FINC3012 NOTES
LECTURE 1: DERIVATIVE SECURITIES
ADMIN
• Lecturer:
o Dr Elvis Jarnecic
• Tutors:
o Salaar Bin Tassadaq (head tutor)
o Jiahuan Cory Zhang
o Gangyu Mi
OBJECTIVES OF COURSE
• Concepts, problems and applications of derivative securities as related to the management of price uncertainty
• At the conclusion of this course, students should understand - what financial futures, options and swaps are,
o How they are traded,
o How they are valued, and
o How they can be employed to manage risk
• Maximise your returns – Learning is an active process
o Lectures:
Before lectures: print out and peruse notes, read through relevant chapters of textbook
During lectures: attend, listen, take notes, ask questions
After lectures: Write a summary of the lecture, read through text chapters again
o Tutorials:
Before tutorial: attempt tut questions to exam standard, identify areas of misunderstanding/difficulty
During tutorial: ensure that your understanding/knowledge is correct, seek direct assistance on areas of
particular difficulty
• Take advantage of Canvas discussion forums
• Feedback – Opportunities to obtain feedback
o Feedback on assessable items:
Examinations (written)
Assignments (written)
o Feedback on your knowledge/understanding of the course
During/after lectures (verbal)
During tutorials (verbal)
Consultation times (verbal)
o Feedback on tutorial problems:
During tutorials (verbal)
Consultation times (verbal)
o Feedback can be offered most timely in verbal manner. Speak with the teaching staff.
OVERVIEW OF THE COURSE
1. Introduction
2. Mechanics of futures markets
3. Hedging strategies using futures
4. Determination of forward and futures prices
5. Swaps 1
6. Swaps 2
7. Mechanics of options markets
8. Trading strategies involving options
9. Binomial trees
10. Black-Scholes-Merton model
11. Currency & Future & Index Options and Delta
12. Exotics, Mishaps and Review
1
,WHY DERIVATIVES?
• The Goldman strategy that’s returned 105% in days
o Simple strategy: buy call options before earnings announcement
• A very important hedging tool central to risk management in financial markets
INTRODUCTION TO DERIVATIVES
THE NATURE OF DERIVATIVES AND THEIR USE
• A derivative is an instrument whose price depends on, or is derived from, the price of another asset
• Examples of derivatives
o Futures contracts
o Forward contracts
o Swaps
o Options
• Derivatives are used to:
o Hedge risks
o Speculate
o Lock in an arbitrage profit
o Change the nature of a liability
o Change the nature of an investment without incurring the costs of selling one portfolio and buying another
FUTURES CONTRACTS
• A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price
o Just a forward contract that has been standardised
o Underlying asset is also called a spot asset
• By contrast, in a spot contract there is an agreement to buy or sell the asset immediately or within a very short period of
time
• Exchanges trading futures
o CBOT and CME (now CME Group)
o NYSE Euronext
o Eurex
o BM&FBOVESPA (Sao Paulo, Brazil)
o ASX
o Many more (see list at end of book)
• Terminology
o A long futures position is an agreement to buy the asset at a certain time in the future for a certain price
o A short futures position is an agreement to sell the asset at a certain time in the future for a certain price
• Futures price
o The futures price is the price at which you agree to buy or sell
o It is determined by supply and demand in the same way as a spot price
• Examples of futures contracts
o Agreement to:
Buy 100 oz of gold @ US$1,050/oz in December
Sell £62,500 @ 1.5500 US$/£ in March
Sell 1,000 bbl of oil @ US$75/bbl in April
Buy 100 90-day bank bill futures contracts expiring in June
• Examples of a futures contract
o March: Trader takes a long position in a June futures contract on 90-day bank accepted bills at 95.00. This
implies a yield of 5% per annum is to be used to value the futures contract
o June: Trader must buy 90-day bank accepted bills with total face value of $1,000,000 at a yield of 5% per
annum
o The futures price that would be paid for the bills is:
$1,000,000
𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 = 5 90 = $987,821.38
1+100×365
2
,FUTURES EXCHANGES
THE AUSTRALIAN SECURITIES EXCHANGE
• Created in 2006 with the merger of the Australian Stock Exchange and the Sydney Futures Exchange
• Futures contracts were initially traded solely on the Sydney Futures Exchange (SFE) in 1960
• In the 1990s the Australian Stock Exchange replicated the individual share futures contract that was trading on the SFE
• This ceased with the creation of the Australian Securities Exchange
• Created in 2006 with the merger of the Australian Stock Exchange and the Sydney Futures Exchange
• Futures contracts initially traded solely on the Sydney Futures Exchange (SFE) in 1960
• In the 1990s the ASX replicated individual share futures contract that was trading on the SFE
• This ceased with the creation of the Australian Securities Exchange
• Futures contracts:
o Gold futures
o 90-day bank accepted bill futures contracts
o Share price index futures contracts
o Contracts for difference
o Electricity futures contracts
OVERSEAS EXCHANGES
• CME Group (CME and CBOT) largest
o Established in 1973 and 1848 to bring farmers and merchants together
o First futures-type contract known as a to-arrive contract
o Offers futures contracts on many different underlying assets
• In 1874 the Chicago Produce Exchange was established
• In 1898 the Chicago Butter and Egg Board was formed
• In 1919 it was renamed the Chicago Mercantile Exchange
• CME provides a futures market for many commodities
ELECTRONIC TRADING
• Traditionally, futures contracts have been traded using the open-outcry system where traders physically meet on the floor
of the exchange
• Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers
• The Australian Securities Exchange relies entirely on electronic trading
OVER-THE-COUNTER
• The over-the-counter (OTC) market is an important alternative to exchanges
• It is a telephone and computer-linked network of dealers who do not physically meet
• Trades are usually between financial institutions, corporate treasurers and fund managers
3
, FORWARDS
• Forward contracts are similar to futures except that they trade in the over-the-counter market
• Futures are forward contracts but traded on the exchange
• Forward contracts are popular on currencies and interest rates
• Spot, forward margins quoted for the USD exchange rate and calculated forward rates, 10 January 2011; quote is number
of USD per AUD
Bid Margin Offer Margin Bid Rate Offer Rate
Spot 0.9934 0.9937
1-Month Forward 40.80 40.50 0.98932 0.98965
3-Month Forward 111.70 111.30 0.98223 0.98257
6-Month Forward 225.30 224.10 0.97087 0.97129
OPTIONS
• A call option gives the holder the right to buy an asset by a certain date for a certain price (the strike price)
• A put option gives the holder the right to sell an asset by a certain date for a certain price (the strike price)
• An American option can be exercised at any time during its life
• A European option can be exercised only at maturity
• Margin prices of options on BHP, 7 January 2011; S = $44.60
Calls Puts
Strike Price ($) 24 FEB. 2011 24 MAR. 2011 28 APR. 2011 24 FEB. 2011 24 MAR. 2011 28 APR. 2011
43.500 2.530 2.780 3.185 0.660 1.095 1.430
44.000 2.155 2.430 2.890 0.760 1.265 1.610
44.500 1.840 2.150 2.555 0.940 1.455 1.810
45.000 1.520 1.835 2.260 1.135 1.675 2.030
45.500 1.240 1.570 2.010 1.365 1.910 2.270
46.000 1.010 1.310 1.755 1.630 2.180 2.525
• Options vs. futures/forwards
o In a futures/forward contract the holder has an obligation to buy or sell the asset at a certain price
o An option gives the holder the right to buy or sell the asset at a certain price (buyer pays premium for right)
• Exchanges trading options
o Chicago Board Options Exchange
o NYSE Euronext
o Eurex (Europe)
o ASX
o Many more (see list at end of book)
• The over-the-counter market for options
o Currently larger than the exchange-traded market
o Advantage: contracts can be tailored to meet the particular needs of a corporate treasurer or fund manager
4
LECTURE 1: DERIVATIVE SECURITIES
ADMIN
• Lecturer:
o Dr Elvis Jarnecic
• Tutors:
o Salaar Bin Tassadaq (head tutor)
o Jiahuan Cory Zhang
o Gangyu Mi
OBJECTIVES OF COURSE
• Concepts, problems and applications of derivative securities as related to the management of price uncertainty
• At the conclusion of this course, students should understand - what financial futures, options and swaps are,
o How they are traded,
o How they are valued, and
o How they can be employed to manage risk
• Maximise your returns – Learning is an active process
o Lectures:
Before lectures: print out and peruse notes, read through relevant chapters of textbook
During lectures: attend, listen, take notes, ask questions
After lectures: Write a summary of the lecture, read through text chapters again
o Tutorials:
Before tutorial: attempt tut questions to exam standard, identify areas of misunderstanding/difficulty
During tutorial: ensure that your understanding/knowledge is correct, seek direct assistance on areas of
particular difficulty
• Take advantage of Canvas discussion forums
• Feedback – Opportunities to obtain feedback
o Feedback on assessable items:
Examinations (written)
Assignments (written)
o Feedback on your knowledge/understanding of the course
During/after lectures (verbal)
During tutorials (verbal)
Consultation times (verbal)
o Feedback on tutorial problems:
During tutorials (verbal)
Consultation times (verbal)
o Feedback can be offered most timely in verbal manner. Speak with the teaching staff.
OVERVIEW OF THE COURSE
1. Introduction
2. Mechanics of futures markets
3. Hedging strategies using futures
4. Determination of forward and futures prices
5. Swaps 1
6. Swaps 2
7. Mechanics of options markets
8. Trading strategies involving options
9. Binomial trees
10. Black-Scholes-Merton model
11. Currency & Future & Index Options and Delta
12. Exotics, Mishaps and Review
1
,WHY DERIVATIVES?
• The Goldman strategy that’s returned 105% in days
o Simple strategy: buy call options before earnings announcement
• A very important hedging tool central to risk management in financial markets
INTRODUCTION TO DERIVATIVES
THE NATURE OF DERIVATIVES AND THEIR USE
• A derivative is an instrument whose price depends on, or is derived from, the price of another asset
• Examples of derivatives
o Futures contracts
o Forward contracts
o Swaps
o Options
• Derivatives are used to:
o Hedge risks
o Speculate
o Lock in an arbitrage profit
o Change the nature of a liability
o Change the nature of an investment without incurring the costs of selling one portfolio and buying another
FUTURES CONTRACTS
• A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price
o Just a forward contract that has been standardised
o Underlying asset is also called a spot asset
• By contrast, in a spot contract there is an agreement to buy or sell the asset immediately or within a very short period of
time
• Exchanges trading futures
o CBOT and CME (now CME Group)
o NYSE Euronext
o Eurex
o BM&FBOVESPA (Sao Paulo, Brazil)
o ASX
o Many more (see list at end of book)
• Terminology
o A long futures position is an agreement to buy the asset at a certain time in the future for a certain price
o A short futures position is an agreement to sell the asset at a certain time in the future for a certain price
• Futures price
o The futures price is the price at which you agree to buy or sell
o It is determined by supply and demand in the same way as a spot price
• Examples of futures contracts
o Agreement to:
Buy 100 oz of gold @ US$1,050/oz in December
Sell £62,500 @ 1.5500 US$/£ in March
Sell 1,000 bbl of oil @ US$75/bbl in April
Buy 100 90-day bank bill futures contracts expiring in June
• Examples of a futures contract
o March: Trader takes a long position in a June futures contract on 90-day bank accepted bills at 95.00. This
implies a yield of 5% per annum is to be used to value the futures contract
o June: Trader must buy 90-day bank accepted bills with total face value of $1,000,000 at a yield of 5% per
annum
o The futures price that would be paid for the bills is:
$1,000,000
𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 = 5 90 = $987,821.38
1+100×365
2
,FUTURES EXCHANGES
THE AUSTRALIAN SECURITIES EXCHANGE
• Created in 2006 with the merger of the Australian Stock Exchange and the Sydney Futures Exchange
• Futures contracts were initially traded solely on the Sydney Futures Exchange (SFE) in 1960
• In the 1990s the Australian Stock Exchange replicated the individual share futures contract that was trading on the SFE
• This ceased with the creation of the Australian Securities Exchange
• Created in 2006 with the merger of the Australian Stock Exchange and the Sydney Futures Exchange
• Futures contracts initially traded solely on the Sydney Futures Exchange (SFE) in 1960
• In the 1990s the ASX replicated individual share futures contract that was trading on the SFE
• This ceased with the creation of the Australian Securities Exchange
• Futures contracts:
o Gold futures
o 90-day bank accepted bill futures contracts
o Share price index futures contracts
o Contracts for difference
o Electricity futures contracts
OVERSEAS EXCHANGES
• CME Group (CME and CBOT) largest
o Established in 1973 and 1848 to bring farmers and merchants together
o First futures-type contract known as a to-arrive contract
o Offers futures contracts on many different underlying assets
• In 1874 the Chicago Produce Exchange was established
• In 1898 the Chicago Butter and Egg Board was formed
• In 1919 it was renamed the Chicago Mercantile Exchange
• CME provides a futures market for many commodities
ELECTRONIC TRADING
• Traditionally, futures contracts have been traded using the open-outcry system where traders physically meet on the floor
of the exchange
• Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers
• The Australian Securities Exchange relies entirely on electronic trading
OVER-THE-COUNTER
• The over-the-counter (OTC) market is an important alternative to exchanges
• It is a telephone and computer-linked network of dealers who do not physically meet
• Trades are usually between financial institutions, corporate treasurers and fund managers
3
, FORWARDS
• Forward contracts are similar to futures except that they trade in the over-the-counter market
• Futures are forward contracts but traded on the exchange
• Forward contracts are popular on currencies and interest rates
• Spot, forward margins quoted for the USD exchange rate and calculated forward rates, 10 January 2011; quote is number
of USD per AUD
Bid Margin Offer Margin Bid Rate Offer Rate
Spot 0.9934 0.9937
1-Month Forward 40.80 40.50 0.98932 0.98965
3-Month Forward 111.70 111.30 0.98223 0.98257
6-Month Forward 225.30 224.10 0.97087 0.97129
OPTIONS
• A call option gives the holder the right to buy an asset by a certain date for a certain price (the strike price)
• A put option gives the holder the right to sell an asset by a certain date for a certain price (the strike price)
• An American option can be exercised at any time during its life
• A European option can be exercised only at maturity
• Margin prices of options on BHP, 7 January 2011; S = $44.60
Calls Puts
Strike Price ($) 24 FEB. 2011 24 MAR. 2011 28 APR. 2011 24 FEB. 2011 24 MAR. 2011 28 APR. 2011
43.500 2.530 2.780 3.185 0.660 1.095 1.430
44.000 2.155 2.430 2.890 0.760 1.265 1.610
44.500 1.840 2.150 2.555 0.940 1.455 1.810
45.000 1.520 1.835 2.260 1.135 1.675 2.030
45.500 1.240 1.570 2.010 1.365 1.910 2.270
46.000 1.010 1.310 1.755 1.630 2.180 2.525
• Options vs. futures/forwards
o In a futures/forward contract the holder has an obligation to buy or sell the asset at a certain price
o An option gives the holder the right to buy or sell the asset at a certain price (buyer pays premium for right)
• Exchanges trading options
o Chicago Board Options Exchange
o NYSE Euronext
o Eurex (Europe)
o ASX
o Many more (see list at end of book)
• The over-the-counter market for options
o Currently larger than the exchange-traded market
o Advantage: contracts can be tailored to meet the particular needs of a corporate treasurer or fund manager
4
