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Chapter 10 Derivatives - Coggle Diagram

- - - - financial futures are difficult to deliver, therefore, delivery involves an exchange of cash
      - “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.”
    - - initial margin: (original margin) : is required when the contract is entered into
      - maintenance margin: minimum amount balance that must be maintained
      - marking to market
        
        It means the settlement of balances each day takes place through the clearinghouse and each client account is adjusted by the brokerage firm to reflect the change in equity after the trading day.
  - - - to speculate
        
        profit from the expectation of rising prices
      - to manage risk
        
        to lock in a purchase price
    - - to speculate
        
        expectation of lower prices ; wants to buy back the futures in the market
      - to manage risk
        
        lock in a selling price
  - - - subscription price (offering price) : the price pay to purchase additional shares of the company ; the price is always lower than the market price
      - record date : determine who will receive the rights
      - ex-rights: one business day before the record day
      - cum rights: between the announcement date and ex-rights date
      - usual method: issue one right for each outstanding common share
      - “A rights holder may take one of the following courses of action:
        
        • 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”
      - Intrinsic value of rights during the ex-rights period
        
        intrinsic value of rights= (S - X) / n S: market price; X :exercise price or subscription price; n; the number of rights needed to buy 1 share
      - Intrinsic value of rights during cum-rights period
        
        Intrinsic value of rights = (S-X)/ (n+1)
      - trading rights
        
        the rights are listed on the exchange automatically
        
        settle by the second business day after the transaction takes place
      - Warrants
        
        “A warrant is a security that gives its holder the right to buy shares in a company from the issuer at a set price for a set period of time. In this sense, warrants are similar to call options. ”
        
        sweetener: (attractive to buyers) :“Warrants are often issued as part of a package that also contains a new debt or preferred share issue. ”
        participate in any appreciation of the issuer's common shares
        
        Valuing warrants
        
        as the expiration time approaches, the time value also falls
        
        Why investors buy warrants
        
        leverage potential: price is much lower than the price of underlying security; capital appreciation
- - - - Option strategies for corporations
        
        corporate put option purchase
        
        “If, in six months, the price of crude oil is less than US$38, the company will exercise its put option and sell the oil to the put option writer at the strike price. If the price is greater than US$38, the company will let the option expire and will sell the oil at the going market price.”
        
        corporate call option purchase
        
        e.g.“o protect itself against this risk, the corporation buys a three-month U.S. dollar call option with a strike price of C$1.35. This option can be bought at the Montréal Exchange or in the OTC market. If, at the end of three months, the exchange rate turns out to be C$1.40, the corporation will exercise the call and buy the U.S. dollars for C$1.35 million. If, however, the U.S. dollar weakens so that in three months the exchange rate is C$1.30, the corporation will let the option expire and buy the U.S. dollars at the lower exchange rate. ”
        
        manage risk related to interest rates, exchange rates, or commodity prices
      - Option strategies for individual and institutional investors
        
        writing put option
        
        cash-secured put write: writing a put, and setting aside an amount of cash equal to the strike price; if possible, the cash should be invested in a short-term liquid money market security like T-bill to earn some interest;
        if is assigned, the cash (proceeds from T-bill) will be used to buy the stock from the exercising put buyer
        
        naked put writer: have no position in the stock and have not specifically earmarked an amount of cash to buy the stock; however, naked put writer must be prepared to buy the stock
        
        profit from stock price that stays the same or goes up, the price of the puts will decline; the naked put writer choose to buy back the options at the lower price to realize a profit;
        if stock price does not rise, put writers may be assigned and suffer a loss.
        
        covered put writer: combines a short put with a short position in the stock;
        
        covered’ really means that if the option buyer decided to exercise his or her option, any action you have to take will merely be an offsetting of a position you’ve already established.
        
        buying put option
        
        buying puts to manage risk
        
        buying puts to speculate
        
        profit from an unexpected decline in the price of stock; speculative strategy : put option prices tend to rise as the price of the stock falls
        
        writing call options
        
        obligation: Deliver the underlying asset and receive the exercise price.
        
        naked call writers
        
        the loss is theoretically unlimited
        
        do not own the underlying stock; if a naked cal writer is assigned, the stock must first be purchased in the market before it can be sold to the call option buyer. assigned naked call writers must buy the stock at market price and sell at a lower price (strike price)
        
        covered call writers : A covered call means owning stock and writing a call ; A covered call position entails writing calls and buying an equivalent amount of the underlying stock.
        
        Investors write call options primarily for the income they provide. The income, in the form of the premium, is the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does.
        
        buying call options
        
        establish a maximum purchase price for a stock
        
        buying calls to manage risk
        
        buying calls to speculate : exercise the option and buy the stock at the lower exercise price , and sell the option to the market at a profit
      - Equity option quotation (book10.15)
    - - Time value
        
        option price = intrinsic value + time value
        
        option price - intrinsic value = time value
        
        the value of uncertainty
      - Intrinsic value
        
        intrinsic value of an in the money put option= strike price- underlying price
        
        intrinsic value of an in the money call option= price of underlying - strike price
        
        the value of certainty; option's intrinsic value: in the money portion of a call/put option
      - Out-of-the-money and at-the-money (not exercise)
        
        at the money: price of underlying asset is equal the strike price
        
        put option out of money: price of underlying asset is higher than the strike price
        
        call option out of money: price of underlying asset is lower than strike price
      - In-the-money (owners will exercise)
        
        a put option is in the money:the price of the underlying asset is lower than the strike price (put option holder exercise the right to sell , and cover the short position at the lower market price )
        
        a call option is in the money: the price of the underlying asset is higher than the strike price (call option holder exercise the right to buy, and turn around and sell it at higher market price)
      - Opening transaction
        
        the party holding the long position will let the option expire worthless: allow it to expire, the option buyer loses money with premium, the seller makes money with premium
        
        The party holding the long position will exercise the option
        
        The position will be offset : offsetting transaction (cancels the position) Offsetting a long position involves selling the same type and number of contracts; offsetting a short position involves buying the same type and number of contracts.
        
        meaning: when an investor establishes a new position in an option contract ( opening buy: long ; opening sell : short position)
      - Long-term equity anticipation securities
        
        a long-term option with the same risks and rewards as a regular one
      - Americanstyle and European style options : A can be exercised at any time (including expiration date); E can only be exercised on the expiration date (specific date)
      - trading unit: NA: 100 shares; premium is quoted on a per unit basis
      - expiration date : the third Friday of the expiration month ; weekly options are listed for trading at the open on Thursday, with expiration dates on any of the five Fridays following the listing week
      - option premium : option buyers pay the sellers a fee
      - strike price (exercise price ) : both side agree on this future price
    - - Writer (short position) 卖出卖权 pay premium to the buyer; has the right to buy; expect the price to remain the same or rise
      - Holder (Long position): 买入卖权 pay premium to the writer; has the right to buy; expect the price to fall
    - - Writer (short position) 卖出买权 pay premium to the buyer; has the right to sell; expect the price to remain the same or fall
      - Holder (Long position): 买入买权 pay premium to the writer; has the right to buy; expect the price to rise
  - - - OTC: chartered banks and their subsidiaries
      - exchange-traded markers: banks investment dealers, professional individuals
    - - hedging risk by buying a forward contract or a call option
      - primarily for hedging purposes (hedge interest rate, currency and commodity price risk)
    - - investment strategies
        
        Yield enhancement
        
        e.g. selling options against the position
        
        boosting returns on an underlying investment portfolio by taking speculative position based on expectations of future market movement
        
        Arbitrage
        
        if 2 transactions are effected simultaneously, there is no investment risk in the arbitrage
        
        a scenario where the same asset or commodity is traded at different prices in 2 separate markets
        
        market entry and exit
        
        more efficient: temporary change to the portfolio
        
        can be inefficient and more costly than expected (e.g. some additional cost like commission fees etc. ; a large sell order may push the price down and vice versa)
      - “use derivatives for both speculation and risk management.”
      - trade OTC derivatives
      - “mutual fund managers, hedge fund managers, pension fund managers, and insurance companies”
    - - can open a special type of account with a brokerage firm
      - need to fully understand the risk
      - trade exchange-traded derivatives only
  - - - Currencies: US dollar, British Pound, Japanese yen, Swiss franc, and European euro (swap: private, contractual agreement between 2 parties)
      - interest rates : interest rate sensitive securities; yields on T-bills and treasury bonds and the London Interbank Offer Rate
      - equities : equity options( options on individual stocks)
    - - energy products
      - precious and industrial metals
      - forest, fibre, and food
      - livestock and meat
      - grains and oilseeds
  - - - exchange-traded
        
        • Used by retail investors, corporations and institutional investors”
        
        • Commission visible
        
        • Delivery rarely takes place
        
        • Heavily regulated
        
        • Gains and losses accrue on a day-to-day basis (marking to market)
        
        • Performance bond required, depending on the type of derivative
        
        • Clearinghouse acts as third-party guarantor ensuring contract’s performance to both trading parties
        
        • Easy termination prior to contract expiry
        
        • Transparent (public)
        
        • Standardized contract
        
        “Traded on an exchange
      - Over-the-counter
        
        • Used by corporations and financial institutions
        
        • Fee usually built into price
        
        • Delivery or final cash settlement usually occurring
        
        • Much less regulated
        
        • Gains and losses generally settled at the end of the contract, rather than marking to market
        
        • Performance bond not required in most cases
        
        • No third-party guarantor
        
        • Early termination more difficult
        
        • Private
        
        • Terms of the contract agreed to between buyer and seller
        
        “Traded largely through computer and/or phone lines
      - privacy
      - liquidity and offsetting
      - default risk (major concern)
      - regulation
    - - Montreal Exchange
      - provide trading floor or electronic trading system
      - is a legal corporate entity for the trading of derivative contracts
    - - contracts can be custom designed to meet specific needs
      - active market; dominated by financial institutions; has no trading floor and no regular trading hours
  - - - gain from one counter-party is exactly offset by the loss to the other counter-party
      - options : the buyer make a payment when the contract is drawn up ( premium)
      - forwards: no up-front payment is required; sometimes both parties make a performance bond or good-faith deposit
      - have an expiration date
      - have a price both parties must agree
      - contractual agreements between 2 parties (buyer & seller)