Swaps, options and other derivatives Options on futures

 

       

Jakob Rehme  

 

Department of Management and Engineering

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Options and swaps This is complicated matter. If you find dubious things tell the examiner!! Sometimes there are details that are not easy to explain. Sometimes the examiner is lost. Today we will continue to talk about derivatives – namely options and swaps

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Derivatives •  A derivative is a financial contract which derives its value from the performance of another entity such as an asset, index, or interest rate, called the "underlying”. •  Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e. bonds and mortgages). •  Derivatives include a variety of financial contracts, including futures, forwards, swaps, options, and variations of these •  Most derivatives are marketed through over-the-counter (offexchange) or through an exchange;.

Futures contracts and options •  Assume you have a futures contract •  An open position = you must sell, or buy, the underlying commodity. •  To get out = close the position Perhaps you will lose all your money •  If you buy an option you can limit this loss

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Options, exchange •  Options must be traded on an exchange •  The exchange does not trade •  The exchange sets up the rules in a contract •  You cannot change things •  The value of an option is set by the market, not by the exchange

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Options, basic idea •

•  Speculators want to earn money •  They want to limit their financial risk •  They are willing to pay, but not too much •  Other speculators have much money •  They can protect the others from the risk •  They want money for that

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Options, writer •  The exchange provides the market with standard contracts •  One party of the contract must sell, or buy oil, in the future for a certain price •  The other party can choose if he wants to sell or buy, i.e. he has an option. •  The first party sets up a price for letting the other have the option. Swaps, options and other strange contracts – p. 7/61

Options, writer •  The price for giving you the option is called a premium. •  The one who gives you the option is called the writer •  Everything must start with the writer who tells the market that an option is available. •  The writer wants money for allowing you to sign the contract, the premium. Swaps, options and other strange contracts – p. 8/61

Options writer •  Writing = ”Sell to open” •  You sell to the market maker •  The market maker gives you the premium •  The buyers buy from the same person. •  They give the premium to the market maker

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Options, writer •  Now, the option exists!! •  The writer hopes that you will not use your option. •  If you do not use it, the writer still has the premium, i.e. he has earned money.

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Options, premium •  If you have ”bought” an option, you can choose what to do. •  Be passive, and do nothing, or active = use your option. •  You are more free, which is positive. •  The seller is less free which is negative. •  Therefore, an option costs money!

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Options writer If you want to be a writer of an option, and do not have the underlying commodity, you must have a lot of money and a margin account, just as if you traded futures. You must go to a broker or a member of the exchange in order to create a new option.

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Options Now, when the option exists, another person can buy it, the holder (or owner). The actual trade goes on between brokers and members just as if you traded futures. A clearing bank is a guarantee for the money involved. Note members!!

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Options The writer now has an open position but it is possible to close this position if needed. The option ”in itself” is still valid for the one who had bought the option.

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Options If you have an option where you are entitled to buy something, you have a call option. If you have an option where you are entitled to sell something, you have a put option.

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Options An option does not live forever. At a special date the option is not valid anymore. This day is called the expiration date. For every buyer of an option there is a seller. But you must sell to, and buy from, the market maker.

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Options The expiration date for ”all” listed options in U.S. is the third Friday in the month. If this is on a ”red” day the expiration day will be on the Thursday. For Nymex heating oil it is three days before the futures contracts stops to trade.

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Options As a holder of an option you can choose if you want to use it. As a writer of an option you face the risk that someone will in fact use the option. A writer must do what the holder wants. This is very risky business. The holder faces a much lower risk, i.e. losing the premium.

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Options The buyer of an option is called the holder, the seller the writer. Source: Chicago Board Options Exchange, Tutorial Swaps, options and other strange contracts – p. 19/61

Options As a holder of an option you can sell or buy, depending on the option, something for a special price. This price is called the strike price. If you want to sell or buy you are exercising the option.

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Options If you want to exercise your option, the broker and in turn the member and the clearing bank?, must find a member who is short, of the same kind of option. When they find this member, the member tells the writer, that he will be assigned to fullfill the criteria on the option.

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Options As with future contracts, most options are never exercised. Normal behaviour is to sell the option and take the profit, i.e. if it is possible.

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Options Normal practice is that options have a rather short life, up to nine months or so – maximum one year. There are, however, so called LEAPS, or Long Term Equity Anticipation Securities – (and Warrants). They have expiration dates up to three years from now.

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Options If you are ”bullish” you think that market prices go up. If you are ”bearish” you think that prices will fall.

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Options The price of an option, at least for stocks, can be reflected by using the so called ”Black-Scholes formula”. This formula includes the current stock prise, the strike price, the time value, the interest rate and the volatility.

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Options on futures Note that you do not have an option to buy physical oil, but instead an option to achieve a futures contract. This latter contract can then be changed into oil, or money. Normally, you will ”close” your options contract. And collect the money.

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Options on futures With options you can limit the risk if the market goes in the wrong direction. If the market goes in the right direction you earn money as if you had a real futures contract.

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Options on futures There are American style options where you can exercise your option whenever you want until expiration date and European style options where you must wait to the expiration date.

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Options on futures Nymex has options on ”all” their futures contracts. There are at least 61 strike prices set after a specific schedule around the so called ”at-the-money” level. At-the-money means that the strike price is approximately the same as the ”spot-price”.

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Options on futures We also have a term called ”in-the-money” when the option has a value and ”out-of-the-money” where the value is zero.

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Options It is common to use graphs in order to show profit or loss on options. P ro fi t +

Break even

P r e m in u m

-

Long c a ll

Oil p ric e Loss Swaps, options and other strange contracts – p. 31/61

Commission charges You have to use a brokerage firm in order to buy options. This firm takes a certain amount of money from you, the commission fee. The comission fee is not the same as the premium which is paid to the seller of the option, i.e. probably the market maker. Also the original seller must pay a commission.

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Option prices, premium An option with a longer ”time-span” is more valuable than a one with a short ditto. The price of the futures contract, and the commodity, has longer time to change in the right direction. When the expiration date closes up, time value decreases fastly. This is called time decay.

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Option prices, premium A call option with a low strike price has a higher value because you can exercise it faster. A put option with a high strike price has a higher value because of the same reason.

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Options If you have an american-style option you can always: •  Offset the option, i.e. selling it back to the market. There is, however, no guarantee that this is possible! •  Continue to hold the option, i.e. you do not do anything •  Exercise the option, i.e. you actually buy or sell the futures contracts Swaps, options and other strange contracts – p. 35/61

Options If you exercise the option you have to buy, or sell, the contracts. All of a sudden you are exposed to a much larger risk and this risk is unlimited. Futures contracts can change prices very rapidly. Normal options traders therefore try to sell back their options to the market, hopefully with some profitability.

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Options The shorter time to expiration the less value has the option. The ”time-value” of the option gets lower and lower and at expiration date it is zero. If an option has a value when it is ”out-of-the-money” then this value is the time-value.

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Options Trading options is only of interest if the market is ”volatile” i.e. the value must change fast. If the value is constant no one wants to buy options.

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Options Also options are cleared by a so called clearing house. In U.S. there is OCC or the Options Clearing Corporation who clears all listed options contracts on stocks, i.e. not on energy futures contracts.

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Example At CME-group, options are sold on CL January 2013. The futures are now, Dec 6, 2012, 87.93 $/barrel. Strike price

Type

Last price

8600

Call

2.68

8600

Put

0.80

8700

Call

1.99

8700

Put

0.99

8800

Call

1.40

8800

Put

1.52

8900

Call

0.95

8900

Put

2.07

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Options, ten commandments I. Thou shalt not under any circumstances allow an option to expire worthless . . . Source: www.transworldfutures.com

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Swaps Now, some notes on a strange contract called ”Swap”. The vast majority of commodity swaps involve oil..

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Swaps When you swap you are normally trading between two persons or institutions. You trade Over-TheCounter, OTC. No exchange has to be involved but there are swap contracts on e.g. Nymex.

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Swaps Assume for a start that you are an oil producer. You have a contract with a buyer of crude oil where the payment is based upon an average monthly settlement price at Nymex. This is called CMA = Calendar Month Average. Hence, you do not actually know how much money you will get.

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Swaps Not knowing the amount of money that you will be paid is a poor situation. You want a hedge and contact a bank. You tell them that you want a fixed price for your oil. The bank tells you that you can get a fixed price but then they must have the possible profits from the CMA.

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Swaps The bank calculates the level of the fixed fee and by this they get money for the risk they are taking. There are different levels if the bank buys or sells the swap contract.

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Swaps The swap contract results in the following: You sell the oil for a floating price, get floating amounts of money and send these amounts to the bank who gives you a fixed sum of money.

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Swaps

Source: www.atb.com

A crude oil producer sells oil for the futures price. He gets money from the buyer which money in turn is paid to the bank. Instead he gets a fixed amount from the bank. Swaps, options and other strange contracts – p. 48/61

Swaps

A crude oil buyer buys oil for the spot price, or settlement price if so agreed. He sends floating money to the seller which money in turn is paid by the bank. Instead he sends a fixed amount to the bank.

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Swaps

Source: www.atb.com

With a swap you can construct a ”perfect” hedge. The bank, however, takes the possible profit. Swaps, options and other strange contracts – p. 50/61

Swaps There are two parties on a swap contract: •

The swap buyer. This is the party that pays the fixed price. A commodity buyer buys the swap from a bank.

 

•

The swap seller. This is the party that pays the floating price. A commodity seller sells the swap to a bank.

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Swaps Swap contracts are not traded on exchanges but ”Nymex” and others can swap OTC contracts into financial contracts due to certain rules. Hence, coal can be traded as if a ”real” futures contract was used.

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Swaps The broker first sets up a bilateral trade on the OTC market. This contract is then swapped and cleared by Nymex ClearPort and all of a sudden both actors have a financially settled contract.

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Swaps A swap contract is used as a hedging device. You change a fixed, known, amount of money for a floating, unknown, amount of money for a special period. When this period has ended we have a swap maturity.

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Swaps A swap contract must include how the floating sums of money will be calculated. This includes a reference price e.g. the average monthly settlement price for oil in U.S. dollar per barrel.

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Swaps The floating price will be the amount of the commodity, the reference quantity, times the reference price. It is also necessary to include information on the fixed price, e.g. 100,000 U.S. dollar per month.

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Swaps Also included is how often money will be transferred, i.e. the pricing periods. Normally there is no commision for entering a swap contract. Swap contracts are financially settled, i.e. you cannot send oil to the bank.

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Swaps Note that in reality there is only one payment. If you get money, or if you must pay money depend on the result on the market.

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Swaps When you enter into a swap contract you do not have to pay anything, but do not forget that the bank enters into the contract in order to earn money. Do not forget that they are not stupid but sometimes they have bad luck. If so, you will have good luck.

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Swaps A swap is a very good hedge. Could be used for managing basis risk = the futures ”price” do not reflect the real spot price.

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Swaps There are an amazing amount of different swap contracts but the details in these are out of the scope in this course.

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Derivatives - summary •  A derivative is a financial contract which derives its value from the performance of another entity such as an asset, index, or interest rate, called the "underlying”. •  Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e. bonds and mortgages). •  Derivatives include a variety of financial contracts, including futures, forwards, swaps, options, and variations of these •  Most derivatives are marketed through over-the-counter (offexchange) or through an exchange;.

Common derivatives (1/4) •  Forwards: A tailored contract between two parties, where payment takes place at a specific time in the future at today's pre-determined price. •  Futures: are contracts to buy or sell an asset on or before a future date at a price specified today. •  A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold; the forward contract is a non-standardized contract written by the parties themselves.

Common derivatives (2/4) •  Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. •  The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. •  The option contract also specifies a maturity date. •  In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date.

Common derivatives (3/4) •  If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction. •  Options are of two types: call option and put option. •  The buyer of a Call option has a right to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right. •  Similarly, the buyer of a Put option has the right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right.

Common derivatives (4/4) •  Warrants: Apart from the commonly used short-dated options which have a maximum maturity period of 1 year, there exists certain long-dated options as well, known as Warrants. These are generally traded over-the-counter. •  Swaps are contracts to exchange cash on or before a specified future date based on the underlying value of an asset such as a commodity spot price •  A commodity swap is an agreement whereby a floating (or market or spot) price based on an underlying commodity is traded for a fixed price over a specified period.