Financial Engineering Lecture 1 Introduction Syllabus Class Format
Financial Engineering Lecture 1
Introduction Syllabus Class Format Part 1 - Generic Derivatives & Options Part 2 - Futures, Swaps, MBS Grade Pricing Project Bloomberg Exam-Computations Email
Derivatives Definition Derivatives are financial instruments whose price and value derive from the value of the underlying assets or other variables (ISDA) Derivatives are a “zero sum game”
History of Derivatives 1840 s Midwest USA farmers 1848 Chicago Board of Trade (CBOT) for grain 1874 Chicago Produce Exchange for butter/eggs 1919 Chicago Mercantile Exchange (CME) Risk management Land options
Derivative Markets OTC vs. Exchanges Eurex (E-X) Chicago Board Options Exchange (CBOE) Chicago Mercantile Exchange (CME) Chicago Board of Trade (CBOT) New York Mercantile Exchange (NYMEX) Hong Kong Futures Exchange (HKFE)
Dec 2007 58, 244 Source: Bank for International Settlements
/ 12 19 / 98 06 19 / 98 12 19 / 99 06 19 / 99 12 20 / 00 06 20 / 00 12 20 / 01 06 20 / 01 12 20 / 02 06 20 / 02 12 20 / 03 06 20 / 03 12 20 / 04 06 20 / 04 12 20 / 05 06 20 / 05 12 20 / 06 06 20 / 06 12 20 / 07 06 20 / 07 12 20 / 08 06 20 / 08 12 20 / 09 06 20 / 09 12 20 / 10 06 20 / 10 12 20 / 11 06 20 / 11 12 20 / 12 06 20 / 12 12 20 / 13 06 20 / 13 12 20 / 14 06 20 / 14 12 20 / 15 06 20 / 15 12 20 / 16 06 20 / 16 12 20 /2 17 01 7 06 Notational outstanding of OTC derivatives ($ trillion) 1600 1400 1200 1000 800 600 400 200 0 Source: Bank for International Settlements https: //stats. bis. org/statx/srs/tseries/OTC_DERIV/H: A: A: B: 5 J: A: TO 1: A: A: 3: C? t=D 5. 1&p=20172&x=DER_RISK. 3. CL_MARKET_RISK. J: T: E: B: D: U&o=w: 20121. 20172, s: stc, t: Derivatives%20 risk%20 category
Source: Bank for International Settlements Exchange Options on OTC derivatives Q 2 2017 = $47, 315 billion
Source: Bank for International Settlements https: //stats. bis. org/statx/srs/tseries/OTC_DERIV/H: A: A: B: 5 J: A: TO 1: A: A: 3: C? t=D 5. 1&p=20172&x=DER_RISK. 3. CL_MARKET_RISK. J: T: E: B: D: U&o=w: 20121. 20172, s: stc, t: Derivatives%20 risk%20 category
Source: WFE/IOMA Derivatives Market Survey 2018
Source: WFE/IOMA Derivatives Market Survey 2018
Source: WFE/IOMA Derivatives Market Survey 2018
Source: WFE/IOMA Derivatives Market Survey 2018
Source: WFE/IOMA Derivatives Market Survey 2018
Derivative Instruments Futures Options / Warrant Future options Swaps Mortgage backed securities Forward Rate Agreement Convertible bonds Real options
Underlying Assets Stocks (example) Bonds Indices Commodities (examples for metal and ag. ) Currencies Weather Carbon emissions Radio bandwidth
Derivative Uses Arbitrage Speculation Hedging
Derivatives Call option Put option Exercise or Strike Price Expiration, Exercise, or Maturity Date Long position Short position
Charting Derivatives
Futures & Forwards Forward Contract Futures Contract -commodities -indexes -interest rates -exchange rates
Swaps An agreement between two firms in which each firm agrees to exchange (or Swap) the “interest rate characteristics” of two different financial instruments of identical principal. Types Interest Rate Swaps Currency Swaps
Ex - Interest Rate Swaps L. T. Fixed Loan S. T. Variable Loan Aaa Corp Baa Corp 7. 25% 7. 50% 11. 5% Swap Aaa Corp Borrows $1 mil fixed loan @ 10% BAA Corp Borrows $1 mil variable loan @ 7. 5% Aaa assumes pmts on variable loan at 7. 5% Baa assumes pmts on fixed loan @ 10. 75%
Ex - Interest Rate Swaps L. T. Fixed Loan S. T. Variable Loan Aaa Benefit Aaa Corp Baa Corp 7. 25% 7. 50% 11. 5% Baa Benefit Pay L. T. @ -10. 00% Pay S. T. @ - 7. 50% Get L. T. @ +10. 75% Get S. T. @ + 7. 50% Pay S. T. @ - 7. 50% Pay L. T. @ -10. 75% S. T. Sav @ + 7. 25% L. T. Sav @ +11. 50% Net Benefit +. 75%
Mortgage Backed Securities FMAC GNMA
Options Read Mc. Millan glossary for terminology IBMSept 80 Call Stock = IBM Expiration Date = 3 rd Friday in Sept (Saturday) Position = Long call Strike Price = $80 # of shares = 100
Options IBMSept 80 Call is selling for $5 Total Cost = 5 x 100 + commissions = $500 +
Options “In The Money” “Out of The Money” Ex. IBMSept 45 Call
Options “In The Money” “Out of The Money” Ex. IBMSept 50 Put
Options Intrinsic Value = P - E Premium = Option price Time Premium = O + E - P
Options Ex. IBMSept 60 Call Price = 65 Call = 7 Strike = 60 Intrinsic Value = 65 - 60 = 5 Premium = 7 Time Value Premium = 7 + 60 - 65 = 2
Options Parity = Intrinsic Value = Cost Over Parity --> E + O - P > 0 Under Parity --> E + O - P < 0
Options Factors in Option Price 1. Stock price 2. Strike price 3. Time to expiration 4. Volatility & distribution 5. Risk free rate 6. Dividends
Options Cross Section Pricing Intrinsic Value Option Price Stock Price
Options Cross Section Pricing / Time Decay Chart Intrinsic Value Option Price Stock Price
Options Interest Rates Settlement Projects Computer software CME Group Video
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