FE6059 Financial Instruments

Dr. Lan Jiang

Office: T3- 01

Email: l.jiang@londonmet.ac.uk
Lecture 1 Introduction

 Financial instruments
 Cash instruments
 Derivative instruments
 Markets for trading financial instruments
 Examples of financial instruments
 Trading of financial instruments
What is a financial Instrument?
 A contract that gives rise to a financial asset of one
entity and a financial liability or equity instrument of an
other entity. (IAS 32 & 39)

 Financial instruments are tradable assets of any

kind.
• Cash
• Evidence of an ownership interest in an entity
• A contractual right to receive or deliver cash or another
financial instrument.
What is a financial Instrument?

Types of financial instruments

 Cash instruments
 Derivative instruments
Cash Instruments Derivatives Instruments
 instruments whose value is  instruments which derive
determined directly by the their value from the value
markets. and characteristics of one or
more underlying entities such
 They can be securities, as an asset, index, or
which are readily interest rate.
transferable, and instruments
such as loans and deposits,  They can be exchange-
where both borrower and traded derivatives and over-
lender have to agree on a the-counter (OTC)
transfer. derivatives
Cash Instruments
 Equity - single stocks and stock indexes

 Bonds - Government and corporate

 Short term interest rates

 Foreign exchange rates

 Commodities - agricultural, metals, energy, precious metals etc.

 Weather
What is a Derivative?

A derivative is an instrument whose value depends on,

or is derived from, the value of another asset.

Examples:
Forwards: Currencies, interest rates
Futures: Currencies, short interest rates, bonds, and
stock indexes
Swaps: Currencies, interest rates, total returns
Options: Stocks, stock indexes, futures
…
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Why Derivatives Are Important?
 Derivatives play a key role in transferring risks in
the economy.
 The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc.
 Many financial transactions have embedded
derivatives.
 The real options approach to assessing capital
investment decisions has become widely accepted.

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How Are Derivatives Traded?

 On exchanges market
 such as the Chicago Board Options Exchange (CBOE)

 In the over-the-counter (OTC) market

 where traders working for banks, fund managers and
corporate treasurers contact each other directly

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The OTC Market Prior to 2008
 Largely unregulated
 Banks acted as market makers quoting bids and
offers
 Master agreements usually defined how
transactions between two parties would be handled
 But some transactions were handled by central
counterparties (CCPs). A CCP stands between the
two sides to a transaction in the same way that an
exchange does

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Since 2008…
 OTC market has become regulated.
- Reduce systemic risk
- Increase transparency

 In the U.S and some other countries, standardized

OTC products must be traded on Swap Execution
Facilities (SEFs) which are similar to exchanges.

 CCPs must be used for standardized transactions

between dealers in most countries.

 All trades must be reported to a central registry.

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 Size of OTC and
Exchange-Traded Markets

800
Size of Market
($ trillion)
700

600

500

400
OTC
300
Exchange

200

100

0
8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9
n-9 un-9 un-0 un-0 un-0 un-0 un-0 un-0 un-0 un-0 un-0 un-0 un-1 un-1 un-1 un-1 un-1 un-1 un-1 un-1 un-1 un-1
Ju J J J J J J J J J J J J J J J J J J J J J

Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
The Lehman Bankruptcy
 Lehman’s filed for bankruptcy on 15 September
2008.
 This was the biggest bankruptcy in US history.
 Lehman was an active participant in the OTC
derivatives markets and got into financial
difficulties because it took high risks and found it
was unable to roll over its short term funding.
 It had hundreds of thousands of transactions
outstanding with about 8,000 counterparties
 Unwinding these transactions has been
challenging for both the Lehman liquidators and
their counterparties.
The Recent Collapse of Big Banks

The SVB and SB

Two U.S. banks Silicon Valley Bank (SVB) and Signature
Bank (SB) collapsed, sending shock waves through the
global financial system.

The Credit Suisse

Credit Suisse, the second-largest bank in Switzerland,
collapsed in March 2023 and was bought by rival UBS for
3 billion CHF (about $3.3 billion USD).
How 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
Foreign Exchange Quotes for GBP
Bid Ask
Spot 1.2217 1.2220

1-month forward 1.2218 1.2222

3-month forward 1.2220 1.2225

6-month forward 1.2224 1.2230

May 21, 2020

Forwards
 A forward contract is an agreement to buy or to sell an asset at a
certain future time for a certain price.

 One of the parties to a forward contract assumes a long position

and agrees to buy the underlying asset on a certain specified
future date for a certain specified price.

 The other party assumes a short position and agrees to sell the
asset on the same date for the same price.
Forwards
 Forwards are Over-the-counter or OFF-exchange
derivatives.

 Forward Contracts are not standardised and

negotiated on OTC markets.
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 (as shown by the table)
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
Forwards

Example
 On May 21, 2020, the treasurer of a corporation enters
into a long forward contract to buy £1 million in six
months at an exchange rate of 1.2230

 This obligates the corporation to pay $1,223,000 for £1

million on November 21, 2020

 What are the possible outcomes?

Profit from a Long Forward Position
(K= delivery price=forward price at time contract is entered into)

Profit

Price of Underlying at
K Maturity, ST
 Profit from a Short Forward Position
(K= delivery price=forward price at time contract is entered into)

Profit

Price of Underlying
K at Maturity, ST
Futures
 A futures contract is an OBLIGATION to buy or sell an agreed
amount of an agreed asset at a certain time in the future for an
agreed price.

 Futures are exchange traded derivatives (ETD).

 Exchange traded futures are standardised in terms of size,

quantity, grade and time.
Exchanges Trading Futures
 CME Group (formed when Chicago Mercantile Exchange
and Chicago Board of Trade merged)

 InterContinental Exchange

 B3 (Brazil)

 Tokyo Financial Exchange (Tokyo)

 and many more (see list at end of book)

Exchanges Trading Futures
 Futures contracts are constructed and traded through regulated
exchanges:

 LIFFE-Euronext

 CBOT

 CME

 EUREX etc.
Futures

Example

Agreement to:
 Buy 100 oz. of gold @ US$1800/oz. in December

 Sell £62,500 @ 1.2500 US$/£ in March

 Sell 1,000 bbl. of oil @ US$40/bbl. in April

1. An Arbitrage Opportunity?
Suppose that:
The price of a non-dividend-paying stock is $60

The 1-year forward price of the stock is $65

The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?

2. Another Arbitrage Opportunity?
Suppose that:

The price of a non-dividend-paying stock is $60

The 1-year forward price of the stock is $60

The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?

The Forward Price of a Non-Dividend
Paying Stock
 If the spot price is S and the forward price for a
contract deliverable in T years is F, then

F = S (1+r )T

where r is the 1-year (domestic currency) risk-free rate of

interest.

In our examples, S = 60, T = 1, and r =0.05 so that

F = 60(1+0.05) = 63
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)
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

Apple Call Option Prices from CBOE
(May 21, 2020); Stock Price is bid 316.23, ask 316.50
Strike Jun 2020 Jun 2020 Sep 2020 Sep 2020 Dec 2020 Dec 2020
Price Bid Ask Bid Ask Bid Ask

290 29.80 30.85 39.35 40.40 46.20 47.60

300 21.55 22.40 32.50 33.90 40.00 41.15

310 14.35 15.30 26.35 27.25 34.25 35.65

320 8.65 9.00 20.45 21.70 28.65 29.75

330 4.20 5.00 15.85 16.25 23.90 24.75

340 1.90 2.12 11.35 12.00 19.50 20.30

Apple Put Option Prices from CBOE
(May 21, 2020); Stock Price is bid 316.23, ask 316.50
Strike Jun 2020 Jun 2020 Sep 2020 Sep 2020 Dec 2020 Dec 2020
Price Bid Ask Bid Ask Bid Ask

290 3.00 3.30 12.70 13.65 20.05 21.30

300 4.80 5.20 15.85 16.85 23.60 24.90

310 7.15 7.85 19.75 20.50 28.00 28.95

320 11.25 12.05 24.05 24.80 32.45 33.35

330 17.10 17.85 28.75 29.85 37.45 38.40

340 24.40 25.45 34.45 35.65 42.95 44.05

Options vs Futures/Forwards
 A futures/forward contract gives the holder the
obligation to buy or sell at a certain price.

 An option contract gives the holder the right to buy or

sell at a certain price.
Types of Traders
 Hedgers
 Speculators
 Arbitrageurs
Dangers
 Traders can switch from being hedgers to speculators
or from being arbitrageurs to speculators.

 It is important to set up controls to ensure that trades

are using derivatives in for their intended purpose.

How do they trade financial instruments?

We will discuss next week.

Summary
 Financial instruments are tradable assets of any kind.

 Financial can be classified as cash instruments and

derivative instruments.

 Financial derivatives can used for hedging, speculation

and arbitrage
Reference

Hull, J.C. (2021). Options, Futures and Other Derivatives,

11th Edition, Pearson Education (Chapter 1)