3.4 Derivatives

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3.4 Derivatives

Objectives
+ Define a derivative
+ Investigate the range of derivatives. What do they have in common, how do they differ?
+ Learn about options
+ Learn about swaps, futures, etc.

Lecture:  Derivatives

Part I – What are derivatives?
Derivatives are contracts. (It’s possible everything is a contract, but that’s a story for another day.) The most common derivatives are options, swaps and futures. They are called derivatives because their value is derived from the value of some underlying asset, be it financial such as an equity or stock, or real such as a commodity like wheat. Derivatives are a way for investors to control the underlying asset without actually owning it. An investor can buy an Apple option without ever buying an Apple share, or sell a pork belly future without ever seeing a pork belly.

Leverage is one big advantage of derivatives. Although the price of an option, for example, can vary considerably, it usually costs between 3% and 30% of the cost of a share in the underlying stock. An investor can buy a lot more options than shares with a given amount of money. This is leverage–controlling a given value of an asset with an instrument that costs a fraction of that value. Leverage also means that a given gain, say $5 is a larger percentage of the cost of the derivative than it is of the underlying asset. Make $5 on a $20 option you get a 25% return, making $5 on the underlying $100 share is only a 5% return.

There are two main motivations for investing in derivatives: to provide insurance, or a hedge against an adverse change in an underlying position, or to speculate on price changes in the underlying asset value. An extreme version of speculation is contained in trading on Nadex (see aside below.) Speculation is a valid motive for investing in derivatives, driven by a sense of having better information, skill, or luck, but it is often advised to speculate with money that is not essential–money that could be lost without dire consequences. The insurance motive for using derivatives is quite common, since the lower cost of derivatives provides insurance against other investment positions, much like car insurance gives people peace of mind when accidents and damage occurs.
Investors using derivatives as insurance are generally more interested in movements in the underlying asset prices rather than any changes in the value of the derivative contract itself. Speculators on the other hand, who aren’t interested in holding the contract to term, or exercising their rights, can be more interested in the value of the derivative as it changes over time, due to many factors including the price of the underlying asset, but also because of changes in expectations regarding the future values of those assets. As investor sentiment about the underlying asset changes over time, the value of the derivative contract can change (via supply and demand for the contract) creating a more (or less) valuable contract for both the buyer and the seller.

Part II – How options work
Options are contracts between two parties–one the seller or writer, the other the buyer. They have the following elements:
1. An underlying security, usually a lot (100) of shares in a particular company.
2. A strike price, being the price at which the underlying shares will be traded.
3. An expiration date, at which time the option is exercised, or goes un-exercised.
Just as an example, the Apple option AAPL170217C00110000 is a call option (the right to buy shares) with a strike price of $110 expiring on Feb 17, 20176. (It was selling for $10.25 at the end of October 2016. More on that below.)
There are two types of options: Call, and Put.
Call options give the buyer the right to buy the underlying shares at the strike price.
Put options give the buyer the right to sell the underlying shares at the strike price.
Every option gives the buyer rights, and creates an obligation for the seller/writer. The buyer has the right to exercise the option, the writer has the obligation to fulfill the contract.

There are four positions that investors can take with options:
1. Long on a call. The person who buys (holds) the right to buy the underlying stock is said to have a long position on a call option.
2. Short on a call. The person who sells (writes) the right to buy the underlying stock–and hence this person must sell the stock to the buyer–has a short position on a call option.
3. Long on a put. The person who buys (holds) the right to sell the underlying stock has a long position on a put option.
4. Short on a put. The person who sells (writes) the right to sell the underlying stock–and so must buy the stock from the buyer–has a short position on a put option.

The writer of the option sells the contract for a price. The price is the value of the right specified in the option. Continuing the earlier example, if a share in Apple is currently selling for $117, but an investor believes the price will rise in the future, a call option (the right to buy Apple shares) at $118 is worth something. If the price of Apple shares goes up to $125, the buyer of the call option can exercise the option and force the writer to sell Apple shares at $118 when they are worth $125. The option buyer can then sell the Apple shares for $125 and make a gain of $7 per share. The net gain to the buyer is less once the purchase price of the options is deducted, but it would, presumably, still be a net gain.

Option contracts define a zero-sum game. The buyer pays the premium (the price asked by the writer) to the seller/writer. The buyer is down $X, and the seller is up $X. If the option is exercised, the buyer is up $Y, but the seller is down $Y also. Someone always gains with an option, and someone always loses with that option.

View the two lecture videos here:
Options I,
Options II

Notes to accompany videos:
1. Video I shows the payoffs to buyer and seller of a call option.
2. The buyer will exercise the option if the market price of the share is above the strike price plus premium. (Note a call option is “in the money” if the market price is above the strike price, even if not above the strike price + premium. The option may not be exercised even if it is in the money.)
3. The buyer pays the premium no matter whether the option is exercised or not.
4. If the option goes unexercised the buyer loses the premium, and the seller gains the premium.
5. If the market price rises enough, the buyer will exercise the option and make money buying the underlying stock at the strike price then selling it on the market at the higher price. The writer of the option is obliged to sell the shares to the buyer, and loses the same amount of value as the buyer gains.
6. Video II shows the payoffs to buyer and seller of a put option. The put payoffs are mirror images of those for a call option.
7. Buyers exercise their option rights if the market price of the underlying shares fall sufficiently. The option goes unexercised if the price rises.

Buyers and sellers of options must hold essentially opposite views of how prices for the underlying shares will move in the future. Buyers are more likely to exercise their options the more prices move away from the strike price, but the probability of such large price movements is usually lower, especially for low volatility stocks. According to the Chicago Board Options Exchange (CBOE) about 10% of options are exercised, while 90% go unexercised. But about 1/3 of those not exercised expire worthless, the other 2/3 are closed. The only way to close, or get out of, an options contract is to buy (or sell) the opposite contract. If an investor long on a call wants to close that position, he/she must take a short position on the same call option. This can be risky as the price of that option may have changed, and the investor can make money, or lose money, on the close of the position. This is another example of the symmetry in the options market.

Part III – Swaps
Swaps are contracts involving income flows from financial assets, usually bonds, but also others such as mortgages. There was approximately $550 trillion (!) worth of swaps outstanding worldwide in 2015 according to the Bank of International Settlements.
The most common swap contract is an interest rate swap. Usually between two banks, but sometimes between a company and a bank or two companies, the contract exchanges a fixed interest stream of payments for a variable interest stream of payments over a given period of time.
For example, suppose Company A can get a fixed interest rate loan of $5m at 5%, but Company B can only get a $5m loan at a floating rate currently at 6%. If Co.A thinks interest rates will fall, they could swap their loan (through the swap instrument) with Co.B. Co.B gets a fixed rate which offers stability, and Co.A gets the chance to only pay, say 4% when the interest rates fall. Both companies potentially benefit from the swap.
Another common swap is a currency swap. Similar to interest swaps, two parties swap loans in different currencies, but unlike interest rate swaps, both principle and interest payments are exchanged under the contract. The objective of currency swaps is to overcome money market inefficiencies in either one, or both, markets by taking advantage of more favorable terms on a loan in another currency. An example could be when Co.A, a US company wishes to open operations in Costa Rica, while Co.B, a company based in Costa Rica, wishes to open operations in the US. Each company can get better loan terms in their home country than in the foreign country they wish to operate in. They enter into a currency swap to take advantage of each other’s better loan terms.
Perhaps the most famous type of swap in recent times is the Credit Default Swap, made (in)famous by the role they played in the financial crisis of 2008. Like many derivative markets, the CDS market is unregulated. An entity (person, company, bank) buys a CDS and pays the seller a regular premium. If a specific event occurs, such as a loan is defaulted on, or a credit rating is lowered, the seller must pay the buyer the face value of a reference bond equal to the amount agreed to in the initial contract. The buyer receives the payment and stops paying the premium. The interesting thing about CDSs is that neither the buyer, or the seller, has to own the underlying or reference asset. So a bank has lots of mortgages on its books. Person A thinks they are all good mortgage loans and the homeowners will pay their monthly mortgage payments on time and in full. Person B thinks the owners are in over their heads and will default on those mortgages very soon. Person A will sell a CDS to Person A, in return for the premium payments. If A is correct, B will pay the premiums and never make a claim since the mortgages are all good. If B is correct, the mortgages will go bad, and A will have to pay her the value of the mortgages! A lot like a night at the casino without the free drinks…

Part IV – Futures
A future is a contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the strike price) with delivery and payment occurring at a specified future date, the delivery date. The buyer takes a long position while the seller takes a short position in the trade. The contract is usually written on the quantity and quality of a commodity, such as crude oil, wheat, soy beans, orange juice. (Remember Trading Places, the movie? Here’s a scene about Duke and Duke, the firm that trades commodity futures.)
Some people buy futures to hedge, or insure, against changes in commodity prices in the future. Futures contracts were originally created to help producers and users of commodities offset fluctuations in agricultural product prices. Futures contracts allow the risks of price rises and falls to be shared across people, and time (as in the pooling of risks to reduce them.) For example the makers of orange juice want to take delivery of truck loads of oranges, and so may buy futures contracts to ensure they have sufficient oranges at a given price when needed in the future.
Many people who trade in futures don’t want to take delivery of the actual commodity or asset. They are speculating about the movement in prices of the underlying product. Like an options trade, the buyer expects/hopes the price to go up, thereby taking advantage of the lower strike price to purchase the underlying asset, usually a real commodity, while the seller expects/hopes the

Aside: European and American options
European options can only be exercised on the day of expiration. American options on the other hand can be exercised at any time before the exercised date. This increases the risk to the option writer (the one with the obligation to fulfill the contract) because they never know if, or when, the buyer will exercise the option.

Aside: Exotic options
Options can get pretty fancy, and have names to match: butterfly spread, straddle, iron condor. Fancy options are combinations of two or more positions on options written on the same underlying asset, usually with the same expiration date, sometimes with different strike prices.

Watch the video about more sophisticated option strategies

Investors can use a covered option strategy to provide insurance, or a hedge, against an underlying position going bad.  A covered call is when an investor has a long (holding) position on an underlying stock, and sells (takes a short position) on a call option written on the same underlying stock. The investor would only exercise the option to sell if the share price falls below the strike price. Since the investor owns the shares he/she can exercise the options and sell the shares at the strike price, guaranteeing a sale at a reasonable price. The investor has limited the loss on owning the shares by exercising the option. If the share price holds or rises, the options will go unexercised and the only loss the investor has is the premium paid for the options. The options were insurance against a fall in the value of the equity assets held by the investor.

Aside: Other types of options
The general concept of options is quite widespread. For example, film studios might buy the option to make a movie based on a book. They pay for the right to do this, but have no obligation to do so. Callable bonds are bonds containing the option, held by the issuer, to pay off the bond before the maturity date. Convertible bonds give the lenders the option of convert the bonds into common stock in the company.

Aside: Nadex
Nadex is the North American Derivative Exchange. It started life as a company called HedgeStreet. It is a regulated exchange where investors, and others, can trade financial derivatives called binary options. These options pay out money if some event happens, and pay nothing if the event does not happen. The events cover a surprising array of activities, usually economic in nature. There are Nadex options for the future value of stock price indexes, economic indicators such as the CPI, the Federal Funds rate, exchange rates for many different currencies, just as an example. Check out the Nadex website for more information.
There are other markets similar to Nadex called prediction markets. Perhaps the most famous prediction market is the Iowa Electronic Markets set up by the University of Iowa business school faculty. What started out as a teaching tool for students has become an active real-money market with an impressive track record of predicting the winner of presidential elections. (There are other political predication markets, as well as Nate Silver’s FiveThirtyEight website that uses large amounts of polling data to predict election outcome. Note, the website used to be a New York Times blog, but Silver took it to ESPN. The NYT blog still exists as an archive.)
Read a well-written criticism of binary “investment” markets from Forbes.

The Quiz is available on the Learn website.

Additional Resources/links
I presume I don’t have remind you to look up Wikipedia (the Internet font of wisdom, or lies, whichever way you see it) on each topic. Read with an open mind.
1. An interesting research paper comparing Nate Silver’s poll predictions with In-Trade’s prediction market results:
http://researchdmr.com/RothschildPOQ2009
2. A totally crazy Kahn Academy video series on interest rate swaps (just more evidence that Sal Kahn is a salesman, not an educator):
https://www.khanacademy.org/economics-finance-domain/core-finance/derivative-securities/interest-rate-swaps-tut/v/interest-rate-swap-1
3. This is a pretty cool infographic. No real point to it, but cool.
http://demonocracy.info/infographics/usa/derivatives/bank_exposure.html
4. This must be one of the most complicated explanations of derivatives I’ve ever come across, and it’s on the NPR website:
http://www.npr.org/blogs/money/2012/10/17/163038597/ask-a-banker-whats-a-derivative Very weird!
5. This is a far more interesting audio interview from NPR with a derivative trader:
http://www.npr.org/templates/story/story.php?storyId=102325715

Homework (due Monday midnight)
Write up to a one page, typed (single spacing is fine) essay on the following topic:
Describe how to make money taking a long position on a call option. Be sure to describe the features of the option contract, and the conditions necessary to make money.

Discussion
Discuss any one, or all, of the following propositions:
1. “The difference between investing in options and gambling is the better atmosphere at the Casino.” Do you agree, or disagree, with this statement? Why?
2. I argue here that options are insurance. Earlier in the semester I asked you if there should be insurance for investing in the stock market. There is: options. Do you want to reconsider your previous position on insurance for stock market losses?
3. People invest in derivatives for two reasons: to insure and to speculate. If you were to invest in derivatives, which would be your motivation, and why? Or why would you stay away from them?

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