Trading in FinancialMarketsChapter 5RiskManagementandFinanciallnstitutions,3e,Chapter5,CopyrightJohnC.Hull2012
Trading in Financial Markets Chapter 5 Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 1
Financial Markets (pages 89-90)Exchange tradedTraditionallyexchanges have used theopen-outcrysystem,butelectronictradinghasnowbecomethenormContracts are standard; there is virtually no credit riskOver-the-counter (OTC)Acomputer-andtelephone-linkednetworkofdealersatfinancial institutions, corporations, and fund managersContractscanbenon-standard;thereissomecreditrisk2RiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull2012
Financial Markets (pages 89-90) ⚫ Exchange traded ⚫ Traditionally exchanges have used the open-outcry system, but electronic trading has now become the norm ⚫ Contracts are standard; there is virtually no credit risk ⚫ Over-the-counter (OTC) ⚫ A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers ⚫ Contracts can be non-standard; there is some credit risk Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 2
Short Selling (Pages 90-92)Short selling involves sellingsecurities you do not ownYour broker borrows the securitiesfrom another client and sells themin the market in the usual wayAt some stage you must buy thesecurities back so they can bereplaced in the account of the clientRiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull20123
Short Selling (Pages 90-92) ⚫ Short selling involves selling securities you do not own ⚫ Your broker borrows the securities from another client and sells them in the market in the usual way ⚫ At some stage you must buy the securities back so they can be replaced in the account of the client Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 3
Short Selling (continued)You must pay dividends and other benefitsthe owner of the securities receivesThe cash flows from a short position that isentered into at time T, and closed out attime T, arethe oppositeof those froma longposition where asset is bought at time T,and sold at time T2,except that there may bea small fee for borrowing the assetRiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull20124
Short Selling (continued) ⚫ You must pay dividends and other benefits the owner of the securities receives ⚫ The cash flows from a short position that is entered into at time T1 and closed out at time T2 are the opposite of those from a long position where asset is bought at time T1 and sold at time T2 ,except that there may be a small fee for borrowing the asset Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 4
DerivativesForwards FuturesSwapsOptionsExotics5RiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull2012
Derivatives ⚫ Forwards ⚫ Futures ⚫ Swaps ⚫ Options ⚫ Exotics Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 5
GrowthofDerivativesMarkets(Figure 5.1)SizeofMarket700($ trillion)600OTCExchange5004003002001000Jun-98Jun-99Jun-00Jun-01Jun-02Jun-03Jun-04Jun-05Jun-06Jun-07Jun-08Jun-09Jun-106RiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull2012
Growth of Derivatives Markets (Figure 5.1) Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 6
Forward Contracts A forward contract is an agreement to buyor sell an asset at a certain price at acertain future time Forward contracts trade in the over-the-counter marketThey are particularly popular on currenciesand interest ratesRiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull20127
Forward Contracts ⚫ A forward contract is an agreement to buy or sell an asset at a certain price at a certain future time ⚫ Forward contracts trade in the over-thecounter market ⚫ They are particularly popular on currencies and interest rates Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 7
ForeignExchangeQuotesforGBPAugust 24,2011 (Seepage93)BidOffer1.63981.6402Spot1.63921.63971-monthforward1.63821.63873-month forward1.63281.63341-yearforward8RiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull2012
Foreign Exchange Quotes for GBP August 24, 2011 (See page 93) Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 8 Bid Offer Spot 1.6398 1.6402 1-month forward 1.6392 1.6397 3-month forward 1.6382 1.6387 1-year forward 1.6328 1.6334
Profit from a Long Forward PositionProfitPrice of UnderlyingKat MaturityRiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull20129
Profit from a Long Forward Position Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 9 Profit Price of Underlying K at Maturity
Profit from a Short Forward PositionProfitPrice of Underlyingat MaturityK10RiskManagementandFinancialInstitutions,3e,Chapter5,CopyrightJohnC.Hull2012
Profit from a Short Forward Position Risk Management and Financial Institutions, 3e, Chapter 5, Copyright © John C. Hull 2012 10 Profit Price of Underlying K at Maturity