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Title: Financial Economics: Speculative Markets UofC, Fernando Alvarez


1
Financial Economics Speculative Markets
UofC, Fernando Alvarez
2
Grading
PS 4 problem sets, graded pass/fail. M optional
midterm F comprehensive Grade based on curve
on G G 0.1 PS 0.9 MaxF, 1/3 M 2/3 F
3
Other Details
-TA sessions review some material, cover special
topics, solutions of PS and Midterm. -TA
Mariano Lanfranoni - No review session during
the 1st week -Office Hours Wed 330 500
4
Pre-requisites
- Basic Calculus derivatives (integration for
optional advanced problem) - Basic Statistics
expected values, variances, binomial formulas
(Central Limit Thm, Law of Large numbers for
optional advanced problem) - Intro to Finance,
not required, but helps.
5
Class Material
  • - I will use my notes (slides) for all the
    topics. Available on my web page
  • http//home.uchicago.edu/falvare/
  • - I may revise the notes (incorporate new
    examples, different explanations, etc).
  • -I will announce whenever there are additions to
    the notes.

6
Class Material (cont)
  • There are many good books on this topic. I will
    follow closely
  • Options, Futures, and Other Derivatives 6th
    Edition, John C. Hull 2005
  • - You may want to buy it if you want to have a
    reference for other topics not covered in class
    and plan to work in the industry.

7
What would you get from this class?
  • Understanding of hedging and pricing of ANY
    derivative
  • Implemented (i.e. recommendation of trading
    strategy) in spread-sheets
  • Focus on general principle, not catalog of all
    contracts available.

8
The Nature of Derivatives
  • A derivative is an instrument whose value depends
    on the values of other more basic underlying
    variables
  • In this class we will focus on how to price and
    hedge derivatives whose underlying is a traded
    asset (non-traded asset)
  • Not covered taxation, institutional details, and
    accounting practices.

9
Examples of Derivatives
  • Futures Contracts
  • Forward Contracts
  • Swaps
  • Options

10
Derivatives contracts considered in this class
  • Forwards, Futures, on commodities, stocks,
    indices, foreign currency and bonds.
  • - Options on commodities, stocks, indices,
    foreign currency, and futures.
  • - If time allows Options on interest rate
    instruments.

11
Derivatives contracts considered in this class
(cont.)
  • From pricing and hedging perspective
  • Futures Contracts, Forward Contracts and Swaps
    are similar use static hedging and
    replication.
  • Options require dynamic hedging and
    replication.
  • Once you understand options, you understand ANY
    derivative.

12
Derivatives Markets
  • Exchange traded
  • Traditionally exchanges have used the open-outcry
    system, but increasingly they are switching to
    electronic trading (example)
  • Contracts are standard there is virtually no
    credit risk
  • Over-the-counter (OTC)
  • A computer- and telephone-linked network of
    dealers at financial institutions, corporations,
    and fund managers
  • Contracts can be non-standard and there is some
    small amount of credit risk

13
Ways Derivatives are Used
  • To hedge risks
  • To speculate (take a view on the future direction
    of the market)
  • To lock in an arbitrage profit
  • To change the nature of a liability
  • To change the nature of an investment without
    incurring the costs of selling one portfolio and
    buying another

14
Forward Contracts
  • Forward contracts are similar to futures except
    that they trade in the over-the-counter market
  • Forward contracts are particularly popular on
    currencies and interest rates
  • Buyer (long) obligation to buy the underlying at
    the delivery price at the maturity date.

15
Foreign Exchange Quotes for GBP June 3, 2003
16
Forward Price
  • The forward price for a contract is the delivery
    price that would be applicable to the contract if
    were negotiated today (i.e., it is the delivery
    price that would make the contract worth exactly
    zero)
  • The forward price may be different for contracts
    of different maturities (example)

17
Terminology
  • The party that has agreed to buy has what is
    termed a long position
  • The party that has agreed to sell has what is
    termed a short position

18
Example
  • On June 3, 2003 the treasurer of a corporation
    enters into a long forward contract to buy 1
    million in six months at an exchange rate of
    1.6100
  • This obligates the corporation to pay 1,610,000
    for 1 million on December 3, 2003
  • What are the possible outcomes?

19
Cash flow from aLong Forward Position
K
20
Cash flow from a Short Forward Position
K
21
Futures Contracts
  • Agreement to buy or sell an asset for a certain
    price at a certain time
  • Similar to forward contract
  • Whereas a forward contract is traded OTC, a
    futures contract is traded on an exchange

22
Exchanges Trading Futures
  • Chicago Board of Trade
  • Chicago Mercantile Exchange
  • LIFFE (London)
  • Eurex (Europe)
  • BMF (Sao Paulo, Brazil)
  • TIFFE (Tokyo)
  • and many more (see list at end of book)

23
Examples of Futures Contracts
  • Agreement to
  • buy 100 oz. of gold _at_ US400/oz. in December
    (NYMEX)
  • sell 62,500 _at_ 1.5000 US/ in March (CME) or
    (WSJ)j
  • sell 1,000 bbl. of oil _at_ US20/bbl. in April
    (NYMEX)

24
Options
  • A call option is an option to buy a certain asset
    by a certain date for a certain price (the strike
    price)
  • A put option is an option to sell a certain asset
    by a certain date for a certain price (the strike
    price)

25
American vs European Options
  • An American option can be exercised at any time
    during its life
  • A European option can be exercised only at
    maturity
  • Example Oil (many other types too!)

26
Intel Option Prices (May 29, 2003 Stock
Price20.83) See also wsj

27
Exchanges Trading Options
  • Chicago Board Options Exchange
  • American Stock Exchange
  • Philadelphia Stock Exchange
  • Pacific Exchange
  • LIFFE (London)
  • Eurex (Europe)
  • and many more (see list at end of book)

28
Options vs Futures/Forwards
  • A futures/forward contract gives the holder the
    obligation to buy or sell at a certain price
  • An option gives the holder the right to buy or
    sell at a certain price

29
Types of Traders
  • Hedgers
  • Speculators
  • Arbitrageurs

Some of the largest trading losses in derivatives
have occurred because individuals who had a
mandate to be hedgers or arbitrageurs switched to
being speculators (See for example Barings Bank,
Business Snapshot 1.2, page 15 in Hull book)
30
Hedging Examples
  • A US company will pay 10 million for imports
    from Britain in 3 months and decides to hedge
    using a long position in a forward contract
  • An investor owns 1,000 Microsoft shares
    currently worth 28 per share. A two-month put
    with a strike price of 27.50 costs 1. The
    investor decides to hedge by buying 10 contracts

31
Cash Flow of Hedge at maturity (as function of
maturity price S)
b) 1 share short 1 call long (reverse)
a) 1 share long 1 call short
K
S
32
Speculation Example
  • An investor with 4,000 to invest feels that
    Amazon.coms stock price will increase over the
    next 2 months. The current stock price is 40 and
    the price of a 2-month call option with a strike
    of 45 is 2 (see wsj)
  • What are the alternative strategies?
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