them the opportunity to participate in any appreciation of the issuer’s common shares i.e., they function as a sweetener. Once issued, they can be sold immediately or after a certain holding period. The expiration date of warrants; which can extend to several years from the date of issue, is longer than that of a right.
  126. 126. warrants may have both intrinsic value and time value. Intrinsic Value is the amount by which the market price of the underlying common stock exceeds the exercise price of the warrant - no intrinsic value if the market price of the common stock is less than the exercise price. Time Value is the amount by which the market price of the warrant exceeds the intrinsic value. If the market price of the underlying common stock is less than the exercise price of the warrant, the warrant has no intrinsic value. This does not mean the warrant has no value; it may still have time value because of the potential for the stock price to increase before the warrants expire. Ceteris paribus, the further away the expiration date, the greater the time value. Warrants (b)
  127. 127. Main Attraction of Warrants is their leverage potential. Market price of a warrants are usually much lower than the price of the underlying securities, and generally move in the same direction at the same time as the price of the underlying. Thus, capital appreciation of a warrant on a percentage basis can greatly exceed that of the underlying security. Warrants (c)
  128. 128. Example: Warrants Example: A warrant has a market value of $4, exercisable at $12 on an underlying common stock that has a market price of $15. If the common stock rises to $23 a share before the warrants expire, the warrants would rise to at least their intrinsic value of $11, generating a 175% return from the original market value. The common stock buyer’s profit would be $8 ($23 – $15), or 53%. The reverse is also true!. A decline in the price of the common stock from $23 to $15 would result in a 35% loss for the shareholder, whereas if the warrants fall from $11 to $4, the buyer will face a 64% loss. In-depth treatment of topic in more advanced module!
  129. 129. Fortuna Favi et Fortus Ltd., :118 Old Ewu Road, Aviation Estate, Lagos, :07032530965 www.ffavifortus.com info@ffavifortus.com

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